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SOUTHERN    c         :  r^,-^ 

UNIVERSITY  OF  CALIFORNIA 
LIBRARY 

LOS  ANGELES,  CAUF. 


INCOME  TAX 

PROCEDURE 

1922 


Including 

FEDERAL  CAPITAL  STOCK  TAX, 

FEDERAL  ESTATE  TAX,  AND  SUPPLEMENT 

TO  EXCESS  PROFITS  TAX  PROCEDURE,  1921 


By 
ROBERT  H.  MONTGOMERY,   C.  P.  A. 

of  Lybrand,  Ross  Brothers  and  Montgomery;  Attorney- 

at-Law ;    Former    President,    American    Association    of 

Public  Accountants;  Professor  of  Accounting,  Columbia 

University 


New  \  ork 

THE  RONALD  PRESS  COMPANY 

1922 


^^  Q>3  G 


Copyright,  1922,  by 
Robert  H.  Montgomery 


PREFACE 

The  1 92 1  federal  tax  law  is  a  disappointment  to  99  per 
cent  of  the  citizens  of  the  United  States  who  are  intelligent 
or  interested  enough  to  think  or  talk  about  it.  The -truth  of 
the  matter  is  that  Congress  did  not  have  the  courage  to  face 
the  issue  and  enact  an  understandable  tax  law.  There  are  only- 
two  kinds  of  income  tax  laws :  one  kind  is  short  and  simple  and 
leaves  much  to  the  discretion  of  administrative  officers;  the 
other  kind  is  long  and  complicated  and  in  its  endeavor  to 
reach  every  one  of  a  thousand  items  of  income,  to  classify 
every  one  of  a  thousand  items  of  deductions,  to  deny  discretion 
to  the  Commissioner  of  Internal  Revenue,  it  omits  reference 
to  items  of  income  numbers  looi  and  1002;  it  fails  to  deal 
with  items  of  deductions  numbers  lOOi  to  loio;  it  neglects  to 
specify  how  the  Commissioner  shall  settle  the  omitted  items, 
and  thus  comes  chaos. 

It  is  bad  enough  when  there  is  enacted  one  law  of  the 
"long"  type;  but  when  such  a  law  is  enacted  in  1913,  a  new 
one  in  1916,  the  19 16  law  is  amended  in  19 17,  a  new  lavv  is 
enacted  in  19 18,  is  it  any  wonder  that  trouble  arose  when 
there  was  a  unanimous  demand  for  another  new  law  in  1921  ? 

The  House  of  Representatives  passed  a  law  of  the  19 17 
type  on  August  20,  1921.  It  attempted  to  merely  amend  the 
1918  law.  The  Senate  attempted  to  follow  the  same  course 
but  as  it  evolved  833  amendments  to  the  House  bill  and  as  the 
House  bill  amended  the  1918  law,  the  effect  of  833  amend- 
ments to  another  series  of  amendments  made  strong  men  weep. 
And  so  the  Senate  passed  a  new  bill,  ignoring  the  1918  draft, 
which  after  undergoing  the  usual  changes  in  conference 
emerged  on  November  23,  1921,  as  the  "Revenue  Act  of  1921." 

The  net  result  is  that  we  have  had  five  tax  laws  in  less 
than  nine  years,  and  no  one  is  satisfied ! 

I  am  strongly  of  the  opinion  that  we  should  have  another 

iii 


IV 


PREFACE 


very  soon.  It  should  be  very  short  and  very  simple  and  it 
should  leave 'it0-tli|  Co^^issibner  ol^nternal  Revenue  broad 
discretion.  Then  we  should  have  a  ten-year  tax  holiday  so 
far  as  changes,  other  than  in  rates,  are  concerned. 

I  would  increase  the  salaries  of  all  responsible  officers  of 
the  Bureau  of  Internal  Revenue  and  in  every  way  possible 
make  service  in  the  Bureau  attractive  so  that  it  will  be  possible 
for  the  good  men  to  remain  with  the  Bureau  and  more  good 
men  to  be  taken  on. 

Even  though  the  income  tax  is  superseded  by  a  general 
sales  tax  which  administers  itself,  there  are  unsettled  tax  prob- 
lems involving  billions  of  dollars  and  the  settlement  of  such 
problems  should  only  ]>e  entrusted  to  men  who  have  discretion, 
breadth  of  vision  and  high  ideals  regarding  public  service. 

Unexpectedly  I  have  had  to  rewrite  almost  entirely  192 1 
Income  Tax  Procedure.  I  did  not  at  first  realize  that  the 
important  court  and  Treasury  decisions  during  192 1,  coupled 
with  the  new  law,  made  so  many  radical  changes  in  present 
procedure  and  made  so  many  changes  of  a  retroactive  nature 
in  former  procedure. 

It  may  be  that  in  my  opening  remarks  and  in  the  book 
itself,  I  am  unduly  critical  and  it  may  be  thought  that  there 
is  a  personal  note  in  some  of  my  comments.  On  the  contrary, 
I  benefit  personally  by  the  confusion.  In  my  zeal  for  im- 
provement in  law  and  procedure  I  am  trying  to  put  myself 
in  the  position  of  the  long-suffering  taxpayer.  In  my  occa- 
sional criticisms  of  the  Treasury,  I  am  absolutely  impersonal. 
Surely  I  cannot  pay  any  higher  tribute  to  the  present  personnel 
of  the  Bureau  of  Internal  Revenue  than  to  suggest  that  a  new 
law  should  give  them  almost  unlimited  discretion.  I  only 
know  of  one  employee  of  the  Bureau  whom  I  would  summarily 
remove;  I  know  of  many  who  are  striving  conscientiously  and 
intelligently  to  interpret  the  regulations  (by  which  they  are 
bound)  impartially.  In  defense  of  my  disagreements  with 
some  of  the  new  regulations  and  rulings,  I  may  say  that  dur- 
ing the  year  1921  the  courts  and  the  Treasury  fully  justified 


PREFACE  V 

many  of  the  comments  and  criticisms  appearing  in  the  191 7 
and  succeeding  editions  of  Income  Tax  Procedure. 

The  greatest  curse  has  Ijeen  the  unsuccessful  attempts  to 
administer  the  laws  as  written,  plus  some  very  unintelligent 
and  unjustified  regulations.  The  new  regulations  (62)  are 
a  vast  improvement  over  previous  regulations.  They  very 
proj)erly  overrule  some  of  the  narrow  and  illegal  interpreta-. 
tions  and  Solicitor's  opinions  which  have  appeared  during 
the  year  1921.  In  themselves,  they  further  justify  the  criti- 
cisms which  I  make  of  such  former  rulings. 

In  response  to  several  requests,  I  have  devoted  a  chapter 
to  the  Federal  Estate  Tax,  in  the  preparation  of  which  I  have 
had  the  valuable  assistance  of  Orrin  R.  Judd,  C.  P.  A.,  Trust 
Officer  of  the  Columbia  Trust  Co.,  to  whom  my  thanks  are  due. 

It  would  be  impossible  to  bring  out  a  new  book  annually 
without  the  help  of  many  associates.  To  a  greater  extent 
than  ever  before,  I  acknowledge  the  invaluable  assistance  of  my 
partner,  Walter  A.  Staub,  C.  P.  A.,  and  my  assistants,  J. 
Marvin  Haynes,  of  the  Bar  of  the  District  of  Columbia,  Ham- 
ilton Howard  and  Robert  Buchanan.  I  am  again  indebted  to 
my  colleague  at  Columbia  Universit}',  Professor  Robert  Mur- 
ray Haig,  for  valuable  assistance  in  the  preparation  of  this 
volume,  and  I  wish  to  repeat  my  expressions  of  appreciation 
of  his  work  on  former  editions  which  is  retained  and  which 
has  met  with  the  approval  of  those  who  have  written  to  me 
from  time  to  time.  I  also  express  my  appreciation  of  the 
authoritative  material  contained  in  the  Income  and  War  Tax 
Services  of  the  Corporation  Trust  Company,  New  York,  which 
I  used  very  freely  with  the  company's  kind  permission. 


Robert  H.  Montgomery. 


no  William  Street,  New  York, 
February  25,  1922. 


CONTENTS 


Chapter 


1      Introdnctorv 


Part    I — Application    and    Administration 


II 

III 

IV 

V 

VI 

VII 

VIII 

IX 

X 

XI 


XII 
XIII 
XIV 

XV 
XVI 

XVII 

xvm 

XIX 
XX 

XXI 

XXII 

XXIII 

XXIV 


Application  of  the  Law — Corporations 
Exempt  from  Taxation  .... 
Returns — When  and  How  to  Make  Them 
Returns  of  Individuals  and  Corporations 
Amendment  and  Examination  of  Returns 

Penalties 

Rates  and  Computation  of  Tax 
Administration,  Assessment  and  Payment 
Appeals,     Refunds    and    Abatements    of 

Over-Assessments 

Information   at   the   Source      .... 
Payment  of  Tax  at  Source      .... 

Part  II — Income 

Credits  and  Exempt  Income 

Income  in  General 

Income  from  Personal  Services 

Income   from   Business 

Income    from    Sales    and    Exchanges 

Securities    and    Other    Property 
Computation    of    Tax    on    Exchange 

Sales  of  Capital  Assets 
Income  from  Royalties  and  Patents 
Income  from  Interest — General 
Income    from   Interest  on   Obligation 

the  United  States 
Income  from  Rents 
Income  from  Dividends 
Income   from   Stock   Dividends 
Income   from    Partnerships   and   Personal 

Service  Corporations 

vii 


or 


s  ot 


PA(iE 

3 


31 

52 

75 
109 
128 
154 
173 

235 
291 
322 


337 

371 
401 

446 

535 

567 
640 
661 

680 
693 
703 
763 

784 


Chapter 

XXV 

XXVI 

XXVII 

XXVIII 

XXIX 

XXX 

XXXI 

XXXII 

XXXIII 
XXXIV 


CONTENTS 


Part  III — Deductions 

Deductions  and  Credits — General 
Deductions    for   Expenses 
Deductions  for  Interest 
Deductions    for   Taxes 
Deductions   for  Losses 
Deductions    for   Bad   Debts 
Deductions    for    Depreciation 
Deductions      for      Extraordinary 
lescence    and    Amortization 


Obso 


XXXV 

XXXVI 

XXXVII 

XXXVIII 

XXXIX 


XL 
XLI 


Deductions    for   Depletion 

Deductions  for  Contnl^utions,  Donations, 

Gifts  and   Subscriptions        .... 

Part  IV — Special  Classes  of  Taxpayers 

Tax  on  Undistributed  Profits  of  Corpora- 
tions ......... 

Non-Resident    Aliens  

Fiduciaries  

Insurance     Companies  

Farmers 

Part  V — Miscellaneous  Taxes 

Federal  Estate  Tax 

b^deral   Capital   Stock  Tax      .... 


Appendices 

Appendix  A — Supplement  to  Excess  Profits  Tax  Pro- 

-1921 


B- 


cedure- 
-Forms 


Page 

845 
851 
923 
937 
975 
1030 
1050 

1 130 
1 167 

1241 


1259 
1269 
1326 

1377 
1407 


1423 
1524 


1567 
1675 


C — Revenue  Act  of  192 1 1725 


Indexes 

Revised     Statutes  .... 

Index  to  Articles  of  Regulations  62 

General  Index 

Index — Federal  Estate  Tax 
Index — Federal  Capital  Stock  Tax 
Index — Excess   Profits  Tax 


1811 
1819 
1833 
1897 
1903 
1907 


TABLE  OF  CASES 


A 

Albers   Brothers   Milling  Co.,   City   of   Oakland,   v.    (184   Pac. 

868)     697,      698 

Allen,  Altheimer  and  Rawlings  Investment  Co.,  v.    (248  Fed. 

688,  160  C.  C.  A.  588;  248  U.  S.  578,  63  L.  Ed.  430,  39  S. 

Ct.  20)    670 

Altheimer  and  Rawlings  Investment  Co.,  v.  Allen,    (248  Fed. 

688,  160  C.  C.  A.  588;  248  U.  S.  578,  62,  L.  Ed.  430,  39  S. 

Ct.  20)    670 

Anderson,  Brady  v.  (240  Fed.  665,  153  C.  C.  A.  463)   222 

Anderson,  New  York  Life  Insurance  Co.  v.  (263  Fed.  527;  269 

Fed.  1021 )   272 

Application  of  Willniann  (112  Atl.  806)    268,  269,  270,       271 


Baldwin   Locomotive   Works   i'.   McCoach    (221    Fed.    59,    136 

C.  C.  A.  660)    ^  .  .  583,     1608 

Baltic  Mining  Co.,  Stanton  v.  (240  U.  S.  103,  36  S.  Ct.  278,  60 

L.  Ed.  546)   252,     1 169 

Baltimore,   Mayor   etc.,   of,    Brickill   v.    (60   Fed.   98,   8   C.    C. 

A.  500)    658,      659 

Biwabik  Mining  Co.,  United  States  v.  (247  U.  S.  116)   1225 

Blakeslee,  Wright  v.  (loi  U.  S.  174,  25  L.  Ed.  1048)   289 

Blum  V.  Wardell  (270  Fed.  309)   1451 

Board  of  Home  Missions  -u.  City  of  Philadelphia  (266  Pa.  405, 

109   Atl.  664)    49 

Bradley   Constructing  Co.,   Pennsylvania   Cement   Co.   v.    (274 

Fed.    1003)     222 

Brady  v.  Anderson  (240  Fed.  665,  153  C.  C.  A.  463)   222 

Brander  v.  Brander  (4  Ves.  Jr.  800  (Am.  Ed.)  ;  31  Eng.  Rep. 

414)    783 

Brewster,  Peopled-  rt'/.   7^  Wendell  (188  X.  Y.  Supp.  510)  .358,       622 

Brewster,  Sayre  v.  (268  Fed.  553)  1476 

Brewster,  Walsh  v.   (— U.  S.— ,  65  L.  Ed.—,  — S.  Ct.— )  567, 

568,  573.      983 
Brickill  ct  al  v.  Mayor,  etc.,  of  Baltimore   (60  Fed.  98,  8  C.  C. 

A.   500)    658,      659 

Brushaber  v.  Union  Pacific  Railroad  Co.  (240  U.  S.  i ;  60  L.  Ed. 

493;  36  S.  Ct.  236)   9,  24,  252,  735,       783 

Bryce  et  al.  v.  Keith   (257  I'^d.   133 )    1021 

ix 


X  TABLE   OF    CASES 

Burton  v.  Burton  Stock  Car  Co.  (50  N.  E.  1029)   658 

Butterick  Co.  v.  United  States  (240  Fed.  539;  248  U.  S.  587, 

63  L.  Ed.  434,  39  S.  Ct.  5)   50 

C 

Camp  Bird  v.  Howbert  (262  Fed.  114;  252  U.  S.  579,  64  L.  Ed. 

725,  40  S.  Ct.  344)   148,      271 

Cadwalader  v.  Lederer  (273  Fed.  879,  274  Fed.  753)    1570 

Cartier  and  Holland  v.  Doyle  (Not  yet  reported)   1664 

Chadwick,  in  re,  (5  Fed.  Cas.  401,  Fed.  Cas.  No.  2570)   114 

Chandler  v.  Kelsey  (205  U.  S.  466,  51  L.  Ed.  882,  27  S.  Ct. 

550)     1466 

Chesebrough  v.  United  States   (192  U.  S.  253,  48  L.  Ed.  432, 

24  S.  Ct.  262)    289 

Chicago  and  Alton  R.R.  v.  U.  S.  (53  Ct.  Cls.  41)    177 

Chicago  Great  Western  Railway  Company,  Des  Moines  Union 

Railway  Co.  %'.  {lyy  N.  W.  90)   701,      702 

Chicago  Title  and  Trust  Co.  v.  Smietanka   (Not  reported;  see 

T.  D.  3193)    92 

Cincinnati  Gas  and  Electric  Co.  v.  Gilligan  (Not  reported;  see 

B.  29-21-1738.  Ct.  D.  16) 268 

Citv   of   Oakland   v.   Albers    Brothers   Milling   Co.    (184    Pac. 

868)    697,      698 

City  of  Philadelphia,  Board  of  Home  INIissions  v.  (266  Pa.  405, 

109    Atl.    664) 49 

City  of  Philadelphia  v.  Collector   (5  Wall.  720,  72  U.  S.  720, 

18   L.    Ed.    614)     288 

Cleveland,    Cincinnati,    Chicago    and    St.    Louis    Railway    Co., 

United  States  v.  (247  U.  S.  195,  38  S.  Ct.  472,  62  L.  Ed. 

1064)    585,      618 

Cliquot's  Champagne    (3  Wall.  411,  70  U.   S.    114,   18  L.   Ed. 

116)    597 

Cofifin  and  Gillmore,  Reeder  v.  (Not  reported;  Court  of  Com- 
mon   Pleas     No.     3     (Philadelphia)     June     Term,     1918, 

No.  3268)    422,       423 

Cohen  v.  Lowe  (234  Fed.  474)    1089,     1123 

Coleman,  Succession  of  (85  Sou.  (La.)  43)   615,       616 

Collector,  City  of  Philadelphia  v.   (5  Wall.  720,  72  U.  S.  720, 

18  L.  Ed.  614)    ." 288 

Collector  v.  Day  (11  Wall.  113,  78  U.  S.  113,  20  L.  Ed.  122)  . .       403 

Commonwealth,  Drexel  v.  (46  Pa.  St.  31 )   24 

Connecticut  Mutual  Life   Insurance   Co.   v.   Eaton    (218  Fed. 

206)    1059,     1086 

Coulby,  United  States  v.  (258  Fed.  27,  169  C.  C.  A.  163) 190 

County  of  Santa  Clara  v.  Southern  Pacific  Railway  Co.   (18 

Fed.  385;  118  U.  S.  394,  30  L.  Ed.  118,  6  S.  Ct.  1132)   ....       220 


TABLE   OF   CASES  xi 

Crews,  Missouri,  Kansas  and  Texas  Railway  Co.  v.  (54  Tex. 

Civ.  App.  612,  120  S.  W.  1150)    598 

Crill,  Hosack  v.  (204  Pa.  St.  97,  53  Atl.  640)   644 

Crocker  v.  Malley   (249  U.  S.  223,  63  L.  Ed.  573,  39  S.  Ct. 

270,  2  A.  L.  R.  looi)    93,  1531.  1532 

Crutchley,  Kemper  Military  School  v.   (274  Fed.   125)    274 

Cryan  v.  Wardell   (263  Fed.  248)    698,  699 

D 

Darlington,  Gray  v.  (15  Wall.  63,  82  U.  S.  63,  21  L.  Ed.  45)  . .  586 

Day,  Collector  ^;.  (11  Wall.  113,  78  U.  S.  113,  20  L.  Ed.  122)  . .  403 
Delaski  &  Thropp  Circular  Woven  Tire  Co.  v.  Iredell  (268  Fed. 

377)     : ••  '660 

Des  Moines  Union  Railway  Co.  v.  Chicago  Great  Western  Rail- 
way Co.  ( 177  N.  W.  90)   701 ,  702 

Dodge  V.  Woolsey  (18  How.  331,  59  U.  S.  331.  i  Miller  284,  15 

L.  Ed.  401 )   252 

Dodge -Bros.  v.  Osborn  (240  U.  S.  118,  36  S.  Ct.  275,  60  T..  Ed. 

557)    223,  251 

Doerscheeck  v.  United  States  (274  Fed.  739)   741 

Doyle,  Cartier  and  Holland  v.  (Not  reported)    1664 

Doyle,  Schwab  v.  (269  Fed.  321 )    1458,  1459 

Doyle  V.  Mitchell  Brothers  Co.  (247  U.  S.  179,  38  S.  Ct.  467, 

62  L.  Ed.  1054)    460,  482,  583,  584,  585,  613 

Drexel  v.  Commonwealth   (46  Pa.  St.  31 )    24 

Dulaney,  State  ex  rel.  v.  Nygaard  (183  N.  W.  884)  763 


Earp's  Appeal  (28  Pa.  St.  368)    783 

Eaton,   Connecticut  Mutual  Life  Insurance  Co.  v.    (218  Fed. 

206)    1059,  1086 

Ebersole  v.  McGrath    (271   Fed.  995)    1464 

Edwards,   Goodrich  v.    ( — U.   S. — ,  65    L.   Ed. — ,  — S.   Ct. — ) 

570,   983,  1621 

Edwards,    New   York   Trust   Co.    ct    al.   v.    (274   Fed.   952; 

— U.  S.— ,  66  L.  Ed.—,  — S.  Ct.— ) 735,  736 

Edwards  zk  Wabash  Railway  Co.  (264  Fed.  610)   190,  239 

Edwards,  Lincoln  Chemical  Co.  v.  (272  Fed.  142)    1610,  1661 

Ehret  Magnesia  Mfg.  Co.  7>.  Lederer  (273  Fed.  689) 1582 

Eisner  v.  Macomber  (252  U.  S.  189,  40  S.  Ct.  189,  64  L.  Ed. 

■521)    696,   763,  814 

Eisner,  N.  Y.  Trust  Co.  v.   (— U.  S.— ,  65  L.  Ed.—,  — S.  Ct.— )  1476 

Eisner,  Mente  v.   (266  Fed.  161 )  996 

Eisner,  Peabody  v.   (247  U.  S.  347,  38  S.  Ct.  546,  62  L.  Ed. 

1152)  587,  7^7 


xii  TABLE   OF    CASES 

Eliot  V.  Freeman  et  al.   (220  U.  S.  178,  55  L.  Ed.  424,  31  S. 

Ct.  360)    1531 

Eliot  National  Bank  v.  Gill  (218  Fed.  600,  134  C.  C.  A.  358) . .  197 
Elliott  z>.  Swartwout   (10  Peters   137,  35  U.  S.   137,  12  Curtis 

46,  9  L.  Ed.  373)    288,  289 

Evans  v.  Gore  (253  U.  S.  245,  64  L.  Ed.  887,  40  S.  Ct.  550)  366,  402 

F 

Farmers'  Loan  and  Trust  Co.,  Pollock  z'.  (157  V.  S.  429,  39  L. 

Ed.  759,   15   S.  Ct.  673;    158  U.   S.  601,  39  L.  Ed.   1108, 

15  S.  Ct.  912)    7,  252,      402 

Field,  United  States  v.   (255  U.  S.  257,  65  L.  Ed.  355,  41   S. 

Ct.  256)    1463 

First  Trust  and  Savings  Bank  z\  .Smietanka   (Not  reported)..      1347 

Fish  z'.  Irwin  ( Not  reported )    141 1 

Flint  c'.  Stone  Tracy  Co.   (220  U.  S.  107,  55  L.  Ed.  389,  31  S. 

Ct.   342) V 8,       115 

Freeman,  ct  at.,  Eliot  z-.  (220  U.  S.  178,  55  L.  Ed.  424,  31  S.  Ct. 

360)     1531 

G 

Gaither  v.   Miles    (268  Fed.   692)    1467 

Gauley  Mountain  Coal  Co.,  Hays  z:   (247  U.  S.  189,  38  S.  Ct. 

470,  62  L.  Ed.  1061 )    585,  615,  617,       618 

Gearin,  Miller  v.   (258  Fed.  225,  169  C.  C.  A.  293;  250  U.  S. 

667,  62  L.  Ed.  1 197,  40  S.  Ct.  13)    697 

General  Film  Corporation,  /•//  re  (274  Fed.  903)  ....275,  727,  903 
Gibbons  z'.  Mahon  (136  U.  S.  540,  34  L.  Ed.  525,  10  S.  Ct.  1057)  783 
Gill,  Boston  Terminal  Co.  v.  (246  Fed.  664,  158  C.  C.  A.  620)  .  .  50 
Gill,  Eliot  National  Bank  v.  (218  Fed.  600,  134  C.  C.  A.  358)  . .  197 
Gilligan,   Cincinnati   Gas   and   Electric   Co.   z>.    (Not   reported; 

B.  29-21-1738,  Ct.  D.  16)    268 

Gilligan,  Park  z'.    (Not  reported;  see  Corp.   Tr.  Co.   1921   In- 
come Tax  Service,  par.  3067  et  seq.)  707,  708,  725,  ^26,  727,       762 
Gillmore,  Coffin  and  Reeder  v.   (Not  reported;  Court  of  Com- 
mon   Pleas    No.    3    (Philadelphia)    June    Term    1918,    No. 

3268)    422,       423 

Goodrich   r.   Edwards    (— U.    S.— ,   63    L.   Ed.—.   — S.    Ct.— ) 

570,  983.  1621 

Gould  V.  Gould  (245  U.  S.  151.  38  S.  Ct.  53,  62  L.  Ed.  211) 

238,  367,  721,  870,  1432,  1619 

Gore,  Evans  v.  (253  U.  S.  245,  64  L.  Ed.  887,  40  S.  Ct.  550)  366,  402 
Grand  Rapids,  etc.,  Railway  Co.,  United  States  v.  (239  Fed.  153; 

256  Fed.  989)    197 

Gray  v.  Darlington  (15  Wall.  63,  82  U.  S.  63,  21  L.  Ed.  45)  .  .  586 


TABLE    OF    CASES  xiii 

Great  Northern  Railway  Co.  v.  J.ynch  (Not  reported;  see  T.  D. 

3147) 520,     1648 

Greenport  Basin  and  Construction  Co.  v.  United  States   (269 

Fed.   58)    287,  288,     1581 

Guggenheim  Exploration  Co.,  United  States  v.  (238  Fed.  231)  583 
Gulf  and   Interstate   Railway   Co.   of  Texas,   Walker   v.    (269 

Fed.  885)    663,     1020 

Gulf  Oil  Corporation  v.  Lewellyn  (248  U.  S.  yi,  39  S.  Ct.  35, 

62,  L-  Efh  133 )   586,  717,       762 

H 

Haiku  Sugar  Co.  ct  al.  v.  Johnstone  (249  Fed.  103)   810 

Hawes  v.  Oakland  (104  U.  S.  450,  14  Otto  450,  26  L.  Ed.  827)  .  .       252 

Hayden,  Suffolk  County  z'.  (3  Wall.  315)    656 

Hays  V.  Gauley  Mountain  Coal  Co.   (247  U.  S.   189,  38  S.  Ct. 

470,  62  L.  Ed.  1061 )   585,  615,  617,       618 

Herold  v.  Kahn  (159  Fed.  608,  86  C.  C.  A.  598;  163  Fed.  947, 

90   C.   C.   A.   307)    290 

Herold,  Mutual  Benefit  Life  Lisurance  Co.  ■c*.   (198  Fed.  199; 

201   Fed.   918,    120   C.   C.   A.   256)    239 

Holbrook  v.  Moore   (Not  reported;  see  T.  D.  3161)    415 

Holland,  Cartier  and,  v.  Doyle    (Not  reported)    1664 

Hornby,  Lynch  v.  (247  U.  S.  339,  38  S.  Ct.  543,  6^  L.  Ed.  1149) 

SSb,  587,  717,  723,  724,  735,  754,       762 

Hosack  V.  Crill   (204  Pa.  St.  97,  53  Atl.  640) 644 

Howbert,  Camp  Bird  v.   (262  Fed.   114;  252  U.  .S.  579,  64  L. 

Ed.  725,  40  S.  Ct.  344)   148,      271 

Howbert,  Stratton's  Independence  z\  {2y  U.  S.  399,  s8  L.  Ed. 

285, 34  s.  Ct.  136) .' ....: 1618 

Hubbard   v.   Kelly    (8   W.    Va.   46)     264 


In  re  Chadwick  (5  Fed.  Cas.  401,  Fed.  Cas.  No.  2570)    114 

In  re  General  Film  Corporation  (274  Fed.  903)   275,  727,       903 

Indiana  Steel  Co.,  Smietanka  7'.  ( — U.  S. — ,  66  L.  Ed. — ,  — S. 

Ct.— ) 267,       268 

Irwin  Fish  v.  (Not  reported)    141 1 

Iredell,  Delaski  &  Thropp  Circular  Woven  Tire   Co.  7'.    (268 

Fed.   377)    1660 

Irwin,   Rensselaer  and   Saratoga   R.R.   Co.   t'.    (239   Fed.   739; 

249  Fed.  726,  i6t  C.  C.  A.  636;  246  U.  S.  671,  38  S.  Ct. 

424,  62  L.  Ed.  93 1  )    700 

Tseminger,  Wilson  7'.    (  185   V.  S.  55,  46  L.   VA.  804.  22  S.  Ct. 

573)     932 


xiv  TABLE   OF   CASES 

J 

Jackson  v.  Smietanka  (267  Fed.  932;  272  Fed.  970)    415 

Johnstone,  Haiku  Sugar  Co.  et  al  v.  (249  Fed.  103)    810 

Jordan  Marsh  Co.,  Suter  et  al.  v.  (225  Mass.  34,  113  N.  E.  580) 

700,      701 

K 

Kahn,  Herold  v.  (159  Fed.  608,  86  C.  C.  A.  598,  163  Fed.  947,  90 

C.  C.  A.  307)    290 

Kansas  City  Title  and  Trust  Co.  et  al.  Smith  v.  ( — U.  S. — ,  65 

L.  Ed.—,  — S.  Ct.— )   682 

Keith,  Bryce  et  al.  v.   (2^7  Fed.   133)    1021 

Kellogg,  United  States  v.  (274  Fed.  903)    275 

Kelly,  Hubbard  t/.  (8  W.  Va.  46)   264 

Kelsey,  Chandler  v.  (205  U.  S.  466,  51  L.  Ed.  882,  27  S.  Ct. 

550)   1466 

Kemper  Military  School  v.  Crutchley,  (274  Fed.  125)   274 

Kirkendall,  Markle  et  al.  v.     (267  Fed.  498)    221,  250 

Kirkpatrick,  Kountz  v.  (72  Pa.  St.  ^76,  13  Am.  Rep.  687)   ....  599 

Kissam  et  al.,  McElligott  v.   (275  Fed.     545)    1462 

Kountz  V.  Kirkpatrick  (72  Pa.  St.  376,  13  Am.  Rep.  687) 599 

L 

La  Belle  Iron  Works  v.  United  States  (— U.  S.— ,  65,  L.  Ed.—, 
41    S.   Ct.   528)    256,    1053,    1054,    1583,   1587,    1598,   1603, 

1604,    1607,     1609 

Lauer  v.  United  States  (5  Ct.  CI.  447)   264 

Lederer,  Cadwalader  v.  (273  Fed.  879,  274  Fed.  753)   1570 

Lederer,  Ehret  Magnesia  Mfg.  Co.  v.  (273  Fed.  689)   1582 

Lederer,   Massey  v.    (Not  reported)    325,      678 

Lederer,  Northern  Trust  Co.  v.   (262  Fed.  52;  252  U.  S.  487, 

64  L.  Ed.  1025,  40  S.  Ct.  483)   1476 

Lederer,    Philadelphia,    Harrisburg   and    Pittsburgh    R.R.    Co. 

V.  (242  Fed.  492)    268 

Lederer  v.  Stockton  (266  Fed.  173;  254  U.  S.  625)   625,     1366 

Levy  V.  United  States  (271  Fed.  942)    136 

Lewellyn,  Gulf  Oil  Corp.  v.  (248  U.  S.  71,  39  S.  Ct.  35,  63    L. 

Ed.  133)   586,  717,      762 

Lewellyn,  United  States  by,  v.  Mellon  (Not  reported;  see  Corp. 

Tr.  Co.  1921  Income  Tax  Service,  par.  3091  et  seq.) .  .765,      766 

Lincoln  Chemical  Co.  v.  Edwards  (272  Fed.  142)   1610,     1661 

Little  Schuylkill  Navigation   R.R.  and   Coal   Co.   v.   Philadel- 
phia and  Reading  Railway  Co.    (44  Pa.   County  Reports 

197)     701 

Loomis  V.  Wattles  (266  Fed.  876)   266,      267 


TABLE   OF   CASES  xv 

Lowe,  Cohen  v.  (234  Fed.  474)   1089,     1 123 

Lowe,  Peck  and  Co.  v.  (247  U.  S.  165,  38  S.  Ct.  432,  62  L.  Ed. 

1049)     527 

Lowe,  Southern  Pacific  Co.  v.  (247  U.  S.  330,  38  S.  Ct.  540,  62 

L.  Ed.   1142)    586,  717,       762 

Lynch,  Great  Northern  Railway  Co.  v.  (Not  reported;  see  T.  D. 

3147)     520,     1648 

Lynch  v.  Hornby  (247  U.  S.  339,  38  S.  Ct.  543,  63  L.  Ed.  1149) 

586,   587,   717,   723,   724,   735,   754,       762 

Lynch,  Northern  Pacific  Railway  Co.  v.  (Not  reported;  see  T. 

D.  3048)    663 

Lynch  v.  Turrish   (247  U.   S.  221,  38  .S.  Ct.  537,  62  L.  Ed. 

1087)  585,  586,  yz'S^      754 

Lynn,  Oliver  v.   { 130  Mass.  143 )    372 


M 

Macomber,  Eisner  v.  (252  U.  S.  189,  40  S.  Ct.  189,  64  L.  Ed. 

521)    696,763,  814 

Madison,  etc.  Railroad  Co.,  Pearce  v.  (62  U.  S.  441 ) 810 

Mahon,  Gibbons  v.   (136  U.  S.  540,  34  L.  Ed.  525,  10  S.  Ct. 

1057)     783 

Mallandaine,  Partridge  v.   (L.  R.   18  Q.   B.  Div.  276)    447 

Malley,  Thayer  v.  (Not  reported)   1476 

Malley,  Crocker  v.  (249  U.  S.  223,  63  L.  Ed.  573,  39  S.  Ct.  270, 

2  A.  L.   R.    looi)    93,    1531,  1532 

Markle  et  at.  v.  Kirkendall  (267  Fed.  498)    221,  250 

Marks,  Snyder  v.  (109  U.  S.  189,  27  L.  Ed.  901,  3  S.  Ct.  157) . .  250 

Martinez  v.  State  ( 16  Tex.  App.  122)    598 

Massey  v.  Lederer    (Not  yet   reported)    325,  678 

Matter  of  Osborne  (209  N.  Y.  450,  50  L.  R.  A.   (N.  S.)   510, 

Am.  Ann.  Cas.  1915  A.  298,  52  N.  Y.  Supp.  48;  166  App. 

Div.  547)   ■ • 783 

Mayor,  etc.,  of  Baltimore,  Brickill  v.   (60  Fed.  98,  8  C.  C.  A. 

500)    658,  659 

McClain,  Spreckles  Sugar  Co.  v.  (192  U.  S.  397,  24  S.  Ct.  376, 

48  L.  Ed.  496)    239 

McCoach,  Baldwin  Locomotive  Works  ?'.  (221  Fed.  S9>  136  C. 

C.  A.  660) .'.;..'. 583,  1608 

McElligott  V.  Kissam  et  al.   (275  Fed.  545)    1462 

McElligott,  Towne  v.   (274  Fed.  960)    775,  yy6 

McGrath,   Ebersole  v.    (271   Fed.  995) 1464 

McHattan  et  al.,  United  States  v.  (266  Fed.  602)    221,  222 

Mellon,  United   States  by  Lewellyn    (Not  reported;   see  Corp. 

Trust  Co.,  1921  Income  Tax  Service,  par.  3091  et  seq.)y6-^,  766 

Mente  v.  Eisner  (266  Fed.  161 )  996 


xvi  TABLE   OF   CASES 

Miles,  Gaither  v.   (268  Fed.  692)    1467 

]\Iiles,  Safe  Deposit  &  Trust  Co.  of   Baltimore  v.    (273   Fed. 

822)    550,     1337 

Miller  v.  Gearin  (258  Fed.  225,  169  C.  C.  A.  293;  250  U.  S.  667, 

63  L.   Ed.   1197,  40  S.  Ct.    13) 697 

Minot  V.  Paine  (99  Mass.  loi )    783 

Missouri,   Kansas  &  Texas   Railway   Co.   v.   Crews,    (54  Tex. 

Civ.  App.  612,   120  S.  W.   1150)    598 

Mitchell  Bros.  Co.,  Doyle  z'.  (247  U.  S.  179,  38  S.  Ct.  467,  62 

L.  Ed.  1054)   460,  482,  583,  584,  585,  613 

Mohawk  Mining  Co.  v.  Weiss  (264  Fed.  502;  254  U.  S.  637) .  .  1225 

Montana  Railway  Company  v.  Warren  (137  U.  S.  348)   .  . .  .657,  658 

Moore,  Holbrook  v.  (Not  reported;  see  T.  D.  3161 )    415 

Mutual  Benefit  Life  Insurance  Co.  v.  Herold   (198  Fed.   199; 

201  Fed.  918.  120  C.  C.  A.  256)    239 

N 

Nashville,  Chattanooga  &  St.  Louis  Ry.  Co.  v.  U.  S.  (269  Fed. 

351 ;  — U.  S. — ,  65  L.  Ed. — ,  — S.  Ct.— )    1061,  1062,     1063 

New   York   Life   Insurance   Co.   v.   Anderson    (263   Fed.   527; 

269  Fed.  1021)    272 

New  York  Trust  Co.  et  al.  v.  Edwards   (274  Fed.  952;  — U. 

S.-,  66  L.  Ed.-   -S.  Ct.-) 735.      736 

New  York  Trust  Co.  ct  a!,  v.  Eisner  ( — U.  S.— ,  65  L.  Ed. — , 

— S.  Ct.— )    1476 

Northern   Pacific   Railway   Co.   v.   Lvnch    ( Not   reported ;    see 

T.    D.    3048)     '. 663 

Northern  Trust  Co.  v.  Lederer   (262  Fed.  52;  252  U.   S.  487, 

64  L.  Ed.  1025,  40  S.  Ct.  483)    1476 

Nygaard,  State  ex  rcl.  Dulaney  v.  ( 183  N.  W.  884) 76;^ 

O 

Oak  Ridge  Coal  Co.  v.  Rogers  (108  Pa.  St.  147)    812 

Oakland,   Citv  of,  v.  Albers   Brothers   Milling   Co.    (  1S4   Pac. 

868)     ..'. 698 

Oakland,   Hawes  v.    (104  U.   S.  450.    14  Otto  450,   26   L.   Ed. 

827)   252 

Oliver  v.  Lynn  (130  Mass.  143)    37^ 

Oregon-Washington  Railway  &  Navigation  Co..  United  States 

V.   (251  Fed.  211)    374.  520,     1006 

Osborn.  Dodge  Bros.  v.  (240  U.  S.  118,  36  S.  Ct.  275,  60  L.  Ed. 

557)    223,       251 

Osborne,  Matter  of  (209  N.  Y.  450,  50  L.  R.  A.  (N.  S.)  510, 
Am.  Ann.  Cas.  1915  A.  298,  52  N.  Y.  Supp.  48;  166  App. 
Div.    547)    7^3 


TABLE   OF   CASES  xvii 

P 

Page,  Polk  V.  (276  Fed.  128) 1519 

Paine,  Minot  v.   (99  Mass.  loi )    783 

Park  V.  Gilligan   (Not  reported;  see  Corp.  Trust -Co.  1921  In- 
come Tax  Service,  par.  3067  et  seq.)  707,  708,  725,  726,  727,       762 

Partridge  v.  jMallandaine  (L.  R.  18  Q.  B.  Div.  276) 447 

Peabody  v.  Eisner   (247  U.   S.  347,  38  S.  Ct.   546,  62   L.  Ed. 

1152)    587,       717 

Pearce  v.  Madison,  etc.,  Railroad  Co.    (62  U.  S.  441)    810 

Peck  &  Co.  V.  Lowe  (247  U.  S.  165,  38  S.  Ct.  432,  62  L.  Ed. 

1049)     • 527 

Pennsylvania  Cement  Co.  v.  Bradley  Construction  Co.  (274  Fed. 

1003) 222 

People  ex  rel.  Brewster  v.  Wendell  (188  N.  Y.  Supp.  510)  358,  622 
People  ex  rel.  Wilson  v.  Wendell  (188  N.  Y.  Supp.  273) .  .358,  622 
Phellis,  United  States  v.   (— U.  S.— ,  66  L.   Ed.—,  41   S.  Ct. 

528)   565,  735,  736,  737,  738,  739,  754,  755,  766,     1649 

Philadelphia  &   Reading   Railway   Co.,   Little    Schuylkill   Rail- 
road,  Navigation  &  Coal   Co.  v.   (44  Pa.  County  Reports 

197)     701 

Philadelphia,   City  of.   Board  of   Home   Missions  v.    (266  Pa. 

405,  109  Atl.  664)    49 

Philadelphia,  City  of,  v.  Collector  (5  Wall.  720,  72  U.  S.  720, 

18   L.   Ed.  614  ) 288 

Philadelphia,  Harrisburg  &  Pittsburg  Railroad  Co.  v.  Lederer 

(242  Fed.  492)    268 

Philadelphia  Knitting  Mills,  United   States  v.    (268  Fed.  270; 

27Z   Fed.   657)     871,    872,      875 

Polk  et  al.  V.  Page  (276  Fed.  128)    1519 

Pollock  V.  Farmers'  Loan  &  Trust  Co.   (157  U.  S.  429,  39  L. 

Ed.  759,  15  S.  Ct.  673;  158  U.  S.  601,  39  L.  Ed.  1108,  15 

S.  Ct,  912)   7,  252,      402 

Putnam,  Tax  Commissioner  v.  (227  Mass.  522,  116  N.  E.  904, 

L.  R.  A.  1917  F.  806)   550,  763,       783 

R 

Rachmil,   United   States  v.    (270  Fed.  869)    136 

Rau  V.  United  States  (260  Fed.  131,  171  C.  C.  A.  167) 153 

Re  Chadwick  (5  Fed.  Cas.  401,  P'ed.  Cas.  No.  2570)    114 

Re  General  Film  Corp.   (274  Fed.  903)    275,  727,      903 

Re  Stanfield's  Estate   (135  N.  Y.  292,  31   N.  E.  1013) 1349 

Reeder  v.  Coffin  &  (iillmore  ("Not  reported;  Court  of  Common 

Pleas,  No.  3  (Philadelphia)  June  Term  1918,  No.  3268)  422,  423 
Rensselaer  &  Saratoga  Railroad  Co.  v.  Irwin    (239  Fed.  739; 

249  Fed.  726,   T6r   C.  C.  A.  636;  246  U.  S.  671,  38  S.  Ct. 

424,   62   L.    Ed.   93  r )    700 


xviii  TABLE   OF   CASES 

Rock   Island,   Arkansas   &   Louisiana   Railroad    Co.    v.   United 

States  (254  U.  S.  141)   265,  266,      267 

Rockefeller  v.  United  States  (274  Fed.  952;  — U.  S. — ,  66  L. 

Ed.—,  — S.  Ct.^)   264,  .565,  735.      736 

Rogers,  Oak  Ridge  Coal  Co.  v.   (108  Pa.  St.  147) 812 

Ryan,  Weiser  Valley  Land  &  Water  Co.  v.  (190  Fed.  417,  11 1 

C.  C.  A.  221 )    599 

S 

Safe  Deposit  and  Trust  Company  of  Baltimore  v.  Miles   (273 

Fed.  822)    550,     1337 

San  Francisco  and  Portland  Steamship  Co.  v.  Scott  (253  Fed. 

•    854) 912 

Santa  Clara,  County  of,  v.  Southern  Pacific  Railway  Co.   (18 

Fed.  385;  118  U.  S.  394,  30  L.  Ed.  118,  6  S.  Ct.  1132) 220 

Sargent  Land  Co.,  Von  Baumbach  v.  (242  U.  S.  503,  61  L.  Ed. 

460,  37   S.   Ct.  201)    642,     1169 

Savings  Bank,  United  States  v.  (14  Otto  728,  104  U.  S.  728,  26 

L.  Ed.  908,  28  Int.  Rev.  Rec.  87)   264 

Sayre  v.  Brewster  (268  Fed.  553)    1476 

Schwab  V.  Doyle  (269  Fed.  321 )   1458,     1459 

Scott,    San    Francisco    and    Portland    Steamship    Co.    v.    (253 

Fed.    854)     912 

Sibley,  Weeks  v.  (269  Fed.  155)    193,       194 

Siegel,  Swarts  v.  ( 1 17  Fed.  13)   1399 

Simpson  v.  United  States  (252  U.  S.  547,  40  S.  Ct.  367,  64  L. 

Ed.  709)    1454 

Skinner,  Union  Pacific  Coal  Co.  v.  (249  Fed.  152,  161  C.  C.  A. 

204;  252  U.  S.  570,  40  S.  Ct.  392,  64  L.  Ed.  721)    587 

Smietanka,  Chicago  Title  and  Trust  Co.  v.  (Not  reported;  see 

T.  D.  3193)    92 

Smietanka,  v.  Indiana  Steel  Co.   ( — U.  S. — ,  66  L.  Ed. — ,  — 

S.   Ct.— )    267,      268 

Smietanka,   First   Trust   and    Savings    Bank    v.    (Not   yet    re- 
ported)          1347 

Smietanka,  Jackson  v.  (267  Fed.  932;  272  Fed.  970)    4i'5 

Smith  V.  Kansas  City  Title  and  Trust  Co.  et  al   ( — U.   S. — , 

65  L.  Ed.—,  — S.  Ct.— )   682 

Snyder  v.  Marks  (109  U.  S.  189,  27  L.  Ed.  901,  3  S.  Ct.  157)       250 
Southern  Pacific  Company  v.  Lowe  (247  U.  S.  330,  38  S.  Ct. 

762 


540,  62  L.  Ed.  1142)    586,  717. 


Southern  Pacific   Railway  Co.   County  of   Santa  Clara  v.    (18 

Fed.  385;  118  U.  S.  394,  30  L.  Ed.  118,  6  S.  Ct.  1132)   ....       220 

Spreckels  Sugar  Co.  v.  McClain  (192  U.  S.  397,  24  S.  Ct.  376, 

48  L.  Ed.  496)   239 

Stanfield's  Estate,  Re  (135  N.  Y.  292,  31  N.  E.  1013)   1349 


TABLE   OF   CASES  xix 

Stanton  v.  Baltic  Mining  Co.   (240  U.  S.  103,  36  S.  Ct.  278, 

60  L.  Ed.  546)    252,  1169 

State  ex  rcl.  Dulaney  v  Nygaard  ( 183  N.  W.  884)   763 

State,  Martinez  v.  ( 16  Tex.  Apps.  122)    598 

Stockton,  Lederer  v.  (266  Fed.  173;  254  U.  S.  625)   625,  1366 

Stone  Tracy  Co.,  Flint  v.  (220  U.  S.  107;  55  L.  Ed.  389;  31  S. 

Ct.  342)    8,  115 

Stratton's  Independence  v.  Howbert  (231  U.  S.  399,  58  L.  Ed. 

285,   34    S.    Ct.    136)     1618 

Succession  of  Coleman  (85  Sou.  (La.)  43)    615,  616 

Suffolk  County  v.  Hayden  V3  Wall.  315)   656 

Suter  et  al.  v.  Jordon  Marsh  Company  (225  Mass.  34,  113  N.  E. 

580)    700,  701 

Swarts  V.   Siegel    (117  Fed.    13.) I399 

Swartwout,  Elliott  i'.   (10  Peters   137,  35  U.  S.  137,   12  Curtis 

46,    9    L.    Ed.    S7s)    288,  289 

T 

Tax    Commissioner    v.    Putnam    (227    Mass.    522,    116    N.    E. 

904,  L.  R.  A.  1917  F.  806)   550,  763,  783 

Thacher  v.  United  States  (15  Blatch.  15,  Fed.  Cas.  No.  1385 1)  240 

Thayer  et  al.  v.  Malley  (Not  reported)   1476 

Thomas  v.  United  States  (274  Fed.  739)    741 

Towne  v.  McElligott    (274  Fed.  960)    775,  776 

Turrish,  Lynch  v.    (247  U.   S.  221,  38  S.   Ct.   537,  62  L.   Ed. 

1087)    ! 585,   586,  735  754 

U 
Union  Pacific  Coal  Co.  v.  Skinner  (249  Fed.  152,  161  C.  C.  A. 

204;  252  U.  S.  570,  40  S.  Ct.  392,  64  L.  Ed.  721)    587 

Union  Pacific  Railroad  Co.,  Brushaber  v.   (240  U.  S.  i,  60  L. 

Ed.  493,  36  S.  Ct.  236)    9,  24.  252.  735,       783 

United  States  z:  Biwabik  Mining  Co.  (247  U.  S.  116)   1225 

United  States,  Butterick  Co.  v.  (240  Fed.  539;  248  U.  S.  587,  63 

L.  Ed.  434.  39  S.  Ct.  5)    50 

United  States,  Chesebrough  v.  (192  U.  S.  253,  48  L.  Ed.  432,  24 

S.  Ct.  262)    .^ 289 

United  States,  Chicago  &  Alton  R.R.  v.   (53  Ct.  CI.  41)    177 

United  States  zk  Cleveland,  Cincinnati,  Chicago  &  St.  Louis  Ry. 

Co.  (247  U.  S.  195,  38  S.  Ct.  472,  62  L.  Ed.  1064)   . . .  .585.       618 
United  States  v.  Coulby  (258  Fed.  27,  169  C.  C.  A.  163)    ....        190 

United  States,  Doerscheeck  z:  (274  Fed.  739)   741 

United  States  v.  Field  (255  U.  S.  257,  65  L.  Ed.  355,  41  S.  Ct. 

256) 1463 

United  States  v.  Grand  Rapids,  etc.  Railway  Co.  (239  Fed.  153; 

256  Fed.  989)    197 


XX  TABLE   OF   CASES 

United  States,  Greenport  Basin  and  Construction  Co.  v.   (269 

Fed.  58)    287,  288,     1581 

United  States  v.  Guggenheim  Exploration  Co.   (238  Fed.  231)       583 

United  States  v.  Kellogg  (274  Fed.  903)    275 

United  States,  LaBelle  Iron  Wks.  v.  (— U.  S.— ,  65  L.  Ed.— 

41  S.  Ct.  528)  256,  1053,  1054,  1583,  1587,  1598,  1603,  1604, 

1609,  1616,  1621,  1644,     1645 

United  States,  Lauer  ^.   (5  Ct.  CI.  447)    264 

United  States,  Levy  v.   (271  Fed.  942)    136 

United  States  by  Lewellyn  v.  Mellon  (Not  reported;  sec  Corp. 

Tr.  Co.  1921  Income  Tax  Service,  par.  3091  ct  scq.)   .  .765,       766 

United  States  v.  McHattan  et  at.  (266  Fed.  602)    .221,       222 

United  States,  Nashville,  Chattanooga  and  St.  Louis  R.R.  Co. 

V.    (269   Fed.  351;  — U.   S.— ,  65   L.   Ed.—,  — S.   Ct— ) 

1061,  1062,       1063 
United  States  z>.  Oregon,  Washington  Railway  and  Navigation 

Co.    (251   Fed.  211)    374,   520,     1006 

United  States  v.  Phellis   (— U.   S.— ,  66  L.   Ed.—,  41   S.  Ct. 

528) 565-  735.  73^^,  737,  73^,  739,  754,  755,  77^,     1649 

United   States  v.   Philadelphia   Knitting  Mills    (268  Fed.   270, 

273  Fed.  657)    871,  872,       875 

United  States  v.  Rachmil   (270  Fed.  869)    136 

United  States,  Ran  v.  (260  Fed.  131,  171  C.  C.  A.  167)    153 

United  States.  Rockefeller  v.   (274  Fed.  952,  — U.  S. — ,  66  L. 

Ed.—,  — S.  Ct.— )   264,  565,  735,      736 

United  States,  Rock  Island,  Arkansas  and  Louisiana  R.R.  Co. 

V.   (254  U.  S.  141 )    265,  266,       267 

United  States  v.  Savings  Bank  (14  Otto  728.  1040  U.  S.  728,  26 

L.  Ed.  908,  28  Int.  Rev.  Rec.  87)    264 

United  States,  Simpson  v.    (252  V.  S.   547,  40  S.  Ct.  367,  64 

L.  Ed.  709)    1454 

United  States,  Thacher  v.  (15  Blatch.  15,  Fed.  Cas.  No.  1385 1)       240 

United  States.  Thomas  v.  (274  Fed.  739)  741 

United  States  v.  Vanderbilt   (275  Fed.  109)    421 

United   States  v.  Woodward  ct  al.   (Not  yet  reported;  see  T. 

D-  3195)    961,  1361 

United  States,  Washington  Water  Power  Co.  v.   (Not  yet  re- 
ported)   1553 

United  States,  Young  v.   (269  Fed.  58)    287,  288 

V 

A'^anderbilt,  United  States  v.  (275  Fed.  109)    421 

Virginia  v.  West  Virginia  (238  U.  S.  202,  59  L.  Ed.  1272,  35  S. 

Ct.  795) 597-      598 

Von  Baumbach  v.  Sargent  Land  Co.  (242  U.  S.  503,  61  L.  Ed. 

460,  37  S.  Ct.  201)    642,     1 169 


TABLE   OF    CASES  xxi 


W 


Wabash  Railway  Co.,  Edwards  v.  (264  Fed.  610)    190,  239 

Walker   v.   Gulf  and  '  Interstate  Railway   Co.   of  Texas    (269 

Fed.    885)     663,  1020 

Walsh    V.    Brewster    (— U.    S.— ,    65    L.    Kd.—     — S.    Ct.— ) 

567,  568,  573.  983 

Walsh,  Willinann  t^^  al.  v.  (i  12  Atl.  804)   268,  269,  270,  271 

Wardell,  Blum  v.  (270  Fed.  309)    1451 

Warden,  Cryan  v.  (263  Fed.  248)    698,  699 

Warren,  Montana  Railway  Co.  v.   (137  U.  S.  348)    657,  658 

Washington  Water  Power  Co.  v.  U.  S.   (Not  yet  reported)    .  .  1553 

Wattles,  Looniis  v.   (266  Fed.  876) 266,  267 

Weeks  V.  Sibley  (269  Fed.  155)    193,  194 

Weiss,  Mohawk  Mining  Co.  v.  (264  Fed.  502,  254  U.  S.  637)  .  .  1225 
Weiser  Valley  Land  and  Water  Co.  -o.   Ryan    (190   Fed.  417, 

HI   C.  C.  A.  221)    599 

Wendell,  People  ex  rcl.  Brewster  v.  (188  N.  Y.  Supp.  510) .  .358,  622 

Wendell,  People  ex  rel.  Wilson  v.  (188  N.  Y.  Supp.  273)  .  .358,  622 
West  Virginia,  Virginia  v.  (238  U.  S.  202,  59  L.  Ed.  1272,  35 

S.   Ct.   795) 597,  598 

Willmann,  Application  of  (112  Atl.  806)    268,  269,  270,  271 

Willmann  et  al.  v.  Walsh   (112  Atl.  804) 268,269,270,  271 

Wilson  V.  Iseminger   (185  U.  S.  55,  46  L.  Ed.  804,  22  S.  Ct. 

573)   932 

Wilson,  People  ex  rel.  v.  Wendell  (188  N.  Y.  Supp.  273)  .  .358,  622 
Woodward    et    al    U.    S.    v.    (Not    yet    reported;    see    T.    D. 

3195) 961,  1361 

Woolsey,  Dodge  v.   (]8  Flow.  331,  59  U.  S.  331,  i  Miller  284, 

15  L.  Ed.  401 )    252 

Wright  V.  Blakeslee  (101  U.  S.  174,  25  L.  Ed.  1048)    289 

Y 

Young  V.  United   States    (269  Fed.   58)    287,  288 


INCOME  TAX  PROCEDURE 

1922 


CHAPTER  I 

INTRODUCTORY 

In  the  192 1  edition  oi  this  book  the  prophecy  was  hazarded 
that  whatever  Congress  might  accompHsh  in  the  direction 
of  reforming  the  federal  tax  system  in  the  year  192 1,  the 
income  tax  was  reasonably  certain  to  remain  our  chief  source 
of  revenue.  The  developments  of  the  past  twelve  months  have 
borne  out  this  forecast.  The  year  1922  finds  the  income  tax 
more  firmly  entrenched  than  ever  before.  Extended  consid- 
eration of  possible  alternatives,  such  as  a  high  tariff  and  a 
general  sales  tax,  has  not  resulted  in  displacing  the  income 
tax  from  its  primary  position  in  the  federal  revenue  system. 
Even  though  a  tariff  with  high  rates  is  passed,  as  now  seems 
probable,  its  yield  will  not  compare  with  the  expected  yield 
from  the  income  tax.  If  a  sales  tax  is  passed,  as  now  seems 
possible,  it  Avill  probably  be  in  addition  to  the  income  tax 
rather  than  in  substitution  for  it. 

Yield  of  the  income  tax. — During  the  fiscal  year  ended 
June  30,  1 92 1,  the  income  and  profits  taxes  produced  about 
three  and  one-quarter  billions  of  dollars,  a  decrease  of  three- 
quarters  of  a  billion  as  compared  with  the  previous  year. 
The  exact  figures  for  the  past  four  years  are  as  follows : 

1918 $2,839,027,938.57 

1919 2,600,783,902.70 

1920 3,956,934499-58 

1921 3,225.790,65300 

The  estimated  collections  of  the  Bureau  of  Internal  Rev- 
enue under  the  new  Revenue  Act  of  1921,  for  the  years  ending 
June  30,  1922  and  1923,  are  as  follows : 

Income  Tax:  1922  1923 

Individual  $850,000,000  $780,000,000 

Corporation    430,000,000  545,000,000 

Profits  tax 660,000,000  150,000,000 

Back  taxes  230,000,000  300,000,000 

Total  income  tax  $2,110,000,000     $1,775,000,000 

.3 


4  INTRODUCTORY 

Miscellaneous:  192J  1923 

Estate  tax    $150,000,000  $150,000,000 

Transportation    135,000,000           

Tobacco    250,000,000  250,000,000 

Automobiles    1 10,000,000  1 10,000,000 

Corporation  capital  stock  tax   75,000,000  75,000,000 

Other  miscellaneous    412,730,000  457,280,000 

Total  miscellaneous    $1,132,730,000    $1,042,280,000 

Total    $3,242,730,000     $2,817,280,000 

This  table  shows  that  the  income  taxes  are  expected  to  yield 
65  per  cent  of  the  total  this  year,  and  69  per  cent  next  year. 
Last  year  they  yielded  approximately  70  per  cent.  The  aboli- 
tion of  the  excess  profits  tax  and  the  readjustment  in  the  in- 
come tax  promises  to  reduce  the  collections  from  income  taxes 
by  about  one-third  of  a  billion  dollars. 

Distribution  of  incomes. — Under  the  authority  given  in 
the  law/  the  Commissioner  of  Internal  Revenue  has  published 
statistics  compiled  from  the  income  tax  returns. 

Number  of  Personal  Returns,  Calendar  Years  1917,  1918  and  1919, 
BY  Income  Classes" 

1918  1919 

1-516,938  1.924.872 

1,496,878  1.569,741 

322,2"^^!  ^.^80-488 

319,356  438,851 
69,992] 

30,227  [  162,485 


13.320 
2.983 

1,864 


42; 

i8c 


Income  Classes 

1917 

$   I. 000  to 

$ 

2,000 

1,640,758 

2,000  " 

3,000 

838.707 

3,000  " 

4,000 

374,958 

4,000  " 

5,000 

185.805 

5.000  " 

10,000 

270,666 

10,000  " 

15,000 

65,800 

15,000  " 

20,000 

29,896 

20,000  " 

25.000 

16.806 

25,000  " 

30,000 

10.571 

30,000  " 

40,000 

12.733 

40,000  " 

50,000 

7.087 

50,000  " 

100,000 

12.439 

100,000  " 

150,000 

3,302 

150,000  " 

200,000 

1,302 

200,000  " 

250,000 

703 

250.000  " 

300,000 

342 

300,000  " 

400,000 

380 

400,000  " 

500,000 

179 

500,000  " 

1 ,000,000 

315 

1,000,000  an 

id 

over 

141 

Total 

.  .  3.472,890 

65 


4,425,114  5.332,760 

'  Section  258. 

'Statistics  of  Income,  Prcliiiiiiiary  Report,  1920,  page  15;  and  Statistics 
ef  Income,  1922,  page  4. 


INTRODUCTORY  5 

The  changes  in  the  groups  in  the  tliree  years  is  of  consider- 
able interest. 

The  total  number  of  persons  paying  income  tax  increased 
from  3,472,890  in  1917,  to  4,425,114  in  1918.  It  will  be  noted 
that  the  entire  19 18  increase  occurred  among  the  comparatively 
small  income  tax  payers,  the  number  of  returns  filed  in  every 
group  above  the  $20,000  line  showing  an  actual  decrease  in 
number  in  1918  as  compared  with  191 7.  The  1919  figures, 
on  the  other  hand,  show  an  actual  increase  all  along  the  line 
as  compared  with  1918,  and  an  increase,  compared  with  19 17, 
up  to  incomes  of  $100,000. 

Cost  of  administration. — The  cost  of  collecting  the  income 
tax  increased  from  55  cents  per  $100  of  tax  in  1920,  to  '^z 
cents  in  192 1.  This  cost  is  still  very  low.  Larger  sums 
could  profitably  be  spent  in  improving  the  administration  of 
the  tax,  in  increasing  the  number  of  districts,  and  in  making 
more  attractive  the  positions  in  the  service.  A  thoroughly 
competent  administrative  force,  adequate  in  size  to  the  task 
it  must  perform,  would  diminish  immeasurably  the  present 
burdens  involved  in  complying  with  the  law. 

Income  Taxation  in  the  United  States 

Intelligent  interpretation  of  the  existing  income  tax 
statute  is  greatly  facilitated  by  a  knowledge  of  its  history.^ 
Indeed  the  great  number  of  unsettled  questions  of  law  and 
procedure  arising  under  acts  in  force  in  earlier  years  renders 
a  knowledge  of  these  acts  almost  indispensable  to  most  per- 
sons who  use  this  book.  Consequently  it  is  deemed  desirable 
to  trace  the  development  of  the  statute,  giving  sufficient  in- 
formation to  enable  the  reader,  with  the  aid  of  the  notes  on 


^  For  a  full  discussion  of  the  history  of  the  income  tax,  see  Edwin  R.  A. 
Seligman,  The  Income  Tax  (2nd  edition.  New  York,  1914).  For  a  detailed 
description  of  modern  income  tax  systems,  see  K.  K.  Kennan,  Income 
Taxation  (Milwaukee,  1910). 


6  INTRODUCTORY 

"Former  Procedure,"  to  gain  a  clear  conception  of  the  evolu- 
tion through  which  it  has  passed. 

The  present  federal  income  tax  is  the  latest  of  a  series  of 
such  taxes  to  be  imposed  for  national  purposes  in  the 
United  States,  and  it  is  not  the  only  income  tax  being  ad- 
ministered within  the  country  at  present,  for  several  states 
utilize  this  source  of  revenue  concurrently  with  the  federal 
government.  In  fact,  important  as  it  is  to  the  federal  sys- 
tem, the  taxation  of  incomes  is  of  scarcely  less  interest  to  the 
several  states,  for  it  is  now  accepted  as  perhaps  the  most 
promising  means  of  bringing  about  state  tax  reform. 

State  income  taxation. — Because  of  the  unhappy  history 
of  early  attempts,  state  income  taxes  were  viewed  askance 
until  Wisconsin,  with  a  law  introduced  in  191 1,  demonstrated 
the  practicability  of  such  taxes.*  The  Wisconsin  precedent 
was  quickly  followed  by  other  states,  including  Connecticut, 
which  began  to  tax  corporations  on  this  basis  in  1915,^  and 
Massachusetts,  which  passed  a  law  of  limited  application  in 
1916.^  A  recent  but  important  convert  to  the  plan  is  the  state 
of  New  York,  which  in  191 7  imposed  a  franchise  tax  on  manu- 
facturing and  mercantile  corporations  and  in  19 19  a  personal 
income  tax.  The  New  York  franchise  law  was  amended  in 
1 9 19  to  make  it  more  general  in  its  scope  and  to  increase 
the  tax  to  a  charge  of  43^2  per  cent  of  the  net  income  of  cor- 
porations as  reported  to  the  Treasury  for  federal  tax  pur- 
poses^ and  was  intended  to  be  in  lieu  of  all  personal  property 
taxes  on  those  corporations.  Its  success  paved  the  way  for 
the  state  income  tax  of  1919,  which  imposes  progressive  rates 
on  the  incomes  of  individuals.  The  procedure  under  the 
New  York  statutes  imposing  income  taxes  on  individuals  and 


*  Laws  of  1911,  Chapter  658. 

"Acts  of  Conn.,  1915,  Ch.  292;  Bulletin  of  the  National  Tax  Associa- 
tion, February,  1916,  page  8. 

'Acts  of  Mass.,  1916.  Ch.  269;  Chas.  V.  Bullock,  The  Massachusetts 
Income  Tax   (Boston,  1916). 

'  Modified  in  certain  particulars. 


INTRODUCTORY  7 

corporations  is  treated  by  the  author  in  a  separate  volume 
entitled  Nezv  York  State  Income  Tax  Procedure,  1921/ 

Evolution  of  the  federal  income  tax  law. — The  present 
federal  income  tax  is  a  recent  development.  Income  taxes 
were  imposed  by  the  national  government  during  the  Civil 
War,  when  they  were  considered  to  be  indirect  in  their  na- 
ture and  consequently  beyond  the  constitutional  prohibition.' 
One  was  imposed  also  in  1894;  but  a  year  later,  when  tested, 
it  was  declared  unconstitutional  by  the  Supreme  Court,  in  the 
famouse  case  of  Pollock  7'.  Farmers'  Loan  &  Trust  Company, ^^ 
on  the  ground  that  it  was  a  direct  tax  and  as  such  could  only 
be  imposed  if  apportioned  according  to  population.  Such 
an  apportionment  would  lead  to  such  monstrous  economic 
consequences  as  to  render  a  general  income  tax  entirely  un- 
available as  a  federal  financial  resource  until  a  constitutional 
amendment  had  been  secured.  The  sixteenth  amendment 
was  finally  passed  eighteen  years  later.     It  provided  that : 

The  Congress  shall  have  power  to  lay  and  collect  taxes  on  in- 
comes, from  whatever  source  derived,  without  apportionment  among 
the  several  states,  and  without  regard  to  any  census  or  enumeration. 

The  necessary  number  of  states  had  ratified  by  February 
25,  1913,  but  as  a  matter  of  convenience,  March  i,  1913, 
is  referred  to  as  the  date  since  which  Congress  has  had  the 
power  to  tax  incomes  without  apportionment. 

But  even  before  the  acquisition  of  this  definite  authority. 
Congress  had  passed  the  corporation  excise  tax  of  1909, 
which  was  an  income  tax  in  fact  although  not  in  form.  The 
evolution  of  the  present  statute  dates  from  this  act.    The  19 13 


'Those  interested  in  the  iirugrcss  of  the  movement  toward  the  taxation 
of  income  by  the  states  will  find  the  following  articles  valuable:  Harley 
L.  Lutz,  "The  Progress  of  State  Income  Tax  Smce  iQii,"  The  American 
Economic  Review,  March  1920;  and  Alzada  Comstock,  "Fiscal  Aspects 
of  State  Income  Taxes,"  in  the  same  journal  for  June,  1920.  A  more  com- 
prehensive treatment  of  the  subject  will  be  found  in  Miss  Comstock's  State 
Taxation  of  Personal  Incomes   (New  York,  1921). 

°  Seligman,  The  Income  Tax,  page  430  et  seq. 

'"  157  U.  S.  429,  39  L.  Ed.  759;  15  S.  Ct.  673;  158  U.  S.  601,  39  L.  Ed. 
1108;  15  S.  Ct.  912. 


8  INTRODUCTORY 

law  widened  the  application  of  the  tax  to  include  individuals, 
and  the  laws  of  1916,  1917,  1918,  and  1921,  represented  defi- 
nite developments  and  refinements,  the  more  significant  details 
of  which  are  briefly  described  in  the  paragraphs  which  follow. 
In  general  there  is  evident  a  distinct  trend  toward  elimination 
of  arbitrary  limitations  on  deductions,  acceptance  of  estab- 
lished business  customs  and  institutions,  and  recognition  of  the 
accountant's  definition  of  profit  and  income. 

The  corporation  special  excise  tax  of  1909. — The  act 
of  August  5,  1909"  (hereinafter  referred  to  as  "the  1909 
law"),  provided  that  every  corporation^^  should  "be  subject  to 
pay  annually  a  special  excise  tax  with  respect  to  the  carrying 
on  or  doing  business  by  such  corporation  ....  equivalent  to 
one  per  centum  upon  the  entire  net  income  over  and  above 
five  thousand  dollars  received  by  it  from  all  sources  during 

such  year "     This  law  was  declared  constitutional  by 

the  Supreme  Court  of  the  United  States^^  on  the  ground  that 
it  was  an  excise  and  not  an  income  tax  within  the  meaning 
of  the  federal  Constitution,  which,  by  clause  four  of  article 
I,  section  9,  declares  that : 

No  capitation  or  other  direct  tax  shall  be  laid,  unless  in  pro- 
portion to  the  census  or  enumeration  hereinbefore  directed  to  be 
taken. 

To  all  intents  and  purposes,  except  that  of  overcoming  the 
constitutional  difficulty,  this  was,  of  course,  an  income  tax. 
The  law  directed  that  "net  income"  should  be  ascertained  by 
deducting  from  gross  income  received  certain  costs,  expenses 
paid  and  losses,  but  in  the  administration  of  the  law  its  re- 
quirements  as   to  income  received   and   expenses   paid   were 


"36  Stat,  at  L.,  C.  6,  page  112;  Comp.  St.  1910,  Supp.  1911,  page  946; 
Pierce  Fed.  Code,  Supp.  §1036. 

""Every  corporation,  joint-stock  company  or  association,  organized 
for  profit  and  having  a  capital  stock  represented  by  shares,  and  every 
insurance  company." 

^^  flint  v.. Stone  Tracy  Co.,  220  U.  S.  107;  55  L.  Ed.  389;  31  Sup.  Ct. 
342. 


INTRODUCTORY  g 

ignored,  and  corporations  generally  paid  a  tax  based  on  net 
income  as  ascertained  by  commercial  practice,  i.e.,  by  deduct- 
ing expenses  accrued  (whether  paid  or  not)  from  income 
earned  (whether  received  or  not).  The  Treasury  forms  and 
regulations  were  designed  for  and  applied  to  net  income,  not 
net  receipts. 

The  statute  was  brief  and  general  in  character,  leaving  to 
the  administration  much  latitude  in  interpretation.  However, 
one  specific  restriction  was  imposed :  that  upon  deductions  for 
interest  paid — a  feature  which  persisted  in  several  later  laws. 
The  corporation  could  deduct  interest  actually  paid  on  in- 
debtedness only  "to  an  amount  of  such  bonded  or  other  in- 
debtedness not  exceeding  the  paid-up  capital  stock  of  such 
corporation  ....  outstanding  at  the  close  of  the  year."^* 

xA.lthough  passed  late  in  the  year,  the  law  applied  to  the 
incomes  of  corporations  as  of  the  beginning  of  the  calendar 
year  1909.  Consequently  the  period  during  which  incomes  were 
affected  by  this  act  was  four  years  and  two  months  in  length, 
extending  from  January  i,  1909,  to  February  28,  191 3,  when 
the  19 1 3  law  replaced  it. 

The  191 3  LAW. — Congress,  almost  immediately  after  the 
ratification  of  the  sixteenth  amendment,  addressed  itself  to  the 
task  of  formulating  a  general  income  tax  law,  and  an  act  was 
finally  approved  October  3,  191 3,  effective  as  of  March  i, 
1913  (hereinafter  referred  to  as  "the  1913  law").  In  spite 
of  its  many  inconsistencies  and  ambiguities,  this  law  must 
be  acknowledged  to  have  been  on  the  whole  an  "intelligent 
and  well-considered  effort. "^^  It  was  upheld  as  constitutional 
by  the  Supreme  Court.^^  Many  of  the  Treasury's  interpreta- 
tions, however,  have  not  been  upheld  by  the  Supreme  Court. 

The  personal  exemption  was  high :  $3,000  for  a  single 
person,  with  an  additional  $1,000  for  a  married  couple.     The 


"  1909  law,  section  38,  second. 
"Seligman,  The  Income   Tax,  page  703. 

^''  Brushabcr  v.  Union  Pacific  R.  R.  Co.,  240  U.  S.  i ;  60  L.  Ed.  493;  36 
Sup.  Ct.  236. 


lO  INTRODUCTORY 

former  exmptioii  of  $5,000  to  corporations  was,  however, 
eliminated.  The  rates,  compared  with  recent  levels  at  least, 
were  very  low.  A  normal  tax  of  i  per  cent  applied  to  the  total 
net  income  of  individuals  and  corporations.  Surtaxes,  levied 
on  individuals  only,  began  with  a  i  per  cent  rate  when  the  net 
income  reached  $20,000  and  increased  gradually  to  6  per  cent 
on  those  portions  of  incomes  which  exceeded  $500,000.^^  The 
yield  the  first  year  was  approximately  $71,000,000. 

Eagerness  to  prevent  evasion  and  to  secure  a  large  yield 
was  responsible  for  several  restrictions  upon  deductions — re- 
strictions which  caused  endless  complications  and  irritations. 
Thus,  individuals  in  deducting  losses  CQuld  subtract  only  those 
which  were  incurred  "in  trade."  Deductions  for  depletion 
of  mines,  whether  owned  by  individuals  or  corporations, 
were  restricted,  to  5  per  cent  of  the  output.  Corporations 
were  forced  to  pay  tax  on  dividends  received  from  other  cor- 
porations whether  or  not  the  other  corporations  w^ere  sub- 
ject to  income  tax.  The  restriction  upon  interest  paid  by 
corporations,  mentioned  as  a  characteristic  of  the  1909  law, 
was  continued  by  the  19 13  law  in  another  form.  A  corpora- 
tion could  now  deduct  interest  on  its  indebtedness  "to  an 
amount  of  such  indebtedness  not  exceeding  one-half  of  the 
sum  of  its  interest-bearing  indebtedness  and  its  paid-up  capital 
stock  outstanding  at  the  close  of  the  year."^^ 

The  law  granted  to  corporations  the  privilege  of  account- 
ing on  the  basis  of  fiscal  years  rather  than  calendar  years,  but 
withheld  it  from  individuals.  Finally,  the  act  adopted  the 
English  system  of  collection  at  the  source,  v/hich  had  proved  so 
effective  in  preventing  evasion  in  Great  Britain.  This  de- 
vice, however,  was  the  occasion  of  so  great  complaint  from 
those  charged  with  the  duty  of  withholding  the  tax  that  after 
four  years'  experience  it  was  abandoned  in  19 17. 


i-'e^or  a  detailed  table  of  the  rates,  see  Chapter  VII. 
is-ii/tjh   several  provisos   including  those   designed   to   cover  the   cases 
f       roor^  Hons  with  no  capital  stock  and  of  corporation.'^  with  indebted- 
^°secured^t^^  collateral  which  was  subject  to  sale  as  stock  in  trade.    1913 
law,  G   (b).     "■' 


INTRODUCTORY  I  j 

The  1 916  LAW. — Three  years  after  its  establishment  the 
income  tax  was  called  upon  to  produce  a  much  larger  revenue. 
Because  of  the  effects  of  the  European  War,  receipts  from 
import  duties  had  diminished,  while  the  necessary  expendi- 
tures of  the  federal  government  had  greatly  increased.  To 
assist  in  meeting  this  emergency,  income  tax  rates  were  raised. 
The  normal  rate  applying  both  to  individuals  and  corporations 
was  made  2  per  cent  and  the  surtax  rates  upon  individual 
incomes  were  made  to  range  from  i  to  13  per  cent.  The 
lowest  surtax  rate  applied  as  before  upon  income  immediately 
above  $20,000,  and  the  highest  rate  on  the  portions  of  income 
exceeding  $2,000,000." 

This  law,  passed  September  8,  19 16  (hereinafter  referred 
to  as  "the  19 16  law"),  was  made  applicable  to  income  received 
after  January  i,  1916.  Consequently  the  19 13  law  was  ef- 
fective as  to  income  received  during  a  period  of  two  years  and 
ten  months,  from  March  i,  19 13,  to  December  31,  19 15. 

In  general,  the  1916  law,  although  a  re-enactment  of  the 
1913  law,  was  entirely  recast  in  form  and  changed  in  a  num- 
ber of  particulars.  The  changes  for  the  most  part  had  the  ef- 
fect of  making  the  statute  clearer  and  more  practicable.  March 
I,  19 1 3,  was  now  definitely  set  as  the  date  from  which  ap- 
preciations or  depreciations  of  property  values  were  to  be 
measured  for  purposes  of  the  tax.  Stock  dividends  were 
specifically  included  in  taxable  net  income,  whereas  the  19 13 
law  had  been  silent  on  this  point.  Proceeds  of  life  insurance 
policies  transferred  upon  the  death  of  the  insured  were  de- 
clared to  be  exempt  only  when  paid  to  individual  benefi- 
ciaries. 

Deductions  were  liberalized  in  two  important  particulars. 
Losses  in  transactions  entered  into  for  profit  but  not  con- 
nected with  an  individual's  trade  or  business  were  made  al- 
lowable deductions,  "to  an  amount  not  exceeding  the  profits 
arising  therefrom. "^°    Again,  the  arbitrary  5  per  cent  limita- 


"For  a  detailed  statement  of  the  rates,  sec  Chapter  VII. 
^'1916  law,  section  5,  fifth. 


12  INTRODUCTORY 

tion  Upon  depletion  allowances,  a  feature  of  the  191 3  law,  was 
eliminated  and  the  way  was  opened  for  the  full  deduction  of 
items  of  this  character. 

The  19 1 6  law  continued  in  effect  for  two  years  from 
January  i,  191 6,  to  December  31,  191 7.  On  October  3,  191 7, 
the  war  income  tax  act  was  passed  and  had  the  force  of  a 
supplement  to  the  19 16  law. 

The  191 7  LAW.-^ — Although  the  1916  law  yielded  about 
360  millions,  such  a  sum  was  entirely  insufificient  as  the  con- 
tribution from  this  source  toward  the  tremendous  expenses 
caused  by  our  entry  into  the  war.  Consequently  an  act  was 
passed  on  the  fourth  anniversary  of  the  passage  of  the  191 3 
law,  October  3,  1917  (hereinafter  referred  to  as  "the  1917 
law"),  which  raised  the  income  tax  rates  to  a  level  never  be- 
fore approached  in  the  history  of  civilization.^"  Thus  after  a 
very  short  period  of  administrative  experience  the  income  tax 
was  put  to  the  most  severe  test  which  a  government  ever  had 
the  courage  to  impose.  It  is  greatly  to  the  credit  of  both  tax- 
payers and  the  Treasury  that  the  system  stood  the  test  as  suc- 
cessfully as  it  did. 

This  191 7  amendment  was  effective  as  of  January  i, 
191 7,  and  remained  valid  for  the  period  of  one  year. 

In  form,  the  191 7  law  was  an  amendment  to  the  1916  law, 
the  object  apparently  being  to  make  possible  the  speedy  re- 
peal of  the  former  without  disturbing  the  law  proper.  This 
policy  must  now  be  declared  to  have  been  a  mistaken  one,  for 
the  confusion  and  difficulty  caused  by  operating  under  the  1916 
law,  with  its  elaborate  amendments,  including  two  separate 
schedules  of  rates  and  two  sets  of  personal  exemptions,  more 
than  counterbalanced  any  advantages  of  the  plan. 

In  addition  to  the  19 16  taxes,  a  new  normal  tax  of  2  per 
cent  was  imposed  on  individuals  and  a  new  4  per  cent  rate  on 
corporations,  making  the  total  normal  rate  4  per  cent,  except 


"For  a  complete  analysis,  see  Income  Tax  Procedure,  1918. 
"Seligman,    "The    War    Revenue    Act,"    Political   Science    Quarterly, 
March,  1918,  page  18. 


INTRODUCTORY 


13 


on  the  income  between  $1,000  and  $2,000,  on  which  the  rate 
was  2  per  cent,  and  making  the  corporation  tax  rate  6  per  cent. 
The  surtaxes  on  individual  incomes,  which  were  to  be  levied 
in  addition  to  the  surtaxes  existing  under  the  1916  law,  ranged 
from  I  to  50  per  cent  and  applied  to  all  persons  with  taxable 
incomes  of  $5,000  or  more.  Consequently  a  tax  rate  of  67  per 
cent  was  applied  to  all  taxable  income  accruing  to  an  individual 
in  excess  of  $2,000,000 — 2  per  cent  normal  and  13  per  cent 
surtax  under  the  19 16  law,  plus  2  per  cent  normal  and  50  per 
cent  surtax  under  the  19 17  law."^  For  the  purposes  of  the 
191 7  amendment  the  personal  exemption  was  reduced  from 
$3,000  to  $1,000,  with  $1,000  additional  for  married  couples, 
and,  for  the  first  time,  a  deduction  of  $200  was  permitted  for 
each  dependent. 

Various  other  changes  were  made  in  the  law.  The  system 
of  collection  at  source  was  virtually  abandoned  and  a  plan  of 
"information  at  source"  was  substituted,  thus  removing  a  pro- 
lific source  of  irritation  and  embarrassment.  The  deduction 
of  gifts  by  individuals  to  charitable,  religious  and  educational 
institutions  was  permitted  to  an  amount  equal  to  15  per  cent 
of  the  net  taxable  income  as  calculated  without  making  this 
deduction.  On  the  other  hand,  limitations  were  imposed  on 
several  deductions,  income  and  excess  profits  taxes  being 
made  non-deductible,  as  was  interest  on  money  borrowed  for 
the  purchase  of  tax-exempt  securities.  For  the  purpose  of 
the  new  4  per  cent  tax  on  corporations,  however,  permission 
was  given  to  deduct  the  dividends  on  stock  in  other  corpo- 
rations. 

The  high  rates  established  as  the  result  of  the  passage  of 
the  191 7  law  were,  of  course,  expected  to  be  temporary.  To 
prevent  corporations  from  avoiding  the  heavy  19 17  tax 
through  the  simple  device  of  postponing  declarations  of  divi- 
dends until  a  period  of  lower  rates  arrived,  Congress  wrote  a 
provision  into  the  law  which  prescribed  that  dividends  should 
be  "taxed  to  the  distributee  at  the  rates  prescribed  by  law  for 


'"  For  a  detailed  statement  of  rates,  see  Chapter  VII. 


14  INTRODUCTORY 

the  years  in  which  such  profit  or  surplus  was  accumulated  by 
the  corporation,"'*  The  years  of  accumulation  could  not  be 
arbitrarily  selected  by  the  corporation  and,  under  the  Treasury 
interpretation,  the  precise  position  of  the  distributions  in  the 
surtax  scales  of  the  previous  years  was  determined  by  adding 
them  to  the  net  income  of  the  current  year.  This  provision 
was  repealed  by  the  191 8  law,^^  but  in  the  short  period  during 
which  it  was  in  force  it  greatly  complicated  the  administration 
of  the  law.  Nevertheless  it  was  essentially  a  just  provision 
even  though  the  prescribed  method  of  applying  the  rates  is 
open  to  criticism,  and,  having  enacted  it.  Congress  should  have 
evolved  some  method  of  safeguarding  the  interests  of  the  cor- 
poration which  acted  under  it  in  good  faith. 

In  1 91 7,  also,  excess  profits  taxes  were  introduced  into  the 
federal  system.  A  law  of  this  nature  was  passed  March  3, 
191 7,  but  was  repealed  by  the  act  of  October  3,  191 7,  which 
imposed  a  heavy  levy  on  supernormal  profits  as  judged  by  the 
standard  of  invested  capital.  A  full  treatment  of  this  act  as 
well  as  of  its  successor  of  1918  will  be  found  in  the  author's 
Excess  Profits  Tax  Procedure,  192 1. 

THE  1918  LAW. — The  need  for  still  greater  revenues  to 
meet  the  growing  demands  of  the  war,  and  an  anxiety  on  the 
part  of  the  Treasury  to  be  relieved  of  some  of  the  responsi- 
bility it  had  assumed  by  its  liberal  interpretation  of  the  excess 
profits  tax  law  of  191 7,  united  with  other  causes  to  bring  about 
a  new  Revenue  Act  for  19 18.  The  law  (hereinafter  referred 
to  as  "the  1918  law")  although  not  finally  approved  until 
February  24,  1919,  affected  incomes  arising  after  January 
I,  191 8.  It  remained  in  force  until  the  eft'ective  date  of  the 
new  Revenue  Act  of  1921,  which,  for  most  of  the  provisions, 
is  January  i,  1921. 

The  19 1 8  law  was  a  complete  statute,  which  replaced  en- 
tirely the  1916  and  191 7  acts,  which  had  existed  concurrently 


*I9I7  law,  section  1210. 

°  Except  in  the  case  of  certain  stock  dividends.    See  Chapter  XXIII. 


INTRODUCTORY  15 

during  19 17.  It  was  a  comprehensive  law  which  imposed 
a  new  version  of  profits  tax,  certain  luxury  taxes,  and  other 
internal  revenue  charges.  Its  text  alone  covered  no  less  than 
106  pages  in  the  official  edition.  The  technical  task  of  drafting 
was  well  done,  the  language  being  for  the  most  part  clear, 
and  the  arrangement  convenient;  the  form,  in  general,  being 
greatly  superior  to  that  of  earlier  laws. 

Rates  applied  to  19 18  income  exceeded  even  the  record 
schedules  of  191 7.  The  normal  rate  and  the  corporation  tax 
rate  both  were  made  12  per  cent,  with  a  reduction  to  6  per 
cent  on  the  first  $4,000  of  the  taxable  income  of  a  citizen 
or  resident  of  the  United  States.  These  rates  stood  for  one 
year  only.  After  January  i,  1919,  the  normal  rate  applying 
to  the  taxable  income  of  a  citizen  or  resident  of  the  United 
States  became  8  per  cent  (4  per  cent  on  the  first  $4,000)  and 
the  corporation  tax  rate  dropped  from  12  to  10  per  cent.  Thus 
there  reappeared  a  discrimination  of  2  per  cent  against  cor- 
porate incomes  similar  to  that  which  obtained  in  the  year  191 7. 

Surtaxes  on  individual  incomes  ranged  from  i  to  65  per 
cent,  the  highest  rate  applying  to  portions  of  income  exceeding 
$1,000,000.  The  maximum  total  rate  in  19 18  was,  conse- 
quently, 10  per  cent  higher  than  that  which  obtained  in  191 7, 
and  the  higher  normal  rate^®  and  the  steeper  progression  made 
the  tax  much  heavier  upon  moderate  incomes  than  the  pre- 
vious one.^^  The  maximum  total  rate  applied  to  1919  and  1920 
incomes  was  73  per  cent. 

The  191 8  law,  wliile  sufficiently  complicated,  was  neverthe- 
less more  simple  and  equitable  than  its  predecessor.  One  set 
of  rates  and  personal  exemptions  replaced  the  double  set  in 
force  in  1917,  and  many  of  the  limitations  and  restrictions 
which,  since  the  beginning,  had  hedged  about  the  various  de- 
ductions and  caused  endless  confusion  and  complication,  were 


'"In  the  case  of  earned  incomes,  the  normal  rate  of  12  per  cent  was 
actually  no  higher  for  individuals  than  in  1917,  because  of  the  application 
in  that  year  of  the  8  per  cent  excess  profits  tax  to  professions  and  occupa- 
tions in  addition  to  the  normal  income  tax  of  4  per  cent. 

"For  a  detailed  table  of  rates,  see  Chapter  VII. 


l6  INTRODUCTORY 

removed.  Under  the  igi8  law,  for  the  first  time,  an  individual 
was  permitted  to  deduct  losses  which  are  not  incurred  in  trade. 
Also  for  the  first  time  he  was  required  to  report  upon  the  basis 
of  his  annual  accounting  period,  even  though  that  period  did 
not  coincide  with  the  calendar  year.  Affiliated  corporations 
were  required  to  file  consolidated  returns.'^  Depreciation 
allowances  were  made  more  liberal.  Depletion  in  the  cases 
of  mines  and  gas  and  oil  wells  was  placed  upon  a  very  generous 
basis,  with  a  special  and  rather  artificial  method  provided  for 
establishing  "discovery  value"  in  the  case  of  properties  owned 
by  prospectors  and  "wild-catters."  Special  provision  was  made 
for  charging  off  reasonable  amortization  on  equipment  which 
contributed  to  the  prosecution  of  the  war.  Corporations  for 
the  first  time  were  relieved  of  the  arbitrary  limitation  on  de- 
ductible interest,  which  had  been  in  force  since  19 13,  and  of 
the  discriminating  tax  on  dividends  received  from  other  cor- 
porations. Income  and  excess  profits  taxes  paid  to  other  juris- 
dictions upon  income  arising  therein  were,  under  certain  con- 
ditions, allowed  as  credits  against  the  tax.  A  specific  credit 
of  $2,000  was  granted  corporations.  The  rule  allocating  divi- 
dends to  the  year  earned,  established  in  the  191 7  law,  was 
abandoned.^'' 

As  in  the  case  of  previous  laws,  partnerships  were  not  taxed 
as  such,  the  individual  members,  instead,  being  made  liable 
on  their  distributive  shares.  The  1918  law  introduced  an  inno- 
vation by  putting  in  the  same  category  with  partnerships,  cer- 
tain corporations  whose  income  was  "to  be  ascribed  primarily 
to  the  activities  of  the  principal  owners  or  stockholders  who 
are  themselves  regularly  engaged  in  the  active  conduct  of  the 
affairs  of  the  corporation  and  in  which  capital  (whether  in- 
vested or  borrowed)  is  not  a  material  income-producing  fac- 
tor" (section  200).  At  the  end  of  the  taxable  year  the  undis- 
tributed net  income  of  each  of  these  "personal-service  corpora- 
tions" was  assigned  for  taxation  to  the  stockholders  in  pro- 


Section  240. 
'  Except  in  the  case  of  certain  stock  dividends.     See  Chapter  XXIII. 


INTRODUCTORY  17 

portion  to  their  holdings.  They  were  relieved  of  the  federal 
profits  taxes,  which  would  otherwise  attach  because  of  the 
corporate  form  of  the  enterprise.  Under  the  192 1  law  this 
class  of  personal  service  corporations  was  abandoned,  effective 
December  31,  1921. 

The  Revenue  Act  of  1921 

Due  to  the  insistence  of  business  men  that  the  taxes  levied 
by  the  191 8  law  were  unduly  burdensome  and  were  not  well 
fitted  to  post-war  conditions,  both  political  parties  during  the 
presidential  campaign  of  1920  committed  themselves  to  a 
revision  of  federal  taxation.  The  Revenue  Act  of  192 1, 
approved  November  23  of  that  year,  is  the  result  of  the 
pledge  of  the  Republican  Party.  Although  it  came  from  the 
House  of  Representatives  in  the  form  of  a  series  of  amend- 
ments, it  finally  emerged  from  Congress  as  a  complete  new 
law.  In  fact  it  follows  the  phraseology  of  the  1918  law  very 
closely  and,  while  the  changes  are  numerous  and  fundamental 
in  character,  the  new  law  is  essentially  a  rewritten  draft  of 
the  19 18  law. 

Tlie  provisions  of  the  Revenue  Act  of  1921  (hereinafter  re- 
ferred to  as  "the  192 1  law")  are  treated  fully  in  the  chapters 
which  make  up  the  body  of  this  book,  but  it  is  desirable  at 
this  point  to  sketch  briefly  its  main  outlines  and  to  make  some 
general  observations  and  criticisms. 

Modifications  made  by  the  1921  law. — The  effective  date 
of  the  new  law  is,  for  most  purposes,  January  i,  1921.  Many 
of  the  most  radical  changes,  however,  do  not  come  into  force 
until  one  year  later,  January  i,  1922.  This  includes  the  sec- 
tions which  abolish  the  excess  profits  tax  and  the  personal  ser- 
vice corporation,  increase  the  corporation  tax  rate,  and  estab- 
lish the  new  class  of  ''capital  gains  and  losses." 

In  spite  of  what  many  considered  to  be  a  definite  pledge 
and  due  largely  to  the  influence  of  the  "agricultural  bloc,"  Con- 
gress finally  declined  to  repeal  the  profits  tax  for  1921  but  did 


l8  INTRODUCTORY 

agree  to  abolish  it  thereafter.  With  it  disappears  the  personal 
service  corporation,  which  was,  of  course,  a  mere  incident  of 
profits  taxation,  devised  to  exclude  corporations  of  a  par- 
ticular type  from  the  application  of  such  taxes.  When  the 
excess  profits  tax  goes,  the  income  tax  rate  on  corporations 
rises  from  lo  to  12^  per  cent.  The  change  in  the  rate  will 
cause  corporations  such  as  public  utility  corporations,  which 
make  only  moderate  profits,  to  pay  higher  taxes,  but  the  total 
tax  burden  on  corporate  income  is  expected  to  be  much  lighter 
as  will  be  seen  from  the  statement  of  official  estimates  pointed 
on  page  3. 

At  the  same  time  that  these  changes  in  the  corporation  in- 
come taxes  are  made,  the  surtax  rates  on  individual  incomes 
are  scheduled  for  a  reduction.  A  full  table  of  the  rates,  old 
and  new,  is  presented  in  Chapter  V^II.  It  will  be  noted  that  the 
change  afifects  small  taxpayers  as  well  as  large  ones.  The 
maximum  rate  remains  very  high — 50  per  cent,  as  compared 
with  the  maximum  rate  of  65  per  cent  under  the  19 18  law. 
The  new  50  per  cent  rate  applies  to  all  income  in  excess  of 
$200,000.  The  old  rate,  which  applied  to  the  increment  of 
income  above  $200,000,  was  60  per  cent.  Under  the  new  scale, 
surtaxes  do  not  begin  until  the  $6,000  point  is  reached  and  are 
I  per  cent  for  incomes  between  $6,000  and  $10,000.  Under 
the  old  scale,  the  surtaxes  begin  at  $5,000  and  mount  by  more 
rapid  steps.  According  to  the  estimates^*'  these  changes  will 
not  provide  much  relief  for  the  individual  taxpayers,  however, 
for  the  government  expects  to  get  $780,000,000  next  year 
with  the  changes  in  effect  as  compared  with  $850,000,000 
this  year. 

The  most  revolutionary  change  in  the  new  law  is  the  estab- 
lishment of  the  new^  division  of  income  to  be  known  as  "capital 
gains."  Beginning  January  i,  1922,  profits  made  by  indivi- 
duals arising  from  sales  or  exchanges  of  property  "held  for 
profit  or  investment,"  are  subject  to  a  maximum  rate  of  12^ 
per  cent  instead  of  the  regular  rates  which,  after  that  date, 

'"See  page  3. 


INTRODUCTORY  I9 

will  range  as  high  as  58  per  cent  (normal  plus  surtaxes ).^^ 
The  reason  for  the  adoption  of  some  such  provision  as  this  is 
plain,  whatever  one  may  think  of  choosing  this  particular 
method  of  meeting  the  situation.  As  everyone  knows,  many 
sales  of  property  which  have  greatly  increased  in  value  since 
March  i,  1913,  have  been  postponed  or  entirely  blocked  by 
the  unwillingness  of  prospective  sellers  to  take  their  profits 
when  they  would  immediately  become  subject  to  heavy  surtaxes 
in  the  year  of  realization.  The  solution  adopted  was  prac- 
tically to  wipe  out  the  offensive  surtaxes  on  profits  from  this 
class  of  transactions. 

It  is  too  early  to  predict  the  effect  of  the  provision.  In 
some  cases  it  will  work  beneficially;  in  general  it  complicates 
the  procedure  and  discriminates  against  earned  income  instead 
of  in  favor  of  it.  It  will  be  taken  advantage  of  by  those  who 
are  able  to  work  out  plans  of  waiving  interest  and  dividends 
and  substituting  therefor  fixed  gains. 

The  advantage  to  the  investor  in  property  conferred  in  the 
"capital  gain"  section  is  greatly  accentuated  by  the  provisions 
of  the  section  prescribing  the  basis  for  determining  gain  or 
loss^^  which  becomes  effective  as  of  January  i,  192 1.  Not 
only  does  this  section  adopt  the  so-called  Frierson  rule  (which, 
in  the  case  of  property  purchased  before  March  i,  1913,  states 
that  a  profit  or  loss  must  be  shown  when  comparison  is  made 
with  original  cost  and  be  limited  to  the  portion  thereof  which 
accrued  after  March  i,  1913),  but  it  also  liberalizes  the  defini- 
tion of  the  closed  transaction.  The  law  now  states  positively 
that  no  gain  or  loss  on  exchanges  of  property  for  property 
shall  be  recognized  unless  the  property  received  in  the  trade 
"has  a  readily  realizable  market  value."  Even  though  it  has 
a  readily  realizable  market  value,  one  need  not  account  for 
the  gain  in  certain  cases.    This  is  one : 

....  When  any  such  property  held  for  investment  or  for  pro- 
ductive use  in  trade  or  business  (not  including  stock-in-trade  or  other 

'^  1921  law,  section  206.     This  is  hedged  about  by  several  restrictions. 
Cf.  infra,  Chapter  XVII. 
^''  Section  202. 


20  INTRODUCTORY 

property  held  primarily  for  sale),  is  exchanged  for  property  of  a 
like  kind  or  use 

Other  exceptions,  covering  cases  of  corporate  reorganizations 
and  sales  of  property  to  corporations,  make  it  unnecessary  to 
report  many  gains  which  have  heretofore  been  subject  to  tax 
at  the  time  the  transaction  was  performed. 

The  new  law  takes  an  important  forward  step  when  it 
breaks  away  from  the  practice  of  refusing  to  permit  a  business 
loss  in  one  period  to  affect  the  income  of  another  accounting 
period.  Section  204  (effective  for  192 1)  permits,  within 
certain  restrictions,  a  net  loss  from  business  suffered  in  one 
year  to  be  offset  against  any  net  income  realized  in  the  two 
next  succeeding  years.  In  other  words,  such  losses  may  now 
be  used  to  blot  out  subsequent  gains,  but  losses  are  "outlawed" 
for  this  purpose  after  the  expiration  of  two  years.  This  change 
goes  far  towards  rendering  unnecessary  any  averaging  device 
such  as  has  been  often  urged  as  a  means  of  making  the  income 
tax  more  equitable. 

In  addition  to  the  reduced  surtax  rates,  effective  in  1922, 
the  personal  exemptions  are  made  more  liberal,  the  changes 
affecting  the  1921  returns.  In  the  case  of  a  married  person 
or  a  head  of  a  family  whose  income  does  not  exceed  $5,000, 
the  exemption  is  increased  from  $2,000  to  $2,500.^^  The 
allowance  for  each  dependent  is  raised  from  $200  to  $400. 

A  new  provision  regarding  gifts  requires  the  recipient,  when 
he  disposes  of  the  gift,  to  account  for  the  gain  in  the  value  of 
the  gift  in  the  hands  of  the  donor  before  he  parted  with  it. 
Another  provision  aims  to  prevent  "wash  sales"  to  establish 
losses.  The  law  also  recognizes,  at  last,  reserves  for  bad 
debts  as  proper  deductions.  The  Liberty  bond  exemptions  are 
consolidated  and  simplified  appreciably  by  another  section. 

The  new^  law  provides  that  personal  service  corporations 
shall  be  taxed  as  ordinary  corporations  from  January  i,  1922, 
and  incorporates  a  saving  clause  that  if  the  Supreme  Court 
declares  invalid  the  method  of  taxing  such  corporations  under 


For  a  full  statement  see  1921  law,  section  216  (c). 


INTRODUCTORY  21 

the  19 18  law,  they  shall  be  taxed  as  corporations  from  Jan- 
uary I,  1918.  The  basis  of  taxation  of  insurance  companies 
is  radically  changed,  as  is  that  of  businesses  drawing  the 
major  portion  of  their  income  from  sources  within  the  pos- 
sessions of  the  United  States. 

Affiliated  corporations  are  given  the  option,  from  January 
r,  1922,  to  file  separate  or  consolidated  returns.  A  clause  is 
also  inserted  validating  the  requirement  of  consolidated  re- 
turns  (including  even  partnerships)  under  the  191 7  law. 

A  Tax  Simplification  Board  has  been  set  up  under  the 
new  law  to  investigate  the  procedure  of  the  Bureau  of  Internal 
Revenue  and  to  make  recommendations  for  its  simplification. 
The  services  to  be  rendered  by  this  board  should  be  of  great 
value  and  should  materially  assist  in  making  the  administra- 
tion of  the  law  more  effective. 

Congress  has  at  last  realized  that  the  Treasury  should  not 
be  allowed  to  withhold  indefinitely  from  taxpayers  any  taxes 
overpaid,  without  granting  some  compensation  for  the  delay. 
The  law  now  provides  that  the  Treasury  shall  pay  interest  on 
taxes  refunded. 

Other  changes  in  the  law  include  a  limitation  of  time  for 
the  filing  of  amortization  claims;  a  provision  that  returns 
must  be  filed  in  all  cases  where  an  individual's  gross  income 
exceeds  $5,000;  a  limitation  on  the  deduction  of  interest 
paid  to  carry  Liberty  bonds;  permission  to  deduct  traveling 
expenses  in  full ;  and  a  change  in  the  limitation  periods  for 
amended  returns.  Finally  there  are  important  changes  in 
administrative  features,  such  as  the  sections  permitting  bind- 
ing agreements  between  the  Treasury  and  the  taxpayer,  chang- 
ing the  procedure  with  reference  to  appeals  and  authorizing  the 
Treasury  to  defer  collection  in  cases  of  undue  hardship. 

All  in  all,  the  new  law  contains  much  that  is  good  but  also 
much  which  is  open  to  serious  criticism.  It  does  not  bear  out 
the  pre-election  promises  of  the  Republican  Party.  It  is  not 
a  total  loss ;  but  it  is  a  disappointment. 

Undoubtedly  progress  is  being  made  toward  a  more  satis- 


22  INTRODUCTORY 

factory  statute  from  the  technical  point  of  view,  but  much 
still  remains  to  be  done.  Perhaps  the  most  damning  indict- 
ment which  can  be  urged  against  the  new  statute  is  that  it 
has  increased  rather  than  decreased  the  technical  difficulties  of 
arriving  at  net  income.  Instead  of  amplifying,  it  has  com- 
plicated the  problem  and  it  has  done  so  in  order  to  achieve 
certain  objects  which  in  the  end  are  not  likely  to  commend 
themselves  to  the  people  of  the  country  generally.  Certainly 
to  set  up  a  new  differentiation  of  income  in  order  to  discrim- 
inate against  earnings  as  compared  with  property  profits, 
does  not  seem  to  constitute  real  progress  toward  a  permanently 
satisfactory  solution  of  the  problem. 

Tax-exempt  securities. — The  high  surtaxes  on  income  have 
been  the  object  of  bitter  attack  recently  on  the  ground  that 
they  are  operating  to  force  capital  into  tax-exempt  securities. 
The  relative  attractiveness  of  tax-exempt  municipal  and  state 
bonds  has  aroused  those  who  are  interested  in  private  business 
undertakings  which  are  dependent  upon  borrowed  capital, 
and  they  demand  either  the  exemption  of  interest  on  their  secur- 
ities or  the  elimination  of  all  exemptions. 

The  plain  facts  are,  of  course,  that  the  surtax  rates  are  un- 
reasonably high  and  that  the  amounts  of  tax-exempt  securities 
available  for  investment  are  unreasonably  large.  The  reduc- 
tion of  the  surtax  rates  to  the  more  moderate  levels  of  the 
1 92 1  law  helps  the  situation  somewhat.  At  the  same  time 
the  problem  of  the  tax-exempt  bond  should  be  vigorously 
attacked.  Active  support  should  be  given  to  the  proposed 
constitutional  amendment  permitting  the  states  and  the  federal 
government  to  tax  the  interest  on  all  future  issues.  Certainly 
there  is  no  solution  in  the  direction  of  further  extension  of 
the  principle  of  exemption.  Tax-exempt  securities  must  be 
reduced  in  amount,  not  increased.  Unless  this  can  be  accom- 
plished, the  whole  future  of  income  taxation  at  progressive 
rates  is  seriously  threatened.^* 

^'  See  page  34.  ,      ■  ' 


INTRODUCTORY 


23 


Differentiation   between  earned   and   unearned   income. — 

There  is  a  growing  sentiment  in  favor  of  relatively  heavier 
taxation  of  unearned  income.  Such  a  change  was  recom- 
mended by  the  Treasury  for  the  19 18  act.  Largely  because 
of  the  administrative  difficulties  involved,  the  suggestion  was 
not  adopted  at  that  time.  The  question  was  made  more  im- 
portant by  the  higher  rates  and  lower  personal  exemptions 
established  by  the  1918  law. 

It  seemed  probable  that  with  all  the  time  there  was  at 
their  disposal,  Congress  between  January  and  December, 
1 92 1,  would  have  been  able  to  work  out  a  satisfactory  plan. 
Instead  of  doing  so,  they  continued  old  discriminations  against 
earned  incomes  and  included  new  ones.  It  cannot  be  pos- 
sible that  this  discrimination  in  favor  of  the  idle  and  the  rich 
is  intentional;  it  must  be  due  to  the  incompetency  and  inat- 
tention of  Congress. 

Some  maintain  that  the  operation  of  state  and  local  prop- 
erty taxes  makes  a  sufficient  discrimination  between  earned 
and  unearned  incomes.  The  burden  imposed  by  local  taxation 
upon  property,  while  nominally  comprehending  personal  prop- 
erty, usually  falls  heavily  upon  real  estate  only.  Therefore  a 
differentiation  between  earned  and  unearned  incomes  in  favor 
of  the  former  would  undoubtedly  increase  the  present  heavy 
taxation  of  real  estate  in  some  communities.  But  where  the 
real  estate  tax  is  already  inordinately  high,  the  remedy  should 
be  sought  in  a  reform  of  the  state  as  well  as  the  local  tax 
system. 

Perhaps  the  greatest  difficulty  in  differentiating  between 
earned  and  unearned  incomes  lies  in  the  distinction  which 
will  have  to  be  made  between  income  derived  by  an  individual 
or  partnership  from  the  conduct  of  a  business  enterprise,  and 
the  dividends  received  by  stockholders  interested  in  a  corpo- 
rate enterprise  engaged  in  the  same  kind  of  business.  This 
apparent  inequality  will  largely  disappear  if  some  means  can 
be  devised  whereby  those  closely  associated  with  the  manage- 
ment of  a  corporation,  as  the  officers  and  directors  of  a  close 


24 


INTRODUCTORY 


corporation,  will  be  deemed  to  be  in  active  business  and  en- 
titled to  the  rate  of  tax  applicable  to  earned  incomes. 

This  distinction  between  "lazy"  and  "industrious"  in- 
comes, to  use  Gladstone's  famous  terminology,  has  been  rec- 
ognized in  Great  Britain  since  1907  and  appeals  powerfully 
to  the  British  people's  sense  of  justice.  There  the  differen- 
tiation is  applied  in  the  case  of  smaller  incomes  only,  which 
materially  simplifies  the  administrative  problem.  Inland 
Revenue  officers  consider  this  a  simple  distinction  to  establish 
in  practice  and  the  people  generally  believe  it  to  be  sound  in 
principle. 

Retroactive  taxation. — The  Revenue  Act  of  19 18  was  not 
approved  by  the  President  until  February  24,  1919,  two  months 
after  the  close  of  the  year  whose  incomes  it  subjected  to  tax. 
President  Harding  signed  the  192 1  law  on  November  23,  192 1, 
three  months  earlier  than  President  Wilson  signed  the  19 18 
law,  but  still  at  least  eleven  months  later  than  it  should  have 
been.  The  legality  of  this  action  appears  to  be  beyond  ques- 
tion,^^  but  its  practical  economic  wisdom  is  quite  another 
matter.  It  is  of  the  highest  importance  that  taxpayers  should 
know  in  advance  what  their  tax  burden  is  to  be.  It  is  also 
important  that  they  should  not  be  put  to  serious  inconvenience 
by  being  asked  to  master  radical  changes  in  complicated  stat- 
utes within  a  few  weeks  before  the  returns  are  due.  Congress 
has  shown  a  strong  disposition  to  postpone  action  on  revenue 
measures  and  to  take  advantage  of  the  fact  that  retroactive 
legislation  of  this  type  is  not  unconstitutional.  In  the  presence 
of  an  overwhelming  emergency  such  as  may  be  occasioned 


"Decision.  "It  is  clearly  ....  constitutional  as  well  as  expedient,  in 
levying  a  tax  on  profits  or  income,  to  take  as  the  measure  of  taxation  the 
profits  or  income  of  a  preceding  year.  To  tax  is  legal,  and  to  assume  as  a 
standard  the  transactions  immediately  prior  is  certainly  not  unreasonable, 
particularly  when  we  find  it  always  adopted  in  exactly  similar  cases." 
(Drcxel  v.  Coiiinionzvealtli,  46  Pa.  St.  31.) 

See  also  Brushaber  v.  Union  Pacific  R.  R.  Co.,  240  U.  S.  i ;  36  Sup.  Ct. 
236;  60  L.  Ed.  493. 

For  a  full  discussion  as  to  the  extent  to  which  the  laws  of  1913  to  1918 
were  retroactive,  see  Income  Tax  Procedure,  1919,  pages  30-32. 


INTRODUCTORY  25 

by  rapidly  changing  conditions  during  a  war  such  legislation 
may  be  excused,  but  under  present  conditions  there  is  no  ade- 
quate reason  why  that  legislation  affecting  a  current  year's 
income  should  not  be  completed  early  in  the  year. 


The  Plan  of  the  Book 

Due  to  the  repeal  of  the  excess  profits  tax  as  of  January 
I,  1922,  it  has  been  considered  unnecessary  to  issue  a  separate 
volume,  as  in  192 1,  dealing  with  that  subject.  Instead,  all 
new  rulings  regarding  the  excess  profits  tax  are  presented 
in  an  appendix  to  this  volume. 

A  chapter  on  the  federal  estate  tax  has  been  added  in  this 
edition.  The  federal  capital  stock  tax  chapter  which  was 
transferred  to  Excess  Profits  Tax  Procedure  in  1921,  reap- 
pears in  this  volume  as  Chapter  XLI. 

Two  features  of  the  book's  arrangement  should  perhaps  be 
emphasized.  One  is  the  policy  of  quoting  exactly  from  law 
and  regulations  all  material  of  importance  in  considering  ques- 
tions connected  with  the  preparation  of  returns.  Since  the 
construction  often  turns  upon  a  single  word  or  punctuation, 
it  seems  to  the  author  important  to  make  the  precise  official 
language  available  in  convenient  and  easily  recognizable  form. 
The  source  of  all  material  quoted  in  the  text  is  plainly  in- 
dicated, the  excerpt  being  labeled  "law,"  "regulation,"  "de- 
cision," etc.,  as  the  case  may  be.  It  should  be  noted  that 
regulations  quoted  in  the  text  are  taken  from  official  Regula- 
tions 62  unless  otherwise  specified.  A  quoted  regulation 
bearing  as  a  reference  merely  an  article  number  is  to  be  con- 
sidered as  coming  from  this  source. 

All  material  changes  in  the  new  regulations  as  compared 
with  Regulations  45  are  commented  upon.  A  regulation  with- 
out comment  is  the  same  as  the  corresponding  article  in 
Regulations  45. 

Since  early  in  1920  and  including  rulings  issued  prior, 
the  Treasury  has  issued  a  series  of  official  bulletins  containing 


26  INTRODUCTORY 

decisions,  opinions  and  rulings  by  the  Attorney  General,  Soli- 
citor of  Internal  Revenue,  and  the  Committee  on  Appeals  and 
Review  and  many  "office"  decisions.  All  of  these  have  been 
carefully  reviewed.  Those  of  importance  are  quoted  in  full. 
When  the  author  disagrees  with  the  Treasury  his  reasons  are 
stated. 

The  following  abbreviations  are  used  by  the  Treasury  in 
these  bulletins : 

Ct.    D Court  Decision 

T.  D Treasury  Decision 

Op.  A.  G Opinion  of  Attorney  General 

S Solicitor's  Memorandum 

O.  or  L.  O Solicitor's  Law  Opinion 

Sol.  Op Solicitor's  Opinion 

T.  B.  R Advisory  Tax  Board  Recommendation 

T.  B.  M Advisory  Tax  Board  Memorandum 

A.  R.  R Committee  on  Appeals  and  Review  Recom- 
mendation 

A.  R.  M Committee  on  Appeals  and  Review  Memor- 
andum 

0.  D Office  Decision 

Mim Mimeograph  letter 

C.  B Cumulative  Bulletin   (  Xo.   i  covers  1919 ;  No. 

2,  January-June,  1920;  No.  3,  July-December, 
1920;  No.  4,  January-June,   1921) 

1.  T Income  Tax  Unit 

E.  T Estate  Tax  Division 

C.  S.  T Capital  Stock  Tax  Division 

A.  B.  C,  etc Represent  names  of  individuals 

M.  N.,  X.  Y.  Z.,  etc.. . .  Represent   names    of   corporations,   places   of 

business,  according  to  context 
X Represents  a  certain  number 

Rulings  issued  prior  to  January  i,  1922,  were  cited  b}'  the 
Treasury  as  1-21-1369,  meaning  Bulletin  No.  i  of  192 1, 
Ruling  No.  1369.  A  new  series  of  bulletins  has  been  issued 
for  1922  in  which  the  method  of  reference  is  different.  Rul- 
ings are  now  quoted  as  I-3-27,  meaning  Volume  I  (of  the  new 
series.  Bulletin  No.  3.  Ruling  No.  27. 

The  author  has  indexed  all  bulletin  rulings  issued  prior  to 
July,    1 92 1,   to  the  pages  of  the   Cumulative   Bulletins  upon 


INTRODUCTORY 


27 


which  they  appear.  Thus  C.  B.  3,  page  23,  O.  D.  587,  shows 
that  the  quotation  is  from  Office  Decision  587  which  will  be 
found  in  full  on  page  2;^  of  Cumulative  Bulletin  No.  3  (July- 
December,  1920).  Rulings  issued  subsequent  to  July  i,  1921, 
are  referred  to  by  number,  as  the  Cumulative  Bulletin  for 
July-December,  192 1,  is  not  yet  published.  1922  rulings 
are  quoted  as  shown  in  the  1922  bulletins. 

The  second  feature  to  which  attention  should  be  drawn  is 
the  treatment  of  former  procedure.  Because  of  the  large  num- 
ber of  returns  for  previous  years  which  are  as  yet  unaudited 
by  the  authorities,  it  is  deemed  desirable  to  include  in  foot- 
notes the  facts  concerning  the  law  and  procedure  which  for- 
merly obtained  wherever  important  changes  have  been  made 
This  makes  it  possible  for  the  book  to  serve  as  a  guide  when 
questions  arise  in  regard  to  old  returns. 


PART    I 
APPLICATION  AND  ADMINISTRATION 


CHAPTER  II 

APPLICATION  OF  THE  LAW 
CORPORATIONS  EXEMPT  FROM  TAXATION 

The  tax  is  imposed  upon  "net  income,"^  a  term  minutely 
described  in  the  law.  In  the  case  of  individuals^  it  means  the 
gross  income,  which  includes  earnings  from  personal  services, 
business  and  trades,  profits  from  sales  of  property,  interest, 
rents,  royalties,  dividends,  etc.,^  less  deductions  for  expenses, 
losses,  interest,  taxes,  depreciation,  etc.*  The  surtax,  which 
commences  at  an  amount  in  excess  of  $5,000  for  192 1  and  of 
$6,000  for  1922,  is  calculated  upon  the  total  net  income  as 
thus  established. 

To  determine  the  basis  for  the  8  per  cent  normal  tax^ 
of  an  individual,  there  are  certain  deductions  (or  "credits," 
as  they  are  called)  for  dividends,  interest  on  Liberty  bonds, 
etc.,  the  personal  exemption  of  $1,000,  $2,000,  or  $2,500,  and 
the  exemption  for  dependents."  The  first  $4,000  of  the  amount 
so  determined  is  subject  to  a  normal  tax  of  only  4  per  cent' 
in  the  case  of  citizens  or  residents  of  the  United  States. 

The  gross  income  of  corporations  includes  the  same  items 
as  for  individuals,^  but  the  deductions  are  not  quite  the  same.'* 
The  net  income  of  corporations  is  taxed  10  per  cent  for  the 
calendar  year  1921,  in  addition  to  the  excess  profits  tax.  The 
flat  rate  is  increased  to  12J/2  per  cent  for  subsequent  years. 


^Sections  210,  230  (a). 
'  Section  212  (a). 

*  Section  213. 

*  Section  214. 

*For  the  year  1918,  the  rate  was  12  per  cent.  The  rate  for  1919  and 
1920  was  8  per  cent. 

'  Section  216. 

'  For  the  year  1918  the  rate  was  6  per  cent.  The  rate  for  1919  and 
1920  was  4  per  cent. 

*  Section  233. 

"The  chief  differences  are  deductions  which  arc  perniitlcd  individuals 
for  losses  not  connected  with  business  or  trade,  and  for  gifts. 

31 


32  APPLICATION   AND   ADMINISTRATION 

The  excess  profits  tax  is  repealed  as  of  December  31,  1921. 
Moreover,  there  are  certain  subtractions  from  corporate  in- 
comes which  are  allowed  under  the  title  of  "credits,"  a  device 
adopted  in  order  to  make  the  meaning  of  the  term  "net  income" 
that  which  is  to  be  taxed  for  excess  profits.  For  a  full  dis- 
cussion of  credits  see  Chapter  XII. 

The  various  types  of  taxable  income  included  under  the 
provisions  of  section  213,  and  the  allowable  deductions  permit- 
ted by  sections  214  and  234,  are  discussed  in  detail  in  the 
series  of  chapters  which  constitute  Parts  II  and  III  of  this 
book. 

Exempt  Income  in  General 

It  is  pertinent  at  this  place  to  discuss  in  a  general  way 
income  which  is  partially  or  wholly  exempt   from  taxation. 
Exempt  income  can  be  divided  into  four  classes : 

1.  Income  which  is  exempt  from  all  taxes  imposed  by 
the  1 92 1  revenue  law  because  it  is  received  by  certain 
types  of  corporations  or  by  states  or  by  the  political 
subdivisions  thereof.  This  class  is  dealt  with  later 
in  this  chapter. 

2.  Income  which  is  exempt  because,  geographically,  it 
lies  beyond  the  scope  and  application  of  the  law.  (See 
Chapter  XII.) 

3.  Income  such  as  is  not  included  in  either  of  the  above 
classes,  which  is  exempt  from  both  normal  tax  and 
surtaxes.  Such  items  are  not  included  in  gross  income. 
(See  Chapter  XII.) 

4.  Income  such  as  is  not  included  in  any  of  the  above 
classes,  which  is  exempt  from  normal  tax  but  is  subject 
to  surtax.     (See  Chapter  XII.) 

The  first  class  can  be  called  an  "exemption  of  the  person," 
while  the  other  three  are  "exemptions  of  the  income." 

No  individual"  is  entirely  exempt  from  the  tax  merely  be- 


'"  This  statement   includes  minors.     See  Chapter  IV. 


EXEMPT   CORPORATIONS 


33 


cause  of  his  status  or  character  as  an  individual  unless  one 
construes  the  personal  exemption  as  an  exception  to  this 
statement.  That  exemption,  of  course,  operates  to  relieve 
entirely  from  taxation  the  person  whose  income  is  smaller 
than  the  specified  amounts. 

If  one  should  receive  all  his  income  from  interest  upon 
the  obligations  of  a  state  or  of  any  political  subdivision  thereof, 
or  upon  certain  of  the  obligations  of  the  United  States  or  its 
possessions  or  securities  issued  under  the  provisions  of  the  Fed- 
eral Farm  Loan  Act  of  July  17,  1916,  he  would  be  subject  to 
no  income  tax  and  would  not  be  required  to  make  any  return. 
He  might  receive  and  enjoy  his  income  as  if  the  tax  did  not 
exist.  This  is  true  even  though,  in  addition,  he  receives  tax- 
able income  of  any  amount  less  than  $1,000  (single  person) 
during  the  year.  If  he  receives  more  than  $1,000  of  such  ad- 
ditional taxable  income,  he  would  proceed  in  the  same  manner 
as  any  other  taxpayer. 

Also,  taxpayers  who  receive  dividends  from  the  stock  of 
American  corporations  subject  to  the  income  tax,  or  who 
receive  interest  on  certain  government  securities,  are  exempt 
from  the  normal,  taxes  on  such  income  but  are  nevertheless 
required  to  report  such  items  annually  if  their  total  net  income 
is  large  enough  to  justify  them  in  making  any  return  at  all, 
or  if  their  gross  income  exceeds  $5,000. 

Another  classification  of  exempt  income  has  been  made 
as  follows  :^^ 

1.  Granted  for  fiscal  or  administrative  reasons: 

(a)  Deductions  necessary  to  tax  true  or  net  income  only  (ordi- 

nary and  necessary  expenses). 

(b)  Credits  required  to  avoid  double  taxation  (dividends,  pro- 

ceeds of  insurance  policies,  and  inheritances). 

2.  Granted  for  constitutional  reasons: 

Interest  from  state  and  municipal  obligations;  salaries  of 
state  and  municipal  employees.  (Amount  of  state  and 
municipal   securities  withdrawn   from  the  federal  income 


"  Rufus  S.  Tucker  "Exemptions  under  the  Federal  Income  Tax,"  Bul- 
letin of  the  National  Tax  Association,  Volume  5,  page  138. 


34  APPLICATION   AND   ADMINISTRATION 

tax  is  at  least  $4,000,000,000,  representing  an  annual  in- 
come of  $160,000,000.^- 

3.  Granted  for  reasons  of  public  welfare: 

(a)  Personal  exemptions  of  $1,000  and  $2,000,  on  the  ground  of 

inability  of  such  small  incomes  to  pay  a  direct  tax. 

(b)  In  Prussia  before   the  war  the   limit  of   exemptions   was 

$220  and  no  European  country  had  as  high  an  exemption 
as  $1,000.  Raising  the  exemption  would  increase  the 
number  of  citizens  who  do  not  knowingly  contribute  to 
the  cost  of  government. 

4.  Granted  to  assist  certain  kinds  of  enterprise  or  to  encourage  certain 

.forms  of  investment,  presumably — 

(a)  Income  from  bonds  of  the  United  States,  its  territories  and 

possessions,  farm  loan  bonds,  and  bonds  of  the  War  Fi- 
nance Corporation. 

(b)  Organizations  not  operating  primarily  for  profit. 

Exempt  Corporations 

Certain  corporations  are  expressly  exempt  from  the  pro- 
visions of  the  law. 

Types  of  corporations  exempt. — The  law  groups  the  ex- 
empt corporations  under   fourteen  heads : 

Law.  Section  231.  That  the  following  organizations  shall  be 
exempt  from  taxation  under  this  title —   .... 

Labor,  agricultural  or  horticultural  organiza- 
tions.— 

Law.  Section  231.  .  .  .  .  (i)  Labor,  agricultural,  or  horticul- 
tural organizations; 

Regulation.  Agricultural  or  horticultural  organizations  exempt 
from  tax  do  not  include  corporations  engaged  in  growing  agricultural 
or  horticultural  products  or  raising  live  stock  or  similar  products  for 
profit,  but  include  only  those  organizations  which,  having  no  net  in- 
come inuring  to  the  benefit  of  their  members,  are  educational  or 
instructive  in  character  and  have  for  their  purpose  the  betterment  of 
the  conditions  of  those  engaged  in  these  pursuits,  the  improvement 


""It  is  estimated  that  there  are  outstanding  perhaps  $10,000,000,000  of 
fully  tax  exempt  securities."  Letter  from  Secretary  of  the  Treasury 
Mellon  to  Chairman  Focdney  of  the  Committee  on  Ways  and  Means,  April 
30,  1921. 


EXEMPT    CORPORATIONS  35 

of  the  grade  of  their  products,  and  the  encouragement  and  promotion 
of  these  industries  to  a  higher  degree  of  efficiency.  Included  in  this 
class  as  exempt  are  organizations  such  as  county  fairs  and  like  asso- 
ciations of  a  quasi-public  character,  which  through  a  system  of 
awards,  prizes,  or  premiums  are  designed  to  encourage  the  production 
of  better  live  stock,  better  agricultural  and  horticultural  products, 
and  whose  income,  derived  from  gate  receipts,  entry  fees,  donations, 
etc.,  is  used  exclusively  to  meet  the  necessary  expenses  of  upkeep 
and  operation.  Societies  or  associations  which  have  for  their  pur- 
pose the  holding  of  annual  or  periodical  race  meets,  from  which 
profits  inure  or  may  inure  to  the  benefit  of  the  members  or  stock- 
holders, do  not  come  within  the  terms  of  this  exemption.  A  corpora- 
tion engaged  in  the  business  of  raising  stock  or  poultry,  or  growing 
grain,  fruits,  or  other  products  of  this  character,  as  a  means  of  liveli- 
hood and  for  the  purpose  of  gain,  is  an  agricultural  or  horticultural 
society  only  in  the  sense  that  its  name  indicates  the  kind  of  business 
in  which  it  is  engaged,  and  it  is  not  exempt  from  tax.     (Art.  512.) 

The  foregoing  regulation  makes  it  clear  that  many  so- 
called  mutual  organizations  are  subject  to  the  tax. 

Ruling.  The  X  Company  is  a  business  activity  organized  for  the 
purpose  of  affording  employment  to  the  members  of  a  certain  labor 
union.  It  is  not  a  part  of  the  union  as  such,  although  it  is  owned  and 
controlled  by  the  union.  Wages  are  paid  to  the  members  employed, 
and  all  profits,  after  paying  expenses,  are  turned  into  the  treasury  of 
the  union. 

Held,  that  the  activities  of  the  company  are  such  as  to  make  it  a 
business  enterprise.  Hence  it  does  not  come  within  the  exemption 
as  a  labor  organization  provided  in  section  231  (i)  of  the  Revenue 
Act  of  1918,  and  will,  therefore,  be  required  to  file  returns  of  net 
income.     (C.  B.  2,  page  211 ;  O.  D.  523.) 

Mutual  savings  banks. — 

Law.     Section  231 (2)   Mutual  savings  banks  not  having 

a  capital  stock  represented  by  shares;   .... 

Regulation.  A  Massachusetts  savings  bank,  otherwise  exempt, 
which  establishes  an  insurance  department  under  the  statutes  of  that 
State,  does  not  thereby  become  subject  to  tax  upon  the  income  re- 
ceived by  such  department.     (Art,  513.) 

Ruling.  A  savings  bank  within  the  accepted  meaning  of  the 
term  contemplates  the  ordinary  institution  of  that  kind  as  organized 
and  conducted  in  accordance  with  the  statutes  of  the  various  States. 
Its  manner  of  investing  the  savings  of  depositors  is  restricted.  Fur- 
thermore, the  funds  are  received  by  deposits  ordinarily  made,  rather 


36  APPLICATION    AND   ADMINISTRATION 

than  by  a  contract  under  which  there  arises  a  binding  duty  to  make 
future  deposits.  Therefore  an  organization  which  receives  deposits 
from  its  members  by  contract  under  which  there  arises  a  binding 
duty  to  make  future  deposits,  and  which  is  operated  for  the  purpose 
of  speculation  rather  than  for  savings,  is  not  a  mutual  savings  bank 
within  the  meaning  of  section  231  (2)  of  the  Revenue  Act  of  1918. 
(C.  B.  4,  page  262 ;  O.  D.  780.) 

Fraternal  beneficiary  societies. — 

Law.     Section    231 (3)  Fraternal    beneficiary    societies, 

orders,  or  associations,  (a)  operating  under  the  lodge  system  or  for 
the  exclusive  benefit  of  the  members  of  a  fraternity  itself  operating 
under  the  lodge  system;  and  (b)  providing  for  the  payment  of  life, 
sick,  accident,  or  other  benefits  to  the  members  of  such  society,  order, 
or  association  or  their  dependents;   .... 

Regulation.  A  fraternal  beneficiary  society  is  exempt  from  tax 
only  if  operated  under  the  "lodge  system,"  or  for  the  exclusive  bene- 
fit of  the  members  of  a  society  so  operating.  "Operating  under  the 
lodge  system"  means  carrying  on  its  activities  under  a  form  of  organ- 
ization that  comprises  local  branches,  chartered  by  a  parent  organiza- 
tion and  largely  self-governing,  called  lodges,  chapters,  or  the  like. 
In  order  to  be  exempt  it  is  also  necessary  that  the  society  have  an 
established  system  for  the  payment  to  its  members  or  their  depend- 
ents of  life,  sick,  accident,  or  other  benefits.     (Art.  514.) 

The  two  rulings  which  follow  indicate  the  Treasury's  inter- 
pretation of  the  law  and  regulations. 

Ruling.  The  M  association  is  an  incorporated  society  operating 
under  the  lodge  system  throughout  the  United  States,  its  charter  pro- 
viding for  the  union  of  eligible  members  into  a  grand  fraternal  benefici- 
ary, educational  and  patriotic  society.  Assessments  are  levied  upon  its 
members  to  provide  for  the  payment  of  sick  and  death  benefits,  for 
disability  relief  in  case  of  accident  and  for  promoting  their  social, 
moral,  educational  and  patriotic  advancement.  It  also  derives  in- 
come from  subscriptions  to  a  daily  and  a  weekly  newspaper  which  it 
publishes  as  well  as  from  job  printing  and  other  sources.  None  of  the 
income  inures  to  the  benefit  of  any  private  stockholder  or  individual. 

Held,  that  although  this  society  has  fraternal  and  benevolent 
features  it  is  chiefly  a  patriotic  organization  interested  in  the  general 
welfare  of  its  members  and  that  its  powers  are  so  extensive  as  to  pre- 
clude its  classification  under  paragraph  3,  section  231  of  the  Revenue 
Act  of  1918.     (C.  B.  3,  page  207;  O.  D.  508.) 

It  would  appear  from  the  facts  as  stated  that  the  Treasury 
has  placed  a  very  narrow  interpretation  on  the  law. 


EXEMPT    CORPORATIONS 


37 


Ruling.  A  fraternal  beneficiary  society  is  a  society  wliose 
members  have  adopted  the  same  or  a  very  similar  calling,  avocation 
or  profession,  or  who  are  working  in  unison  to  accomplish  some 
worthy  object  and  who  for  that  reason  have  bound  themselves  to- 
gether as  an  association  or  society  to  aid  and  assist  one  another  and 
to  promote  the  common  cause.  The  term  "fraternal"'  can  properly 
be  applied  to  such  an  association  for  the  reason  that  the  pursuit  of 
a  common  object  usually  has  a  tendency  to  create  a  brotherly  feeling 
among  those  who  are  thus  engaged.  The  absence  of  profit  in  the  opera- 
tion of  such  an  association  is  not  the  test  as  to  whether  it  is  within  the 
exemption  as  a  fraternal  beneficiary  society,  but  the  want  of  a 
fraternal  side  or  object  which  it  is  in  some  manner  organized  to  pro- 
mote. A  fraternal  beneficiary  society  may  be  a  mutual  insurance  com- 
pany, but  must  be  something  more ;  it  must  be  primarily  fraternal 
and  also,  in  order  to  fall  within  the  exemption  provided  for  by 
section  231  (3)  of  the  Revenue  Act  of  1918  must  be  operated  under 
the  lodge  system  or  for  the  exclusive  benefit  of  the  members  of  a 
fraternity  itself  operating  under  the  lodge  system.  (See  Commercial 
Travellers  Life  and  Accident  Association  z'.  Rodzvay,  235  Fed.  370.) 
(C.  B.  3,  page  236;  O.  D.  690.) 

Building  and  loan  associations. — 

Law.  Section  231.  .  .  .  .  (4)  Domestic  building  and  loan  as- 
sociations; substantially  all  the  business  of  which  is  confined  to  making 
loans  to  members;  and  cooperative  banks  without  capital  stock  or- 
ganized and  operated  for  mutual  purposes  and  without  profits;     .... 

The  principal  tests  applied  to  a  btiilding  and  loan  associa- 
tion to  determine  its  right  to  exemption,  are  whether  the  mem- 
bers share  in  the  profits  on  practically  the  same  footing  and 
that  substantially  all  its  btisiness  is  confined  to  making  loans 
to  members. 

Regulation.  In  general,  a  building  and  loan  association  entitled 
to  exemption  is  one  organized  pursuant  to  the  laws  of  any  State, 
Territory,  or  the  District  of  Columbia,  which  accumulates  funds  to 
be  loaned  primarily  to  its  shareholders  for  the  purpose  of  building 
or  acquiring  homes.  In  order  to  be  exempt  the  association  (i)  must 
be  mutual,  that  is,  all  of  its  stockholders  or  members  must  share  in  the 
profits  on  substantially  the  same  footing;  and  (2)  must  be  operated 
so  that  substantially  all  of  its  business  is  confined  to  the  making  of 
loans  to  bona  fide  shareholders.  A  building  and  loan  association 
otherwise  exempt  does  not  lose  its  exempt  status  because — 

(i)   It  has  paid-up  shares  wliich  are  (a)  preferred  as  to    earnings, 


38  APPLICATION    AND    AD^^IINISTRATION 

and   (b)   have  a  definite  rate  of  interest  which  may  be  higher  than 
the  rate  of  dividends  paid  on  other  stock. 

(2)  It  borrows  money  (accepting  deposits  is  held  to  be  a  form 
of  borrowing)  which  it  uses  for  loans  to  shareholders,  the  dues, 
fines,  and  penalties  paid  by  shareholders  being  inadequate  for  this 
purpose. 

(3)  It  makes  loans  to  nonmembers  from  accumulated  funds  which 
are  not  needed  for  loans  to  shareholders.  In  any  such  case,  however, 
the  burden  will  be  upon  the  association  to  show  that  substantially 
all  of  its  loans  are  made  to  members. 

(4)  The  amount  of  its  prepaid  or  full-paid  stock  is  disproportion- 
ate to  running  or  installment  stock,  provided  the  issuance  of  such 
prepaid  or  full-paid  stock  is  ancillary  to  the  furtherance  of  the 
main  business  of  the  association;  that  is,  that  it  is  intended  to  pro- 
vide a  fund  from  which  loans  may  be  made  primarily  to  persons  sub- 
scribing to  running"  or  installment  stock  to  enable  them  to  acquire  or 
build  homes. 

Cooperative  banks  without  capital  stock  organized  and  operated 
for  mutual  purposes  and  without  profit  are  exempt.  Credit  unions 
such  as  those  organized  under  the  laws  of  Massachusetts,  being  in 
substance  and  in  fact  the  same  as  cooperative  banks,  are  likewise 
exempt  from  tax.     (Art.  515.) 

The  new  article  paraphrases  the  old  one,  no  essential  change 
Ijeing  made  therein. 

Rulings.  Where  a  large  proportion  of  the  loans  of  an  associa- 
tion are  made  upon  such  securities  as  stocks,  automobile  notes  and 
personal  endorsements  and  only  a  small  proportion  upon  real  estate, 
it  is  held  that  such  an  association  is  not  a  domestic  building  and  loan 
association  within  the  meaning  of  section  231  (4)  of  the  Revenue 
Act  of  1918,  and  must  file  returns  of  annual  net  income  and  pay  any 
tax  shown  to  be  due  thereon.     (B.  44-21-1900;  O.  D.  1088.) 

A  building  and  loan  association  which  loans  its  funds  to  non- 
members,  on  endorsed  notes,  a  very  small  amount  only  being  secured 
by  real  estate,  and  divides  the  profits  among  the  holders  of  the  paid- 
up  certificates,  these  being  the  only  members  of  the  association  par- 
ticipating in  the  management  and  in  the  profits,  is  held  to  be  engaged 
in  business  in  the  nature  of  a  banking  business,  and  does  not  come 
within  the  exemption  provided  in  section  231  (4)  of  the  Revenue 
Act  of  1918.     (C.  B.  4,  page  262;  O.  D.  768.) 

A  building  and  loan  association  which  conducts  an  insurance 
agency  and  sells  insurance  is  not  entitled  to  exemption  under  section 
231  (4)  of  the  Revenue  Act  of  1918.  (B.  Digest  49-21-1965;  O.  D. 
1 129.) 


EXEMPT   CORPORATIONS 


Certain  cemetery  companies. 


39 


Law.     Section  231 (5)  Cemetery  companies  owned  and 

operated  exclusively  for  the  benefit  of  their  members  or  which  are  not 
operated  for  profit;  and  any  corporation  chartered  solely  for  burial 
purposes  as  a  cemetery  corporation  and  not  permitted  by  its  charter 
to  engage  in  any  business  not  necessarily  incident  to  that  purpose, 
no  part  of  the  net  earnings  of  which  inures  to  the  benefit  of  any 
private  stockholder  or  individual;   .... 

Regulation.  A  cemetery  company  in  order  to  be  exempt  must 
be  owned  and  operated  exclusively  for  the  benefit  of  its  lot  owners  or 
must  not  be  operated  for  profit.  Any  cemetery  corporation  chartered 
solely  for  burial  purposes  and  not  permitted  by  its  charter  to  engage  in 
any  business  not  necessarily  incident  to  that  purpose,  no  part  of  the  net 
earnings  of  which  inures  to  the  benefit  of  any  private  stockholder  or 
individual,  is  exempt  from  income  tax.  A  cemetery  company  of 
which  all  lot  owners  are  members,  issuing  preferred  stock  entitling 
the  holder  to  a  semiannual  dividend  of  4  per  cent,  and  whose  articles 
of  incorporation  provide  that  the  preferred  stock  shall  be  retired  at 
par  as  soon  as  sufficient  funds  are  realized  from  sales  and  that  all 
funds  realized  in  addition  thereto  shall  be  used  by  the  company  for 
the  care  and  improvement  of  the  cemetery  property,  is  within  the 
exemption.     (Art.  516.) 

The  wording  of  the  new  regulation  is  changed  to  give  effect 
to  the  additional  requirement  of  the  192 1  law,  that  profits  do 
not  inure  to  the  benefit  of  private  stockholders  or  individuals. 

Ruling.  A  cemetery  company,  in  order  to  be  exempt  under 
section  231  (5)  of  the  Revenue  Act  of  1918,  must  be  owned  and 
operated  exclusively  for  the  benefit  of  all  lot  owners.  (B.  Digest 
39-21-1846;  Sol.  Op.  120.) 

Religious,  charitable,  educational,  etc.,  societies. — 

Law.  Section  231 (6)  Corporations,  and  any  com- 
munity chest,  fund,  or  foundation,  organized  and  operated  exclusively 
for  religious,  charitable,  scientific,  literary,  or  educational  purposes, 
or  for  the  prevention  of  cruelty  to  children  or  animals,^'  no  part  of 
the  net  earnings  of  which  inures  to  the  benefit  of  any  private  stock- 
holder or  individual; 

Regulation.  This  exemption  applies  to  corporations,  associations, 
and  community  chests,  funds,  or  foundations.  In  order  to  be  exempt, 
the  organization  must  meet  three  tests:  (o)  it  must  be  organized  and 


"  [Former  Procedure]     The   societies    for   the   prevention   of   cruelty 
to  children  or  animals  were  included  for  the  first  time  in  the  1918  law. 


40  APPLICATION    AND   ADMINISTRATION 

operated  for  one  or  more  of  the  specified  purposes;  (&)  it  must  be 
organized  and  operated  exclusively  for  such  purposes;  and  (c)  no 
part  of  its  net  income  must  inure  to  the  benefit  of  private  stock- 
holders or  individuals. 

(i)  Charitable  corporations  include  an  association  for  the  relief 
of  the  families  of  clergymen,  even  though  the  latter  make  a  contribu- 
tion to  the  fund  established  for  this  purpose;  or  for  furnishing  the 
services  of  trained  nurses  to  persons  unable  to  pay  for  them;  or  for 
aiding  the  general  ^ody  of  litigants  by  improving  the  efficient  admin- 
istration of  justice.  Educational  corporations  may  include  an  associ- 
ation w^hose  sole  purpose  is  the  instruction  of  the  public.  This 
is  true  of  an  association  to  promote  acquaintance  with  the  Spanish 
language  and  literature,  although  it  has  incidental  amusement  features; 
of  an  association  to  increase  knowledge  of  the  civilization  of  another 
country;  and  of  a  Chautauqua  association  whose  primary  purpose  is 
to  give  lectures  on  subjects  useful  to  the  individual  and  beneficial  to 
the  community  and  whose  amusement  features  are  incidental  to  this 
purpose.  But  associations  formed  to  disseminate  controversial  or 
partisan  propaganda  are  not  educational  within  the  meaning  of  the 
statute.  Scientific  corporations  include  an  association  for  the  scien- 
tific study  of  law,  to  the  end  of  improvement  in  its  administration. 

(2)  Where  a  religious  corporation  owns  a  large  quantity  of  farm 
land  and  works  it,  and  also  manufactures  and  sells  clothing  and  other 
articles  for  profit,  it  is  not  operated  exclusively  for  religious  purposes 
and  is  not  exempt,  even  though  its  property  is  held  in  common  and 
its  profits  do  not  inure  to  the  benefit  of  individual  members  of  the 
society. 

(3)  It  does  not  prevent  exemption  that  private  individuals,  for 
whose  benefit  a  charity  is  organized,  receive  the  income  of  the  cor- 
poration or  association.  The  statute  refers  to  individuals  having  a 
personal  and  private  interest  in  the  activities  of  the  corporation,  such 
as  stockholders.  If,  however,  a  corporation  issues  "voting  shares," 
which  entitle  the  holders  upon  the  dissolution  of  the  corporation  to 
receive  the  proceeds  of  its  property,  including  accumulated  income, 
the  right  to  exemption  does  not  exist,  even  though  the  by-laws  pro- 
vide that  the  shareholders  shall  not  receive  any  dividend  or  other 
return  upon  their  shares.     (Art.  517.) 

This  article  now  includes  community  chests,  funds,  or 
foundations,  and  literary  societies.  The  inhibition  against 
orchestral  societies  and  against  trusts,  the  income  of  which 
is  used  for  religious  purposes,  is  now  removed. 

Rulings.  The  M  Hospital  Association  was  incorporated  under 
the  laws  of  the  State  of  Y  to  build,  own,  lease,  acquire,  and  operate 
a   hospital   to    furnish    and    provide    medical,    surgical,    and    hospital 


EXEMPT    CORPORATIONS 


41 


services  and  care  to  all  employees  of  other  corporations,  persons,  or 
partnerships  with  whom  contracts  may  be  made.  Said  services  are 
intended  to  take  care  of  the  needs  of  sick  and  injured  employees  re- 
quiring and  entitled  to  such  care  by  virtue  of  membership  in  said 
corporations  and  in  conformity  to  the  provisions  of  the  by-laws  of 
the  corporation  and  the  care  of  injured  employees  as  contemplated 
and  provided  for  m  the  laws  of  the  State  of  Y  and  the  rules,  regula- 
tions, and  practices  now  or  hereafter  promulgated  by  the  State  Med- 
ical Aid  Board.  The  corporation  also  contemplates  hospital  services 
and  care  for  the  families  of  employees  and  for  other  persons. 

The  income  of  the  association  is  received  from  the  corporations 
with  which  it  has  contractual  relations,  from  the  Medical  Aid  De- 
partment of  the  State  for  services  to  injured  employees  who  do  not 
have  contract  arrangements,  and  from  direct  payments  by  patients. 
No  patients  are  treated  free,  but  where  destitute  patients  have  been 
admitted  as  objects  of  public  charge  the  services  are  rendered  at 
cost  to  the  municipal  corporation  paying  for  such  services. 

Based  upon  the  foregoing  facts,  it  is  held  that  the  M  Hospital  As- 
sociation is  not  a  charitable  organization  within  the  meaning  of  sec- 
tion 231  (6)  of  the  Revenue  Act  of  1918,  and  that  it  will  be  required 
to  file  returns  of  annual  net  income  and  pay  any  tax  shown  to  be  due. 
(B.  33-21-1769;  O.  D.  993.) 

A  memorial  fund  of  which  the  M  Corporation  is  trustee  is  con- 
trolled by  a  board  of  directors.  It  is  organized  not  to  engage  in  a 
charitable  undertaking  itself,  but  to  distribute  its  income  to  chari- 
table institutions  and  to  worthy  individuals.  Held,  it  is  not  a  chari- 
table corporation  or  association  within  the  provisions  of  section  11 
(a)  Sixth  of  the  Revenue  Act  of  1916  as  amended,  or  section  231 
(6)   of  the  Revenue  Act  of  1918. 

To  hold  such  an  organization  exempt  and  relieve  it  from  filing 
returns  of  income  and  paying  taxes  thereon  would  in  effect  delegate 
to  it  authority  to  determine  what  institutions  and  gifts  are  charitable, 
which  is  not  permissible. 

Consequently,  contributions  made  to  such  a  fund  are  not  deductible 
under  section  5  (a)  Ninth  of  the  Revenue  Act  of  1916  as  amended, 
or  section  214  (a)  11  of  the  Revenue  Act  of  1918.  (C.  B.  4,  page 
264;  O.  D.  872.) 

A  private  corporation  without  capital  stock  was  organized  and  is 
operated  under  State  laws  and  managed  by  a  board  of  trustees  for  the 
purpose  of  conducting  a  school  to  educate  and  train  men  and  women 
in  those  subjects  that  will  prepare  them  for  practical  business  and 
commercial  and  industrial  occupations.  It  derives  its  income  from 
tuition  fees  paid  by  students  attending  its  courses.  After  payment  of 
expenses  the  balance  remaining  is  placed  in  an  operating  fund  to 
meet  operating  expenses  in  the  future.    If  this  operating  fund  exceeds 


42  APPLICATION    AND    ADMINISTRATION 

the  current  year's  income,  any  amount  in  excess  of  25  per  cent  is 
placed  in  a  students'  loan  fund  from  which  deserving  students  may 
borrow  money  for  the  purpose  of  pursuing  a  course  of  study  in  the 
school.  No  part  of  the  earnings  of  the  school  inures  to  the  benefit  of 
any  individual  or  individuals  connected  with  the  corporation  in  any 
manner  whatever,  and  the  by-laws  provide  that  no  remuneration  of 
any  kind  shall  be  paid  to  the  board  of  trustees  for  their  services  as 
such. 

The  corporation  is  held  to  be  exempt  from  taxation  under  the  pro- 
visions of  section  231  (6).     (B.  46-21-1923;  O.  D.  1102.) 

A  corporation  organized  for  the  purpose  of  conducting  a  military 
school  for  profit,  the  stock  of  which  is  owned  entirely  by  the  officers, 
directors,  and  teachers  of  the  institution,  is  not  exempt  from  income 
tax  as  an  educational  institution  no  part  of  the  net  earnings  of  which 
inures  to  the  benefit  of  any  private  stockholder  or  individual  within 
the  meaning  of  subdivision  6,  section  231,  Revenue  Act  of  1918. 

The  term  "private"  is  not  used  in  the  statute  in  contradistinction 
to  "official,"  whether  the  latter  be  used  in  a  military  or  an  institutional 
sense,  but  as  the  antonym  of  "public,"  the  supposed  beneficiary  of 
the  benevolent  activities  of  an  institution  devoted  exclusively  to 
public  betterment;  private  pecuniary  profit  and  gain  is  the  test  to 
be  applied,  and  the  officers,  directors,  and  teachers  of  a  military 
school  corporation,  owning  the  stock  thereof,  are  "private  stock- 
holders" within  the  meaning  of  the  Act.  (C.  B.  4,  page  266;  T.  D. 
3164.) 

A  publishing  corporation  which  is  primarily  religious  in  character, 
but  not  exclusively  so,  does  not  come  within  the  exemption  provided 
in  section  231  (6)  of  the  Revenue  Act  of  1918.  (B.  Digest  51-21- 
1983;  O.  D.  1 142.) 

A  lyceum  and  Chautauqua  association  was  organized  to  take  over 
the  assets  of  a  partnership  for  the  purpose  of  promoting  the  intel- 
lectual, social,  physical,  moral,  and  nonsectarian  religious  welfare 
of  the  people  in  the  places  where  it  operates  and  especially  in  the 
United  States. 

Its  income  is  received  from  admission  charges  to  its  entertain- 
ments. The  income  is  used  first  to  defray  expenses  of  operating;  sec- 
ond to  the  payment  of  the  members  of  the  partnership  for  assets 
purchased,  and  third,  to  build  up  a  surplus.  The  members  of  the 
partnership  whose  assets  were  taken  over  were  made  life  members 
of  the  board  of  trustees. 

Held,  that  the  association  is  engaged  in  an  ordinary  business  en- 
terprise and  is  precluded  from  exemption  under  any  of  the  provisions 
of  section  231  of  the  Revenue  Act  of  1918.  (B.  43-21-1886;  O.  D. 
1077.) 


EXEMPT    CORPORATIONS 


43 


Chambers  of  commerce,  etc. — 

Law.  Section  231.  ....  (7)  Business  leagues,  chambers  of 
commerce,  or  boards  of  trade,  not  organized  for  profit  and  no  part 
of  the  net  earnings  of  which  inures  to  the  benefit  of  any  private  stock- 
holder or  individual;   .... 

Regulation,  A  business  league  is  an  association  of  persons 
having  some  common  business  interest,  which  limits  its  activities  to 
work  for  such  common  interest  and  does  not  engage  in  a  regular 
business  of  a  kind  ordinarily  carried  on  for  profit.  Its  work  need 
not  be  similar  to  that  of  a  chamber  of  commerce  or  board  of  trade. 
The  fact  that  it  engages  in  a  regular  business  of  a  kind  ordinarily 
carried  on  for  profit  but  on  a  cooperative  basis  or  so  as  to  produce 
only  sufficient  income  to  be  self-sustaining,  is  not  ground  for  exemp- 
tion. An  association  engaged  in  furnishing  information  to  pros- 
pective investors,  to  enable  them  to  make  sound  investments,  is  not 
such  a  league,  since  its  members  have  no  common  business  interest, 
and  it  is  not  exempt,  even  though  all  of  its  income  is  devoted  to  the 
purpose  stated.  A  clearing  house  association,  not  organized  for 
profit,  no  part  of  the  net  income  of  which  inures  to  any  private  stock- 
holder or  individual,  is  exempt  provided  its  activities  are  limited  to 
the  exchange  of  checks  and  similar  work  for  the  common  benefit 
of  its  members.  An  association  of  persons  who  are  engaged  in  the 
business  of  carrying  freight  and  passengers  by  boats  propelled  by 
steam,  which  is  designed  to  promote  the  legitimate  objects  of  such 
business,  and  all  of  the  income  of  which  is  derived  from  membership 
dues  and  is  expended  for  office  expenses  and  the  salary  of  a  secretary- 
treasurer,  is  exempt  from  tax.  An  incorporated  cotton  exchange  whose 
shares  carry  the  right  to  dividends  is  organized  for  profit  and  is 
not  exempt.     (Art.  518.) 

The  only  change  in  this  regulation  is  the  insertion  of  the 
third  sentence  which  contains  the  substance  of  a  192 1  ruling 
(C.  B.  4,  page  266;  O.  D.  786). 

Civic  leagues. — 

Law.  Section  231.  ....  (8)  Civic  leagues  or  organizations 
not  organized  for  profit  but  operated  exclusively  for  the  promotion  of 
social  welfare;  .... 

Regulation.  A  corporation  having  capital  stock  and  possessing 
a  charter  which  authorizes  it  to  buy,  improve,  and  sell  real  estate  is 
organized  for  profit  within  the  meaning  of  the  statute  and  is  not 
exempt  from  tax  as  a  civic  league  or  organization,  even  though  it 
no  longer  exercises  such  powers  for  profit  and  is  operated  exclusively 
for  the  promotion  of  social  welfare.     (Art.  519.) 


44 


APPLICATION    AND   ADMINISTRATION 


Social  clubs. — 

Law.  Section  231.  ....  (9)  Clubs  organized  and  operated 
exclusively  for  pleasure,  recreation,  and  other  nonprofitable  purposes, 
no  part  of  the  net  earnings  of  which  inures  to  the  benefit  of  any  private 
stockholder  or  member;  .... 

Regulation.  The  exemption  applies  to  practically  all  social  and 
recreation  clubs  which  are  supported  by  membership  fees,  dues,  and 
assessments.  If  a  club,  by  reason  of  the  comprehensive  powers 
granted  in  its  charter,  engages  in  traffic,  in  agriculture  or  horticul- 
ture, or  in  the  sale  of  real  estate,  timber,  etc.,  for  profit,  such  club 
is  not  organized  and  operated  exclusively  for  pleasure,  recreation,  or 
social  purposes,  and  any  profit  realized  from  such  activities  is  sub- 
ject to  tax.     (Art.  520.) 

Rulings.  A  provision  in  the  by-laws  of  a  country  club,  that,  in 
the  event  of  the  dissolution  of  the  club,  the  holder  of  a  life  member- 
ship shall  participate  in  the  distribution  of  the  assets  of  the  club  after 
its  other  debts  are  paid  and  before  any  sums  are  paid  to  either  regular 
members  or  shareholders,  is  not  alone  sufficient  to  make  the  club 
liable  to  render  income  tax  returns.     (C.  B.  i,  page  202;  S.  958.) 

A  club  formed  for  the  purpose  of  providing  for  the  members 
thereof  a  suitable  meeting  place,  a  library,  and  a  dining  room,  where 
meals  will  be  furnished  to  the  members,  the  income  being  derived 
from  membership  dues  and  the  receipts  for  food,  wine,  and  cigars 
purchased  by  members,  and  no  part  of  the  net  earnings  inuring  to 
the  private  benefit  of  any  member,  is  entitled  to  exemption  from 
taxation  and  will  not  be  required  to  file  returns  of  annual  net  income. 
(C.  B.  1,203;  O.  D.  108.) 

Mutual  insurance  companies,  etc. — Included  under 
this  caption  are  mutual  hail,  cyclone  or  fire  insurance  com- 
panies, mutual  ditch  or  irrigation  companies,  and  mutual  or 
co-operative  telephone  companies.  For  law  and  regulations, 
see  Chapter  XXXVIII,  "Insurance  Companies." 

Co-operative  associations,  etc- — 

Law.     Section  231 (11)  Farmers',  fruit  growers',  or  like 

associations,  organized  and  operated  as  sales  agents  for  the  purpose 
of  marketing  the  products  of  members  and  turning  back  to  them  the 
proceeds  of  sales,  less  the  necessary  selling  expenses,  on  the  basis 
of  the  quantity  of  produce  furnished  by  them;  or  organized  and  oper- 
ated as  purchasing  agents  for  the  purpose  of  purchasing  supplies  and 
equipment  for  the  use  of  members  and  turning  over  such  supplies  and 
equipment  to  such  members  at  actual  cost,  plus  necessary  expenses; 


EXEMPT   CORPORATIONS  45 

The  second  half  of  subsection  (11)  which  refers  to  pur- 
chasing operations,  is  a  new  provision  of  the  192 1   law. 

Regulation,  (a)  Cooperative  associations,  acting  as  sales 
agents  for  farmers,  fruit  growers,  dairymen,  etc.,  and  turning  back 
to  them  the  proceeds  of  the  sales,  less  the  necessary  selling  expenses, 
on  the  basis  of  the  produce  furnished  by  them,  are  exempt  from  in- 
come tax.  Thus  cooperative  dairy  companies,  which  are  engaged  in 
collecting  milk  and  disposing  of  it  or  the  products  thereof  and  dis- 
tributing the  proceeds,  less  necessary  operating  expenses,  among  their 
members  upon  the  basis  of  the  quantity  of  milk  or  of  butter  fat  in 
the  milk  furnished  by  such  members,  are  exempt  from  the  tax.  If  the 
proceeds  of  the  business  are  distributed  in  any  other  way  than  on  such 
a  proportionate  basis,  or  if  the  association  deducts  more  than  neces- 
sary selling  expenses,  it  does  not  meet  the  requirements  of  the  statute 
and  is  not  exempt.  The  maintenance  of  a  reasonable  reserve  for  de- 
preciation or  possible  losses  or  a  reserve  required  by  State  statute  will 
not  necessarily  destroy  the  exemption.  A  corporation  organized  t®  act 
as  a  sales  agent  for  farmers  and  having  a  capital  stock  on  which  it 
pays  a  fixed  dividend  amounting  to  the  legal  rate  of  interest,  all  of  the 
capital  stock  being  owned  by  such  farmers,  will  not  for  that  reason 
be  denied  exemption. 

(b)  Cooperative  associations  organized  and  operated  as  purchas- 
ing agents  for  farmers,  fruit  growers,  dairymen,  etc.,  for  the  purpose 
of  buying  supplies  and  equipment  for  the  use  of  members  and  turning 
over  such  supplies  and  equipment  to  members  at  actual  cost, 
plus  necessary  expenses,  are  also  exempt.  In  order  to  be  exempt 
under  either  (o)  or  (&)  an  association  must  establish  that  it  has  no  net 
income  from  its  own  account.  An  association  acting  both  as  a  sales 
and  a  purchasing  agent  is  exempt  if  as  to  each  of  its  functions  it 
meets  the  requirements  of  the  statute.     (Art.  522.) 

This  article  now  permits  a  sales  organization  to  be  incor- 
porated and  to  pay  a  fixed  dividend  on  its  capital  stock  without 
forfeiting  its  right  to  exemption.  A  purchasing  agency  is  now 
entitled  to  exemption. 

Rulings.  An  incorporated  fruit  growers'  union  which  conducts 
its  business  at  a  profit,  thereby  accumulating  a  fund  out  of  which 
dividends  are  paid,  is  deprived  of  exemption  from  tax  if  it  allows 
persons  who  are  not  fruit  growers  to  acquire  stock  and  thus  share  in 
the  profits.  To  the  extent  that  it  has  such  stockholders  it  loses  its 
character  as  sales  agent  acting  for  the  mutual  benefit  of  the  fruit 
growers,  and  accordingly  its  exemption  from  tax  also.  The  union 
may,  however,  deduct  from  gross  income  amounts  periodically  re- 
turned to  members  as  a  refund  of  profits  on  business  transacted  with 


46  APPLICATION   AND   ADMINISTRATION 

them,  and  proportioned  to  the  amount  of  such  business.  (C.  B.  i, 
page  208;  O.  D.  64.) 

A  cooperative  store  managed  by  a  university  for  the  purpose  of 
selling  to  its  students  supplies  of  every  kind,  and  in  case  of  dissolu- 
tion its  property  reverting  to  the  trustees  of  the  school,  does  not  come 
within  the  class  of  corporations  organized  for  the  exclusive  pur- 
pose of  holding  title  to  property,  collecting  income  therefrom,  and 
turning  over  the  entire  amount  thereof.  It  is  actively  engaged  in 
the  operation  of  a  business  in  which  profits  are  realized  and  will, 
therefore,  be  required  to  file  returns  of  annual  net  income  and  to 
pay  any  tax  thereby  shown  to  be  due.     (C.  B.  i,  page  208;  O.  D.  65.) 

It  is  hardly  possible  that  any  actual  profit  would  accrue 

to  a  university  store.     Before  paying  tax  on   an  apparent 

profit  from  such  a  project  as  that  described  in  the  last  ruling, 

a  university  should  make  sure  that  all  proper  charges,  such 

as  rent  for  quarters  furnished  the  store,  etc.,  are  deducted. 

Ruling.  A  cooperative  apartment-owning  corporation,  which  de- 
rives its  income  from  collecting  the  expense  of  operating  the  apart- 
ments each  month  from  its  members,  each  of  whom  is  entitled  to 
occupy  an  apartment  in  the  building,  is  not  exempt  from  taxation. 
(B.  Digest,  38-21-1832;  O.  D.  1042.) 

Corporations  serving  exempt  corporations. — 

Law.     Section  231 (12)  Corporations  organized  for  the 

exclusive  purpose  of  holding  title  to  property,  collecting  income  there- 
from, and  turning  over  the  entire  amount  thereof,  less  expenses,  to  an 
organization  which  itself  is  exempt  from  the  tax  imposed  by  this 
title  ;i*  .... 

Federal  land  banks. — 

Law.  Section  231.  ....  (13)  Federal  land  banks  and  national 
farm-loan  associations  as  provided  in  section  26  of  the  act  approved 
July  17,  1916,  entitled  "An  Act  to  provide  capital  for  agricultural  de- 
velopment, to  create  standard  forms  of  investment  based  upon  farm 
mortgage,  to  equalize  rates  of  interest  upon  farm  loans,  to  furnish 
a  market  for  United  States  bonds,  to  create  Government  depositaries 
and  financial  agents  for  the  United  States,  and  for  other  purposes"; 


Personal  service  corporations. — 

Law.     Section     231 (14)  Personal     service     corpora- 


"  [Former  Procedure]     Such    corporations    were    taxable    under    the 
1913  law,  T.  D.  2137   (January  30,   1915)- 


EXEMPT    CORPORATIONS  47 

tions.'^     This  subdivision   shall  not  be  in  effect   after   December   31, 
1921. 

Corporations  of  this  type  were  first  distinguished  from 
corporations  in  general  in  the  191 8  law,  which  defined  them 
as  follows : 

1918  Law.  Section  200.  ....  The  term  "personal  service  cor- 
poration" means  a  corporation  whose  income  is  to  be  ascribed  primarily 
to  the  activities  of  the  principal  owners  or  stockholders  who  are  them- 
selves regularly  engaged  in  the  active  conduct  of  the  affairs  of  the  cor- 
poration and  in  which  capital  (whether  invested  or  borrowed)  is  not 
a  material  income-producing  factor;   .... 

This  definition  has  been  re-enacted  into  the  1921  law. 
For  regulations  and  procedure,  see  Chapter  XXIV. 

Establishing  a  right  to  exemption. — -A  corporation  is  not 
exempt  from  the  tax  merely  because  it  is  not  organized  and 
operated  primarily  for  profit.  If  it  does  not  come  within 
one  of  the  fourteen  classes  enumerated  above,  it  is  taxable  even 
though  the  purpose  of  the  corporation  may  not  be  to  operate 
for  the  profit  of  its  members  or  stockholders. 

Not  all  of  the  corporations  mentioned  in  the  above  classes 
are  unconditionally  exempt.  In  all  cases  in  which  a  condition 
is  inserted,  such  as  to  the  effect  that  no  part  of  the  net  earn- 
ings shall  inure  to  the  benefit  of  any  private  stockholder,  the 
right  to  exemption  must  be  demonstrated  in  accordance  with 
the  following  regulation : 

Regulation.  In  order  to  establish  its  exemption,  and  thus  be 
relieved  of  the  duty  of  filing  returns  of  income  and  paying  the  tax,  it 
is  necessary  that  every  organization  claiming  exemption,  except  per- 
sonal service  corporations,  file  an  affidavit  with  the  collector  of  the 
district  in  which  it  is  located,  showing  the  character  of  the  organiza- 
tion, the  purpose  for  which  it  was  organized,  the  sources  of  its  in- 
come and  its  disposition,  whether  or  not  any  of  its  income  is  credited 
to  surplus  or  may  inure  to  the  benefit  of  any  private  stockholder  or 
individual,  and  in  general  all  facts  relating  to  its  operations  which 
affect  its  right  to  exemption.     To  such  affidavit  should  be  attached 


"*  [Former  Procedure]  As  the  14th  type  of  exempt  corporation  the 
1916  law  gave  the  following :  "Joint-stock  land  bank,  as  to  income  derived 
from  bonds  or  debentures  of  other  joint-stock  land  banks  or  any  federal 
land  bank  belonging  to  such  joint-stock  land  bank." 


48  APPLICATION   AND   ADMINISTRATION 

a  copy  of  the  charter  or  articles  of  incorporation  and  by-laws  of  the 
organization,  upon  receipt  of  the  affidavit  and  other  papers  by  the 
Collector,  he  will  inform  the  organization  whether  or  not  it  is  exempt. 
If,  however,  the  collector  is  in  doubt  as  to  the  taxable  status  of  the  or- 
ganization, he  will  refer  the  affidavit  and  accompanying  papers  to 
the  Commissioner  for  decision.  When  an  organization  has  estab- 
lished its  right  to  exemption,  it  need  not  thereafter  make  a  return  of 
income  or  any  further  showing  with  respect  to  its  status  under  the 
law,  unless  it  changes  the  character  of  its  organization  or  operations 
or  the  purpose  for  which  it  was  originally  created.  Collectors  will 
keep  a  list  of  all  exempt  corporations,  to  the  end  that  they  may 
occasionally  inquire  into  their  status  and  ascertain  whether  or  not 
they  are  observing  the  conditions  upon  which  their  exemption  is 
predicated.  Personal  service  corporations  are  not  exempt  after  De- 
cember 31,  1921 ;  see  section  218  of  the  statute  and  articles  336-339. 
(Art.  511.) 

The  new  article  inserts  the  statement  that  the  exemption 
of  personal  service  corporations  expires  December  31,  1921, 
as  a  result  of  the  change  in  status  of  these  corporations  after 
that  date.  It  also  provides  that  the  Commissioner,  not  the 
collector,  will  decide  whether  corporations  are  exempt. 

Ruling.  An  organization  which  would  otherwise  be  exempt 
from  taxation  but  which  operates  in  a  nonexempt  manner  is  not  en- 
titled to  exemption  under  the  provisions  of  section  231  of  the  Revenue 
Act  of  1918;  and  furthermore,  an  organization  which  is  ordinarily 
exempt  but  which  owns  property  in  excess  of  its  needs  and  carries 
on  industrial  pursuits  distinct  from  its  exempt  activities  is  not  exempt 
from  taxation.     (C.  B.  4,  page  261 ;  O.  D.  953.) 

If  there  is  any  doubt  concerning  the  status  of  a  corporation 
under  the  law,  it  should  file  a  return  (in  blank,  if  desired) 
and  attach  thereto  a  statement  setting  forth  fully  the  facts 
mentioned  above.  This  will  enable  it  to  avoid  the  imposition  of 
penalties  should  the  Treasury  later  hold  it  to  be  taxable. 

Section  231  is  applicable  to  both  foreign  and  domestic  cor- 
porations alike,  except  that  foreign  building  and  loan  associa- 
tions and  co-operative  banks  are  not  exempt.  If  doubt  exists 
as  to  whether  a  foreign  corporation  comes  within  the  classes 
of  exempt  organizations  enumerated,  an  affidavit  showing  all 
the  material  facts  must  be  presented  to  the  Treasury,  which 
will  then  examine  the  claim  and  determine  its  status. 


EXEMPT    CORPORATIONS 


49 


Ruling.  In  dealing  with  cases  coming  under  section  231,  the 
character  of  the  corporation  must  be  judged  by  its  articles  of  incor- 
poration, constitution,  and  by-laws  rather  than  by  the  declarations  of 
its  officers  or  the  method  by  which  it  conducts  or  has  conducted  its 
business.  Accordingly,  if  the  activities  of  a  company  are  confined 
to  cooperative  selling  for  the  benefit  of  its  patrons,  but  it  is  granted 
additional  powers  by  its  charter,  it  will  nevertheless  be  required  to 
file  returns  and  pay  the  tax  if  any  is  shown  to  be  due.  (C.  B.  i,  page 
194;  O.  D.  190.) 

The  foregoing  ruling  may  operate  to  defeat  the  purpose 
of  the  law.  The  law  exempts  "organizations"  and  contains 
no  requirements  as  to  by-laws,  etc.  An  organization  which 
is  entitled  to  exemption  on  meritorious  grounds  will  get  it 
even  though  its  by-laws  are  improperly  drawn. 

The  following  summary  of  a  recent  case  illustrates  the 
attitude  taken  by  the  courts  in  deciding  doubtful  questions  :^  ■' 

Exemption  of  a  building  owned  and  used  by  a  church  for  mission- 
ary work  was  contested  as  not  being  a  "purely  public  charity"  within 
the  meaning  of  the  Pennsylvania  constitution.  The  court  sustained 
the  exemption,  holding  that  such  a  charity  was  not  necessarily  one 
solely  controlled  by  the  state  as  claimed  but  extended  to  a  private 
charitable  institution  not  administered  for  individual  gain;  that  the 
true  test  was  the  character  of  the  objects  sought  to  be  attained. 

Exempt  corporations  must  withhold  taxes  and  furnish 
information. — A  corporation  exempt  as  to  its  income  is  not 
thereby  exempt  from  "the  witholding  requirements^^  nor 
from  furnishing  information  in  accordance  with  the  pro- 
visions of  the  Act^^  .  .  .  ." 

While  under  the  law  only  such  corporations  as  are  sub- 
ject to  the  tax  imposed  are  specifically  required  to  make  annual 
returns  of  net  income,  the  Treasury  under  the  law  may  require 
such  returns.     It  is  not  an  unreasonable  requirement. 

Salaries  paid  by  an  exempt  corporation  are,  of  course, 
taxable  to  the  recipient. ^^ 

^' Board  of  Home  Missions  v.  City  of  Philadelphia,  109  Atl.  664;  266 
Pa.  405. 

"  See  Chapter  XL 
"  See  Chapter  X. 
"  Section  213. 


50  APPLICATION    AND   ADMINISTRATION 

Holding  companies  exempt  on  certain  dividends  re- 
ceived.— The  provision  of  the  law  which  permits  corporations 
to  deduct  dividends  received  from  other  corporations  [section 
234  (a-6)]  operate  to  exempt  the  income  of  the  "not  doing 
business"  type  of  holding  company  from  this  source.^"  This, 
of  course,  is  not  an  express  exemption  of  that  type  of  corpora- 
tion. Practically  it  amounts  to  this,  however,  in  the  case 
of  a  holding  company  which  receives  no  income  except  divi- 
dends from  other  companies.  Even  though  it  has  no  taxable 
income  a  holding  company  must  make  a  return. 

Income  of  states  from  public  utilities. — In  addition  to 
exempt  corporations,  there  is  another  "exemption  of  the  per- 
son" which  should  be  considered  in  this  chapter.  Since  the 
federal  government  possesses  no  power  to  tax  income  which 
accrues  to  states  or  political  subdivisions  thereof,  the  income 
received  by  such  states  from  public  utilities  or  from  the  exer- 
cise of  governmental  functions  is  not  taxable. 

Law.     Section    213.     That    ....     the    term    "gross    income" — 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title:  .... 

(7)  Income  derived  from  any  public  utility  or  the  exercise  of  any 
essential  governmental  function  and  accruing  to  any  State,  Territory, 
or  the  District  of  Columbia,  or  any  political  subdivision  of  a  State 
or  Territory,  or  income  accruing  to  the  Government  of  any  possession 
of  the  United  States,  or  any  political  subdivision  thereof. 

Whenever  any  State,  Territory,  or  the  District  of  Columbia,  or 
any  political  subdivision  of  a  State  or  Territory,  prior  to  September  8, 
1916,  entered  in  good  faith  into  a  contract  with  any  person,  the  object 
and  purpose  of  which  is  to  acquire,  construct,  operate,  or  maintain  a 
public  utility,  no  tax  shall  be  levied  under  the  provisions  of  this  title 
upon  the  income  derived  from  the  operation  of  such  public  utility,  so 
far  as  the  payment  thereof  will  impose  a  loss  or  burden  upon  such 
State,  Territory,  District  of  Columbia,  or  political  subdivision;  but  this 
provision  is  not  intended  and  shall  not  be  construed  to  confer  upon 


"  [Former  Procedure]  The  societies  for  the  prevention  of  cruelty 
were  held  to  be  exempt  (Buttcrick  Co.  v.  U.  S.,  240  Fed.  539;  appeal  dis- 
missed, 248  U.  S.  587;  63  L.  Ed.  434;  39  Sup.  Ct.  5).  Under  the  1913,  1916, 
and  1917  laws,  holding  companies  are  held  to  be  taxable.  (Boston  Terminal 
Co.  V.  Gill,  24b  Fed.  664;  158  C.  C.  A.  620.) 


EXEMPT    CORPORATIONS  51 

such  person  any  financial  gain  or  exemption  or  to  relieve  such  person 
from  the  payment  of  a  tax  as  provided  for  in  this  title  upon  the  part 
or  portion  of  such  income  to  which  such  person  is  entitled  under  such 
contract;  .... 

Regulation.  Income  derived  from  any  public  utility  or  the  ex- 
ercise of  any  essential  governmental  function  and  accruing-  to  any 
State  or  Territory  of  the  United  States,  or  to  any  political  subdivision 
thereof,  or  to  the  District  of  Columbia,  or  income  accruing  to  the 
Government  of  any  possession  of  the  United  States,  or  any  political 
subdivision  thereof,  is  exempt  from  tax.  See  art.  74.  The  income 
of  State  workmen's  compensation  insurance  funds  established  by 
State  statutes  is  not  taxable.  In  the  case  of  a  public  utility  acquired, 
constructed,  operated,  or  maintained  by  a  taxpayer  under  contract 
with  any  State,  Territory,  or  political  subdivision  thereof,  or  with 
the  District  of  Columbia,  containing  an  agreement  that  a  portion  of 
the  net  earnings  of  such  public  utility  shall  be  paid  to  the  State,  Ter- 
ritory, or  political  subdivision  thereof,  or  the  District  of  Columbia, 
the  amount  so  paid  may  be  deducted  by  the  taxpayer  as  a  necessary 
expense  in  transacting  business.  (See  sec.  214  (a)  (i)  of  the 
statute.     (Art.  87.) 

The  intent  of  the  Act,  in  so  far  as  corporations  are  con- 
cerned, is  apparently  to  permit  a  corporation,  in  which  a  state 
or  local  government  has  a  part  interest,  to  deduct  the  amount 
of  income  paid  to  the  state  or  local  government,  and  to  require 
the  tax  to  be  paid  only  upon  the  portion  which  accrues  to  the 
corporation  or  its  stockholders  or  to  private  persons. 

The  fact  that  a  public  tttility  may  be  under  contract  with 
any  state,  territory,  or  political  subdivision  thereof,  does  not 
imply  that  salaries  and  wages  paid  to  officers  and  employees 
of  such  ptiblic  utility  are  exempt  from  taxation.-^ 


See  Chapter  XIV. 


CHAPTER  III 

RETURNS— WHEN  AND  HOW  TO  MAKE  THEM 

The  income  tax  law  imposes  upon  taxpayers  the  duty  of 
"self-assessment,"  but  Congress  empowers  the  Commissioner 
of  Internal  Revenue  to  require  detailed  returns  so  that  there 
may  be  a  check  on  the  taxpayers'  methods  of  computation. 

Generally  speaking,  a  "return"  may  be  defined  as  a  state- 
ment of  taxable  net  income  or  of  information. 

Who  shall  make  returns? — A  return  shall  be  made  by 
every  individual  having  a  net  income  of 

1.  $i,ooo  or  more  if  single,  or  if  married  and  not  living 

with  husband  or  wife;^ 

2.  $2,000  or  more  if  married  and  living  with  husband 

or  wife. 

3.  $1,000  or  more  if  the  head  of  a  family,  even  though  in 

some  cases  no  tax  mayl^e  due,  and 

4.  $1,000  or  more  ($2,000  if  married)  if  a  minor  and 

not  dependent  on  the  parent. 

Also,  every  individual  having  a  gross  income  for  the  tax- 
able year  of  $5,000  or  over,  regardless  of  the  amount  of  his 
net  income,  must  file  a  return."  By  a  specific  provision,  a  re- 
turn is  required  if  the  aggregate  gross  income  of  husband  and 
wife  is  $5,000  or  over.  These  requirements  are  new  and 
will  enable  the  Treasury  to  scrutinize  the  deductions  which 
result  in  reducing  a  gross  income  of  over  $5,000,  below 
$1,000  or  $2,000,  as  the  case  may  be,  in  which  cases  no  return 
was  heretofore  required. 


^For  cases  of  changes  in  marital  status,  see  Chapter  XII.  Fiduciaries 
must  make  returns  for  individuals,  trusts  or  estates  for  which  they  act.  See 
Chapter  XXXVII.    For  returns  of  non-resident  aliens,  see  Chapter  XXXVI. 

"  [Former  Procedure]  Before  1921,  net  income  was  the  sole  basis  for 
individual  returns.  If  there  was  no  taxable  net  income,  no  return  was 
required. 

52 


RETURNS— WHEN    AND    HOW   TO    MAKE    THEM  53 

Every  partnership  and  corporation^  (not  specifically  ex- 
empt),* no  matter  if  it  has  no  net  income,  is  required  to  file 
an  annual  income  tax  return.  Partnerships  are  not  themselves 
taxable  upon  the  net  income  so  reported,  but  the  returns  must 
nevertheless  be  made.^  Personal  service  corporations,  for  the 
calendar  year  1921  only,  are  not  taxable  as  such  but  must 
make  returns.**  From  January  i,  1922,  personal  service  cor- 
porations are  taxed  as  ordinary  corporations,  except  that  no 
provision  seems  to  have  been  made  for  the  imposition  of  the 
capital  stock  tax  until  July  i,  1922. 

In  addition  to  these  statements  of  total  net  income  re- 
ceived, there  are  various  other  returns  to  be  made  under  the 
income  tax  law  which  give  to  the  Treasury  information  con- 
sidered essential  to  proper  administration.  The  more  impor- 
tant of  the  various  types  of  returns  are  considered  individually 
later.' 

Commissioner  may  require  any  returns  "necessary." — In 

addition  to  making  specific  provisions  for  certain  returns,  the 

law  grants  to  the  Commissioner  the  broad  and  inclusive  power 

to  require  any  returns  which  he  may  consider  necessary.     The 

authority  is  given  in  the  following  sections : 

Law.  Section  1300.  That  ....  every  person  liable  to  any  tax 
imposed  by  this  Act,  or  for  the  collection  thereof,  shall  keep  such 
records  and  render,  under  oath,  such  statements  and  returns,  and  shall 


'  The  term  "corporation"  includes  associations,  joint-stock  companies, 
and  insurance  companies  (section  i).  Corporations  must,  of  course,  file 
excess  profits  tax  returns.  Both  income  and  profits  tax  returns  are  now 
made  in  one  return. 

*  The  law  (section  239)  states  the  requirement  positively  rather  than 
negatively.  Exempt  corporations  must  establish  their  right  to  exemption. 
(See  Chapter  H.) 

'  [Former  Procedure]  Before  1918  no  income  tax  returns  were  re- 
(juired  from  partnerships  except  upon  call  from  the  Commissioner.  Excess 
profits  tax  returns  were  required  under  1917  law. 

"  For  a  definition  of  personal  service  corporation,   see  Chapter  XXIV. 

'  Detailed  illustrations  of  returns  under  the  1918  law  for  individuals 
api^ear  in  the  Appendix  of  Income  Tax  Procedure,  1920;  for  corporations 
in  the  Appendix  of  Excess  Profits  Tax  Procedure,  1921. 

Illustrations  of  returns  covering  special  features  under  the  1921  law, 
for  individuals,  appear  in  Chapter  VII,  and  for  corporations  in  Chapter  V 
of  the  excess  profits  tax  section  (Appendix  A)   of  this  volume. 


54 


APPLICATION    AND    ADMINISTRATION 


comply  with  such  regulations  as  the  Commissioner,  with  the  approval 
of  the  Secretary,  may  from  time  to  time  prescribe. 

Law.  Section  1307.  That  whenever  in  the  judgment  of  the  Com- 
missioner necessary  he  may  require  any  person,  by  notice  served  upon 
him,  to  make  a  return  or  such  statements  as  he  deems  sufficient  to 
show  whether  or  not  such  person  is  liable  to  tax. 

Law.  Section  1303.  That  the  Commissioner,  with  the  approval 
of  the  Secretary,  is  hereby  authorized  to  make  all  needful  rules  and 
regulations  for  the  enforcement  of  the  provisions  of  this  Act 

The  Treasury  requires  various  special  returns  which  give 
details  regarding  complicated  calculations,  such  as  those  in- 
volved in  ascertaining  depletion  allowances  and  income  from 
the  appreciation  of  property  A^alues.^ 

Time  for  fiUng  returns.^ — Returns  are  due  two  months 
and  fifteen  days  after  the  close  of  the  taxable  year,  except 
in  the  case  of  non-resident  aliens,  for  whom  see  Chapter 
XXXVI.  The  following  section  of  the  law  applies  to  the  an- 
nual returns  of  both  individuals  and  corporations.^" 

Law.  Section  227.  (a)  That  returns  (except  in  the  case  of  non- 
resident aliens)  1^  shall  be  made  on  or  before  the  fifteenth  day  of  the 
third  month  following  the  close  of  the  fiscal  year,  or,  if  the  return  is 
made  on  the  basis  of  the  calendar  year,  then  the  return  shall  be  made 
on  or  before  the  15th  day  of  March. 12   .... 

"Last  due  date." — 

Regulation.  The  last  due  date  is  the  last  day  upon  which  a 
return  is  required  to  be  filed  in  accordance  with  the  provisions  of  the 


*  Form  O  revised,  (oil  and  gas)  form  D  (minerals),  form  E  (coal), 
form  F  (non-metals),  form  T  (timber). 

°  For  extension  of  time,  see  page  55. 

^"  For  corporations,  see  section  241    (a). 

"  Non-resident  alien  individual  returns  under  the  i(j2i  law  need  not  be 
filed  until  the  fifteenth  day  of  the  sixth  month  following  the  close  of  the 
year   (sec  Chapter  XXXVI). 

"  [Former  Procedure]  The  laws  prior  to  1918  made  March  i  the  date 
for  filing  returns,  except  for  taxpayers  reporting  on  the  basis  of  fiscal  years. 
In  such  cases  the  return  was  due  sixty  days  after  the  close  of  the  fiscal 
year  [1913  law,  section  G  (c)  ;  1916  and  1917  laws,  section  13  (b)].  To 
cover  the  case  of  individuals  who  desired  to  change  from  a  calendar  to  a 
fiscal  year  under  the  power  granted  by  the  1918  law,  the  regulations  (Art. 
441)  provided  that  returns  for  fiscal  years  ending  during  1918  rnight  be 
made  "on  or  before  the  fifteenth  day  of  March,  igiQ-" 


RETURNS— WHEN    AND   HOW   TO    MAKE   THEM  55 

statute  or  the  last  day  of  the  period  covered  by  an  extension  of  time 
granted  by  the  collector  or  Commissioner.  When  the  last  due  date 
falls  on  Sunday  or  a  legal  holiday,  the  last  due  date  for  filing  returns 

will  be  the  day  following  such  Sunday  or  legal  holiday (Art. 

446,  Reg.  45,  Art.  447.) 

Filing  date  in  cases  of  liquidation. — A  concern  which 
goes  into  Hquidation  may  file  a  return  before  the  expiration 
of  its  taxable  year. 

Regulation A  corporation  going  into  liquidation  during 

any  taxable  year  may  upon  the  completion  of  such  liquidation  pre- 
pare a  return  covering  its  income  for  the  fractional  part  of  the  year 
during  which  it  was  engaged  in  business  and  may  immediately  file 
such  return  with  the  collector (Art.  651.) 

Although  a  liquidating  corporation  may  be  a  subsidiary 
of  a  holding  company,  the  regulations  permit  the  filing  of  a 
return  immediately  after  liquidation;  but  if  for  the  purposes 
of  a  consolidated  return  the  holding  company  desired  to  with- 
hold the  return  until  the  end  of  its  fiscal  year,  it  could  do  so. 
The  regulation  is  permissive,  not  mandatory. 

If  a  return  is  made  for  a  portion  of  a  taxable  year,  the 
exemptions  and  invested  capital  must  be  reduced. ^^  Since 
this  results  in  a  great  tax  it  is  advantageous  to  wait  until  the 
close  of  the  year. 

A  corporation  which  is  dissolved  before  the  close  of  its 
taxable  year  has  the  same  time  in  which  to  file  its  final  return 
as  if  it  had  continued  in  existence  during  its  entire  taxable 
year.^* 

Extensions  of  time  for  filing  returns. — In  the  case  of  both 
individuals  and  corporations : 

Law.  Section  227.  (a)  .  .  .  .  The  Commissioner  may  grant 
a  reasonable  extension  of  time  for  filing  returns  whenever  in  his  judg- 
ment good  cause  exists  and  shall  keep  a  record  of  every  such  exten- 
sion and  the  reason  therefor.     Except  in  the  case  of  taxpayers  who 


^^  Excess  Profits  Tax  Procedure,  1921,  pages  no,  259. 
"C.  B.  4,  page  277;  O.  D.  692. 


56  APPLICATION    AND   ADMINISTRATION 

are  abroad,  no  such  extension  shall  be  for  more  than  six  months.^s 

This  authorization  is,  of  course,  broad  enough'  to  permit 
general  extensions  as  well  as  extensions  in  the  cases  of  par- 
ticular taxpayers.  Authority  has  been  delegated  to  the  local 
collectors  of  internal  revenue  to  make  an  extension  of  thirty 
days  only  in  case  of  sickness  or  absence.  Power  to  grant 
other  extensions  rests  with  the  Commissioner." 

Extension  of  time  for  joint  return. — 

Ruling.  Where  a  husband  and  wife  file  a  joint  return  and  an 
extension  of  time  has  been  granted  to  either  of  them,  the  benefit  of 
the  extension  inures  to  both  and  it  will  be  unnecessary  for  the  other 
party  to  secure  additional  authority.     (C.  B.  2,  page  203;  O.  D.  521.) 

Application  to  the  collector  for  thirty-day  exten- 
sion IN  case  of  absence  or  sickness. — In  case  an  extension 
of  not  more  than  thirty  days  is  desired  because  of  absence  or 
sickness,  application  should  be  made  by  letter  to  the  local  col- 
lector with  whom  the  return  is  to  be  filed. 

Law.  Section  131 1.  [Section  3176,  Rev.  Stat.]  ....  If  the 
failure  to  file  a  return  or  list  is  due  to  sickness  or  absence,  the  collector 
may  allow  such  further  time,  not  exceeding  thirty  days,  for  making 
and  filing  the  return  or  list  as  he  deems  proper 

From  the  above  section  of  the  law,  it  clearly  appears  that 
application  may  be  made  after  the  expiration  of  the  period 
in  which  the  return  is  normally  required  to  be  filed;  but  the 
application  for  such  extension  must  not  be  delayed  beyond 
the  period  (thirty  days)  for  which  the  extension  is  desired. 
The  conditions  which  govern  extensions  of  time  in  cases  of 
individuals  and  corporations  are  fully  set  forth  in  the  follow- 
ing regulation : 


"  [Former  Procedure]  Under  the  1913  law  (section  3176)  the  Com- 
missioner was  authorized  to  grant  extensions  only  in  case  of  sickness  or 
absence  and  even  then  was  limited  to  thirty  days.  The  1916  law  [sec- 
tion 14  (c)]  introduced  this  provision:  "That  the  Commissioner  of  In- 
ternal Revenue  shall  have  authority,  in  the  case  of  either  corporations 
or  individuals,  to  grant  a  reasonable  extension  of  time,  in  meritorious  cases 
as  he  may  deem  proper."  The  six  months'  limitation  was  first  introduced 
in  the  191 8  law. 

'°See  page  58. 


RETURNS— WHEN    AND   HOW   TO    MAKE   THEM  57 

Regulation.  It  is  important  that  the  taxpayer  render  before  the 
return  due  date  a  return  as  complete  and  final  as  it  is  possible  for  him 
to  prepare.  However,  in  cases  of  sickness  or  absence,  collectors  are 
authorized  to  grant  an  extension  of  not  exceeding  30  days,  where  in 
their  judgment  such  further  time  is  actually  required  for  the  making 
of  an  accurate  return.  See  article  1002.  The  application  for  such 
extension  must  be  made  prior  to  the  due  date  of  the  return.  The 
absence  or  sickness  of  one  or  more  officers  of  a  corporation  at  the 
time  the  return  is  required  to  be  filed  will  not  be  accepted  as  a  reason- 
able cause  for  failure  to  file  the  return  within  the  prescribed  time, 
unless  it  is  satisfactorily  shown  that  there  were  no  other  principal 
officers  available  and  sufficiently  informed  as  to  the  affairs  of  the 
corporation  to  make  and  verify  the  return.  As  a  condition  of  granting 
an  extension  of  time  for  filing  a  return  the  collector  may  require 
the  submission  of  a  tentative  return  and  estimate  of  the  tax  and  the 
payment  of  one-fourth  of  the  estimated  amount  of  tax.  A  tentative 
return  should  be  made  on  the  usual  return  form,  plainly  marked 
"tentative"  at  the  top,  contain  a  statement  as  to  the  estimated  amount 
of  tax  believed  to  be  due,  and  be  properly  executed.  No  other  data 
need  be  given.  Tentative  returns  will  not  be  accepted  unless  per- 
mission is  obtained  previous  to  filing.  A  copy  of  the  authority  for 
filing  the  tenative  return  must  be  attached  thereto  when  filed.  Where 
a  taxpayer  has  filed  a  tentative  return  and  has  failed  to  file  a  com- 
plete return  within  the  period  of  the  extension  requested  by  him, 
the  complete  return  when  filed  is  subject  to  penalties  prescribed  for 
delinquency.  Where  a  tentative  return  has  been  filed  and  no  time 
has  been  fixed  within  which  a  complete  return  must  be  filed,  the  col- 
lector may  at  any  time  send  notice  to  the  taxpayer  to  file  a  complete 
return  within  a  period  of  time  therein  specified  by  him,  and  a  tax- 
payer who  fails  to  comply  with  such  request  will  incur  the  penalties 
prescribed  by  statute  for  delinquency  in  filing  a  return.  As  to  interest 
see  article  1003.  Collectors  should  not  grant  extensions  of  time  for 
filing  Forms  1096  and  1099.  Requests  for  such  extensions  should  be 
made  to  the  Commissioner.     (Art.  443.) 

The  new  article  requires  applications  to  collectors  for  ex- 
tensions, in  cases  of  absence  or  sickness,  to  be  made  prior  to 
the  due  date  of  the  returns.  The  former  procedure  was  to 
apply  for  the  extension  within  thirty  days  after  the  due  date  of 
the  return.  Forms  1040-T  (individuals)  and  1031-T  (part- 
nerships) are  no  longer  to  be  used  for  tentative  returns;  the 
ordinary  forms  plainly  marked  "tentative"  are  to  be  used.  A 
tentative  return  will  not  be  accepted  unless  previous  permis- 
sion to  file  such  a  return  has  been  given. 


58  APPLICATION    AND   ADMINISTRATION 

Applications  to  Commissioner  for  other  extensions. 
— Local  collectors  are  not  authorized  to  grant  extensions  of 
more  than  thirty  days  or  in  cases  other  than  those  of  sickness 
or  absence/^  The  circumstances  under  which  the  Commis- 
sioner may  grant  a  limited  further  extension  are  set  forth  in 
the  following  regulation. 

Regulation.  If  before  the  end  of  an  extension  of  thirty  days 
granted  by  the  collector  an  accurate  return  can  not  be  made,  an 
appeal  for  a  further  extension  must  be  made  to  the  Commissioner 
with  a  full  recital  of  the  causes  for  the  delay.  The  Commissioner 
will  not  grant  an  additional  extension  without  a  clear  showing  that 
a  complete  return  can  not  be  made  at  the  end  of  the  thirty  day  period. 
The  Commissioner  will  grant  no  such  extension  beyond  the  original 
due  date  of  the  third  installment  of  the  tax.  Either  a  complete  or  a 
tentative  return,  as  complete  as  possible  and  giving  a  ground  for 
assessment  of  the  tax,  must  be  submitted  on  or  before  the  due  date 
as  extended,  and  the  tax  shown  to  be  due  must  be  paid  with  the  sub- 
mission of  the  return.  If  a  complete  return  can  not  be  made  at  that 
time,  the  facts  must  be  submitted  to  the  Commissioner  for  such 
further  action  as  he  deems  warranted.  In  exceptional  circumstances 
the  taxpayer  may  apply  originally  to  the  Commissioner  for  an  ex- 
tension of  time (Art.  444.) 

Extension  of  time  for  filing  returns  due  March  15, 
1922.^^ — Under  the  law  collectors  may  grant  extensions  of 
thirty  days  in  case  of  sickness  or  absence.  The  Commissioner 
grants  extensions  up  to  six  months  "whenever  in  his  judgment 
good  cause  exists."  In  view  of  the  many  and  complicated 
problems  involved,  it  has  become  increasingly  difficult  for  in- 
dividuals and  corporations  to  prepare  their  returns  by  March 
15,  even  when  the'  law  remains  unchanged.     The  192 1  law  was 


"  See  page  56. 

''Corporations  were  granted  an  extension  to  May  15,  1920.  for  filing  the 
1919  returns.  Tentative  returns  had  to  be  filed  by  March  15  on  form  1120, 
on  which  was  written  "Tentative  Return."  It  was  only  necessary  to  show 
the  estimated  amount  of  tax  due.  The  return,  of  course,  had  to  be  accom- 
panied by  one-fourth  of  the  estimated  tax,  together  with  a  statement  setting 
forth  the  reason  why  the  return  could  not  be  completed  within  the  pre- 
scribed time  and  a  formal  request   for  the  extension. 

In  the  statement  granting  this  extension,  the  Commissioner  stated  that 
no  further  extension  would  be  granted  except  in  extraordinary  cases. 
(I.  T.  M.  2420,  dated  March  4,  1920.) 

There  was  no  general  extension  of  time  in  1921  but  individual  extensions 
were    granted  in  all  meritorious  cases. 


RETURNS— WHEN    AND   HOW   TO   MAKE   THEM  59 

not  passed  until  November  23,  192 1.  It  will-  not  be  possible 
for  taxpayers  to  secure  authoritative  interpretations  of  the 
law  and  adjust  their  accounts  before  March  15,  1922.  It  is 
possible,  however,  to  submit  tentative  returns  which  contain 
merely  an  estimate  of  the  amount  of  tax  due.  Since  the  gov- 
ernment can  require  that  at  least  25  per  cent  of  the  estimate 
be  paid  on  or  before  March  15,  and  since  in  no  event  is  any 
audit  made  of  the  returns  until  a  year  or  more  later,  it  may 
be  expected  that  the  Commissioner  will  freely  accept  tentative 
returns  on  March  15,  1922,  and  require  final  returns  by,  say, 
May  15.  There  are  corporations  with  ramifications  extend- 
ing the  world  over  which  have  never  before  or  since  the  exist- 
ence of  the  federal  income  tax  laws  been  able  to  close  their 
books  within  a  75-day  period.  The  Treasury  has  not  dealt 
harshly  with  this  class  of  taxpayers.  It  does,  however,  very 
properly  require  that,  when  additional  time  is  required,  it  shall 
be  asked  for  in  due  season  and  that  sound  reasons  shall  be 
given  for  the  request. 

When  taxpayers  live  abroad. — Section  227  (a)  of  the 
'law  provides  that  the  six  months'  limitation  shall  not  cover 
the  case  of  taxpayers  who  are  abroad.  American  citizens 
residing  abroad,  v^'ho,  because  of  war  conditions  or  of  absence 
from  the  country,  have  not  been  able  to  file  their  returns  for 
past  years,  may  take  advantage  of  this  provision,  which  oper- 
ates generally  and  without  request  by  the  taxpayer.  The  de- 
tails concerning  extensions  in  such  cases  a])pear  in  the  follow- 
ing regulation : 

Regulation.  Where  a  delinquent  return  is  filed  I)y  or  on  behalf 
of  a  person  who  is  abroad,  an  affidavit  must  be  attached  to  the  return, 
stating  the  cause  of  the  delay  in  filing  it,  in  order  that  the  commissioner 
may  determine  whether  the  failure  to  file  the  return  in  time  was 
due  to  a  reasonable  cause  and  whether  the  return  was  filed  without  any 
unnecessary  delay.  If  the  showing  justifies  the  conclusion  that  the 
failure  to  file  the  return  in  time  was  excusable,  no  penalty  will  be 
imposed.  The  installments  of  tax  which  are  actually  due  must  be 
paid  at  the  time  of  filing  the  return,  and  the  other  installments  shall 
be  paid  as  they  fall  due.     fn  case  an  extension  is  granted,  interest  is 


Co  APPLICATION    AND   ADMINISTRATION 

payable  at  the  rate  of  one-half  of  i  per  cent  per  month  from  the  time 
the  tax  would  have  been  due  if  no  extension  had  been  granted.  (Art. 
445-) 

The  extension  granted  under  the  old  regulation  was  to 
allow  for  the  disturbed  conditions  arising  from  the  war,  but 
the  new  article  is  apparently  applicable  in  any  case  where 
a  taxpayer  is  abroad  and,  in  consequence,  is  unable  to  file  his 
return. 

The  Treasury  held^®  that  the  old  article  445  applied  to 
domestic  corporations  which  transacted  their  business  and 
kept  their  books  of  account  abroad.  There  appears  to  be  no 
reason  why  a  similar  interpretation  should  not  be  applied  to 
the  new  article. 

Extension  of  time  for  non-resident  enemies. — 

Regulation.  An  extension  of  time  is  hereby  granted  for  such 
period  as  may  be  necessary,  not  exceeding  ninety  days  after  proclama- 
tion by  the  President  of  the  end  of  the  war  with  Germany,  for  filing 
returns  of  income  for  1918  and  subsequent  years  and  for  paying  the 
tax  by  or  for  nonresident  enemies  or  allies  of  enemies,  as  defined 
by  section  2  of  the  Trading  with  the  Enemy  Act  of  October  6,  191 7, 
not  holding  licenses  granted  under  the  provisions  of  that  act.  The 
whole  tax  shown  to  be  due  must  be  paid  at  the  time  of  filing  the 
return.  This  extension,  however,  does  not  authorize  any  delay  in 
filing  returns  of  information.  This  extension  is  also  subject  to  the 
condition  that  all  persons  who  on  October  6,  1917,  had  or  since  have 
had  or  may  hereafter  have  control  of  any  money  or  other  property 
for  any  such  enemy  or  ally  of  enemy,  or  who  on  October  6,  1917, 
were  or  since  have  been  or  may  hereafter  be  indebted  to  any  such 
enemy  or  ally  of  enemy,  shall  hold  and  deliver  all  said  money  and 
property  in  all  respects  subject  to  the  Trading  with  the  Enemy  Act 
and  to  the  orders  of  the  President  and  of  the  alien  property  cus- 
todian thereunder,  and  shall  in  due  course  file  returns  of  income  in 
respect  of  all  such  money  and  property  for  such  period  as  may  elapse 
or  have  elapsed  prior  to  the  actual  delivery  of  such  money  and 
property  to  the  alien  property  custodian (Reg.  45,  Art.  446.) 

This  article  does  not  appear  in  the  new  regulations.  It 
is  included  here  as  returns  under  it  may  be  made  until  Feb- 
ruary 12,  1922. 


C.  B.  2,  page  203;  O.  D.  443. 


RETURNS— WHEN    AND    HOW   TO   MAKE   THEM  6l 

"Termination  of  the  war" — when  ninety  day  period 
BEGINS  TO  RUN. — The  Joint  Resolution  of  Congress,^"  approved 
by  the  President  March  3,  192 1,  declared:  "That  in  the  inter- 
pretation of  any  provision  relating  to  the  duration  or  date 
of  the  termination  of  the  present  war  ....  the  date  when 
the  resolution  becomes  effective  shall  be  construed  and  treated 
as  the  date  of  the  termination  of  the  war  .   .  ." 

The  war  was  terminated  by  Joint  Resolution  of  Congress, 
approved  by  the  President  July  2,  1921.  The  proclamation 
of  the  President,  declaring  the  war  terminated  as  at  July  2, 
1 92 1,  was  issued  on  November  14,  192 1. 

For  purposes  of  amortization"'  the  Treasury  has  held  that 
the  war  terminated  on  March  3,  1921. 

The  Treasury  holds  that  the  ninety-day  extension  for 
filing  returns  in  case  of  taxpayers  abroad  dates  from  November 
14,  1 92 1.  The  President's  proclamation  of  November  14, 
1 92 1,  fixes  July  2,  1921,  as  the  date  of  the  termination  of  the 
war.  However,  it  can  hardly  be  contended  that  the  ninety- 
day  period  runs  from  July  2,  1921,  since  the  latest  date  for 
filing  returns  under  such  an  assumption  would  have  passed 
before  the  proclamation  was  signed  by  the  President  and  those 
concerned  were  thereby  notified. 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  March  11, 
1921,  requesting  to  be  advised  whether  the  joint  resolution  relating 
to  the  termination  of  the  war  for  certain  purposes  passed  by  Con- 
gress and  approved  by  the  President  on  March  3,  1921,  is  construed 
by  this  office  to  set  running  the  period  of  ninety  days  after  the  termin- 
ation of  the  war  granted  to  nonresident  enemies  for  filing  income  tax 
returns  for  19 18  and  subsequent  years  under  the  provisions  of  Article 
446  of  Regulations  45 

Article  446  of  Regulations  45  is  based  upon  the  authority  vested  in 
the  Commissioner  by  Section  227  of  the  Revenue  Act  of  1918  to 
grant  reasonable  extensions  of  time  for  filing  returns  whenever  in 
his  judgment  good  cause  exists.  Since  Section  227  does  not  relate  to 
the  duration  or  date  of  termination  of  the  present  war  with  Ger- 
many and  Austro-Hungary,  it  does  not  fall  within  the  purview  of 
the  Joint  Resolution  approved  March  3,  1921,    The  ninety  days  men- 


'  Public  No.  64 — 66th  Congress. 
See  Chapter  XXXH. 


62  APPLICATION   AND   ADMINISTRATION 

tioned  in  Article  446  will  become  effective  from  the  date  of  the 
termination  of  the  war  with  Germany  when  such  date  has  been 
established  by  the  President  through  a  proclamation.  Article  446  is 
still  in  effect  and  will  remain  in  effect,  until  revoked  either  by  oper- 
ation of  its  own  terms,  operation  of  law,  or  the  action  of  this  office. 
The  Joint  Resolution  approved  March  3,  1921,  therefore,  did  not 
affect  the  provisions  of  Article  446  of  Regulations  45.  (Letter 
signed  by  Commissioner  Wm.  M.  Williams,  dated  April  7,  1921.) 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  May  2'i^,  1921, 
in  which  you  inquire  whether  office  letter  of  April  7,  192 1,  is  not  in 
conflict  with  the  opinion  of  the  Solicitor  sent  you  under  date  of 
March  22,  1921,  in  answer  to  your  question  as  to  when  the  present 
war  was  terminated  for  amortization  purposes. 

In  the  opinion  of  the  Solicitor,  it  was  held  that  the  termination 
of  the  war  was  March  3,  1921,  in  view  of  the  Joint  Resolution  of 
Congress. 

In  office  letter  of  March  7,  i^ii,  this  office  held  that  Article  446, 
Regulations  45,  did  not  fall  within  the  purview  of  the  Joint  Resolution 
approved  March  3,  1921. 

Article  187,  Regulations  45,  is  based  on  Section  214  (a)  of  the 
Revenue  Act  of  1918,  which  provides,  in  part,  that  "at  any  time 
within  three  years  after  the  termination  of  the  present  war,  the  Com- 
missioner may,  and  at  the  request  of  the  taxpayer  shall,  re-examine 
the  return,  and  if  he  then  finds  as  a  result  of  an  appraisal  or  from 
other  evidence  that  the  deduction  originally  allowed  was  incorrect 
the  taxes  imposed  by  this  title  and  by  Title  III  for  the  year  or  years 
affected  shall  be  redetermined."  Article  187  is,  therefore,  affected  by 
the  date  of  the  termination  of  the  present  war.  Prior  to  the  approval 
of  the  Joint  Resolution,  the  date  of  the  termination  of  the  present 
war,  under  Section  i  of  the  Act,  was  to  be  determined  by  proclama- 
tion of  the  President.  The  Joint  Resolution  provided,  however,  that 
the  date  when  such  resolution  becomes  eft'ective  shall  be  treated  as 
the  date  of  the  termination  of  the  war  or  existing  emergency  not- 
withstanding any  provision  in  any  Act  of  Congress. 

Article  446,  Regulations  45,  derives  its  force  and  effect  from 
Section  227  (a)  of  the  Revenue  Act  of  1918,  which  provides  that 
''the  Commissioner  may  grant  a  reasonable  extension  of  time  for 
filing  returns  whenever  in  his  judgment  good  cause  exists  and  shall 
keep  a  record  of  every  such  extension  and  the  reason  therefor. 
Except  in  the  case  of  taxpayers  w^ho  are  abroad,  no  such  extension 
shall  be  for  more  than  six  months."  Since  this  Section  of  the  Act 
does  not  relate  to  the  duration  or  date  of  termination  of  the  present 
war,  it  was  not  affected  by  the  Joint  Resolution  approved  March  3, 
1921. 

There  w-as  no  conflict,  therefore,  between  the  ruling  of  this 
office  made  under  date  of  April  7,  1921,  and  the  opinion  of  the  So- 


RETURNS— WHEN   AND   HOW   TO   MAKE   THEM         63 

Hcitor  sent  you  under  date  of  March  22,  1921.     (Letter  to  Prentice- 
Hall,  Inc.,  signed  by  E.  H.  Batson,  dated  June  7,  1921.) 

The  foregoing  ruling  liolds  that  the  Joint  Resolutions  of 
Congress  (March  3,  1921,  and  July  2,  1921)  are  not  con- 
trolling. Articles  445  and  446,  promulgated  by  the  Com- 
missioner, both  state  that  the  extension  is  for  a  period  "not 
exceeding  ninety  days  after  proclamation  by  the  President 
of  the  end  of  the  war  with  Germany."  Since  the  proclamation 
was  not  issued  until  November  14,  1921,  there  is  no  doubt 
but  that  the  ninety-day  period  begins  to  run  from  that  date. 

Place  for  filing  returns.— In  the  case  of  individuals  the  law 
prescribes  that: 

Law.  Section  227 (b)  Returns  shall  be  made  to  the  col- 
lector for  the  district  in  which  is  located  the  legal  residence  or  prin- 
cipal place  of  business  of  the  person  making  the  return,  or,  if  he  has 
no  legal  residence  or  principal  place  of  business  in  the  United  States, 
then  to  the  collector  at  Baltimore,  Maryland. 

An  individual  whose  legal  residence  and  principal  place  of 
business  are  not  in  the  same  district  has  the  option  as  to  which 
place  he  will  file  his  annual  return. 

In  the  case  of  corporations,  returns  must  be  filed  in  the  dis- 
trict in  which  "is  located  the  principal  place  of  business  of  the 
corporation. 

Law.  Section  241.  ....  (b)  Returns  shall  be  made  to  the 
collector  of  the  district  in  which  is  located  the  principal  place  of 
business  or  principal  office  or  agency  of  the  corporation,  or,  if  it  has 
no  principal  place  of  business  or  principal  office  or  agency  in  the 
United  States,  then  to  the  collector  at  Baltimore,  Maryland. 

Returns  filed  by  mail. — Returns  may  be  delivered 
either  by  hand  or  by  mail. 

Regulation I'f  placed  in  the  mails  the  return  should  be 

posted  in  ample  time  to  reach  the  collector's  office,  under  ordinary 
handling  of  the  mails,  on  or  before  the  date  on  which  the  return  is 
required  to  be  filed.  If  a  return  is  made  and  placed  in  the  mails  in 
due  course,  properly  addressed  and  postage  paid,  in  ample  time  to 
reach  the  office  of  the  collector  on  or  before  the  last  due  date,  no 
penalty  will  attach  should  the  return  not  be  actually  received  by  such 


64  APPLICATION    AND   ADMINISTRATION 

ofl&cer  until  subsequently  to  that  date.  Where  a  question  may  be 
raised  as  to  whether  or  not  the  return  was  posted  in  ample  time  to 
reach  the  collector's  office  on  or  before  the  due  date,  the  envelope 
in  which  the  return  was  transmitted  will  be  preserved  by  the  col- 
lector and  forwarded  to  the  Commissioner  with  the  return.  (Art. 
446.) 

This  article  was  heretofore  numbered  447. 

Period  for  which  returns  are  made. — Returns  of  net  in- 
come are  ordinarily  made  for  the  "taxable  year.""^  Only  in 
unusual  circumstances  are  returns  made  for  a  shorter  period, 
as  where  corporations  are  entering  or  going  out  of  business, 
individuals  or  corporations  are  changing  fiscal  years,  and 
in  case  of  administrators  who  have  made  final  accountings  of 
estates. 

"Taxable  year"  and  "fiscal  year"  defined. — The 
terms  "taxable  year"  and  "fiscal  year"  are  defined  in  the  law 
as  follows : 

Law.  Section  200.  .  .  .  .  (i)  The  term  "taxable  year"  means 
the  calendar  year,  or  the  fiscal  year  ending  during  such  calendar  year, 
upon  the  basis  of  which  the  net  income  is  computed  under  section  212 
or  section  232.  The  term  "fiscal  year"  means  an  accounting  period  of 
twelve  months  ending  on  the  last  day  of  any  month, other  than  De- 
cember. The  first  taxable  year,  to  be  called  the  taxable  year  192 1, 
shall  be  the  calendar  year  1921  or  any  fiscal  year  ending  during  the 
calendar  year  1921;   .... 

Fiscal  year  basis  now  available  to  all  taxpayers. — 
By  1917'^  corporations  and  partnerships  had  acquired  the 
privilege  of  reporting  on  the  basis  of  a  fiscal  instead  of  a  cal- 
endar year.  The  191 8  law  extended  the  privilege  to  indi- 
viduals. The  same  provision  is  re-enacted  in  the  1921  law, 
which  reads : 

Law.     Section   212 (b)  The  net  income  shall  be  com- 


"  Returns  may  not  be  made  for  a  period  exceeding  twelve  months  (see 
page  72). 

"  [Former  Procedure]  The  1917  law,  section  8  (e)  extended  to  part- 
nerships the  fiscal  year  privilege  given  in  the  1913  and  1916  laws  to  cor- 
porations. 


RETURNS— WHEN    AND   HOW   TO   MAKE   THEM  65 

puted  upon  the  basis  of  the  taxpayer's  annual  accounting  period  (fiscal 
year  or  calendar  year,  as  the  case  may  be)-*  ....  If  the  taxpayer's 
annual  accounting  period  is  other  than  a  fiscal  year  as  defined  in  sec- 
tion 200  or  if  the  taxpayer  has  no  annual  accounting  period  or  does 
not  keep  books,  the  net  income  shall  be  computed  on  the  basis  of  the 
calendar  year. 

(c)  If  a  taxpayer  changes  his  accounting  period  from  fiscal  year 
to  calendar  year,  from  calendar  year  to  fiscal  year,  or  from  one  fiscal 
year  to  another,  the  net  income  shall,  with  the  approval  of  the  Com- 
missioner, be  computed  on  the  basis  of  such  new  accounting  period, 
subject  to  the  provisions  of  section  226.  -^ 

A  newly  organized  business,  whether  incorporated  or  not, 
may  estabhsh  its  fiscal  year  without  securing  the  approval  of 
the  Commissioner.'"  In  such  a  case  the  first  return  may  or 
may  not  be  for  less  than  twelve  months,  depending  upon  the 
date  of  organization  and  the  month  selected  as  the  close  of  its 
fiscal  period. 

In  order  to  report  on  a  fiscal  year  basis  it  is  necessary  that 
the  taxpayer  keep  books  of  account."^  This  is  in  accordance 
with  the  law,  which  provides  that  if  a  taxpayer  "does  not  keep 
books,  the  net  income  shall  be  computed  on  the  basis  of  the 
calendar  year."  Since  the  partnership  books  are  the  books  of 
each  partner,  permission  to  make  his  personal  returns  on  a 
fiscal  year  basis  would  doubtless  be  granted  to  a  partner. 

Fiscal  year  required  if  accounts  are  kept  on  that 
BASIS. — A  taxpayer  who  has  an  existing  accounting  period 
which  is  a  fiscal  year  within  the  meaning  of  the  statute,  is 
required  to  make  his  return  on  the  basis  of  such  a  taxable 
year  regardless  of  the  former  basis  of  rendering  returns." 

Recognition  of  accounting  periods  as  taxable  years. — A 
sharp  distinction  must  be  drawn  between  the  procedure  which 
applies  in  cases  which  have  a  fiscal  year  already  established, 
and  cases  in  which  it  is  desired  to  change  one's  accounting 

"  See  section  218. 

"  See  page  69. 

"  C.  B.  2,  page  67 ;  O.  D.  404. 

'  C.  B.  3,  page  81 ;  O.  D.  696. 

"  See  page  64. 


66  APPLICATION   AND   ADMINISTRATION 

l)crio(l  and  to  have  the  newly  established  year  accepted  as  the 
taxable  year."^ 

The  192 1  law  re-enacts  the  provisions  of  the  1918  law  and 
makes  it  obligatory  for  all  taxpayers,  both  individuals  and 
corporations,  to  report  on  the  basis  of  their  accounting  periods, 
whether  these  end  on  December  31  or  on  the  last  day  of  any 
other  month  of  the  year.  The  procedure  is  discussed  in  the  fol- 
lowing paragraph.  The  case  of  taxpayers  who  desire  both 
to  establish  a  new  accounting  year  and  to  have  it  recognized  for 
tax  purposes  is  discussed  on  page  67. 

Recognition  of  existing  fiscal  yeyvr  as  "taxable" 
yi:Ai^ — The  law  provides  no  formality  such  as  a  notice  to  the 
collector""  as  a  condition  of  the  recognition  of  a  fi.scal  year 
already  established  in  the  taxpayer's  accounts.  When  any 
change  is  made  in  the  taxable  3^ear,  section  212  (b),  quoted 
on  page  65,  provides  that  the  net  income  "with  the  approval 
of  the  Commissioner"  shall  be  computed  on  the  basis  of  such 
ne\v  accounting  period.  But  it  has  been  ruled  that  the  Com- 
missioner's permission  need  not  be  specifically  sought  if  the 
question  is  merely  one  of  recognition  of  an  existing  status.'^ 
As  will  be  seen  from  the  following  regulation,  the  fiscal  year 
in  such  cases  becomes  established  as  the  taxable  year  through 
tlie  mere  act  of  the  taxpayer  in  reporting  on  that  basis.  This 
point  is  of  particular  significance  to  intlividuals  who  prior  to 
the  passage  of  the  191S  law  kept  their  accounts  on  a  fiscal  j^ear 
basis. 

Regulation.  The  return  of  a  taxpayer  is  made  and  his  income 
computed  for  his  taxable  year,  which  means  his  fiscal  year,  or  the 

""Taxpayers  making  their  first  returns  may  do  so  on  the  basis  of  fiscal 
years  if  they  have  established  such  fiscal  years.     See  page  64. 

■"'  [Former  Procedure]  Under  the  1916  law,  section  13  (a),  notice 
was  required  of  the  day  designated  as  the  closing  date  of  the  fiscal  year 
"not  less  than  thirty  days  prior  to  the  first  day  of  March  of  the  year 
in  which  its  return  would  be  filed  if  made  on  the  basis  of  the  calendar 
year."  In  the  case  of  a  change  from  a  fiscal  year  to  a  calendar  year,  a 
thirty-day  notice  was  required  "prior  to  March  i  next  following  the 
closing  dale  of  the  established  fiscal  year."  (Reg.  33,  1918,  Art.  217.)  In 
the  absence  of  notice  fiscal  year  returns  were  not  acceptable.  (Ibid., 
Art.  2op;.) 

"'{'.   !!.  -1,  page  67;  A.  R.  R.  301. 


RETURNS— WHEN    AND    HOW    TO    MAKE    THEM  6/ 

calendar  year  if  he  has  nut  established  a  fiscal  year.  The  term 
"fiscal  year"  means  an  accounting  period  of  twelve  months  ending 
on  the  last  day  of  any  month  other  than  December.  No  fiscal  year 
will,  however,  be  recognized  unless  before  its  close  it  was  definitely 
established  as  an  accounting  period  by  the  taxpayer  and  the  books 
of  such  taxpayer  were  kept  in  accordance  therewith.  The  taxable 
year  1921  is  the  calendar  year  1921  or  any  fiscal  year  ending  during 
the  calendar  year  1921.  See  sec.  200  of  the  statute.  A  person  having 
no  such  fiscal  year  must  make  return  on  the  basis  of  the  calendar 
year.  Except  in  the  case  of  a  first  return  for  income  tax  a  taxpayer 
shall  make  his  return  on  the  basis  (fiscal  or  calendar  year)  upon 
which  he  made  his  return  for  the  taxable  year  immediately  preceding 
unless,  with  the  approval  of  tlie  commissioner,  he  has  changed  his 
accounting  period.     (Art.  25.) 

Ruling.  An  individual  who  is  sole  proprietor  of  a  business  must 
compute  his  income  from  all  sources  on  the  same  basis,  and  unless 
he  maintains  personal  books  of  account  in  which  his  income  from  all 
business  and  other  sources  is  reflected  on  the  basis  of  a  fiscal  year 
he  does  not  have  a  fiscal  year  which  can  be  recognized  as  the  basis 
upon  which  his  return  may  be  matle.      (C.  B.  4,  page  71  ;  O.  D.  941.) 

All  taxpayers  have  been  on  notice  since  February,  19 19, 
that,  as  stated  in  section  212  (b)  of  the  19 18  law,  which  is 
re-enacted  in  the  192 1  law:  ".  .  .  .  The  net  income  shall  be 
computed  upon  the  basis  of  the  taxpayer's  annual  accounting 
l)eriod  (fiscal  3'ear  or  calendar  year  as  the  case  may  be)  .  .  .  ." 
The  Commissioner  is  not  given  any  discretion  as  to  requiring 
returns  on  the  basis  stated.  If  any  taxpayer  has  been  reporting 
on  a  calendar  year  basis  when  his  or  its  books  have  been  kept 
on  a  fiscal  year  basis,  there  has  been  a  technical  but  clear 
violation  of  the  law  which  should  be  adjusted  as  speedily  as 
possible. 

Recognition  of  a  changed  accounting  period  as  a 
TAXABLE  YEAR. — When  taxpayers  desire  to  change  from  one 
accounting  period  already  established  and  recognized  for  tax 
purposes  to  some  other  period,  thev  must  give  a  thirty-day 
written  notice  and  their  reasons  for  the  intended  change.  It  is 
quite  proper  that  changes  of  this  character  should  be  made  sub- 
ject to  the  approval  of  the  cVimmissioncr,  for  taxpayers  should 
not  be  free  tu  change  frequently  and  arbitrarily  from  one  fiscal 


68  APPLICATION   AND   ADMINISTRATION 

year  to  another.  The  application  must  be  made  by  the  tax- 
payer directly  interested  or  by  his  duly  authorized  agent.  If 
the  latter  makes  the  application,  the  authority  to  act  for  the 
taxpayer  must  be  produced. ^^ 

When  is  change  in  fiscal  year  "established"? — 
After  having  secured  the  permission  of  the  Commissioner  to 
change  the  basis  of  his  return,  a  taxpayer  may  for  various  rea- 
sons wish  to  continue  to  report  on  the  basis  of  the  old  account- 
ing period.  The  taxpayer  may  discover  that  it  is  not  practicable 
to  prepare  his  return  on  this  new  basis,  or  he  may  discover 
that  there  are  certain  conditions  which  he  failed  to  consider 
when  he  applied  for  a  change.  If  he  fails  to  report  on  this  new 
basis,  will  he  be  subject  to  penalties? 

There  appear  to  be  two  things  required  to  bring  about  a 
change :  ( i )  the  approval  of  the  Commissioner  must  be  se- 
cured, and  (2)  the  change  must  actually  be  made  and  a  return 
filed  on  the  new  basis.  The  law  says  that  the  Commissioner 
may  approve  changes  in  accounting  periods,  but  it  does  not 
provide  that  he  may  create  new  accounting  periods;  therefore 
penalties  cannot  be  imposed  unless  a  new  accounting  period  has 
been  fully  established. 

The  Treasury  has  held,  however,  that  if  application  to 
make  a  change  is  made  b)^  the  taxpayers  and  is  authorized, 
the  change  nmst  be  made.''^  It  is  difficult  to  discover  under 
what  provision  of  the  law  the  Treasury  can  force  a  taxpayer 
to  make  a  change  in  its  accounting  period  if  an  intention  to 
change  has  not  been  made  effective  in  the  taxpayer's  books. 
A  taxpayer  may  apply  for  authority  to  change  his  accounting 
period  with  the  intention  of  making  such  a  change  if  and 
when  the  permission  is  received.  In  the  interval  between 
making  the  application  and  receiving  the  authorization,  cir- 
cumstances may  arise  which  cause  the  taxpayer  to  alter  his 
desire  to  change.    There  is  no  provision  of  the  law  which  can 


C.  B.  4,  page  71 ;  Mim.  2738. 
'  C.  B.  4,  page  71 ;  Mim.  2738. 


RETURNS— WHEN    AND   HOW   TO    MAKE   THEM  69 

force  the  taxpayer  to  make  the  change.  An  actual  change 
must  be  made  and  a  return  must  be  filed  on  the  new  basis  before 
the  taxpayer  loses  his  right  to  continue  the  old  accounting 
period. 

When  a  corporation  has  regularly  closed  its  books  on 
December  31,  and  also  for  business  reasons  on  some  other  date 
in  the  year,  returns  are  accepted  on  a  calendar  year  basis.'* 

Changes  made  during  191 8  or  prior. — If  a  taxpayer 
made  a  change  in  his  accounting  period  during  191 8,  the 
approval  of  the  Commissioner  was  not  necessary.  The  Rev- 
enue Act  of  19 1 8  was  not  approved  until  February  24,  1919; 
so  any  changes  made  prior  to  the  passage  of  the  law,  whether 
from  calendar  to  fiscal  year  or  vice  versa,  were  confirmed 
thereby." 

Fiscal  years  fixed  by  state  legislatures. — If  a  state 
wishes  to  change  the  accounting  period  of  public  service  cor- 
porations, it  is  not  necessary  for  taxpa3^ers  to  secure  the  per- 
mission of  the  Commissioner  to  report  on  the  new  basis."" 

It  seems  to  follow  that,  if  a  state  wished  to  fix  the  fiscal 
years  of  all  corporations  created  by  that  state,  which  it  could 
no  doubt  do,  such  corporations  would  be  obligated  to  report 
on  this  new  basis,  and  it  would  not  be  necessary  to  secure  the 
permission  of  the  Commissioner.  The  approval  of  the  Com- 
missioner appears  to  be  necessary  only  when  the  taxpayer 
voluntarily  changes  his  fiscal  year. 

Return  v^hen  accounting  period  is  changed. — 

Law.  Section  226.  (a)  That  if  a  taxpayer,  with  the  approval 
of  the  Commissioner,  changes  the  basis  of  computing  net  income 
from  fiscal  year  to  calendar  year  a  separate  return  shall  be  made 
for  the  period  between  the  close  of  the  last  fiscal  year  for  which 
return  was  made  and  the  following  December  31.  If  the  change 
is  from  calendar  year  to  fiscal  year,  a  separate  return  shall  be  made 


"C.  B.  4,  page  69;  A.  R.  R.  501. 
"  C.  B.  3,  page  81 ;  A.  R.  R.  342. 
"C.  B.  I,  page  62;  O.  D.  100. 


JO 


APPLICATION    AND   ADMINISTRATION 


for  the  period  between  the  close  of  the  last  calendar  year  for  which 
return  was  made  and  the  dale  designated  as  the  close  of  the  fiscal  year. 
If  the  change  is  from  one  fiscal  year  to  another  fiscal  year  a  separate 
return  shall  be  made  for  the  period  between  the  close  of  the  former 
fiscal  year  and  the  date  designated  as  the  close  of  the  new  fiscal 
year 

The  provision  found  in  the  1918  law"'  to  the  effect  that 
in  the  case  of  a  first  return  on  a  fiscal  year  basis  a  return 
should  be  filed  for  the  period  between  the  beginning  of  the 
calendar  year  in  which  the  fiscal  year  ends  and  the  end  of  the 
fiscal  year,  was  not  re-enacted  in  the  1921  law.  This  pro- 
vision was  ambiguous  and  unnecessary. 

Law.  Section  226.  ....  (b)  In  all  cases  where  a  separate 
return  is  made  for  a  part  of  a  taxable  year  the  net  income  shall  be  com- 
puted on  the  basis  of  such  period  for  which  separate  return  is  made, 
and  the  tax  shall  be  paid  thereon  at  the  rate  for  the  calendar  yiear 
in  which  such  period  is  included. 

(c)  In  the  case  of  a  return  for  a  period  of  less  than  one  year  the 
net  income  shall  be  placed  on  an  annual  basis  by  multiplying  the  amount 
thereof  by  twelve  and  dividing  by  the  number  of  months  included  in 
such  period;  and  the  tax  shall  be  such  part  of  a  tax  computed  on  such 
annual  basis  as  the  number  of  months  in  such  period  is  of  twelve 
months.  "^ 

The  foregoing  provision  places  net  income  on  an  annual 
basis  and  has  the  effect  of  subjecting  such  income  to  a  higher 
surta.x  rate  than  was  the  case  imder  the  former  method  of 
computation.  The  law  now  subjects  the  net  income  to  the  same 
high  rates  as  would  be  the  case  if  income  throughout  the  year 


^'  [Former  Procedure] 

1918  Law.  Section  226 If  a  taxpaj-er  making  his  first  return  for 

income  tax  keeps  his  accounts  on  the  basis  of  a  fiscal  jear  he  shall  make  a 
separate  return  for  the  period  between  the  beginning  of  the  calendar  year 
in  which  such  fiscal  year  ends  and  the  end  of  such  fiscal  year 

"  [Former  Procedure] 

1918  Law.     Section  226 In  all  of  the  above  cases  the  net  income 

shall  be  computed  on  the  basis  of  such  period  for  which  separate  return  is 
made,  and  the  tax  sliall  he  paid  thereon  at  the  rate  for  the  calendar  year  in 
which  such  period  is  inckided ;  and  the  credits  provided  in  subdivisions  (c) 
and  (d)  of  section  216  shall  be  reduced  respectively  to  amounts  which 
bear  the  same  ratio  to  the  full  credits  provided  in  such  subdivisions  as  the 
number  of  montlis  in  such  period  bears  to  twelve  months. 

The  credits  wliich  nuist  be  prorated  [section  216  (c)  and  (d)]  are 
the    $1,000    or    $.',000    exemiilions    and    the    $200    credits    for    dependents. 


RiaURNS— WHEN    AND    ilUVV    TO    MAKE    THEM  71 

were  received  at  the  same  rate  as  during  the  fractional  i)criod. 
An  ilhistration  of  the  increased  tax  payable  under  the  new 
method  of  computation  is  given  in  Chapter  VII. 

It  is  not  necessary  to  apply  the  provisions  to  corporations 
in  determining  the  excess  profits  tax,  because  the  same  result 
is  reached  by  providing  for  a  pro  rata  reduction  of  invested 
capital  and  the  specific  exemption  of  $3,000."" 

Notice  to  Commissioner  required. — 

Regulation.  If  a  taxpayer  changes  his  accounting  period  he 
shall  as  soon  as  possible  give  to  the  collector  for  transmission  to  the 
Commissioner  written  notice  of  such  change  and  of  his  reasons  there- 
for. Tlie  Commissioner  will  not  approve  a  change  of  the  basis  of 
computing  net  income  unless  such  notice  is  given  30  days  before  the 
close  of  the  proposed  or  new  taxable  year  or  period.  The  due  date  of 
the  separate  return  for  such  period  is  the  fifteenth  day  of  the  third 
month  following  the  close  of  that  period.  If  the  change  in  the  basis 
of  computing  the  net  income  of  the  taxpayer  is  approved  by  the 
Commissioner,  the  taxpayer  shall  thereafter  make  his  returns  and 
compute  his  net  income  upon  the  basis  of  the  new  accounting  period. 
....      (Art.  26.) 

The  foregoing  regulation  changes  the  date  1)YU)Y  to  which 
notice  of  change  of  fiscal  year  must  be  filed  with  the  collector 
for  transmission  to  the  Commissioner.'" 


='See   Chapter   VII. 

*"  [Former  Procedure]  Since  the  1916  law  and  the  1917  amendments 
thereto  specifically  provided  that  all  returns  must  be  made  on  a  calendar 
year  basis,  unless  a  fiscal  year  was  designated  according  to  the  provisions 
of  the  law,  any  changes  made  in  the  accounting  period  during  1918  or  sub- 
sequently cannot  affect  any  returns,  calendar  or  fiscal,  made  for  the  year 
1917.  It  also  follows  that  the  Commissioner  is  without  power  to  accept 
amended  returns  for  the  year  1917  on  the  basis  of  a  changed  accounting 
period. 

Ruling.  "A  corporation  having  kept  its  accounts  on  a  fiscal  year  basis, 
and  not  having  made  application  for  permission  to  change  to  a  calendar 
year  basis  until  July  6,  1920,  will  not  be  permitted  to  file  its  returns 
on  the  calendar  vcar  basis  for  tlie  years  1918  and  1919."  (C.  I'.  4.  page  67; 
A.  R.  R.  391.) 

Under  Art.  26  of  Reg.  45,  notice  bad  to  be  given  at  a  time  wliicb  was 
both  (a)  thirty  days  before  the  due  date  of  the  taxpayer's  return  on  its 
existing  basis,  and  (b)  thirty  days  before  the  due  date  of  the  return  for  the 
period  between  the  end  of  his  existing  taxable  year  and  the  end  of  the 
proposed  taxable  year.  The  Treasury  held  that  in  the  case  of  a  taxpayer 
who  filed  a  return  for  a  fiscal  year  ended  June  30,  and  desired  to  change 
to  a  calendar  year  basis,  notice  nmst  be  given  at  least  thirty  days  prior  to 
March  15  of  the  following  year.     (C.  B.  2,  page  67;  Sol.  Op.  5.) 


72  APPLICATION   AND   ADMINISTRATION 

Change  of  fiscal  year  to  obtain  greater  advantage  from  net 
loss  provision. — Section  204  (b)  of  the  192 1  law  provides 
that  if  a  taxpayer  sustains  a  net  loss,  it  may  be  deducted 
from  the  net  income  of  the  next  succeeding  two  years  ending 
after  December  31,  1920.*^  Subdivision  (d)  of  the  same 
section  provides  that  in  the  case  of  a  fiscal  year  beginning  in 
1920  and  ending  in  1921,  the  taxpayers  shall  be  entitled  to 
the  benefits  of  the  net  loss  provision  in  proportion  to  the  part 
of  such  fiscal  year  falling  in  1921. 

It  is  quite  conceivable  that  a  future  shifting  of  fiscal 
year  dates  may  result  in  reduced  taxes.  It  may  result  in  in- 
creased taxes.  The  law  regarding  changes  in  fiscal  periods  is 
clear,  so  no  retroactive  shifting  is  possible.  With  lower  rates 
of  tax  and  the  certainty  that  tax  laws  will  continue  to  change, 
the  possibilities  of  tax-saving  by  fiscal-year  shifting  are  not 
worth  much  thought. 

Return  must  not  cover  period  exceeding  twelve  months. — 

Throughout  the  law  reference  is  made  to  a  taxable  year 
or  to  a  calendar  year  and  to  parts  of  a  taxable  year,  and 
it  is  stated  that  a  fiscal  year  means  an  accounting  period  of 
twelve  months.*-  In  no  case  is  there  a  specific  prohibition 
in  the  law  against  a  return  covering  a  period  of  more  than 
twelve  months;  but  the  direction  to  file  for  a  year  or  less 
would  be  held  to  be  a  prohibition.  A  regulation  specifically 
prohibits  the  use  of  a  period  of  more  than  twelve  months. 

Regulation.  No  return  can  be  made  for  a  period  of  more  than 
twelve  months (Art.  431.) 

Blank  forms  for  returns. — Returns  must  be  made  in  the 
form  prescribed  by  the  Commissioner,  with  the  approval  of  the 
Secretary  of  the  Treasury.  Blank  forms  are  to  be  had  from 
collectors.     They  are  mailed  without  special  request  to  the 


"  [Former  Procedure]  Section  204  (b)  of  tlie  1918  law  enacted  a 
somewhat  similar  net  loss  provision.  See  Income  Tax  Froci'dure,  1921, 
page  783,  et  seq. 

■*■"■  Section  200. 


RETURNS— WHEN  AND  HOW  TO  MAKE  THEM 


7Z 


taxpayers  on  the  records,  but  failure  to  receive  a  form  does 
not  excuse  the  taxpayer  from  reporting  in  due  season.  If 
the  form  is  not  received  in  ample  time  to  prepare  and  file  it  on 
or  before  the  due  date,  usually  March  15,  application  for  a 
copy  should  be  made  to  the  office  of  the  local  collector  of  in- 
ternal revenue  or  to  any  bank  or  post-office.  Taxpayers 
should  retain  exact  copies  of  returns  as  filed.  The  forms 
to  be  used  in  1922  for  individual  returns  of  $5,000  and  over 
include  a  duplicate  sheet  as  an  integral  part  of  the  return.  This 
duplicate  will  obviate  the  necessity  of  securing  an  extra  copy 
of  the  form.  In  the  case  of  forms  which  do  not  include  dupli- 
cate sheets,  taxpayers  should  secure  extra  copies  of  the  blanks 
and  retain  exact  duplicates  of  all  returns  filed.  When  not 
obtainable  from  collectors  application  for  them  should  be 
made  direct  to  the  Commissioner  in  Washing^ton. 


'fc)" 


Regulation.  Copies  of  the  prescribed  return  forms  will  so  far 
as  possible  be  furnished  taxpayers  by  collectors.  Failure  on  the  part 
of  any  taxpayer  to  receive  a  blank  form  will  not,  however,  excuse 

him  from  making  a  return In  lack  of  a  prescribed  form  a 

statement  made  by  a  taxpayer  disclosing-  his  gross  income  and  the  de- 
ductions therefrom  may  be  accepted  as  a  tentative  return,  and  if  filed 
within  the  prescribed  time  a  return  so  made  will  relieve  the  taxpayer 
from  liability  to  penalties,  provided  that  without  unnecessary  delay 
such  a  tentative  return  is  replaced  by  a  return  made  on  the  proper 
form (Art.  407.) 

Forms  for  1922. — Form  1040  will  be  used  in  1922  by 
individuals  whose  net  income  exceeds  $5,000;  for  the  separate 
returns  of  husband  and  wife  when  the  combined  net  incomes 
exceed  $5,000;  for  returns  covering  less  than  a  year  when  the 
net  income  placed  on  an  annual  basis  exceeds  $5,000;  when  the 
individual's  net  income  exceeds  $4,000  and  the  entire  family 
exemption  is  taken  in  a  separate  return  filed  by  husband  or 
wife. 

Form  1040A,  with  the  exceptions  noted  above,  will  be  used 
in  cases  where  the  net  income  of  individual  taxpayers  is  less 
than  $5,000. 

Copies  of  forms  1040 A  and  1040  appear  in  Appendix  B. 


74  APPLICATION   AND   ADMINISTRATION 

Form  1 04 1  will  be  used  for  filing  returns  of  fiduciaries,*^ 
form  1065  for  partnerships  and  personal  service  corporations, 
and  form  1120  for  corporations. 

It  has  been  suggested  to  the  Treasury  that  it  would  be 
a  great  improvement  if  returns  such  as  those  required  from 
corj)orations  were  prepared  on  forms  not  over  83^  x  1 1  inches 
in  size,  using  as  many  sheets  as  necessary. 


*'  See  Chapter  XXXVII  for  the  use  of  other  forms  by  fiduciaries. 


CHAPTER  IV 

RICTURNS  OF  INDIVIDUALS  AND  CORPOl^N  IIONS 

The  preceding  chapter  explained  the  law  and  regulations 
as  to  who  must  make  returns,  the  time  for  filing  returns,  and 
other  such  requirements.  The  specific  procedure  to  be  fol- 
lowed Ijy  individuals  and  corporations  now  follows/ 

Annual  Returns  by  Individuals 

Who  shall  make  returns. — 

Law.  Section  22T).  (a)  That  the  following  individuals  shsll  each 
make  under  oath  a  return  stating  specifically  the  items  of  his  gross 
income  and  the  deductions  and  credits  allowed  under  this  title. — - 

(i)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$1,000  or  over,  if  single,  or  if  married  and  not  living  with  husband  or 
wife; 

(2)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$2,000  or  over,  if  married  and  living  with  husband  or  wife;  and 

(3)  Every  individual  having  a  gross  income  for  the  taxable  year  of 
$5,000  or  over,  regardless  of  the  amount  of  his  net  income 

The  192 1  law  for  the  first  time  requires  a  return  to  be 
filed  whenever  the  gross  income  of  an  individual  is  «$5,ooo 
or  over. 

A  taxpayer  with  a  gross  income  of  $7,000,  and  allowable 
deductions  of  $5,100  (leaving  net  income  of  $1,900)  would, 
under  the  1918  law,  if  he  were  married,  make  no  return, 
since  his  net  income  is  under  $2,000.  Under  the  192 1  law, 
however,  it  is  necessary  to  file  a  complete  return  even  though 
no  tax  is  payable. 

Regulation Whether  or  not  an  individual  is  the  head  of 

a  family'^  or  has  dependents  is  innnaterial  in  determining  his  liability 


'Returns  of  jjartnershijis  and  r)ers(inal  service  corporations  arc  fully  dis- 
cussed in  Chai)ter  XXIV. 
'  See  page  52. 
^  For  delinition  of  "head  of  a   family,''  see  Chapter  XII. 

75 


76  APPLICATION   AND   ADMINISTRATION 

to  render  a  return.  If  an  individual  is  a  married  person  living  with 
husband  or  wife,  no  return  need  be  made  unless  their  aggregate  gross 
income  is  at  least  v$5,ooo  or  their  aggregate  net  income  is  at  least 
$2,000 ;  but  a  separate  return  must  be  made  by  each  of  them,  regardless 
of  the  amount  of  the  individual  income  of  each,  where  their  aggregate 
gross  income  is  $5,000  or  over,  or  their  aggregate  net  income  is 
$2,000  or  over,  unless  they  join  in  a  single  joint  return.  Where  the 
income  of  each  is  included  in  a  single  joint  return,  the  tax  is  com- 
puted on  the  aggregate  income  and  all  deductions  and  credits  to  which 
either  is  entitled  shall  be  taken  from  such  aggregate  income.  The 
husband  shall  include  in  his  return  the  income  derived  from  services 
rendered  by  the  wife  or  from  the  sale  of  products  of  her  labor  if  she 
does  not  file  a  separate  return  or  join  with  him  in  a  return  setting 
forth  her  income  separately (Art.  401.) 

This  article  has  been  amended  to  take  cognizance  of  the 
fact  that  a  gross  income  of  $5,000  is  a  determining  factor  in 
filing  returns. 

It  should  be  noted  that  the  terms  "net  income"  and  "gross 
income"  are  used,  which  means  that  dividends,  exemptions 
for  dependents,  and  other  ''credits"  may  not  be  deducted  from 
the  amount  which  determines  whether  or  not  a  return  is  to  be 
made.*  Thus  there  are  undoubtedly  many  individuals  who 
are  required  to  make  returns  who,  after  they  have  applied  all 
their  '"credits,"^  will  have  no  tax  to  pay. 

Taxpayers  whose  entire  net  income  is  derived  from  interest 
on  tax-exempt  securities  enumerated  in  section  213  (b-4) 
are  relieved,  under  the  192 1  law,  from  the  necessity  of  making 
any  return.  They  do  not  come  under  the  provision  of  section 
223  (a-3)  requiring  a  return  where  the  gross  income  is  $5,000 
or  over,  because  such  tax-exempt  interest  is  expressly  excluded 
from  gross  income.  In  fact,  all  taxpayers  are  relieved  from 
reporting  income  from  tax-exempt  securities." 


'See  Chapter  XII. 

''  Section  216. 

°  In  the  Senate  bill  the  proviso  in  section  213  of  the  1918  law  calling 
for  the  return  of  such  income  was  eliminated,  but  an  amendment  to  section 
258  was  inserted,  reading  in  part : 

"In  connection  with  ever}'  return  is  to  be  submitted  a  statement  showing 
holdings  of  all  tax  free  securities,  including  all  Government  bonds,  notes, 
etc.,  and  the  income  received  therefrom.     Penalty  for   failure  to  comply. 


RETURNS— INDIVIDUALS  'jj 

It  is  apparent,  also,  that  the  only  individual  who  can  take 
advantage  of  the  permission  to  refrain  from  reporting  when 
his  net  income  exceeds  $i,ooo  but  is  less  than  $2,000  (and 
whose  gross  income  together  with  that  of  his  wife  is  less 
than  $5,000)  is  one  who  is  "married  and  living  with  husband 
or  wife."  Heads  of  families  who  are  unmarried'^  must  report 
when  they  have  net  incomes  in  excess  of  $1,000  even  though, 
because  of  dependents,  they  may  have  "credits"  enough  to 
cancel  all  their  income  above  that  amount. 

Return  may  be  filed  by  agents — when. — 

Law.     Section  223 If  the  taxpayer  is  unable  to  make  his 

own  return,  the  return  shall  be  made  by  a  duly  authorized  agent  or 
by  the  guardian  or  other  person  charged  with  the  care  of  the  person 
or  property  of  such  taxpayer. 

In  the  case  of  a  personal  return,  "the  affidavit  must  be 
executed  by  the  person  whose  income  is  reported  unless  he  is 
a  minor  or  incompetent  or  unless  he  is  ill,  absent  from  the 
country  or  otherwise  incapacitated,  in  which  case  the  legal 
representative  or  agent  may  execute  the  affidavit."^ 

Regulation.  There  may  be  a  fiduciary  relationship  between  an 
agent  and  a  principal,  but  the  word  "agent"  does  not  denote  a  fidu- 
ciary. A  fiduciary  relationship  can  not  be  created  by  a  power  of 
attorney.  An  agent  having  entire  charge  of  property,  with  authority 
to  effect  and  execute  leases  with  tenants  entirely  on  his  own  respon- 
sibility and  without  consulting  his  principal,  merely  turning  over  the 
net  profits  from  the  property  periodically  to  his  principal  by  virtue 
of  authority  conferred  upon  him  by  a  power  of  attorney,  is  not  a 
fiduciary  within  the  meaning  of  the  statute.  In  cases  where  no  legal 
trust  has  been  created  in  the  estate  controlled  by  the  agent  and  attor- 
ney the  liability  to  make  a  return  rests  with  the  principal.  (Art. 
1522.) 

Fiduciaries   use   form    1041.     An   agent   uses   the   form 


in  addition  to  all  other  penalties  provided  by  law,  is  5%  of  amount  of  tax 
(if  any)." 

The  requirement   was,  however,  eliminated  in   the   1921   law  as   finally 
enacted. 

~'  See  Chapter  XII. 

*Form  1040A   (1922),  instructions. 


78  MTLICATION    AND   ADMINISTRATION 

(usually  form  .1040)  which  his  principal  would  file  if  able  to 

do  so  in  person. 

Rfx.ulation The  return  may  be  made  by  an  agent  when 

bv  reason  of  ilhiess,  absence,  or  nonresidence  the  person  Hable  for 
the  return  is  unable  to  make  it,  the  agent  assuming  the  responsibihty 
for  making  the  return  and  incurring  liability  to  the  specific  penalties 
provided  for  erroneous,  false,  or  fraudulent  returns (Art.  402.) 

Return  must  be  under  oath. — The  law  requires  that  "every 
person  liable  to  any  tax  imposed  by  this  Act,  or  for  the  collec- 
tion thereof,  shall  ....  render,  under  oath,  such  statements 
and  returns  ....  as  the  Commissioner,  with  the  approval 
of  the  Secretary,  may  from  time  to  time  prescribe."" 

The  following  regulation  gives  instructions  for  executing 

an  affidavit: 

Regulation.  All  income  tax  returns  must  be  verified  under 
oath  or  aftirmation  before  an  officer  duly  authorized  to  administer 
oaths  either  by  the  laws  of  the  United  States  or  by  the  laws  of  the 
State  or  Territory  where  such  officer  resides.  Persons  in  the  naval  or 
military  service  of  the  United  States  may  verify  their  returns  before 
any  official  authorized  to  administer  oaths  for  the  purposes  of  those 
services.  Income  tax  returns  executed  abroad  may  be  attested  free  of 
charge  before  United  States  consular  officers.  Where  a  foreign 
notary  or  other  official  having  no  seal  shall  act  as  attesting  officer,  the 
authority  of  such  attesting  officer  should  be  certified  to  by  some  judi- 
cial official  or  other  proper  officer  having  knowledge  of  the  appoint- 
ment and  official  character  of  the  attesting  officer.     (Art.  406.) 

The  Treasury  has  held  that  oaths  should  be  administered 
by  officers  having  general  rather  than  specific  authority.  Post- 
masters, it  was  held,  cannot  therefore  j)ropcrly  adnu'nister 
oaths   for  income  tax  purposes."' 

Separate  returns  of  husband  and  v/ife — when  desirable. — 

Law.     Section    223 (b)   If    a    husband    and    wife    living 

together  have  an  aggregate  net  income  for  the  taxable  year  of  $2,000 
or  over,  or  an  aggregate  gross  income  for  such  year  of  $5,000  or  over — 

(i)   Each  shall  make  such  a  return,  or 

(2)  The  income  of  each  shall  be  included  in  a  single  joint  return, 
in  which  case  the  tax  shall  be  computed  on  the  aggregate  in- 
come  

"  Section  1300.    For  verification  of  corporation  returns,  sre  Chnptcr  \'l\. 
'"C.  B.  3,  page  22S:  O.  I).  701. 


RJiTURNS— INDIVIDUALS  79 

Under  the  foregoing  provision  of  the  192 1  law,  the  re- 
quirement that  a  return  must  be  filed  where  the  gross  income  is 
$5,000  or  over,  is  made  to  apply  to  the  aggregate  gross  income 
of  husband  and  wife,  when  they  are  living  together. 

If  husband  and  wife  are  not  living  together,  and  if  the 
net  income  of  either  is  $1,000  or  more,  separate  returns  must 
be  made. 

If  husband  and  wife,  living  together,  elect  to  make  a  single 
joint  return,  the  tax  then  "shall  be  computed  on  the  aggregate 
income."  This  provision  of  the  192 1  law  is  new.  The  privi- 
lege of  applying  one  spouse's  loss  or  deductions  against  the 
other's  income,  however,  may  be  availed  of  in  the  making  of  a 
single  joint  return. 

If  husband  and  wife  heretofore  have  filed  separate  returns, 
nevertheless  in  192 1  or  any  future  year  they  may  file  a  joint 
return. 

Rulings.  A  husband  and  wife  may  elect  to  file  a  joint  return  one 
year  and  separate  retiuMis  the  next,  regardless  of  whether  such  election 
results  in  a  benefit  to  them  or  a  benefit  to  the  Government.  (B.  27- 
21-1715;  O.  D.  968.) 

Where  husband  and  wife  clearly  indicate  on  a  single  return  form 
the  net  income  of  each  and  compute  the  tax  on  the  basis  of  such  sep- 
arate income,  the  return  so  filed  does  not  constitute  a  joint  return, 
but  the  separate  return  of  each  individual.  Where,  however,  a  single 
return  form  is  used  clearly  indicating  the  separate  net  income  of  hus- 
band and  wife  but  the  tax  is  computed  upon  the  basis  of  combined 
income,  such  return  is  a  joint  return.  (C.  B.  4,  page  255;  O.  D, 
960.) 

In  practically  every  case  where  a  husband  and  a  wife  have 
a  substantial  income,  separate  returns  should  be  filed  in  order 
that  the  surtax  may  be  applied  separately.  It  is  not  necessary 
to  file  separate  returns  to  secure  the  benefit  of  the  calculation 
if  the  taxpayer  is  careful  to  segregate  the  income  and  deduc- 
tions of  each.     Usually  it  is  better  to  file  separate  returns." 

In  case  husband  and  wife  each  received  an  independent 

"  [Former  Procedure]  The  Treasury  has  not  always  assessed  the  sur- 
tax separately,  InU  has  in  some  cases  levied  and  collected  an  excessive  tax 
which  would  not  have  been  imposed  if  separate  returns  had  been  made. 


8o  APPLICATION   AND   ADMINISTRATION 

net  income  equal  to  or  in  excess  of  $i,ooo,  separate  returns 
may  be  made,  but  a  joint  return  will  ordinarily  serve  unless 
the  combined  net  income  exceeds  $5,000.  Below  that  figure 
the  taxes  would,  with  two  exceptions,  be  the  same  even  though 
the  incomes  were  merged,  i.e.,  4  per  cent  of  the  amount  by 
which  the  total  net  income  exceeded  the  "credits,"  whether 
individual  returns  or  a  joint  return  were  filed. 

The  exceptions,  when  a  combined  return  is  desirable  even 
though  the  incomes  are  substantial,  arise  (a)  in  case  the 
husband  or  wife  has  allowable  charitable  contributions  in  ex- 
cess of  the  15  per  cent  limitation,  full  credit  for  which  would  be 
lost  if  separate  returns  were  made ;  (b)  in  case  one  spouse  has 
a  net  loss  which  may  be  applied  against  the  income  of  the  other. 

When  the  net  income  for  1921  shown  in  a  single  return 
exceeds  $5,000,  the  surtaxes  begin  to  apply.  By  rendering 
separate  returns  the  application  of  the  surtaxes  is  forestalled 
to  the  extent  of  an  additional  $5,000.^" 

In  addition  to  the  surtaxes  which  begin  to  apply  when  a 
net  income  reaches  $5,000,  there  is  also  the  8  per  cent  normal 
rate  which  applies  in  place  of  the  4  per  cent  rate  when  the  ex- 
cess of  net  income  over  credits  (personal  exemptions,  divi- 
dends, etc.,  see  Chapter  XII)  is  greater  than  $4,000. 

In  the  case  of  a  married  man  with  no  dependents  (citizen  or 
resident  of  the  United  States)  having  a  net  income  of  $40,000 
for  1921  (none  from  dividends)  the  tax  would  be  arrived  at  thus  : 

He  receives  an  exemption  of  $2,000,  pays  a  normal  tax  of 
4  per  cent  on  the  next  $4,000,  and  8  per  cent  on  $34,000. 
Surtax  begins  at  $5,000^"  and  is  i  per  cent  on  the  first  $1,000 
in  excess  of  that  amount,  and  i  per  cent  additional  on  each 
$2,000  above  $6,000,  until  it  reaches  18  per  cent  on  the  last 
$2,000  of  the  $40,000.^*  The  normal  tax  is  $2,880  and  the 
surtax  $3,410,  a  total  of  $6,290. 


''For  1922,  surtaxes  begin  at  $6,000.     See  Chapter  VII. 

"  Ibid. 

"  For  1922  the  surtax  rates  start  at  i  per  cent  on  the  first  $2,000  in 
excess  of  $6,000,  and  are  graduated  upwards  so  that  on  the  last  $2,000  of 
the  $40,000  the  rate  is  17  per  cent. 


RETURNS— INDIVIDUALS  8l 

If  husband  and  wife  each  have  an  income  of  $20,000,  each 
will  presumably  take  $1,000  exemption.  The  normal  tax  is 
then  4  per  cent  on  the  next  $4,000,  and  8  per  cent  on  $15,000. 
Surtax  begins  as  before  at  $5,000,  and  runs  to  8  per  cent 
on  the  $2,000  between  $18,000  and  $20,000.  The  tax  for 
each  is:  normal  $1,360,  surtax  $710;  total  $2,070.  The 
combined  tax  is  $4,140,  a  saving  of  $2,150  secured  by  making 
separate  returns. 

When  w^ife  should  take  no  part  of  personal  ex- 
emption.— The  following  illustrates  when  a  wife  should  take 
no  personal  exemption. 

Husband's  income  $20,000;  wife's  income  $4,000;  3  children 

Method  A — wife  takes  exemption  : 

Tax 

Wife's  income  $4,000.00 

Less:  Exemption    2,000.00^" 

Taxable  at  4  per  cent $2,000.00  $80.00 

Husband's  income  $20,000.00 

Less:  Exemption   (three  children)  .. .      1.200.00 

$18,800.00 
Taxable  at  4  per  cent 4,000.00  160.00 

Taxable  at  8  per  cent $14,800.00        1,184.00 

Combined  normal  tax    $1,424.00 

Method  B — husband  takes  exemption  : 

Wife's  income — ^'taxable  at  4  per  cent....  $4,000.00         $160.00 

Husband's  income $20,000.00 

Less:  Exemption    3,200.00 

$16,800.00 
Taxable  at  4  per  cent 4,000.00  160.00 

Taxable  at  8  per  cent .$12,800.00        1.024.00 

Combined  normal  tax   1,344.00 

Saving  in  normal  tax  =  4  per  cent   on  exemption  of  $2,000  =:        $     80.00 


"The  personal  e.xcmiUion  is  only  $2,000,  since  the  tuinregatc  net  inctmie 
of  husband  and  wife  is  .$24,000.     See  section  216   (c).  Chapter  XII. 


82  APPLICATION   AND    ADMINISTRATION 

If  a  wife  has  an  income  of  $4,000  or  less,  and  the  husband 
has  income  which,  after  deducting  the  full  personal  exemption, 
is  large  enough  to  subject  some  of  his  income  to  the  8  per 
cent  normal  tax,  the  application  of  the  entire  personal  exemp- 
tion to  the  husband's  income  results  in  a  saving  equal  to  4  per 
cent  of  the  exemption. 

Joint  returns  of  husband  and  wife — when  desirable.— it 
is  well  to  remember  that  a  joint  return  or  separate  returns  may 
be  rendered  when  husband  and  wife  are  living  together,  and 
advantage  may  thus  be  taken  each  year  of  the  most  advan- 
tageous basis  of  filing  returns,  as  hereinbefore  outlined. 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  January  17th, 
1921,  in  which  you  state  that  during  the  year  1920  your  income  was 
approximately  $54,000.00.  During  the  same  period  your  wife  suffered 
a  net  loss  of  $62,000.00. 

You  request  to  be  advised  whether  under  the  circumstances  you 
and  your  wife  may  file  a  joint  return  for  the  purpose  of  applying  your 
wife's  net  losses  against  your  income. 

You  are  advised  that  there  is  no  provision  of  the  law  by  which 
a  husband  and  wife  can  be  denied  the  privilege  of  filing  a  joint  return. 
Your  wife's  net  losses  may  therefore  be  deducted  from  your  income 
in  determining  income  subject  to  both  the  normal  tax  and  the  surtax 
where  you  and  your  wife  elect  to  file  a  joint  return.  (Letter  signed 
by  Commissioner  Wm.  M.  Williams,  and  dated  February  3,  1921.) 

Community  property. — The  Attorney  General,  in  opinions 
dated  September  10,  1920,^*^  and  February  26,  1921,^^  holds 
that  community  income  as  defined  by  the  laws  of  Texas,  Wash- 
ington, Arizona,  Idaho,  New^  Mexico,  Louisiana,  and  Nevada 
(but  not  California)  may  be  equally  divided  between  husband 
and  \vife.  Separate  returns  filed  by  husband  and  wife  in 
many  cases  will  result  in  a  considerable  saving  in  tax. 

A  full  discussion  of  community  property  wall  be  found 
in  Chapter  XIII  which  should  guide  the  preparation  of  returns 
for  1 92 1  and  subsequent  years. 

As  to  the  returns  for  years  prior  to  1921,  amended  returns 


'"  C.  B.  3,  page  221 ;  T.  D.  3071 ;  32   Op.  Att.  Gen.  298. 
■'C.  B.  4,  page  238;  T.  D.  3138;  32  Op.  Att.  Gen.  443. 


RETURNS— INDIVIDUALS  83 

and  claims  fur  refund  may  be  Hied  within  the  five-year  period 
laid  down  by  the  lyji  law. 

Ruling.  Amended  separate  returns  may  be  filed  for  each  of  the 
taxing  years  in  which  the  law  of  Texas  contains  a  provision  giving 
husband  and  wife  equal  rights  to  community  property,  subject  to  five- 
year  limitation  in  section  252,  Revenue  Act  of  191S. 

Claim  for  credit  of  net  amount  of  taxes  overpaid  for  any  of  the 
taxing  years  may  be  filed  for  the  amount  of  assessment  outstanding 
and  claim  for  refund  filed  for  balance.  Claim  for  abatement  instead 
of  claim  for  credit,  however,  should  be  filed  for  excess  of  tax  assessed 
for  1919  over  tax  due  for  1919  under  amended  separate  returns.  Claim 
for  refund  may  be  filed  for  entire  net  overpayment  if  no  assessment 
is  outstanding.  Adjustment  of  taxes  between  husband  and  wife  due 
on  amended  separate  returns  will  be  made  as  a  matter  of  accounting 
and  no  claim  for  credit  should  be  filed. 

Any  claim  for  abatement,  refund,  or  credit  must  be  accompanied 
by  an  agreement  signed  by  husband  and  wife  consenting  to  adjust- 
ments therein  demanded. 

In  all  cases  in  which  it  appears  that  returns  are  filed  as  a  result 
of  the  ruling  contained  in  Treasury  Decision  3071,'^  and  the  income 
shown  in  the  returns  now  filed  was  disclosed  in  a  prior  return  or  re- 
turns, penalty  on  account  of  delinquency  will  not  be  asserted  and  in- 
terest on  account  of  failure  to  pay  the  tax  shown  by  the  returns  of 
the  date  payment  was  required  by  law,  will  not  be  assessed.  Where 
a  claim  for  credit  is  filed  under  this  ruling,  bond  will  not  be  required. 

Claims  for  credit  may  be  filed  for  unpaid  additional  taxes  assessed 
under  office  ruling  43-20-1270.^'' 

.'should  the  above  outlined  procedure  not  cover  anv  specific  case 
which  may  arise,  the  facts  therein  should  be  presented  to  this  office 
for  a  specific  ruling.     (C.  B.  3,  page  31c    O.  D.  757.) 

The  above  rnling  under  the  1918  law  applies  specificallv 
to  Texas,  but  it  can  equally  well  apply  to  the  other  states  hav- 
ing community  property  laws  (listed  above).  The  claims  will 
now  be  made  under  section  252  of  the  192 1  law-. 

With  the  amended  returns  a  claim  for  refund,  credit,  or 
abatement  must  be  filed  in  order  to  adjust  the  excess  tax  paid  by 
one  spouse.  Although  tlie  ruling  is  not  commendable  for  its 
clarit}',    a    sul)sc(juent    decision""    cnnfirnis    the    inference    that 


See  Chapter  XIII. 
C.  B.  3,  page  30Q. 
C.  B.  4,  paye  .135 ;  O.  D.  ^54- 


§4  At^PLICATION    AND   ADMINISTRATION 

underpayment  by  one  spouse  may  be  offset  against  overpay- 
ment by  the  other.     Claim  is  to  be  filed  for  the  excess. 

Change  of  domicile  does  not  affect  the  right  to  render 
amended  returns. 

Ruling.  A  husband  and  wife,  who  were  domiciled  in  Texas, 
January  i,  1918,  and  abandoned  that  domicile  in  August,  1919,  the 
husband  having-  included  in  his  1918  and  1919  income  tax  returns 
income  received  from  all  sources  including  personal  earnings  and 
no  returns  having  been  filed  by  the  wife,  may  file  amended  separate 
returns  for  191 8,  each  reporting  as  gross  income  one-half  the  income 
received  during  that  year  which  constituted  community  income  as 
defined  in  T.  D.  3071.  They  may  also  file  amended  separate  returns 
for  1919,  each  reporting  as  gross  income  one-half  the  income,  received 
prior  to  the  abandonment  of  the  marital  domicile  in  Texas,  which 
constituted  community  income  as  so  defined. 

The  date  of  the  abandonment  of  the  Texas  domicile  is  determined 
by  the  application  to  the  facts  in  the  case  of  general  principles  of 
law.     (C.  B.  4,  page  235;  O.  D.  810.) 

Change  of  domicile  does  not  cause  the  forfeiture  of  the 
right  to  file  separate  returns  of  income  from  community  prop- 
erty acquired  while  domiciled  in  a  state  in  which  community 
property  laws  are  in  effect. 

Ruling.  Where  husband  and  wife  acquire  community  property 
while  domiciled  in  the  State  of  Idaho,  and  then  take  up  domicile  in 
California,  they  may  continue  to  render  separate  returns  of  the  in- 
come from  such  property.     (B.  Digest  39-21-1845;  S.  O.  121.) 

Returns  by  minors. — Minors  in  receipt  of  taxable  income 
are  required  to  make  returns,  or  returns  must  be  made  for  them. 

Regulation.  An  individual  under  the  statutory  age  of  majority 
is  required  to  render  a  return  of  income  if  he  has  a  net  income  of  his 
own  of  $1,000  or  over,  or  a  gross  income  of  $5,000  or  over,  for  the 
taxable  year.-^  If  he  is  married,  see  article  401.--  If  a  minor  has 
been  emancipated  by  his  parent  his  earnings  are  his  own  income,  and 
such  earnings,  regardless  of  amount,  are  not  required  to  be  included 
in  the  return  of  the  parent.  If  the  aggregate  of  the  net  income  of 
a  minor  from  any  property  whicli  he  possesses,  and  from  any  funds- 


''  [Former  Procedure]  Under  the  1916  and  1917  laws,  the  returns 
of  minors  were  filed  by  their  guardians  (Reg.  33,  1918,  Art.  27).  The 
words  "of  lawful  age"  are  omitted  from  section  223  of  the  1918  law, 
requiring  returns  of  "every  individual,"  etc. 

"'See  page  76. 


RETURNS— INDIVIDUALS  85 

lield  in  trust  for  him  by  a  trustee  or  guardian,  and  from  his  earnings 
in  case  he  has  been  emancipated,  is  at  least  $1,000,  or  his  gross  in- 
come is  at  least  $5,000,  a  return  as  in  the  case  of  any  other  individual 
must  be  made  by  him  or  by  his  guardian,  or  some  other  person  charged 
with  the  care  of  his  person  or  property  for  him.-^  In  the  absence  of 
proof  to  the  contrary,  a  parent  will  be  assumed  to  have  the  legal  right 
to  the  earnings  of  the  minor  and  must  include  them  in  his  return. 
(Art.  403.) 

The  latter  part  of  the  article  which  holds  that  a  parent  will 
be  assumed  to  have  the  legal  right  to  the  earnings  of  his  minor 
child  is  reasonable,  otherwise  minor  children  with  taxable 
incomes  might  erroneously  assume  that  they  were  not  indi- 
vidually responsible  for  making  returns  and  the  parent  in  turn 
might  assume  that,  since  the  minor  had  a  taxable  income,  the 
latter  was  responsible  for  the  making  of  a  return. 

It  has  been  stated  that  the  Treasury  has  advised  taxpayers 
that  the  mere  failure  of  a  parent  to  assert  his  right  to'  appro- 
priate the  earnings  of  his  minor  child  does  not  constitute 
emancipation  within  the  meaning  of  the  income  tax  law ;  also 
that  where  a  parent  relinquishes  his  right  to  appropriate,  such 
earnings  are  constructive  income  to  the  parent  and  are  con- 
sidered as  gifts  to  the  minor,  and  consequently  are  not  deduc- 
tible in  computing  the  parent's  net  income  subject  to  income  tax. 

In  view  of  the  reluctance  of  the  courts  to  impute  taxable 
income  to  a  taxpayer  when  none  has  actually  been  received, 
this  far-fetched  doctrine  of  constructive  receipt  is  hardly 
likely  to  be  adopted. 

The  question  then  arises — what  constitutes  emancipation? 
The  courts  have  hekP'  that : 

Emancipation  of  a  minor  occurs  by  the  voluntary  act  of  the 
parent  in  surrendering  the  rights  or  renouncing  the  duties  of  his 
position,  or  in  some  way  conducting  himself  in  relation  thereto  in 
a  manner  inconsistent  with  any  further  performance  of  them.  The 
emancipation  may  be  expressed  or  implied,  or  in  writing  or  oral.  The 
test  to  be  applied  is  that  of  the  preservation  or  destruction  of  the 
parental  and  filial  relations.    The  child's  arrival  at  the  age  of  majority 


^  See  Article  422. 

^29  Cyc.  1673,  citing  cases. 


86  ArPLICATION   AND   ADMINISTRATION 

is  priiuii  l.'icio,  but  nut  necessarily,  an  emancipation.  The  mar- 
riage of  the  child  is  an  emancipation  from  the  control  and  authority  of 
the  parent,  even  though  the  parent  did  not  consent  to  the  marriage. 
....  The  father's  desertion  of  a  minor  child  will  operate  as  an 
emancipation ;  but  the  child's  desertion  of  the  father's  home  does  not 
constitute  emancipation  so  long  as  the  father  has  not  relinquished 
his  right  of  control  or  consented  that  the  child  should  act  for  himself 
independently  of  the  father.  The  fact  that  the  child  is  allowed  to  live 
away  from  the  parent  does  not  amount  to  an  emancipation,  unless 
it  is  the  intention  of  the  parent  to  release  all  parental  authority  and 
control.     On  the  other  hand  the  fact  that  the  son  lives  in  the  family 

of  the  father  docs  not  establish  that  he  is  not  emancipated 

The  payment  of  a  weekly  allowance  by  the  parent  to  the  child  does  not 
constitute  emancipation.  Where  a  father  who  is  able  to  support  his 
minor  son  forces  him  to  leave  home  and  labor  abroad  for  a  livelihood, 
the  law  implies  an  emancipation.  So  also  an  infant  is  emancipated 
where  he  supports  himself  and  pays  his  board  at  home,  or  where 
the  parent  allows  him  to  carry  on  a  business  for  himself  and  exer- 
cises no  control  over  him  or  his  earnings.  Where  the  child  con- 
tracts for  his  services  and  collects  and  uses  his  own  earnings,  eman- 
cipation is  to  be  inferred;  but  a  complete  emancipation  does  not  nec- 
essarily result  from  the  fact  that  the  father  allows  the  child  to  re- 
ceive and  spend  his  own  wages,  or  even  to  contract  for  his  services. 
If  the  father  gives  or  sells  the  child  his  time  the  law  implies  emancipa- 
tion. 

It  thus  appears  that  the  Treasury  has  adopted  a  rather 
narrow  interpretation  of  the  law  and  one  that  will  be  modified 
later  in  favor  of  the  taxpayer. 

The  requirement  [section  (a-3)]  that  returns  must  be 
made  if  gross  income  is  $5,000  or  over,  applies  also  to  minors. 

Returns  by  soldiers  and  sailors. — All  persons  in  the  mili- 
tary or  naval  service  of  the  United  States  who  are  unable  to 
file  returns  within  the  statutory  time  limit  may  obtain  an  ex- 
tension of  time,  or  returns  may  be  made  for  them  by  agents. 
They  may  file  their  returns  in  "the  district  in  which  they  have 
a  legal  residence,  or  with  the  collector  of  internal  revenue  at 
Baltimore,  jMaryland."-^ 

Regulation persons  in  the  military  or  naval  service  of 

the  United  States,  may  file  their  returns  of  income  with  the  collector 
of  Baltimore.     (Art.  447;  Reg.  45,  Art.  448. j 


For  verification  of  such  returns,  see  page  78. 


RETURNS— INiDIVIDUALS  87 

Returns  by  fiduciaries. — The  duties  of  fiduciaries  (includ- 
ing their  liabihty  to  make  returns,  and  the  procedure  therefor) 
are  fully  explained  in  Chapter  XXXVII.  The  law"*^  classes 
fiduciaries  as  individuals  in  so  far  as  returns  are  concerned. 

Income  from  partnerships  included  in  individual  returns 
of  partners.— The  individual  returns  of  partners  for  192 1 
should  include  the  entire  distributive  shares  credited  to  such 
partners  ''for  any  accounting  period  of  the  partnership  ending 
within  the  fiscal  or  calendar  year  upon  the  basis  of  which  the 
partners'  net  income  is  computed.''"' 

Many  partners  have  all  their  personal  accounts,  including 
income  from  investments,  etc.,  kept  in  the  partnership  books, 
and  so  far  as  an  accounting  period  is  concerned  have  never 
recognized  the  calendar  year  except  for  federal  income  tax  re- 
quirements. If  it  is  more  convenient  for  a  partner  to  make 
a  return  at  some  date  other  than  as  of  December  31,  he  should 
apply  for  permission  to  make  the  change. 

When  there  is  income  from  partnerships  and  the  partner- 
ships' accounting  periods  are  fiscal  years  during  which  differ- 
ent rates  of  tax  are  in  effect,  three  steps  must  be  considered  in 
the  returns  of   individuals : 

(a)  Partners  must  report  their  share  of  the  income  of 
the  partnershij)  credited  to  them  on  the  last  day  of  the 
month  which  marked  the  close  of  the  partnerships' 
fiscal  years. '^ 

(b)  The  partnership  income  must  be  divided  into  the 
shares  applicable  to  each  of  tb.e  calendar  years,  included 
in  the  fiscal  year."^ 

(c)  Such  partnership  income  is  then  taxed  to  the  indi- 
vidual partners  at  the  rates  obtaining  during  the  cal- 
endar vears  to  which  it  is  allocated.'''^ 


''  Section  225. 
"  Section  218   (a). 
"Section  218  (a). 

"'Section  205    (c).     This  docs  not  apply  to  fiscal  years  ending  in   1921 
as  the  1920  and  1921  rates  are  the  same. 
'"  Ibid. 


88  APPLICATION   AND   ADMINISTRATION 

Assume  the  case  of  a  partnership  with  a  fiscal  year  ending 
June  30,  1922,  and  with  a  taxable  net  income  of  $120,000. 
A  partner  owning  one-half  interest  in  the  partnership,  having 
income  from  other  sources  of  $80,000,  and  reporting  on  a  cal- 
endar year  basis,  would  prepare  his  1922  return  as  follows: 

Other  income $  80,000  taxable  at  1922  rates 

Partnership  income   (yi) $60,000 

Partnership  income  allocated  to  1922 30,000  taxable  at  1922  rates 

$110,000  total  taxable  at  1922 
rates 
Partnership    income    allocated    to    1921 30,000  taxable  at  1921  rates 

Total  nef  income  for  1922 $140,000 


The  author  has  protested  against  the  inequity  of  the  method 
of  superimposition  of  income  attributable  to  a  prior  year  on 
the  income  of  the  current  year,  and  has  suggested  that  such 
income  be  superimposed  on  the  income  already  reported  for 
the  previous  year.^'^ 

Congress  did  not  re-enact  in  the  1921  law  the  provisions 
of  section  206  of  the  1918  law.  It  w^ould  seem  clear,  therefore, 
that  they  intended  to  give  the  taxpayer  relief  from  the  former 
inequitable  method.  No  specific  method  is  provided  in  the 
new  law  as  to  how  such  income  is  to  be  reported  and  taxed, 
but  the  Treasury  has  now,  by  regulation,  provided  for  the 
superimposition  of  the  income,  earned  during  the  prior  year 
by  a  partnership,  on  the  other  income  of  the  individual  for 
the  current  year  at  the  rates  of  the  preceding  year.  (See 
article  335.) 

Section  206  of  the  1918  law^^  provided  for  superimposition 


^^  Income  Tax  Procedure,  1919,  pages  122-124;  Income  Tax  Procedure, 
1920,  pages  152-157- 

"'  [Former  Procedure]  Section  206  of  the  1918  law  reads : 
"That  whenever  parts  of  a  taxpayer's  income  are  subject  to  rates  for 
different  calendar  years,  the  part  subject  to  the  rates  for  the  most  recent 
calendar  year  shall  be  placed  in  the  lower  brackets  of  the  rate  schedule 
provided  in  this  title,  the  part  subject  to  the  rates  for  the  next  preceding 
calendar  year  shall  be  placed  in  the  next  higher  brackets  of  the  rate  schedule 
applicable  to  that  year,  and  so  on  until  the  entire  net  income  has  been  ac- 
counted for.  In  determining  the  income,  any  deductions,  exemptions  or 
credits  of  a  kind   not  plainly  and  properly  chargeable  against  the   income 


RETURNS— CORPORATIONS  89 

of  the  income  attributed  to  a  preceding  year  upon  the  income 
subject  to  the  current  year's  rate.  For  instance,  the  $30,000 
in  the  above  example  taxable  at  the  1921  rates  would  be  sub- 
jected to  the  surtax  rates  for  192 1,  beginning  at  $110,000 
and  running  up  to  $140,000.  Tliis  method  resulted  in  an 
increase  of  tax  when  the  income  of  the  taxpayer  was  greater 
in  one  year  than  in  the  preceding  year.  Conversely,  it  resulted 
in  a  decrease  of  tax  when  the  income  of  a  taxpayer  decreased 
as  compared  with  a  preceding  year.  Accordingly  there  was 
a  penalty,  or  bonus,  in  changing  to  a  fiscal  year  basis,  depend- 
ing upon  the  income  received  in  the  current  year  as  compared 
with  the  preceding  year.  This  method  has  been  continued  in 
the  new  regulations. 

Incorporation  of  a  partnership  or  of  an  individual — return 
as  a  corporation. — The  192 1  law  provides^^^  that  under  certain 
conditions  the  income  of  a  business  organized  as  a  corporation 
within  four  months  after  the  passage  of  the  act  (the  act  was 
passed  November  23,  1921)  may,  at  the  option  of  the  individ- 
ual or  partnership,  be  treated  as  if  such  corporation  had  been 
in  existence  on  and  after  January  i,  192 1,  and  make  return 
accordingly.  For  full  discussion  of  procedure,  see  Chapter 
XXIV. 

Annual  Returns  by  Corporations 

For  1 92 1,  corporations  are  required  to  file  income  and 
excess  profits  tax  returns.  For  1922  and  subsecjuent  years, 
income  tax  returns  only  are  required. 

Corporations  which  are  specifically  exempt  under  the 
law^*  need  make  no  annual  return;  but,  it  will  be  recalled, 
must  in  certain  cases  establish  the   fact  of  their  exemption. 


taxable  at  rates  for  a  preceding  year  shall  first  be  applied  against  the  income 
subject  to  rates  for  the  most  recent  calendar  year;  but  any  balance  thereof 
shall  be  applied  against  tlie  income  subject  to  the  rates  of  the  next  pre- 
ceding year  or  years  until  fully  allowed." 

^■'  Section  229. 

"See  page  34- 


90 


APPLICATION    AND    ADMINISTRATION 


All  other  CDi'poratiuns  must  file  returns,  regardless  of  the 
amount  of  their  net  income.  But  when  corporations  have 
taxable  income  of  $3,000  or  less,  the  excess  profits  data  need 
not  be  furnished. 

Law.  Section  239.  (a)  That  every  corporation  subject  to  taxa- 
tion under  this  title  and  every  personal  service  corporation  shall  make 
a  return,  stating  specifically  the  items  of  its  gross  income  and  the  de- 
ductions and  credits  allowed  by  this  title 

Corporations  are  required  to  file  returns  for  their  account- 
ing periods,  the  same  as  arc  individuals."^  If  corporations 
have  been  closing  their  books  on  a  fiscal  year  basis  and  report- 
ing on  a  calendar  year  basis,  they  must  change  their  method 
and  report  for  fiscal  years. 

Return  sworn  to  by  two  officials.— - 

Law.  Section  239.  (a)  ....  The  return  shall  be  sworn  to  by 
the  president,  vice  president,  or  other  principal  officer  and  by  the 
treasurer  or  assistant  treasurer 

When  onl}-  one  officer  is  available,  the  officer  signing  the 
return  may  sign  for  the  other  in  the  latter's  official  capacity.^*"' 

"Corporation"  defined, — The  law"'  states  that  the  term 
"corporation"  shall  include  "associations,  joint-stock  com- 
panies and  insurance  companies."  Under  the  latest  rulings 
limited  partnerships  are  or  are  not  corporations,  depending 
upon  their  type."®  Massachusetts  trusts  have  been  held  not  to 
be  associations."^ 

Domestic  corporations,  for  the  purpose  of  the  revenue  act, 
are  those  organized  in  the  United  States,  which  include  only 
the  states,  the  District  of  Columbia,  and  the  territories  of 
A.laska  and  Hawaii.  Those  created  outside  these  limits  are 
foreign  corporations. 


^°  See  page  64. 

''  C.  B.  4,  page  307. 

'■  Section  i. 

''  See  Chapter  XXIV. 

''  See  page  93. 


RETURNS— CORPORATIONS  Ot 

The  Treasury  has  held,  however,  that  a  corporation  re- 
ceiving a  charter  from  tlie  United  States  Court  for  Lhina,  and 
holding  itself  out  to  be  a  corporation  under  the  laws  of  the 
United  States,  will,  for  tax  purposes,  be  considered  a  domestic 
corporation.*" 

Joint-stock   companies   and   associations. — 

Regulation.  Associations  and  joint-stock  companies  include  as- 
sociations, common-law  trusts,  and  organizations  l)y  whatever  name 
known,  which  act  or  do  business  in  an  organized  capacity,  whether 
created  under  and  pursuant  to  State  laws,  agreements,  declarations  of 
trust,  or  otherwise,  the  net  income  of  which,  if  any,  is  distril)uted  or 
distributable  among  the  members  or  shareholders  on  the  basis  of  the 
capital  stock  which  each  holds  or,  where  there  is  no  capital  stock, 
on  the  basis  of  the  proportionate  share  or  capital  which  each  has  or 
has  invested  in  the  business  or  property  of  the  organization.  A  cor- 
poration which  has  ceased  to  exist  in  contemplation  of  law  but  con- 
tinues its  business  in  corporate  form  is  an  association  or  corporation 
within  the  meaning  of  section  2,  but  if  it  continues  its  business  in  the 
form  of  a  trust,  it  becomes  subject  to  the  provisions  of  section  219. 
(Art.  1502.) 

The  last  sentence  of  this  article  is  new. 

Syndicates  and  joint  adventures. — The  ordinary  syn- 
dicates and  joint  adventures  are  held  not  to  be  associations.''^ 
But  a  syndicate  where  "a  shareholder's  certificate  entitles  him 
to  share  in  the  distribution  of  profits  during  the  life  of 
the  enterprise,  to  share  in  the  distribution  of  assets  upon 
dissolution,  and  to  vote  on  questions  affecting  the  man- 
agement and  control  of  the  business,"  was  held  to  be  an  asso- 
ciation.*- 

Alining  "partnerships"  in  Colorado  and  Idaho  have  been 
held  to  be  associations  because  the  shares  are  transferal)le 
and  Ijccause  such  an  organization  "in  all  its  essential  elements 
is  precisel}-  like  a  cor[)oration."^'' 


'"C.  B.  3,  page  19;  O.  D.  661. 
"  Reg.  45,  Art.  1507. 
*' C.  B.  4,  page  y;   O.  I).  8y6. 
"  B.  45-JI-19UJ;  A.  R.  R.  652. 


92 


APPLICATION   AND   ADMINISTRATION 


The  courts*^  have  diftereiitiated  a  trust  from  an  association, 
holding  that : 

An  organization,  in  form  a  trust,  created  by  an  agreement  of  the 
stockholders  of  several  street  railway  corporations  desiring  to  effect 
a  unitary  control  of  the  properties  of  such  corporations,  is  an  associ- 
ation within  Section  II,  Paragraph  G  (a),  of  the  Act,  where  the 
agreement  uses  language  that  reads  much  like  the  state  corporation 
law,  and  superimposes  that  organization  upon  the  several  corporations 
by  placing  the  legal  title  to  the  capital  stock  of  those  corporations  in 
the  trustees  named,  who  are  to  do  certain  specified  things  only,  and 
by  providing  for  a  committee  which  controls  even  the  power  of  the 
trustees  to  vote  the  capital  stock  of  the  corporations,  and  which  is 
elected  and  controlled  by  what  are  called  participating  shareholders, 
who  hold  certificates  of  common  and  preferred  participating  shares 
issued  by  the  trustees  in  lieu  of  the  capital  stocks  of  the  corporations. 

An  association  may  be  organized  independently  of  any  statute, 
and  when  so  organized  is  nevertheless  subject  to  income  tax  as  such. 

This  case  was  decided  under  the  191 3  law,  but  the  same 
principle  will  apply  under  all  later  statutes. 

Association  distinguished  from  partnership. — 

Regulation.  An  organization  the  membership  interests  in  which 
are  transferable  without  the  consent  of  all  the  members,  however  the 
transfer  may  be  otherwise  restricted,  and  the  business  of  which  is 
conducted  by  trustees  or  directors  and  officers  without  the  active 
participation  of  all  the  members  as  such,  is  an  association  and  not  a 
partnership.  A  partnership  bank  conducted  like  a  corporation  and  so 
organized  that  the  interests  of  its  members  may  be  transferred  with- 
out the  consent  of  the  other  members  is  a  joint-stock  company  or 
association  within  the  meaning  of  the  statute.  A  partnership  bank 
the  interests  of  whose  members  can  not  be  so  transferred  is  a  partner- 
ship.    (Art.  1503.) 

A  bank  which  had  issued  certificates  of  ownership  was 
held  not  to  be  an  association  but  a  partnership.  Certificates 
could  not  be  transferred  without  the  consent  of  the  other 
members,  and  each  member  was  liable  for  all  debts. ^^ 

A  private  banking  institution,  unincorporated,  where  the 


"  Chicago  Title  &  Trust  Company  as  Trustee  v.  Smietanka,  Collector, 
U.  S.  District  Court,  Northern  District  of  Illinois,  Eastern  Division,  March 
14,  1921   (not  reported,  see  T.  D.  3193,  July  i,  1921). 

"B.  44-21-1895;  O.  D.   1083. 


RETURNS— CORPORATIONS 


93 


interests  were  transferable  without  the  consent  of  the  other 
members,  was  held  to  be  an  association. "^^ 

Massachusetts  trusts. — Massachusetts  trusts  have 
grown  up  in  part  because,  until  about  ten  years  ago,  it  was 
not  possible  to  organize  a  corporation  under  the  Massachusetts 
law  to  own  and  operate  real  estate.  Out  of  the  common  prac- 
tice of  putting  real  estate  in  the  hands  of  trustees  for  legal 
ownership  and  management,  with  certificates  issued  to  the 
beneficiaries,  grew  the  practice  of  carrying  on  other  lines  of 
business  with  the  same  trust  organization  in  cases  where  it 
was  considered  that  a  trust  was  preferable  to  a  corporation. 
Hence,  in  practice,  there  are  all  kinds  of  Massachusetts  trusts. 
In  some  the  beneficiaries  have  little  or  no  control  over  the 
management  of  the  trust;  others  have  practically  all  the  char- 
acteristics of  corporations  (except  the  actual  corporate  exist- 
ence and  the  limited  liability  of  a  stockholder  in  a  corporation), 
and  are  governed  by  elaborate  by-laws  providmg  for  annual 
meetings  of  certificate  holders,  and  for  the  election  of  trustees 
for  relatively  short  periods  of  time,  thus  vesting  a  large  meas- 
ure of  control  in  certificate  holders. 

From  a  tax  standpoint  the  question  is :  Is  a  Massachu- 
setts trust  an  ordinary  trust  or  an  association?  If  the  latter, 
it  is  taxable  as  a  corporation.  If  the  former,  the  income,  if 
distrilxitable,  is  taxable  to  the  beneficiaries. 

In  the  case  of  Crocker  v.  MaUcy,^'^  the  court  pointed  out 
that,  by  the  terms  of  the  trust,  the  beneficiaries  were  "trust 
beneficiaries  only,  without  partnership,  association  or  other 
relation  whatever  inter  sese."  It  also  pointed  out  that  the 
trustees  had  discretion  to  distribute  income  or  to  add  it  to 
capital,  although  in  fact  they  did  make  complete  distribution, 
and  that  the  beneficiaries  had  no  control  over  the  management 
of  the  trust,  except  that  they  must  assent  to  any  increase  of 
the  trustees'  compensation,  to  the  filling  of  vacancies  among 

"I-i-i.  I.  T.  1150. 

"249  y.  S.  223;  62,  L.  Ed.  573;  39  Sup.  Ct.  270;  2  A.  L.  R.  looi. 


94 


APPLICATION   AND   ADMINISTRATION 


the  trustees  and  to  the  modifieation  of  the  terms  of  the  trust. 
.In  this  case  also,  the  purpose  of  the  trust  was  not  to  run  a 
l)usiness,  l)Ut  to  hold  certain  shares  of  stock  and  property  for 
a  limited  period  of  years,  preparatory  to  liquidation  of  the 
trust  property.  Upon  these  facts  the  court  found  that  the 
trust  did  not  have  the  attributes  of  an  association,  and  that 
the  provisions  of  the  Income  Tax  Act  of  October  3,  1913, 
section  II,  G  (a),  did  not  require  that  such  a  trust  be  treated 
as  a  corporation  for  the  purpose  of  taxation.  The  opinion  in 
the  case  does  not  deal  directl}-  with  the  question  whether  the 
trust,  as  a  trust,  or  the  loeneficiaries  are  accountable  for  a  tax 
on  the  dividends  received  by  the  trust,  because  under  the  with- 
holding provisions  of  the  19 13  act,  the  trustees  were  liable  to 
make  a  payment  of  tax  in  any  event,  whether  they  were  taxable 
themselves  or  merely  paid  on  behalf  of  the  beneficiaries. 

The  test  laid  down  by  the  Treasury  is  whether  the  bene- 
ficiaries have  a  voice  in  the  business. 

Ruling.  Where  beneficiaries  holding  certificates  evidencing  their 
interest  under  a  so-called  'Massachusetts  trust'  agreement  annually 
elect  persons  delegated  to  conduct  the  affairs  of  the  trusts,  thus  re- 
taining a  voice  in  the  business,  the  trust  is  an  association  and  is  sub- 
ject to  the  normal  tax  upon  its  income  under  the  Acts  of  1913,  1916, 
and  1918;  the  excess  profits  tax  under  the  Acts  of  1917  and  1918; 
the  capital  stock  tax  under  the  Acts  of  1916  and  1918;  and  the  cer- 
tificates issued  by  the  trust  to  the  beneficiaries  are  subject  to  the  stamp 
tax  under  the  Acts  of  1917  and  1918. 

Where  the  trustees  originally  appointed  were  to  hold  office  during 
the  entire  period  of  the  trust,  the  right  of  the  shareholders  being 
limited  to  filling  vacancies,  the  beneficiaries  not  retaining  any  sub- 
stantial control  over  the  affairs  of  the  trust,  such  a  trust  is  not  an 
association  or  taxable  as  such  under  section  230  of  the  act  of  19 18, 
but  under  section  219  relating  to  trusts.  They  are  not  subject  to  the 
excess  profits  tax  nor  the  capital  stock  tax,  nor  are  the  certificates 
issued  by  the  trustees  subject  to  stamp  tax.     (C.  B.  i,  page  5  ;  S.  1068.) 

The  question,  whether  beneficiaries  in  such  trusts  must 
return  their  distributive  shares  of  income  of  the  trust,  or 
merely  the  income  which  is  distributed  to  them,  answers  itself 
in  accordance  with  the  general  rules  applicable  to  corporations 
and  trusts.     Clearh*,  if  the  trust  is  of  such  a  nature  that  it 


RETURNS— COnrORATIONS  95 

niiisl  l)c  taxed  as  a  corporation,  its  distributions  are  dividends 
and  its  shareholders  have  no  taxable  interest  in  its  undistrib- 
uted earnings.  On  the  other  hand,  if  the  trust  upon  its  pecu- 
liar facts  is  classifiable  for  tax  purposes  as  a  trust,  and  not  as 
a  corporation,  the  question  whether  the  beneficiaries  must  re- 
turn their  distributive  shares  of  income,  or  only  the  income 
distributed  to  them,  depends  upon  their  rights  under  the  trust 
to  have  income  distributed.  In  the  Crocker  case  the  trustees 
had  discretion  to  distribute  income  or  to  add  it  to  capital. 
According  to  the  Treasury,*^  in  such  a  case  all  the  income 
would  be  taxed  to  the  trustees.  It  would  seem,  however,  that 
the  language  in  section  219  (a-3)  and  (c),  which  makes  in- 
come taxa1)le  to  the  trustees  if  "held  fur  future  distrilnition 
under  the  terms  of  the  will  or  trust,"  looks  to  the  act  of 
the  trustee  under  his  authority  given  by  the  trust  instrument 
as  determining  whether  or  not  the  income,  under  tlie  language 
of  the  statute,  is  ''held  for  future  distribution." 

Returns  of  incomplete  and  inactive  corporations. — In  the 

language  of  section  239,  '"every  corporation  subject  to  taxation 
under  this  title"*^  must  make  a  return.""  Consequently  all 
corporations,  no  matter  how  small  the  income  or  whether  or 
not  they  have  any  income  at  all,  provided  only  that  as  corpora- 
tions they  are  subject  to  the  tax,  must  file  a  return.  Such 
corporations,  if  in  existence  during  any  part  of  the  year,  are 
liable  and  must  report  from  the  first  of  the  year  to  the  date 
uf  dissolution  or  liquidation,  or  from  the  date  of  incorpora- 
tion to  the  end  of  the  taxable  year. 

The  general  rule  is  that,  "so  long  as  it  has  the  right  to 
function  as  a  corporation  under  the  laws  of  the  State  in  which 
it  was  incorporated,  regardless  of  whether  or  not  it  received 


"C.  B.  I,  page  176;  S.  1088. 

■""  "And  every  personal  service  corporation"  l)ut  sucli  corporations  are 
exempt  under  this  title   (section  239). 

""Section  13  (h)  of  the  1017  law  reads,  "every  corporation  not  spe- 
cifically enumerated  as  exempt  shall  make  return  of  annua!  net  income 
whether  or  not  it  may  have  for  the  parlicnlar  year  any  net  incuuie." 


96  APPLICATION   AND    ADMINISTRATION 

any  income  during  the  period  for  which  the  return  is  rendered," 
a  return  must  be  made.'^^ 

It  has  been  held  that  a  return  must  be  filed  although  the 
organization  as  a  corporation  has  not  been  completed  ;^^  where 
a  single  stockholder  acquires  all  the  stock  and  continues  the 
business,  the  corporation  is  not  thereby  dissolved;"  where 
after  expiration  of  the  charter  by  limitation,  its  business  is 
continued  in  the  corporate  form.^*  A  stockholder  purchased 
the  business  of  a  corporation,  operated  the  same  as  an  indi- 
vidual, filed  a  "change  of  attitude"  with  the  Secretary  of  State 
in  Michigan.  A  return  was  required  because  it  was  held  that 
the  corporation  was  not  dissolved  but  its  powers  merely  sus- 
pended.^^ 

As  was  pointed  out  by  the  Solicitor  in  the  first  ruling  cited, 
the  question  whether  a  corporation  has  been  properly  organ- 
ized or  not  is  a  question  which  cannot  be  raised  collaterally. 

Regulation A  corporation  having  an  existence  during 

any  portion  of  a  taxable  year  is  required  to  make  a  return.  A  corpor- 
ation which  has  received  a  charter,  but  has  never  perfected  its  organ- 
ization, and  which  has  transacted  no  business  and  had  no  income 
from  any  source,  may  upon  presentation  of  the  facts  to  the  collector 
be  relieved  from  the  necessity  of  making  a  return  so  long  as  it  re- 
mains in  an  unorganized  condition.  In  the  absence  of  a  proper  show- 
ing to  the  collector  such  a  corporation  will  be  required  to  make  a 
return.  A  corporation  which  was  dissolved  in  1921  prior  to  the 
enactment  of  the  present  statute  is  not  relieved  from  the  necessity 
of  rendering"  returns  thereunder  for  such  portion  of  1921  as  elapsed 
before  its  dissolution (Art.  621.) 

Ruling.  A  charter  was  granted  A  and  B  in  1915  to  carry  on 
business  as  a  corporation.  The  charter  was  granted  under  section 
2823  of  the  Civil  Code  of  Georgia,  which  provides  in  part  that  "*  *  * 
No  charter  shall  have  any  force  or  effect  for  a  longer  period  than 
two  years  unless  the  corporation,  within  that  time,  shall  in  good  faith 
commence  to  exercise  the  powers  granted  by  the  act  of  incorporation 
*  *  *.  "  Prior  to  the  application  for  a  charter  A  and  B  operated 
the  business  as  a  partnership,  and  since  the  granting  of  the  charter 


"  C.  B.  4,  page  307 ;  O.  D.  882. 

"C.  B.  I,  page  233;  S.  972.     But  see  also  Art.  621. 

''C.  B.  4,  page  302;  S.  O.  91  • 

"  C.  B.  4,  page  305 ;  S.  O.  93. 

"C.  B.  4,  page  308;  O.  D.  919. 


RETURNS— CORrORATIONS 


97 


they  iiavc  continued  its  operation  as  a  partnership.  Corporation  re- 
turns were  filed  for  1916,  1917,  and  1918.  No  articles  of  incorporation 
or  by-laws  exist ;  no  meeting  of  the  stockholders  was  ever  held ;  no 
stock  was  issued  nor  any  officers  elected;  and  the  company  has  never 
held  itself  out  as  a  corporation  in  any  of  its  dealings  and  has  never 
brought  suit  nor  been  sued  as  a  corporation.  The  company  has  always 
been  taxed  for  State,  county,  and  school  purposes  as  a  copartnership. 
Held,  that  the  organi;cation  of  A  and  B  never  existed  either  as  a 
de  jure  or  a  de  facto  corporation.     (B.  43-21-1887;  O.  D.  1078.) 

When  a  change  is  made  from  the  corporate  form  to  single 
proprietorship  or  partnership,  corporations  are  not  always 
formally  dissolved.  Care  should  be  taken  in  such  cases  to 
observe  all  legal  requirements,  or  the  Treasury  may  require 
corporation  returns  to  be  made,  even  though  entries  have 
been  made  on  the  books  transferring  the  assets.  This  com- 
ment is  particularly  applicable  to  those  closely  held  corpora- 
tions in  which  there  is  laxity  in  the  holding  of  stockholders' 
meetings  and  proper  authorization  of  the  acts  of  the  officers. 

In  general,  if  the  business  is  continued  under  the  corporate 
form,  the  Treasury  takes  the  position  that  such  an  organiza- 
tion, if  not  a  corporation  de  jure  or  de  facto,  is  an  association.^" 

The  Treasury  may  not  require  a  return  if  a  proper  state- 
ment of  the  facts  is  made. 

Ruling.  The  M  Company  was  incorporated  in  July,  1919,  but 
did  not  commence  business  until  September  i,  1919,  on  which  date 
the  corporation  opened  its  books  and  established  a  fiscal  year  ending 
August  31. 

In  March,  1920,  it  filed  a  return  for  the  fractional  part  of  the  year 
from  September  i,  1919,  to  December  31,  1919,  but  failed  to  render 
a  return  for  the  fractional  period  from  July,  1919,  to  August  31,  1919, 
during  which  time  it  remained  in  an  unorganized  condition  and  had 
no  income. 

Article  621,  Regulations  45,  provides  that  a  corporation  which 
has  received  a  charter  but  has  not  perfected  its  organization  and 
received  no  income,  may,  upon  presentation  of  the  facts  to  the  col- 
lector, be  relieved  of  the  necessity  of  making  a  return  for  the  fractional 
period  during  which  it  remained  in  an  unorganized  condition  and  had 
no  income. 


'  C.  P..  4,  page  305 ;  Sol.  Op.  93. 


Qg  APPLICATION   AND   ADMINISTRATION 

Held,  that  a  failure  to  make  such  presentation  of  facts  on  or 
before  November  15,  1919,  the  last  due  date  of  the  return  for  the 
period  July,  1919,  to  August  31,  1919,  will  be  construed  as  a  waiver 
of  the  privilege  on  the  part  of  the  taxpayer;  a  return  covering  the 
fractional  period  July,  1919,  to  August  31,  1919,  accompanied  with 
an  affidavit  stating  the  reason  for  the  delay  in  filing,  will  accordingly 
be  required,  although  there  was  nn  income  for  the  period.  (  B.  48- 
21-1951 ;  O.  D.  1120.) 

Ruling.  The  M  Company  was  formed  by  incorporating  the  busi- 
ness of  a  copartnership.  It  was  intended  that  the  business  of  the 
partnership  would  be  transferred  to  the  new  corporation  as  of  May 
— ,  1920,  the  beginning  of  the  partnership's  fiscal  year,  but  the  neces- 
sary legal  preliminaries  were  not  begun  in  time  and  the  charter  of 
the  corporation  was  not  issued  until  October  — ,  1920.  However,  the 
employees  were  sold  the  common  stock  at  par  with  the  understanding 
that  they  would  thereby  share  proportionately  in  the  profits  from 
May  — ,  and  in  transferring  the  business  the  corporation  assumed  the 
operation  thereof  from  May  —  and  entered  the  same  on  its  books. 

Inquiry  is  made  as  to  whether  or  not  it  is  proper  for  the  cor- 
poration to  make  return  for  the  12  months  ending  April  — ,  1921,  and 
report  as  its  net  income  the  net  income  of  the  business  for  this  period. 

It  is  held  that  October  — ,  1920,  is  the  date  to  be  taken  as  the  be- 
ginning of  the  period  to  be  covered  by  the  return  of  the  M  Company 
and,  therefore,  the  corporation  can  not  make  return  for  the  12  months 
ending  April  — ,  1921.  The  corporation  was  not  in  existence  nor 
did  it  receive  income  prior  to  October  — ,  1920.  (B.  35-21-1796; 
O.  D.  1016.) 

The  foregoing  ruling  is  not  consistent  with  the  position 
taken  l)y  the  Treasury  in  those  cases  where  it  was  held  that 
a  return  nnist  l)e  made  as  a  corporation  even  though  the  cor- 
])orate  organization  has  not  been  coni])]eted.  In  another  case 
the  Treasury  held  that  tlie  taxable  jjcriod  of  the  C(ir])iiratii)n 
l)egan  as  of  the  date  of  the  issuance  of  the  certilicate  l)y  the 
Secretary  of  State. •'^^' 

Rtti.inc.  In  accordance  with  the  terms  of  a  contract  between  the 
O  Corporation  and  the  M  Corporation,  the  assets  and  liabilities  uf 
the  O  Corporation  were  transferred  to  the  M  Corporation  on  December 
31,  1919,  and  the  M  Corporation  vvas  to  have  the  income  received  by 
the  O  Corporatian  between  October  4,  T919.  and  December  31.  1919, 
the  end  of  its  taxable  year. 

Held,  that  each  corporation  is  required  to  render  a  return  for  its 


E.  4S-21-1952;  O.  D.  1 121. 


RETURNS— CORPORATIONS 


99 


full  taxable  year  and  that  the  O  Coi"i)oratioii  must  iuckule  in  its 
return  the  entire  income  received  in  1919,  including  any  gain  realized 
from  the  sale  of  its  assets  to  the  M  Corporation.  (B,  36-21-1808; 
O.  D.  1025.) 

It  is  proper  that  returns  should  cover  the  full  period  during 
which  both  corporations  were  in  existence;  but  the  ruling 
should  have  stated  that  the  O  corporation  could  claim  as  an 
allowable  deduction  the  income  turned  over  after  October  4  to 
the  M  corporation.  The  net  income  after  October  4  was 
taxable  income  only  to  the  corporation  wliich  retained  it. 

Return  by  new  corporation. — The  provision  in  the  1918 
law^^  with  reference  to  the  making  of  a  first  return  in  case 
of  a  fiscal  year,  w^as  never  clear  and  has  been  repealed.  In 
making  a  first  return  a  corporation  simply  makes  return  on 
the  basis  of  its  fiscal  year.  No  notice  to  the  Commissioner 
of  the  date  of  the  close  of  the  fiscal  year  is  required  from  a 
new  corporation. 

Holding  companies  with  income  only  from  dividends  must 
make  returns. — Section  239,  quoted  on  page  90.  appears  t(j 
include  holding  companies  receiving  no  income  other  than 
dividends  from  subsidiaries.  Dividends  received  by  a  cor- 
poration must  be  reported  as  gross  income  [section  233  (a) 
and  section  213]  even  though  they  are  deducted  in  order  to 
ascertain  net  income.  If  any  doubt  arises  concerning  tlie 
liability  of  holding  companies  to  submit  returns,  the  Commis- 


■"  [Former  Procedure]  Section  226  of  the  igi8  law  provides:  "If  a 
taxpayer  making  his  first  return  for  income  tax  keeps  his  accounts  on  the 
basis  of  a  fiscal  year  he  shall  make  a  separate  return  for  the  period  between 
the  beginning  of  the  calendar  year  in  which  such  fiscal  year  ends  and  the 
end  of  such  fiscal  year." 

In  answer  to  an  inquiry  as  to  the  method  of  reporting  used  by  a  cor- 
poration which  organized  on  October  i,  1Q18,  and  wished  to  establish 
September  30,  1919,  as  its  first  fiscal  period,  Commissioner  Roper  on  March 
12,  1919,  advised  as  follows  :  "If  your  books  are  kept  on  basis  of  a  fiscal  year 
ending  September  thirtieth  you  should  file  your  first  corporate  income  tax 
return  upon  basis  of  such  fiscal  year  ending  in  nineteen  nineteen  on  or  before 
December  fifteenth,  nineteen  nineteen.  No  notice  of  date  of  close  of  fiscal 
year  required."  This  interpretation  obviated  any  necessity  for  reporting 
a  fractional  part  of  the  year  when  a  new  corporation  did  not  wish  to  do  so. 


lOO  APPLICATION   AND   ADMINISTRATION 

sioner  will  undoubtedly  require  such  returns  through  an  exer- 
cise of  his  power  under  section  1307  to  demand  returns  when- 
ever in  his  judgment  he  considers  them  "necessary."^^ 

Return  of  foreign  corporation  filed  by  agent. — 

Law.  Section  239.  (a)  ....  If  any  foreign  corporation  has 
no  office  or  place  of  business  in  the  United  States  but  has  an  agent  in 
the  United  States,  the  return  shall  be  made  by  the  agent 

Regulation.  Every  foreign  corporation'^*'  and  corporations  satis- 
fying the  conditions  set  forth  under  section  262,  having  income  from 
sources  within  the  United  States,  must  make  a  return  of  income  on 
Form  1 120.  If  such  a  corporation  has  no  office  or  place  of  business 
here,  but  has  a  resident  agent,  he  shall  make  the  return.  It  is  not  nec- 
essar}',  however,  for  it  to  be  required  to  make  a  return  that  the  for- 
eign corporation  shall  be  engaged  in  business  in  this  country  or  that 
it  have  any  office,  branch,  or  agency  in  the  United  States.     (Art.  625.) 

The  first  sentence  of  this  article  has  been  changed  to  give 
effect  to  corporations  entitled  to  the  benefits  of  section  262 
of  the  law. 

Returns  of  insurance  companies. — The  new  law®^  provides 
for  taxation  of  life  insurance  companies  on  the  basis  of  in- 
vestment income  only.  No  excess  profits  tax  return  or  capital 
stock  tax  return  is  to  be  made  for  1921,  as  is  the  case  with 
ordinary  corporations.  Beginning  with  1922,  insurance  com- 
panies®" (other  than  life  or  mutual  insurance  companies)  make 
special  returns  in  lieu  of  the  ordinary  income  and  capital  stock 
tax  returns.     For  detailed  discussion,  see  Chapter  XXXVIII. 

Returns  of  mergers,  reorganizations  and  corporations  with 
changed  names. — 

Regulation,  (a)  Where  corporations  are  affiliated  at  the  be- 
ginning of  a  taxable  year  but  due  to  a  change  in  stock  ownership  or 
control  during  the  year  the  affiliated  status  is  terminated,  or  (&) 
where  corporations  are  not  affiliated  at  the  beginning  of  the  taxable 


^'See  Chapter  III._  _ 

°"  For  special  provisions  appl3'ing  to  foreign  life  insurance  companies, 
see  Chapter  XXXVIII. 
"  Section  243. 
"  Section  246. 


RETURNS— CORPORATIONS  lOl 

year  but  through  change  of  stock  ownership  or  control  durhig  the 
year  become  affiliated,  a  full  disclosure  of  the  circumstances  of  such 
changes  of  stock  ownership  shall  be  submitted  to  the  Commissioner. 
Ordinarily  in  such  cases  the  parent  or  principal  company,  under  the 
conditions  described  in  (a)  above,  should  exclude  from  its  return  the 
income  and  invested  capital  of  such  subsidiary  or  subordinate  com- 
pany from  the  date  of  the  change  of  stock  ownership,  and  under  the 
conditions  described  in  (&)  above,  should  include  in  its  return  the  in- 
come and  invested  capital  of  such  subsidiary  or  subordinate  company 
from  the  date  of  the  change  of  stock  ownership.  In  either  case  the 
subsidiary  or  subordinate  corporation  whose  status  is  changed  dur- 
ing the  taxable  year  should  make  a  separate  return  for  that  part  of 
the  taxable  year  during  which  it  was  outside  of  the  affiliated  group. 

Where,  in  accordance  with  the  procedure  set  forth  above,  a  return 
is  made  by  a  corporation  for  a  period  less  than  a  year,  the  tax  shall 
be  computed  in  accordance  with  sections  226  and  239  and  the  articles 
thereunder.  In  any  case  in  which  the  change  of  consolidated  status 
is  for  a  period  so  short  as  to  be  negligible,  a  consolidated  return  or 
separate  returns  for  the  entire  period,  as  the  case  may  be,  may  be 
filed;  in  such  cases,  however,  there  should  accompany  the  return  a 
complete  statement  setting  forth  the  changes  in  the  affiliated  status 
occurring  during  the  taxable  year.     (Art.  634.) 

The  new  article  takes  into  account  the  option  available  to 
affiliated  corporations  after  January  i,  1922,  to  file  separate 
or  consolidated  returns.  It  also  clarifies  the  procedure  to  be 
followed. 

It  may  be  necessary  to  file  three  or  more  returns  for  a 
single  year  in  case  of  merger — one  for  each  corporation  before 
the  merger,  covering  the  portion  of  the  year  during  which 
the  corporations  existed  as  separate  entities,  and  one  for  the 
merged  corporation  after  consolidation.  When  the  change 
consists  of  the  absorption  of  one  company  by  another  and  the 
effect  has  been  merely  the  enlargement  of  the  absorbing  cor- 
poration, separate  returns  for  the  companies  before  and  after 
the  merger  are  not  required.  Generally  speaking,  it  is  not 
advantageous  to  file  separate  returns  when  consolidated  returns 
may  be  filed. 

In  what  are  known  as  "seasonal"  businesses,  care 
should  be  taken  to  avoid  making  a  change  at  a  time  of  year 
when  there  may  be  a  net  loss  for  the  period  elapsed  since  the 


ID2  APPLICATION    AND   ADMINISTRATION 

beginning  of  the  liscal  year.  Althongh,  under  the  1921  law,"^ 
a  net  loss  may  be  carried  forward  and  "deducted  from  the  net 
income  of  the  taxpayer  for  the  succeeding  year,"  such  net 
loss  could  not  be  taken  advantage  of  by  a  siicct'ssor  cor- 
poration. 

Returns  by  receivers,  trustees  in  bankruptcy  or  assignees. — 

Law.  Section  239.  (a)  ....  In  cases  where  receivers,  trustees 
in  bankruptcy,  or  assignees  are  operating  the  property  or  business  of 
corporations,  such  receivers,  trustees,  or  assignees  shall  make  returns 
for  such  corporations  in  the  same  m.anner  and  form  as  corporations 
are  required  to  make  returns.  Any  tax  due  on  the  basis  of  such  re- 
turns made  by  receivers,  trustees,  or  assignees  shall  be  collected  in 
the  same  manner  as  if  collected  from  the  corporations  of  whose  busi- 
ness or  property  they   have   custody   and   control. 

Regulations.  A  receiver  who  stands  in  the  stead  of  an  individual 
or  corporation  must  render  a  return  of  income  and  pay  the  tax  for 
his  trust,  but  a  receiver  of  only  part  of  the  property  of  an  individual 

or  corporation  need  not In  general,  statutory  receivers  and 

common  law  receivers  of  all  the  property  or  business  of  an  individual 
or  corporation  must  make  returns (Art.  424.) 

When  a  corporation  is  dissolved,  its  affairs  are  usually  wound  up 
by  a  receiver  or  trustees  in  dissolution.  The  corporate  existence  is 
continued  for  the  purpose  of  liquidating  the  assets  and  paying  the 
debts,  and  such  receiver  or  trustees  stand  in  the  stead  of  the  corpora- 
tion for  such  purposes.  Any  sales  of  property  by  them  are  to  be 
treated  as  if  made  by  the  corporation  for  the  purpose  of  ascertaining 
the  gain  or  loss.  No  gain  or  loss  is  realized  by  a  corporation  from 
the  mere  distribution  of  its  assets  in  kind  upon  dissolution,  however 
they  may  have  appreciated  or  depreciated  in  valtie  since  their  acquisi- 
tion       (Art.  548:  Reg.  45.  Art.  547.) 

Receivers,  trustees  in  dissolution,  trustees  in  bankruptcy,  and  as- 
signees, operating  the  property  or  business  of  corporations,  must  make 
returns  of  income  for  such  corporations  on  form  1120,  covering  each 
year  or  part  of  a  year  during  which  they  are  in  control.  Notwith- 
standing that  the  powers  and  functions  of  a  corporation  are  sus- 
pended and  that  the  ])roperty  and  business  are  for  the  time  being  in 
the  custody  of  the  receiver,  trustee,  or  assignee,  subject  to  the  order 
of  the  court,  such  receiver,  trustee,  or  assignee  stands  in  the  place  of 

"  Section  204. 


RETURNS— C(JRPORATIONS  103 

tlic  corporate  officers  and  is  required  to  perform  all  the  duties  and 
assume  all  the  liabilities  which  would  devolve  upon  the  officers  of  the 
corporation  were  they  in  control.  A  receiver  in  charge  of  only  part 
of  the  property  of  a  corporation,  howeyer,  as  a  receiver  in  mortgage 
foreclosure  proceedings  involving  merely  a  small  portion  of  its  prop- 
erty, need  not  make  a  return  of  income (Art.  622.) 

Consolidated  returns. — Affiliated  corporations''^  arc  rc- 
(|uircd  by  the  new  law  to  make  consolidated  returns  for  1921  in 
the  same  manner  as  is  provided  by  the  1918  law."'  For  1922 
and  subsequent  years,  affiliated  corpoi-ations  may  file  consoli- 
dated returns  or  separate  returns  for  each  corporation,  at  the 
oi)tion  of  the  taxpayer.  However,  once  the  option  is  exercised, 
returns  nnist  be  made  on  the  same  basis  thereafter.  Careful 
consideration  should  be  given,  therefore,  before  deciding  which 
basis  to  adopt. 

From  the  standpoint  of  income  tax,  it  makes  little  differ- 
ence whether  or  not  the  accounts  of  affiliated  concerns  are 
consolidated,  unless  one  or  more  of  a  group  should  be  losing 
money.  In  such  a  case,  under  separate  returns  no  credit  could 
be  taken  for  the  loss,  in  the  current  year's  return;  a  net  loss, 
however,  could  be  carried  forward. 

,An  attempt  might  be  made  in  such  circumstances  to  shift 
some  of  the  profit  to  a  losing  subsidiary,  but  a  new  provision  of 
the  192 1  law  gives  the  Commissioner  power  to  consolidate  the 
accounts  of  "two  or  more  related  trades  or  businesses  .  .  .  . 
owned  or  controlled  directly  or  iridirectl5^  by  the  same  inter- 
ests ....  for  the  purpose  of  making  an  accurate  distribu- 
tion or  apportionment  of  gains,  profits,  income  .  .  .  ."''^ 
Under  these  largely  increased  powers,  it  may  be  expected  that 


[Former  Procedure]  There  was  a  similar  specific  requirement  in 
the  1918  law.  The  1917  law  specified  that  the  return  include  information 
regarding  "the  tax  years  and  the  applicable  amounts  in  which  such  divi- 
dends were  earned."  This  was  necessary  because  in  1917  dividends  were 
taxable  at  the  rates  which  were  in  force  during  the  years  to  which  the 
dividends  were  applicable,  under  the  rule  that  dividends  were  deemed  to 
have  been  paid  out  of  most  reccntlv  accumulated  surplus  (1917  law,  section 
26). 

"'bor  dcbnition  of  alliliatecl  cnri)oration.  Sec  h.Virss  Profils  lax  I'yn- 
ccdure.  1921,  page  308. 

"Section  240   (c).     See  Chaiiter  XIV  of  Appendix  A. 

"Section  240  (d). 


I04 


APPLICATION   AND    ADMINISTRATION 


the  Commissioner  will  exercise  them  in  those  cases  where  the 
income  or  deductions  are  illegally  shifted.  If  minority  inter- 
ests are  not  affected,  there  is  nothing  illegal  or  immoral  in 
shifting  profits  or  losses  in  order  to  bring  about  an  equitable 
tax  burden. 

Consolidated  returns  after  January  i,  1922. — 

Law.  Section  240.  (a)  That  corporations  which  are  affiliated 
within  the  meaning  of  this  section  may,  for  any  taxable  year  beginning 
on  or  after  January  i,  1922,^^  make  separate  returns  or,  under  regula- 
tions prescribed  by  the  Commissioner  with  the  approval  of  the  Sec- 
retary, make  a  consolidated  return  of  net  income  for  the  purpose  of  this 
title,  in  which  case  the  taxes  thereunder  shall  be  computed  and  de- 
termined upon  the  basis  of  such  return.  If  return  is  made  on  either 
of  such  bases,  all  returns  thereafter  made  shall  be  upon  the  same 
basis  unless  permission  to  change  the  basis  is  granted  by  the  Commis- 
sioner  

If  the  tax  is  assessed  upon  the  basis  of  a  consolidated  re- 
turn, the  total  tax  shall  be  computed  in  the  first  instance  as  a 
unit. 


"  [Former  Procedure]  Under  the  1918  law,  consolidated  returns 
were  required  for  both  income  and  profits  taxes  (see  Excess  Profits  Tax 
Procedure,  1921,  Chapter  XIV).  No  specific  provision  in  the  1917  law 
required  the  filing  of  consolidated  returns ;  but  by  regulation  (Reg.  41, 
Arts.  77  and  78)  the  Treasury,  under  the  general  provision  of  section  201, 
required  the  filing  of  consolidated  returns  for  excess  profits  tax  in  the  case 
of  corporations,  when  there  was  either  substantial  stock  ownership,  or  close 
financial  relationship  or  control.  Partnerships,  which  in  1917  were  subject 
to  excess  profits  tax,  were,  under  the  1917  regulations,  neither  required  nor 
permitted  to  make  conscriidated  return.  In  a  specific  case  the  Treasury 
refused  to  accept  a  consolidated  return  where  a  partnership  was  affiliated 
with  a  corporation. 

Considerable  doubt  as  to  the  right  of  the  Treasury  to  require  any  con- 
solidated returns  under  the  1917  law,  gave  rise  to  the  inclusion  in  the  1921 
law  of  section  1331,  declaratory  of  the  1917  law,  in  effect  validating  Reg. 
41,  Arts.  77  and  78,  referred  to  above. 

A  comparison  of  the  language  of  section  1331  of  the  1921  law,  with 
that  of  Reg.  41,  Arts.  77  and  79,  reveals  the  fact  that  while  section  1331 
follows  the  wording  of  the  regulations,  an  important  change  is  made  in  that 
the  law  specifically  treats  partnerships  on  the  same  basis  as  corporations 
as  regards  affiliation.  Under  this  section,  amended  returns  may  be  desirable 
and  necessary  in  those  cases  in  which  a  partnership  has  previously  been 
denied  affiliation  either  with  another  partnership  or  with  a  corporation. 

Under  previous  income  tax  laws,  prior  to  1918,  every  corporation  was 
held  to  be  "a  separate  and  distinct  entity"  and  the  tax  was  imposed  upon  each 
separately.  If  the  subsidiary  corporations  had  merely  a  nominal  existence, 
however,  being  integral  parts  of  the  parent  corporation,  they  were  held  not 
to  be  separately  taxable  (Reg.  33,  1918,  Art.  208). 


RETURNS— CORPORATIONS  105 

The  distribution  of  the  tax  among  the  affihatecl  corporations 
may  be  made  on  the  basis  of  the  net  income  properly  assign- 
able to  each,  or  as  may  be  agreed  upon  between  them.*'^ 

Foreign  affiliated  corporations — -and  corporations 
having  income  from  united  states  possessions. a  for- 
eign corporation  cannot  be  included  in  a  consolidated  return, 
since  section  240  applies  only  to  domestic  corporations.  A 
corporation  entitled  to  the  benefits  of  section  262''^  (receiving 
the  major  portion  of  its  income  from  sources  within  posses- 
sions of  the  United  States)  is  treated  as  a  foreign  corporation, 
and  cannot,  therefore,  be  included  in  a  consolidated  return.'^" 

The  subject  of  consolidated  returns  is  fully  dealt  with  in 
the  author's  Excess  Profits  Tax  Procedure,  1921,  Chap- 
ters XIII  and  XIV. 

New  "government  contract"  corporations  must  make  sep- 
arate returns.— Since  consolidated  returns  for  192 1  are  to  be 
made  "subject  to  the  same  conditions  as  provided  by  the  Rev- 
enue Act  of  19 18,""  the  following  sections  of  that  law  apply 
to  certain  corporations  in  1921,  but  will  not  apply  in  1922  be- 
cause sections  240  (a)  and  1408  of  the  19 18  law  have  not 
been  re-enacted  in  the  new  law^ 

191 8  Law.  Section  240.  (a)  .  .  .  .  Provided,  That  there  shall 
be  taken  out  of  such  consolidated  net  income  and  invested  capital,  the 
net  income  and  invested  capital  of  any  such  affiliated  corporation 
organized  after  August  i,  1914,  and  not  successor  to  a  then  existing 
business,  50  per  centum  or  more  of  whose  gross  income  consists  of 
gains,  profits,  commissions,  or  other  income,  derived  from  a  Govern- 
ment contract  or  contracts  made  between  April  6,  1917,  and  November 
II,  1918,  both  dates  inclusive.  In  such  case  the  corporation  so  taken 
out  shall  be  separately  assessed  on  the  basis  of  its  own  invested  capital 
and  net  income  and  the  remainder  of  such  affiliated  group  shall  be  as- 
sessed on  the  basis  of  the  remaining  consolidated  invested  capital  and 
net  income 


Section  240   (b).     See  page  209. 
See  Chapter  XXXVI. 
'  Section  240  (d). 
Section  240  (e). 


I06  APPLICATION   AND   ADMINISTRATION 

The  intention  of  this  section  evidently  was  to  prohi])it 
any  relief  to  a  new  subsidiary  corporation  organized  by  an 
existing  corporation  to  handle  war  contracts. 

191S  Law.     Section  140M The  Commissioner  shall  (when 

not  violative  of  the  technical  military  or  naval  secrets  of  the  Govern- 
ment) have  access  to  all  information  and  data  relating  to  any  such  con- 
tract, undertaking  or  agreement,  in  the  possession,  control  or  custody  of 
any  department,  bureau,  board,  agency,  officer  or  commission  of  the 
United  States,  and  may  call  upon  any  such  department,  bureau,  board, 
agency,  officer  or  commission  for  a  full  statement  and  description  of  any 
allowance  .for  amortization,  obsolescence,  depreciation  or  loss,  or  of  any 
valuation,  appraisal,  adjustment,  or  final  settlement,  made  in  pursuance 
of  any  such  contract,  undertaking,  or  agreement. 

Copies  of  government  contracts. — 

J918  Law.  Section  1408.  That  every  person  who  on  or  after  April 
6,  191 7,  has  entered  into  any  contract,  undertaking,  or  agreement,  with 
the  United  States,  or  with  any  department,  bureau,  officer,  commis- 
sion, board,  or  agency  under  the  United  States  or  acting  in  its  be- 
half, or  with  any  other  person  having  contract  relations  with  the  United 
States,  for  the  performance  of  any  work  or  the  supplying  of  any 
materials  or  property  for  the  use  of  or  for  the  account  of  the  United 
States,  shall,  within  thirty  days  after  a  request  of  the  Commissioner 
therefor,  file  with  the  Commissioner  a  true  and  correct  copy  of  every 
such  contract,  undertaking,  or  agreement. 

Whoever  fails  to  comply  with  such  request  of  the  Commissioner 
shall  be  guilty  of  a  misdemeanor  and  shall  be  punished  by  a  fine  of 
not  more  than  $1,000,  or  by  imprisonment  for  not  m.ore  than  one 
year,  or  both 

"(io\i:RN]\IENT    contracts"    DEFINED. ''' 

Regulation.  Government  contracts  may  include  (a)  a  con- 
tract with  the  United  States,  (b)  a  contract  with  an  agency  of  tlie 
United  States,  (c)  a  contract  with  an  agency  of  such  agency,  and 
(d)  a  subcontract  with  a  contractor  under  any  such  contract;  pro- 
vided in  every  case  the  contract  or  subcontract  is  for  the  benefit  of 
the  United  States.  The  term  "Government  contract  or  contracts 
niade  l)etween  April  6.  1917  and  November  ii,  1918,  both  dates  in- 
clusive," inchules  contracts  which  although  entered  into  during  such 
period  were  originally  not  enforceable  but  which  have  been  or  may 
become  enforceable  by  reason  of  subsequent  validation  in  pursuance 
of  law The  realization  by  a  corporation  of  income  from  a 


'"See  section   i,  and  CIiai)ter  X\\     Also  see  Hxrrss  I'rofils  Tax  I'lo 
:cdit)\\   lo-i.  Cli;i]i1er   XV'lll,  and   AjJiiendix   A  nf  this  vnUnne. 


RETURNS— L(  )RFU1v:ATI0NS  I07 

Government  contract  may  atfect  its  status  under  the  consolidated 
returns  provision  and  the  amount  of  its  war  profits  and  excess  profits 
tax.'-''    ....      (Art.   1510.) 

The  Treastiry  has  alsij  held  that  ''a  contract  entered  inlu 
subsequent  to  Novemljcr  11,  1918,  which  is  supplementary  t(^ 
an  original  contract  .  .  .  ."  is  to  be  treated  as  a  government 
contract.'^'* 


Return  of  earnings  allocated  to  distributions.— The  1921 

law  contains  a  new  [)rovision  relative  to  ftiniishing  with  the 
corporation  return  a  statement  of  the  allocation  of  earnings 
to  distributions  made  by  a  corporation. 

Law.  Section  239 (c)  There  shall  be  included  in  the  re- 
turn or  appended  thereto  a  statement  of  such  facts  as  will  enable  the 
Commissioner  to  determine  the  portion  of  the  earnings  or  profits  of  the 
corporation  (including  gains,  profits  and  income  not  taxed)  accumu- 
lated during  the  taxable  year  for  which  the  return  is  made,  which  have 
been  distributed  or  ordered  to  be  distributed,  respectively,  to  its  stock- 
holders or  members  during  such  year. 

The  general  rule  is  that  dividends  are  deemed  to  be  paid 
from  the  ''most  recentl}-  accunuilated  earnings  or  profits,"'^ 
and  the  alxjve  requirement  will  more  readily  enable  the  Treas- 
ury to  make  the  pro]X'r  allocation.'"  What  is  desired  is  the 
amount  of  each  dividend  only,  not  the  names  of  stockholders 
lo  whom  they  are  payable. 

The  Treasury  has  been  sending  out  to  taxpayers  a  fcjrm 
of  surplus  and  profit  and  loss  analysis,  from  which  the  infor- 
mation called  for  in  the  above  provision  of  the  law  is  oljtain- 
able. 


"  [Former  Procedure]  TIic  following  sentence  was  found  in  Art. 
1510,  Reg.  45:  "Tlic  agreements  for  the  oiieration  of  transportation  sys- 
tems while  under  federal  control  and  for  the  just  compensation  of  their 
owners  made  pursuant  to  the  Act  of  March  21,  iyi8,  arc  not  Government 
contracts  within  the  meaning  of  tliis  article." 

;•'  See  Chapter  XV. 

"  Section  201    (b). 

'"  For  discussion  of  how  tlie  allocation  should  be  made,  see  Chap- 
ter XXII. 


I08  APPLICATION   AND   ADMINISTRATION 

Miscellaneous   ''Information"   Returns 

Corporation  returns  of  dividends  paid. — In  order  that  the 
Treasury  may  be  able  to  check  the  returns  of  those  who  re- 
ceive dividends  the  law  provides  that,  upon  request  by  the 
Commissioner,  corporations  must  file  returns  of  dividends 
paid. 

Law.  Section  254.  That  every  corporation  subject  to  the  tax 
imposed  by  this  title  and  every  personal  service  corporation  shall,  when 
required  by  the  Commissioner,  render  a  correct  return,  duly  verified 
under  oath,  of  its  payments  of  dividends,  stating  the  name  and  ad- 
dress of  each  stockholder,  the  number  of  shares  owned  by  him,  and 
the  amount  of  dividends  paid  to  him."" 

The  following  regulation  makes  it  clear  that  the  return 
may  be  required  in  the  discretion  of  the  Commissioner. 

Regulation.  When  directed  by  the  Commissioner,  either  spe- 
cially or  by  general  regulation,  every  domestic  or  resident  foreign 
corporation  and  every  personal  service  corporation  shall  render  a 
return  on  form  1097  of  its  payments  of  dividends  and  distributions  to 
stockholders  for  such  period  as  may  be  specified,  stating  the  name 
and  address  of  each  stockholder,  the  number  and  class  of  shares 
owned  by  him,  the  date  and  amount  of  each  dividend  paid  him,  and 
when  the  surplus  out  of  wliich  it  was  paid  was  accumulated.  Art. 
1060.     (Reg.  45,  Art.  1051.) 


CHAPTER  V 

AMENDMENT  AND  EXAMINATION  OF  RETURNS 

After  returns  are  made  questions  may  arise  with  regard 
to  their  amendment,  their  examination  by  the  Treasury,  and 
their  inspection  by  outsiders.  These  questions  are  discussed  in 
this  chapter. 

Amended  Returns 

The  discovery  that  error  exists  in  returns  previously  filed 
may  occasion  a  request  for  an  amended  return  either  from  the 
government  or  from  the  taxpayer/  In  regard  to  corporations 
the  instructions  from  the  Commissioner  to  collectors  are  as 
follows : 

Ruling.  All  returns  should  be  carefully  scrutinized,  and,  if  im- 
properly prepared,  they  should  be  returned  to  the  taxpayer  for  cor- 
rection, with  instructions  that  if  a  new  return  be  executed,  the  old 
one,  showing"  the  date  of  the  receipt  thereon,  should  be  forwarded 
to  the  collector  to  avoid  the  possibility  of  subjecting  the  taxpayer  to 
additional  tax  or  penalties  for  failure  to  file  the  return  within  the 
period  required  by  law. 

A  record  of  each  return  sent  back  to  the  taxpayer  for  correction 
should  be  made  in  the  office  of  the  collector,  so  that  if  the  taxpayer 
fails  to  properly  amend  and  forward  same,  the  collector  may  take 
steps  to  secure  the  return.     (Mini,  letter  1160,  February  9,  1915.) 

In  the  case  of  individuals,  however,  the  instructions  to 
collectors  state  that  under  these  circumstances  the  amended 
return  will  not  be  required. 

Ruling.  Hereafter,  in  cases  where  an  individual,  a  fiduciary  or 
a  withholding  agent  has  been   found  subject  to  a   further  tax  as  a 


'It  is  not  the  general  practice  to  require  amended  returns  from  a  tax- 
payer. If  an  examination  is  made  by  a  revenue  agent  and  additional  tax  is 
to  be  assessed,  the  revenue  agent  prepares  the  equivalent  of  an  amended 
return  on  which  the  adjusted  tax  is  based,  and  the  taxpayer  is  informed 
by  the  Treasury  of  the  reasons   for  the  additional  assessment. 

109 


no  APPLICATION    AND   ADMINISTRATION 

result  of  the  audit  of  a  return  in  this  office,  or  of  an  investigation 
made  by  a  revenue  agent,  an  amended  return  will  not  be  required. 
(Mini,  letter  1232,  June  22,  1915.) 

In  such  cases  notice  of  the  proposed  additional  tax  is  set 
forth  in  the  form  of  a  letter  from  the  Commissioner.  This 
procedure  has  also  been  extended  to  corporations. 

The  foregoing  instructions  do  not  cover  the  procedure 
to  be  followed  when  taxpayers  on  their  own  initiative  de- 
sire to  file  amended  returns.  The  Treasury  prefers  that  a 
taxpayer  desiring  to  file  an  amended  return  should  request 
permission,  stating  his  reasons.  It  is  obvious  that  when  cases 
come  up  for  examination  those  that  have  attached  letters  from 
the  Commissioner  granting  such  permission  will  receive  better 
consideration  than  those  without  such  permission,  because  to 
some  extent  at  least  the  changes  between  original  and  amended 
returns  will  have  been  already  passed  upon  by  the  Treasury. 
But  the  formal  refusal  by  the  Treasury  to  sanction  amended 
returns  should  not  be  deemed  to  be  final  in  meritorious  cases. 
If  the  formal  consent  is  withheld  it  would  seem  to  be  proper 
procedure  for  the  taxpayer  to  prepare  corrected  returns^  and 
file  them  with  his  local  collector  who  should  not  refuse  to 
accept  them  for  transmission  to  the  Commissioner. 

The  regulations  specifically  provide  for  amended  returns 
in  certain  contingencies.  1m )r  example,  the  regulation  in  regard 
to  losses  points  out  the  taxpayer's  privilege  to  file  an  amended 
return. 

Regulation If  subsequently  to  its  occurrence,  however,  a 

taxpayer  first  ascertains  the  amount  of  a  loss  sustained  during  a  prior 
taxable  year  which  has  not  been  deducted  from  gross  income,  he  may 
render  an  amended  return  for  such  preceding  taxable  year  including 
such  amount  of  loss  in  the  deductions  from  gross  income  and  may  file 
a  claim  for  refund  of  the  excess  tax  paid  by  reason  of  the  failure  to 
deduct  such  loss  in  the  original  return (Art.  in.) 

Ruling.  A  corporation  may  submit  amended  returns  for  previous 
years  when  through  vvrong  accounting  practice  capital  charges  have 
been  made  to  income.    An  affidavit  should  be  attached,  explaining  the 


"When  amended  returns   for   igi6  and  years  prior  are  filed  the  form 
prescribed  for  the  year  1916  should  be  used. 


RETURNS-AMI'INDMENT,    EXAMINATION  m 

changes  made  by  sucli  amended  rehirns  in  the  amounts  shown  on  the 
original  return,  and  explaining  why  the  original  returns  were  not 
properly  prepared  and  the  object  of  the  company  in  preparing 
amended  returns.  Such  amended  returns  will  be  accepted  only  when 
the  erroneous  charge  can  be  specifically  pointed  out  and  the  facts 
proven.  The  Internal  Revenue  Bureau  reserves  the  right  to  penalize 
for  the  making  of  false  returns  in  the  past.  (C.  B.  r,  page  234; 
O.  D.  113.) 

Amended  returns  may  of  course  be  made  for  reasons  other 
tlian  incorrect  accounting. 

Amended  returns — community  property. — Those  taxpay- 
ers who  ha\e  not  taken  adwintage  of  the  decision  on  coni- 
iniiiiity  property''  are  still  entililed  to  file  amended  returns  so 
as  to  give  effect  to  the  treatment  of  communit}-  i)roperty'  as 
separate  property  of  husband  and  wife. 

Amended    returns    barred    four    years    after    payment. — 

Amended  returns  may  be  bled  for  lOiy  or  su])sequent  years. 

Law.  Section  13(6.  [Section  3228,  Rev.  Stat.]  All  claims  for 
the  refunding  or  crediting  of  any  internal  revenue  tax  alleged  to  have 
been  erroneously  or  illegally  assessed  or  collected,  or  of  any  penalty 
alleged  to  have  been  collected  without  authority,  or  of  any  sum  alleged 
to  have  been  excessive  or  in  any  manner  wrongfully  collected,  must 
be  presented  to  the  Commissioner  of  Internal  Revenue  within  four 
years  next  after  payment  of  such  tax,  penalty,  or  sum. 

This  section,  except  as  modified  by  section  252,  shall  apply  retro- 
actively to  claims  for  refund  under  the  Revenue  Act  of  1916,  the  Reve- 
nue Act  of  1917,  and  the  Revenue  Act  of  1918. 

It  should  be  noted  that  the  period  begins  to  run  ''after  pay- 
ment of  such  tax,  penaUy,  or  sum."  Therefore  when  addi- 
tional taxes  are  assessed  in  respect  of  the  year  19 17  or  prior, 
the  four-year  hmitation  does  not  bc(/in  to  run  until  payment 
is  made. 

Amended  returns  not  necessary  to  adjust  minor  items. — 
In  cases  in  which  there  are  only  a  few  items  requiring  adjust- 

""C.  B.  3,  page  309;  O.  D.  708, 
*  See  page  82. 


112  APPLICATION    AND    ADMINISTRATION 

meiit,  a  statement  showing"  the  recomputation  of  tax  is  suffi- 
cient. 

If  the  adjustments  show  an  additional  tax,  the  Commis- 
sioner will  in  due  course  make  an  assessment.  Where  an 
overpayment  is  shown,  the  statement  should  be  attached  to 
either  a  claim  for  refund  or  a  claim  for  credit. 

Supplemental  returns  must  be  filed  by  corporations  with 
fiscal  years  ending  in  192 1. — Where  the  tax  due  under  the 
new  law  differs  from  that  shown  by  the  returns  already  filed, 
supplemental  returns  should  be  prepared  to  show  the  adjusted 
tax.  The  return  already  filed  under  the  1918  law  will  be  used 
as  the  basis  for  assessing  the  tax  for  that  portion  of  the  fiscal 
year  included  in  the  calendar  year  1920.  The  supplemental 
return,  i.e.,  the  return  under  the  192 1  law,  will  be  the  basis 
for  the  tax  applicable  to  that  portion  of  the  fiscal  year  included 
in  the  calendar  year  192 1. 

Tax  adjustment  when  amended  returns  for  1913-1916  are 
filed. — When  the  filing  of  amended  returns  results  in  a  refund 
from  or  an  additional  payment  to  the  government,  the  matter 
is  not  finally  settled  if  the  returns  are  for  1916  or  prior  years. 
Until  December  31,  19 16,  federal  income  taxes  paid  or  ac- 
crued were  an  allowable  deduction.  If  net  income  during 
19 1 6  or  prior  years  was  greater  or  less  than  that  shown  by 
the  returns,  and  the  tax  thereon  is  readjusted,  there  will  be 
required  a  corresponding  adjustment  of  net  income  in  the 
succeeding  year  equal  to  the  refund  received  or  additional 
payment  made.  If  a  refund  is  received,  the  tax  for  the  fol- 
lowing year  will  be  increased.  If  an  additional  payment  is 
made,  the  tax  for  the  following  year  will  be  decreased. 

This  is  usually  taken  care  of  by  setting  up  a  statement 
showing  all  adjustments  of  income  on  the  corrected  basis  and 
including  the  corrected  tax  of  previous  years  as  a  deduction 
in  succeeding  years. 


RETURNS— AMENDAIENT,    EXAMINATION  113 

Payment  of  tax  shown  by  amended  returns — payable 
when? — Generally  speaking,  additional  taxes  shown  by  an 
amended  return  are  not  payable  until  they  have  been  assessed 
by  the  Commissioner.  Aside  from  those  cases  arising  under 
T.  D.  3220,^  the  procedure  is  that  collectors  forward  the  re- 
turns to  the  Commissioner,  and  after  they  have  been  audited, 
assessments,  if  any,  are  sent  to  the  collector,  who  in  due 
course  demands  payment. 

Examinations  to  Ascertain  Correctness  of  Returns 

Treasury  officers  have  full  power  to  examine  books  and 
records  and  to  require  attendance  of  the  necessary  persons 
in  the  course  of  examinations  to  establish  the  accuracy  of  in- 
come tax  returns. 

Law.  Section  1308.  That  the  Commissioner,  for  the  purpose 
of  ascertaining  the  correctness  of  any  return  or  for  the  purpose  of 
making  a  return  where  none  has  been  made,  is  hereby  authorized,  by 
any  revenue  agent  or  inspector  designated  by  him  for  that  purpose, 
to  examine  any  books,  papers,  records  or  memoranda  bearing  upon  the 
matters  required  to  be  included  in  the  return,  and  may  require  the  at- 
tendance of  the  person  rendering  the  return  or  of  any  officer  or  employee 
of  such  person,  or  the  attendance  of  any  other  person  having  knowledge 
in  the  premises,  and  may  take  his  testimony  with  reference  to  the  mat- 
ter required  by  law  to  be  included  in  such  return,  with  power  to  ad- 
minister oaths  to  such  person  or  persons. 

Law.  Section  1310.  (a)  That  if  any  person  is  summoned  under 
this  Act  to  appear,  to  testify,  or  to  produce  books,  papers,  or  other 
data,  the  district  court  of  the  United  States  for  the  district  in  which  such 
person  resides  shall  have  jurisdiction  by  appropriate  process  to  com- 
pel such  attendance,  testimony,  or  production  of  books,  papers,  or 
other  data. 

(b)  The  district  courts  of  the  United  States  at  the  instance  of  the 
United  States  are  hereby  invested  with  such  jurisdiction  to  make 
and  issue,  both  in  actions  at  law  and  suits  in  equity,  writs  and  orders 
of  injunction,  and  of  ne  exeat  republica,  orders  appointing  receivers, 
and  such  other  orders  and  process,  and  to  render  such  judgments 
and  decrees,  granting  in  proper  cases  both  legal  and  equitable  relief 
together,  as  may  be  necessary  or  appropriate  for  the  enforcement  of 
the    provision    of    this    Act.      The    remedies    hereby    provided    are    in 

"See  B.  37-21-1822. 


114 


API'LICATION    AND   ADMINISTRATION 


addition  to  and  not  exclusive  of  any  and  all  other  remedies  of  the 
United  States  in  such  courts  or  otherwise  to  enforce  such  pro- 
visions  

It  sh(»u1(l  1)C  noted  that  the  plenary  power  of  examination 
extends  also  to  i)ersons,  other  than  the  tax[)a3"er,  who  have 
knowledge  of  his  income." 

Tlie  anthor  has  frecpiently  been  asked  by  taxpayers : 
"What  shall  we  do  when  an  inspector  calls?"  Perhaps  tax- 
payers will  have  a  better  understanding  of  their  own  obliga- 
tions if  acquainted  with  the  duties  of  income  tax  inspectors, 
as  set  forth  in  the  regulations.     These  are,  in  part,  as  follows : 

Rm  rN(;.  The  duties  nf  (ifiicers  of  tliis  class  arc  to  ascertain 
and  report  the  names  of  persons  who  in  their  opinion  are  liable  to 
the  income  tax  and  who  have  failed  to  make  return  as  required  Viy 
law;  to  imjuire  into  income  tax  rclurns  where  there  is  any  suspicion 
that  the  return  made  is  erroneous;  to  examine  the  l^ooks  and  accounts 
of  persons  who  have  made  returns,   for  the  purpose  of  ascertaining 

and  reporting;-  as  to  whether  the  law  has  been  complied  with 

In  the  discharge  of  their  official  duties  officers  of  this  class, 
as  well  as  all  officers  of  the  Internal  Revenue  Bureau,  in  making  in- 
quiries and  investigations  are  expected  to  exercise  sound  discretion, 
treat  all  persons  with  due  courtesy,  and,  while  acting  firmly  and 
courageously,  to  avoid  all  contention  or  controversy  that  would  give 
just  ground  for  complaint.     (T.  D.  1932,  January  13,  1914.) 

Inspectors  usually  call  upon  individual  taxpayers  without 
notice.  In  the  case  of  business  concerns  appointments  con- 
venient to  both  are  made  over  the  telephone.  Although  the 
right  of  inspectors  to  examine  the  books  and  accounts  of  all 
taxpayers  is  unquestioned,  the  author  does  not  know  of  an  in- 
stance when  an  immediate  examination  has  been  insisted  upon 
to  the  inconvenience  of  the  taxpayer.  There  should  be  no 
trouble  in  arranging  a  convenient  time. 

Taxpayers  should  furnish  the  inspector  w'ith  all  informa- 
tion called  for,  and,  by  placing  at  his  disposal  tlie  original  data 
supporting  the  returns,  the  examination  will  be  expedited.     In 


'In  re  Chadzvick,  5  Fed.  Cas.  401;  Fed.  Cas.  No.  2570,  held  that  a  cor- 
poration was  net  compelled  to  produce  its  books  upon  an  inquiry  into  the 
income  of  its  stockholders. 


RETURNS— AMENDMENT,    EXAMINATION  115 

case  of  doubt,  too  much  rather  than  too  Httle  information 
should  be  tendered. 

Ruling.  Under  section  1305  [Section  1308  of  the  1921  law]  of 
the  Revenue  Act  of  19 18,  it  is  held  that  the  Commissioner  of  Internal 
Revenue  is  authorized,  hy  any  revenue  agent  or  inspector  designated 
by  him  for  that  purpose,  to  examine  any  of  the  books,  papers,  records 
or  memoranda  of  a  hank,  bearing  upon  any  matter  required  to  be  in- 
cluded in  a  tax  return  of  one  of  its  depositors  or  customers.  The 
bank,  however,  is  entitled  to  satisfy  itself  in  a  reasonable  manner  of 
the  official  character  and  authority  of  any  person  making  request 
to  examine  books  or  accounts  of  the  bank  as  an  official  of  the  Inter- 
nal Revenue  Bureau.     ( C.  B.  3,  page  371  ;  O.  D.  609.) 

The  new  law  provides  that  there  sliall  ])e  onl}'  one  examina- 
tion each  year,  unless  the  taxpayer  recpiests  it  or  the  Commis- 
sioner notifies  the  taxpayer  in  writing  that  an  additional  in- 
spection is  necessary.'^ 


Publicity  of  Returns  and  Disclosure  of  Information 

Returns  are  guarded  very  carefully.  Section  257  pro- 
vides that  they  may  be  inspected  by  certain  parties  under  cer- 
tain conditions.  Inspection  must  Ije  made  under  rules  and 
regulations  prescri])ed  by  the  Secretar}-  of  the  Treasury  and 
approved  by  the  President. 

The  Senate  attempted  to  amend  section  257,  so  as  to  per- 
mit either  house  of  Congress  to  inspect  returns.  The  con- 
ferees very  wisely  eliminated  this  amendment. 

Law.  Section  257.  That  returns  upon  which  the  tax  has  been 
determined  by  the  Commissioner  shall  constitute  public  records;  but 
they  shall  be  open  to  inspection  only  upon  order  of  the  President 
and  under  rules  and  regulations  prescribed  by  the  Secretary  and 
approved  by  the  President:  .... 

The  followijig  regulation  has  ])een  recently  pronnilgated 
with  reference  to  inspection  of  returns  liled  under  the  igr^, 
1916,  1917,  1918  and   1921    laws.''     Tliis  regulation  has  been 


'  Section  130Q. 

"A  similar  ])r()\  isioii  (if  the  kjoo  law  was  declared  constitntinnal.     (I'lint 
f.  Stain-  'inuy  Co.,  :>.'\)  C.  S.  107;  55  I,,  h'd.  jXij;  31  S.  Ct.  3  l-^J 


Ii6  APPLICATION   AND   ADMINISTRATION 

signed  by  I'le  Secretary  of  the  Treasury  and  approved  by  the 
President. 

It  should  be  noted  that  a  written  appHcation  must  be  made 
to  inspect  a  return. 

Regulation i.  These  regulations  deal  only  with  in- 
spection of  returns,  as  the  statutes  expressly  require  the  approval  of 
the  President  of  regulations  on  this  subject.  Other  uses  to  which 
returns  may  be  lawfully  put,  without  action  by  the  President,  are  not 
covered  by  these  regulations. 

2.  The  word  "corporation''  when  used  alone  herein  shall,  unless 
otherwise  indicated,  include  corporations,  associations,  joint-stock 
companies,  and  insurance  companies.  The  word  "return"  when  so 
used  shall,  unless  otherwise  indicated,  include  income  and  profits  tax 
returns;  and  also  special  excise  tax  returns  of  corporations  filed 
pursuant  to  Section  looo,  Title  X,  of  each  of  the  Revenue  Acts  of 
1918  and  1921. 

3.  Written  statements  filed  with  the  Commissioner  of  Internal 
Revenue  designed  to  be  supplemental  to  and  to  become  a  part  of  tax 
returns  shall  be  subject  to  the  same  rules  and  regulations  as  to  in- 
spection as  are  the  tax  returns  themselves. 

4.  Except  as  hereinafter  specifically  provided,  the  Commissioner 
of  Internal  Revenue  may,  in  his  discretion,  upon  written  application 
setting  forth  fully  the  reasons  for  the  request,  grant  permission  for 
the  inspection  of  returns  in  accordance  with  these  regulations.  The 
application  will  be  considered  by  the  Commisisoner  and  a  decision 
reached  by  him  whether  the  applicant  has  met  the  conditions  imposed 
by  these  regulations  and  whether  the  reasons  advanced  for  permission 
to  inspect  are  sufficient  to  permit  the  inspection.  Such  written  ap- 
plication is  not  required  of  the  officers  and  employees  of  the  Treasury 
Department  whose  official  duties  require  inspection  of  a  return,  or 
of  the  Solicitor  of  Internal  Revenue 

13.  When  it  becomes  necessary  for  the  Department  to  furnish 
returns  or  copies  thereof  for  use  in  legal  proceedings,  inspection  of 
such  returns  or  copies  that  necessarily  results  from  such  use  is  per- 
mitted. 

14.  Except  as  provided  in  paragraph  13  returns  may  be  inspected 
only  in  the  office  of  the  Commissioner  of  Internal  Revenue,  Wash- 
ington, District  of  Columbia. 

15.  A  person  who,  under  these  regulations,  is  permitted  to  inspect 
a  return  may  make  and  take  a  copy  thereof  or  a  memorandum  of 
data  contained  therein. 

16.  By  Section  3167  R.  S.,  as  amended  by  the  Revenue  Act  of 
1918,  and  reenacted  without  change  in  Section  131 1  of.  the  Revenue 
Act  of  1921,  it  is  made  a  misdemeanor  for  any  person  to  print  or 


RETURNS— AMENDMENT,    EXAMINATION  117 

publish  in  any  manner  whatever  not  provided  by  law  any  income  re- 
turn, or  any  part  thereof  or  source  of  income^  profits,  losses,  or  ex- 
penditures, appearing  in  any  income  return,  which  misdemeanor  is 
punishable  by  a  fine  not  exceeding  $1,000  or  by  imprisonment  not 
exceeding  one  year,  or  both,  at  the  discretion  of  the  Court,  and  if 
the  offender  be  an  officer  or  employee  of  the  United  States,  by  dis- 
missal from  office  or  discharge  from  employment. 

17.  All  former  regulations  bearing  on  the  subject  of  inspection 
of  returns  are  hereby  superseded. 

18.  These  regulations  shall  remain  in  force  until  expressly  with- 
drawn or  overruled.  (T.  D.  3277,  signed  by  A.  W.  Mellon,  Secretary 
of  the  Treasury,  approved  by  the  President,  and  dated  January  24, 
1922.) 

Method  of  securing  copy  of  return. — Persons  or  corpora- 
tions desiring  copies  of  their  own  returns  may  secure  them. 
Representatives  of  taxpayers  holding  powers  of  attorney  are 
legally  entitled  to  inspect  or  secure  copies  of  returns.  Access 
to  corporation  returns  is  permitted  stockholders  and  receivers 
as  a  right  and  to  state  officers  under  carefully  restricted  con- 
ditions.^ Copies  of  returns  are  furnished  the  proper  officers 
and  employees  of  the  Treasury,  and  to  the  proper  officers  of 
a  court  for  use  in  a  trial  of  any  case  to  which  both  the  United 
States  and  the  person  rendering  the  return  are  parties.^"  Other- 
wise returns   are   considered   "inviolably   confidential."" 

Regulation 2.  A  copy  of  an  income  return  may  be  fur- 
nished by  the  Commissioner  of  Internal  Revenue  to  the  person  who 
made  the  return  or  to  his  duly  constituted  attorney,  or  if  the  person  is 
deceased,  to  his  executor  or  administrator;  or  if  the  entity  is  in  the 
hands  of  a  receiver,  trustee  in  bankruptcy,  guardian,  or  similar  legal 
custodian,  to  the  receiver,  trustee,  or  other  similar  custodian  upon  writ- 
ten application  for  same,  accompanied  by  satisfactory  evidence  that  the 
applicant  comes  within  this  provision.  "The  person  who  made  the  re- 
turn," as  herein  used,  refers  in  the  case  of  an  individual  return  to  the 
individual  whose  return  is  desired,  and  in  the  case  of  a  return  of  a 
corporation,  association,  joint-stock  company,  insurance  company,  or 
fiduciary  to  the  corporation,  association,  joint-stock  company,  or 
fiduciary,  a  copy 'of  whose  return  is  desired.  A  corporation  may  also 
designate  by  proper  action  of  its  board  of  directors  the  officer  or 
individual  to  whom  a  copy  of  a  return  made  by  the  corporation  may 

°See  pages   124-125. 

"Art.  1091. 

^'^  Income  Tax  Primer,  igi8,  question  142. 


Il8  APPLICATION    AND    ADMINISTRATION 

be  furnishetl,  and  upon  sufficient  evidence  of  such  action  and  of  the 
identity  of  the  officer  or  individual,  a  copy  may  be  furnished  to  such 
person.  A  copy  of  a  partnership  income  return  vi^ill  be  furnished 
to  the  partners  only  in  case  all  the  partners  join  in  the  request  there- 
for, it  matters  not  what  particular  partner  or  officer  of  the  partner- 
ship made  the  return.  If  the  partnership  has  been  dissolved,  the 
members  surviving  may  be  furnished  a  copy  if  all  the  members  sur- 
viving join  in  the  request.     (Art.  1091.) 

Inspection  of  individual  returns. — 

Rkgl'lation 5.  The  return  of  an  individual  shall  be  open 

to  inspection  as  follows: 

(o)  By  the  officers  and  employees  of  the  Treasury  Department 
whose  official  duties  require  such  inspection  and  by  the  Solicitor  of 
Internal  Revenue;  (b)  by  the  person  who  made  the  return,  or  by  his 
duly  constituted  attorney  in  fact;  (c)  by  the  administrator,  executor, 
or  trustee  of  the  taxpayer's  estate,  or  by  the  duly  constituted  attor- 
ney in  fact  of  such  administrator,  executor,  or  trustee,  where  the 
maker  of  the  return  has  died;  and  (d)  in  the  discretion  of  the  Com- 
missioner of  Internal  Revenue,  by  one  of  the  heirs  at  law  or  next  of 
kin  of  such  deceased  person  upon  showing  that  he  has  a  material 
interest  which  will  be  affected  by  information  contained  in  the  return. 

6.  A  joint  return  of  a  husband  and  wife  shall  be  open  to  inspec- 
tion (a)  by  the  officers  and  employees  of  the  Treasury  Department 
whose  official  duties  re(|uire  such  inspection  and  by  the  Solicitor  of 
Internal  Revenue;  and  (b)  by  either  spouse  for  whom  the  return 
was  made  (or  his  or  her  duly  constituted  attorney  in  fact  or  legal 
representative),  upon  satisfactory  evidence  of  such  relationship  being 
furnished (Art.   1090.) 

It  is  well  to  remember  that  not  even  the  officers  of  a  stale 
imposing  an  income  tax  have  been  able  to  sectire  access  to 
individual  returns. 


Inspection   of  partnership  returns. — 

Regulation 7.  The  return  of  a  partnership  shall  be  open 

to  inspection  (a)  by  the  officers  and  employees  of  the  Treasury  De- 
partment whose  official  duties  require  such  inspection  and  by  the 
Solicitor  of  Internal  Revenue:  and  (b)  by  any  individual  (or  his 
duly  constituted  attorney  in  fact  or  legal  representative)  who  was  a 
member  of  such  partnership  during  any  part  of  the  time  covered  by  the 
return,  upon  satisfactory  evidence  of  such  fact  being  furnished. 
(Art.  1090.) 


RETURNS-AMENDMENT,   EXAMINATION  119 

Inspection  of  returns  of  estates  and  trusts. — 

Regulation 8.     The    return    of    an    estate    shall    be 

open  to  inspection  (a)  by  the  officers  and  employees  of  the 
Treasury  Department  whose  official  duties  require  such  inspection, 
and  by  the  Solicitor  of  Internal  Revenue;  (b)  by  the  ad- 
ministrator, executor,  or  trustee  of  such  estate,  or  by  his  duly  con- 
stituted attorney  in  fact;  and  (t)  by  one  of  the  heirs  at  law  or  next 
of  kin  of  the  deceased  person  whose  estate  is  being  administered  upon 
a  showing  of  a  material  interest  which  will  be  affected  by  information 
contained  in  the  return (Art.   1090.) 

Beneficiaries  are  entitled  to  inspect  returns  of  the  estate. 

Regulation 9.  The  return  of  a  trust  upon  which  a  tax  has 

been  determined  shall  be  open  to  inspection  (a)  by  the  officers  and  em- 
])loyees  of  the  Treasury  Department  whose  official  duties  require  such 
inspection,  and  by  the  Solicitor  of  Internal  Revenue;  (b)  by  the 
trustee  or  trustees,  or  the  duly  constituted  attorney  in  fact  of  such 
trustee  or  trustees;  and  (c)  by  any  individual  (or  his  duly  constituted 
attorney  in  fact  or  legal  representative)  who  was  a  beneficiary  under 
such  trust  during  any  part  of  the  time  covered  by  the  return,  upon 
satisfactory  evidence  of  such  fact  being  furnished.     (Art.  1090.) 

Rulings.  An  original  letter  with  regard  to  his  return  written  by 
a  decedent  to  the  collector  may  not  be  furnished  to  the  attorneys  for 
the  estate.  A  certified  or  photostatic  copy  may,  however,  be  given 
to  them  provided  the  executors  submit  a  copy  of  the  letters  testa- 
mentary issued  to  them  by  the  court,  together  with  a  letter  signed  by 
them  authorizing  the  attorneys  to  receive  a  copy  of  the  letter  in 
question.     (C.   B.  3,  page  313;  O.  D.  576.) 

The  executor  of  an  estate  may  secure  copies  of  income  tax  re- 
turns filed  by  the  decedent  upon  submission  to  the  ("onnnissioner  of  a 
certified  copy  of  letters  testamentary  cvi<lcncing  his  ajipointment  as 
executor.     (C.  B.  i,  page  131 ;  O.  D.  355.) 

Inspection  of  corporation  returns. — 

l\F.(;uLATioN TO.  'Jlic  rctum  of  a  corporation   shall   he 

open  to  inspection  (a)  by  the  officers  and  employees  of  the  Treasury 
i)e])artment  whose  official  duties  require  such  inspection  and  by  the 
Solicitor  of  Internal  Revenue;  (b)  upoy  satisfactory  evidence  of 
identity  and  ofiicial  position,  Ijy  the  ])resident,  vice-president,  secretary 
or  treasurer  of  such  corporation  or  if  none,  its  principal  officer;  and 
(c)  by  a  stockholder  of  such  cor])orati(in  as  ])rovidcd  in  paragraph 
IT  hereof.      (T.  D.  3277;  January  24,  1922.) 

This  pfDvision  is  new.  Tt  would  apjjcar  that  under  this 
article   a   sini^lc   ])artiicr   may    inspccl    ihc   partnership   return 


T20  APrUCATION    AND    ADMINISTRATION 

and  make  a  copy  thereof,  allhough  he  could  not  require  the 
Commissioner  to  supply  a  copy  under  article  1091. 

Certified  copies  of  returns  for  use  as  evidence. — 

Regulation,  i.  The  original  income  return  of  an  individual,  part- 
nership, corporation,  association,  joint-stock  company,  insurance  com- 
pany, or  fiduciary,  or  a  copy  thereof,  may  be  furnished  by  the  Com- 
missioner of  Internal  Revenue  to  a  United  States  attorney  for  use 
as  evidence  before  a  United  States  grand  jury  or  in  litigation  in  any 
court,  where  the  United  States  is  interested  in  the  result,  or  for  use 
in  the  preparation  for  such  litigation,  or  to  an  attorney  connected 
with  the  Department  of  Justice  designated  to  handle  such  matters, 
upon  written  request  of  the  Attorney  General,  the  Assistant  to  the 
Attorney  General,  or  an  Assistant  Attorney  General.  When  an  in- 
come return  or  copy  thereof  is  thus  furnished,  it  must  be  limited  in 
use  to  the  purpose  for  which  it  is  furnished  and  is  under  no  conditions 
to  be  made  public  except  where  publicity  necessarily  results  from 
such  use.  In  case  the  original  return  is  necessary,  it  shall  be  placed 
in  evidence  by  the  Commissioner  of  Internal  Revenue  or  by  some 
other  officer  or  employee  of  the  Internal  Revenue  Bureau  designated 
by  the  Commissioner  for  that  purpose,  and  after  it  has  been  placed 
in  evidence  it  shall  be  returned  to  the  files  in  the  office  of  the  Com- 
missioner in  Washington.  An  original  return  will  be  furnished  only 
in  exceptional  cases,  and  then  only  when  it  is  made  to  appear  that  the 
ends  of  justice  may  otherwise  be  defeated.  Neither  the  original  nor 
a  copy  of  an  income  return,  desired  for  use  in  litigation  in  court  where 
the  United  States  Government  is  not  interested  in  the  result  and  where 
such  use  might  result  in  making  public  the  information  contained 
therein,  will  be  furnished,  except  as  otherwise  provided  in  the  next 
succeeding  paragraph.'-   ....      (Art.  1091.) 

Ruling.  Ownership  certificates  are  income  returns  within  the 
meaning  of  section  3167,  Revised  Statutes,  as  amended.  Since  they 
are  filed  as  a  result  of  income  tax  laws  for  the  purpose  of  being  used 
in  connection  with  income  tax  returns  they  are  to  be  treated  as  such 
under  the  regulations  governing  the  furnishing  of  copies.  (C.  B. 
I,  page  262;  O.  879.) 

Inspection  of  returns  of  various  federal  agencies. — 

Regulation.  .  .  .  .  12.  \\'hen  the  head  of  an  executive  de- 
partment   (other   than   the    Treasury    Department)    or   of   any   other 


"  [Former  Procedure]  This  is  an  amendment  of  section  i,  paragraph 
I,  of  T.  D.  2962.  Formerly  the  Attorney  General  had  to  make  a  written 
request  for  an  original  return.  Under  the  present  Treasury  decision,  the 
Attorney  General,  the  Assistant  to  the  Attorney  General,  or  an  Assistant 
Attorney  General  may  request  an  original  return. 


RETURNS— AMENDMENT,    EXAMINATION  121 

United  States  Government  establishment,  desires  to  inspect  or  to  have 
some  other  officer  or  employee  of  his  branch  of  the  service  inspect  a 
return  in  connection  with  some  matter  officially  before  him,  the  in- 
spection may,  in  the  discretion  of  the  Secretary  of  the  Treasury,  be 
permitted  upon  written  application  to  him  by  the  head  of  such  execu- 
tive department  or  other  Government  establishment.  The  application 
must  be  signed  by  such  head  and  must  show  in  detail  why  the  in- 
spection is  desired,  the  name  and  address  of  the  taxpayer  who  made 
the  return,  and  the  name  and  official  designation  of  the  one  it  is  de- 
sired shall  inspect  the  return.  When  the  head  of  a  bureau  or  office 
in  the  Treasury  Department,  not  a  part  of  the  Internal  Revenue 
Bureau,  desires  to  inspect  a  return  in  connection  with  some  matter 
officially  before  him,  other  than  an  income,  profits  tax  or  corporation 
excise  tax  matter,  the  inspection  may,  in  the  discretion  of  the  Secre- 
tary, be  permitted  upon  written  application  to  him  by  the  head  of 
such  bureau  or  office  showing-  in  detail  why  the  inspection  is  desired. 
The  reasons  submitted  for  permission  to  inspect  as  provided  in  this 
paragraph  shall  be  considered  by  the  Secretary  and  a  decision  reached 
by  him  whether  the  reasons  are  sufficient  to  permit  the  inspection. 
(T.  D.  3277,  January  24,  1922.) 

It  is  questionable  whether  "the  head  of  an  executive  depart- 
ment (other  than  the  Treasury  Department)  or  of  any  other 
United  States  Government  estabHshment,"  may  legahy  inspect 
tax  returns  filed  under  any  of  the  laws. 

Inspection  of  corporation  returns  by  officers  of  states  im- 
posing income  taxes. — 

Law.  Section  257.  ....  Provided,  That  the  proper  officers  of 
any  State  imposing  an  income  tax  may,  upon  the  request  of  the  gov- 
ernor thereof,  have  access  to  the  returns  of  any  corporation,  or  to  an 
abstract  thereof  showing  the  name  and  income  of  the  corporation,  at 
such  times  and  in  such  manner  as  the  Secretary  may  prescribe:  .... 

Federal  returns  are  apparently  available  to  states  which 
impose  income  taxes  on  corporations  irrespective  of  whether 
they  impose  a  similar  tax  on  individuals  as  well.^^  The  permis- 
sion, however,  extends  merely  to  corporation  returns.  In- 
dividual returns  are  not  open  to  inspection  by  state  officers, 
although  efforts  have  been  made  to  change  the  law  so  as  to 
make  them  so. 


"  [Former  Procedure]     The    1916    law    [section    14    (b)]    permitted 
examination  when  the  state  imposed  a  "general  income  tax." 


122  APPLICATION   AND    ADAHN  ISTRATION 

The  following  regulations  set  forth  the  procedure  to  follow 
to  secure  permission  to  examine  such  returns : 

Regulation,  i.  The  proper  officers  of  a  State  imposing  an  in- 
come tax  are  entitled  as  of  right  upon  the  reqnest  of  its  governor  to 
have  access  to  the  income  and  profits  tax  returns  of  a  corporation, 
association,  joint-stock  company,  or  insurance  company,  or  to  an  ab- 
stract thereof,  showing  its  name  and  income.  Proper  officers  in  this 
connection  are  only  those  officers  of  the  State  who  are  charged  with 
the  enforcement  of  the  State  income-tax  law  and  who  are  to  use  the 
information  gained  by  the  access  only  in  connection  with  such 
enforcement. 

2.  The  request  or  appHcation  of  tlie  governor  must  be  in  writing, 
signed  by  him  under  the  seal  of  his  State,  and  must  show  : 

(a)  That   the   State   imposes   an    income   tax. 

(b)  The  name  and  address  of  the  corporation,  association,  joint- 
stock  company,  or  insurance  company  making  the  returns  to  which 
access  is  desired. 

(c)  Why  access  is  desired. 

(d)  The  names  and  official  positions  of  the  officers  designated  to 
have  the  access. 

(c)  That  such  designated  officers  are  charged  with  the  enforce- 
ment of  the  State  iHcome-tax  law. 

(/)  That  the  information  to  be  gained  by  the  access  is  to  be  used 
only  in  connection  with  such  enforcement. 

3.  The  request  or  application  of  the  governor  may  be  addressed 
either  to  the  Secretary  of  the  Treasury  or  to  the  Commissioner  of 
Internal  Revenue,  but  should  be  transmitted  to  the  Commissioner, 
who  will  set  a  convenient  time  for  the  access  to  the  returns  (or  to  an 
abstract  thereof  as  he  may  determine). 

4.  Access  shall  be  given  only  in  the  office  of  the  Commissioner  of 
Internal  Revenue  in  Washington. 

5.  The  officers  designated  by  the  governor  will  not  be  permitted  to 
name  another  person  or  persons  to  examine  the  returns  (or  abstracts) 
for  them. 

6.  The  officers  designated  will  be  given  access  only  to  the  returns 
of  those  corporations,  associations,  joint-stock  companies,  or  insur- 
ance companies  organized  or  doing  business  in  their  State. 

y.  The  officers  designated  may  have  access  to  lists  furnished  to 
supplement  and  become  a  part  of  the  returns  to  which  they  are  given 
access. 

8.  The  proper  officers,  as  defined  in  paragraph  i,  may  have  access 
to  the  capital  stock  tax  returns  filed  under  the  provisions  of  section 
1000  of  the  revenue  act  of  H)2I  under  the  same  conditions  prescribed 
in  the  preceding  paragraph  for  access  to  the  income  and  profits  tax 
returns  of  corporations,  associations,  joint-stock  companies,  and  in- 


RETURNS— AMENDMENT,    EXAMINATION 


123 


surance  companies.  This  right  dues  not  extend  ti)  the  examination 
of  capital  stock  tax  returns  filed  pursuant  to  prior  acts  of  Congress, 
except  the  revenue  act  of  1918.     (Art.  1092.) 

This  article  incorporates  in  the  regulations,  T.  D.  2962 
which  has  been  extended  to  the  Revenue  Act  of  192 1  (see 
B.  1-6-80;  T.  D.  3273). 

Under  this  regulation  access  to  the  returns  is  limited  to 
officers  who  are  "'charged  with  the  enforcement  of  the  state 
income  tax  law"  and  are  to  use  tlie  information  only  for  jnir- 
poses  of  such  enforcement. 

Inspection    of    corporation    returns   by    stockholder.— The 

law  sets  forth  the  exact  conditions  which  shall  govern  the 
inspection  of  a  corporate  return  Ijy  a  stockholder.'"' 

Law.  Section  257.  ....  Provided  fnrtlicr,  That  all  bona  fide 
stockholders  of  record  owning  i  per  centum  or  more  of  the  outstand- 
ing stock  of  any  corporation  shall,  upon  making  request  of  the  Com- 
missioner, be  allowed  to  examine  the  annual  income  returns  of  such 
corporation  and  of  its  subsidiaries.  Any  stockholder  who  pxirsuant 
to  the  provisions  of  this  section  is  allowed  to  examine  the  return  of 
any  corporation,  and  who  makes  known  in  any  manner  v/hatever 
not  provided  by  law  the  amount  or  source  of  income,  profits,  losses, 
expenditures,  or  any  particular  thereof,  set  forth  or  disclosed  in  any 
such  return,  shall  be  guiltj'  of  a  misdemeanor  and  be  punished  by  a 
fine  not  exceeding  $1,000,  or  by  imprisonment  not  exceeding  one 
year,  or  both 

The  privilege  granted  by  the  above  section  is  an  express 
exception  in  the  law.  It  is  personal  to  the  stockholder  and 
may  not  be  delegated.  It  should  not  be  inferred  from  the 
phrase  "provided  by  law"  that  a  stockholder  could  use  the 
figures  obtained  from  an  examination  of  the  corporation's 
return  on  file  in  the  Commissioner's  office  in  a  lawsuit  which 
he  might  bring  against  the  corporation.  A  stockholder  who 
has  acquired  shares  merely  for  the  puri)ose  of  inspecting  the 
returns  of  the  corporation  is  not  a  bona  fide  stockholder. 


'*  [Former  Procedure  1  Ho  fore  tlie  passage  "f  the  191 8  law,  the  Treas- 
ury rej4iil;iti(ins  iicnnittcd  iiis|ii(-li()ii  imder  certain  cimditinns.  (T.  1).  ;7()i6, 
April  18,  1914). 


124 


APPLICATION   AND   ADMINISTRATION 


Regulation.  A  bona  fide  stockholder  of  record  owning  i  per 
cent  or  more  of  the  outstanding  stock  of  a  corporation  shall  be 
entitled  as  of  right,  upon  making  request  of  the  Commissioner  of 
Internal  Revenue,  to  examine  the  annual  income  returns  of  such 
corporation  and  of  its  subsidiaries  made  under  Titles  II  and  III 
of  the  revenue  acts  of  1918  or  1921,  and  all  returns  of  corporations 
filed  for  purposes  of  the  tax  imposed  by  section  1000,  Title  X,  of 
said  acts.  His  request  for  permission  to  examine  such  returns  must 
be  made  in  writing  and  must  be  in  the  form  of  an  affidavit  showing 
his  address,  the  name  of  the  corporation,  the  period  of  time  covered 
by  the  return  he  desires  to  inspect,  the  amount  of  the  corporation's 
outstanding  capital  stock,  the  number  of  shares  owned  by  him,  the 
date  when  he  acquired  them,  and  whether  he  has  the  beneficial  as 
well  as  the  record  title  to  such  shares.  It  must  also  show  that 
he  has  not  acquired  his  shares  for  the  purpose  of  the  examination 
of  the  income  returns  of  the  corporation.  If  he  has  acquired  them 
for  this  purpose  he  is  not  a  bona  fide  stockholder  within  the  mean- 
ing of  the  statute.  The  application  must  be  supported  by  satisfactory 
evidence  showing  that  the  applicant  is  a  bona  fide  stockholder  of 
record  of  the  required  amount  of  stock  of  the  corporation.  The 
supporting  evidence  may  be  partly  in  the  form  of  a  certificate  signed 
by  the  president  or  vice  president  of  the  corporation,  and  counter- 
signed by  the  secretary  under  the  corporate  seal.  Upon  being  satis- 
fied from  the  evidence  presented  that  the  applicant  has  fully  met 
these  conditions  the  commissioner  will  grant  the  permission  to  ex- 
amine the  returns  and  set  a  convenient  time  for  the  examination  in  the 
office  of  the  commissioner.  This  privilege  is  personal  and  will  be 
granted  only  to  the  stockholder,  who  can  not  delegate  it  to  another. 
(Art.  1093.) 

Ruling.  A  "stockholders'  protective  committee,"  to  which  de- 
posited stock  has  been  transferred  for  the  purpose  of  safeguarding 
the  interests  of  the  minority  stockholders,  is  not  considered  a  bona 
fide  stockholder  within  the  meaning  of  section  257  of  the  Revenue 
Act  of  1918.     (C.  B.  I,  page  133;  O.  D.  273.) 

When  it  is  desired  to  inspect  returns  of  years  prior  to 
1918,  the  procedure  laid  down  in  T.  D.  3277  must  be  followed. 

Unofficial  disclosure  of  information  forbidden. — During 
192 1,  several  employees  and  ex-employees  of  the  Treasury 
were  indicted  for  giving  out  information  about  tax  returns. 
Considering  the  opportunities  for  graft  and  the  large  number 
of  employees,  there  are  very  few  violations.  "Leaks"  are 
occasionally  heard  of.     Taxpayers,  as  well  as  those  who  are 


RETURNS— AMENDMENT,    EXAMINATION  125 

practicing  before  the  Treasury,  should  notify  the  officials  at 
once  if  it  is  believed  that  any  confidential  information  has 
been  illegally  disclosed.     It  is  their  duty  to  do  so. 

Law.  Section  131 1.  [Section  3167,  Rev.  Stat.]  It  shall  be  un- 
lawful for  any  collector,  deputy  collector,  agent,  clerk,  or  other  officer 
or  employee  of  the  United  States  to  divulge  or  to  make  known  in  any 
manner  whatever  not  provided  by  law  to  any  person  the  operations, 
style  of  work,  or  apparatus  of  any  manufacturer  or  producer  visited 
by  him  in  the  discharge  of  his  official  duties,  or  the  amount  or  source 
of  income,  profits,  losses,  expenditures,  or  any  particular  thereof,  set 
forth  or  disclosed  in  any  income  return,  or  to  permit  any  income  re- 
turn or  copy  thereof  or  any  book  containing  any  abstract  or  particu- 
lars thereof  to  be  seen  or  examined  by  any  person  except  as  provided 
by  law;  and  it  shall  be  unlawful  for  any  person  to  print  or  publish 
in  any  manner  whatever  not  provided  by  law  any  income  reurn,  or  any 
part  thereof  or  source  of  income,  profits,  losses,  or  expenditures  ap- 
pearing in  any  income  return;  and  any  offense  against  the  foregoing 
provision  shall  be  a  misdemeanor  and  be  punished  by  a  fine  not  ex- 
ceeding $1,000  or  by  imprisonment  not  exceeding  one  year,  or  both, 
at  the  discretion  of  the  court;  and  if  the  offender  be  an  officer  or  em- 
ployee of  the  United  States  he  shall  be  dismissed  from  office  or  dis- 
charged from  employment. 

Referring  to  sections  3152,  3167,  3173  and  3176  of  the 
Revised  Statutes,  a  Treasury  decision  states : 

Ruling.  Reading  these  provisions  of  law  together,  it  is  evident 
that  any  collector,  deputy  collector,  agent,  clerk,  or  other  officer  or  em- 
ployee of  the  Bureau  of  Internal  Revenue,  including  internal  revenue 
agents,  who  divulges  or  makes  known  in  any  manner  whatsoever  not 
provided  by  law  the  amount  or  source  of  income,  profits,  losses,  ex- 
penditures, or  any  particulars  thereof  set  forth  or  disclosed  in  any  in- 
come return  made  by  any  taxpayer,  or  by  a  collector  or  deputy  col- 
lector, or  by  the  Commissioner  of  Internal  Revenue,  or  who  permits 
any  income  return  or  copy  thereof,  or  any  book  containing  any  ab- 
stract or  particulars  thereof,  to  be  seen  or  examined  by  any  person, 
except  as  provided  by  law,  or  who  prints  or  publishes  in  any  manner 
whatever,  not  provided  by  law,  any  income  return  or  any  part  tliereof, 
or  source  of  income,  profits,  losses,  or  expenditures  appearing  in  any 
income  return,  is  guilty  of  a  misdemeanor  and  subject  to  a  fine  not 
exceeding  $1,000  or  to  imprisonment  not  exceeding  one  year,  or  both, 
at  the  discretion  of  the  court,  and  if  he  be  an  officer  or  employee  of 
the  United  States,  to  be  dismissed  from  office  or  discharged  from  em- 
ployment.    (T.  D.  2903,  July  30,  1919.) 


126  APPLICATION   AND   ADMINISTRATION 

List  of  taxpayers  to  be  posted. — The  law  requires  that  the 
names  and  addresses  of  taxpayers  be  thrown  open  to  pnbhc 
inspection. 

Law.      Scctiuu   257 The    Commissioner    shall   as    soon    as 

practicable  in  each  year  cause  to  be  prepared  and  made  available  to 
public  inspection  in  such  manner  as  he  may  determine,  in  the  office  of 
the  collector  in  each  internal-revenue  district  and  in  such  other  places 
as  he  may  determine,  lists  containing  the  names  and  the  post-office 
addresses  of  all  individuals  making  income-tax  returns  in  such  district. 

The  regulations  are  silent  as  to  the  foregoing  section  of 
the  law.  Since  the  words  "shall"'  and  "in  each  year"'  are  used 
in  the  law,  the  posting  of  the  lists  is  obligatory. 

Ruling.  In  accordance  with  section  257  of  the  Revenue  Act  of 
1918  lists  containing  the  names  and  post-office  addresses  of  individuals 
making  income  tax  returns  to  collectors  are  posted  for  public  in- 
spection in  the  public  corridors  of  collectors'  offices  and  post-offices. 
Persons  will  not  be  allowed  to  enter  the  workrooms  of  collectors' 
offices  either  outside  or  during  office  hours  for  the  purpose  of  making 
copies  of  such  lists.     (C.  B.  2.  page  259;  O.  D.  531.) 

Publication  of  statistics. — The  Senate  attempted  to  con- 
tintie  in  the  192 1  law"  the  provision  of  the  1918  law  which 
required  taxpayers  to  report  for  statistical  purposes  tax-exempt 
securities. ^°  It  was  also  proposed  to  require  the  Commissioner 
to  make  a  report  to  Congress  which  would  enable  it  to  know  the 
amoimt  of  income  escaping  through  tax-exempt  securities. 
The  conferees  eliminated  these  proposals.  The  Commissioner, 
notwithstanding  that  these  proposals  were  not  adopted,  is 
authorized  under  his  broad  powers  to  collect  this  information. 

The  law  does,  however,  require  the  Commissioner  to  pub- 
lish statistics.     In  this  respect  it  is  the  same  as  the  1918  law'. 

Law.  Section  258.  That  the  Commissioner,  v/ith  the  approval  of 
the  Secretary,  shall  prepare  and  publish  annually  statistics  reasonably 
available  with  respect  to  the  operation  of  the  income,  w^ar-profits  and 
excess-profits-tax  laws,  including  classifications  of  tax-payers  and  of 
income,  the  amounts  allowed  as  deductions,  exemptions,  and  credits, 
and  any  other  facts  deemed  pertinent  and  valuable. 


Section  213  (b-4). 


RETURNS— AMENDMENT,   EXAMINATION  127 

Regulation.  The  Commissioner  will  publish  annually  a  volume 
of  statistics  of  income,  showing,  among  other  things,  the  distribution 
of  incomes  between  corporations  and  individuals  and  by  States,  by 
classes  and  by  occupations.      (Art.   iioi.) 

Compilations,  giving  very  full  details  regarding  statistics 
of  income  for  the  calendar  years  1916  and  1917,  were  issued 
some  time  ago.  In  November,  1920,  a  summary  of  the  sta- 
tistics gathered  from  the  1918  returns  was  made  public.  Dur- 
ing the  year  1921,  a  preliminary  report  of  statistics  for  the 
fiscal  year  1919  was  issued.  A  more  detailed  report  was 
issued  during  Februarv,  1922. 


CHAPTER    VI 

PENALTIES 

Before  and  after  the  filing  of  returns,  taxpayers  may  inad- 
vertently or  otherwise  render  themselves  liable  to  penalties 
for  negligent  or  fraudulent  returns,  insufficient  or  delayed  pay- 
ments of  taxes,  or  other  shortcomings.  These  matters  are 
discussed  in  this  chapter. 

Penalties  and  Procedure  in  Cases  of  Delinquency 

The  following  is  a  synopsis  of  penalties  for  failure  to  file 
returns  and  for  the  filing  of  false  or  fraudulent  returns,  as  well 
as  other  penalties  imposed  by  the  Revenue  Act  of  192 1.  In- 
terest at  a  reasonable  rate  can  hardly  be  called  a  penalty,  but 
as  interest  rates  vary  considerably,  and  as  interest  runs  from 
various  dates,  the  synopsis  includes  all  interest  liability. 

SYNOP.SIS   OF   INTEREST  REQUIREMENTS  AND 
PENALTIES 

Abstract  of  Revenue  Act  of  192 i 

Section  of  Act  Penalty 

Understatejment  of  Amount  of  Tax 

250  (b) If  not  due  to  negligence  or  in-       3^   of   1%  per  month  from 

tentional  disregard  of  author-  the  time  the  tax  was  due 
ized  rules  and  regulations  with  (or  if  paid  on  the  instal- 
knowledge  thereof,  or  fraud.  ment    basis,    on    the    defi- 

ciency of  each  instalment 
from  the  time  the  instal- 
ment was  due)  to  the  ex- 
tent same  is  not  covered  by 
any  credits  due  to  the  tax- 
payer under  section  252. 

128 


PENALTIES 


129 


250(b) If  due  to  negligence  or  inten- 
tional disregard  of  authorized 
rules  and  regulations  with 
knowledge  thereof,  but  with- 
out intent  to  defraud. 


250  (b) ...  .If  any  part  of  the  deficiency  is 
due  to  fraud  with  intent  to 
evade  tax. 


1311 ....... .False  or    fraudulent   return  or 

(R.  S.3176)    list  willfully  made. 


253 Willful    attempt   to    evade   tax 

(applies    to    taxpayer',    officers 
and  employees). 


5%  of  the  total  amount  of 
the  deficiency  in  the  tax, 
and  interest  at  the  rate  of 
1%  per  month  on  the 
amount  of  such  deficiency 
from  the  time  it  was  due 
(or  if  paid  on  the  instal- 
ment basis,  on  the  amount 
of  the  deficiency  in  each  in- 
stalment from  the  time  the 
instalment   was  due). 

50%  of  the  total  amount  of 
the  deficiency  in  the  tax  in 
lieu  of  penalty  provided  by 
section  1311  (R.  S.  3176) 
but  in  addition  to  specific 
penalties  (see  section  253). 

50%  of  amount  of  tax  in 
addition  to  specific  pen- 
alties (but  not  in  addition 
to  the  50%  penalty  in  pre- 
ceding section).  (See  sec- 
tion 253.) 

Maximum  fine  $10,000,  or 
maximum  imprisonment 
one  year,  or  both,  with 
costs,  in  addition  to  ad 
valorem  penalties.  [See  sec- 
tions   250    (b)    and    131 1.] 


Failure  to  File  Return  of  Information 


253 Failure  to  file  when  due. 


253 Refusal  willfully  to  make  re- 
turn or  willful  attempt  in  any 
manner  to  defeat  or  evade  the 
tax. 


1311 Failure  to  file  when  due  (unless 

(R.  S.3176)    shown  to  be  due  to  reasonable 
cause). 


Maximum  fine  $1,000;  in 
addition  to  ad  valorem 
penalty.  (See  section  131 1 
below.) 

Maximum  fine  $10,000,  or 
maximum  imprisonment 
one  year,  or  both,  with 
costs,  in  addition  to  ad  va- 
lorem penalty.  (See  sec- 
tion 1311  below.) 

25%  of  amount  of  tax  in 
addition  to  specific  penalty. 
(See  section  253  above.) 


130 


APPLICATION   AND   ADMINISTRATION 


1408 Failure  to  file  true  and  correct 

(igiSact)        copy  of  any  government  con- 
tract on   request. 


^1,000    fine,    one    year    im- 
prisonment, or  both. 


Failure  to  Pay  Tax  When  Due 


250  (a)  . . .  .When  extension  is  granted   for 
filing  final  returns. 

250  (a) . . . .  When    instalment    is    not    paid 
when  due. 


250  (e)  . .  .  .Failure  to  pay  when  due,  unless 
covered  by  a  bona  fide  claim 
for  abatement  which  was  filed 
within  ten  days  after  notice 
and  demand  by  the  collector, 
and  without  the  taxpayer  hav- 
ing had  the  benefit  of  the  pro- 
visions of  subdivision  (d)  of 
this  section,  in  which  case  the 
only  penalty  is  J/2  of  i%per 
month  except  claims  for  in- 
ventory losses  (under  1918 
act)  interest  on  which  is  1% 
per  month.  [See  sections  214 
(a-12)  and  234  (a-14),  1918 
act.]  (This  applies  to  taxes 
under  1917,  1918  and  1921 
acts.) 

250  (f)....When  extension  is  granted  for 
paying  deficiency  in  tax  under 
1917,  1918  or  1921  act. 


14%  per  month  interest  on 
amount  of  deficiency,  if 
any,    in   initial   instalments. 

Entire  tax  becomes  due  and 
payable  on  notice  and  de- 
mand ;  5%  on  amount  due 
and  unpaid;  1%  per  month 
interest  in  addition  to 
specific  penalty.  (See  sec- 
tion 253.) 

5%  on  amount  due,  1%  per 
month  interest  in  addition 
to  specific  penalty.  (See 
section   253.) 


Within  period  of  18  months 
from  passage  of  1921  act 
(November  23,  1921),  ex- 
tension may  be  granted 
for  paying  deficiency  upon 
cause  shown.  From  date 
of  extension  until  payment 
of  interest  at  rate  of  Ys  of 
1%  per  month,  except 
where  such  interest  pro- 
vided by  law  is  in  excess 
thereof. 


PENALTIES 


131 


250(f) When    deficiency    or    any    part 

thereof  is  not  paid  in  accord- 
ance with  the  terms  of  exten- 
sion granted. 


250  (g) When,  after  Commissioner  has 

taken  action  under  this  sec- 
tion, a  taxpayer  violated  or  at- 
tempts to  violate  the  provi- 
sions thereof;  also  when  an 
alien  violates  or  attempts  to 
violate  the  provisions  of  this 
section  relating  to  the  secur- 
ing of  certificate  prior  to  de- 
parture from  the  United 
States  (with  respect  to  taxes 
under  1917,  1918  and  1921 
acts). 

253 Failure  to  pay  or  collect  tax  at 

time  required. 

253 Willful     refusal     to     pay     tax 

when  required  (applies  to  tax- 
payer, officers  and  employees). 


5%  of  the  amount  of  the 
deficiency,  and  interest  on 
the  deficiency  at  the  rate 
of  1%  per  month  from  the 
time  it  became  payable,  in 
accordance  with  the  terms 
of  the  extension,  in  lieu  of 
other  penalties  and  interest 
that  would  attach  under 
the  law. 

25%  of  the  total  amount  of 
the  tax  or  the  deficiency  in 
the  tax,  together  with  in- 
terest at  the  rate  of  1% 
per  month  from  the  time 
the  tax  became  due,  in  ad- 
dition to  all  other  penalties. 


Maximum  fine  $1,000  in  ad- 
dition to  ad  valorem  pen- 
alty.    (See  section  250.) 

Maximum  fine  $10,000, 
maximum  imprisonment 
one  year,  or  both,  with 
costs,  in  addition  to  ad 
valorem  penalty.  (See  sec- 
tion 250.) 


Failure  to  make  return — collector  to  supply  deficiency. — 

Law.  Section  1311.  [.Section  3176,  Rev.  Stat.]  If  any  person, 
corporation,  company,  or  association  fails  to  make  and  file  a  return 
or  list  at  the  time  prescribed  by  law  or  by  regulation  made  under 
authority  of  law,  or  makes,  willfully  or  otherwise,  a  false  or  fraudulent 
return  or  list,  the  collector  or  deputy  collector  shall  make  the  return 
or  list  from  his  own  knowledge  and  from  such  information  as  he  can 
obtain  through  testimony  or  otherwise.  In  any  such  case  the  Com- 
missioner may,  from  his  own  knowledge  and  from  such  information 
as  he  can  obtain  through  testimony  or  otherwise,  make  a  return  or 
amend  any  return  made  by  a  collector  or  deputy  collector.     Any  re- 


132 


APPLICATION   AND    ADMINISTRATION 


turn  or  list  so  made  and  subscribed  by  the  Commissioner,  or  by  a 
collector  or  deputy  collector  and  approved  by  the  Commissioner,  shall 
be  prima  facie  good  and  sufficient  for  all  legal  purposes 

Accordingly,  in  cases  where  the  collector  or  Commissioner 
makes  a  return,  the  amount  of  tax  determined  under  the 
substitute  return  is  payable  upon  notice  and  demand.^ 

Penalties  for  failure  to  make  return. — There  are  two  pen- 
alties for  failure  to  file  a  return,  viz.,  a  specific  fine  and  a 
percentage  (ad  valorem)  penalty.  The  former  can  be  imposed 
only  by  the  courts,  while  the  latter  may  be  assessed  by  the 
Commissioner. 

Penalty  of  fine.- — The  192 1  law,  as  compared  with  the 
1918  law,  did  not  make  any  change  in  the  following  provision: 

Law.  Section  253.  That  any  individual,  corporation,  or  part- 
nership required  under  this  title  to  pay  or  collect  any  tax,  to  make  a 
return  or  to  supply  information,  wrho  fails  to  pay  or  collect  such  tax, 
to  make  such  return,  or  to  supply  such  information  at  the  time  or 
times  required  under  this  title,  shall  be  liable  to  a  penalty  of  not  more 
than  $1,000.3.    _        _ 

Penalty  of  25  per  cent  additional  tax.* — Aside  from 
changing  the  section  number  from  1317  to  1311,  the  1921 
law  does  not  make  any  change  in  the  following  provision  of 
the  19 1 8  law: 

Law.  Section  131 1.  [Section  3176,  Rev.  Stat.]  ....  In  case 
of  any  failure  to  make  and  file  a  return  or  list  within  the  time  prescribed 
by  law,  or  prescribed  by  the  Commissioner  of  Internal  Revenue  or  the 
collector  in  pursuance  of  law,  the  Commissioner  of  Internal  Revenue 
shall  add  to  the  tax  25  per  centum  of  its  amount,  except  that  when  a 
return  is  filed  after  such  time  and  it  is  shown  that  the  failure  to  file  it 


'  See  Chapter  VIII. 

^  The  above  penalties  are  for  cases  where  the  failure  to  file  return  or 
pay  tax  is  not  "wilful."  For  penalties  in  cases  of  wilful  refusal  to  file 
return  or  pay  tax,  see  page  137. 

^  [Former  Procedure]  A  minimum  fine  of  $20  was  provided  by  sec- 
tion 18  of  the  1916  law. 

*  [Former  Procedure]     Fifty  per  cent  under   1916  law   (section   16). 


PENALTIES  133 

was  due  to  a  reasonable  cause  and  not  to  willful  neglect/'  no  such  ad- 
dition shall  be  made  to  the  tax.*^ 

This  is  broader  than  the  earlier  law,  in  that  it  is  now 
necessary  only  to  show  that  failure  was  "due  to  a  reasonable 
cause  and  not  to  willful  neglect."  Before  the  Solicitor  issued 
Law  Opinion  1060,  it  was  considered  necessary  in  addition 
that  the  return  be  filed  "voluntarily  and  without  notice  from 
the  collector."  Such  voluntary  filing,  however,  is  obviously 
the  best  possible  evidence  that  the  failure  to  file  was  due  to  a 
reasonable  cause  and  not  to  wilful  neglect.  Certainly  the 
taxpayer  seeking  relief  from  a  penalty  is  in  a  much  stronger 
position  if  his  return  has  been  voluntarily  filed.  The  regula- 
tions in  the  past  have  prescribed  that  the  penalty  of  increased 
tax  shall  be  remitted  only  if  the  cause  "is  found  to  be  reason- 
able." It  can  be  assumed  that  any  cause  short  of  fraud  or 
wilful  neglect  will  be  deemed  to  be  reasonable. 

Regulation If  the  taxpayer  exercised  ordinary  busi- 
ness care  and  prudence  and  was  nevertheless  unable  to  file  the  return 
in  the  prescribed  time,  then  the  delay  is  due  to  "reasonable  cause." 
....      (Art.  1004.) 

Ruling.  Where  the  attendant  and  surrounding  circumstances 
have  a  tendency  to  cast  doubt  and  suspicion  upon  a  taxpayer,  a  plea 


"  [Former  Procedure]  Under  the  earlier  law  this  remission  of  pen- 
alty was  granted  only  when  a  return  was  filed  "voluntarily  and  without  notice 
from  the  collector."     (Section  16,  section  3176,  Rev.  Stat.) 

During  1921  the  Solicitor  made  a  more  liberal  interpretation  of  this 
section  of  the  law.  The  50  per  cent  penalty  is  imposed  only  where  there 
has  been  "a  refusal  or., inexcusable  neglect"  to  file  a  return. 

Ruling.  "A  mere  failure  to  file  a  return  as  required  by  and  within  the 
time  prescribed  in  the  Act  of  October  3,  1913,  does  not  of  itself  constitute 
a  'refusal  or  neglect'  to  file  such  return  within  the  meaning  of  section  3176 
R.  S.,  as  amended  by  the  Act  of  October  3,  1913. 

"The  Commissioner  is  authorized  and  required  to  add  the  50  per  cent 
to  the  tax  provided  for  in  section  3176,  R.  S.,  as  amended  by  the  Act  of 
October  3,  1913,  only  where  there  has  been  a  refusal  or  inexcusable  neglect 
on  the  part  of  the  taxpayer  to  file  the  return  within  the  time  prescribed  by 
law."     (C.  B.  4,  page  318;  Digest  L.  O.  1060.) 

•  In  the  case  of  this  25  per  cent  penalty  as  well  as  the  50  per  cent 
penalty  for  false  or  fraudulent  list,  "The  amount  so  added  to  any  tax 
shall  be  collected  at  the  same  time  and  in  the  same  manner  and  as  a  part 
of  the  tax  unless  the  tax  has  been  paid  before  the  discovery  of  the  neglect, 
falsity,  or  fraud,  in  which  case  the  amotmt  so  added  shall  l)e  collected  in 
the  same  manner  as  the  tax."     (Law,  section  1311,  section  3176,  Rev.  .Stat.) 


134 


APPLICATION   AND    ADMINISTRATION 


of  mere  ignorance  is  not  sufficient  to  constitute  a  reasonable  cause 
for  failure  to  make  and  file  a  return  within  the  time  prescribed  by 
law  for  the  purpose  of  being  relieved  of  the  penalty.  (C.  B.  i,  page 
247;  O.  818.) 

The  above  quoted  regulation  further  declares  that,  to  avoid 
the  penalty,  the  taxpa3^er  should  attach  to  the  return  an  affidavit 
showing  the  facts  alleged  as  a  reasonable  cause  for  failure  to 
make  the  return  in  due  time.  The  Commissioner  passes  upon 
the  validity  of  the  showing  and  without  his  consent  no  remis- 
sion is  made.  Relief  from  the  ad  valorem  penalty  does  not  nec- 
essarily relieve  the  taxpayer  from  liability  to  the  specific  fine.'^ 

Ruling,  (i)  The  ad  valorem  penalties  for  fraudulent  returns 
should  be  assessed  against  withholding  agents  under  the  income  tax 
provisions  of  the  law. 

(2)  The  ad  valorem  penalties  for  delinquent  returns  should  be 
assessed  against  withholding  agents  under  the  income  tax  provisions 
of  the  law,  except  that  if  the  tax  required  to  be  withheld  is  paid  by 
the  recipient  of  the  income,  no  such  penalty  should  be  collected  from 
the  withholding  agent  unless  his  delinquency  was  fraudulent  and  for 
the  purpose  of  evading  payment (C.  B.  2,  page  229;  S.  1334.) 

In  answering  the  contention  that  ad  valorem  penalties  did 
not  apply  to  withholding  agents,  the  solicitor  stated  that : 

I  can  see  no  good  reason  for  distinguishing  between  taxpayers 
and  withholding  agents  as  regards  the  assessment  of  the  ad  valorem 
penalties  for  delinquent  or  fraudulent  returns. 

The  50  per  cent  penalty. — The  50  per  cent  penalty  applies 
only  to  false  or  fraudulent  returns.  This  penalty  also  becomes 
a  part  of  the  tax  and  may  be  assessed  by  the  Commissioner. 

Law.  Section  131 1.  [Section  3176  Rev.  Stat.]  ....  In  case  a 
false  or  fraudulent  return  or  list  is  willfully  made,  the  Commissioner 
of  Internal  Revenue  shall  add  to  the  tax  50  per  centum  of  its 
amount 

Prior  to  1918,  section  3176  of  the  Revised  Statutes  pro- 
vided for  a  penalty  of  100  per  cent.  In  the  1918  law  the 
penalty  was  reduced  to  50  per  cent. 

Section  25b   (b)   of  the  new  law  reads  as  follows: 

'  See  page  132. 


PENALTIES  135 

Law.  Section  250 (b)  ....  If  any  part  of  the  de- 
ficiency is  due  to  fraud  with  intent  to  evade  tax,  then,  in  lieu  of  the 
penalty  provided  by  section  3176  of  the  Revised  Statutes,  as  amended, 
for  false  or  fraudulent  returns  willfully  made,  but  in  addition  to  other 
penalties  provided  by  law  for  false  or  fraudulent  returns,  there  shall 
be  added  as  part  of  the  tax  50  per  centum  of  the  total  amount  of  the 
deficiency  in  the  tax.  In  such  case  the  whole  amount  of  the  tax  un- 
paid, including  the  penalty  so  added,  shall  become  due  and  payable 
upon  notice  and  demand  by  the  collector 

The  distinction  between  the  penalties  imposed  under  sec- 
tion 3176,  Revised  Statutes,  and  section  250  (b),  is  that 
under  the  former  the  50  per  cent  penalty  is  computed  on  the 
full  amount  of  the  tax  correctly  payable  (both  original  and  ad- 
ditional assessments),  whereas  under  the  latter  section  the  pen- 
alty is  computed  only  on  the  deficiency  of  tax,  i.e.,  the  amount 
of  tax  under-reported  on  the  false  or  fraudulent  return. 

In  view  of  the  notice  by  the  Commissioner  that  "tax 
slackers"  are  to  be  severely  dealt  with,  it  should  be  noted 
that  in  addition  to  all  other  penalties  there  will  be  added  to 
the  deficiency  in  tax  an  additional  50  per  cent  thereof.  Deter- 
mination of  what  constitutes  a  false  return  will  depend  on  the 
circumstances  of  each  case,  but  it  is  reasonable  to  suppose  that 
the  wide  publicity  during  the  last  several  years  given  to  all  in- 
come tax  matters  will  put  the  burden  of  proof  upon  every  citi- 
zen who  makes  an  understatement,  and  when  it  is  found  that 
there  has  been  a  failure  to  report  income  it  will  be  much  more 
difficult  than  heretofore  to  claim  ignorance  of  the  law. 

Rulings.  "Understatement"  as  used  in  section  250  (b)  has  par- 
ticular reference  to  the  understatement  of  the  amount  of  the  tax  in 
the  return.  This  is  true  whether  such  understatement  resulted  from 
the  false  or  fraudulent  computation  of  the  tax  or  from  false  or  fraud- 
ulent misstatements  or  omissions  of  items  of  income  or  misstatements 
of  items  of  deduction  or  from  other  false  or  fraudulent  entries  or 
omissions. 

Section  250  (b),  providing  for  the  addition  as  part  of  the  tax  50 
per  centum  of  the  amount  of  the  deficiency,  and  not  section  3176, 
R.  S.,  as  amended  by  the  revenue  act  of  19 18,  is  applicable  to  income 
and  profits  tax  matters  arising  under  the  revenue  act  of  191 8,  where 
there  is  an  understatement  of  the  amount  of  the  tax  in  the  return 


136  APPLICATION   AND    ADMINISTRATION 

and  the  understatement  resulted  from  fraud  with  intent  to  evade  the 
tax.  In  all  other  cases  of  false  or  fraudulent  returns  willfully  made 
in  matters  arising  under  the  revenue  act  of  1918,  section  3176,  Re- 
vised Statutes,  as  amended  by  that  act,  is  applicable.  (C.  B.  2,  page 
232;   O.   1008.) 

A  taxpayer  who  filed  a  return  of  income  which  did  not  include 
profit  on  the  sale  of  certain  corporate  stock  and  in  reply  to  an  inquiry 
by  an  examining  officer  stated  that  he  had  not  made  any  money  on 
outside  investments  during  the  year,  but  in  reply  to  a  direct  inquiry 
in  regard  to  the  sale  of  the  stock,  based  on  confidential  information, 
admitted  the  sale,  but  made  no  explanation  of  his  failure  to  include 
the  profit  on  the  sale  in  his  return  for  the  taxable  year,  is  held  to 
have  filed  a  false  and  fraudulent  return  for  the  purpose  of  evading 
taxation  and  the  100  per  cent  additional  tax  should  be  assessed. 
(1913  Act.)     (C.  B.  I,  page  248;  S.  926.) 

In  Lci'y  V.  United  States,^  the  defendant  made  an  amended 
income  and  excess  profits  tax  rettn'n  which  was  proven  tcj 
be  false.  It  was  urged  that  the  offense  related  to  an  "amended" 
return  and  no  return  of  that  character  was  known  to  the  crim- 
inal law.  The  court  held  that  while  amended  returns  may  not 
be  prescribed  by  statute,  they  nevertheless  fall  within  its  con- 
templation. 

In  United  States  i'.  RocJitnil,^  it  was  held,  in  an  indict- 
ment for  conspiracy  to  evade  payment  of  an  income  tax,  the 
preparation,  signing,  and  acknowledgment  of  a  false  return, 
alleged  as  overt  acts,  w^ould  not  constitute  an  attempt  to  evade 
payment  of  the  tax.  However,  the  filing  of  the  false  return 
with  the  collector  would  be  such  an  attempt. 

Rulings.  Where  an  income  tax  return  under  the  Revenue  Act 
of  1916,  or  an  income  or  excess  profits  tax  return  under  the  Revenue 
Act  of  191 7,  has  been  found  to  be  false  and  fraudulent  and  the  ad- 
ditional tax  has  been  assessed  and  paid  at  a  time  when  the  grounds 
for  asserting  the  100  per  cent  fraud  penalty  under  section  3176  R.  S., 
as  amended  by  the  Revenue  Act  of  1916,  were  fully  known  to  the  de- 
partment, no  fraud  penalty  may  be  thereafter  assessed;  where  under 
such  circumstances  the  additional  tax  has  been  assessed  but  not  paid 
or  paid  but  not  assessed,  the  fraud  penalty  may  still  be  assessed. 

The  rule  under  the  Revenue  Act  of  1918,  however,  is  different. 
The  50  per  cent  fraud  penalty  under  section  250  (b)  thereof  may  be 


'271  Fed.  942. 
•  270  Fed.  869. 


PENALTIES  137 

subsequently    assessed    although    the    additional    tax    has    been    both 
assessed  and  paid  after  the  discovery  of  the  fraud. 

Under  all  three  of  these  Acts,  if  the  additional  tax  has  been 
assessed  or  paid,  or  assessed  and  paid  prior  to  discovery  of  the  fraud, 
the  penalty  may  be  assessed  at  any  time  after  the  discovery  and  within 

the  statutory  period  for  assessment  of  taxes (C.  B.  3,  page 

290;   Sol.  Op.  52.) 

....  Taxes  may  be  collected  by  suit,  whether  assessed  or  not,  but 
this  is  not  true  with  respect  to  ad  valorem  penalties  which  can  not  be 
collected  by  suit  without  first  having  been  assessed;  furthermore  even 
though  they  have  been  assessed  they  may  not  be  collected  by  suit 
after  five  years  from  the  time  they  accrued. 

A  waiver  by  a  taxpayer  of  his  rights  as  to  the  limitation  of  assess- 
ment of  taxes  does  not  carry  with  it  a  similar  waiver  as  to  the  assess- 
ment of  ad  valorem  penalties.     (C.  B.  3,  page  295;  Sol.  Op.  60.)  . 

The  foregoing  ruling  was  made  for  a  specific  case  in 
which  the  taxpayer  had  filed  in  19 18  amended  returns  for  the 
years  1909  to  1916,  inclusive.  Under  the  amended  returns 
the  net  income  was  shown  to  be  much  larger  than  was  origin- 
ally reported.  The  Treasury  held  that,  inasmuch  as  the  books 
clearly  reflected  the  correct  net  income  and  the  original  re- 
turns did  not,  there  was  evidence  of  fraud.  Furthermore  it 
was  held  that  the  real  purpose  of  filing  the  amended  returns 
was  to  secure  a  large  invested  capital  for  191 7,  which  had 
been  reduced  by  various  understatements  in  original  returns. 

Penalty  for  w^ilful  refusal  to  make  return  or  attempt  to 

evade — fine  or  imprisonment. — The  1921  law  as  compared  with 

the  1918  law  does  not  make  any  change  in  the  following  specific 

penalty : 

Law.  Section  253.  ....  Any  individual,  corporation,  or  part- 
nership, or  any  officer  or  employee  of  any  corporation  or  member  or 
employee  of  a  partnership,  who  willfully  refuses  to  pay  or  collect  such 
tax,  to  make  such  return,  or  to  supply  such  information  at  the  time  or 
times  required  under  this  title,  or  who  willfully  attempts  in  any  man- 
ner to  defeat  or  evade  the  tax  imposed  by  this  title,  shall  be  guilty  of  a 
misdemeanor  and  shall  be  fined  not  more  than  $10,000'"  or  imprisoned 
for  not  more  than  one  year,  or  both,  together  with  the  costs  of  prose- 
cution. 


'"  [Former  Procedure]     Under  the   earlier   law   the   fine   applying  to 
individuals  was  restricted  to  $2,000   (1917  law,  section  18). 


138  APPLICATION    AND    ADMINISTRATION 

Regulation If  tlie  failure  is  willful,  however,  or  an  at- 
tempt is  made  to  defeat  or  evade  the  tax,  the  offender  is  liable  to  im- 
prisonment and  to  a  fine  of  not  more  than  $10,000  and  costs.  See 
also  the  Act  of  July  5,  1884.  In  addition  to  these  specific  penalties 
ad  valorem  penalties  are  imposed  in  various  cases.  An  ad  valorem 
penalty  is  assessed  and  collected  as  a  part  of  the  tax,  while  a  specific 

penalty   is   recoverable   only   by   suit (Art.   1055.   Reg.   45, 

Art.    1041.) 

Rulings.  The  giving  of  instructions  or  advice  with  the  purpose 
and  intent  of  inducing  persons  liable  to  make  income  returns  or  pay 
income  tax  to  refrain  from  making  such  returns  or  paying  such  tax 
is  an  attempt  to  defeat  the  tax  within  the  meaning  of  the  statute, 
and  those  giving  such  instructions  or  advice  are  amenable  thereto. 
(C.  B.  I,  page  259;  S.  931.) 

if  a  citizen  about  to  leave  the  United  States  willfully  refuses  to 
pay  such  tax  as  is  properly  due,  he  may  be  arrested  and  detained  for 
the  purpose  of  facing  prosecution  criminally  for  a  violation  of  section 
253  of  the  Revenue  Act  of  1918.  Furthermore,  the  district  courts 
of  the  United  States,  at  the  instance  of  the  United  States,  are  vested 
with  jurisdiction  to  make  and  issue  writs  and  orders  of  injunction 
and  ne  exeat  republica  and  such  orders  and  process  as  may  be  neces- 
sary or  appropriate  for  the  enforcement  of  the  provisions  of  the  Reve- 
nue Act  of  1918.  (Sec.  1318.)  With  respect  to  these  provisions  a 
citizen  departing  is  in  no  different  position  from  a  citizen  continuing 
in  the  United  States — the  Act  being  enforceable  alike  against  tax- 
payers continuing  in  the  United  States  and  taxpayers  departing  from 
the  United  States.     (C.  B.  i,  page  260;  O.  D.  168.) 

The  foregoing  relates  to  tax  which  is  due  and  shonid  not 
be  confused  with  the  provisions  of  section  250   (g)." 

Imperfect  returns  not  acceptable. — Notwithstanding  the 
requirement  of  the  Treasury  that  taxpayers  must  secure  the 
approval  of  the  Commissioner  to  file  tentative  returns,  the 
following  would  seem  to  permit  the  filing  of  tentative  returns 
without  permission : 

Regulation Each  taxpayer  should  carefully  prepare  his 

return  so  as  fully  and  clearly  to  set  forth  the  data  therein  called  for. 
Imperfect  or  incorrect  returns  will  not  be  accepted  as  meeting  the 
requirements  of  the  statute.  In  lack  of  a  prescribed  form  a  statement 
made  by  a  taxpayer  disclosing  his  gross  income  and  the  deductions 

"  See  page  VIII. 


PENALTIES  139 

therefrom  may  be  accepted  as  a  tentative  return,  and  if  filed  within 
the  prescribed  time  a  return  so  made  will  relieve  the  taxpayer  from 
liability  to  penalties,  provided  that  without  unnecessary  delay  such  a 
tentative  return  is  replaced  by  a  return  made  on  the  proper  form. 
(Art.  407.) 

The  author  knows  of  a  case  where  a  tentative  return  was 
filed  without  permission,  due  to  a  misunderstanding.  The  es- 
timated amount  of  tax  paid  was  considerably  in  excess  of 
that  shown  by  the  final  return  which  was  filed  about  a  month 
later. 

Notwithstanding  the  fact  that  the  Commissioner  knew  all 
the  facts  and  knew  absolutely  that  there  was  no  evidence 
of  fraud,  and  also  had  received  an  excessive  payment  for  the 
first  instalment,  a  penalty  of  about  $30,000  was  assessed  against 
the  taxpayer.  The  employees  of  the  Treasury  then  had  the 
audacity  to  offer  to  compromise  the  penalty  for  about  $5,000! 

The  author  is  of  the  opinion  that  article  407  places  a  cor- 
rect interpretation  upon  the  law.  If  a  taxpayer  is  able  to  file 
only  a  tentative  return  on  the  due  date,  he  has  filed  a  return 
within  the  meaning  of  the  law.  A  complete  return  should  be 
filed  as  soon  as  possible.  Of  course  taxpayers  are  not  excused 
from  the  obligation  to  request  extensions  of  time,  which  are 
freely  granted  in  all  meritorious  cases.  The  foregoing  dis- 
cussion concerns  taxpayers  who  without  negligence  have 
failed  to  secure  formal  extensions  of  time. 


Penalties  for  Understatements  and  for  Failure  or  Delay 

of  Payment 

Under  both  the  1918  and  192 1  laws,  if  it  appears  that  an 
understatement  of  the  amount  of  tax  due  has  been  made  in 
good  faith,  there  shall  be  no  penalty  because  of  such  under- 
statement, but  if  due  to  negligence,  there  shall  be  a  penalty 
of  5  per  cent  added  to  the  additional  tax,  plus  interest  at  the 
rate  of  12  per  cent  per  annum. 

The  1921  law  does  not  make  any  material  change  in  the 
provision  of  the  1918  law  regarding  understatements  of  tax 


140  APPLICATION   AND   ADMINISTRATION 

liability.^^  The  phrase,  "intentional  disregard  of  authorized 
rules  and  regulations  with  knowledge  thereof,"  constitutes  the 
only  change  of  any  importance.  This  phrase  previously  ap- 
peared in  article  1005  of  Regulations  45. 

Law.  Section  250 (b)  ....  If  any  part  of  the  defici- 
ency is  due  to  negligence  or  intentional  disregard  of  authorized  rules  and 
regulations  with  knowledge  thereof,  but  without  intent  to  defraud, 
there  shall  be  added  as  part  of  the  tax  5  per  centum  of  the  total  amount 
of  the  deficiency  in  the  tax,  and  interest  in  such  a  case  shall  be  col- 
lected at  the  rate  of  i  per  centum  per  month  on  the  amount  of  such 
deficiency  in  the  tax  from  the  time  it  was  due  (or,  if  paid  on  the  in- 
stallment basis,  on  the  amount  of  the  deficiency  in  each  installment  from 
the  time  the  installment  was  due),  which  penalty  and  interest  shall  be- 
come due  and  payable  upon  notice  and  demand  by  the  collector 

It  is  therefore  of  importance  to  taxpayers  that,  if  an  addi- 
tional assessment  is  made,  care  be  taken  to  produce  evidence 
that  there  was  no  negligence  involved,  but  that  on  the  con- 
trary the  return  was  made  in  good  faith  and  not  due  to  any 
fault  of  the  taxpayer. 

Regulation Negligence  is   the  absence  of  reasonable 

care  under  the  circumstances (Art.  1005.) 

Of  course,  if  the  instructions  on  the  return  are  contrary  to 
the  law,  it  is  not  necessary  to  follow  them.  It  is  good  prac- 
tice, however,  to  indicate  how  and  why  the  instructions  were 
not  followed.  This  is  confirmed  by  the  Committee  on  Appeals 
and  Review. 

Ruling.  Held,  that  the  5  per  cent  penalty  for  negligence  should 
not  attach  in  any  case  where  a  complete  disclosure  of  all  the  facts 
is  made  by  the  taxpayer  in  the  return  so  that  the  Department  can 
make  an  assessment  of  additional  tax  if  it  desires  to  do  so.  (C.  B.  4, 
page  322;  A.  R.  M.  105.) 


"  [Former  Procedure]     The   1918  law   reads  as   follows : 

Law.     Section  250 (b) if  the  return   is  made  in  good 

faith  and  the  understatement  of  the  amount  in  the  return  is  not  due  to  any 
fault  of  the  taxpayer,  there  shall  be  no  penalty  because  of  such  understate- 
ment. If  the  understatement  is  due  to  negligence  on  the  part  of  the  tax- 
payer, but  without  intent  to  defraud,  there  shall  be  added  as  part  of  the 
tax  5  per  centum  of  the  total  amount  of  the  deficiency,  plus  interest  at  the 
rate  of  i  per  centum  per  month  on  the  amount  of  the  deficiency  of  each 
installment  from  the  time  the  installment  was  due 


PENALTIES 


141 


The  foregoing  was  a  case  where  appreciation  was  inckidcd 

in  invested  capital. 

The  following  ruling  of  the  Committee  is  also  of  interest : 

RuLLNG.  The  penalty  for  negligence  should  not  be  asserted 
against  a  corporation  where  the  amount  of  a  contribution  to  the  Red 
Cross  and  other  similar  war  works  was  specifically  and  separately 
listed  in  tbe  schedule  of  general  expenses  supporting  item  12  in  its 
return  for  1918.     (C.  B.  4,  page  322;  A.  R.  R.  360.) 

The  detailed  opinion  stated  that: 

There  was  no  specific  instruction  on  the  return  form  dealing  with 
contributions  to  the  Red  Cross  and  other  similar  war  works,  and  it 
is  a  known  fact  that  many  lawyers  and  tax  consultants  of  ability 
were  of  the  ppinion,  and  so  advised  their  clients,  that  contributions 
to  these  objects  under  conditions  that  existed  in  1918  when  the 
United  States  was  at  war,  were  legitimate  and  proper  deductions 
in  determining  net  income,  not  of  course  as  charitable  contributions 
under  section  214  (a)  li  but  as  ordinary  and  necessary  expenses  of 
business.  That  the  Bureau  itself  had  not  made  up  its  mind  on  this 
question  is  clearly  indicated  by  the  fact  that  the  question  was  sub- 
mitted to  the  Attorney  General  for  an  opinion  which  at  the  date  of 
filing  the  return  had  not  been  rendered. 

Any  interest  paid  under  section  250  should  be  charged  to 
an  expense  account  as  the  same  is  a  deductible  item. 

Penalty  for  understated  tax. — If  the  mistake  is  one  of 
which  an  average  reasonable  man  might  be  capable,  the  5 
per  cent  penalty  will  not  be  imposed.  It  is  obvious  that 
the  penalty  will  not  ])e  imposed  when  arithmetical  or  other 
errors  have  been  made,  provided  only  that  they  are  such  errors 
as  the  average  man  may  make.  The  honest  taxpayer  can  point 
out  in  his  defense  many  conflicting  and  ambiguous  regulations. 

In  view  of  the  complexities  and  ambiguities  of  the  law, 
w^iich  are  recognized  by  the  Treasury  itself,  no  reasonably 
careful  person  need  fear  this  penalty.  Of  course,  if  a  mistake 
results  in  a  very  large  understatement  of  the  tax,  the  whole  bur- 
den of  proof  is  placed  upon  the  taxpayer  to  show  that  he  was 
not  on  notice  that  a  mistake  had  probably  been  made,  because 
there  are  available  methods  of  approximating  the  amount  of 
tax  due  upon  a  given  amount  of  net  income. 


142 


APPLICATION   AND   ADMINISTRATION 


The  Treasury  has  imposed  penalties  when  the  returns  ren- 
dered were  incorrect,  interpreting  "incorrect"  to  mean  "in- 
correct, misleading,  false  and  fraudulent"  in  view  of  the  facts 
in  particular  cases. 

Rulings.  ''Negligence  on  the  part  of  the  taxpayer,  but  without 
intent  to  defraud"  is  presumed  to  exist  in  every  case  in  which  a  deduc- 
tion has  been  made  or  income  has  been  omitted  in  direct  conflict 
with  the  specific  provisions  of  the  law  and  regulations,  but  is  not 
presumed  to  exist  if  the  understatement  may  be  ascribed  to  an  error 
of  judgment  as  to  some  matter  not  so  concluded 

....  This  section  [250  (b)]  places  upon  the  taxpayer  the  duty 
of  knowing  and  understanding  such  parts  of  the  regulations  as  are 
applicable  to  the  submission  of  his  return.  This  requirement  should 
not  be  carried  to  the  extent  of  expecting  the  judgment  of  the  tax- 
payer on  questions  involving  judgment  to  concur  exactly  with  the 
judgment  of  representatives  at  the  Bureau.  If  the  understatement 
is  due  to  writing  off  more  depreciation  than  is  proper,  in  the  judgment 
of  representatives  of  the  Bureau,  or  the  deduction  of  salaries  which 
are  excessive,  or  similar  approximations,  then  negligence  can  not  be 
imputed  to  the  taxpayer,  unless  the  position  taken  is  so  unreasonable 
as  to  indicate  bad  faith (C.  B.  2,  page  231;  A.  R.  M.  23.) 

Where,  through  fraud  with  intent  to  evade  tax,  an  understatement 
of  the  amount  of  the  tax  in  an  income  tax  return  results,  the  under- 
statement is  false  or  fraudulent  and  the  50  per  cent  of  the  whole 
amount  of  the  deficiency  is  required  to  be  added  to  the  tax.  The  5 
per  cent  penalty  provided  for  understatements  due  to  negligence  has 
no  application  to  any  part  of  the  deficiency  in  such  a  case.  (C.  B. 
2,  page  233;  O.  1028.) 

If  a  taxpayer  in  preparing  his  tax  return  for  1920  omitted  from 
gross  income  the  gain  derived  from  the  sale  of  capital  assets,  and 
failed  to  make  a  full  disclosure  of  the  facts  pertaining  to  the  trans- 
action, the  Bureau  holds  he  is  guilty  of  negligence  or  fraud,  as  the 
case  may  be,  for  making  the  understatement. 

Collectors  should  so  far  as  possible  expedite  the  examination  of 
the  returns  as  filed  to  discover  those  cases  in  which  the  taxpayer 
omitted  from  gross  income  the  gain  derived  from  the  sale  of  capital 
assets  and  made  a  full  disclosure.  If  a  full  disclosure  was  made, 
negligence  will  not  be  imputed  to  the  taxpayer.  These  returns  should 
be  reported  to  the  Commissioner  on  Form  23-A  in  the  usual  manner 
prior  to  the  serving  of  notice  and  demand.  After  the  Commissioner 
has  assessed  the  tax  on  the  basis  of  the  collectors'  lists,  the  collectors 
shall  immediately  serve,  upon  Form  17,  notice  and  demand  for  the 
additional  tax  due,  and  after  the  ten-day  period  proceed  to  collect  the 


PENALTIES  143 

tax,  plus  interest  and  the  penalty  for  delinquency,  as  provided  for 
in  section  250  (e)  of  the  Revenue  Act  of  1918,  by  distraint  if  neces- 
sary.    (C.  B.  4,  page  72;  Mini.  2791.) 

No  penalty  when  understatement  is  made  in  good  faith. — 

If  claim  for  abatement  is  made  and  denied,"  interest  at  the  rate 
of  6  per  cent  per  annum  is  charged  from  the  date  originally 
fixed  for  payment  of  the  additional  assessment  on  such  part 
of  the  claim  as  has  been  denied.  The  interest  charge  at  the  rate 
of  6  per  cent  (instead  of  12  per  cent)  depends  upon  whether  or 
not  the  claim  for  abatement  was  "bona  fide."" 

Taxpayers  who  make  claims  in  good  faith  may  confidently 
rely  upon  the  Commissioner  to  accord  to  them  the  benefit  of 
the  6  per  cent  rate.^° 

Notice  from  collector  of  alleged  understatement. — Section 
250  (b)  of  the  1918  and  192 1  laws  and  the  usual  procedure 
which  governs  the  examination  of  returns  by  inspectors  from 
the  Commissioner's  ofiice  in  Washington,  are  supplemented 
by  the  provision  of  the  law  which  gives  to  local  collectors 
the  right  to  question  the  accuracy  of  returns. 

Law.  Section  228.  That  if  the  collector  or  deputy  collector  has 
reason  to  believe  that  the  amount  of  any  income  returned  is  under- 
stated, he  shall  give  due  notice  to  the  taxpayer  making  the  return 
to  show  cause  why  the  amount  of  the  return  should  not  be  increased, 
and  upon  proof  of  the  amount  understated,  may  increase  the  same 
accordingly.^**  Such  taxpayer  may  furnish  sworn  testimony  to  prove 
any  relevant  facts  and  if  dissatisfied  with  the  decision  of  the  collector 
may  appeal  to  the  Commissioner  for  his  decision,  under  such  rules  of 
procedure  as  may  be  prescribed  by  the  Commissioner  with  the  approval 
of  the  Secretary. 

It  is  confusing  to  the  average  taxpayer  to  have  his  returns 
questioned  from  two  different  sources.  In  view  of  the  right 
of  appeal  to  the  Commissioner  in  any  event,  if  the  collector 


"  Under  the  1921  law  claims  for  abatement  may  be  filed  only  in  a  few 
instances.     See  page  IX. 

"  Section  250  (e). 

"  [Former  Procedure]  Prior  to  the  1918  law  the  rate  was  12  per 
cent  per  annum. 

"See  page  135. 


144  APPLICATION   AND   ADMINISTRATION 

gives  notice  of  intention  to  increase  an  assessment,  taxpayers 
should  appeal  at  once  to  the  Commissioner  and  follow  the 
procedure  outlined  in  this  chapter. 

Regulation.  If  a  collector  has  reason  to  believe  that  the  amount 
of  any  income  is  understated  in  a  return,  he  may  on  his  own  initiative 
take  up  the  matter  with  the  taxpayer  and  upon  becoming  satisfied  that 
the  amount  was  understated  may  increase  it  accordingly,  subject  to  the 
right  of  the  taxpayer  to  appeal  to  the  Commissioner.  The  Commis- 
sioner, however,  without  the  intervention  of  the  collector  may  ex- 
ercise original  jurisdiction  in  cases  of  understatements  or  other 
errors  in  returns,  in  which  event  sections  250  and  1300  of  the  statute 
and  section  3176  of  the  Revised  Statutes,  as  amended  by  section  131 1 
of  the  statute,  are  applicable  instead  of  section  228 (Art.  451.) 

Penalties  for  failure  or  delay  in  payment. — 

Specific  penalty. — 

Law.  Section  253.  That  any  individual,  corporation,  or  partner- 
ship required  under  this  title  to  pay  ....  any  tax,  ....  who  fails 
to  pay  ....  such  tax,  ....  shall  be  liable  to  a  penalty  of  not 
more  than  $1,000.  Any  individual,  corporation,  or  partnership,  or  any 
officer  or  employee  of  any  corporation  or  member  or  employee  of  a 
partnership,  who  willfully  refuses  to  pay  ....  such  tax,  ....  at 
the  time  or  times  required  under  this  title,  ....  shall  be  fined  not 
more  than  $10,000  or  imprisoned  for  not  more  than  one  year,  or  both, 
together  with  the  costs  of  prosecution. 

The  specific  penahies  mentioned  in  the  foregoing  section 
of  the  law,  that  is,  those  of  not  more  than  $10,000,  are  col- 
lectible only  by  suit.  What  are  known  as  ad  valorem  pen- 
alties, such  as  the  25  per  cent  and  50  per  cent  penalties,  are  as- 
sessed and  collected  as  a  part  of  the  tax  and  increase  the  tax 
accordingly." 

No  INTERE.ST  ON  PENALTIES. — The  interest  charge  of  i  per 
cent  a  month  imposed  upon  taxes  overdue  applies  only  to  the 
amount  of  tax,  not  to  any  specific  penalties  which  may  be 
imposed. 

Penalty  of  percentage  and  interest. — 

Law.     Section  250 (e)  If  any  tax  remains  unpaid  after 

"  See  page  174. 


PENALTIES 


145 


the  date  when  it  is  due,  and  for  ten  days  after  notice  and  demand  by 
the  collector,  then,  except  in  the  case  of  estates  of  insane,  deceased,  or 
insolvent  persons,  there  shall  be  added  as  part  of  the  tax  the  sum  of  5 
per  centum  on  the  amount  due  but  unpaid,  plus  interest  at  the  rate  of  i 
per  centum  per  month  upon  such  amount  from  the  time  it  became  due: 
Provided,  That  as  to  any  such  amount  which  is  the  subject  of  a  bona 
fide  claim  for  abatement  filed  within  ten  days  after  notice  and  demand 
by  the  collector,  where  the  taxpayer  has  not  had  the  benefit  of  the 
provisions  of  subdivision  (d),  such  sum  of  5  per  centum  shall  not  be 
added  and  the  interest  from  the  time  the  amount  was  due  until  the 
claim  is  decided  shall  be  at  the  rate  of  one-half  of  i  per  centum  per 
month  on  that  part  of  the  claim  rejected 

The  circumstances   in   which  penaUy   interest   is  collected, 
are  set  forth  in  the  following  regulation : 

Regulation.  .Where  the  time  for  the  payment  of  any  instalhuent 
of  the  tax  is  postponed  at  the  request  of  the  taxpayer,  interest  at  the 
rate  of  6  per  cent  per  annum  is  added  from  the  original  due  date  until 
paid.  Except  in  the  case  of  estates  of  insane,  deceased,  or  insolvent 
persons,  if  any  tax  remains  due  and  unpaid  for  10  days  after  notice 
and  demand  by  the  collector  (in  the  case  of  the  first  installment  the 
instructions  printed  on  the  return  and  the  taxpayer's  computation  of 
the  tax  on  the  return  constitute  notice  and  demand)  there  shall  be 
added  as  part  of  the  tax  5  per  cent  of  the  amount  due  but  unpaid,  plus 
interest  at  the  rate  of  12  per  cent  per  annum  from  the  due  date, 
except  that  the  interest  on  any  amount  which  is  the  subject  of  a  bona 
fide  claim  in  abatement  filed  within  10  days  (where  the  taxpayer  has 
not  had  the  benefit  of  the  notice  and  the  30-day  period  for  filing  an 
appeal  as  provided  in  sec.  250  (d)  and  art.  1006)  shall  be  at  the  rate 
of  6  per  cent  per  annum  and  the  5  per  cent  penalty  shall  not  be 
added.  Upon  receipt  of  notice  of  rejection  of  claim  in  abatement 
(or  so  much  thereof  as  is  not  allowed)  the  collector  will  notify  the 
claimant  and  demand  payment  of  the  tax.  If  the  tax  is  not  then 
paid  within  10  days  the  5  per  cent  penalty  will  be  assessed  on  the 
amount  of  tax  not  abated.  If  abatement  of  the  entire  tax  was  not 
requested  and  the  balance  of  the  tax  was  not  paid  within  the  required 
10  days,  the  5  per  cent  penalty  accrues  immediately  on  such  balance. 
Interest  is  to  be  added  in  all  cases  in  which  the  demand  of  payment 
is  made  of  the  taxpayer  personally,  although  he  subsequently  dies, 
or  becomes  insane  or  insolvent,  so  that  collection  of  the  tax  is  made 
from  his  estate  in  the  hands  of  his  legal  representative;  but  the  estate 
of  a  deceased  person,  regardless  of  the  date  of  his  death,  or  of  an 
insane  or  insolvent  person,  can  not  be  charged  with  liability  to  the 
5  per  cent  penalty  on  account  of  his  or  the  fiduciary's  delinquency 
in  making  payment  of  the  tax.  This  article  applies  to  the  assessment 
and  collection  of  taxes  which  have  accrued  or  may  accrue  under  the 


146  APPLICATION   AND   ADMINISTRATION 

Revenue  Act  of  1918,  and  the  Revenue  Act  of  1921,  and  except  inso- 
far as  it  relates  to  the  installment  plan  of  payment,  under  the  Revenue 
Act  of  1917.     (Reg.  45,  Arts.  1003  and  1006.) 

Ruling.  The  interest  collectible  under  section  250  (e)^^  of  the 
Revenue  Act  of  1918  upon  the  amount  of  tax  due  and  unpaid  10  days 
after  notice  and  demand  by  the  collector  should  be  computed  only 
upon  the  amount  of  tax  shown  by  the  return  to  be  due,  and  not  upon 
the  tax  plus  the  five  per  cent  penalty.     (C.  B.  3,  page  290;  O.  D.  725.) 

But  if  the  taxpayer  has  been  subjected  to  the  25  per  cent 
or  50  per  cent  penalty,  the  5  per  cent  penahy  and  interest  are 
computed  upon  the  amount  of  the  tax  plus  the  penalty. 

Rulings.  In  cases  where  an  addition  of  25  per  cent  or  50  per 
cent  is  made  to  the  tax  on  account  of  delinquency  or  fraud,  and  the 
taxpayer  fails  to  pay  the  tax  within  10  days  after  notice  and  demand 
from  the  collector,  the  5  per  cent  pcnalt}'-,  and  interest  attach  not 
only  to  the  amount  of  tax  shown  to  be  due  by  the  return,  but  also  to  the 
25  per  cent  or  50  per  cent  addition  to  the  tax.  (C.  B.  2,  page  229; 
O.  D.  441.) 

A  filed  an  amended  return  showing  a  lesser  amount  of  tax 
due  than  was  shown  in  his  original  return,  but  did  not  file  a  claim 
for  abatement  of  the  excess  tax  shown  in  his  original  return  until 
after  10  days  following  notice  and  demand  from  the  collector  for 
payment  of  the  tax  due,  assuming  that  the  amended  return  was  a 
substitute  for  the  original  return.  The  claim  was  subsequently  al- 
lowed. 

The  5  per  cent  penalty  and  i  per  cent  interest  will  not  be  asserted 
for  the  reason  that  the  allowance  of  the  claim  for  abatement  is  evi- 
dence of  the  fact  that  the  tax  was  not  originally  actually  due  and 
payable  by  the  taxpayer.     (C.  B.  4,  page  324;  O.  D.  846.) 

There  has  been  submitted  for  a  ruling  the  following  question  : 
Is  there  a  penalty  of  5  per  cent  and  a  penalty  of  interest  at  the 
rate  of  i  per  cent  a  month,  which  can  be  assessed  against  a  tax- 
payer filing  a  delinquent  return  and  paying  therewith  all  of  the  tax 
due,  which  penalties  are  to  be  computed,  not  with  any  reference  to 
the  first  quarterly  installment,  but  on  the  entire  amount  of  tax  from 
March  15  until  paid? 

Where  a  delinquent  return  is  filed  and  the  whole  amount  of  tax 
is  paid  at  the  time  of  filing,  the  penalty  of  5  per  cent  of  the  first 
installment  attaches  and  also  the  interest  on  such  installment  at  the 

'^  See  page  144. 


PENALTIES  147 

rate  of  i  per  cent  per  month  from  the  due  date  of  the  return,  as 
fixed  by  statute,  to  the  time  the  tax  was  actually  paid,  the  due  date 
in  the  case  of  "the  taxpayer  rendering  his  returns  on  a  calendar  year 
basis  being  March  15.  The  instructions  on  the  return  constitute 
notice  and  demand  for  the  first  installment  only,  and  where  the  first 
installment  is  not  paid  on  or  before  the  due  date,  such  penalty  and 
interest  provisions  apply  to  so  much  of  the  first  installment  as  was 
not  paid  on  time.  The  balance  of  the  tax  over  and  above  the  amount 
of  the  first  installment  becomes  due  and  payable  upon  notice  and 
demand  by  the  collector.  If  the  whole  or  any  part  of  such  balance 
remains  unpaid  after  10  days  from  such  notice  and  demand,  the 
penalty  and  interest  provisions  of  section  250  (e)  apply  to  the  unpaid 
amount. 

The  first  installment  is  due  at  the  time  fixed  by  law  for  filing  the 
return;  that  is,  on  March  15  in  the  case  of  returns  made  on  a  calendar- 
year  basis.  The  law  also  provides  that  the  instructions  printed  on 
the  return  are  deemed  sufficient  notice  and  demand.  Accordingly,  if 
the  first  installment  is  not  paid  on  March  15,  it  becomes  delinquent, 
and  in  such  cases  the  5  per  cent  penalty  and  interest  at  the  rate  of  i 
per  cent  per  month,  from  March  16,  should  be  collected  on  the  first 
installment. 

The  5  per  cent  penalty  is  assessed  by  law ;  it  is  asserted,  com- 
promised, or  waived  as  the  case  may  be,  by  the  Department. 

O.  D.  313,  C.  B.  I,  p.  249,  overruled.  (B.  47-21-1935;  O.  D. 
nil.) 

Penalties  apply  only  after  notice  and  assessment. — 
Penalties  for  failure  or  delay  in  the  payment  of  tax  are  not 
applied  until  after  assessment  has  been  made  and  notice  has 
been  given  to  the  taxpayer,  except  (i)  when  extensions  of 
time  are  secured  by  taxpayers,"  and  (2)  when  there  is  negli- 
gence (without  intent  to  defraud)  on  the  part  of  the  taxpayer. 

Ruling.  No  interest  is  collectible  on  the  difference  between  the 
amount  of  tax  paid  on  the  basis  of  an  original  return  and  that  shown 
to  be  due  by  an  amended  return  if  the  understatement  in  the  original 
return  was  not  due  to  negligence  of  the  taxpayer.  (C.  B.  3,  page 
290;  O.  D.  691.) 

Penalties  in  case  of  death  of  delinquent. — Section  250  (e) 
of  the  law  specifically  exempts  "estates  of  insane,  deceased  or 
insolvent  persons"  from  the  5  per  cent  penalty  and  interest  at 


Sections  250  (a)  and  250  (f). 


148  APPLICATION   AND   ADMINISTRATION 

the  rate  of  1  per  cent  a  month  otherwise  imposed  if  the  tax 
remains  unpaid  after  ten  days  notice  and  demand.^" 

The  exemption  also  apphes  to  the  6  per  cent  interest  added 
when  claims  for  abatement  are  disallowed. 

Regulation the  estate  of  a  deceased  person,  regardless 

of  the  date  of  his  death,  or  of  an  insane  or  insolvent  person,  cannot 
be  charged  with  a  liability  to  the  5  per  cent  penalty  on  account  of  his 
or  the  fiduciary's  delinquency  in  making  payment  of  the  tax.^^  .... 
(Art.  1003.) 

Penalty  paid  on  illegal  tax  may  be  recovered. — In  Camp 
Bird  V.  Hozvhcrt,^-  it  was  held  that,  wdiere  an  illegal  tax  is 
paid,  the  fact  that  it  w^as  not  paid  within  the  time  allowed  by 
law  will  not  prevent  any  taxpayer  from  recovering  the  penalty 
of  I  per  cent  per  month  paid  by  him  for  the  non-payment  of 
an  illegal  tax.  If  the  tax  was  illegal  it  was  never  due  and  there- 
fore the  penalty  was  as  much  unauthorized  as  the  tax  itself. 

In  an  opinion"^  dated  June  3,  1919,  the  United  States  At- 
torney General  held  that  claims  falling  in  the  following  classes 


'■"  [Former  Procedure]  Under  the  1918  law,  exemption  from  penalty, 
however,  did  not  extend  to  a  decedent's  estate  when  claim  for  abatement  on 
the  ground  of  loss  in  inventory  had  been  disallowed.  Section  214  (a-12), 
covering  inventory  claims,  does  not  mention  estates,  etc.,  as  in  section  250 
(e),  this  distinction  apparently  being  the  basis  for  the  following: 

Regulation.  ".  .  .  .  But  if  any  part  of  a  claim  for  abatement  on  the 
ground  of  a  loss  in  inventory  under  section  214  (a)  (12)  ....  of  the 
statute  is  disallowed,  interest  from  the  original  due  date  at  the  rate  of  12 
per  cent  per  annum  will  be  added  to  the  tax  not  abated;  and  interest  is  to 
be  added  in  all  cases  in  which  the  demand  of  payment  is  made  of  the  tax- 
payer personal!}',  although  he  subsequent!}'  dies,  or  Ijecomes  insane  or 
insolvent,  so  that  collection  of  the  tax  is  made  from  his  estate  in  the  hands 
of   his   representative "   IReg.   45    (1918),   Art.    1003.] 

"'  [Former  Procedure] 

Regulation.  "Specific  penalties  provided  by  the  income  tax  law 
are  held  to  attach  to  the  person  and  in  case  of  death  of  such  person  are 
non-enforceable. 

"Ad  valorem  penalties  (those  measured  by  income)  attach  to  income 
and  are  to  be  enforced  regardless  of  the  death  of  the  owner  of  the  income 
by  which  the  penalty  is  measured."      (Reg.  2>2)^  1918,  Art.  52.) 

"'262  Fed.  114.  Petition  for  writ  of  certiorari  denied,  March  8,  1920, 
252  U.  S.  579 ;  64  L.  Ed.  725 ;  40  S.  Ct.  344. 

''31  Op.  Att.  Gen.  459. 

[Former  Procedure]  Prior  to  this  opinion  it  was  held  by  some 
authorities  tliat  tlie  Commissioner  liad  no  power  to  mitigate  the  25  and 
50  per  cent  penalties. 


PENALTIES 


149 


may  be  compromised  by  the  Commissioner  whenever,  in  his 
judgment,  such  compromises  are  for  the  interest  of  the  United 
States : 

(i)  Claims  for  amounts  50  per  cent  in  addition  to  amounts  of 
income  and  excess-profit  taxes  assessed  under  authority  of  section 
3176  of  Revised  Statutes,  as  amended  by  section  16  of  the  act  of 
September  8,  1916,  and  of  section  212  of  the  act  of  October  3,  1917, 
in  cases  of  failure  to  make  and  file  returns  or  lists  within  the  time  pre- 
scribed by  law  or  by  the  collector; 

(2)  Claims  for  amounts  100  per  cent  in  addition  to  amounts  of 
income  and  excess-profit  taxes  assessed  under  authority  of  said  sec- 
tions in  cases  of  false  or  fraudulent  returns  or  lists  willfully  made; 

Collectors  have  no  authority  to  waive  penahies  or  interest."* 

When  specific  penalties  will  not  be  subject  of  suit. — In 
view  of  the  extraordinary  conditions  now  existing  it  is  beheved 
by  some  that  many  taxpayers  have  subjected  themselves  to 
penalties.  Under  the  circumstances  it  may  be  of  interest  to  re- 
produce instructions  to  collectors  regarding  the  imposition  of 
the  specific  penalties  and  the  attempt  to  recover  them  by  suit. 

Ruling.  Liability  to  specific  penalty  attaches  upon  all  delinquent 
returns  and  is  recoverable  by  suit.  By  Section  3214  R.  S.  the  Com- 
missioner of  Internal  Revenue  may  or  may  not  institute  suit.  It  has 
been  decided  not  to  institute  suit  nor  to  assert  specific  penalty  in  cer- 
tain cases.  The  assertion  of  specific  penalty  does  not  depend  upon 
the  fact  of  whether  or  not  the  50  per  cent  addition  to  tax  has  been 
assessed.  In  some  cases  where  the  50  per  cent  addition  to  tax  must 
be  assessed  because  the  return  was  filed  after  notice  from  the  col- 
lector, the  specific  penalty  will  not  be  asserted.  It  will  not  be  as- 
serted, regardless  of  whether  the  50  per  cent  addition  to  tax  has  been 
assessed,  in  cases  falling  under  any  of  the  following  designations: 

1.  Extension  granted.  Where  a  return  is  filed  within  the  thirty- 
day  period  of  extension  granted  by  the  collector  or  within  a  further 
period  of  extension  granted  by  the  Commissioner  of  Internal  Revenue, 
as  provided  by  Section  14  (c)  of  the  act  of  September  8,  1916. 

2.  Return  on  time.  Specific  penalty  will  not  be  asserted  upon  an 
amended  return  provided  the  original  return  was  filed  within  the 
prescribed  time. 

3.  Mailed  in  time.    Where  an  affidavit  is  filed  satisfactorily  estab- 

-■*  1-2-22 ;  L  T.  1 161. 


I50 


APPLICATION   AND   ADMINISTRATION 


lishing  that  the  return  was  placed  in  the  mails  in  ample  tiine  to  reach 
the  collector's  office  in  ordinary  course  of  mails  before  the  close  of 
business  on  the  final  day  for  filing. 

4.  Tentative  return.  Where  an  informal  return  was  filed  within 
the  time  prescribed.  The  return  of  a  parent  company  including 
therein  the  income  of  a  subsidiary  company  will  be  accepted  as  a  ten- 
tative return  of  the  subsidiary  company,  if  the  fact  is  stated  that  the 
tentative  return  includes  the  income  of  the  subsidiary. 

5.  Filed  in  wrong  district.  Where  the  return  was  filed  in  some 
other  collection  district  within  the  prescribed  time. 

6.  Net  income  under  $3,000.  Where  it  develops  that  the  net  in- 
come of  an  individual  for  1913,  1914,  1915  or  1916  was  less  than 
$3,000,  or  under  the  act  of  October  3,  1917,  for  1917,  etc.,  less  than 
$1,000  or  $2,000. 

7.  Erroneous  information.  Where  the  delinquency  is  alleged  to 
be  due  to  erroneous  or  misleading  information  given  by  officials  or 
employees  of  the  Internal  Revenue  Service  and  there  is  no  evidence 
in  conflict  therewith. 

8.  Organization  incomplete.  Where  it  is  established  that  the  or- 
ganization of  a  corporation,  joint-stock  company  or  association,  or 
insurance  company  was  not  completed  until  after  the  expiration  of 
the  period  for  which  the  return  should  have  been  filed. 

9.  Death.  Where  by  reason  of  the  death  of  an  individual  his  re- 
turn for  the  year  or  portion  of  the  year  prior  to  his  death  is  not  filed 
within  the  time  prescribed.  The  death  of  a  delinquent  abates  liability 
to  specific  penalty.  An  administrator  or  executor  is  charged  with  the 
duty  of  rendering  a  return  for  the  decedent,  and  if  he  is  appointed  in 
ample  time  to  make  the  return  prior  to  March  i  and  fails  to  do  so,  he 
should  be  charged  as  delinquent  and  the  specific  penalty  should  be 
asserted  against  him.  The  administrator  or  executor  will  not  be  re- 
lieved from  specific  penalty  unless  the  return  is  made  within  a  rea- 
sonable time  after  his  appointment. 

10.  Severe  illness  or  unavoidable  absence.  Where  it  is  clearly 
established  that  the  delinquency  in  the  filing  of  a  return  of  an  indi- 
vidual or  of  a  corporation  within  the  time  prescribed  was  due  to 
severe  illness  of  the  individual  or  of  an  officer  of  a  corporation  whose 
duty  it  was  to  prepare  or  sign  the  return,  or  to  unavoidable  absence 
from  place  of  business  or  place  of  abode. 

11.  Absence  from  the  United  States.  Where  it  appears  that  the 
filing  of  a  return  within  the  time  prescribed  was  rendered  impossible 
by  reason  of  absence  from  the  United  States.  Delinquency  heyond 
the  period  of  extension  which  may  be  granted  by  the  Commissioner 
of  Internal  Revenue  will  not  be  excused   under  this  heading. 

12.  Military  or  naval  service  of  United  States.  Where  the  de- 
linquency of  an  individual  was  occasioned  by  service  in  the  military 
or  naval  forces  of  the  United  States. 


PENALTIES 


151 


13.  Not  organized  for  profit.  CouiprcheiKls  minicroiis  small  cor- 
porations not  organized  primarily  for  profit,  such  as  local  telephone 
companies,  co-operative  purchasing  societies,  etc.,  concerning  whose 
liability  under  the  law  to  make  a  return  there  may  have  been  a  rea- 
sonable doubt. 

14.  Inactive  corporations.  Those  which  transacted  no  business 
and  had  no  income  during  the  return  year. 

15.  Fiscal  year.  Corporations  which  have  established  a  fiscal 
year  in  the  manner  prescribed  by  law  which  file  a  return  on  or  before 
the  first  day  of  the  third  month  following  the  close  of  the  fiscal  year. 

16.  Assigned.  Where  corporations  have  made  an  assignment  on 
account  of  insolvency  and  do  not  intend  again  to  engage  in  business. 

17.  Insolvent.  Where  the  assets  of  a  corporation  are  insufficient 
for  the  payment  of  its  debts  and  the  corporation  has  ceased  to  do 
business. 

18.  Charter  forfeited.  Where,  prior  to  the  date  when  the  return 
was  due,  the  charter  of  a  corporation  is  forfeited  on  account  of  non- 
compliance with  state  laws.  It  must  be  clear,  however,  that  business 
in  the  name  of  the  corporation  was  suspended  at  the  time  of  such  for- 
feiture. If  business  was  continued  under  the  same  name,  the  con- 
cern will  be  held  to  be  an  association  and  the  same  liabilities  will 
attach  as  if  the  charter  had  not  been  forfeited. 

19.  Defunct.  Where  corporations  are  out  of  business,  have  no 
assets,  maintain  no  organization,  and  the  purpose  for  which  organized 
has  been  abandoned. 

20.  Dissolved.  Where  all  the  assets  of  a  corporation  have  been 
distributed. 

21.  Sale.  Where  corporations  have  disposed  of  all  their  assets 
and  property  by  sale  to  other  corporations,  firms,  or  individuals  and 
business  is  no  longer  carried  on  under  their  charters. 

22.  Consolidated,  merged  or  succeeded.  Where  corporations 
have  terminated  their  existence  as  represented  by  these  terms  and  it 
appears  that  no  assets  or  property  remain  in  the  name  of  the  retiring 
corporation. 

23.  No  assets.  Includes  all  corporations  having  no  assets  from 
which  to  submit  an  offer  in  compromise. 

In  cases  not  included  in  any  of  the  above  classes,  the  specific 
penalty  will  be  asserted,  and  if  the  delinquency  was  not  due  to  an  in- 
tention to  delay  the  administration  of  the  law  the  minimum  amount 
which  will  be  accepted  in  compromise  is  as  follows: 

$5  in  the  case  of  an  individual  or  withholding  agent. 
$10  in  the  case  of  a  corporation,  joint-stock  company  or  asso- 
ciation, or  insurance  company. 

These  amounts  will  be  considered  insuflicient  and  will  not  be 
accepted  in  any  case  where  it  appears  that  a  taxpayer  was  intention- 


152  APPLICATION   AND   ADMINISTRATION 

ally  violating  the  provisions  of  law,  and  purposely  delaying  the  filing 
of  the  returns.  In  all  cases  where  revenue  agents  or  other  examin- 
ing officers  discover  that  any  individual  has  an  appreciable  taxable  in- 
come and  the  examining  officer  is  of  the  opinion  that  the  individual 
knew  or  should  have  known  that  he  was  required  to  make  a  return, 
he  should  make  a  recommendation  as  to  the  minimum  amount  which 
should  be  accepted  as  an  ofYer  in  compromise,  and  where  the  intent 
to  evade  tax  is  plain  he  should  recommend  prosecution.  Special  atten- 
tion should  be  called  to  cases  of  individuals  having  a  taxable  income 
who  have  failed  to  file  returns  for  a  number  of  years. 

In  all  cases  of  delinquency  discovered  by  revenue  agents  and  other 
examining  officers,  if  the  delinquency  falls  within  a  period  for  which 
the  penalty  can  be  asserted,  such  officers  should  secure  from  the  de- 
linquent a  sworn  statement  setting  forth  the  reason  for  delinquency. 
This  statement  should  be  attached  to  the  return  forwarded  to  the 
collector.  The  examining  officer  should  state  in  his  report  the  alleged 
reason  for  delinquency  and  if  he  is  of  the  opinion  that  the  minimum 
amount  should  not  be  accepted  as  an  offer  in  compromise  of  liability 
to  specific  penalty,  he  should  make  a  recommendation  as  to  the  mini- 
mum amount  which  should  be  accepted.  Consideration  will  be  given 
such  recommendation  by  this  office  in  accepting  an  offer  in  compro- 
mise. In  forwarding  offers  in  compromise  on  form  656  collectors 
should  call  attention  to  revenue  agents'  reports,  if  any,  in  which  the 
non-acceptance  of  the  minimum  amount  as  an  offer  in  compromise  is 
recommended.  The  statement  or  affidavit  attached  to  the  return  set- 
ting forth  the  reason  for  delinquency  is  not  in  lieu  of  the  affidavit 
required  to  be  attached  to  form  656.  (Mim.  Letter  to  Collectors  No. 
1675,  November  3,  iQi/."* 

Suits  for  penalties  barred  after  5  years. — Section  1047, 
Revised  Statutes,  in  part,  is  as  follows: 

Law.  Section  1047  [Rev.  Stat.].  No  suit  or  prosecution  for  any 
penalty  or  forfeiture,  pecuniary  or  otherwise,  accruing  under  the 
laws  of  the  United  States,  shall  be  maintained,  except  in  cases  where 
it  is  otherwise  specially  provided,  unless  the  same  is  commenced  within 
five  years  from  the  time  when  the  penalty  or  forfeiture  accrued 

Limitation  on  prosecution  for  criminal  violations. — 

Law.  Section  1321.  (a)  That  the  Act  entitled  "An  Act  to  limit 
the  time  within  which  prosecutions  may  be  instituted  against  persons 
charged  with  violating  internal-revenue  laws,"  approved  July  5,  1884, 
is  amended  to  read  as  follows: 

"That  no  person  shall  be  prosecuted,  tried,  or  punished  for  any 
of  the  various  offenses  arising  under  the  internal-revenue  laws  of  the 
United  States  unless  the  indictment  is  found  or  the  information  insti- 


PENALTIES  153 

tuted  within  three  years  next  after  the  commission  of  the  offense: 
Provided,  That  the  time  during  which  the  person  committing  the  of- 
fense is  absent  from  the  district  wherein  the  same  is  committed  shall 
not  be  taken  as  any  part  of  the  time  limited  by  law  for  the  com- 
mencement of  such  proceedings:  Provided  further,  That  the  provisions 
of  this  Act  shall  not  apply  to  offenses  committed  prior  to  its  passage: 
Provided  further.  That  where  a  complaint  shall  be  instituted  before 
a  commissioner  of  the  United  States  within  the  period  above  limited, 
the  time  shall  be  extended  until  the  discharge  of  the  grand  jury  at 
its  next  session  within  the  district:  -liid  provided  further.  That  this  Act 
shall  not  apply  to  offenses  committed  by  officers  of  the  United  States." 
(b)  Any  prosecution  or  proceeding  under  an  indictment  found  or 
information  instituted  prior  to  the  passage  of  this  Act  shall  not  be 
affected  in  any  manner  by  this  amendment,  but  such  prosecution  or 
proceeding  shall  be  subject  to  the  limitations  imposed  by  law  prior  to 
the  passage  of  this  Act. 

Law.  Section  1046.  [Rev.  Stat.]  No  person  shall  be  prosecuted, 
tried,  or  punished  for  any  crime  arising  under  the  revenue  laws,  .... 
unless  the  indictment  is  found  or  the  information  is  instituted  within 
five  years  next  after  the  committing  of  such  crime. 

No  person  shall  be  prosecuted,  tried  or  punished  for  any  of  the 
various  offenses  arising  under  the  internal  revenue  laws  of  the  United 
States  unless  the  indictment  is  found  or  the  information  instituted 
within  three  years  next  after  the  commission  of  the  offense,  in  all 
cases  where  the  penalty  prescribed  may  be  imprisonment  in  the  peni- 
tentiary, and  within  two  years  in  all  other  cases:  Provided.  That  the 
time  during  which  the  person  committing  the  offense  is  absent  from 
the  district  wherein  the  same  is  committed  shall  not  be  taken  as  any 
part  of  the  time  limited  by  law  for  the  commencement  of  such  pro- 
ceedings: 


Compromise  of  penalty  a  bar  to  prosecution. — In  a  recent 
case-'  in  which  internal  revenue  officers,  after  defend- 
ant had  admitted  that  he  had  not  filed  an  income  tax  return 
as  required  by  section  1004,  accepted  not  only  the  tax  but 
the  penalty,  informing  defendant  that  such  payment  would 
end  the  matter  and  there  would  be  no  indictment,  it  was  held 
that  such  acceptance  and  statement  was  a  "compromise" 
within  section  3229,  Revised  Statutes,  and  was  a  bar  to  prose- 
cution. 


Rau  V.  U.  S.,  260  Fed.  131 ;  171  C.  C.  A.  167. 


CHAPTER  VII 

RATES  AND  COMPUTATION  OF  TAX 

The  changes  in  rates  and  in  the  computation  of  tax  under 
the  1 92 1  law  may  be  summarized  as  follows: 

1.  There   is   a   decrease   in   the   individual   surtax    rates 

for  1922. 

2.  There  is  an  increase  in  the  corporation  income  tax 

rate  to  12^  per  cent  for  1922. 

3.  Capital  net  gains   are  taxed  at  a   flat   rate  of    12J/2 

per  cent   (including  normal  tax),  from  January  i, 
1922. 

4.  Computations  in  case  of  fiscal  years  of  individuals, 

partnerships,     personal    service    corporations,     and 
regular  corporations  are  changed. 

5.  When  return  is  made  for  less  than  one  year,  income 

is  calculated  on  annual  basis. 

6.  When  individuals   are   not   entitled   to   increased   ex- 

emption,  or  specific  credit  of   $2,000  is   denied   a 
corporation,  special  computations   are  necessary. 

Rates 

The  1 92 1  law  introduces  an  additional  problem  for  the 
taxpayer  because  of  a  change  in  rates,  a  change  of  basis  of 
taxation  (as  in  the  case  of  personal  service  corporations  after 
December  31,  1921),  and  because  of  the  adjustments  that  must 
be  made  in  the  case  of  fiscal  year  taxpayers  whenever  the  tax 
rates  and  basis  of  taxation  (such  as  elimination  of  excess 
profits  tax  after  192 1)  are  changed. 

Under  the  1921  law  the  rates  of  tax  imposed  by  the  19 18 
law  remain  unchanged  for  192 1,  but  are  changed  commenc- 
ing January  i,  1922. 

154 


RATES    AND    COMPUTATION    OF   TAX 


155 


Rates  applicable  to  individuals. — The  total  rate  applying 
to  the  income  of  individuals  consists  of  two  parts,  the  normal 
tax  and  the  surtax.  For  the  calendar  year  192 1  and  subse- 
quent years,  the  normal  tax  is  a  fiat  rate  of  8  per  cent  (re- 
duced to  4  per  cent  upon  the  first  $4,000  subject  to  normal 
tax).^  The  surtaxes  begin  to  apply  when  the  net  income  ex- 
ceeds $5,000  for  192 1  and  $6,000  for  1922  and  are  rapidly 
progressive. 

The  rates  are  applied  to  "net  income"  which  is  ascertained 
by  subtracting  (specified  deductions  from  "gross  (income,"' 
the  latter  being  defined  in  the  law  to  include  the  distributive 
shares  of  the  profits  of  partnerships  and  personal  service  cor- 
porations. Beginning  with  January  i,  1922,  personal  ser- 
vice corporations  are  taxed  as  ordinary  corporations,  and 
the  undistributed  profits  thereof  are  not  taxed  to  the  in- 
dividual stockholders." 

The  terms  "gross  income"  and  "net  income"  are  fully 
explained  in  Chapter  XIII.  For  the  purposes  of  the  normal 
tax  only,  further  deductions  are  permitted  under  the  title  of 
"credits."^  These  credits  consist  of  dividends,  interest  on  cer- 
tain securities,  and  the  personal  exemptions  of  $1,000,  $2,000, 
or  $2,500,  together  with  $400  for  each  dependent. 

Normal  tax. — 

Law.  Section  210.  That,  ....  there  shall  be  levied,  collected, 
and  paid  for  each  taxable  year  upon  the  net  income  of  every  individual 
a  normal  tax  of  8  per  centum^  of  the  amount  of  the  net  income  in  ex- 


_'  Citizens  or  residents  of  the  United  States  entitled  to  the  benefits  of 
section  262  are  subject  to  normal  tax  at  the  rate  of  4  per  cent  on  the  first 
$4,000  of  total  net  income  from  sources  within  the  United  States,  in  excess 
of  credits  and  8  per  cent  on  the  balance.     See  Chapter  XXXVI. 

'Section  218   (d). 

'  See  XXV. 

'[Former  Procedure]  The  normal  rate  under  the  1913  law  was  i 
per  cent  (section  II,  A,  sub.  i).  This  applied  for  the  years  1913,  1914 
and  1915.  The  1916  law  made  the  normal  rate  2  per  cent  [section  i  (a)]. 
This  rate  was  in  force  for  one  year  (1916)  before  it  was  supplemented 
by  an  additional  normal  tax  of  2  per  cent  (1917  law,  section  i).  Conse- 
quently in  191 7  the  normal  tax  amounted  to  4  per  cent  in  all,  the  entire 
4  per  cent,  however,   not  applying  to   the   smaller   incomes.     The   normal 


156  APPLICATION   AND   ADMINISTRATION 

cess  of  the  credits  provided  in  section  216  ■/•  Provided,  That  in  the  case 
of  a  citizen  or  resident  of  the  United  States  the  rate  upon  the  first 
$4,000  of  such  excess  amount  shall  be  4  per  centum. 


Surtax. — For  192 1  all  individual  net  incomes  in  ex- 
cess of  $5,000  are  subject  to  surtaxes.'''  For  1922  and  sub- 
sequent years  the  surtaxes  start  at  $6,000.' 

The  personal  exemptions  and  other  credits  such  as  divi- 
dends do  not  relieve  the  taxpayer  of  surtaxes.^ 

The  surtax  rates  for  1921  are  the  same  as  in  the  1918 
law,  increasing  i  per  cent  with  each  $2,000  of  income,  until 
the  rate  of  48  per  cent  is  applied  to  the  increment  between 
$98,000  and  $100,000.  Thereafter  the  steps  are  more  widely 
separated,  until  a  maximum  is  reached  of  "65  per  centum  of 
the  amount  by  which  the  net  income  exceeds  $1,000,000.'' 

The  surtax  rates  for  1922,  starting  with  i  one  per  cent  on 
the  $4,000  between  $6,000  and  $10,000,  increase  by  i  or  2 
per  cent  steps,  and  reach  47  per  cent  of  income  between 
$98,000  and  $100,000.  The  maximum  rate  is  50  per  cent  of 
all  over  $200,000.  Thus  on  incomes  up  to  $100,000  the  sur- 
tax is  slightly  less  and  on  incomes  over  $100,000  the  rates 
are  considerably  reduced,  as  compared  with   192 1. 

The  House  bill  provided  for  same  surtax  rates  as  under 
19 18  law  to  $66,000  with  a  flat  rate  of  32  per  cent  on  all  over 
that  amount.  As  ])assed  by  the  Senate  the  bill  provided  for  a 
maxinuim  rate  of  50  per  cent  on  all  over  $200,000. 

The  rates  which  ajjply  to  each  successive  increment  of  in- 
come, the  tax  which  results  from  the  application  of  the  rates 


rate  for  tlie  calendar  year  1918  was  12  per  cent  upon  net  incomes  exceed- 
ing $4,000  and  6  per  cent  on  the  first  $4,000  or  any  part  thereof.  In  the  case 
of  the  individual's  fiscal  year,  beginning  in  1918.  the  rates  of  1918  were 
applicable  to  a  portion  of  the  year's  income.  See  Income  Tax  Procedure, 
1920,  page   III. 

'  See  Chapter  XII. 

•  Section  211    (a-i). 

'  Section  211    (a-2). 

"^See  Chapter  XII. 


RATES    AND    COMPUTATION    OF   TAX 


157 


to  the  increments,  and  the  cumulation  of  these  taxes,  are  set 
forth  in  the  following  table  :^ 

In  1916  the  surtax  rates  were  changed  to  the  scale  shown  in  column  A 
in  the  table  given  below  [1916  law,  section  i  (b)].  These  rates  applied 
in  1916,  and  in  1917  the  scale  of  rates  shown  in  column  B  was  added  to 
the  1916  rates  and  the  resulting  combined  rates  shown  in  column  C  were 
imposed  for  that  year. 


Net  income  subject  to  tax 

A 
1016  law 

(percentage) 

B 
1917  law 

(percentage) 

C 

Total  surtax 

applied  in  1917 

(percentage) 

S       5.000  to  $     7,500 

7.500  "        10,000 

'i% 

3 

4 

5 

6 

7 

8 

9 
10 
10 
11 
12 
13 

i'7« 

3 

4 

5 

7 

10 
14 
IS 
22 
25 
30 
34 
37 
40 
45 
50 
50 
50 

1% 
2 

10.000  "        12..500 

12,500  "        15,000 

3 
4 

15.000  "        20.000 

5 

20,000  "        40.000 

8 

40,000  "        60.000 

12 

60  000  "        80,000 

17 

80.000  "      100.000 

22 

100  000  "      150  000  . 

27 

150.000  "      200.000 

31 

200.000  "      250.000 

37 

250.000  "      300.000 

42 

300.000  "      500,000 

46 

500,000  "      750,000 

50 

750  000  "   1,000,000 

55 

1,000,000  "    1,500,000 

1,500,000  "   2,000.000 

61 
62 

On  excess  of    2.000.000 

63 

In  1918,  1919,  and  1920  the  surtax  rates  were  the  same  as  those  given 
Oil  page  158  for  1921. 


•  [Former  Procedure]  Under   the    1913   law    (section    II,    A, 
the  surtax  rates  on  net  income  of  individuals  were  as  follows : 


Net  income  subject  to  tax. 


J  20,000  to 
50,000  " 
75,000  " 

100,000  " 

250,000 


^  50,000 

75,000 

100,000 

250,000 

500,000 


500,000  and  over 

These  rates  were  in  force  in  1913,  1914  and  1915- 


sub.   2) 

1% 
2 

3 
4 
5 
6 


158 


APPLICATION   AND   ADMINISTRATION 


SURTAX    RATES    AND    AMOUNTS    OF    SURTAXES    PAYABLE 
UNDER  1921  LAW 


come 

1921 

1922  and  subsequent  years 

Net  In 

Total 

Total 

Per  cent 

Surtax 

cumulative 

Per  cent 

Surtax 

cumulative 

surtax* 

surtax* 

%  5,000  to 

$  6.000 

1% 

SIO 

810 

6,000  " 

8.000 

2 

40 

50 

"'i% 

26' 

26' 

8,000  « 

10,000 

3 

60 

110 

1 

20 

40 

10,000  " 

12.000 

4 

80 

190 

2 

40 

80 

12.000  " 

14.000 

5 

100 

290 

3 

60 

140 

14,000  " 

16.000 

6 

120 

410 

4 

80 

220 

16.000  " 

18,000 

7 

140 

550 

5 

■  100 

320 

18,000  •' 

20,000 

8 

160 

710 

6 

120 

440 

20.000  " 

22,000 

9 

ISO 

890 

8 

160 

600 

22,000  " 

24,000 

10 

200 

1.090 

9 

180 

780 

24,000  " 

26,000 

11 

220 

1,310 

10 

200 

B80 

26,000  " 

28,000 

12 

240 

1,.5.50 

11 

220 

1.200 

28,000  " 

30,000 

13 

260 

1,810 

12 

240 

1.440  • 

30,000  " 

32,000 

14 

280 

2,090 

13 

260 

1.700 

32,000  " 

34,000 

15 

300 

2,390 

15 

300 

2.000 

34,000  " 

,S6.000 

16 

320 

2.710 

15 

300 

2,300 

36,000  ' 

38.000 

17 

340 

3.050 

16 

320 

2,620 

38,000  " 

40.000 

18 

360 

3.410 

17 

340 

2,960 

40.000  " 

42.000 

19 

380 

3,790 

18 

360 

3.320 

42.000  " 

44.000 

20 

400 

4.190 

19 

380 

3.700 

44.000  " 

46.000 

21 

420 

4,610 

20 

400 

4.100 

46.000  " 

48.000 

22 

440 

5,050 

21 

420 

4.520 

48.000  " 

50,000 

23 

460 

5,510 

22 

440 

4.960 

50.000  " 

52,000 

24 

480 

5,990 

23 

460 

5.420 

52.000  " 

54.000 

25 

500 

6.490 

24 

480 

5.900 

54.000  « 

56.000 

26 

520 

7,010 

25 

500 

6.400 

58,000  ' 

58.000 

27 

540 

7,550 

26 

520 

6,920 

58,000  " 

60.000 

28 

560 

8,110 

27 

540 

7.460 

60,000  " 

62.000 

29 

580 

8,690 

28 

560 

8.020 

62,000  " 

64.000 

30 

600 

9,290 

29 

580 

8.600 

64,000  " 

66,000 

31 

620 

9,910 

30 

600 

9.200 

66,000  " 

68.000 

32 

640 

10,5.50 

31 

620 

9.820 

68.000  " 

70.000 

33 

660 

11.210 

32 

640 

10.460 

70.000  " 

72.000 

34 

680 

11,890 

33 

660 

11.120 

72,000  " 

74.000 

35 

700 

12,590 

34 

680 

11.800 

74,000  " 

76.000 

36 

720 

13,310 

35 

700 

12.500 

76,000  " 

78,000 

37 

740 

14,050 

36 

720 

13.220 

78,000  " 

80.000 

38 

760 

14,810 

37 

740 

13.960 

80,000  " 

82.000 

39 

780 

15,590 

38 

760 

14.720 

82,000  " 

84.000 

40 

800 

16,390 

39 

780 

15.500 

84,000  " 

86.000 

41 

820 

17,210 

40 

800 

16.300 

86,000  " 

88.000 

42 

840 

18,050 

41 

820 

17.120 

88,000  " 

90.000 

43 

860 

18,910 

42 

840 

17,960 

90,000  " 

92.000 

44 

880 

19,790 

43 

860 

18,820 

92,000  " 

94.000 

45 

900 

20,690 

44 

880 

19,700 

94,000  " 

96.000 

46 

920 

21,610 

45 

900 

20,600 

96,000  " 

98.000 

47 

940 

22,550 

46 

920 

21,520 

98,000  " 

100.000 

48 

960 

23,510 

47 

940 

22,460 

100,000  " 

1.50.000 

52 

26,000 

49,510 

48 

24,000 

46,460 

150.000  " 

200.000 

56 

28.000 

77.510 

49 

24.500 

70,960 

200.000  " 

300.000 

60 

60.000 

137.510 

50 

50,000 

120,960 

300,000  " 

500.000 

63 

126.000 

263,510 

50 

100,000 

220,960 

500.000  " 

1.000.000 

64 

320.000 

583.510 

50 

250.000 

470,960 

1,000,000  up 

65 

50 

*To  ascertain  the  total  tax  payable,  the  normal  tax  of  8  per  cent  (reduced  to  4  per  cent  on  the  first 
$4,000)  must  be  applied  to  the  total  net  income  minus  the  credits,  and  the  result  added  to  the  figures  given 
in  this  table. 


RATES    AND    COMPUTATION    OF    TAX 


159 


The  official  directions  for  interpreting  the  foregoing  table 
read  as  follows : 

Regulation The  surtax  for  any  amount  of  net  income 

not  shown  in  the  above  tables  is  computed  by  adding  to  the  total  sur- 
tax for  the  largest  amount  shown,  which  is  less  than  the  income,  the 
surtax  upon  the  excess  over  that  amount  at  the  rate  indicated  in  the 
table.  For  example,  if  the  amount  of  net  income  is  $63,128,  the  sur- 
tax for  calendar  year  192 1  is  the  sum  of  $8,690  (the  surtax  upon 
$62,000  as  shown  by  Table  I)  plus  30  per  cent  of  $1,128,  or  $338.40, 
making  a  total  surtax  of  $9,028.40 (Art.  12.) 

The  total  surtax  of  $9,028.40  shown  in  the  foregoing  is 
based  on  1921  rates.  At  1922  rates  the  surtax  would  be 
$8,347.12  (the  surtax  as  shown  by  the  table,  $8,020,  plus  29 
per  cent  of  $1,128,  or  $327.12,  making  a  total  surtax  of 
$8,347.12). 

Surtax  on  sale  of  mineral  deposits. — 

Law.     Section  21 1 (b)  In  the  case  of  a  bona  fide  sale  of 

mines,  oil  or  gas  wells,  or  any  interest  therein,  where  the  principal 
value  of  the  property  has  been  demonstrated  by  prospecting  or  ex- 
ploration and  discovery  work  done  by  the  taxpayer,  the  portion  of  the 
tax  imposed  by  this  section  attributable  to  such  sale  shall  not  exceed, 
for  the  calendar  year  1921,  20  per  centum,  and  for  each  calendar  year 
thereafter  16  per  centum,  of  the  selling  price  of  such  property  or  in- 
terest. 

The  new  law  re-enacts  the  provision  of  the  1918  law  limit- 
ing the  surtax  to  20  per  cent  of  the  selling  price,  for  1921, 
in  case  of  the  sale  of  mineral  properties,  but  for  1922  and 
subsequent  years  the  limit  is  placed  at  16  per  cent. 

Regulation.  Where  the  taxpayer  by  prospecting  and  locating 
claims,  or  by  exploring  and  discovering  undeveloped  claims,  has 
demonstrated  the  principal  value  of  mines,  oil  or  gas  wells,  which 
prior  to  his  efforts  had  a  relatively  minor  value,  the  portion  of  the 
surtax  attributable  to  a  sale  of  such  property  or  of  the  taxpayer's  in- 
terest therein  shall  not  exceed  for  the  calendar  year  1921,  20  per 
cent,  and  for  subsequent  calendar  years  16  per  cent  of  the  selling 
price.  Exploration  work  alone  without  discovery  is  not  sufficient  to 
bring  a  case  within  this  provision.  Shares  of  stock  in  a  corporation 
owning  mines,  oil  or  gas  wells,  do  not  constitute  an  interest  in  such 
property.    To  determine  the  application  of  this  provision  to  a  particu- 


l6o  APPLICATION   AND    ADMINISTRATION 

lar  case  the  taxpayer  should  first  compute  the  surtax  in  the  ordinary 
way  upon  his  net  income,  including  his  net  income  from  any  such 
sale.  The  proportion  of  the  surtax  indicated  by  the  ratio  which  the 
taxpayer's  net  income  from  the  sale  of  the  property,  or  his  interest 
therein  computed  as  prescribed  in  article  715,^°  bears  to  his  total  net 
income  is  the  portion  of  the  surtax  attributable  to  such  sale,  and  if 
it  exceeds  for  the  calendar  year  1921,  20  per  cent  and  for  subsequent 
calendar  years  16  per  cent  of  the  selling  price  of  the  property  or  in- 
terest, such  portion  of  the  surtax  shall  be  reduced  to  that  amount. ^^ 
(Art.  13.) 

If  the  taxpayer  has  held  the  property  for  more  than  two 
years,  he  may,  however,  elect  to  be  taxed  at  a  maximum  rate 
of  I2j4  per  cent  under  the  capital  gains  provision. ^^ 

Ruling.  Where  individuals  transfer  property  to  a  corporation 
which  later  demonstrates  the  principal  value  of  such  property  as  oil- 
producing  property  "by  prospecting  or  exploration  and  discovery 
work"  and  then  dissolves,  transferring  the  property  to  the  individuals, 
who  remain  stockholders  without  change  in  interests,  and  such  stock- 
holders sell  the  property,  the  portion  of  the  surtax  attributable  to 
such  sale  is  not  limited  to  20  per  cent  of  the  selling  price  of  such 
property  or  interests  under  the  provisions  of  section  211  (b).  (C. 
B.  I,  page  57;  T.  B.  R.  8.) 

It  is  well  to  bear  in  mind  that  in  computing  the  profit  on 
the  sale  of  oil  wells  the  "discovery  value"  is  not  a  factor.  The 
"discovery"  itself  operates  to  give  the  seller  the  benefit  of  the 
20  per  cent  tax.  The  "discovery  value"  is  used  only  in  com- 
puting the  depletion  allowance.  Some  confusion  has  arisen  on 
this  point  in  rulings  handed  down  by  the  Committee  on  Ap- 
peals and  Review  and  by  the  Advisory  Tax  Board,  but  the 
question  was  definitely  settled  in  Solicitor's  Opinion  26,  C.  B.  4, 
page  44. 

Rates  applicable  to  corporations. — The  new  law  imposes 
on  corporations,  for  1921,  the  same  rate  of  income  tax,  viz., 
10  per  cent,  as  was  imposed  for  1919  and  1920  under  the 
1918  law,  and  the  same  rates  of  excess  profits  tax.     For  1922 


i 


"  See  Appendix  A,  Chapter  V. 

"  Ibid. 

^'  Section  206,  see  Chapter  XVII. 


RATES    AND    COMPUTATION    OF   TAX  i6i 

and  subsequent  years  the  income  tax  rate  is  12}4  per  cent. 
The  excess  profits  tax  is  not  imposed  on  net  income  which 
accrues  after  January  i,  1922/^ 

Corporations  in  general. — 

Law.  Section  230.  That,  ....  there  shall  be  levied,  collected, 
and  paid  for  each  taxable  year  upon  the  net  income  of  every  corpora- 
ion  a  tax  at  the  following  rates: 

(a)  For  the  calendar  year  1921,^^  10  per  centum  of  the  amount 
of  the  net  income  in  excess  of  the  credits  provided  in  section  236;  and 

(b)  For  each  calendar  year  thereafter,  12^  per  centum  of  such 
excess  amount.^^ 

Although  the  limitation  of  tax  on  capital  gains  does  not 
apply  to  corporations,  no  hardship  is  suffered  by  a  corporation 
because  the  minimum  tax  under  those  provisions^"  in  any 
event  must  amount  to  12^/^  per  cent,  which  is  the  rate  imposed 
upon  corporations. 

Computation  of  the  Tax 

The  application  of  the  rates,  the  arrangement  upon  the 
return  blanks  of  the  various  items  going  to  make  up  the  tax 
base,  the  subtraction  of  the  various  credits  and  deductions, 
and  the  calculation  of  the  tax  payable  are  problems  which 
have  been  greatly  complicated  by  the  extension  of  the  privilege 
of  reporting  upon  the  basis  of  fiscal  years  to  individuals  tax- 
able at  progressive  rates." 


"  See  Appendix  A. 

"  [Former  Procedure]  The  1913  rate  on  corporate  incomes  was  iden- 
tical with  the  normal  rate  on  individual  incomes,  i  per  cent  [section  II, 
G  (a)].  Again  in  the  1916  law  it  was  made  the  same,  2  per  cent  (section 
10).  In  1917,  however,  when  an  additional  normal  tax  of  2  per  cent  was 
made  to  apply  to  individuals,  the  additional  corporation  rate  was  made  4 
per  cent  (section  4),  the  total  rate  applying  to  corporations  in  191 7  being 
6  per  cent  as  compared  with  a  total  normal  tax  of  4  per  cent  on  individuals. 
Corporations  were  permitted  to  take  credit,  in  the  case  of  dividends  received, 
for  only  4  per  cent  in  place  of  6  per  cent,  the  2  per  cent  difference  operating 
as  a  penalty  upon  the  corporate  form.  The  rate  for  1918  was  fixed  at  12 
per  cent,  and  for  1919  and  1920  at  10  per  cent. 

For  rates  on  transportation  companies  under  government  control,  sec 
Income  Tax  Procedure,  1921,  page  154. 

'^  See  page  166. 

"See  Chapter  XVII. 

"  See  page  164. 


l62  APPLICATION   AND   ADMINISTRATION 

The  192 1  law  specilies  the  procedure  to  be  followed  in 
certain  cases  which  the  regulations  issued  by  the  Treasury 
have  greatly  amplified. 

Reconcilement  of  returns  and  books  of  account. — In  vari- 
ous parts  of  this  book  the  author  has  called  attention  to  the 
desirability  of  maintaining  uniformity  between  the  tax  returns 
and  the  books  of  account.  When  tax  rates  were  low  it  made 
little  difference  to  the  taxpayer  whether  or  not  the  returns 
could  readily  be  reconciled  with  his  books.  Preparation  of 
the  returns  with  the  numerous  adjustments  required  has  been 
such  an  annoying  matter  and  the  time  allowed  for  preparing 
returns  has  been  so  limited,  that  the  matter  was  dismissed  with 
a  sigh  of  relief  as  soon  as  the  returns  were  filed.  The  honest 
taxpayer  is  quite  as  likely  to  make  mistakes  against  himself  as 
against  the  government. 

With  high  rates  in  effect  it  is  most  important  that  returns 
be  accurate,  in  the  interest  of  both  taxpayers  and  government. 
It  is  impossible  to  know  that  a  return  is  accurate  unless  it  is 
reconciled  with  the  books  of  account.  It  must  be  known  that 
every  item  omitted  from  or  added  to  the  books  and  every 
item  omitted  from  or  added  to  the  returns  is  justified,  and 
in  subsequent  periods  it  must  be  readily  apparent  why  the 
omissions  and  additions  occurred. 

In  addition  to  a  hasty  examination  which  is  made  soon 
after  filing,  the  Treasury's  policy  is  to  examine  in  a  detailed 
and  exhaustive  manner  every  return  which  involves  or  should 
involve  a  substantial  amount  of  tax.  Taxpayers  wnll  avoid 
many  hours  of  annoyance  if  a  careful  memorandum  is  kept 
of  all  differences  between  books  and  returns.  A  complete 
form  for  recording  the  reconciliation  between  books  of  ac- 
count and  income  and  excess  profits  tax  returns  is  given  in 
Excess  Profits  Tax  Procedure,  192 1. 

Capital  net  gains  taxed  at  12^/2  per  cent. — A  new  provision 
is  found  in  the  192 1  law,^^  under  which  gains  from  the  sale 

"  Section  206. 


RATES    AND    COMPUTATION    OF   TAX  163 

or  exchange  of  capital  assets  are  taxed  at  I2j/^  per  cent  instead 
of  at  the  higher  rates  when  the  tax  on  net  income  is  computed 
at  the  regular  normal  and  surtax  rates.  For  a  full  discussion 
of  capital  gains,  capital  deductions,  and  for  illustrations  of 
the  necessary  computations,  see  Chapter  XVII. 

Fiscal  years  ending  in  1921. — 

Law.  Section  205.  (a)  That  if  a  taxpayer  makes  return  for  a 
fiscal  year  beginning  in  1920  and  ending  in  1921,  his  tax  under  this  title 
for  the  taxable  year  1921  shall  be  the  sum  of:  (i)  the  same  proportion 
of  a  tax  for  the  entire  period  computed  under  Title  II  of  the  Revenue 
Act  of  1918  at  the  rates  for  the  calendar  year  1920  which  the  portion 
of  such  period  falling  within  the  calendar  year  1920  is  of  the  entire 
period,  and  (2)  the  same  proportion  of  a  tax  for  the  entire  period  com- 
puted under  this  title  at  the  rates  for  the  calendar  year  1921  which  the 
portion  of  such  period  falling  within  the  calendar  year  1921  is  of  the 
entire  period. 

Any  amount  paid  before  or  after  the  passage  of  this  Act  on  ac- 
count of  the  tax  imposed  for  such  fiscal  year  by  Title  II  of  the  Revenue 
Act  of  1918  shall  be  credited  toward  the  payment  of  the  tax  imposed 
for  such  fiscal  year  by  this  Act,  and  if  the  amount  so  paid  exceeds  the 
amount  of  such  tax  imposed  by  this  Act,  the  excess  shall  be  credited  or 
refunded  in  accordance  with  the  provisions  of  section  252.^®.  .  .  . 

Regulation.  In  computing  the  tax  attributable  to  the  calendar 
year  1920  the  net  income  computed  for  the  entire  period  under  Title 
II  of  the  Revenue  Act  of  1918  shall  be  credited  with  the  amount  of  the 
excess-profits  tax  computed  for  the  entire  period  under  Title  III 
of  the  Revenue  Act  of  1918.  In  computing  the  tax  attributable  to  the 
calendar  year  1921  the  net  income  computed  for  the  entire  period 
under  the  present  statute  shall  be  credited  with  the  amount  of  the 
excess-profits  tax  computed  for  the  entire  period  under  Title  III  of 
this  statute.  ....  Amounts  previously  paid  by  the  taxpayer  on 
account  of  tlie  income  tax  for  such  fiscal  year  shall  be  credited  to- 
ward the  payment  of  the  income  tax  imposed  for  such  fiscal  year  by 
the  present  statute.  Any  excess  shall  be  credited  or  refunded  in  ac- 
cordance with  the  provisions  of  section  252 (Art.  1623.) 

The  tax  is  computed  as  follows : 

(a)  At  1920  rates,  on  the  entire  "net  income  as  if  such 
entire  net  income  were  earned  during  the  calendar 
year  1920,  and  as  if  the  19 18  law  were  still  in  force. 


See  Chapter  IX. 


164  APPLICATION   AND   ADAIINISTRATION 

(b)  At  1 92 1  rates,  on  the  entire  net  income  as  if  earned 
during  the  calendar  year  1921    (under  the  1921  law). 

(c)  Add  as  many  twelfths  of  the  tax  under  (a)  as  there 
are  months  in  1920,  to  as  many  twelfths  of  the  tax 
under   (b)   as  there  are  months  in  192 1. 

Fiscal  years  of  individuals  ended  in  1921. — Assume  an  in- 
dividual taxpayer  with  fiscal  year  ended  September  30,  192 1. 
married,  with  three  dependents,  and  having  net  income  of 
$20,000.  At  1920  rates  (under  the  19 18  law)  his  total  tax 
on  $20,000  is  $1,942.  At  1921  rates  (under  1921  law)  his 
total  tax  is  $1,894.  The  difference  of  $48  is  accounted  for 
by  the  fact  that  under  the  1921  law  the  exemption  for  de- 
pendents is  $400  each  instead  of  $200  each.    The  total  tax  is : 

3/12  of  $1,942 $485-50 

9/12  of    1,894 1,420.50 

Total    $1,906.00    • 


Fiscal  years  of  partnerships  and  personal  service  corpora- 
tions.— Partners  are  taxable  on  their  distributive  shares  of  net 
income  of  the  partnership  for  the  taxable  year  of  the  partner- 
ship ending  in  the  period  for  which  the  individual  partner 
reports.  Personal  service  corporations  are  taxed  as  ordinary 
corporations  after  December  31,  192 1.  In  both  of  these  cases 
special  problems  arise  which  are  treated  in  Chapter  XXIV, 
"Income  from  Partnerships  and  Personal  Service  Corpora- 
tions." 

Fiscal  years  of  corporations  ended  in  1921. — The  income 
tax  rates  upon  corporations  for  1920  and  192 1  are  the  same, 
viz.,  10  per  cent.  The  net  income  on  which  the -tax  is  based 
may  differ  as  computed  for  1920  (under  the  19 18  law)  and  for 
1 92 1  (under  the  1921  law)  in  such  items  as  bad  debts,  interest 
paid  to  carry  Liberty  bonds,  etc.  All  corporations  which  have 
a  fiscal  year  ended  in  1921  should  prepare  new  returns  under 
the  192 1  law,  even  though  the  tax  rate  is  unchanged. 


RATES   AND    COMPUTATION    OF   TAX  165 

Fiscal  years  ending  in  1922. — 

Law.     Section  205 (b)   If  a  taxpayer  makes  return  for  a 

fiscal  year  beginning  in  1921  and  ending  in  1922,  his  tax  under  this  title 
for  the  taxable  year  1922  shall  be  the  sum  of:  (i)  the  same  proportion 
of  a  tax  for  the  entire  period  computed  under  this  title  (as  in  force 
on  December  31,  1921)  at  the  rates  for  the  calendar  year  1921  which  the 
portion  of  such  period  falling  within  the  calendar  year  1921  is  of  the 
entire  period,  and  (2)  th^  same  proportion  of  a  tax  for  the  entire  period 
computed  under  this  title  (as  in  force  on  January  i,  1922)  at  the  rates 
for  the  calendar  year  1922  which  the  portion  of  such  period  falling 
within  the  calendar  year  1922  is  of  the  entire  period:  Provided,  That 
in  the  case  of  a  personal  service  corporation  the  amount  to  be  paid 
shall  be  only  that  specified  in  clause  (2).-'^.  .  .  . 

The  principle  of  prorating  the  tax  as  indicated  above  in 
the  case  of  1920-192 1  fiscal  years,  is  also  applied  to  192 1- 
1922  fiscal  years.  The  important  change  in  the  case  of  indi- 
viduals is  the  decrease  in  the  surtax  rates  in  1922.  The 
repeal  of  the  excess  profits  tax  in  the  case  of  corporations,  as 
of  December  31,  192 1,  gives  rise  to  a  special  problem  in  the 
fiscal  years  192 1- 1922. 

Fiscat  years  of  corporations  ending  in  1922. — In  the  case  of 
fiscal  years  ending  in  1922,  there  is,  of  course,  no  excess  profits 
tax  applicable  to  income  earned  in  1922.  The  law  [section 
236  (c-2)]  provides  that  the  excess  profits  tax  applicable  to 
192 1  [computed  under  section  335  (b)]  shall  be  credited 
against  the  net  income  computed  for  the  zvJioIe  period,  in  com- 
puting the  income  tax  under  section  205  (b). 

If  section  236  of  the  law  is  interpreted  hterally,  the  excess 
profits  tax  computed  under  section  335  (]))  would  be  prorated 
l)efore  being  appHed  as  a  credit  against  net  income  for  the  pur- 
pose of  determining  the  amount  subject  to  income  tax.  The 
following  regulation  permits  the  full  excess  profits  tax  to  ]>e 
credited  when  computing  income  tax  under  192 1  law. 

Regulation.  In  computing  the  tax  for  a  fiscal  year  beginning 
in  1921  and  ending  in  1922  the  procedure  is  as  follows:  (o)  The  tax 
attributable  to  the  calendar  year  1921  is  found  by  computing  the  in- 
come of  the  taxpayer  and  the   lax  thereon   in   accordance   with   the 

^"Sce  Chapter  XXIV. 


l66  APrUCATION   AND   ADMINISTRATION 

statute  as  in  force  on  December  31,  1921,  as  if  the  fiscal  year  was  the 
calendar  year  1921  and  determining  the  proportion  of  such  tax 
which  the  portion  of  such  period  within  the  calendar  year  1921  is  of 
the  entire  period;  before  calculating  the  tax  the  net  income  computed 
for  the  entire  period  shall  be  credited  with  the  excess-profits  tax 
computed  for  the  entire  period  under  Title  III  of  this  statute  as  if  the 
fiscal  year  was  the  calendar  year  1921 ;  (&)  the  tax  attributable  to 
the  calendar  year  1922  is  found  by  computing  the  income  of  the  tax- 
payer and  the  tax  thereon  in  accordance  with  the  statute  as  in  force 
on  January  i,  1922,  as  if  the  fiscal  year  was  the  calendar  year  1922, 
and  determining  the  proportion  of  such  tax  which  the  portion  of  such 
fiscal  year  falling  within  the  calendar  year  1922  is  of  the  entire  period ; 
and  (c)  the  tax  for  the  fiscal  year  is  found  by  adding  the  tax  at- 
tributable to  the  calendar  year  1921  to  the  tax  attributable  to  the 
calendar  year  1922 (Art.  1624.) 

The  following  illustration  shows  how  the  income  tax  is 
computed  under  the  foregoing  regulation : 

COMPUTATION     OF    INCOME    TAX— FISCAL    YEAR    ENDING 

MAY  31,  1922 

Net  income  for  full  year  (before  taxes) $240,000 

Excess  profits  tax  for  full  year 36,000 

$20^.000 

Income  tax  at   10% $20,400 

Excess  profits  tax  as  above 36,000 

Total  tax   $56,400 

Tax  for  7  months  in  ig_'i    (7/12  of  $56,400) $32,900 

Net  income  $240,000 

Income  tax  at  I2|^% $  30,000 

Tax  for  5  months  in  1922   (5/12  of  $30,000) 12,500 

Total  tax  payable   $45,400 

Consisting  of  excess  profits  tax   (7/12  of  $36,000) $  21,000 

Income  tax  (7/12  of  $20,400  plus  5/12  of  $30,000) 24,400 

$45,400 


The  computation  set  forth  above,  authorized  by  the  regu- 
lations, prevents  prorating  twice  the  excess  profits  credit."^ 


"'For  illustration  of  the  imposition  of  excessive  income  tax  due  to 
method  of  prorating  excess  profits  tax,  for  fiscal  years  ended  in  1917,  sec 
Income  Tax  Procedure,  1919,  pages  125-128;  for  fiscal  years  ended  in  1919, 
see  Income  Tax  Procedure,  1920,  pages  145-149. 


RATES   AND    COMPUTATION    OF   TAX  167 

Return  for  period  of  less  than  one  year — placing  income 
on  annual  basis. — A  new  provision  has  been  inserted  in  the 
1 92 1  law  whereby  in  the  case  of  returns  for  less  than  one  year 
the  tax  is  to  be  computed  after  the  income  has  been  placed  on 
an  annual  basis: 

Law.     Section   226 (c)  In    the    case    of   a   return    for   a 

period  of  less  than  one  year  the  net  income  shall  be  placed  on  an 
annual  basis  by  multiplying  the  amount  thereof  by  twelve  and  dividing 
by  the  number  of  months  included  in  such  period;  and  the  tax  shall 
be  such  part  of  a  tax  computed  on  such  annual  basis  as  the  number 
of  months  in  such  period  is  of  tvs^elve  months. 

This  change  has  a  material  effect  on  the  tax  payable  ])y 
individuals  who  are  subject  to  the  graduated  surtaxes^^  but 
should  have  no  effect  on  the  tax  payable  by  a  corporation. 

Corporations. — Whether  the  tax  is  computed  on  the  basis 
of  the  actual  income  for  the  period,  the  various  credits  being 
proportionately  reduced  (the  practice  under  the  19 18  law),  or 
whether  the  income  is  placed  on  an  annual  Ijasis  and  the  tax 
computed,  full  credits  being  allowed,  and  the  resulting  tax  be- 
ing prorated,  should  make  no  dift'erence.  This  is  shown  by  the 
following  examples : 

Method  A — Not  Reducing  Exemptions  and  Credits 
Net  income  (6  months)   $  12,000 

12 
Net  income  placed  on   an  annual   basis    ( —   X   $12,000)    [Section 

6 
226  (c)  ]   24,000 

Invested  capital    150,000 

Excess  profits  credit : 

8%  of  invested  capital    (.$150,000) $12,000 

Specific    3,000 

Total    15,000 

Net  income    (all  in  20%  bracket)    24,000 

Less:  Excess  profits  credit iS,ooo 

Subject  to  e.\cess  profits  tax 9,000  at  20% 

Excess  profits  tax    1,800 

"'  Sec  page  169. 


l68  APPLICATION   AND   ADMINISTRATION 

Net  income    $24,000 

Less:  Excess  profits  tax  $1,800 

Specific   2,000      3,800 

Subject  to  income  tax  20,200  at  10% 

Income  tax    $  2,020 

Total    3.820 

Tax  for  6  months  (^  of  $3,820) 1,910 

Method  B — Reducing  Exemptions  and  Credits 
Net  income   (6  months)    12,000 

Invested   capital    150,000 

Excess  profits  credit : 

8%  of  invested  capital  ($150,000) $12,000 

Specific     3,000 

Total    15,000 

Yj    of    $15,000     7,500 

Net  income   (all  in  20%  bracket)    12,000 

Less:  Excess  profits  credit  7.500 

Subject  to  excess  profits  tax 4.500  at  20% 

Excess  profits  tax   $       900 

Net   income    12,000 

Less:   Excess  profits  tax    $   900 

Specific   (^  of  $2,000)    i.ooo      1,900 

Subject  to  income  tax  «pio,ioo  at  10% 

Income   tax    1,010 

Total  tax    i.Qio 

However,  article  626  provides : 

This  prorated  credit  shall  be  applied  to  the  net  income  before  such 
net  income  is  placed  on  an  annual  basis,  as  provided  in  Section 
22t    (c). 

This  regulation  should  be  interpreted  to  apply  only  to  the 
computation  of  normal  tax,  otherwise  an  application  of  the 
prorated  $2,000  credit  to  the  income  before  computing  the 
excess  profits  tax  would  result  in  a  reduction  of  the  latter  tax 
in  a  way  obviously  not  intended  by  the  law. 


RATES    AND    COMPUTATION    OF   TAX  169 

Section  236  provides  "That  for  the  purpose  only  of  the 
tax  imposed  by  section  230"  (the  lo  per  cent  corporation  in- 
come tax),  there  shall  be  allowed  as  credits: 

A  specific  credit  of  $2,000  [subdivision   (b)]. 

"The  amount  of  any  war-profits  end  excess-profits  taxes 
imposed  ....  for  the  same  taxable  year"  [sub- 
division  (c)]. 

The  amount  of  excess  profits  tax  payable  in  the  foregoing  illus- 
tration is    $     goo 

The  prorated  credit  mentioned  in  article  626  above  0/2  of  $2,000)  is         1,000 

Total    $1,900 

Deducting  $1,900  from  the  net  income,  $12,000,  leaves  subject  to 
income   tax    $10,100 

12 

Placing  this  amount  on  an  annual  basis  ( —  X  $10,100)  ^= $20,200 

6  = 

Income  tax   10%  of  $20,200 $  2,020 

Income  tax  for  6  months  (^  of  $2,020) $  1,010 

Add  excess  profits  tax  for  6  months 900 

Total  tax  for  6  months  period $  1,910 

This  method  of  computation  seems  rather  superfluous  but 
it  is  apparently  the  only  way  in  which  the  Treasury  could  recon- 
cile sections  226  (c)  and  239  (b)  of  the  law — the  latter 
section  being  retained  in  the  192 1  law  obviously  by  an  over- 
sight. 

Individuals. — When  an  individual  return  is  made  for  a 
period  less  than  one  year  and  the  income  is  placed  on  an  annual 
basis,  the  personal  exemption  and  the  credit  for  dependents 
are  not  reduced.  An  individual  reporting  for,  say,  six  months 
ended  December  31,  1921,  with  net  income  for  that  period  of 
$20,000,  would  compute  his  tax  as  follows  :"^ 

'^  [Former  Procedure]  Section  226  of  the  1918  law  provided  for  re- 
duction of  the  personal  exemption  and  credit  for  dependents. 

1918  Law.  Section  226.  "  .  .  .  .  the  credits  provided  in  subdivisions 
(c)  and  (d)  of  section  216,  shall  be  reduced  respectively  to  amounts  which 
bear  the  same  ratio  to  the  full  credits  provided  in  such  subdivisions  as  the 
number  of  months  in  such  period  bears  to  twelve  months." 


170  APPLICATION   AND   ADMINISTRATION 

Income  Taj 

Net  income  for  six  months $20,000 


Placed  on  annual  basis   (20,000  x  12/6) $40,000 

Less:  Exemption  (married,  3  children) 3,200 

$36,800 
Taxable  at  4  per  cent    4,000  $    160 

Taxable  at  8  per  cent     $32,800  2,624 

Surtax  on  $40,000  (1921  rates) 3,410 


Total    $6,194 


Tax  payable,  6/12  of  $6,194 $3-097 


Ruling.  Where,  under  the  Revenue  Act  of  1918,  a  taxpayer  has 
been  permitted  to  change  his  accounting  period  from  a  calendar  to 
fiscal  year  basis  and  renders  a  return  for  the  period  from  January  i 
to  the  end  of  such  fiscal  year  both  the  normal  tax  and  the  surtax 
shall  be  computed  as  though  the  return  were  filed  for  a  full  twelve- 
month period,  after  the  reduction  of  the  exemptions  and  credits  pro- 
vided in  section  216  (c)  and  (d)  of  the  Act.  (C.  B.  3,  page  230; 
O.  D.  723.) 

Under  the  method  prescribed  Iw  the  19 18  law  the  tax, 
using  the  illustration  above,  would  be  computed  as  follows : 

Income  Tax 

Net  income  for  six  months $20,000 

Less:   Personal  exemption    (reduced  one-half) 1,600 

$18,400 
Taxable  at  4  per  cent    4,000  $    160 

Taxable  at  8  per  cent    $14400  1,152 

Surtax  on  $20,000  710 

Total  tax    $2,022 


The  effect  of  the  new  method  of  computation  is  to  subject 
the  income  for  part  of  a  year  to  the  higher  surtax  rates  which 
would  be  applied  if  reporting  for  a  full  year  and  net  income 
were  received  at  the  same  rate,  using  the  above  illustration, 
for  twelve  months  as  for  six  months.  Merely  because  an  indi- 
vidtial  receives  a  certain  income  in  a  six  months'  period,  or 
any  other  period  less  than  a  year,  is  no  reason  for  assuming 


RATES    AND    COMPUTATION    OF   TAX  171 

that  he  will  receive  a  proportionate  part  throughout  the  entire 
twelve  months.  He  may  never  receive  another  dollar.  He 
may  lose  all  he  gained,  say,  in  the  first  six  months  and"  more. 
To  subject  his  income  received  for  part  of  a  year  to  the  higher 
surtax  rates  applicable  to  a  theoretical  income  which  may  never 
materialize,  is  inequitable. 

The  larger  the  income  for  the  period  less  than  a  year,  the 
greater  the  relative  difference  in  tax  as  compared  with  the  old 
method,  because  of  the  increasing  rates  in  the  higher  surtax 
brackets. 

The  following  illustration,  given  in  Regulations  62,  article 
431,  is  here  compared  on  the  basis  of  the  1921  and  1918  laws: 

For  the  calendar  year  1921  the  income  tax  of  a  married  person 
entitled  to  a  personal  exemption  of  $2,000,  making  a  return  for  a  six 
months'  period  of  $10,000  net  income,  is  $995,  computed  as  follows: 

Net  income   , $  10,000 

Multiplied  by  12 120,000 

Divided  by  6  20,000 

Subtracting  exemption  of  $2,000 18,000 

Normal  tax  on  $18.000 1,280 

Surtax  on  $20,000  710 

Total    1,990 

Divided  by  2   995 

Computation  Under  1918  Law 

Net    income    $10,000 

Less:   Exemption    1,000 

$  9,000 

Normal  tax  on  $9,000   $       560 

Surtax  on  $10,000  no 

Total    $       670 

Increased  tax    $       325 


Reduction  of  personal  exemption   of  individuals. — When 

the  aggregate  net  income  of  husband  and  wife  is  in  excess  of 

$5,000,  the  personal  exemption  is   reduced  to  $2,000.     But 

the  law  provides : 

T.AW.     Section  216 (c)   In  no  case  shall  the  reduction  of 

the  personal  exemption  from  $2,500  to  $2,000  operate  to  increase  the 


172  APPLICATION   AND   ADMINISTRATION 

tax,  which  would  be  payable  if  the  exemption  were  $2,500,  by  more 
than  the  amount  of  the  net  income  in  excess  of  $5,000;  .... 

An 'illustration  of  the  two  computations  necessary  to  de- 
termine the  tax  payable  under  the  above  limitation  is  given  in 
Chapter  XII.  The  point  is  that  when  the  net  income  is  slightly 
in  excess  of  $5,000  (up  to  $5,020),  the  taxpayer  does  not 
have  to  pay  more  tax,  because  of  the  reduction  in  the  exemp- 
tion, than  the  amount  of  net  income  in  excess  of  $5,000. 

When  the  specific  credit  of  $2,000  is  not  allowed  a  cor- 
poration.— If  the  net  income  of  a  corporation  is  $25,000  or 
less,  a  specific  credit  of  $2,000  is  allowed.     But 

Law.  Section  2}^^.  ....  (b)  ....  if  the  net  income  is  more 
than  $25,000  the  tax  imposed  by  section  230  shall  not  exceed  the  tax 
which  would  be  payable  if  the  $2,000  credit  were  allowed,  plus  the 
amount  of  the  net  income  in  excess  of  $25,000;  and   .... 

The  necessary  computation  is  shown  in  Chapter  XII. 

Fractional  part  of  a  cent  not  to  be  disregarded  in  computa- 
tion of  tax. — 

Regulation.  In  the  payment  of  taxes  a  fractional  part  of  a  cent 
shall  be  disregarded  unless  it  amounts  to  one-half  cent  or  more,  in 
which  case  it  shall  be  increased  to  one  cent.  Fractional  parts  of  a 
cent  should  not  be  disregarded  in  the  computation  of  taxes.  (Reg. 
45,  Art.  1721.) 


CHAPTER  VIII 

ADMINISTRATION,  ASSESSMENT  AND 
PAYMENT 

Administration  in  General 

The  administration  of  the  Revenue  Act  is  placed  in  the 
hands  of  the  Commissioner  of  Internal  Revenue,  referred 
to  hereafter  as  the  "Commissioner,"  subject  to  the  general 
supervision  and  control  of  the  Secretary  of  the  Treasury. 

Bureau  of  Internal  Revenue, — The  Bureau  of  Internal 
Revenue,  referred  to  in  this  book  as  the  "Bureau,"  as  its  name 
implies,  is  charged  with  the  collection  of  all  federal  revenue 
from  inland  sources.  There  are  five  deputy  commissioners^ 
and  one  assistant  to  the  Commissioner,  who  is  authorized  to 
act  in  the  Commissioner's  place.  Income  and  excess  profits 
taxes  are  collected  through  the  local  collectors  of  internal  rev- 
enue, who  are  also  charged  with  the  collection  of  all  other 
internal  revenue  taxes.  The  collectors  of  internal  revenue 
are  the  officers  who  come  into  the  most  direct  touch  with  the 
taxpayers  and  they  are  held  primarily  responsible  for  the 
proper  collection  of  the  tax  in  their  districts.  At  present  there 
are  some  sixty-four  collection  districts,  each  with  a  collector 
at  its  head  assisted  by  a  staff  of  subordinates.  In  addition 
there  are  thirty-five  internal  revenue  divisions  with  internal 
revenue  agents  or  supervising  internal  revenue  agents  m 
charge. 

Law.  Section  T311.  [Section  3172^  Rev.  Stat.]  Every  collector 
shall,  from  time  to  time,  cause  his  deputies  to  proceed  through  every 


'The  deputies  are  in  cliarge  of  the  following: 

1.  Income  Tax   Unit 

2.  Estate  Tax  Division 

3.  Sales  Tax  Unit 

4.  Accounts  Divisions 

5.  Miscellaneous    (publications,  administration,  etc.) 


174  APPLICATION   AND   ADMINISTRATION 

part  of  his  district  and  inquire  after  and  concerning  all  persons  therein 
who  are  liable  to  pay  any  internal-revenue  tax,  and  all  persons  owning 
or  having  the  care  and  management  of  any  objects  liable  to  pay  any 
tax,  and  to  make  a  list  of  such  persons  and  enumerate  said  objects. 

Law.  Section  131 1.  [Section  3165,  Rev.  Stat.]  Every  collector, 
deputy  collector,  internal-revenue  agent,  and  internal-revenue  officer  as- 
signed to  duty  under  an  internal-revenue  agent,  is  authorized  to  admin- 
inster  oaths  and  to  take  evidence  touching  any  part  of  the  administra- 
tion of  the  internal-revenue  laws  with  which  he  is  charged,  or  where 
such  oaths  and  evidence  are  authorized  by  law  or  regulation  authorized 
by  law  to  be  taken. 

They  may  summon  any  person  residing  or  found  within 
the  state  or  territory  in  which  their  districts  He,  and  even 
in  other  districts,  and  make  examinations  authorized  by  the 
law.  If  a  return  is  not  filed,  the  collectors  are  required  to 
make  returns  from  their  own  knowledge  and  from  such  in- 
formation as  they  can  obtain  through  testimony  or  otherwise. 

Procedure  of  the  Bureau  of  Internal  Revenue. — The  steps 
in  procedure  of  the  Bureau  of  Internal  Revenue  have  been 
described  as  follows  :^ 

1.  The  taxpayer  makes  a  return  and  pays  to  the  collector 
who  receives  the  return,  one-fourth  or  all  the  tax  shown  due  on 
the  face  of  the  return. 

2.  The  collector  lists  the  returns,  shows  the  taxes  due, 
makes  a  few  obvious  corrections  in  some  cases  and  forwards 
the  returns  to  Washington. 

3.  In  Washington  the  returns  are  first  checked  against  the 
collector's  lists  and  the  original  tax  is  verified. 

4.  The  "audit"  of  the  returns  begins  and  additional 
amounts  of  taxes  due  are  determined;  the  taxpayer  is  infor- 
mally notified  and  the  return  is  sent  to  a  separate  section  of 
the  Bureau  for  entry  on  a  supplemental  list. 

5.  Supplemental  lists  are  transmitted  monthly  to  the  col- 
lectors; the  taxpayer  is  formally  notified  and  the  tax  is  due 
for  payment  within  10  days  after  such  notice. 


'A.  E.  James,  Bulletin  of  Njutioiial  Tax  Association,  November,  1920. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      175 

Committee  on  Appeals  and  Review. — Under  the  19 18 
law^  the  Commissioner  was  empowered  to  appoint  an  Advisory 
Tax  Board.*  The  Board  was  appointed  March  14,  1919,  and 
abolished  October  i,  19 19. 

It  is  said  that  history  cannot  be  written  at  or  near  the 
time  events  transpire.  It  is  too  soon  to  w^ite  the  history  of 
the  Advisory  Board  of  1919,  but  the  author  is  willing  to  pre- 
dict now  that  when  the  history  is  vv'ritten  it  will  be  found 
that  the  Board  performed  a  hard  and  thankless  task  in  an 
energetic  and  equitable  manner,  that  it  decided  almost  in- 
soluble problems  and  retained  the  respect  and  earned  the 
gratitude  of  taxpayers  even  though  it  did  not  always  give  them 
what  they  wanted. 

If  we  are  ever  able  to  evolve  an  organization  which  will 
enlist  the  active  assistance  of  a  considerable  number  of  the 
best  business  and  professional  men  of  the  country  it  probably 
will  be  necessary  to  make  an  arrangement  whereby  they  will 
give  their  services  for  only  a  small  part  of  each  year.  The 
sacrifice  involved  in  accepting  a  full-time  appointment  is  too 
great.  The  British  Board  of  Referees  decides  many  different 
problems  for  the  British  Treasury  without  calling  upon  its 
members  for  more  than  two  weeks  of  service  per  year. 

In  the  place  of  the  Board,  a  Committee  on  Appeals  and 
Review  was  established,  the  membership  of  which  has  been  re- 
cruited from  within  the  Bureau. 

Organization. — The  Committee"'  is  entirely  independent 


^Section  1301   (d-i). 

*For  a  full   discussion   of   its   powers  and  procedure   see  Income   Tax 
Procedure,  1920,  pages  159-161. 

"At  the  present  time,  the  Connnittce  is  composed  of  the  following: 

N.  T.  Johnson,  Chairman 

G.  R.  Davis,  Vice-Chairman 

Leslie  Gillis 

C.  P.  Hoffman 

W.  H.  Lawder 

C.  P.  AIcGinley 

R.  J.  Service 

M.  E.  Stickley 

F.  G.  Smith,  Secretary 
There  are  still  two  vacancies  to  be  filled. 


176  APPLICATION   AND   ADMINISTRATION 

of  the  Income  Tax  Unit  and  is  responsible  only  to  the  Com- 
missioner. Its  personnel  embraces  a  chairman,  vice-chair- 
man, eight  members,  and  a  secretary,  who  give  their  entire 
time  and  attention  to  all  matters  referred  to  the  Committee 
for  consideration.  All  of  the  members  have  held  responsible 
positions  in  the  Bureau  as  heads  of  divisions  or  chiefs  of  sec- 
tions and  are  either  attorneys  at  law  or  accountants. 

Procedure. — The  principal  duties  of  the  Committee  are 
as  follows : 

1.  Hearing  and  consideration  of  cases  which  have  been 
appealed  by  taxpayers  from  the  action  of  the  Income 
Tax  Unit. 

2.  Consideration  of  questions  su1)mitted  1)y  the  Income 
Tax  Unit  upon  which  the  advice  of  the  Committee  is 
asked. 

3.  Criticism  or  approval  of  letters  making  new  rulings 
or  new  applications  of  old  rulings  which  are  submitted 
by  the  Income  Tax  Unit  or  the  office  of  the  Commis- 
sioner. 

4.  Criticism  or  approval  of  proposed  Treasury  decisions. 

5.  Consideration  of  matters  presented  in  informal  con- 
ferences by  officers  of  the  Bureau  and  by  taxpayers 
upon  questions  of  interpretation,  policy,  or  procedure. 

Cases  may  be  appealed  to  the  Committee  only  after  final 
disposition  has  been  made  of  the  case  by  the  Income  Tax  Unit, 
and  upon  such  questions,  either  as  to  the  law  or  the  facts,  as 
are  in  controversy  between  the  taxpayer  and  the  Income 
Tax  Unit."  The  taxpayer  accordingly  has  no  cause  to  appeal 
until  a  decision  has  been  rendered  by  the  Income  Tax  Unit 
which,  in  the  opinion  of  the  taxpayer,  is  not  in  accordance 
with  the  law  and  the  facts. 


"  Prior  to  the  1921  law,  it  was  contrary  to  the  policy  of  the  Bureau  to 
defer  assessments  pending  the  taking  up  of  an  appeal.  This  was  an  unjust 
rule  which  is  now,  in  most  cases,  abolished  by  section  250  (d)  of  the  1921 
law.     See  page  202. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      177 

The  following  ruling  indicates  the  procedure  which  should 
be  followed  when  making  an  appeal  to  the  Committee : 

Ruling.  The  appeal  must  be  filed  in  the  office  of  the  Commis- 
sioner in  Washington  within  thirty-one  days  from  the  mailing  of  the 
notice,'  but  if  it  is  mailed  in  time  to  be  received  by  the  Commissioner 
within  such  period  in  the  ordinary  course  of  the  mails  it  will  be 
considered  as  having  been  filed  within  such  period.  No  particular 
form  of  appeal  is  required,  but  said  appeal  must  set  forth  specifically 
the  exceptions  upon  which  said  appeal  is  taken.  The  appeal  shall  be 
under  oath  and  must  contain  a  statement  that  it  is  not  taken  for  the 
purpose  of  delay.  Opportunity  for  a  hearing  shall  be  granted  if 
requested  within  a  reasonable  time.  The  taxpayer  in  his  appeal  may 
rely  upon  the  data  previously  submitted  or  he  may  obtain  a  reasonable 
extension  of  time  if  cause  therefor  is  shown  in  which  to  file  additional 
data,  evidence  or  argument.  Such  request  shall  be  under  oath  and 
must  state  specifically  the  reasons  for  additional  time.  (T.  D.  3269, 
dated  January  5,  1922.) 

The  following  ruling  outlines  the  procedure  in  hearings 
before  the  Committee: 

Ruling.  When  an  appeal  is  taken  from  a  ruling  of  the  Income 
Tax  Unit  to  the  Committee  on  Appeals  and  Review  or  a  question  is 
certified  to  that  Committee  at  the  request  of  the  taxpayer  and  an  oral 
presentation  is  desired,  the  record  shall  immediately  be  examined 
to  ascertain  as  to  whether  there  is  a  question  of  law  involved.  If 
it  is  found  that  a  question  of  law  is  involved,  the  Solicitor  shall  be 
notified  and  he  will  thereupon  designate  one  member  of  the  Solicitor's 
office  to  sit  with  the  Committee  and  himself  for  the  purpose  of  hear- 
ing the  appeal,  or  if  the  Solicitor  finds  it  inconvenient  to  sit  with  the 
Committee  he  may  designate  two  members  of  his  office  to  do  so.^ 

At  the  hearing  before  the  Committee  the  taxpayer  or  his  attorney 
or  representative  will  be  expected  to  make  his  full  oral  argument  on 
the  law  as  well  as  the  facts,  and  this  presentation  shall  be  the  only 
oral  presentation  except  in  unusual  circumstances,  or  unless  a  further 
argument  of  the  facts  or  the  law  is  deemed  desirable  by  either  the 
Chairman  of  the  Committee  or  the  Solicitor. 

The  attorney  or  attorneys  so  designated  by  the  Solicitor  for  the 
hearing  will  be  expected,  in  conjunction  with  the  Solicitor  and  the 
Conference  Committee  in  the  Solicitor's  office,  if  the  Solicitor  so  de- 
sires, to  consider  the  legal  aspects  of  the  case,  and  the  Solicitor's 
recommendation  in  the  form  of  an  opinion  or  memorandum  will  then 

Notice  to  the  taxpayer  of  the  decision  of  the  Income  Tax  Unit  from 
which  the  taxpayer  wished  to  appeal  to  the  Committee. 

"  As  a  general  rule,  tlie  auditor  who  has  handled  the  case  attends  the 
conferences  of  the  Committee. 


178  APPLICATION   AND   ADMINISTRATION 

be  made  to  the  Chairman  of  the  Committee,  and  thereupon  the  Com- 
mittee's findings  shall  be  prepared  and  submitted  to  the  Commis- 
sioner for  his  approval (C.  B.  4,  page  370;  O.  D.  709.) 

Three  copies  of  a  sworn  statement  of  fact  or  brief  are  re- 
quired. 

Upon  receipt  o'f  written  request  appealing  from  the  action 
of  the  Income  Tax  Unit,  together  with  sworn  statement  of 
facts  or  brief,  the  Income  Tax  Unit  is  requested  by  the  Com- 
mittee to  submit  the  case  and  related  papers  to  it  and,  upon 
receipt  of  case,  the  appeal  is  docketed  for  assignment  to  a 
member  for  consideration. 

Upon  assignment  of  case  the  papers  are  carefully  examined 
and  in  the  event  that  additional  information  is  desired  or  an 
oral  hearing  has  been  requested  or  is  deemed  advisable,  the 
taxpayer  is  notified. 

In  the  event  of  an  oral  hearing,  which  is  expected  to  be 
final,  the  taxpayer  is  expected  to  submit  such  arguments  and 
presentation  both  as  to  the  law  and  the  facts  as  he  desires 
to  have  considered  by  the  Bureau.  Tlie  oral  hearing  may  be 
supplemented  by  a  written  brief  to  be  submitted  after  the 
hearing.     Three  copies  of  this  brief  should  be  furnished. 

The  conclusions  of  the  individual  members  of  the  Com- 
mittee, after  being  formulated  and  reduced  to  writing,  are  sub- 
mitted to  a  conference  of  the  entire  Committee  and,  when 
agreed  to,  are  submitted  to  the  Commissioner  in  the  form  of 
recommendations. 

Upon  the  approval  of  the  recommendation  of  the  Com- 
mittee by  the  Commissioner  of  Internal  Revenue,  the  decision 
is  final  as  far  as  the  Bureau  is  concerned,  and  the  decision 
will  not  be  reconsidered  except  upon  the  presentation  of  new 
and  material  evidence,  accompanied  by  an  explanation  satis- 
factory to  the  Committee  of  the  failure  to  produce  such  evi- 
dence prior  to  the  closing  of  the  case. 

The  taxpayer  is  notified  by  the  Committee  of  its  recom- 
mendation and  the  case  and  related  papers  are  thereupon  re- 
turned to  the  Income  Tax  Unit  for  such   further  action  as 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      179 

may  be  necessary  in  accordance  with  the  decision  of  the  Com- 
mittee of  which  action  the  taxpayer  is  duly  notified  by  the 
Income  Tax  Unit. 

Tax  Simplification  Board. — The  new  law  creates  what  is 
known  as  the  Tax  Simplification  Board.^ 

Law.  Section  1327.  (a)  That  there  is  hereby  established  in  the 
Department  of  the  Treasury  a  board  to  be  known  as  the  "Tax  Simplifi- 
cation Board"  (hereinafter  in  this  section  called  the  "Board"),  to  be 
composed  as  follows: 

(i)  Three  members  who  shall  represent  the  public,  to  be  appointed 
by  the  President;  and 

(2)  Three  members  who  shall  represent  the  Bureau  of  Internal 
Revenue  and  shall  be  officers  or  employees  of  the  United  States  serving 
in  such  Bureau,  to  be  appointed  by  the  Secretary. 

(b)  Any  vacancy  in  the  Board  shall  be  filled  in  the  same  manner 
as  the  original  appointment.  The  members  representing  the  public 
shall  serve  without  compensation  except  reimbursement  for  traveling, 
subsistence,  and  other  necessary  expenses  incurred  in  the  performance 
of  the  duties  vested  in  them  by  this  section.  The  members  represent- 
ing the  Bureau  of  Internal  Revenue  shall  serve  without  compensation 
in  addition  to  that  received  for  their  service  in  such  Bureau. 

(c)  The  Secretary  shall  furnish  the  Board  with  such  clerical  as- 
sistance, quarters  and  stationery,  furniture,  office  equipment,  and  other 
supplies  as  may  be  necessary  for  the  performance  of  the  duties  vested 
in  them  by  this  section. 

(d)  It  shall  be  the  duty  of  the  Board  to  investigate  the  procedure 
of  and  the  forms  used  by  the  Bureau  in  the  administration  of  the 
internal  revenue  laws,  and  to  make  recommendations  in  respect  to 
the  simplification  thereof.  The  Board  shall  make  a  report  to  the  Con- 
gress on  or  before  the  first  Monday  of  December  in  each  year. 

(e)  The  expenditures  of  the  Board  shall  be  paid  upon  vouchers 
approved  by  the  Board  and  signed  by  the  chairman  thereof.     For  the 


'The  membership  of  the  Board  is  as  follows: 
Appointed  by  the  President  to  represent  the  public: 

Mr.  James  H.  Beal,  of  Reed,  Smith,  Shaw  &  Beal,  Pittsburgh,  Pa., 

Mr.  Joseph  E.  Sterrett,  of  Price,  Waterhouse  &  Co.,  New  York,  and 

Mr.  William  T.  Abbott,  Vice-President,  Central  Trust  Company   of 

Chicago,  Illinois. 

Appointed  by  the  Secretary  of  the  Treasury  to  represent  the  Bureau  of 

Internal  Revenue : 

Mr.  Charles  P.  Smith,  Assistant  Commissioner  of  Internal  Revenue, 
Mr.  Jesse  D.  Burks,  Special  Assistant  to  Deputy  Commissioner  of 

Internal  Revenue,  and 
Mr.    George    W.    Skilton,    Assistant    to    Supervisor    of    Collectors' 
Offices. 


l8o  APPLICATION   AND    ADMINISTRATION 

expenditures  of  the  Board  for  the  fiscal  year  ending  June  30,  1922, 
there  is  authorized  to  be  appropriated,  out  of  any  money  in  the  Treasury 
not  otherwise  appropriated,  the  sum  of  $10,000. 

(f)  The  Board  shall  cease  to  exist  on  December  31,  1924. 

This  Board  is  in  a  position  to  render  a  distinct  service 
to  the  pubHc,  especially  with  reference  to  the  simplification  of 
the  procedure  before  the  Bureau. 

Regulations    governing    practice    before    the    Treasury. — 

•  The  Commissioner  has  issued  regulations  (Circular  No.  230, 

Form  23)  governing  the  recognition  of  attorneys  and  agents 

and  other  persons  representing  taxpayers  before  the  Treasury. 

The  following  extracts  from  Circular  230  are  of  interest : 

Applicants  for  enrollment  pursuant  to  these  regulations 
shall  submit  to  the  Secretary  of  the  Treasury  an  application,  prop- 
erly executed,  on  the  form  attached  hereto  (Exhibit  A).  Appli- 
cations in  any  other  form  will  not  be  considered.  Persons  members 
of  the  bar  of  a  court  of  record  will  apply  for  enrollment  as  "attor- 
ney"; all  others  will  apply  for  enrollment  as  "agent."  Members  of  a 
firm  may  apply  for  enrollment  either  individually  or  collectively.  In 
the  latter  case  application  should  be  made  in  the  firm  name,  giving 
the  name  of  each  member  and  the  required  information  as  to  each, 
and  the  application  should  be  signed  in  the  firm  name  and  by  each 
member  of  the  firm  The  Secretary  of  the  Treasury  may  in  any  case 
require  other  and  further  evidence  of  qualification.  Applicants  will 
be  notified  of  the  approval  or  rejection  of  their  application. 

The  committee  on  enrollment  and  disbarment  shall  maintain  in 
the  office  of  the  chief  clerk,  Treasury  Department,  a  roll  of  attorneys 
and  agents  entitled  to  practice  before  the  Treasury  Department.  It 
shall  likewise  maintain  lists  of  those  whose  applications  for  enrollment 
have  been  rejected  and  those  who  have  been  suspended  or  disbarred. 
The  chief  clerk  shall  furnish  copies  of  the  said  roll  and  lists,  with  such 
additions  thereto  or  subtractions  therefrom  as  may  be  made  from  time 
to  time,  to  the  bureaus,  ofiices,  and  divisions  of  the  Treasury  De- 
partment. 

All  bureaus,  offices,  and  divisions  of  the  Treasury  Department  are 
hereby  prohibited  from  recognizing  or  dealing  with  anyone  appearing 
as  attorney  or  agent  unless  the  name  of  such  attorney  or  agent  ap- 
pears upon  the  list  of  those  entitled  to  'practice  before  the  Treasury 
Department.  Nothing  herein  contained  shall  preclude  individual 
parties  or  members  of  firms  or  officers  of  corporations  from  appearing, 
upon  proper  identification,  as  representatives  of  their  own  interests 
or  of  their  respective  firms  or  corporations  in  any  matter  before  tiie 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      i8l 

department  in  which  such  person,  firm,  or  corporation  is  concerned  as 
a  principal ;  but  attorneys,  counsel,  or  solicitors  or  other  agents  for 
such  persons,  firms,  or  corporations  must  be  enrolled. 

It  shall  be  the  duty  of  the  bureaus,  offices  and  divisions  of  the 
Treasury  Department  to  ascertain  in  each  case  whether  the  name 
of  one  appearing  before  them  in  a  representative  capacity  appears  on 
the  roll  of  those  entitled  to  practice.  In  any  case  where  such  enroll- 
ment does  not  appear,  the  requirement  therefor  shall  be  brought  to  the 
attention  of  such  representative.  The  head  of  such  bureau,  office,  or 
division  may,  in  his  discretion,  temporarily  recognize  such  represen- 
tative pending  application  for  enrollment,  provided  his  name  does  not 
appear  on  the  list  of  those  whose  applications  for  enrollment  have 
been  rejected  or  on  the  list  of  those  who  have  been  suspended  or 
disbarred. 

On  July  25,  1921,  the  Coniniissioner  issued  the  following 
statement  with  reference  to  these  regulations : 

There  is  in  operation  now  a  new  system  of  enrollment.  Ap- 
plicants are  enrolled  and  certified  by  a  committee,  which  con- 
stantly is  functioning  for  that  purpose.  They  must  submit  a 
sworn  statement  that  they  are  familiar  with  the  laws  and  regulations 
of  the  Treasury  Department,  and  are  qualified  to  act  as  the  represen- 
tative of  others  and  "render  them  valuable  service."  Reply  must  be 
given  to  the  question  of  whether  or  not  they  have  ever  been  rejected, 
suspended  or  disbarred  from  appearing  as  an  attorney  or  agent,  or 
in  any  other  representative  capacity,  before  any  branch  of  the  Federal 
or  any  State  Government,  or  municipality  or  court  thereof. 

Scores  of  applications  are  now  being  held  for  investigation,  which 
is  conducted  by  field  agents  of  the  Bureau  of  Internal  Revenue. 

Applicants  are  required  also  to  state  whether  they  have  read  and 
noted  paragraph  5  of  Treasury  Department  Circular  230  relating  to  the 
recognition  of  attorneys,  agents  and  other  persons  representing  claim- 
ants before  the  Treasury  Department,  and  especially  the  following 
significant  paragraph: 

"The  Secretary  of  the  Treasury  regards  as  unethical  any  sug- 
gestion of  acquaintance  with  officials  or  prior  connection  with  tlie 
Treasury   Department." 

Supplemental  regulations  provide  that  "no  attorney  or  agent  shall 
be  permitted  to  appear  in  a  representative  capacity  as  attorney,  or 
agent  before  the  Treasury  Department,  or  any  of  the  bureaus,  depart- 
ments, divisions,  subdivisions,  units  or  other  agencies  thereof,  in  re- 
gard to  any  claim,  application  or  re-audit,  refund,  al)atement,  rcduc-* 
tion  in  tax  assessed,  or  in  any  other  matter  to  which  he  gave  actual 
personal  consideration,  or  as  to  the  facts  of  which  he  had  actual  per- 
sonal knowledge  while  in  the  service  of  the  Treasury  Department." 


l82  APPLICATION   AND   ADMINISTRATION 

On  and  after  August  i,  1921,  power  of  attorney  from  the  princi- 
pal in  each  case  will  be  required  of  all  attorneys,  agents  or  other 
person  representing  claimants  before  the  Bureau  of  Internal  Revenue. 
Such  power  of  attorney  must  be  filed  before  such  agent,  attorney  or 
other  person  is  recognized  by  the  Bureau. 

These  regulations  are  intended  to  raise  the  standard  of 
the  practice  before  the  Treasury.  Measures  of  this  kind  should 
be  encouraged. 

Unnecessary  examinations. — The  following  is  a  new  fea- 
ture of  the  192 1  law: 

Law.  Section  1309.  That  no  taxpayer  shall  be  subjected  to  un- 
necessary examinations  or  investigations,  and  only  one  inspection  of  a 
taxpayer's  books  of  account  shall  be  made  for  each  taxable  year  unless 
the  taxpayer  requests  otherwise  or  unless  the  Commissioner,  after 
investigation,  notifies  the  taxpayer  in  writing  that  an  additional  in- 
spection is  necessary. 

^Vhether  or  not  taxpayers  secure  relief  under  the  fore- 
going section  depends  entirely  on  the  action  of  the  Commis- 
sioner. In  his  sole  discretion  as  many  examinations  may  be 
made  hereafter  as  have  been  made  in  the  past. 

Retroactive  regulations. — The  following  section  per- 
mits the  Commissioner  to  apply  new  regulations  without  retro- 
active effect.  The  Commissioners  have  assumed  that  changes 
in  regulations  automatically  became  retroactive  to  the  effective 
dates  of  the  laws  to  wdiich  the  regulations  were  applicable. 

Law.  Section  13 14.  That  in  case  a  regulation  or  Treasury  de- 
cision relating  to  the  internal-revenue  laws  made  by  the  Commissioner 
or  the  Secretary,  or  by  the  Commissioner  with  the  approval  of  the 
Secretary,  is  reversed  by  a  subsequent  regulation  or  Treasury  decision, 
and  such  reversal  is  not  immediately  occasioned  or  required  by  a  de- 
cision of  a  court  of  competent  jurisdiction,  such  subsequent  regulation 
or  Treasury  decision  may,  in  the  discretion  of  the  Commissioner,  with 
the  approval  of  the  Secretary,  be  applied  without  retroactive  effect. 

If  the  Treasury  should  issue  regulations  interpreting  a 
section  of  the  law*  and  later  should  change  the  interpretation 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      183 

by  subsequent  regulations,  the  author  is  of  the  opinion  that, 
notwithstanding  the  foregoing  section,  a  taxpayer  overpaying 
a  tax  under  the  first  interpretation  can  force  a  retroactive 
apphcation  of  the  latest  regulation.  If  the  Commissioner 
objects,  it  would  be  necessary  to  institute  suit.  It  should  be 
noted  that  the  language  of  the  foregoing  section  is  not  manda- 
tory— "subsequent  regulations  may,  in  the  discretion  of  the 
Commissioner,  with  the  approval  of  the  Secretary,  be  applied 
without  retroactive  effect." 

Organization  of  Bureau. — Those  who  have  dealings  with 
the  Bureau  will  be  interested  in  the  organization  of  the  Income 
Tax  Unit,  as  set  forth  in  the  chart  reproduced  on  page  184. 
Changes  are  being  made  from  time  to  time,  but  the  chart  is 
recent  enough  to  be  of  interest. ^° 

The  Committee  on  Appeals  and  Review  is  entirely  inde- 
pendent of  the  Income  Tax  Unit  and  is  responsible  only  to 
the  Commissioner. 

Criticism  of  overcentralization. — Criticism  may  be  urged 
against  the  general  organization  of  the  Bureau  of  Internal 
Revenue  on  the  ground  of  overcentralization.  At  present 
only  the  most  routine  matters  can  be  handled  in  the  offices 
of  the  local  collectors,  all  others  being  carried  to  Washington 
for  consideration.  Uniformity  of  procedure  is,  of  course,  im- 
portant, but  to  secure  it  the  present  organization  sacrifices  the 
convenience  of  the  taxpayer  to  an  unjustifiable  extent.  More- 
over, with  the  increased  volume  of  the  work  of  the  Bureau,  due 
to  the  wider  application  of  the  law  since  1917,  it  is  important 
that  decentralization  in  administration  be  introduced  if  intol- 
erable congestion  and  delay  are  to  be  avoided. 

At  the  present  time  every  appeal  must  be  carried  to  Wash- 
ington, even  though  a  taxpayer  lives  on  the  Pacific  Coast. 
Some  method  should  be  devised  whereby  local  hearings  could 


'The  chart  here  was  approved  Oct.  22,  1921. 


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184 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      185 

be  arranged."  This  is  of  especial  importance  in  the  case  of 
individual  returns.  Of  course  no  effort  should  be  made  to  en- 
courage unfounded  claims,  but  on  the  other  hand  nothing 
should  be  left  undone  to  give  an  impartial  and  patient  hearing 
to  all  just  claims,  and  the  way  of  the  claimant  should  be  made 
easy  rather  than  hard. 

The  degree  of  decentralization  which  can  be  adopted  de- 
pends upon  the  quality  and  number  of  the  administrators  ob- 
tainable for  the  local  work.  Large  discretion  in  dealing  with 
important  assessments  cannot  be  entrusted  to  poorly  trained 
or  ignorant  assessors.  At  the  present  time  the  rewards  offered 
are  not  sufficient  to  attract  and  retain  in  the  service  men  of  the 
quality  needed.  Some  method  of  making  the  career  of  the 
government  officer  attractive  must  be  devised  before  the  in- 
come tax  administration  can  be  put  upon  an  entirely  satisfac- 
tory basis. 

The  following  opinion  is  an  argument  against  decentraliza- 
tion : 

I  personally  believe  the  entire  review  and  appeal  should  be 
centered  at  Washington.  Large  taxpayers,  except  for  those  who 
might  desire  improperly  to  influence  local  collectors,  should  prefer 
this  method  since,  in  the  event  of  an  unfavorable  decision  before  the 
local  officials,  an  appeal  would  unquestionably  be  taken  to  Washing- 
ton. In  view  of  the  intricacy  of  income  tax  questions,  local,  non- 
expert boards  are  unsuited  for  the  work.  Even  in  Wisconsin 
the  local  boards  of  review  have  no  jurisdiction  over  corpora- 
tions.^- 

Criticism  of  the  organization  and  procedure  of  the  Income 
Tax  Unit. — \'ery  little,  if  any,  fault,  can  be  found  with  the 
general  organization  of  the  Income  Tax  Unit.  The  various 
divisions,  subdivisions  and  sections  have  been  organized  along 
natural  lines.  The  Bureau  should  be  commended  for  this  ex- 
cellent piece  of  work. 


"Such  opportunity  was  given  by  the  act  of  1894,  which  in  this  matter 
took  particular  pains  to  make  the  remedy  as  inexpensive  to  the  taxpayer 
as  possible   (Vol.  25,  Congressional  Record,  6828-6830). 

'"  A.  E.  James,  Bulletin  of  the  National  Tax  dissociation,  November, 
1920. 


l86  APPLICATION   AND   ADMINISTRATION 

The  author  knows  of  no  changes  which  should  be  made  in 
this  general  plan,  but  it  may  be  necessary  to  make  a  few  changes 
to  bring  about  a  simplification  of  the  procedure. 

The  Income  Tax  Unit,  like  most  of  the  government  depart- 
ments, is  bound  hard  and  fast  by  "red  tape."  The  chief  fault 
of  the  Unit  is  that  there  are  too  many  so-called  checks  and  re- 
views. When  one  of  the  checkers  or  reviewers  makes  a  de- 
cision he  in  turn  is  checked  or  reviewed — there  are  so  many 
checks  and  they  are  so  numerous  and  involved  that  the  author 
is  not  able  to  state  the  number.  These  numerous  checks  not 
only  add  to  the  cost  of  collection,  but  they  cause  confusion,  dis- 
please taxpayers,  and  destroy  the  initiative  of  the  employees. 
Not  long  ago,  it  is  understood,  one  of  the  heads  of  the  sections 
remarked  that  he  was  more  interested  in  having  proper  checks 
to  prevent   fraud  than  he  was  in  production. 

There  can  be  no  question  about  the  vital  necessity  of  enough 
supervision  to  detect  fraud  on  the  part  of  taxpayers  and  col- 
lusion of  one  kind  or  another.  It  would  be  highly  desirable 
for  the  Bureau  to  lessen  the  leaks  regarding  proposed  assess- 
ments and  other  information  which  so  frequently  appear  to  be 
in  the  possession  of  so-called  tax  experts.  The  connections  of 
each  ex-employee  who  practices  before  the  Department  require 
careful  inspection. 

The  Bureau,  no  doubt,  has  thousands  of  claims  which  have 
been  pending  for  over  a  year  on  which  no  definite  action  has 
been  taken — the  Unit  is  still  auditing  191 7  returns. 

The  author  makes  the  following  suggestion  which  he  be- 
lieves will  simplify  the  procedure,  speed  up  the  Unit  and  re- 
duce the  cost  of  collection. 

Up  to  the  time  when  the  A-2  letter  is  issued,  wdiich  is  based 
either  upon  an  office  audit  or  field  examination,  no  change 
should  be  made  in  the  procedure.  Precaution  should,  how^ever, 
be  taken  to  see  that  the  conferees  do  not  actively  participate 
in  the  preparation  of  the  A-2  letter,  i.e.,  they  should  not  make 
decisions  on  a  point  in  a  case  which  should  disqualify  them 
when  the  taxpayer  presents  his  case. 


ADMINISTRATION,   ASSESSMENT   AND   PAYMENT      187 

After  an  A-2  letter  has  been  issued,  if  the  taxpayer  makes 
a  protest  against  the  proposed  additional  assessment,  the  case 
should  be  referred  to  the  conferees. 

All  formal  conferences  should  be  attended  by  three  repre- 
sentatives of  the  Bureau :  a  lawyer,  from  the  Solicitor's  office, 
an  accountant,  who  should  be  attached  to  that  particular  sub- 
division or  section,  and  an  auditor.  The  lawyer  should  pass 
upon  the  legal  points  of  the  case.  The  accountant  should 
handle  all  the  accounting  problems  and  dispose  of  them.  These 
two  men  should  co-operate,  and  many  points  will  have  to  be 
passed  upon  by  both.  The  auditor,  in  charge  of  the  audit 
of  the  case,  merely  attends  the  conference  so  that  he  may  be 
in  a  better  position  to  carry  out  the  decisions  of  the  two  con- 
ferees. 

The  regulation  requiring  the  filing  of  a  brief  (in  duplicate 
and  supported  by  an  affidavit  of  the  taxpayer)  at  least  five 
days  before  the  date  for  the  conference  is  a  good  rule  and 
should  not  be  changed.  When  a  taxpayer  does  not  request 
a  formal  conference,  a  brief  in  duplicate  and  in  affidavit  form 
should  be  filed  before  the  case  is  considered  by  the  conferees. 
Where  there  are  no  formal  conferences,  the  three  representa- 
tives should  meet  and  consider  the  case  as  though  a  formal 
conference  were  held. 

After  a  case  has  been  heard  and  tlie  conferees  are  convinced 
that  all  the  facts  have  been  developed,  a  decision  should  be 
announced  on  all  the  points  involved.  This  decision  should 
not,  however,  be  announced  in  conference.  A  letter  should  be 
sent  the  taxpayer  notifying  him  of  the  results.  This  letter 
would  furnish  the  Bureau  auditor  with  instructions  on  which 
to  close  the  case  finally. 

The  procedure  of  these  conferees  should  correspond  with 
the  procedure  of  a  lower  court.  The  chiefs  of  the  sections 
should  have  no  control  whatever  over  their  decisions.  The 
chief  should,  however,  control  the  assignment  of  cases  for  de- 
cision. It  might  be  well  for  each  subdivision  or  section  to 
have  a  committee  of  conferees  to  which  cases  ready  for  atten- 


i88  APPLICATION   AND   ADMINISTRATION 

lion  should  be  assigned.  A  head  ccniferee  should  take  care  of 
the  assignments.  It  might  even  be  well  to  make  the  conferees 
an  independent  organization. 

Either  the  government  or  the  taxpayer  could  appeal  from 
the  decision  of  the  conferees.  This  appeal  should  be  made  to 
the  Committee  on  Appeals  and  Review. 

The  appeal  on  the  part  of  the  government  would  be  made  by 
the  Chief  of  the  subdivision  or  section  if  he  were  not  satis- 
fied with  the  ruling.  He  should,  of  course,  in  every  case  re- 
view the  decision  of  the  conferees.  He  should  also  consult 
freely  with  the  auditor.  After  the  decision  has  been  announced 
no  appeal  should  be  permitted  by  either  party  unless  notice 
thereof  is  given  within  say  thirty  days  after  the  decision  was 
announced. 

Claims  should  be  handled  in  the  same  manner.  The  author 
is  of  the  opinion  that  all  special  subdivisions,  sections,  and  re- 
view boards  handling  claims  should  be  abolished.-  Claims 
should  be  assigned  to  those  general  subdivisions  or  sections  to 
wdiich  they  naturally  belong. 

Under  present  procedure  many  of  the  conferences  and 
decisions  of  conferees  are  farces.  Review  bodies  are  per- 
mitted to  review  decisions,  and  to  reverse  them  without  notify- 
ing the  taxpayer.  The  taxpayer  is  not  notified  of  the  appeal 
within  the  Bureau,  hence  he  is  not  allowed  to  appear  to  present 
his  case.  The  reviewers  do  not  attend  conferences,  hence 
do  not  hear  the  oral  arguments.  This  is  closely  akin  to  "Star 
Chamber"  proceedings. 

Administrative  interpretation. — Pending  the  construction 
of  the  statutes  by  the  courts  and  subject,  of  course,  to  such 
construction,  the  Treasury  is  called  upon  to  supply  an  official 
interpretation  of  the  law  for  the  guidance  of  taxpayers. ^^  Until 
the  statutes  are  completely  adjudicated,  disagreements  may 
always  be  expected  between  taxpayers  and  the  Treasury  re- 

'^  For  description  of  official  publications  see  page  25. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      189 

garding  the  meaning  of  the  law ;  for,  as  a  matter  of  policy, 
the  Treasury  interprets  the  law  in  a  strict  and  narrow  fashion. 
There  are  large  sums  continually  involved  in  disputes  turning 
upon  close  constructions  of  the  law  and  taxpayers  cannot  as- 
sume that  their  interests  will  be  adequately  protected  by  a 
blind  conformity  to  the  Treasury  rulings.  Indeed  the  system 
rests  upon  the  assumption  that  they  will  not  follow  the  rulings 
blindly,  but  will  rather  contest  doubtful  points  which  operate  to 
their  disadvantage.  This  throws  a  heavy  burden  upon  the 
taxpayer — one  wdiich  in  some  cases  is  essentially  unjust.  Es- 
pecially in  the  case  of  minor  points  which  involve  relatively 
small  sums,  the  Treasury  should  make  a  reasonably  liberal  in- 
terpretation of  the  law  at  the  very  beginning,  because  a  tax- 
payer w^ill  not  contest  a  trifling  matter,  but  will,  nevertheless, 
smart  bitterly  if  he  feels  that  the  Treasury  has  imposed  upon 
him.  Common  sense  in  the  interpretation  of  doubtful  points 
is  absolutely  essential  to  successful  administration  of  the  law. 

In  recent  regulations  there  has  been  evident  a  very  com- 
mendable effort  to  make  the  interpretation  as  general  and 
illuminating  as  possible.  Regulations  45  and  62  are  superior 
to  their  predecessors.  Regulations  33  and  Regulations  41.  In- 
stead of  restricting  itself  to  the  treatment  of  a  very  narrow, 
particular  instance,  the  Treasury  has  in  most  cases  essayed  a 
comprehensive  treatment  of  the  problem  of  procedure  in- 
volved and  has  not  hesitated  to  enunciate  general  principles 
which  are  to  serve  as  official  guides  to  action  by  taxpayers. 

It  must  always  be  remembered,  however,  that  the  Supreme 
Court  of  the  United  States  is  the  "last  word"  on  income  tax 
questions — not  the  Treasury  through  its  regulations  and  deci- 
sions, nor,  in  fact,  Congress.  Many  acts  of  Congress  deal- 
ing with  taxation  have  been  held  to  be  unconstitutional  and 
many  regulations  of  the  Treasury  have  been  overruled.  In 
this  chapter  the  author  covers  the  procedure  pcnnitted  by  the 
Treasury.  In  the  following  chapter  the  taxpayer's  legal  rights 
are  discussed. 


190 


APPLICATION   AND   ADMINISTRATION 


The  following  statements,  made  in  two  recent  cases,  are  of 
interest  in  a  consideration  of  the  regulations  of  the  Treasury:      ■ 

Decisions.  The  question  has  been  decided  both  ways  in  the  In- 
ternal Revenue  Department  [Montgomery's  Income  Tax  Procedure 
(Ed.  1918)  pp.  231,  232]  ;  and  hence  the  effect  usually  given  to  an 
established  practice  of  an  executive  department  charged  with  the 
execution  of  a  statute  has  no  present  relevancy.  {United  States  v. 
Coulby,  258  Fed.  27;  169  C.  C.  A.  163.) 

A  practical  construction  by  public  officers  whose  duty  it  is 
to  enforce  a  statute  is  conceded  to  be  entitled  to  great  influence, 
provided  the  statute  presents  an  ambiguity  which  is  real  and  not 
captious. 

Where  a  statute  that  has  been  construed  by  the  courts  has  been 
re-enacted  in  the  same  or  substantially  the  same  terms,  the  legisla- 
ture is  presumed  to  have  been  familiar  with  its  construction,  and  to 
have  adopted  it  as  a  part  of  the  law,  unless  a  different  intention 
is  indicated ;  and  the  same  principle  is  applied  to  statutes  and  parts 
of  statutes  which  have  been  re-enacted  after  they  have  been  con- 
strued by  the  legislative  or  executive  departments  of  the  government. 
{Edwards  v.   Wabash  Raihvay  Co.,  264  Fed.  610.) 

This  is  exemplified  in  the  ruling  of  the  Treasury,  regarding 
the  allowable  deduction  for  gifts  in  Regulations  62,  article 
251,  as  well  as  in  a  letter  to  attorneys  dated  August  14,  1919. 
The  basis  was  stated  to  be  (subject  to  the  15  per  cent  lim- 
itation) the  "fair  market  value  of  the  property  at  the  time 
given"  in  cases  of  gifts  other  than  money.  On  the  strength 
of  this  ruling  donations  were  solicited  by  universities  and  elee- 
mosynary institutions  which  issued  tabulations  showing  the 
saving  in  tax  resulting  from  donations  of  securities  as  con- 
trasted with  donations  of  cash. 

In  T.  D.  2998,  issued  in  1920,  the  Treasury  changed  its 
position  on  this  point,  holding  that  the  basis  must  be  "cost         ! 
....  or  its  fair  market  value  at  March  i,  19 13." 

Notwithstanding  the  official  regulation,  made  in  good 
faith  the  basis  of  action,  those  who  made  the  donations  of 
securities  which  cost  less  than  their  value  at  time  of  gift  will 
no  doubt  be  required  to  pay  additional  taxes. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      191 
Policy  of  the  Bureau  of  Internal  Revenue  with 

REGARD    to    REQUESTS    FOR    RULINGS    AND    ADVICE    UPON    AB- 
STRACT propositions. 

Ruling.  Requests  are  being  received  daily  for  rulings  and  ad- 
vice upon  abstract  cases  or  prospective  transactions  involving  que's- 
tions  of  income  tax  and  profits  liability.  These  requests  are  so  numer- 
ous and  the  insistence  on  prompt  action  so  great  that  it  seems  ad- 
visable at  this  time  definitely  to  outline  the  Bureau's  policy  which 
will  govern  the  consideration  of  these  requests. 

The  Revenue  Acts  of  1918  and  192 1  depart  widely  at  many  points 
from  prior  law  or  practice,  and  have  given  rise  to  new  questions  of 
such  importance,  complexity,  and  number  that  the  resources  of  the 
Bureau  are  no  more  than  adequate  to  advise  taxpayers  promptly  of 
their  present  liabilities  arising  out  of  past  transactions.  It  is  im- 
possible to  answer  every  question  which  the  invention  or  ingenuity 
of  the  inquirer  may  devise  without  neglecting  the  fundamental  duty 
of  determining  tax  liability  upon  the  basis  of  actual  happenings. 
Under  these  circumstances,  the  administrative  necessity  is  obvious 
of  giving  precedence  over  abstract  or  prospective  cases  to  actual 
cases  in  which  the  taxpayer  desires  to  know  what  are  his  immediate 
liabilities  under  the  law. 

It  will  be  the  policy  of  the  Bureau  not  to  answer  any  inquiry  ex- 
cept under  the  following  circumstances : 

(a)  The  transaction  must  be  completed  and  not  merely  proposed 
or  planned. 

(b)  The  complete  facts  relating  to  the  transaction,  together  with 
abstracts  from  contracts,  or  other  documents,  necessary  to  present 
the  complete  facts,  must  be  given. 

(c)  The  names  of  all  the  real  parties  interested  (not  "dummies" 
used  in  the  transaction)  must  be  stated,  regardless  of  who  presents 
the  question,  whether  attorney,  accountant,  tax  service,  or  other  rep- 
resentative.    (I-2-26;  Mini.  2880.) 

Administrative  efficiency — evasion. — There  is  no  full  and 
trustworthy  information  concerning  the  completeness  of  the 
income  tax  assessment.  It  is  a  tax  which  can  be  evaded,  at 
least  for  a  time,  by  those  who  are  willing  to  perjure  them- 
selves, but  in  spite  of  this  there  is  reason  to  believe  that  upon 
the  whole  the  law  is  well  observed. 

The  Annalist,  of  December  13,  1920,  contained  an  article 
purporting  to  show  that  approximately  as  many  persons 
liable  to  the  tax  are  evading  it  as  are  paying  it.     The  data 


192 


APPLICATION   AND   ADMINISTRATION 


supporting  tliis  cuiitcntion,  although  very  interesting,  are  far 
from  definite  and  conclusive.  It  was  shown  that  while  in  19 18 
there  were  4,409,588  personal  returns  filed,  there  were  on 
December  31,  1919,  no  less  than  7,523,664  motor  owners  in 
the  country.  It  was  shown  that,  whereas  in  the  District  of  Col- 
umbia there  were  two  and  one-half  returns  for  each  automobile 
and  in  New  York  one  return  for  each  car,  in  South  Carolina 
there  were  five  automobiles  to  each  income  tax  return." 

Recently  the  government  has  prosecuted  several  taxpayers 
for  making  false  returns.  Out  of  millions  of  returns  there 
are  sure  to  be  some  which  are  fraudulent.  The  Treasury 
should  be  unremitting  in  its  efforts  to  punish  the  offenders. 
All  reputable  accountants  and  lawyers  should  lend  their  aid. 
If  it  be  found  that  taxpayers  have  been  advised  how  they  can 
evade  the  law,  the  advisors  should  be  indicted  and  punished  as 
conspirators. 

There  are,  of  course,  thousands  of  cases  in  which  there  have 
been  dififerences  of  opinion  as  to  what  is  and  what  is  not  tax- 
able and  as  to  what  is  and  what  is  not  deductible.  The 
Treasury  reverses  its  own  decisions  so  often  that  procedure 
which  is  allowable  one  day  results  in  technical  "evasion"  the 
next.  Moreover,  from  a  rather  extensive  inquiry,  the  author 
has  come  to  the  conclusion  that  in  more  than  half  the  cases 
where  additional  sums  were  collected  by  assessments  based 
on  examinations  the  taxpayers  made  no  mistakes  whatever 
in  their  returns,  the  assessments  being  changed  by  incompetent 
revenue  agents.  The  additional  taxes,  which  would  be  classi- 
fied as  evasions,  are  paid  in  many  cases  without  protest,  solely 
because  of  the  expense  and  annoyance  of  bringing  suit. 


"A  very  careful  stud\'  of  income  has  recently  been  made  by  the  staff 
of  the  National  Bureau  of  Economic  Research  (Income  in  the  United 
States,  Harcourt,  Brace  and  Company,  1921).  According  to  their  best 
estimates  (page  136),  there  were  in  1918  no  less  than  5,290,649  persons  in 
receipt  of  incomes  in  excess  of  $2,000.  In  contrast,  there  were  less  than 
three  milhon  income  tax  returns  filed  in  that  year.  However,  it  is  not  to  be 
concluded  that  the  evasion  is  as  great  as  might  be  inferred  .by  these  bare 
figures.  "Income"  as  used  in  this  study  was  not  "taxable  net  income." 
It  is  significant  also  that  3,065,024  of  the  5,290,649  persons,  who  were  in 
receipt  of  incomes  over  $2,000,  fell  within  the  group  of  $2,000  to  $3,000. 
The  evasions  are  probably  very  largely  those  of  persons  just  within  the 
income  tax  paying  class. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      193 

The  great  difficulties  under  which  the  Treasury  labors  in 
securing  competent  assistants  are,  of  course,  apparent.  Im- 
provement in  the  quaHty  of  the  administration,  however, 
should  be  made  steadily  as  the  law  becomes  more  clearly  un- 
derstood and  more  fully  adjudicated.  There  is  imperative  need 
for  better  administration  if  widespread  evasion  is  to  be  avoided. 
The  heavy  rates,  coupled  with  a  growing  distrust  of  the 
Treasury,  promise  to  give  rise  to  a  lamentable  situation. 

Legal  effect  of  changes  in  form  of  organization  which  are 
made  to  reduce  taxation. — The  owners  of  the  stock  of  a  cor- 
poration dissolved  the  corporation  and  formed  themselves  into 
a  partnership  or  trust,  apparently  in  order  to  avoid  paying 
excess  profits  tax  on  a  contemplated  sale  of  assets.  The 
Treasury  held  that  the  tax  nevertheless  might  be  assessed 
against  the  corporation  on  the  ground  that  the  transaction 
was  an  attempt  to  evade  a  tax. 

Ruling.  A  change  of  form  from  that  of  a  corporation  or  asso- 
ciation to  that  of  a  trust  or  partnership  accompanied  l)y  a  transfer  of 
capital  assets  to  trustees  for  the  henefit  of  shareholders  followed  by 
a  sale  of  such  assets  at  a  price  in  excess  of  the  cost  thereof  to  the 
corporation  or  association,  and  the  distribution  of  proceeds  to  the 
beneficiaries  (shareholders),  such  change  being  made  for  the  main 
purpose  of  avoiding  the  tax  which  would  accrue  to  the  corporation 
had  the  sale  been  made  by  it,  should  be  disregarded  as  a  mere  sham 
to  avoid  assessment  of  tax  against  the  corporation  or  association 
upon  the  profit  derived  from  such  sale,  and  the  corporation  or  asso- 
ciation should  be  required  to  return  as  income  any  profit  derived  as 
though  the  sale  had   been  made  by  it  directly.      ( C.   R.  2,  page  203; 

s.  1385.) 

The  taxpayer  in  the  foregoing  case  appealed  to  the  courts 
and  the  opinion  of  the  Solicitor  was  reversed.^"' 

Decision. ^^  It  is  insisted  in  the  opinion  of  the  solicitor  for  the 
Bureau  of  Internal  Revenue  that  this  change  is  a  sham  and  a  sub- 
terfuge and  is  ineffective.  This  same  opinion  admits  the  right  of  an 
individual  or  corporation  to  regulate  or  change  its  business  with   a 


"  The  position  taken  by  tlie  author  in  this  case  has  been  sustained  in  the 
court  decision  above  quoted.     See  Income  Tax  Procedure,  1921,  page  444. 
"'Weeks  V.  Sibley,  269  Fed.  155. 


194  APPLICATION   AND   ADMINISTRATION 

view  of  reducing  or  avoiding  taxation  in  the  future,  but  in  contra- 
diction with  this  admission  holds  that  the  parties  involved  in  this 
transaction  could  not  do  so.  Supporting  this  view  there  are  several 
cited  cases,  most  of  them  by  state  courts.  The  case  of  Pollard  v. 
Bank,  47  Kans.  406,  28  Pac,  202,  cited  by  the  solicitor,  is  directly  op- 
posed to  his  contention 

Bearing  in  mind  the  rule  of  construction  which  the  Supreme 
Court  announced  in  the  case  of  Gould  v.  Gould,  245  U.  S.  151,  38 
Sup.  Ct.  53,  62  L.  Ed.  211,  and  numerous  other  cases,  to  the  effect 
that  the  provisions  of  the  taxing  statutes  are  not  to  be  extended  by 
implication  beyond  the  clear  import  of  the  language  used,  and  that 
they  are  to  be  construed  most  strongly  against  the  government  and  in 
favor  of  the  taxpayer,  it  is  the  opinion  of  this  court  that  the  right 
to  change  the  status  of  an  organization,  or  to  dissolve  an  organization 
in  any  legal  manner,  is  not  made  ineffectual  because  the  motive  im- 
pelling the  change  is  to  reduce  or  avoid  taxation  in  the  future.  The 
right  so  to  do  is  an  incidental  right  inseparably  connected  with  an 
individual's  right  to  ow-n  and  control  his  property.  It  is  practically 
identical  with  the  sale  by  a  citizen  of  tax-burdened  securities  and  the 
investment  of  the  proceeds  thereof  in  tax-exempt  ones,  for  the  pur- 
pose of  reducing  or  avoiding  taxation. 

It  is  not  unnatural  that  any  thoughtful  business  man  should  take 
such  steps.  It  is  altogether  different  from  tax  dodging,  the  hiding  of 
taxable  property,  or  the  doing  of  some  unlawful  or  illegal  thing  in 
order  to  avoid  taxation 

Assessment 

The  function  of  assessing  the  tax  is  delegated  to  the  Com- 
missioner. 

Law.  Section  1311.  [Section  3176,  Rev.  Stat.]  ....  The 
Commissioner  of  Internal  Revenue  shall  determine  and  assess  all  taxes, 
other  than  stamp  taxes,  as  to  which  returns  or  lists  are  so  made  under 
the  provisions  of  this  section 

The  place  of  the  assessment  as  a  step  in  the  administra- 
tive process  is  made  clear  in  the  following  regulation. 

Regulation.  When  the  returns  are  received  at  the  collectors' 
offices  they  are  examined  and  listed  before  being  forwarded  to  the 
Commissioner.  As  soon  as  practicable  after  the  returns  are  received 
in  the  office  of  the  Commissioner  they  are  carefully  audited  in  con- 
nection with  any  reports  of  examination  that  may  have  been  made 
by  agents  of  the  Department.  If  error  in  the  amount  of  tax  as  stated 
in  the  return  is  detected  the  tax  is  recomputed  and  if  the  amount  is  less 
than  that  shown  in  the  return  the  excess  will  be  credited  or  refunded. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      195 

If  the  amount  is  greater  than  that  shown  in  the  return  the  deficiency 
will  be  handled  as  provided  in  section  250  (d)  of  the  statute  and 
article  1006 (Art.   1012.) 

The  returns,  or  at  least  the  larger  ones,  are  exhaustively 
audited  as  soon  as  practicable  [section  250  (b)],  but  this  is 
usually  long  after  the  payment  of  the  tax.  If  found  incorrect, 
additional  tax  is  demanded.  The  Commissioner  may  examine 
the  books  of  the  taxpayer  for  the  purpose  of  discovering 
whether  or  not  the  net  income  has  been  properly  reported  and 
the  tax  liability  of  the  individual  or  corporation  has  been  sat- 
isfied. The  auditing  and  examination  of  the  books  is  per- 
formed by  local  internal  revenue  agents  who  are  under  the 
direction  of  the  authorities  at  Washington,  not  of  the  local  col- 
lectors. 

Assessment  must  be  made  within  four  years — exception. — 

The  1 92 1  law  made  some  radical  changes  with  reference  to 
the  period  within  which  the  Commissioner  may  summarily 
assess  the  taxpayer  on  any  income  he  has  failed  to  report. 

Law.  Section  250.  ....  (d)  The  amount  of  income,  excess- 
profits,  or  war-profits  taxes  due  under  any  return  made  under  this  Act 
for  the  taxable  year  1921  or  succeeding  taxable  years  shall  be  deter- 
mined and  assessed  by  the  Commissioner  within  four  years  after  the 
return  was  filed,  and  the  amount  of  any  such  taxes  due  under  any  re- 
turn made  under  this  Act  for  prior  taxable  years  or  under  prior  income, 
excess-profits,  or  war-profits  tax  Acts,  or  under  section  38  of  the  Act 
entitled  "An  Act  to  provide  revenue,  equalize  duties,  and  encourage  the 
industries  of  the  United  States,  and  for  other  purposes,"  approved 
August  5,  1909,  shall  be  determined  and  assessed  within  five  years  after 
the  return  was  filed,  unless  both  the  Commissioner  and  the  taxpayer 
consent  in  writing  to  a  later  determination,  assessment,  and  collection 
of  the  tax;  and  no  suit  or  proceeding  for  the  collection  of  any  such 
taxes  due  under  this  Act  or  under  prior  income,  excess-profits,  or  war- 
profits  tax  Acts,  or  of  any  taxes  due  under  section  38  of  such  Act  of 
August  5,  1909,  shall  be  begun,  after  the  expiration  of  five  years  after 
the  date  when  such  return  was  filed,  but  this  shall  not  affect  suits  or 
proceedings  begun  at  the  time  of  the  passage  of  this  Act:  Provided. 
That  in  the  case  of  income  received  during  the  lifetime  of  a  decedent, 
all  taxes  due  thereon  shall  be  determined  and  assessed  by  the  Com- 
missioner within  one  year  after  written  request  therefor  by  the  executor, 
administrator,  or  other  fiduciary  representing  the  estate  of  such  de- 


196  APPLICATION    AND   ADJ^IINISTRATION 

cedent:  Provided  furtlirr,  That  in  the  case  of  a  false  or  fraudulent  return 
with  intent  to  evade  tax,  or  of  a  failure  to  file  a  required  return,  the 
amount  of  tax  due  may  be  determined,  assessed,  and  collected,  and  a  suit 
or  proceeding  for  the  collection  of  such  amount  may  be  begun,  at  any 
time  after  it  becomes  due:  Provided  further,  That  in  cases  coming 
within  the  scope  of  paragraph  (9)  of  subdivision  (a)  of  section  214,  or 
of  paragraph  (8)  of  subdivision  (a)  of  section  234,  or  in  cases  of  final 
settlement  of  losses  and  other  deductions  tentatively  allowed  by  the 
Commissioner  pending  a  determination  of  the  exact  amount  deductible, 
the  amount  of  tax  or  deficiency  in  tax  due  may  be  determined,  assessed, 
and  collected  at  any  time;  but  prior  to  the  assessment  thereof  the  tax- 
payer shall  be  notified  and  given  a  period  of  not  less  than  thirty  days 
in  which  to  file  an  appeal  and  be  heard  as  hereinafter  provided  in  this 
subdivision. 

It  should  be  noted  that  the  tax  must  be  both  determined  and 
assessed  within  the  Hmitation  period. 

Limitation  period  five  years  under  19 18  and  prior 
LAWS. — The  hmitation  period  of  the  1918  law  has  not  been 
disturbed,  but  in  the  case  of  all  acts  prior  to  the  1918  law. 
the  period  has  been  increased  to  five  years.  Before  this  change, 
the  government,  notwithstanding  the  fact  assessment  could  not 
be  made,  could  bring  suit  at  any  time  under  laws  prior  to  the 
1918  act.  The  192 1  law  now  provides  that  neither  assess- 
ment nor  suit  under  1918  and  prior  laws  shall  be  legal  after 
the  five-year  limitation  period  has  expired.^^ 


'"  [Former  Procedure]  Prior  to  the  enactment  of  the  1921  law,  the 
government  under  the  1917  law  fsection  14  (a)]  was  unable  to  make  assess- 
ment and  to  enforce  payment  of  an  additional  tax  by  the  usual  (summary 
statutory)  proceedings  after  three  years  had  elapsed  since  date  at  which  the 
return  was  due.  It  could,  however,  when  it  discovered,  or  alleged  that  it 
had  discovered,  additional  tax  to  be  due,  bring  suit  at  any  time  against  the 
taxpayer  for  the  amount  alleged  to  be  due.  This  was  a  distinct  advantage 
to  a. taxpayer,  because  it  shifted  the  burden  of  proof  from  himself  to  the 
government  and  made  the  case  altogether  different  from  one  in  which  the 
government  was  able  to  send  in  a  bill,  compel  payment  and  put  upon  the 
innocent  ta.xpayer  the  cost  of  initiating  a  suit. 

The  Bureau  claims  (C.  B.  3,  page  302;  Sol.  Op.  79)  that  if  a  "discovery" 
shall  have  been  made  within  three  years  from  the  time  the  return  was  due 
assessment  may  be  made  at  any  time  thereafter.  Such,  however,  could 
hardly  have  been  the  intention  of  the  law.  The  punctuation  conveys  to 
the  author  the  very  clear  meaning  that  assessments  must  be  made  im- 
mediately after  discovery  and  the  additional  tax  must  be  paid  upon  demand 
and  that  the  discovery  and  the  assessment  must  be  made  within  three 
years  from  the  time  when  the  return  was  due.  Any  other  construction 
requires   a   vivid    imagination.     As  the    section    covers   the    imposition   of 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      197 

Limitation  period  four  years  under  1921  law. — Any 
tax  due  under  a  return  filed  for  the  taxable  year  1921,  or  any 
subsequent  year,  must  be  assessed  within  four  years  after  the 
return  was  filed.  If,  however,  any  tax  is  due  under  any 
return  made  under  the  1921  law  for  prior  taxable  years,  the 
assessment  must  be  made  within  five  years  after  the  return 
^'as  filed. 

The  limitation  period  for  taxes  under  the  1921  law  is  not 
die  same  for  assessment  and  suit.  Assessment  must  be  made 
\vithin  four  years  after  the  return  was  filed.  Suit  or  proceed- 
ings must  be  instituted  within  five  years  after  the  return  was 
filed. 

Limitation  period  one  year  in  case  of  estates. — 
Section  250  (d)  provides,  "that  in  case  of  income  received 
during  the  lifetime  of  a  decedent,  all  taxes  due  thereon  shall 
be  determined  and  assessed  by  the  Commissioner  within  one 
year  after  written  request  therefor  by  the  executor,  adminis- 


penalties  it  should  be  construed  in  favor  of  the  taxpayer.  The  United 
States  courts  have  not  specifically  passed  upon  this  question.  In  a  suit 
brought  within  three  years  from  the  time  when  a  return  was  due  (Eliot 
National  Batik  v.  Gill,  218  Fed.  600;  134  C.  C.  A.  358)  the  court  said  that  the 
tax  could  be  assessed  after  three  years  if  the  fact  that  it  was  due  was  dis- 
covered within  the  three  years.  But  the  point  in  question  was  not  before  the 
court,  so  the  statement  is  dictum,  and  need  not  be  considered  a  precedent. 

It  is  well  settled  that  where  a  tax  of  a  fixed  percentage  is  imposed  by 
statute,  or  is  so  definitely  described  in  the  statute  that  its  amount  can  be 
readily  ascertained  or  determined,  no  assessment  need  be  made  in  order  to 
recover  the  tax.  In  the  case  of  United  States  v.  Grand  Rapids,  etc.,  Rail- 
way Company,  239  Fed.  153,  the  United  States  District  Court  held  thai 
the  limitation  in  the  statute  is  a  limitation  upon  the  right  of  collectors  to 
make  assessment  and  to  enforce  payment  by  the  customary  summary  pro- 
ceedings, but  does  not  prevent  suit  for  taxes,  which  will  lie  without  an 
assessment.     (Judgment  affirmed,  256  Fed.  989  |mem.].) 

The  Treasury  has  also  held  the  fcjilowing  with  reference  to  the  three- 
year  limitation  period : 

Ruling,  "i.  The  extension  of  time  granted  by  the  Commissioner  to 
taxpayers  for  filing  their  income  returns  operates  to  shift  the  due  date  for 
filing  their  returns  to  the  expiration  of  the  period  of  extension;  the  three- 
year  limitation  begins  to  run  from  the  due  date  as  thus  shifted. 

"2.  Where  an  excess  amount  of  tax  is  assessed,  the  Commissioner  is 
authorized  by  section  3220,  R.  S.,  as  amended  by  the  Revenue  Act  of  1918 
to  abate  the  excess  amount. 

"3.  Where  the  tax  assessed  is  less  than  the  amount  due  an  assessment 
of  the  additional  amount  due  can  be  made,  where  discovery  was  made  within 
the  three-year  limitation  period."     (C.  B.  4,  page  32=;;  Sol.  Op.  92.) 


198  APPLICATION    AND    ADMINISTRATION 

trator,  or  other  fiduciary  representing'  the  estate  of  such  de- 
cedent." 

A  request  for  determination  must  be  made  by  the  executor. 
Such  an  apphcation  should  be  rendered  unnecessary  by  more 
expeditious  handhng  of  returns.  This  section  does  not  apply 
to  the  income  of  the  decedent's  estate  but  only  to  that  received 
by  the  decedent  during  his  lifetime. 

The  one-year  period  does  not  apply  to  suits.  The  govern- 
ment would  have  to  institute  suit  within  five  years  after  the 
return  was  filed. 

No  LIMITATION   PERIOD  IN  CASE  OF  FALSE  OR  FRAUDULENT 

RETURN. — Where  a  taxpayer  has  filed  a  false  or  fraudulent 
return  with  intent  to  evade  tax,  or  has  failed  to  file  a  required 
return,  an  assessment  may  be  made  or  suit  instituted  at  any 
time.^^ 

Limitation  period  w^here  amortization  is  claimed 
OR  deductions  are  tentatively  ALLOW' ED. — The  following 
part  of  section  250  (d)  is  of  especial  importance  to  taxpayers 
who  have  filed  amortization  claims : 

Law.  Section  250.  ....  (d)  ...  .  That  in  cases  coming 
within  the  scope  of  paragraph  (9)  of  subdivision  (a)  of  section  214, 
or  of  paragraph  (8)  of  subdivision  (a)  of  section  234,  or  in  cases  of 
final  settlement  of  losses  and  other  deductions  tentatively  allowed  by 
the  Commissioner  pending  a  determination  of  the  exact  amount  de- 
ductible, the  amount  of  tax  or  deficiency  in  tax  due  may  be  deter- 
mined, assessed,  and  collected  at  any  time;  but  prior  to  the  assessment 
thereof  the  taxpayer  shall  be  notified  and  given  a  period  of  not  less 
than  thirty  days  in  which  to  file  an  appeal  and  be  heard  as  hereinafter 
provided  in  this  subdivision 

It  would  appear  from  the  foregoing  that  the  Commissioner 
may,  in  a  case  wdiere  amortization  has  been  claimed  or  where 
the  Commissioner  has  tentatively  allowed  a  deduction,  reopen 
the  case  to  make  an  assessment  or  bring  suit  at  any  time.  The 
assessment  or  suit  would  have  to  be  confined  to  amortization 
or  to  the  deduction  tentativelv  allowed.     The  other  limita- 


"  Section  250  (d). 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT      199 

tion  periods  of   section   250   (d)   would  apply  to   the  other 
items  of  the  return. 

There  is  an  apparent  conflict  between  section  250  (d)  and 
section  214  (a-9).  Section  234  (a-8)  has  the  same  language 
as  section  214  (a-9).  One  applies  to  individuals  and  the  other 
to  corporations. 

Law.  Section  214.  (a)  ....  (9)  ....  At  any  time  before 
March  3,  1924,  the  Commissioner  may,  and  at  the  request  of  the  tax- 
payer shall,  reexamine  the  returns,  and  if  he  then  finds  as  a  result  of  an 
appraisal  or  from  other  evidence  that  the  deduction  originally  allowed 
was  incorrect,  the  income,  war-profits,  and  excess-profits  taxes  for  the 
year  or  years  affected  shall  be  redetermined;  and  the  amount  of  tax 
due  upon  such  redetermination,  if  any,  shall  be  paid  upon  notice  and 
demand  by  the  collector,  or  the  amount  of  tax  overpaid,  if  any,  shall 
be  credited  or  refunded  to  the  taxpayer  in  accordance  with  the  pro- 
visions of  section  252;  .... 

The  rule  of  law  is  that  a  specific  section  controls  a  general 
section.  It  might  be  thought  that  each  section  is  specific. 
A  careful  reading  shows,  however,  that  section  214  is  spe- 
cific with  reference  to  the  deduction  for  amortization,  whereas 
section  250  is  specific  with  reference  to  limitation. 

Should  the  courts  hold  that  section  214  governs  section 
250,  the  Commissioner  would  have  to  re-examine  amortization 
claims  before  March  3,  1924,  but  could  make  an  assessment 
or  bring  suit  at  any  time  thereafter. 

Limitation  period  may  be  extended  by  agreement. — 
A  new  provision^"  has  been  added  to  the  192 1  law  which 
makes  it  possible  for  the  Commissioner  and  the  taxpayer  to 
extend  the  limitation  period  with  reference  to  assessment. 
This  provision  will  no  doubt  be  attacked  in  the  courts  if  tax- 
payers should  inadvertently  sign  waivers  in  ignorance  of  their 
legal  rights. 

Taxpayers  should  not  sign  blanket  extensions  or  waivers. 
The  agreements  should  be  carefully  drawn.  A  limitation  date 
should  be  specifically  mentioned. ^° 


'*  Section  250  (d) 


Section  250  (d). 

In  December,  1920,  the  Commissioner  notified  many  taxpayers  that 


200  APPLICATION    AND   ADMINISTRATION 

No    LIMITATION    PERIOD    FOR    EXAMINATION    OF    BOOKS. — • 

There  is  no  limitation  on  the  right  of  the  Commissioner  or 
his  collectors  to  examine  the  books  of  a  taxpayer  beyond  the 
five-year  period,  but  no  tax  can  be  assessed  by  the  government 
unless  fraud  is  alleged. 

Examination  of  returns  and  accounts. — After  the  original 
returns  are  forwarded  to  Washington,  the  returns  are  filed 
and  in  due  course  audited.  An  audit  is  made  of  the  return 
itself  and,  if  necessary,  another  may  be  made  of  the  books 
and  accounts  of  the  taxpayer.  All  of  the  auditing,  whether 
done  in  the  office  or  in  the  field,  is  under  the  direction  of 
the  Commissioner  at  Washington. 

Field  agents,  as  a  general  rule,  discuss  their  proposed  re- 
ports very  freely  with  taxpayers.  When  the  examination  has 
been  made  by  an  agent  under  the  immediate  supervision  of 
the  revenue  agent  in  charge  of  a  particular  district,  the  tax- 
payer is  sent  a  copy  of  the  report  after  it  has  been  reviewed 
by  the  agent  in  charge.  If  an  examination  is  made  by  an  agent 
directly  from  Washington,  a  copy  of  the  report  is  not  fur- 
nished the  taxpayer.  The  A-2  letter"'  is  the  first  official  notice 
to  the  taxpayer  of  the  results  of  the  examination. 

Procedure  when  audit  discloses  additional  taxes, 
DUE. — If  an  examination  of  the  original  returns  or  of  the  ac- 
counts of  the  taxpayer  indicates  that  an  additional  amount  is 
due,  an  assessment  will  be  made,  unless  the  taxpayer  is  able  to 


1 


there  would  not  be  sufficient  time  before  March  i,  1921,  to  audit  all  1917 
returns  and  asked  for  waivers.  When  taxpayers  had  good  reasons  to 
infer  that  the  Bureau  would  rush  through  an  audit  and  assess  additional 
taxes  without  proper  investigation  (as  the  letter  of  the  Commissioner  inti- 
mated would  be  done),  perhaps  it  was  the  part  of  wisdom  to  relinquish 
one's  legal  right  and  yield  to  the  "hold-up."  Those  who  had  no  definite 
knowledge  of  proposed  additional  assessments  should  not  have  signed  the 
waivers. 

There  is  a  serious  question  as  to  the  validity  of  waivers  executed  after 
the  expiration  of  the  three-year  limitation.  The  law  does  not  authorize  the 
Commissioner  to  extend  this  period.  Furthermore,  the  consideration  cited 
in  the  waivers  is  "unreal."  Another  criticism  of  the  waiver  is  vagueness 
of  the  persons  bound  or  the  promisees.  Their  identity  and  authority  are 
not  disclosed. 

"  See  page  201, 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     201 

satisfy  the  Treasury  before  the  audit  is  closed  that  an  error  has 
been  made  by  the  inspector.  The  taxpayer  may  prepare  a  state- 
ment of  all  relevant  facts,  furnish  one  copy  to  the  inspector 
with  a  request  that  it  be  forwarded  to  the  Treasury  and 
send  another  copy,  with  affidavit  attached,  to  the  personal  or 
corporation  audit  department  of  the  income  tax  unit  at  Wash- 
ington. This  does  not  constitute  an  amended  return,  but  is 
merely  a  presentation  of  the  case  of  the  taxpayer  for  con- 
sideration by  the  audit  section,  which  will  also  have  before 
it  the  report  of  the  insp£ctor.  If  the  taxpayer  does  not  feel 
that  his  statement,  unsupported  by  oral  evidence,  is  sufficient, 
he  may  in  the  statement  forwarded  to  Washington  request  a 
hearing  and  an  opportunity  to  submit  additional  evidence  if 
it  should  appear  to  the  audit  section  that  an  adverse  report 
is  likely  to  be  made.  If  this  request  is  filed  the  taxpayer  will 
be  granted  a  hearing  in  person  or  by  attorney  before  any  addi- 
tional tax  is  assessed  against  him.  After  the  hearing  a  decision 
will  be  made  by  the  audit  section  from  which  an  appeal  can 
be  taken,  as  herein  after  explained. 

A-2  LETTER. — If  after  the  Treasury  has  made  an  examina- 
tion of  a  taxpayer's  return  (either  office  or  a  field  audit) 
it  appears  that  an  assessment  is  required,  a  letter,  which 
the  Treasury  has  designated  as  the  "A-2  letter,"  is  sent  notify- 
ing the  taxpayer  that  an  examination  shows  that  he  is  liable 
for  an  additional  amount  of  tax. 

The  new  law  [section  250  (d)]"  requires  that  the  tax- 
payer must  be  notified  by  registered  mail. 

The  A-2  letter  not  only  states  the  amount  of  the  tax,  but 
also  sets  forth  the  reasons  for  it.  The  amount  of  detail  given 
varies,  some  letters  giving  very  full  details  of  adjustments  and 
computations,  others  giving  only  meager  details.  The  letter 
also  notifies  the  taxpayer  that  if  he  does  not,  within  thirty 
days  from  the  date  of  the  letter,  file  an  appeal  and  show  cause 

"  See  page  208. 


202  APPLICATION    AND    ADMINISTRATION 

Of  reason  why  the  tax  should  not  he  paid,  the  collector  of  his 
district  will  notify  him  in  due  course  as  to  the  time  and  man- 
ner of  making  payment.  The  letter  usually  concludes  with 
a  paragraph  similar  to  the  following: 

In  accordance  with  the  Revenue  Act  of  1921,  you  will  be  given 
thirty  days  to  present  any  exceptions  to  the  additional  assessment 
referred  to  in  the  enclosed  letter,  and  to  show  cause  or  reason  why 
the  same  should  not  be  paid.  This  may  be  done  either  by  way  of  a 
sworn  statement  of  facts  and  exceptions  submitted  within  thirty  days 
from  the  mailing  date  of  the  attached  letter,  or  at  a  conference,  which 
may  be  arranged  upon  request,  for  a  date  prior  to  the  expiration  of 
the  30-day  period. 

The  foregoing  notice,  while  it  usually  mentions  a  thirty- 
day  period,  is  not  intended  to  cover  the  thirty-day  period  men- 
tioned in  the  law.  Therefore,  if  the  taxpayer  believes  that 
the  proposed  assessment,  or  any  part  thereof,  is  erroneous, 
he  should  immediately  take  proper  steps  to  protest  against  it. 

Section  250   (d)   of  the  new  law  reads  as  follows: 

Law.  Section  250.  ....  (d)  ....  If  upon  examination  of  a 
return  made  under  the  Revenue  Act  of  1916,  the  Revenue  Act  of  1917, 
the  Revenue  Act  of  1918,  or  this  Act,  a  tax  or  a  deficiency  in  tax  is  dis- 
covered, the  taxpayer  shall  be  notified  thereof  and  given  a  period  of  not 
less  than  thirty  days  after  such  notice  is  sent  by  registered  mail  in 
which  to  file  an  appeal  and  show  cause  or  reason  why  the  tax  or  de- 
ficiency should  not  be  paid.  Opportunity  for  hearing  shall  be  granted 
and  a  final  decision  thereon  shall  be  made  as  quickly  as  practicable. 
Any  tax  or  deficiency  in  tax  then  determined  to  be  due  shall  be  assessed 
and  paid,  together  with  the  penalty  and  interest,  if  any,  applicable  there- 
to, within  ten  days  after  notice  and  demand  by  the  collector  as  herein- 
after provided,  and  in  such  cases  no  claim  in  abatement  of  the  amoimt 
so  assessed  shall  be  entertained:  Provided,  That  in  cases  where  the 
Commissioner  believes  that  the  collection  of  the  amount  due  will  be 
jeopardized  by  such  delay  he  may  make  the  assessment  without  giving 
such  notice  or  awaiting  the  conclusion  of  such  hearing 

The  following  ruling  indicates  the  procedure  which  should 
be  followed  when  a  taxpayer  receives  an  A-2  letter  or  any 
kind  of  a  notice  showing  a  proposed  additional  assessment. 

Regulation.  Section  250  (d)  of  the  Revenue  Act  of  1921  pro- 
vides that  if  upon  examination  of  a  return  made  under  the  Revenue 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     203 

Act  of  1916,  1917,  191S,  or  1921,  an  income  or  excess  profits  tax  or  a 
deficiency  tlierein  (which  deficiency  is  defined  in  section  250  (b) 
as  meaning  the  difference,  to  the  extent  not  covered  by  any  credit 
due  to  the  taxpayer  under  section  252,  between  the  amount  of  the  tax 
already  paid  and  that  which  should  have  been  paid)  is  discovered  the 
taxpayer  shall  be  notified  thereof  and  shall  have  the  right  of  an  ap- 
peal and  a  hearing  before  an  assessment  is  made.  As  soon  as  prac- 
ticable, therefore,  after  a  return  is  filed,  whether  by  the  taxpayer  or  as 
provided  in  section  3176  Revised  Statutes,  as  amended,  it  is  examined, 
and  if  a  tax  or  a  deficiency  in  tax  is  discovered,  the  taxpayer  shall  be 
notified  thereof  by  letter  in  which  he  shall  be  given  a  reasonable  time 
in  which  to  protest  and  file  exceptions  specifying  the  reasons  why 
the  tax  or  deficiency  should  not  be  assessed. 

(a)  If  the  taxpayer  protests  against  the  proposed  assessment  after 
the  first  notification  by  mail  as  above  set  forth,  he  will  present  his 
exceptions  in  writing  to  the  income  tax  unit  in  Washington  or  to  the 
division  thereof  where  the  said  proposed  assessment  is  being  consid- 
ered. Such  exceptions  must  state  fully  the  facts  and  grounds  upon 
which  the  taxpayer  relies.  A  reasonable  additional  time  in  which  to 
file  other  data  in  support  of  the  taxpayer's  contentions  may  be  allowed 
upon  request  showing  cause  for  such  extension.  A  hearing  by  the 
income  tax  unit  shall  be  granted  the  taxpayer  if  requested  by  him;  if 
no  hearing  is  requested  a  decision  will  be  made  by  the  income  tax  unit 
upon  the  written  data  submitted.  Whether  a  hearing  is  had  or  not  a 
decision  shall  be  made  by  the  income  tax  unit  at  the  earliest  practicable 
date  and  the  taxpayer  notified  thereof.  The  notification  of  the  decision 
of  the  income  tax  unit  shall  be  made  by  registered  mail  and  a  period  of 
not  less  than  thirty  days  given  the  taxpayer  in  which  to  file  an  appeal 
to  the  Commisisoner  and  show  catise  or  reason  why  such  tax  or  de- 
ficiency should  not  be  paid.  Full  thirty  days  from  the  mailing  (not 
the  receipt)  of  such  notice  to  file  an  appeal  shall  be  given  the  tax- 
payer. The  appeal  must  be  filed  in  the  office  of  the  Commissioner 
in  Washington  within  thirty-one  days  from  the  mailing  of  the  notice, 
but  if  it  is  mailed  in  time  to  be  received  by  the  Commissioner  within 
such  period  in  the  ordinary  course  of  the  mails  it  will  be  considered 
as  having  been  filed  within  such  period.  No  particular  form  of  ap- 
peal is  required,  but  the  appeal  must  set  forth  specifically  the  excep- 
tions upon  which  it  is  taken.  The  appeal  shall  be  under  oath 
and  must  contain  a  statement  that  it  is  not  taken  for  the  purpose 
of  delay.  Opportunity  for  a  hearing  shall  be  granted  if  requested 
within  a  reasonable  time.  The  taxpayer  in  his  appeal  may  rely  upon 
the  data  previously  submitted,  or  he  may  obtain  a  reasonable  extension 
of  time  if  cause  therefor  is  shown  in  which  to  file  additional  data,  evi- 
dence or  argument.  Such  request  shall  be  under  oath  and  must  state 
specifically  the  reasons  for  additional  time.  When  a  decision  has  been 
made  by  the  proper  officer,  employee  or  employees  of  the  bureau  and 


204 


APrUCATION   AND   ADMINISTRATION 


approved  by  the  Commissioner,  an  assessment,  if  any,  shall  be  made 
forthwith  in  accordance  with  the  terms  of  such  decision. 

(b)  If  the  taxpayer  does  not  protest  within  the  time  fixed  by  the 
first  notification  by  mail,  then  and  in  that  case  the  proposed  assessment 
shall  be  the  decision  of  the  income  tax  unit  and  the  taxpayer  shall 
be  notified  thereof.  This  notification  of  the  decision  of  the  income 
tax  unit  shall  be  made  by  registered  mail  and  a  period  of  not  less 
than  thirty  days  given  the  taxpayer  in  which  to  file  an  appeal  to  the 
Commissioner  and  to  show  cause  or  reason  why  such  tax  or  deficiency 
should  not  be  paid.  The  procedure  on  said  appeal  shall  be  the  same 
as  in  the  case  of  an  appeal  to  the  Commissioner  as  provided  in  (a) 
above. 

In  the  case  of  a  return  which  is  examined  in  the  collector's  office 
where  a  tax  or  deficiency  of  tax  is  discovered  and  notice  of  the  pro- 
posed assessment  is  sent  out  by  the  collector,  the  procedure  shall  be 
the  same  in  said  collector's  office  as  herein  provided  for  in  the  income 
tax  unit.  The  decision  of  the  collector  may  be  appealed  from,  which 
appeal  shall  be  to  the  Commissioner  at  Washington,  and  shall  follow 
the  same  procedure  as  provided  for  in  (a)  or   (b)   above. 

No  assessment  under  section  250  (d)  shall  be  made  without  notifi- 
cation to  the  taxpayer  of  his  right  to  appeal  and  show  cause,  except 
that  in  any  case  where  the  Commissioner  believes  that  the  collection  of 
the  amount  due  will  be  jeopardized  by  delay,  he  may  make  the  assess- 
ment without  giving  such  notice  or  awaiting  the  conclusion  of  a 
hearing. 

Where  a  taxpayer  has  been  given  an  opportunity  to  appeal  and 
has  not  done  so,  as  above  set  forth,  and  an  assessment  has  been  made, 
or  where  a  taxpayer  has  appealed  and  an  assessment  in  accordance 
with  the  final  decision  on  such  appeal  has  been  made,  no  claim  in 
abatement  of  the  assessment  shall  be  entertained. 

Where  an  assessment  has  been  made  without  giving  the  taxpayer 
an  opportunity  to  appeal  or  without  awaiting  a  decision  on  an  appeal 
that  has  been  perfected,  a  bona  fide  claim  in  abatement  of  the  assess- 
ment, filed  within  ten  days  after  notice  and  demand  by  the  col- 
lector, may  be  entertained.     (Art.  1006.) 

The  author  is  of  the  opinion  that  the  foregoing  regula- 
tion brings  about  a  greater  delay  than  was  intended  by  Con- 
gress. It  is  probable  that  the  procedure  will  be  changed  so 
that  the  first  notice  may  be  sent  out  by  registered  mail,  and 
thus  meet  the  requirements  of  the  statute.  Under  the  present 
ruling,  it  would  appear  that  a  taxpayer  may  ignore  the  first 
notice  and  wait  for  the  second  notice  which  entitles  him  to 
fight  the  case  out  before  the  Committee  on  Appeals  and  Re- 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     205 

view,  which  body  acts  for  the  Commissioner.  This  should  not 
and  probably  will  not  be  permitted.  If  the  taxpayer  does  not 
file  his  protest  within  the  first  thirty-day  period,  it  will  not  be 
unreasonable  that  the  assessment  be  made.  In  other  words, 
taxpayers  who  do  not  protest  at  once  should  not  be  entitled 
to  the  second  notice  provided  for  by  the  foregoing  ruling. 
To  accomplish  this,  the  first  notice  would  have  to  go  out  by 
registered  mail. 

In  order  to  stop  the  assessment  of  the  proposed  tax,  the 
taxpayer  must  (i)  file  his  protest  within  thirty  days  from 
the  date  the  notice  was  sent,  and  (2)  the  protest  must  show 
the  cause  or  reason  why  the  tax  should  not  be  paid.  In  most 
cases  the  taxpayer  will  wish  to  take  the  matter  up  in  conference. 
In  such  cases  a  request  should  be  made  for  an  oral  hearing. 

The  protest  should  also  make  a  specific  demand  for  a 
hearing  before  the  Committee  on  Appeals  and  Review  if  the 
decision  of  the  Income  Tax  Unit,  or  any  part  thereof,  is  ad- 
verse to  the  contentions  of  the  taxpayer. 

In  many  cases,  especially  where  the  amount  involved  is 
very  large,  it  will  not  be  possible  to  file  a  complete  brief  taking 
up  in  detail  the  proposed  assessment.  In  such  cases,  it  should 
be  sufficient,  as  is  contemplated  by  article  1006,  to  file  the  formal 
protest  within  thirty  days,  setting  forth  the  items  which  will  be 
contested  and  the  reasons  in  a  general  way  why  the  tax  should 
not  be  paid.  These  reasons  should  not  be  too  general,  but 
should  be  specific  enough  to  enable  the  Treasury  to  decide 
whether  or  not  the  contentions  arc  meritorious. 

Taxpayers  should  make  all  protests  in  good  faith  and  as 
soon  as  practicable.  This  will  encourage  a  fair  administra- 
tion of  the  law.  1'axpayers  should  request  reasonable  exten- 
sions of  time  in  which  to  prepare  properly  the  details  of  their 
cases.  In  all  conii)licated  cases  an  oral  hearing  should  be  re- 
quested, since  the  questions  involved  are  of  the  same  nature 
as  in  litigated  cases  and  no  one  would  think  of  taking  a  case 
into  the  courts  and  of  waiving  the  right  to  a  trial  before  a  judge 
or  a  jury. 


2o6  APPLICATION    AND    ADMINISTRATION 

After  a  case  has  been  heard  ])y  the  Income  Tax  Unit,  an 
appeal  hes  to  the  Committee  on  Appeals  and  Review  before  the 
assessment  is  made.^^  While  the  law  and  article  1006  do  not 
state  that  notice  of  intention  to  appeal  to  the  Committee  must 
be  given  within  the  thirty-day  period,  the  safest  procedure  is, 
as  suggesed  above,  to  give  such  notice  at  the  time  of  filing  the 
formal  protest. 

Since  the  language  of  article  1006  is  somewhat  involved, 
the  following  analysis  may  prove  helpful : 

I.  Abatement  claims  may  Ijc  filed  only  in  the  following  cases: 

(a)  When  the  taxpayer  is  not  notified  of  the  intenlion  of  the 

Treasury  to  make  an  additional  assessment;  and  the 
Treasury  does  not  send  notices  by  registered  mail.  It 
is  not  likely  that  assessments  will  be  made  unless  notice 
is  given. 

(b)  If  the  taxpayer  has  appealed  to  the  Commissioner  of  In- 

ternal Revenue,  or  has  had  a  hearing  before  the  Commis- 
sioner or  his  representatives,  or  has  filed  objections  and 
has  had  a  hearing, 'and  pending  the  promulgation  of  the 
Commissioner's  decision,  the  proposed  assessment  has 
nevertheless,   been   made. 

(c)  If  unable  to  pay. 

II.  Taxpayers  are  to  be  notified  by  mail  that,  as  a  result  of  the 
examinations  of  their  returns,  the  government  finds  that  additional 
taxes  are  due.     Thereupon, 

(a)   The  taxpayer  has  a  right  to  file  exceptions  to  the  proposed 
assessment,  and  also 
(b)   The  taxpayer  is  entitled  to  a  hearing  before  the  Income 
Tax  Unit. 

A  reasonable  time  will  be  afforded  taxpayers  in  which  to  file  their 
exceptions  or  to  ask  for  a  hearing  or  to  do  both.  There  is  no  statu- 
tory time.  The  Treasury  will  probably  suggest  a  fixed  time,  prob- 
ably thirty  days,  and  give  taxpayers  additional  time  if  circumstances 
warrant. 

III.  If  the  taxpayers  exercise  the  right  referred  to  in  II  above,  and 
submit  their  objections, 

(a)   A  decision  is  made  either  on  the  basis  of  the  taxpayer's 
original  data,  or  on  the  basis  of  the  taxpayer's  written 


^For  procedure  before  Committee  on  Appeals  and  Review,  see  page 
175  et  seq. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     207 

presentation,  or  on  the  basis  of  his  oral  presentation, 
or  on  the  basis  of  both  presentations, 
(b)   The  decision   of  the  Unit  must  be   communicated  to  the 
taxpayer  by  registered  mail. 

(c)  Thereupon,  the  taxpayer  has  thirty  days  in  which  to  appeal 

to  the  Commissioner  from  the  decision.  This  appeal  must 
be  in  writing.  After  the  filing  of  the  appeal,  an  oral 
hearing  may  be  had. 

(d)  The  assessment,  if  any,  is  thereupon  made  and  this  decision 

is  final. 

IV.  If  taxpayers  fail  to  exercise  the  right  referred  tu  in  II 
above, 

(a)   The  decision  of  the  Unit  nuist  be  communicated  to  the  tax- 
payer by  registered  mail. 

Thereupon,  the  procedure  is  as  in  III  above  and  the  result  is  as  in 
III  (d),  above. 

V.  If  the  collector's  ofiicc  discovers  apparent  cause  for  an  addi- 
tional assessment,  the  collector  notifies  the  taxpayer  whose  procedure 
thereafter  may  be  either  as  outlined  in  II  or  in  IV  above. 

VI.  When  the  assessment  is  made,  no  abatement  claim  with  refer- 
ence to  such  assement  may  be  filed,  except  in  the  specific  instances 
indicated  in  I  above. 

If  taxpayers,  after  receiving  notices  of  proposed  addi- 
tional assessments,  file  appeals  within  the  specified  time,  as- 
sessments cannot  be  made  until  hearings  have  been  granted 
and  final  decisions  are  made. 

After  final  decisions  are  made,  or  if  appeals  are  not  made 
within  the  specified  time,  the  proposed  assessments  are  included 
in  the  next  list  sent  to  the  collector."*  Upon  receipt  of  the  lists, 
the  collector  issues  notice  and  demand  for  payment  as  soon  as 
possible.  The  tax  must  be  paid  within  ten  days  after  notice 
and  demand.  The  collector  cannot  accept  a  claim  for  abate- 
ment.^'"' If  the  taxpayer  still  wishes  to  contest  the  assessment, 
a  claim  for  refund  may,  however,  be  filed  immediately  after 
payment  is  made — a  procedure  which  is  necessary  in  order  to 


**  Lists  are  usually  sent  to  the  collectors  about  the  19th  of  each  months 
Sometimes,  however,  a  special  Hst  is  sent. 
'■''See  page  202. 


2o8  APPLICATION    AND    ADMINISTRATION 

file  suit.""     Under  all  circumstances  payments  should  be  made 
under  protest.'' 

Section  250  (d)  provides  that  in  cases  where  the  Com- 
missioner believes  that  the  collection  of  the  tax  will  be  jeopar- 
dized by  the  delay  due  to  the  appeal,  he  may  make  the  assess- 
ment without  giving  notice  or  awaiting  the  conclusion  of  a 
final  hearing.  In  such  a  case,  if  the  collector  will  accept  it,  a 
claim  for  abatement  may  be  filed."*  If  a  claim  is  accepted,  the 
collector  will  no  doubt  require  a  bond  or  security.  The  merits 
of  the  case  would  then  be  fought  out  under  a  claim  in  abate- 
ment. If  the  collector  refuses  to  accept  a  claim  in  abatement, 
the  tax  must  be  paid  and  a  claim  for  refund  filed. "^ 

Can  assessments  be  made  if  taxpayer  has  not  been  properly 
notified? — The  192 1  law  provides  that  in  the  case  of  an  addi- 
tional assessment : 

Law.  Section  250 (d)  ....  the  taxpayer  shall  be  noti- 
fied thereof  and  given  a  period  of  not  less  than  thirty  days  after  such 

notice  is  sent  by  registered  mail  in  which  to   file  an  appeal 

Opportunity  for  hearing  shall  be  granted  and  a  final  decision  thereon 
shall  be  made  as  quickly  as  practicable 

The  foregoing  section  applies  to  the  1916,  191 7,  1918, 
and  192 1  laws.  Therefore,  any  assessment  made  after  Nov- 
ember 23,  1 92 1,  the  date  of  enactment  of  the  1921  law,  is  il- 
legal if  the  above  section  has  not  been  followed. 

No  doubt  there  were  many  assessments  in  the  hands  of  col- 
lectors and  still  others  ready  to  be  sent  to  collectors  by  the 
Commissioner  under  the  old  procedure  when  the  192 1  law 
was  approved.  These  proposed  assessments  cannot  legally 
be  made  until  the  Treasury  has  complied  with  section  250   (d). 

Additional  assessments  bear  interest. — Prior  to  the  enact- 
ment of  the  192 1  law,  additional  assessments  did  not  bear  in- 


"°  See  page  263. 

^  See  page  286  ct  scq. 

"'  See  page  202. 

=»  Ibid. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     209 

terest  unless  they  were  not  paid  within  ten  days  after  receipt 
of  notice  and  demand  from  the  collector.  Under  the  new  law, 
the  assessment  bears  interest  from  the  date  the  tax  was  due. 

Law.     Section  250 (b)    ....   If  the  amount  already 

paid  is  less  than  that  which  should  have  been  paid,  the  difference,  to  the 
extent  not  covered  by  any  credits  due  to  the  taxpayer  under  section  252 
(hereinafter  called  "deficiency"),  together  with  interest  thereon  at  the 
rate  of  one-half  of  i  per  centum  per  month  from  the  time  the  tax 
was  due  (or,  if  paid  on  the  installment  basis,  on  the  deficiency  of  each 
installment  from  the  time  the  installment  was  due),  shall  be  paid  upon 
notice  and  demand  by  the  collector 

The  foregoing  provision  ap[)lies  only  to  returns  for  192 1 
and  subsequent  years. 

Assessment  when  consolidated  returns  are  filed. — The  new 
law  continues  the  right  given  corporations  making  consoli- 
dated returns  by  the  1918  law,  to  elect  in  what  proportions  the 
tax  shall  be  assessed  against  each  corporation  in  the  group. 

Law.  Section  240 (b)  In  any  case  in  which  a  tax  is  as- 
sessed upon  the  basis  of  a  consolidated  return,  the  total  tax  shall  be 
computed  in  the  first  instance  as  a  unit  and  shall  then  be  assessed  upon 
the  respective  affiliated  corporations  in  such  proportions  as  may  be 
agreed  upon  among  them,  or,  in  the  absence  of  any  such  agreement, 
then  on  the  basis  of  the  net  income  properly  assignable  to  each.  There 
shall  be  allowed  in  computing  the  income  tax  only  one  specific  credit 
computed  as  provided  in  subdivision  (b)  of  section  236. 

The  foregoing  formula  for  apportionment  of  taxes  when 
consolidated  returns  for  19 17  are  filed  by  corporations  and 
partnerships  is  modified  in  the  following : 

Ruling.  It  is  held,  therefore,  that  where  corporations  and  part- 
nerships are  consolidated  the  excess  profits  tax  should  be  allocated  to 
the  partnerships  as  a  group  according  to  the  invested  capital  and  net 
income  assignable  to  the  partnership  group.  After  the  proper  amount 
of  the  excess  profits  tax  has  been  allocated  to  the  partnership  group, 
article  78  may  then  be  applied  within  the  partnership  group  as  it  is 
now  applied  within  the  corporation  group.     (B.  I-3-37;  L.  O.  1083.) 

Final  determination  and  assessment. — The  1921  law  pro- 
vides that  a  case,  under  certain  conditions,  may  be  finally  de- 


2IO  APPLICATION    AND    ADMINISTRATION 

termined,  thus  overcoming  the  uncertainty  which  has  hereto- 
fore existed  as  to  when  a  tax  case  was  actually  closed. 

Law.  Section  1312.  That  if  after  a  determination  and  assessment 
in  any  case  the  taxpayer  has  without  protest  paid  in  whole  any  tax  or 
penalty,  or  accepted  any  abatement,  credit,  or  refund  based  on  such 
determination  and  assessment,  and  an  agreement  is  made  in  writing 
between  the  taxpayer  and  the  Commissioner,  with  the  approval  of 
the  Secretary,  that  such  determination  and  assessment  shall  be  final 
and  conclusive,  then  (except  upon  a  showing  of  fraud  or  malfeasance 
or  misrepresentation  of  fact  materially  affecting  the  determination  or 
assessment  thus  made)  (i)  the  case  shall  not  be  reopened  or  the  de- 
termination and  assessment  modified  by  any  officer,  employee,  or  agent 
of  the  United  States,  and  (2)  no  suit,  action,  or  proceeding  to  annul, 
modify,  or  set  aside  such  determination  or  assessment  shall  be  enter- 
tained by  any  court  of  the  United  States. 

The  foregoing  applies  to  all  the  various  kinds  of  taxes.  A 
question  may  arise  as  to  whether  this  section  applies  only  to 
the  192 1  law.  The  language  is  broad  enough,  however,  to 
cover  all  previous  laws. 

To  bring  about  such  a  final  determination,  there  must  be 
(i)  an  agreement  in  writing  between  the  taxpayer  and  the 
Commissioner,  and  (2)  the  agreement  must  be  approved  by  the 
Secretary  of  the  Treasury.  In  case  of  a  corporation  a  certified 
copy  of  the  minutes  of  the  board  of  directors  authorizing  an  of- 
ficer to  sign  the  agreement  must  be  filed  with  the  Treasury.  The 
agreement  should  be  executed  in  duplicate.  (See  article  1141). 

Aside  from  the  general  question  as  to  whether  the  fore- 
going section  is  constitutional,  a  question  may  arise  as  to  its 
breadth.  What  is  meant  by  "after  a  determination  and  assess- 
ment in  any  case  ....  the  case  shall  not  be  reopened?" 
What  do  the  words  "in  any  case"  and  *'the  case"  include? 

Generally  speaking,  the  words  "any  case"  or  "the  case" 
include  only  those  particular  questions  under  consideration. 
Such  an  interpretation  would  make  invalid  any  agreement  be- 
tween the  taxpayer  and  Commissioner  to  the  effect  that  no 
question  would  be  raised  by  either  with  reference  to  the  tax 
return  for  any  particular  year  or  years.  The  law  does  not 
refer  to  tax  returns  or  vears. 


ADMINISTRATION,   ASSESSMENT   AND   PAYMENT     21 1 

Webster's  Dictionary  defines  the  word  "case"  to  mean : 

"The  matters  of  fact  or  conditions  involved  in  a  suit, 
as  distinguished  from  the  questions  of  law;  a  suit 
or  action  in  law  or  equity;  a  cause." 

Under  the  sMionyiiis  of  the  same  dictionary  appear  the 
following- : 

"Case  made,  Law,  a  case  stated  submitted  to  the  court 
for  a  decision  on  the  law  without  previous  proceedings." 

"Case  on  appeal,  Law,  the  statement  which  an  appellant 
lays  before  the  court  for  the  prosecution  of  his  appeal 
as  the  presentation  of  the  facts  on  which  the  appeal  is 
based." 

"Case  stated,  Law,  an  agreed  statement  of  facts  made 
for  presentation  to  a  court  in  order  to  obtain  a  decision 
of  law  upon  the  facts  stated." 

Against  the  foregoing  definitions  are  the  facts  which  con- 
fronted Congress  when  this  section  was  written.  Taxpayers 
have  complained  that  they  never  know  that  their  tax  cases, 
meaning  tax  returns,  have  been  finally  closed.  Arguments 
have  been  advanced  that  this  fact  has  prevented  many  busi- 
ness transactions.  It  is  possible  that  Congress  realized  that 
the  subject  of  such  a  l)road  agreement  would  be  too  indefinite 
and  vague,  and  therefore  not  legal. 

Final  determination  of  claims. — It  is  difficult  to  distin- 
guish the  following  [jrovision  from  section  1312: 

Law.  Section  13 13.  That  in  the  absence  of  fraud  or  mistake  in 
mathematical  calculation,  the  findings  of  facts  in  and  the  decision  of 
the  Commissioner  upon  (or  in  case  the  Secretary  is  authorized  to 
approve  the  same,  then  after  such  approval)  the  merits  of  any  claim 
presented  under  or  authorized  by  the  internal-revenue  laws  shall  not 
be  subject  to  review  by  any  other  administrative  officer,  employee,  or 
agent  of  the  United  States. 

The  foregoing  section  falls  under  that  division  of  the  law 
which   Congress  terms   "Administrative  Review."     It  is  the 


212  APPLICATION    AND   ADMINISTRATION 

only  section  under  this  division  and  follows  immediately 
section  13 12.  The  language  of  section  13 12,  which  states  that 
"the  case  shall  not  be  reopened  or  the  determination  and  assess- 
ment modified  by  any  officer,  employee,  or  agent  of  the  United 
States,"  should  be  broad  enough  to  stop  all  administrative 
review. 

It  is  possible,  notwithstanding  the  heading,  that  Congress 
intended  this  section  to  apply  only  to  claims  filed  by  the  tax- 
payer. Section  13 12  is  confined  to  "a  determination  and 
assessment  in  any  case  the  taxpayer  has  without  protest  paid 
in  wdiole  any  tax  .........  or  accepted  any  abate- 
ment, credit,  or  refund  based  on  such  determination  and  assess- 
ment." It  is  possible  that  section  1312  is  intended  to  apply 
to  cases  initiated  by  the  government,  and  section  1313  to  cases 
initiated  by  the  taxpayer. 

It  is  significant  to  note  that  the  conference  committee  in- 
serted the  word  "other"  immediately  before  the  phrase  "ad- 
ministrative officer,  employee,  or  agent  of  the  United  States." 

Procedure  to  reopen  a  case. — The  following  ruling  applies 
to  cases  which  have  been  finally  settled  by  the  Treasury.  It 
does  not  apply  to  cases  closed  under  sections  13 12  and  13 13 
of  the  new  law. 

Ruling.  Where  any  case  in  the  Bureau  of  Internal  Revenue  has 
been  finally  closed  after  the  taxpayer,  or  other  party  thereto,  has 
had  a  hearing  or  has  been  afforded  by  written  notice  an  opportunity 
to  present  oral  or  written  arguments  or  statements  of  fact  in  support 
of  his  contentions,  the  case  will  not  be  reopened  except  (i)  where  a 
showing  is  made  of  new  and  material  facts,  accompanied  by  an  ex- 
planation, satisfactory  to  the  Commissioner  of  Internal  Revenue,  of 
the  failure  to  produce  such  facts  prior  to  the  closing  of  the  case,  or 
(2)  where  the  case  is  materially  affected  by  the  change  of  regula- 
tions or  by  the  final  decision  of  another  case  either  by  the  Commis- 
sioner of  Internal  Revenue  or  by  a  court  of  competent  jurisdiction. 
The  application  for  reopening  a  case  should  be  addressed  to  the  Com- 
missioner of  Internal  Revenue,  should  state  succinctly  the  facts  and 
circumstances  upon  which  the  application  is  based,  and  must  be  sup- 
ported by  the  affidavit  of  a  person  having  knowledge  of  the  facts. 

This  decision  is  not  to  be  construed  as  modifying  the  regulations 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     213 

relating  to  the  filing  of  claims  in  abatement  or  claims  for  refund,  nor 
as  denying  the  right  of  a  taxpayer  to  a  hearing  or  to  an  appeal  at 
any  stage  of  his  case  until  the  case  has  been  finally  closed.  After 
the  taxpayer  has  exhausted  his  remedies  within  the  Bureau,  how- 
ever, and  the  case  has  been  finally  closed,  it  will  be  reopened  only 
under  the  conditions  stated  in  the  decision.  (B.  46-21-1927;  T.  D. 
3240.) 

Procedure  in  cases  arising  prior  to  T.  D.  3269. — Prior  to 
the  passage  of  the  1921  law  (November  23,  1921)  and  the  is- 
suance of  T.  D.  3269,''"  it  was  contrary  to  the  poHcy  of  the 
Treasury  to  permit  an  appeal  to  Committee  before  assessment. 
That  is,  a  proposed  assessment  was  not  withheld  pending  an 
appeal.  Consequently,  there  are  many  cases  pending  before 
the  Committee  on  Appeals  and  Review.  There  are  others 
which  have  been  assessed  and  formal  appeal  not  yet  made. 
The  present  procedure  should  not  affect  any  of  these  cases. 

Taxpayers  were  advised  to  file  claims  in  abatement  pending 
an  appeal, ^^  and  collectors  should  be  notified  by  the  Secretary 
of  the  Treasury  to  postpone  any  action  looking  to  collection 
until  final  decisions  by  the  Committee  are  handed  down. 

Claims  procedure  should  be  revised. — The  word  "claiius," 
as  used  above,  includes  claims  for  abatement,  refund,  and 
credit. 

The  procedure  of  the  Treasury  should  provide  for  an 
orderly  appeal  to  the  Committee  on  Appeals  and  Review  in 
cases  where  the  Unit  has  ruled  adversely  on  a  claim.  Hereto- 
fore in  the  case  of  claims  for  abatement  and  credit,  taxpayers 
did  not  know  that  their  claims  were  denied  until  collectors  de- 
mand payment. 

Tn  view  of  the  provisions  of  the  1921  law,  all  decisions  of 
the  Unit  should  be  sent  to  taxpayers  and  their  right  to  dissent 
and  appeal  made  clear. 

A  rule  should  be  made  that  taxpayers  should  be  notified 
by  letter  that  the  Unit  has  rejected  their  claims  and  that  they 


*'This  Treasury  Decision  now  appears  as  Art.  1006,  page  202. 
"'  C.  B.  4,  page  370;  O.  D.  709. 


214 


APPLICATION   AND   ADMINISTRATION 


have,  say,  thirty  days,  to  give  notice  of  appeal  to  the  Com- 
mittee. If  notice  of  appeal  is  not  filed,  collectors  may  reason- 
ably demand  payment  in  case  of  rejected  claims  for  abatement 
or  credit. 

Until  such  a  rule  is  promulgated,  taxpayers  should  notify 
the  Treasury  when  claims  are  filed  that  if  the  decision  of  the 
Unit  is  adverse,  the  right  of  appeal  to  the  Committee  is  re- 
quested before  the  claims  are  formally  rejected. 

Summary  proceedings  in  case  of  contemplated  evasion. — 

Law.     Section  250 (g)  If  the   Commissioner  finds  that 

a  taxpayer  designs  quickly  to  depart  from  the  United  States  or  to 
remove  his  property  therefrom,  or  to  conceal  himself  or  his  property 
therein,  or  to  do  any  other  act  tending  to  prejudice  or  to  render  wholly 
or  partly  ineffectual  proceedings  to  collect  the  tax  for  the  taxable 
year  then  last  past  or  the  taxable  year  then  current  unless  such  pro- 
ceedings be  brought  without  delay,  the  Commissioner  shall  declare  the 
taxable  period  for  such  taxpayer  immediately  terminated  and  shall 
cause  notice  of  such  finding  and  declaration  to  be  given  the  taxpayer, 
together  with  a  demand  for  immediate  payment  of  the  tax  for  the  tax- 
able period  so  declared  terminated  and  of  the  tax  for  the  preceding 
taxable  year  or  so  much  of  said  tax  as  is  unpaid,  whether  or  net  the 
time  otherwise  allowed  by  law  for  filing  return  and  paying  the  tax  has 
expired;  and  such  taxes  shall  thereupon  become  immediately  due  and 
payable.  In  any  action  or  suit  brought  to  enforce  payment  of  taxes 
made  due  and  payable  by  virtue  of  the  provisions  of  this  subdivision 
the  finding  of  the  Commissioner,  made  as  herein  provided,  whether 
made  after  notice  to  the  taxpayer  or  not,  shall  be  for  all  purposes  pre- 
sumptive evidence  of  the  taxpayer's  design.  A  taxpayer  who  is  not 
in  default  in  making  any  return  or  paying  income,  war-profits,  or  excess- 
profits  tax  under  any  Act  of  Congress  may  furnish  to  the  United 
States,  under  regulations  to  be  prescribed  by  the  Commissioner  with 
the  approval  of  the  Secretary,  security  approved  by  the  Commissioner 
that  he  will  duly  make  the  return  next  thereafter  required  to  be  filed 
and  pay  the  tax  next  thereafter  required  to  be  paid.  The  Commissioner 
may  approve  and  accept  in  like  manner  security  for  return  and  pay- 
ment of  taxes  made  due  and  payable  by  virtue  of  the  provisions  of 
this  subdivision,  provided  the  taxpayer  has  paid  in  full  all  other  income, 
war-profits,  or  excess-profits  taxes  due  from  him  under  any  Act  of 
Congress.  If  security  is  approved  and  accepted  pursuant  to  the  pro- 
visions of  this  subdivision  and  such  further  or  other  security  with 
respect  to  the  tax  or  taxes  covered  thereby  is  given  as  the  Commis- 
sioner shall  from  time  to  time  find  necessary   and   require,  payment 


ADMINISTRATION,    ASSESSMENT   AND    PAYMENT 


215 


of  such  taxes  shall  not  be  enforced  by  any  proceedings  under  the 
provisions  of  this  subdivision  prior  to  the  expiration  of  the  time  other- 
wise allowed  for  paying  such  respective  taxes.''-  In  the  case  of  a 
citizen  of  the  United  States  about  to  depart  from  the  United  States 
the  Commissioner  may,  at  his  discretion,  waive  any  or  all  of  the  re- 
quirements placed  on  the  taxpayer  by  this  subdivision.  No  alien  shall 
depart  from  the  United  States  unless  he  first  secures  from  the  col- 
lector or  agent  in  charge  a. certificate  that  he  has  complied  with  all 
the  obligations  imposed  upon  him  by  the  income,  war-profits,  and 
excess-profits  tax  laws.  If  a  taxpayer  violates  or  attempts  to  violate 
this  subdivision  there  shall,  in  addition  to  all  other  penalties,  be  added 
as  part  of  the  tax  25  per  centum  of  the  total  amount  of  the  tax  or 
deficiency  in  the  tax,  together  with  interest  at  the  rate  of  i  per  centum 
per  month  from  the  time  the  tax  became  due 

Congress  wisely  empowered  the  Commissioner,  in  cases  of 
intent  to  evade,  to  declare  all  taxes  to  be  due  and  payable. 

Persons  going  abroad  must  present  certificates  of 
compliance. 

Ruling.  In  order  to  obtain  income  tax  clearance,  American  citi- 
zens planning  to  leave  the  United  States  are  required  to  present 
their  certificates  of  compliance  or  receipts  showing  payment  of  in- 
come tax,  at  the  office  of  the  internal  revenue  agent  in  charge  at  the 
port  of  embarkation,  rather  than  to  the  internal  revenue  agent  at  the 
pier.     (C.  B.  3,  page  301 ;  O.  D.  666.) 

The  new  law  gives  the  Commissioner  power  to  waive  this 
requirement  as  to  citizens  of  the  United  States. 

Collectors  have  attempted  to  collect  instalments  not  due 
from  citizens  going  abroad  for  a  short  time.  The  law  was 
intended  only  to  reach  those  who  attempt  to  evade  payment, 
and  collectors  are  not  empowered  to  impose  unreasonable  re- 
quirements. 

Aliens  departing  from  the  United  States  must  present  evi- 
dence that  they  have  satisfied  their  income  tax  obligations. 
Detailed  procedure  is  set  forth  in  Chapter  XXXVI,  "Non- 
Resident  Aliens."  Many  aliens  when  leaving  the  United 
States  are  classed  as  non-residents. 


^The  portion  of  this  subdivision  following  this  point  was  added  to  the' 
provision  of  the  lyiS  law. 


2i6  APPLICATION   AND   ADMINISTRATION 

Certificate  of  compliance. — 

Rulings.  Certificates  of  compliance  with  income  tax  obligations 
may  be  procured  either  from  the  office  of  a  collector  of  internal  rev- 
enue or  from  the  branch  office  of  the  collector  within  the  same  collec- 
tion district.  The  deputy  collector  or  revenue  agent  acting  for  the 
collector  will  issue  the  certificates.     (C.  B.  i,  page  252;  O.  D.  324.) 

Inasmuch  as  this  office  has  not  presj:ribed  a  form  of  certificate 
o"f  compliance  for  the  use  of  resident  aliens,  a  letter  or  statement  from 
the  collector  is  acceptable  to  show  to  the  revenue  agent  at  the  port  of 
embarkation  that  the  resident  alien  has  satisfied  all  income  tax  obli- 
gations up  to  date  of  departure.  The  letter  or  statement  should  set 
forth  the  facts  that  the  alien  is  a  subject  of  (insert  name  of  country), 
that  he  is  a  resident  of  the  United  States,  satisfactory  proof  of  such 
claim  of  residence  having  been  submitted,  that  he  has  satisfied  all  in- 
come tax  obligations  for  the  years  1918,  1919,  1920,  and  up  to  date  of 
departure  and  has  satisfactorily  proved  to  the  collector  that  his  ab- 
sence is  to  be  only  temporary.  This  statement  should  be  attached  to 
the  duplicate  Form  1040-A  issued  to  the  alien  to  be  presented  to  the 
revenue  agent  at  the .  port  of  embarkation.  The  duplicate  Form 
1040-A  should  contain  a  notation  by  the  examining  officer  in  the 
collector's  office  to  the  effect  that  the  alien  is  a  resident  leaving  the 
United  States  for  a  temporary  visit  abroad.  (C.  B.  4,  page  329; 
O.  D.  840.) 

The  servants  of  a  diplomatic  representative  of  a  foreign  country 
should  not  be  examined  for  income  tax  purposes  when  such  servants 
accompany  the  diplomat  upon  his  departure  from  the  United  States. 
(C.  B.  4,  page329;0.  D.  812.) 

Consular  receipts  acceptable. — 

Ruling.  Consular  receipts  showing  payment  of  United  States 
income  taxes  through  a  United  States  consulate  by  citizens  of  this 
country  residing  abroad  will  be  accepted  by  revenue  agents  at  ports 
of  embarkation  as  evidence  of  satisfaction  of  income  tax  obligations 
in  the  case  of  departure  of  such  citizens  who  are  temporarily  in  this 
country.     (C.  B.  2,  page  244;  O.  D.  500.) 


Payment 

Payment  may  be  made  in  instalments.^^ — The  1921  as  well 
as  the  1 9 18  law  permits  the  taxpayer  either  to  divide  his  tax 


"  The  payment  of  the  excess  profits  tax  is  made  in  exactly  the  same 
manner  as  the  income  tax.     (See  section  336.) 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     217 

into  four  instalments,  spread  evenly  throughout  the  year,^*  or 
to  pay  it  in  a  Uimp  sum  at  the  time  of  fiVmg  the  return. 

Law.  Section  250.  (a)  That  except  as  otherwise  provided  in 
this  section  and  sections  221  and  237  [payment  at  the  source]  the 
tax  shall  be  paid  in  four  installments,  each  consisting  of  one-fourth 
of  the  total  amount  of  the  tax.  The  first  installment  shall  be  paid 
at  the  time  fixed  by  law  for  filing  the  return,-^  and  the  second  install- 
ment shall  be  paid  on  the  fifteenth  day  of  the  third  month,  the  third 
installment  on  the  fifteenth  day  of  the  sixth  month,  and  the  fourth 
installment  on  the  fifteenth  day  of  the  ninth  month,  after  the  time 
fixed  by  law  for  filing  the  return.  Where  an  extension  of  time  for 
filing  a  return  is  granted  the  time  for  payment  of  the  first  installment 
shall  be  postponed  until  the  date  of  the  expiration  of  the  period  of 
the  extension,  but  the  time  for  payment  of  the  other  installments 
shall  not  be  postponed  unless  the  Commissioner  so  provides  in  grant- 
ing the  extension.  In  any  case  in  which  the  time  for  the  payment  of 
any  installment  is  at  the  request  of  the  taxpayer  thus  postponed,  there 
shall  be  added  as  a  part  of  such  installment  interest  thereon  at  the  rate 
of  K'  of  I  per  centum  per  month  from  the  time  it  would  have  been 
due  if  no  extension  had  been  granted,  until  paid.  If  any  installment 
is  not  paid  when  due,  the  whole  amount  of  the  tax  unpaid  shall  be- 
come due  and  payable  upon  notice  and  demand  by  the  collector. 

The  tax  may  at  the  option  of  the  taxpayer  be  paid  in  a  single  pay- 
ment instead  of  in  installments,  in  which  case  the  total  amount  shall 
be  paid  on  or  before  the  time  fixed  by  law  for  filing  the  return,  or, 
where  an  extension  of  time  for  filing  the  return  has  been  granted,  on 
or  before  the  expiration  of  the  period  of  such  extension 

It  should  be  noted  particularly  that  the  extension  of  time 
for  filing  the  return  ordinarily  operates  to  extend  the  time 
of  payment  of  the  first  instalment  only."" 

Ruling.  Where  an  understatement  of  the  tax  in  a  return  is  not 
attributable  to  negligence  or  fraud  and  a  taxpayer  accordingly  fails 
to  pay  at  least  one  quarter  of  the  tax  due  at  the  time  for  filing  the  re 
turn,  he  does  not  lose  his  right  to  make  installment  payments.  (C.  B.  4, 
page  317;  O.  D.  96:.) 


"[Former  Procedure]  Under  the  1909  and  1913  laws  the  tax  was 
due  June  30;  under  the  1916  and  1917  laws  the  tax  was  due  June  15. 

"The  fifteenth  day  of  the  third  month  following  the  close  of  the 
taxable  year — March  15  in  case  the  calendar  is  used. 

"  [Former  Procedure]  Extension  of  time  for  making  a  return  for- 
merly did  not  n])cratc  to  postpone  the  ])ayincnt  of  the  tax.  If  an  extension 
carried  beyond  the  regular  date  of  payment,  the  tax  was  payable  "upon 
notice  and  demand."     (Reg.  33,  1918,  Art.  230.) 


2i8  APPLICATION    AND   ADMINISTRATION 

Notice  of  payment  due. — The  law  states  that  the  tax  "shall 
be  paid"  at  dates  fixed  by  section  250  (a)  quoted  above,  but 
penalties  cannot  be  imposed  until  notice  and  demand  has  been 
made  in  accordance  with  the  following: 

Law.     Section  250 (e)    ....   In  the  case  of  the  first 

installment  provided  for  in  subdivision  (a)  the  instructions  printed  on 
the  return  shall  be  sufficient  notice  of  the  date  when  the  tax  is  due  and 
sufficient  demand,  and  the  taxpayer's  computation  of  the  tax  on  the 
return  shall  be  sufficient  notice  of  the  amount  due.  In  the  case  of 
each  subsequent  installment  the  collector  may,  within  thirty  days  and 
not  later  than  ten  days  before  the  installment  becomes  due,  mail  to  the 
taxpayer  notice  of  the  amount  of  the  installment  and  the  date  on  which 
it  is  due  for  payment.  Such  notice  of  the  collector  shall  be  sufficient 
notice  and  sufficient  demand  under  this  section 

Subdivision  (h)  of  this  section  makes  this  change  retro- 
active with  respect  to  the  191 7  and  19 18  laws. 

The  foregoing  is  an  enactment  of  T.  D.  3136^'  in  which 
the  1918  law  was  erroneously  interpreted.  This  section  of  the 
law  was  intended  to  cure  one  of  the  known  defects  of  the  1918 
law  which  the  Department  attempted  to  change  by  regula- 
tion.^^ The  author  knows  of  at  least  one  case  where  payment 
was  withheld  in  order  to  test  the  regulations,  but  the  Depart- 
ment would  not  assess  the  penalty. 

There  is  no  advantage  in  waiting  for  notice  from  the  col- 
lector on  the  second  and  third  instalments.  Subdivision  (a) 
of  section  250,  which  fixes  the  dates  when  the  instalments 
must  be  paid,  provides  that  "if  any  installment  is  not  paid 
when  due,  the  whole  amount  of  the  tax  unpaid  shall  become 
due  and  payable  upon  notice  and  demand  by  the  collector." 
In  the  case  of  the  fourth  instalment  the  taxpayer  can  post- 
pone payment  until  he  receives  notice  in  accordance  with  sec- 
tion 250  (e).  No  penalty  or  interest  can  be  assessed  until 
proper  notice  has  been  given. 

Additional  notice  in  cases  of  absence. — The  Treas- 
ury recognizes  that  "by  reason  of  absence  in  foreign  countries 


"  C.  B.  4,  page  316. 

"  See  Income  Tax  Procedure,  1921,  for  procedure  under  1918  law,  pages 
178-183. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     219 

or  on  account  of  traveling  abroad,  or  of  absence  from  their 
homes  or  places  of  business  in  the  military  or  other  service 
of  the  country,  and  the  consequent  delay  in  receiving  mail,  it 
is  impossible  for  many  individuals  to  receive  notice  and  de- 
mand on  form  17  and  make  payment  of  the  taxes  assessed 
thereon  so  that  such  taxes  can  be  received  by  the  collector 
within  the  ten-day  period."  In  such  cases  additional  time  is 
allowed. 

Regulation By  reason,   however,  of  the  absence   from 

home  or  place  of  business  in  a  foreign  country  or  in  the  military  or 
other  service  of  the  country  and  the  consequent  delay  in  receiving 
mail,  or  by  reason  of  the  location  of  the  residence  of  an  individual  or 
of  the  office  of  a  corporation  to  which  the  notice  was  addressed  at  a 
distance  from  the  collector's  office,  it  is  frequently  impossible  for  a 
taxpayer  to  receive  notice  and  demand  and  to  make  payment  of  the 
tax  so  that  such  payment  may  be  received  by  the  collector  within  the 
lo-day  period  (following  the  service  of  notice  and  demand).  In  all 
such  cases  the  collector  will  enter  on  the  notice  as  the  date  on  which 
the  tax  becomes  due  and  payable  a  date  as  nearly  as  possible  10  days 
after  the  time  that  the  notice  should  be  received  in  the  ordinary  course 
of  the  mails  by  the  taxpayer.  In  such  cases  where  it  is  established 
that  a  remittance  for  the  tax  was  placed  in  the  mails  within  the  lo-day 
period  after  the  due  date  specified  in  the  notice,  and  tardiness  was  oc- 
casioned because  the  notice  was  not  delivered  in  due  time  by  reason 
of  delay  in  the  mail  and  satisfactory  evidence  of  that  fact  is  furnished, 
the  penalty  and  interest  will  not  be  collected.     (Art.  1007.) 

A  few  immaterial  changes  have  been  made  in  this  article. 

Ruling.  A  taxpayer  having  filed  his  return  and  paid  the  first 
installment  of  tax  is  aware  of  his  liability  to  pay  the  balance  of  the 
tax  on  the  respective  due  dates,  and  failure  to  receive  notice  and  de- 
mand for  the  payment  of  the  later  installments  by  reason  of  his  ab- 
sence from  this  country  does  not  constitute  a  sufficient  cause  for  waiv- 
ing the  penalty  and  interest  on  any  installment  of  the  tax  not  paid 
when  due.     (C.  B.  2,  page  236;  O.  D.  408.) 

Notice  required  in  all  cases. — It  appears  that  some  col- 
lectors are  too  arbitrary  in  their  demands  for  additional  re- 
turns, collection  of  additional  taxes,  etc.  Taxpayers  may  be 
assured  that  precipitate  action  is  illegal.  Reasonable  notice  of 
any  proposed  action  must  be  given  or  the  act  is  illegal,  because 


220  APPLICATION   AND    ADMINISTRATION 

it  is  in  violation  of  the  constitutional  guarantee  of  due  process 
of  law.'^ 

The  courts  have  held  that  as  a  general  principle  of  law 
a  proceeding  for  the  assessment  of  property  for  taxation  is 
judicial  in  its  character,  and  in  order  to  assure  its  validity  the 
law  authorizing  it  must  provide  some  kind  of  notice.^" 

The  law  binds  the  Commissioner  and  the  collectors  to  give 
ample  notice  of  all  proceedings,  including  the  im.position  of 
penalties.  The  notices  must  allow  sufficient  time  to  the  tax- 
payer to  produce  evidence  supporting  his  original  returns,  or 
to  pay  within  the  statutory  time  of  lo  days  after  formal 
demand. 

Method  of  calculating  interest. — 

Ruling,  (a)  Where  interest  is  collectible  at  the  rate  of  i  per 
cent  per  month  from  the  due  date  interest  must  be  collected  for  the 
fractional  part  of  a  month  where  the  tax  is  not  paid  within  lo  days 
from  notice  and  demand  for  payment. 

(b)  Under  sections  502,  504,  629,  903,  and  905/^  interest  is  col- 
lectible at  the  rate  of  i  per  cent  for  each  full  month,  and  fractional 
parts  of  a  month  must  be  disregarded. 

(c)  Interest  is  collectible  from  the  month  tax  becomes  due.  (C. 
B.  I,  page  244;  O.  884.) 

Who  pays  the  tax  w^hen  a  corporation  liquidates? — The 
question  as  to  who  shall  pay  the  tax  in  case  a  corporation  is 
dissolved  is  satisfactorily  answered  in  the  following  regula- 
tions :*' 

Regulations.  A  corporation  going  into  liquidation  during  any 
tax  period  may,  at  the  time  of  such  liquidation,  prepare  a  "final  re  ■ 


"  See  Alex.  M.  Hamburg,  "Limitations  upon  the  Federal  Taxing 
Power,"  3  National  Tax  Association  Bulletin,  pages  34-39. 

*"  County  of  Santa  Cla7-a  v.  Southern  Pacific  Railway  Co.,  18  Fed.  385; 
judgment  affirmed,  118  U.  S.  394;  30  L.  Ed.  118;  6  Sup.  Ct.  11 32. 

"  Section  502  relates  to  taxes  due  on  transportation  and  telegraph,  etc., 
service ;  section  504,  to  taxes  due  on  insurance  policies  issued ;  section  629 ; 
to  taxes  due  on  soft  drinks ;  sections  903  and  905,  to  taxes  due  on  luxuries. 

In  the  detailed  ruling  by  the  Treasury,  it  is  stated:  "Heretofore  this 
office  has  held  repeatedly  that  no  interest  for  a  fraction  of  a  month  shall 
be  demanded." 

"  See  also  C.  B.  4,  page  262;  O.  D.  768.  Also  C.  B.  4,  page  279;  O.  D. 
821. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     221 

turn"  covering  the  income  received  or  accrued  to  it  during  the  frac- 
tional part  of  the  year  during  which  it  was  engaged  in  business,  and 
immediately  file  the  same  with  the  collector  of  the  district  in  which  the 
corporation  has  its  principal  place  of  business.  Before  distributing 
its  assets,  a  dissolving  corporation  should  reserve  funds  sufficient  to 
pay  any  income  tax  assessable  against  it.  Otherwise  the  tax  may  be 
collected  by  suit  against  the  stockholders.     (Reg.  33,  1918,  Art.  612.) 

When  a  corporation  is  dissolved,  its  affairs  are  usually  wound 
up  by  a  receiver  or  trustees  in  dissolution.  The  corporate  existence 
is  continued  for  the  purpose  of  liquidating  the  assets  and  paying  the 
debts,  and  such  receiver  or  trustees  stand  in  the  stead  of  the  corpora- 
tion for  such  purposes.  Any  sales  of  property  by  them  are  to  be 
treated  as  if  made  by  the  corporation  for  the  purpose  of  ascertaining 
the  gain  or  loss (Art.  548;  Reg.  45,  Art.  547.) 

A  federal  coiirt*'^  has  recently  held  that  collection  by  dis- 
traint, of  taxes  assessed  by  a  collector  ex  parte  against  a  long 
since  dissolved  corporation,  the  business  being  continued  by 
the  former  stockholders  as  a  partnership  (Pennsylvania),  and 
the  property  against  which  the  collector  is  proceeding  being 
that  of  the  partnership,  may  not  be  enjoined  by  the  members 
of  the  partnership,  they  being  taxable  persons  and  the  property 
itself  being  such  as  to  be  liable  to  distraint  for  any  tax  assessed 
against  them. 

It  was  held  that  a  corporation  which  liquidated  in  19 17 
before  the  passage  of  the  191 7  law  was  nevertheless  liable  to 
taxation  under  that  law.**  Similarly  the  Treasury  expressly 
declared  that  a  corporation  liquidating  in  1918  or  early  in 
1919  was  subject  to  the  rates  imposed  by  the  new  act  of  1918, 
even  though  it  was  not  passed  until  19 19. 

Regulation A  corporation  which  was  dissolved  in  1921 

prior  to  the  enactment  of  the  present  statute  is  not  relieved  from  the 
necessity  of  rendering  returns  thereunder  for  such  portion  of  1921  as 
elapsed  before  its  dissolution (Art.  621.) 

It  is,  of  course,  important  to  consider  the  liability  for 
taxes  whenever  a  corporation  liquidates,  but  it  is  difficult  to 
provide  for  a  liability  so  uncertain  as  subsequent  tax  legisla- 


'  Markle  et  al.  v.  Kirkendall,  267  Fed.  498. 
'  U.  S.  V.  McHatton  et  al.,  266  Fed.  602. 


222  APPLICATION   AND   ADMINISTRATION 

tion.  In  Brady  v.  Anderson^^  the  estate  was  not  settled  when 
the  law  of  19 13  was  passed.  But  a  corporation  which  dis- 
solved, say,  in  February,  19 18,  could  hardly  foresee  the  exact 
liability  to  be  incurred  under  a  law  which  was  not  passed  until 
a  full  year  later.  In  the  meantime  the  corporation  might  have 
dissolved  as  it  had  a  legal  right  to  do.  It  was  willing  to  set 
aside  all  taxes  accrued  under  existing  laws.  To  assess  a  tax 
in  1919  under  a  law  passed  in  February,  1919,  on  a  corpora- 
tion which  was  dissolved  in  February,  1918,  would  certainly 
appear  to  be  reviving  a  dead  corporation.*" 

Ruling.  Where  a  corporation  dissolves  and  disposes  of  its  as- 
sets without  making  provision  for  the  payment  of  its  accrued  Federal 
income  tax  liability  for  the  tax  follows  the  assets  so  distributed,  and 
upon  failure  to  secure  the  unpaid  amount  suit  to  collect  the  tax  should 
be  instituted  against  the  stockholders  and  other  persons  receiving 
the  property,  except  bona  fide  purchasers  for  a  valuable  consideration. 
The  penalties  prescribed  in  section  253  of  the  Revenue  Act  of  1918 
will  attach  to  the  principal  officers  of  the  corporation  upon  failure 
to  comply  with  the  provisions  of  that  section.  (C.  B.  3,  page  300; 
O.  D.  597.) 

The  foregoing  conforms  with  a  recent  court  decision. 

Stockholders  of  a  corporation,  who  received  in  distribution 
the  entire  proceeds  of  its  property  on  its  dissolution  in  1916, 
after  payment  of  its  federal  excise  tax,  but  before  the  passage 
of  the  Income  Tax  Act  of  September  8,  1916,  increasing  the 
amount  of  the  tax  on  the  net  income  of  all  corporations  for 
that  year,  were  held  liable  for  the  increased  tax.*® 

A  stockholder  received  a  liquidating  dividend  in  191 7. 
It  was  found  that  the  distribution  was  excessive  because  federal 
taxes  had  not  been  sufficiently  paid.  Held,  that  the  stock- 
holder may  file  an  amended  return  for  19 17  deducting  the 
assessment  paid  in  1920.     (I-3-27;  I.  T.  1164.) 

Receivers  personally  responsible — when? — In  the  case  of 
Pennsylvania    Cement    Company    and    Bradley    Constructing 


"240  Fed.  665;  153  C.  C.  A.  463. 

■"'  See  "Retroactive  legislation,"  page  21. 

*'  U.  S.  V.  Mcllailon,  266  Fed.  602. 


ADMINISTRATION,   ASSESSMENT   AND   PAYMENT     223 

Company  {2.y^  Fed.  1003),  receivers  were  directed  not  to 
declare  a  dividend  to  creditors  before  federal  taxes  had  been 
adjusted,  because  they  could  be  held  personally  responsible 
for  the  taxes  under  sections  3466  and  3467  of  the  Revised 
Statutes. 

Delinquent  assessment  payable  "upon  notice  and  de- 
mand."— 

Law.     Section  250 (c)  If  the  return  is  made  pursuant 

to  section  3176*8  of  the  Revised  Statutes  as  amended,  the  amount  of 
tax  determined  to  be  due  under  such  return  shall  be  paid  upon  notice 
and  demand  by  the  collector 

Erroneous  or  illegally  assessed  taxes  must  be  paid. — In  all 
cases  it  must  be  remembered  that  the  tax  levied  by  the  col- 
lectors must  be  paid  if  (after  an  appeal  to  the  Commissioner) 
the  assessment  is  confirmed,  even  if  it  is  clearly  in  error.  The 
United  States  Supreme  Court  has  held  that  Congress  has  af- 
forded a  complete  and  adequate  remedy  at  law  open  to  all  per- 
sons aggrieved  by  the  collection  of  an  erroneous  or  illegal 
revenue  tax,  and  that  the  taxpayer  must  pay  the  tax  and  may 
then  bring  an  action  to  recover  it  after  appeal. 

The  Supreme  Court  has  affirmed  this  old  rule  under  the 
income  tax  laws.  In  a  fairly  recent  case*°  the  court  reiterated 
the  provision  in  section  3224,  Revised  Statues,  that  "no  suit 
for  the  purpose  of  restraining  the  assessment  or  collection  of 
any  tax  shall  be  maintained  in  any  court."^° 

In  a  pending  case  in  Delaware  a  taxpayer  is  attempting  to 
enjoin  a  collector  from  collecting  a  tax  imposed  for  the  year 
191 5,  on  the  ground  that  no  assessment  was  made  or  suit  com- 
menced prior  to  March  i,  192 1,  that  date  being  five  years  after 
the  191 5  return  was  filed. 


■"Section  3176  deals  with  the  subject  of  false  and  fraudulent  returns 
and  is  quoted  on  page  136. 

*' Dudge  v.  Oshorn,  Commissioner  240  U.  S.  118;  36  Sup.  Ct.  275; 
60  L.  Ed.  557  (February  21,  1916). 

'"  See  page  250. 


224 


APPLICATION   AND   ADMINISTRATION 


Media  of  payment. — 

Payment  may  be  made  by  mailing  uncertified 
CHEQUES. — Taxes  may  be  paid  to  the  collector  by  cheque  and 
should  be  mailed  at  least  a  day  or  two  before  the  date  fixed 
for  payment.  During  the  last  few  days  of  the  payment  period 
many  taxpayers  pay  in  person  at  the  offices  of  the  collectors, 
and  this  causes  congestion  and  long  delays.  The  use  of  the 
mails  is,  therefore,  preferable  and  is  on  the  whole  trustworthy. 

Until  the  enactment  of  the  191 7  law,  practically  all  taxes 
were  paid  by  certified  cheques.  The  law^^  now  authorizes  the 
collectors  of  internal  revenue  to  accept  uncertified  cheques  in 
payment  of  income  and  excess  profits  taxes.  Cheques  should 
be  made  payable  to  "Collector  of  Internal  Revenue  at  (City), 
(State)"  and  be  made  collectible  at  par  without  deduction  for 
exchange. 

Ruling.  A  taxpayer  who  tenders  a  check  whether  certified  or 
uncertified  in  payment  for  taxes  is  not  released  from  his  obligation 
until  the  check  is  paid.  Where  such  a  check  is  lost  in  the  mails, 
a  Collector  of  Internal  Revenue  is  not  required,  as  a  condition  prece- 
dent to  the  issuing  of  a  duplicate  check  by  a  taxpayer,  to  furnish 
bond  indemnifying  him  against  possible  loss  in  connection  with  the 
first  check.     (C.  B.  3,  page  371 ;  O.  D.  626.) 

Payments  in  treasury  notes  or  certificates  of  in- 
debtedness.— 

L.\w.  Section  132V  That  collectors  may  receive,  at  par  with 
an  adjustment  for  accrued  interest,  notes  or  certificates  of  indebtedness 
issued  by  the  United  States  ....  in  payment  of  income,  war-profits 
and  excess-profits  taxes  and  any  other  taxes  payable  other  than  by 
stamp,'-   .... 

This  practice  was  begun  in  19 17." 

The  purchase  of  certificates  of  indebtedness  affords  a  con- 
venient and  economically  sound  method  of  providing  in  ad- 


'' Section  1325.     See  also  Art.  1733. 

[Former  Procedure]  The  1917  law  (section  loio)  was  the  first  to 
authorize  collectors  to  accept  uncertified  cheques  in  payment  of  taxes.  (See 
T.  D.  2627  and  2666.) 

°"' With  exception  of  the  words  "notes  or"  after  the  words  "accrued 
interest,"  this  section  is  the  same  as  section  1314  of  the  1918  law. 

"  Section  lOio,  1917  law. 


ADMINISTRATION,  ASSESSMENT  AND   PAYMENT     225 

vance  for  taxes.  They  may  be  purchased  at  par,  they  bear 
interest  at  a  fair  rate  and  mature  at  various  dates.  Tax- 
payers can  accumulate  the  certificates,  as  funds  are  available, 
at  any  time  before  the  tax  payments  are  due  and  on  the  due 
dates  present  them  with  the  tax  bills.  In  the  meantime  in- 
terest will  have  accrued. 

The  latest  available  instructions  relative  to  the  acceptance 
of  certificates  of  indebtedness  are  as  follows : 

Regulations.  Collectors  of  internal  revenue  are  authorized  and 
directed  to  receive  at  par  United  States  Treasury  certificates  of  in- 
debtedness of  series  TM-1922  dated  March  15,  1921,  series  TM-2, 
1922,  dated  August  i,  1921,  and  series  TM-3,  1922,  dated  September  15, 

1921,  all  maturing  March  15,  1922,  in  payment  of  income  and  profits 
taxes  payable  on  March  15,  1922-  Treasury  certificates  of  indebted- 
ness of  series  TJ-1922,  dated  June  15,  1921,  and  series  TJ-2,  1922, 
dated  December  15,  1921,  both  maturing  June  15,  1922,  in  pay- 
ment of  income  and  profits  taxes  due  on  June  15,  1922;  series  TS- 

1922,  dated  September  15,  1921,  TS-2,  1922,  dated  November  i, 
1921,  both  maturing  on  September  15,  1922,  in  payment  of  income  and 
profits  taxes  payable  on  September  15,  1922;  and  TD-1922,  dated 
December  15,  1921,  maturing  on  December  15,  1922,  in  payment  of 
income  and  profits  taxes  payable  on  December  15,  1922.  Col- 
lectors are  further  authorized  and  directed  to  receive  at  par,  in 
payment  of  income  and  profits  taxes  payable  at  the  ma- 
turity of  the  certificates,  respectively,  Treasury  certificates 
of  indebtedness  of  any  other  series  which  may  be  issued  ma- 
turing on  March  15,  June  15,  September  15,  or  December  15,  1922. 
Collectors  are  not  authorized  hereunder  to  receive  in  payment  of  income 
or  profits  taxes  any  Treasury  certificates  of  indebtedness  not  expressed 
to  be  acceptable  in  payment  of  income  and  profits  taxes^  nor  any 
Treasury  certificates  maturing  on  a  date  other  tlian  the  date  on 
which  the  taxes  are  payable.  Collectors  are  authorized  to  receive 
Treasury  certificates  of  indebtedness  which  are  acceptable  as  herein 
provided  in  payment  of  income  and  profits  taxes  in  advance  of  the 
respective  dates  on  which  the  certificates  mature.  Treasury  cer- 
tificates acceptable  in  payment  of  income  and  profits  taxes  have  one 
or  more  interest  coupons  attached,  including  as  to  each  series  a  coupon 
payable  at  the  maturity  of  the  certificates,  but  all  interest  coupons 
must  in  each  case  be  detached  by  the  taxpayer  before  presentation  to 
the  collector,  and  collected  in  ordinary  course  when  due.  The  amount, 
at  par,  of  the  Treasury  certificates  of  indebtedness  presented  by  any 
taxpayer  in  payment  of  income  and  profits  taxes  must  not  exceed  the 
amount  of  the  taxes  to  be  paid  by  him,  and  collectors  shall  in  no  case 


226  APPLICATION   AND   ADMINISTRATION 

pay  interest  on  the  certificates  or  accept  them  for  an  amount  other 
or  greater  than  their  face  value.     (Art.  1731.) 

....  Collectors  of  internal  revenue  are  not  authorized,  unless 
express  instructions  otherwise  are  given  by  the  Secretary  of  the 
Treasury,  to  receive  in  payment  of  income  or  profits  taxes  interim 
receipts  issued  by  Federal  reserve  banks  in  lieu  of  definitive  certificates 
of  the  series  herein  described 

For  the  purpose  of  saving  taxpayers  the  expense  of  transmitting 
such  certificates  as  are  held  in  Federal  reserve  cities  or  Federal  re- 
serve branch-bank  cities  to  the  ofiice  of  the  collector  in  whose  district 
the  taxes  are  payable,  taxpayers  desiring  to  pay  income  and  profits 
taxes  by  such  Treasury  certificates  of  indebtedness  acceptable  in  pay- 
ment of  taxes,  should  communicate  with  the  collector  of  the  district  in 
which  the  taxes  are  payable  and  request  from  him  authority  to  de- 
posit such  certificates  with  the  Federal  reserve  bank  in  the  city  in 
which  the  certificates  are  held.  Collectors  are  authorized  to  permit 
deposits  of  Treasury  certificates  of  indebtedness  in  any  Federal  re- 
serve bank  with  the  distinct  understanding  that  the  Federal  reserve 
bank  is  to  issue  a  certificate  of  deposit  in  the  collector's  name  cover- 
ing the  amount  of  the  certificates  of  indebtedness  at  par  and  to  state 
on  the  face  of  the  certificate  of  deposit  that  the  amount  represented 
thereby  is  in  payment  of  income  and  profits  taxes.  The  Federal  re- 
serve bank  should  forward  the  original  certificate  of  deposit  to  the 
Treasurer  of  the  United  States,  with  its  daily  transcript,  and  trans- 
mit to  the  collector  the  duplicate  and  triplicate,  accompanied  by  a 
statement  giving  the  name  of  the  taxpayer  for  whom  the  payment 
is  made  in  order  that  the  collector  may  make  the  necessary  record  and 
forward  the  duplicate  to  the  office  of  the  Commissioner  of  Internal 
Revenue.     (Art.  1732.) 

Victory  notes  in  coupon  form  accepted  for  income 

AND   PROFITS   TAXES  PAYABLE   MaRCH    1 5,    1^22. 

Collectors  of  Internal  Revenue  are  authorized  and  directed  to  re- 
ceive at  par  Victory  notes  of  either  the  4%  per  cent  or  the  3%  per  cent 
series,  in  coupon  form,  in  payment  of  income  and  profits  taxes  pay- 
able on  March  15,  1922.  Registered  Victory  notes  are  not  acceptable. 
Coupon  Victory  notes  tendered  in  payment  of  income  and  profits 
taxes  payable  March  15,  1922,  must  have  all  unmatured  interest 
coupons  attached  (that  is  to  say,  coupons  for  June  15  and  December 
15,  1922,  and  May  20,  1923),  but  all  matured  coupons  must  be  de- 
tached and  collected  in  ordinary  course  when  due.  The  amount,  at 
par,  of  the  Victory  notes  presented  by  any  taxpayer  in  payment  of 
income  and  profits  taxes  must  not  exceed  the  amount  of  the  taxes 
to  be  paid  by  him,  and  collectors  shall  in  no  case  pay  interest  on  the 
notes  or  accept  them  for  an  amount  other  or  greater  than  their  face 


ADMINISTRATION,   ASSESSMENT   AND   PAYMENT     227 

value.  Accrued  interest  on  the  notes  accepted,  from  December  15, 
1921,  to  March  15,  1922,  will  be  remitted  to  the  taxpayer  by  the 
Federal  Reserve  Bank  with  which  the  collector  makes  his  deposits, 
on  the  basis  of  the  schedules  furnished  by  the  collector.  Receipts 
given  by  collectors  to  taxpayers  should  show  the  amount  of  notes  of 

each   series   received   in   payment   of  taxes (T.   D.   3281, 

dated  February  7,  1922.) 

Commissioner  may  extend  date  of  payment. — The  new  law 

permits  the  Commissioner,  under  certain  condiiions,  to  extend 
the  date  of  payment  of  additional  assessments. 

Law.     Section    250 (f)  In    the    case    of    any    deficiency 

(except  where  the  deficiency  is  due  to  negligence  or  to  fraud  with 
intent  to  evade  tax)  where  it  is  shown  to  the  satisfaction  of  the  Com- 
missioner that  the  payment  of  such  deficiency  would  result  in  undue 
hardship  to  the  taxpayer,  the  Commissioner  may,  with  the  approval 
of  the  Secretary,  extend  the  time  for  the  payment  of  such  deficiency 
or  any  part  thereof  for  such  period  not  in  excess  of  eighteen  months 
from  the  passage  of  this  Act  as  the  Commissioner  may  determine. 
In  such  case  the  Commissioner  may  require  the  taxpayer  to  furnish 
a  bond  with  sufficient  sureties  conditioned  upon  the  payment  of  the 
deficiency  in  accordance  with  the  terms  of  the  extension  granted.  There 
shall  be  added  in  lieu  of  other  interest  provided  by  law,  as  a  part  of 
such  deficiency,  interest  thereon  at  the  rate  of  two-thirds  of  i  per 
centum  per  month  from  the  time  such  extension  is  granted;  except 
where  such  other  interest  provided  by  law  is  in  excess  of  interest  at  the 
rate  of  two-thirds  of  i  per  centum  per  month.  If  the  deficiency  or 
any  part  thereof  is  not  paid  in  accordance  with  the  terms  of  the 
extension  granted,  there  shall  be  added  as  part  of  the  deficiency,  in 
lieu  of  other  interest  and  penalties  provided  by  law,  the  sum  of  5  per 
centum  of  the  deficiency  and  interest  on  the  deficiency  at  the  rate  of 
I  per  centum  per  month  from  the  time  it  becomes  payable  in  accord- 
ance with  the  terms  of  such  extension 

Subdivision  (h)  of  this  section  provides  that  the  above 
shall  also  apply  to  any  assessments  which  may  be  made  imder 
the  1917  and  1918  laws. 

Regulation.  Section  250  (f)  of  the  Revenue  Act  of  1921  con- 
tains a  special  relief  provision  which  will  be  in  effect  for  only 
eighteen  months  after  November  23,  1921,  the  date  of  the  passage 
of  the  Act.  .  It  provides  that  in  the  case  of  any  deficiency  in  tax 
'  revealed  on  the  examination  of  an  income  or  profits  tax  return  (except 
■  where  the  deficiency  is  due  to  negligence  or  to  fraud  with  intent 
to  evade  tax)  where  it  is  shown  to  the  satisfaction  of  the  Commis- 


228  APPLICATION    AND    ADMINISTRATION 

sioner  that  the  payment  of  such  deficiency  would  result  in  undue 
hardship  to  the  taxpayer,  the  Commissioner  may,  with  the  approval 
of  the  Secretary,  extend  the  time  for  the  payment  of  such  deficiency 
or  any  part  thereof  for  a  period  not  to  extend  beyond  i8  months 
from  November  23,  1921.  Where  such  an  extension  is  granted  there 
is  to  be  added  as  part  of  the  deficiency  in  lieu  of  other  interest  pro- 
vided by  law,  interest  at  the  rate  of  two-thirds  of  I  per  cent  per  month 
from  the  time  the  extension  is  granted.  Where  such  other  interest 
provided  by  law,  however,  is  in  excess  of  two-thirds  of  I  per  cent 
per  month  the  higher  rate  will  be  charged.  If  the  deficiency  or  any 
part  thereof  is  not  paid  in  accordance  with  the  terms  of  the  ex- 
tension agreement,  there  is  to  be  added  as  part  of  the  deficiency,  in 
lieu  of  other  interest  and  penalties  provided  by  law,  the  sum  of  5  per 
cent  of  the  deficiency  together  with  interest  on  the  deficiency  at  the 
rate  of  i  per  cent  per  month  from  the  time  it  became  payable  under 
the  terms  of  the  extension  agreement.  The  extension  will  be  granted 
only  in  case  the  taxpayer  establishes  to  the  satisfaction  of  the  Com- 
missioner that  without  such  extension  undue  hardship  will  result  to 
the  taxpayer.  The  term  "undue  hardship"  means  more  than  an  incon- 
venience to  the  taxpayer.  It  is  defined  as  meaning  that  substantial 
financial  loss  or  sacrifice  will  result  to  the  taxpayer  from  making 
payments  of  the  deficiency  at  the  due  date.  This  provision  of  the 
statute  is  applicable  only  to  deficiencies  in  taxes  which  have  accrued 
or  may  accrue  under  the  Revenue  Act  of  1917,  the  Revenue  Act  of 
1918,  or  the  Revenue  Act  of  1921,  and  the  deficiency  referred  to  is 
only  such  deficiency  in  tax  as  is  revealed  on  the  examination  of  an 
income  or  profits  tax  return.  It  has  no  application  to  deficiencies  in 
taxes  other  than  deficiencies  in  income  and  profits  taxes  under  the 
three  Acts  named.  No  extension  of  time  may  be  granted  under  sub- 
division (f)  of  section  250  for  the  payment  of  any  regular  install- 
ment of  tax  due  as  showing  by  the  original  return  of  the  taxpayer. 

Any  application  for  the  extension  must  be  made  under  oath  on 
Form  1 127''*  in  accordance  with  instructions  printed  thereon  and 
must  be  accompanied  by  evidence  showing  that  undue  hardship  to 
the  taxpayer  would  result  if  the  extension  were  refused.  The  ex- 
tension will  not  be  granted  on  a  general  statement  of  hardship,  but 
in  each  case  there  must  be  furnished  a  statement  of  the  specific  facts 
showing  what,  if  any,  financial  loss  or  sacrifice  will  result  if  the  ex- 
tension is  not  granted.  Teh  application  should,  whenever  practicable, 
contain  a  certified  statement  of  assets  and  liabilities  of  the  taxpayer. 
The  application,  with  the  evidence,  must  be  filed  with  the  collector, 
who  will  at  once  transmit  it  to  the  Commissioner  with  his  recom- 
mendations as  to  the  extension.  When  it  is  received  by  the  Com- 
missioner it  will  be  examined  and  within  thirty  days  either  rejected 
or  tentatively  approved. 


See  Appendix  B. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     229 

Where  the  application  is  tentatively  approved  and  a  bond  is  re- 
quired it  must  be  filed  with  the  collector  within  10  days  after  the  noti- 
fication by  the  Commissioner  that  a  bond  is  required.  It  shall  be 
conditioned  for  the  payment  of  the  deficiency  and  applicable  penalties, 
if  any,  and  interest  in  accordance  with  the  terms  of  the  extension  to  be 
granted  and  shall  be  executed  by  a  surety  company  holding  a  certificate 
of  authority  from  the  Secretary  of  the  Treasury  as  an  acceptable 
surety  on  Federal  bonds  and  shall  be  subject  to  the  approval  of  the 
Commissioner.  In  lieu  of  such  a  bond  the  taxpayer  may  file  a  bond 
secured  by  deposit  of  Liberty  bonds  or  other  bonds  or  notes  of  the 
United  States  equal  in  their  total  par  value  to  the  amount  of  the 
deficiency  and  applicable  penalties,  if  any,  and  interest,  as  provided 
in  section  1329  of  the  Revenue  Act  of  1921.     (Art.  1014.) 

If  collectors  insist  on  surety  bonds  in  all  cases,  the  "relief" 
will  be  barren  because  most  taxpayers  who  cannot  pay  are 
also  unable  to  comply  with  the  requirements  of  surety  com- 
panies. If  taxpayers  are  able  to  furnish  bond,  that  fact  alone 
should  make  the  filing  of  bonds  unnecessary. 

The  United  States  has  a  first  lien  on  the  property  of  tax- 
payers and  this  is  reasonable  protection.  It  is  not  fair  to 
creditors  whose  claims  are  subordinate,  that  surety  bonds  be 
demanded  when  taxpayers  are  unable  to  furnish  them. 

Receipts  for  taxes  paid. — The  law  requires  collectors  to 

give  receipts  only  when  requested  to  do  so  by  taxpayers. 

Law.  Section  251.  That  every  collector  to  whom  any  payment 
of  any  tax  is  made  under  the  provisions  of  this  title  shall  upon  re- 
quest give  to  the  person  making  such  payment  a  full  written  or  printed 
receipt,  stating  the  amount  paid  and  the  particular  account  for  which 
such  payment  was  made;  and  whenever  any  debtor  pays  taxes  on  ac- 
count of  payments  made  or  to  be  made  by  him  to  separate  creditors 
the  collector  shall,  if  requested  by  such  debtor,  give  a  separate  receipt 
for  the  tax  paid  on  account  of  each  creditor  in  such  form  that  the 
debtor  can  conveniently  produce  such  receipts  separately  to  his  several 
creditors  in  satisfaction  of  their  respective  demands  up  to  the  amounts 
stated  in  the  receipts;  and  such  receipt  shall  be  sufficient  evidence  in 
favor  of  such  debtor  to  justify  him  in  withholding  from  his  next  pay- 
ment to  his  creditor  the  amount  therein  stated;  but  the  creditor  may, 
upon  giving  to  his  debtor  a  full  written  receipt  acknowledging  the  pay- 
ment to  him  of  any  sum  actually  paid  and  accepting  the  amount  of  tax 
paid  as  aforesaid  (specifying  the  same)  as  a  further  satisfaction  of  the 
debt  to  that  amount,  require  the  surrender  to  him  of  such  collector's 
receipt. 


230  APPLICATION   AND   ADMINISTRATION 

Ruling Receipts  are  documents  required  by  provisions 

of  the  internal  revenue  laws  and  by  regulations  made  in  pursuance 
thereof,  within  the  meaning  of  section  3451,  Rev.  Stat.,  making  it  an 
offense  to  simulate  or  falsely  or  fraudulently  execute  or  sign  any  docu- 
ment required  by  the  internal  revenue  laws,  or  any  regulation  made  in 
pursuance  thereof,  or  to  procure  the  same  to  be  falsely  or  fraudu- 
lently executed,  or  to  advise,  aid  in,  or  connive  at  such  execution 
thereof 

The  offense  may  be  committed  either  where  the  receipt  itself  is  a 
genuine  receipt  of  the  kind  kept  for  that  purpose  in  the  office  of  the 
internal  revenue  collector  but  signed  by  the  defendant  without  au- 
thority, or  where,  even  if  not  a  blank  of  the  kind  required  to  be  kept, 
the.  blank  itself  is  simulated  or  falsely  or  fraudulently  executed  and 

issued  by  a  person  who  has  no  power  or  authority  to  do  so (T.  D. 

2874,  June  23,  1919.) 

The  author  is  informed  that  some  taxpayers  have  not  re- 
ceived receipts  although  specific  requests  were  made  for  them, 
and  that  such  failure  has  caused  great  inconvenience  when  tax- 
payers have  gone  abroad.  Moreover,  inconvenience  is  often 
caused  by  the  lack  of  receipts  when  taxpayers  file  claims  for 
refund.  If  receipts  are  not  available  to  accompany  claims, 
photostated  copies  of  paid  cheques  should  be  used. 


Collection  of  Taxes  by  Suit  and  Summary  Process 

In  view  of  the  possibility  that  during  the  coming  year 
certain  taxpayers  may  be  unable  to  pay  the  tax  assessed  upon 
them,  it  may  be  of  interest  to  include  the  articles  of  the  regu- 
lations dealing  with  collection  by  suit  and  by  summary  process 
peculiar  to  United  States  practice. 

Collection  by  suit. — ^^Obviously  the  government  will  not 
resort  to  an  action  at  law  if  taxes  can  be  collected  by  sum- 
mary assessment  followed  by  distraint  on  the  property  of  the 
taxpayer.  In  the  latter  case  the  government  "gets  the  money," 
in  the  former  case  a  long  period  of  time  elapses  before  the 
action  can  be  tried  and  in  very  many  cases  the  government 
fails  in  its  action.  Therefore  taxpayers  who  have  meritorious 
cases  cannot  be  criticized  for  not  signing  waivers  in  order  to 


ADMINISTRATION,   ASSESSMENT   AND   PAYMENT     231 

enable  the  government  to  force  the  collection  of  taxes  illegally 
assessed. 

If  the  taxpayer  agrees  that  the  additional  tax  is  due,  the 
waivers  should  be  signed,  but  not  otherwise.^^  Specific  and 
not  blanket  waivers  should  be  signed. 

Under  the  19 17  and  prior  laws  there  was  no  limitation  on 
the  time  within  which  the  government  could  bring  suit.  The 
19 1 8  law  provided  that,  except  in  the  case  of  fraud,  suit  had  to 
be  brought  within  five  years  from  the  time  when  the  return 
was  due.  The  1921  law  has  made  some  radical  changes  with 
reference  to  limitation.  There  is  now  a  limitation  period 
both  as  to  suits  and  assessments^*^  for  all  laws. 

Suits  for  taxes  barred  after  five  years. — 

Law.  Section  1320.  That  no  suit  or  proceeding  for  the  collection 
of  any  internal  revenue  tax  shall  be  begun  after  the  expiration  of  five 
years  from  the  time  such  tax  was  due,  except  in  the  case  of  fraud  with 
intent  to  evade  tax,  or  willful  attempt  in  any  manner  to  defeat  or 
evade  tax.  This  section  shall  not  apply  to  suits  or  proceedings  for 
the  collection  of  taxes  under  section  250  of  this  Act,  nor  to  suits  or 
proceedings  begun  at  the  time  of  the  passage  of  this  Act. 

The  foregoing  section  applies  to  all  internal  revenue  taxes. 
While  included  in  the  192 1  law,  it  also  covers  all  prior  laws. 

Collection  of  tax  by  distraint. — The  Revised  Statutes" 
authorize  collectors-  to  collect  taxes  by  distraint  and  sale.  The 
following  regulation  summarizes  sections  3187  and  3196  of 
the  Revised  Statutes : 

Regulation.  If  any  person  lia1)lc  to  pay  any  taxes  neglects  or 
refuses  to  pay  them  within  ten  days  after  notice  and  demand,  it  shall 
be  lawful  for  the  collector  or  his  deputy  to  collect  such  taxes  with  5 
per  cent  additional  and  interest  at  12  per  cent  per  annum  by  distraint 
and  sale  of  the  goods,  chattels  or  effects,  including  stocks,  securities, 
and  evidences  of  debt,  or  other  property  or  rights  of  property,  of  the 
person  delinquent.  When  goods,  chattels,  or  effects  sufficient  to  satisfy 
the  taxes  and  penalties  imposed  upon  any  person  are  not  found  by 


'For  discussion  of  legality  of  waivers,  see  footnote  20,  page  199. 
'  See  page  195. 
Sections  3187  to  3196,  inclusive. 


232 


APPLICATION   AND   ADMINISTRATION 


the  collector  or  deputy  collector,  he  is  authorized  to  collect  such  taxes 
by  seizure  and  sale  of  real  estate (Art.  1009.) 

Rulings.  The  property  of  one  spouse  is  not  subject  to  distraint 
to  enforce  payment  of  an  income  tax  obligation  of  the  other  spouse 
unless  there  has  been  a  transfer  of  property  from  one  spouse  to 
the  other  after  a  tax  has  been  assessed  and  demand  made  for  pay- 
ment thereof.     (B.  40-21-1856;  O.  D.  1056.) 

Property  possessed  by  a  taxpayer  at  the  time  a  lien  for  tax  at- 
tached under  section  3186,  R.  S.,  is  subject  to  distraint  for  the  col- 
lection of  the  tax  and  interest  in  the  hands  of  a  person  who  acquired 
it  by  reason  of  his  death.     (B.  51-21-1986;  O.  D.  1144.) 

Enforcement  of  tax  lien  by  bill  in  equity. — The  govern- 
ment may  secure  a  lien  for  unpaid  taxes.  The  following  regu- 
lation outlines  the  procedure  which  must  be  followed  under 
section  3186  of  the  Revised  Statutes: 

Regulation.  In  the  event  of  nonpayment  of  a  tax  and  penalties 
after  demand,  the  amount  becomes  a  lien  in  favor  of  the  United 
States  from  the  time  when  the  assessment  list  was  received  by  the 
collector  upon  all  property  and  rights  to  property  belonging  to  the 
taxpayer,  except  that  the  lien  is  not  valid  as  against  any  bona  fide 
mortgagee,  purchaser,  or  judgment  creditor  until  notice  thereof  is  filed 
in  the  proper  public  office  or  offices  on  Form  668.  The  collector  may 
file  such  notice  of  lien  upon  making  demand  for  payment  of  the 
tax,  unless  payment  is  made  immediately  upon  demand.  What  is  im- 
mediate payment  will  depend  upon  the  nature  of  the  demand.  Where 
the  collector  contemplates  filing  such  notice  of  lien  on  demand,  when- 
ever practicable,  the  demand  should  be  made  upon  the  taxpayer  in 
person.  In  any  case  where  there  has  been  refusal  or  neglect  to  pay 
the  tax  and  it  has  become  necessary  to  seize  and  sell  real  estate  to 
satisfy  it,  a  bill  in  equity  may  be  filed  in  a  district  court  of  the 
United  States  to  enforce  the  lien  of  the  United  States  for  tax  upon 
any  real  estate  in  which  the  delinquent  has  any  right,  title,  or  interest 
subject  to  the  lien.  This  remedy  does  not  supersede  distraint  but  is 
cumulative.      (Art.   loio.) 

The  district  courts  of  the  United  States  are  invested  with 
jurisdiction  to  render  such  judgments  and  decrees,  both  in 
law  and  in  equity,  as  may  be  necessary  or  appropriate  for  the 
enforcement  of  the  provisions  of  the  law.^* 

"Section  1318. 


ADMINISTRATION,   ASSESSMENT   AND    PAYMENT     233 

Compromise  of  taxes  and  penalties. — Section  3229  of  the 
Revised  Statutes  gives  the  Commissioner  power  to  compro- 
mise cases  of  taxes  and  penalties  both  before  and  after  suit 
has  been  commenced.  The  nature  and  extent  of  this  power 
are  explained  in  the  following  regulation. 

Regulation.  The  Commissioner,  with  the  advice  and  consent 
of  the  Secretary  of  the  Treasury,  may  compromise  any  civil  or  crim- 
inal case  arising  under  the  internal  revenue  laws  instead  of  commenc- 
ing suit  thereon,  and  with  the  advice  and  consent  of  the  Secretary  and 
the  recommendation  of  the  Attorney  General  may  compromise  any 
such  case  after  suit  thereon  has  been  commenced  by  the  United  States. 
Accordingly,  the  power  to  compromise  extends  to  (a)  civil  and 
criminal  cases;  (b)  cases  whether  before  or  after  suit;  and  (c)  taxes 
and  penalties,  except  that  taxes  legally  due  from  a  solvent  taxpayer 
may  not  be  compromised.  Refunds  can  not  be  made  of  accepted  offers 
in  compromise  in  cases  where  it  is  subsequently  ascertained  that  no 
violation  of  law  was  involved (Art.  loii.) 

A  letter,  similar  in  content  to  the  following,  suitably  modi- 
fied if  the  delinquent  was  a  corporation,  has  been  used  in  the 
past  by  the  collectors  in  charging  taxpayers  with  delinquency 
and  in  notifying  them  of  their  privilege  to  submit  offers  in 
compromise. 

Sir:     Your  return  of  net  income  was  not  received  in  this  office 

until ,  thereby  involving  you  in  liability  to  a  specific  penalty  of 

not  less  than  $20.00,  or  more  than  $1,000,  under  the  act  of  , 

in  addition  to  the  50  per  cent  additional  tax  which  will  be  assessed  and 
collected. 

The  provisions  of  the  act  are  mandatory,  and  no  excuse  or  ex- 
planation can  be  accepted,  except  a  showing  that  a  complete  or  tenta- 
tive return  was  in  fact  mailed  in  time  to  have  reached  this  office,  or 
a  Deputy  Collector,  in  the  ordinary  course  of  business  on  or  before 
March  i,  

However,  before  instituting  proceedings  in  court  for  the  imposi- 
tion of  the  specific  penalty,  I  am  directed  to  call  your  attention  to  the 
provisions  of  section  3229,  revised  statutes,  which  reads  in  part  as 
follows : 

"The  Commissioner  of  Internal  Revenue  with  the  advice  and 
consent  of  the  Secretary  of  the  Treasury,  may  compromise  any 
civil  or  criminal  case  arising  under  the  internal  revenue  laws 
instead  of  commencing  suit  thereon,  .  .  .  ." 

Should  you  desire  to  take  advantage  of  your  privilege  under  this 


234  APPLICATION   AND   ADMINISTRATION 

section  and  to  submit  an  offer  in  compromise,  the  amount  offered 
should  be  forwarded  promptly  to  this  office  in  the  form  of  cash,  pos- 
tal money  order,  or  certified  check  which  can  be  cashed  without  cost, 
payable  to  my  order,  accompanied  by  an  affidavit  substantially  in  the 
following  form: 

"To  the  Commissioner  of  Internal  Revenue: 

"I  hereby  solemnly  swear  (or  affirm)  that  my  delinquency  in 

filing  return  of  net  income  as  required  by  the  act  of was 

not  due  to  any  intent  to  violate  the  law  or  evade  taxation,  but 
was  due  to  (here  insert,  concisely  and  clearly,  the  reason  for 
delay). 

"Desiring  to  compromise  my  liability  I  hereby  tender  the  sum 

of  $ ,  which   I   request  be  accepted  in  compromise  of  the 

specific  penalty  only." 

To  be  signed  and  sworn  to  before  a  deputy  collector,  notary,  or 
other  officer  authorized  to  administer  oaths. 

This  affidavit  will  then  be  forwarded  by  me,  together  with  the 
sum  offered,  to  the  Commissioner  for  consideration,  and  you  will  be 
notified  by  him  of  his  acceptance  or  rejection  of  your  proposal.  In 
the  latter  event,  you  may  increase  your  offer,  if  you  so  desire. 

In  an  opinion  dated  June  3,  1919,°^  the  United  States  At- 
torney General  held  that  claims  falling  in  the  following  classes 
may  be  compromised  by  the  Commissioner  whenever,  in  his 
judgment,  such  compromises  are  for  the  interest  of  the  United 
States : 

Claims  for  sums  of  5  per  cent  on  amounts  of  income  and  excess- 
profit  taxes  not  paid  when  due  and  interest  at  the  rate  of  i  per  cent 
per  month  on  said  taxes,  the  collection  of  which  is  authorized  by  sec- 
tions 9(a)  and  14(a)  of  the  act  of  September  8,  1916,  and  section  212 
of  the  act  of  October  3,  1917. 

The  Treasury  has  also  held  in  a  law  opinion*'"  that  an  ad 
valorem  fraud  penalty  "may  at  any  stage  be  compromised  by 
the  Commissioner  and  the  approving  officials,  whether  or  not 
it  be  formally  assessed." 


"31  Op.  Alt.  Gen.  459. 

"^  Bulletin  41-21-1864;  L.  O.  1072. 


CHAPTER  IX 

APPEALS,    REFUNDS   AND   ABATEMENTS    OF 
OVER-ASSESSMENTS 

The  preceding  chapter  deals  with  the  administrative  pro- 
cedure in  connection  with  assessments  and  payments  of  taxes. 
This  chapter  deals  with  the  remedial  procedure  provided  by  the 
Treasury  or  the  courts  whereby  the  taxpayer  may  abate  the 
assessment  and  either  secure  a  cancellation  of  the  assessment  or 
obtain  a  refund  of  taxes  overpaid. 

Prior  to  the  passage  of  the  1921  law,  the  Treasury  acted 
on  the  theory  that  additional  assessments  should  be  made  as 
soon  as  possible,  usually  upon  the  recommendation  of  the  audit 
section/  in  order  that  interest  would  commence  to  accrue  to 
the  government. 

The  present  law  should  bring  about  a  reversal  in  the  policy 
of  the  Treasury.  Additional  assessments  for  the  taxable 
year  192 1  and  subsequent  years  will  bear  interest  at  the  rate  of 
6  per  cent  per  annum  from  the  time  the  tax  was  originally 
due.^ 

Proposed  additional  assessments  should  be  carefully  con- 
sidered before  demand  for  payment  is  made.  The  new  law 
also  provides  that  interest  shall  be  paid  on  taxes  illegally  col- 
lected and  later  refunded.^ 

The  policy  of  the  Treasury  prior  to  1922  in  making  assess- 
ments of  additional  taxes  before  final  decisions,  had  the  in- 
evitable result — the  majority  of  taxpayers  filed  claims  in  abate- 
ment instead  of  paying  the  assessments.  The  Treasury  recog- 
nized that  the  claim  in  aljatcmcnt  evil  had  grown  to  serious 
proportions. 


'  See  Income  Tax  Procedure,  1921,  page  171. 
'  Section  250   (b). 
°  Section  1324. 


236  Al'PLlCATION    AND    ADMINISTRATION 

The  great  defect  has  been  that  taxpayers  inevitably  gained 
the  iinpression  that  conferees  had  little  discretion  and  that 
the  assessment  would  be  made  as  a  matter  of  course.  A  sharp 
distinction  should  be  drawn  between  the  work  of  an  auditor, 
whether  done  in  the  field  or  in  the  office,  and  the  work  of  the 
conferees.  The  auditors,  in  effect,  must  attempt  to  assess  the 
maximum  amount  of  tax  which  under  any  interpretation  of 
the  regulations  can  be  assessed.  The  conferees,  however, 
should  act  as  disinterested  judges.* 

The  hearings  before  the  conferees  should  be  as  impartial  as 
those  before  the  Committee. 

Subdivision  (d)  of  section  250  permits  an  appeal  to  the 
highest  body  in  the  Treasury  before  assessment.  This  sub- 
division provides  that  after  a  taxpayer  has  been  notified  of  a 
proposed  additional  assessment,  he  shall  be  given  "a  period 
of  not  less  than  thirty  days  ....  in  which  to  file  an  ap- 
peal." This  subdivision  further  provides  that,  "Opportunity 
for  hearing  shall  be  granted  and  a  final  decision  thereon  shall 
be  made  as  quickly  as  practicable." 

These  two  changes  should  result  in  more  deliberate  action 
by  the  Treasury  in  the  assessing  of  additional  taxes. ^ 

Importance  of  filing  claims. — The  preceding  chapter  fully 
covers  appeals  from  the  findings  of  revenue  agents,  and  in 
general  all  remedial  measures  up  to  the  time  of-  assessment. 
After  an  assessment  has  once  been  entered  on  the  collectors' 
lists,  there  is  no  recourse  except  by  a  claim  for  abatement  (be- 
fore the  tax  is  paid)*^  or  refund  (after  the  tax  is  paid). 

Many  of  the  additional  assessments  following  examina- 
tions of  taxpayers'  returns  are  based  upon  erroneous  conclu- 
sions drawn  by  examiners,  which  the  courts  would  promptly 
reverse  if  the  taxpayers  brought  suit.    But  suits  at  law  are  so 
expensive,  or  are  thought  to  be,  and  delays  and  postponements 


*  For  discussion  of  procedure  of  Income  Tax  Unit,  see  page  174. 
°  See  page  241. 

'  Qaims  for  abatement  may  now  be  filed  in  only  a  few  instances.     See 
page  242. 


APPEALS,    REFUNDS,   ABATEMENT  237 

are  so  frequent  and  annoying,  that  most  of  those  reassessed 
pay  even  when  they  are  sure  of  the  injustice  of  the  tax. 

Because  of  the  many  erroneous  assessments  which  have 
been  made,  taxpayers  should  be  informed  as  to  the  details  of 
steps  to  be  taken  to  question  an  assessment.  If  a  claim 
is  refused,  the  necessary  procedure  to  secure  from  the  courts 
an  impartial  opinion  as  to  the  sufficiency  of  the  taxpayer's  side 
of  the  contention  should  be  understood.  Until  the  case  reaches 
the  courts  it  cannot  always  be  said  that  the  facts  are  passed 
upon  impartially.^ 

Many  of  the  inequalities  which  existed  under  past  practice 
were  due  to  the  thought  on  the  part  of  those  administering  the 
law  that  there  was  no  middle  ground.  Any  doubtful  point,  no 
matter  how  great  an  injustice  it  might  work,  was  decided 
against  the' taxpayer.  During  recent  years  the  Treasury  has, 
however,  shown  some  improvement  in  this  respect. 

It  is  probable  that  many  court  decisions  will  be  required 
before  the  rights  of  taxpayers  are  fully  protected.  In  the 
meantime,  all  legal  formalities  should  be  observed  by  tax- 
payers so  that  they  may  secure  the  benefit  of  any  future  deci- 
sions which  reverse  past  rulings  of  the  Treasury. 

Taxpayer's  right  to  question  assessment. — Vast  numbers 
of  persons  pay  too  much  tax  for  a  variety  of  reasons:  igno- 
rance ;  the  desire  to  overpay  rather  than  to  underpay ;  the  tend- 
ency to  follow  Treasury  rulings  even  though  obviously  il- 
legal; fear  of  penalties;  fear  that  failure  to  pay  will  be  called 
unpatriotic;  and  many  others.  In  view  of  the  fact  that  in  a 
democracy  the  people  are  supposed  to  be  sovereign  and  public 
officers  their  servants,  this  tendency  is  hard  to  understand. 
It  probably  results  from  the  disinclination  of  the  average 
well-to-do  American  to  go  to  any  trouble  about  overcharges 
of  any  kind.  He  will  pay  a  cab  driver  an  extortionate  fare 
rather  than  question  the  rate.     He  will  tip  an  insolent  and 


'For  appeals  to  tlie   Committee  of  Appeals  and  Review,  see  page   175 
et  scq. 


238  APPLICATION   AND   ADMINISTRATION 

inefficient  waiter  rather  than  be  looked  at  unkindly  or  spoken 
to  offensively. 

It  is  so  with  taxes.  But  there  should  be  a  change.  Public 
officers,  at  least  those  in  Washington,  are  not  to  blame.  An 
effort  has  been  made  to  render  the  remedy  of  an  aggrieved 
taxpayer  as  inexpensive  and  as  little  troublesome  as  possible. 
Taxpayers  who  refuse  to  acquaint  themselves  with  the  reme- 
dies and  means  for  correcting  erroneous  assessments  have 
only  themselves  to  blame. 

Right  to  question  Treasury  rulings. — Regarding  the 
taxpayer's  right  to  question  rulings  and  assessments,  the  fol- 
lowing authoritative  quotation  is  pertinent : 

And  it  follows  that  it  will  be  a  legitimate  mode  of  construing  the 
present  income  tax  law,  in  cases  where  its  language  in  relation  to  a 
particular  point  or  subject  is  obscure,  confusing,  or  unintelligible,  to 
compare  it  with  the  corresponding  provisions  on  the  same  point  in 
the  earlier  acts,  which  may  be  more  clear  and  precise,  and  to  presume 
that  Congress  intended  its  words  to  be  understood  in  the  same  sense 
as  before,  unless  there  is  such  a  distinct  change  of  language  as  to 
compel  the  inference  that  a  change  in  legislation  was  certainly  in- 
tended.* 

Also  the  following  quotations  from  decisions  of  the  United 
States  Supreme  Court  are  of  interest.  The  first  quotation  is 
taken  from  Gould  v.  Gould.^ 

Decisions.  In  the  interpretation  of  statutes  levying  taxes  it  is 
the  established  rule  not  to  extend  their  provisions,  by  implication, 
beyond  the  clear  import  of  the  language  used,  or  to  enlarge  their 
operations  so  as  to  embrace  matters  not  specifically  pointed  out.  In 
case  of  doubt  they  are  construed  most  strongly  against  the  govern- 
ment, and  in  favor  of  the  citizen.  United  States  v.  Wigglesworth, 
2  Story  369,  Fed.  Cas.  No.  16,690;  American  Net  and  Twine  Co.  v. 
Worthington,  141  U.  S.  468,  474,  35  L.  Ed.  821,  824,  12  Sup.  Ct.  Rep. 
55;  Bcnzinger  v.  United  States,  192  U.  S.  38,  55,  48  L.  Ed.  331,  338, 
24  Sup.  Ct.  Rep.  189. 

Keeping  in  mind  the  well-settled  rule,  that  the  citizen  is  exempt 
from  taxation,  unless  the  same  is  imposed  by  clear  and  unequivocal 
language,  and  that  where  the  construction  of  a  tax  law  is  doubtful, 


'Black,  Income  and  Other  Federal  Taxes,  4th  edition,  page  36. 
•24S'U.  S.  151;  38  S.  Ct.  53;  62  L.  Ed.  211. 


APPEALS,   REFUNDS,   ABATEMENT  239 

the  doubt  is  to  be  resolved  in  favor  of  those  upon  whom  the  tax  is 
sought  to  be  laid.^"   .... 

Taxpayers  should  inform  themselves  as  to  the  attitude  of 
the  courts  on  doubtful  points  which  arise  in  the  course  of  the 
administration  of  the  law  as  indicated  by  the  foregoing  quota- 
tions and  by  the  following  clear-cut  statement  in  a  recent  case. 

Decision.  Where  there  is  an  ambiguity  in  the  language  of  a 
statute  imposing  a  tax,  and  that  ambiguity  raises  a  doubt  as  to  the 
legislative  intent,  the  persons  upon  whom  it  is  sought  to  impose 
the  burden  arc  to  be  given  the  benefit  of  the  doubt.^^ 

In  an  earlier  case  this  is  found : 

Decision.  At  the  outset  it  may  be  remarked  that  a  statute  pro- 
viding for  the  imposition  of  taxes  is  to  be  strictly  construed,  and  all 
reasonable  doubts  in  respect  thereto  resolved  against  the  government 
and  in  favor  of  the  citizen. ^- 

The  question  of  the  authority  of  Treasury  regulations  is 

most  aptly  discussed  in  Black's  Income  Taxes  (4th  edition), 

page  9. 

But  of  course  it  is  not  within  the  lawful  power  of  these  officers 
to  go  a  step  beyond  the  limits  of  the  act  of  Congress  under  which 
their  authority  is  exercised.  They  could  neither  bring  within  the 
purview  of  the  law  or  of  their  regulations  anything  not  definitely 
within  the  words  of  the  act,  nor  except  from  its  operation  anything 
not  clearly  meant  to  be  excluded,  nor  add  to  the  burden  of  the  tax- 
payer anything  which  Congress  did  not  intend  to  impose  upon  him. 
But  within  the  limits  of  their  rightful  authority,  regulations  pre- 
scribed by  the  Commissioner  of  Internal  Revenue,  pursuant  to  statu- 
tory authority,  with  the  approval  of  the  Secretary  of  the  Treasury 
where  necessary,  in  respect  to  the  assessment  and  collection  of  in- 
ternal revenue  taxes,  or  for  the  government  of  the  officers  of  the 
revenue  department,  have  all  the  force  and  effect  of  law,  and  are  as 
binding  as  if  incorporated  in  the  statute  law  of  the  United  States; 
and  the  acts  of  the  Commissioner  are  presumed  to  be  the  acts  of  the 
Secretary.  But  the  construction  given  to  an  act  of  Congress  impos- 
ing internal  revenue  taxes  by  the  Commissioner  of  Internal  Revenue, 
though  officially  published,  is  not  a  construction  of  so  much  dignity 


^"Spreckles  Sugar  Co.  v.  McCla'm,  192  U.  S.  397;  24  S.  Ct.  376;  48 
L.  Ed.  496. 

"  Edwards  v.  Wabash  Raihvay  Co.,  264  Fed.  610,  619. 

"Mutual  Benefit  Life  Ins.  Co.  v.  Herold,  ig8  Fed.  199;  affirmed  201 
Fed.  918;  120  C.  C.  A.  256. 


240 


APPLICATION   AND   ADMINISTRATION 


that  a  re-enactment  of  the  statute  subsequent  to  the  construction  is 
to  be  regarded  as  a  legislative  adoption  of  that  construction,  and 
especially  when  the  construction  would  make  a  proviso  to  the  act 
repugnant  to  the  body  of  the  act. 

In  T hacker  v.  United  States, ^^  the  court  said : 

Decision.  The  Commissioner  of  Internal  Revenue  cannot  alone, 
or  in  connection  with  the  Secretary  of  the  Treasury,  alter  or  amend 
the  internal  revenue  law.  All  he  can  do  is  to  carry  into  effect  that 
which  Congress  has  enacted.  His  regulations  in  aid  of  the  execution 
of  the  law  must  be  reasonable,  and  made  with  a  view  to  the  due  assess- 
ment and  collection  of  the  revenue. 

Changed  interpretation — retroactive  effect. — It 
should  be  borne  in  mind  that  Treasury  interpretations  are, 
after  all,  merely  interpretations.  Therefore,  if  the  courts 
decide  that  the  law  means  something  different  from  what  the 
Treasury  has  held  it  to  mean,  the  rulings  must  be  reversed  and 
redress  granted  or  additional  levies  made  back  to  the  date  of 
the  passage  of  the  law. 

The  new  law  provides : 

Law.  Section  13 14.  That  in  case  a  regulation  or  Treasury  decision 
relating  to  the  internal-revenue  laws  made  by  the  Commissioner  or  the 
Secretary,  or  by  the  Commissioner  with  the  approval  of  the  Secretary, 
is  reversed  by  a  subsequent  regulation  or  Treasury  decision,  and  such 
reversal  is  not  immediately  occasioned  or  required  by  a  decision  of  a 
court  of  competent  jurisdiction,  such  subsequent  regulation  or  Treasury 
decision  may,  in  the  discretion  of  the  Commissioner,  with  the  approval 
of  the  Secretary,  be  applied  without  retroactive  effect. 

It  is  not  easy  to  make  a  general  statement  as  to  how  far 
a  Treasury  ruling  which  reverses  some  previous  Treasury 
ruling  is  retroactive.  Much  depends  upon  the  circumstances. 
Certainly  administrative  difficulties  are  .sufficient  to  justify 
the  prohibition  of  wholesale  readjustments  of  returns  unless 
the  changes  are  of  considerable  importance.  In  the  language 
of  the  regulations,  "cases  previously  adjusted  in  contravention 
of  law,  as  pronounced  in  such  decisions,  are  subject  to  read- 
justment in  accordance  with  the  decisions." 


15  Blatch  15,  Fed.  Gas.  No.  13851. 


APPEALS,   REFUNDS,    ABATEMENT  241 

Abatement 

When  notice  of  assessment  of  additional  tax  was  received 
prior  to  the  1921  law,  it  was  difficult  to  decide  whether  to  file 
claim  for  abatement  and  at  least  defer  payment  of  the  tax,  or 
to  pay  the  tax  and  file  claim  for  refund. 

Under  the  new  law  a  claim  for  abatement  may  be  filed  only 
in  a  few  instances. 

Law.     Section  250 (d)  ....  If  upon  examination  of  a 

return  made  under  the  Revenue  Act  of  1916,  the  Revenue  Act  of  1917, 
the  Revenue  Act  of  1918  or  this  Act,  a  tax  or  a  deficiency  in  tax  is 
discovered,  the  taxpayer  shall  be  notified  thereof  and  given  a  period  of 
not  less  than  thirty  days  after  such  notice  is  sent  by  registered  mail 
in  which  to  file  an  appeal  and  show  cause  or  reason  why  the  tax  or 
deficiency  should  not  be  paid.  Opportunity  for  hearing  shall  be 
granted  and  a  final  decision  thereon  shall  be  made  as  quickly  as  prac- 
ticable. Any  tax  or  deficiency  in  tax  then  determined  to  be  due  shall 
be  assessed  and  paid,  together  with  the  penalty  and  interest,  if  any, 
applicable  thereto,  within  ten  days  after  notice  and  demand  by  the  col- 
lector as  hereinafter  provided,  and  in  such  cases  no  claim  in  abatement 
of  the  amount  so  assessed  shall  be  entertained:  Provided,  That  in  cases 
where  the  Commissioner  believes  that  the  collection  of  the  amount 
due  will  be  jeopardized  by  such  delay  he  may  make  the  assessment 
without  giving  such  notice  or  awaiting  the  conclusion  of  such 
hearing 

There  can  be  no  doubt  as  to  the  meaning  of  the  foregoing 
section.  Except  in  those  cases  where  the  Commissioner  may 
believe  the  additional  tax  is  in  jeopardy,  an  application  in  the 
nature  of  a  formal  appeal  must  be  allowed.  Whether  the  ap- 
peal is  heard  by  the  Commissioner  himself  through  the  Com- 
mittee on  Appeals  and  Review,  or  before  some  other  appeal 
body  of  unquestioned  standing,,  is  immaterial.  The  reference 
of  an  appeal  to  a  subordinate  section  or  to  anyone  who  had 
theretofore  passed  upon  the  case  will  not  be  an  appeal  within 
the  meaning  of  the  law. 

Decision  must  be  made  before  assessment,  provided,  of 
course,  notice  of  appeal  is  filed  in  accordance  with  the  statu- 
tory provision.  1 

If  notice  of  appeal  is  not  given  within  the  specified  time, 


242  APPLICATION   AND   ADMINISTRATION 

the  assessment  must  be  paid  in  due  course.  The  collector  is 
not  authorized  to  accept  a  claim  for  abatement.  In  such  a 
case  a  claim  for  refund  is  the  only  recourse. 

Abatements  may  be  filed — when? — Claims  for  abatement 
have  not,  however,  been  entirely  abolished.  Use  for  such 
claims  may  be  found  in  the  following  cases : 

1.  Where  the  Commissioner  believes  the  tax  is  in 
jeopardy. 

2.  Where  it  is  necessary  to  postpone  payment  of  one 
or  several  instalments.  Cases  of  this  kind  may  occur 
where  an  error  has  been  discovered  before  all  instal- 
ments of  a  tax  have  been  paid. 

3.  Where  a  claim  for  abatement  or  credit  on  file  with  the 
Treasury  has  been  disallowed  without  the  taxpayer 
having  had  an  opportunity  to  be  heard  on  appeal. 
Cases  of  this  kind  can  be  eliminated  by  changing  the 
procedure  with  regard  to  claims  of  all  kinds.  This 
change  is  discussed  elsewhere." 

4.  Where  an  erroneous  assessment  is  made.  It  is  pre- 
dicted that  assessments  will  be  made  where  the  taxpayer 
has  not  been  notified  in  accordance  with  the  law.  Also, 
taxpayers  will  often  file  a  notice  of  appeal  and  yet  the 
assessment  will  be  made.  It  is  natural  for  mistakes  of 
this  sort  to  happen,  especially  in  government  offices. 

Experience  will  no  doubt  show  that  other  cases  will  arise, 
because  a  claim  for  abatement  may  be  used  where  there  is  any 
good  reason  to  hold  a  payment  in  abeyance ;  provided,  however, 
that  the  case  is  of  a  kind  in  which  the  law  does  not  specifically 
forbid  the  acceptance  thereof. 

Interest  payable  on  abatement — when? — When  claim  for 
abatement  is  filed  there  is  in  any  case  some  chance  that  the 
claim  of  the  taxpayer  will  be  denied.    Therefore  it  is  important 

"  Sec  page  213. 


APPEALS,    REFUNDS,    ABATEMENT  243 

that  the  claim  for  abatement  be  filed  within  ten  days  from  date 
of  assessment  in  order  to  prevent  the  5  per  cent  penalty  from 
being  imposed. 

Law.     Section  250 (e)   If  any  tax  remains  unpaid  after  the 

date  when  it  is  due,  and  for  ten  days  after  notice  and  demand  by  the 
collector,  then,  except  in  the  case  of  estates  of  insane,  deceased,  or 
insolvent  persons,  there  shall  be  added  as  part  of  the  tax  the  sum  of 
5  per  centum  on  the  amount  due  but  unpaid,  plus  interest  at  the  rate 
of  I  per  centum  per  month  upon  such  amount  from  the  time  it  became 
due:  Provided,  That  as  to  any  such  amount  which  is  the  subject  of  a 
bona  fide  claim  for  abatement  filed  within  ten  days  after  notice  and  de- 
mand by  the  collector,  where  the  taxpayer  has  not  had  the  benefit  of 
the  provisions  of  subdivision  (d),  such  sum  of  5  per  centum  shall  not 
be  added  and  the  interest  from  the  time  the  amount  was  due  until 
the  claim  is  decided  shall  be  at  the  rate  of  one-half  of  i  per  centum 
per  month  on  that  part  of  the  claim  rejected 

If  the  claim  or  any  part  of  it  is  denied,  interest  at  the 
rate  of  6  per  cent  per  annum^^  will  be  added  to  the  amount 
disallowed.  Where,  however,  a  claim  for  an  abatement  is 
filed  under  the  1918  act,  based  on  the  grounds  of  a  loss  in 
inventory,"  interest  at  the  rate  of  12  per  cent  per  annum  will 
be  added  to  the  tax  not  abated,  beginning  with  the  original 
due  date." 

Section  250  (e)  applies  to  claims  for  abatement  under  both 
the  1918  and  192 1  laws. 

The  192 1  law  does  not  make  any  important  change  in  this 
section. 

Under  laws  previous  to  that  of  1918,  interest  at  the  rate  of 
I  per  cent  a  month  is  imposed  upon  the  amount  disallowed." 
The  author  is  of  the  opinion  that  this  interest  may  in  certain 
cases  be  reduced  to  6  per  cent  by  paying  any  additional  assess- 
ment for  the  year  1917  and  filing  a  claim  for  credit  against  any 
instalments  which  will  fall  due  within  that  year.     The  taxes 


"  If  it  is  held  that  the  claim  is  not  made  in  good  faith  the  rate  of  inter- 
est is  12  per  cent. 

'"Income  Tax  Procedure,  1921,  page  188. 
"Section  214  (a-12),  1918  law. 
"C.  B.  4,  page  318;  O.  D.  798. 


244 


APPLICATION    AND   ADMINISTRATION 


against  which  the  credit  would  be  claimed  would  of  course 
be  a  year  subsequent  to  191 7.  Under  the  19 18  and  1921  laws 
a  claim  for  credit  bears  interest  at  6  per  cent  per  annum.  The 
191 7  payment  should  of  course  be  made  under  protest  and  it 
would  also  be  well  at  that  time  to  advise  the  collector  of  the 
taxpayer's  intentions. 

Ruling.  Advice  is  requested  whether  it  is  permissible  for  an 
individual  to  file  a  claim  for  abatement  of  tax  and  penalties  assessed 
after  service  of  second  notice  and  demand  on  Form  21  and  issuance 
of  warrant  of  distraint  on  Form  69. 

Held,  that  a  bona  fide  claim  for  abatement  may  be  filed  at  any 
time  prior  to  payment  of  the  tax.  The  filing  of  a  claim  for 
abatement,  however,  does  not  necessarily  operate  as  a  suspension  of 
the  collection  of  the  tax  or  make  it  any  less  the  duty  of  the  collector 
to  exercise  due  diligence  to  prevent  the  collection  of  the  tax  being 
jeopardized.  He  should,  if  he  considers  it  necessary,  collect  the  tax 
and  leave  the  taxpayer  to  his  remedy  by  claim  for  refund. 

H  a  claim  for  abatement  of  a  tax  is  filed  after  the  taxpayer  has 
incurred  the  5  per  cent  penalty  and  i  per  cent  a  month  interest  for 
nonpayment  within  the  prescribed  time,  the  penalty  and  interest 
should  not  be  collected  unless  the  claim  is  decided  adversely  to  the 
taxpayer. 

In  the  case  of  an  adverse  decision,  the  amount  disallowed  in  claim 
for  abatement,  plus  interest  thereon,  at  the  rate  of  I  per  cent  a 
month  from  the  original  due  date  of  the  tax  until  the  date  of  filing 
abatement  claim,  and  at  the  rate  of  one-half  of  i  per  cent  per  month 
from  the  latter  date  until  the  date  of  the  adverse  decision,  together 
with  the  5  per  cent  penalty  on  the  amount  of  tax  disallowed,  should 
be  collected  from  the  taxpayer.     (P..  51-21-1985;  O.  D.  1143.) 

May  abatement  be  allowed  if  an  equivalent  amount  of 
tax  is  due? — Since  very  few  abatement  claims  will  be  filed 
under  the  1921  law,  the  following  ruling  applies  principally 
to  cases  arising  under  the  1918  and  prior  laws: 

Ruling.  The  validity  of  an  assessment  depends  upon  the  law  and 
actual  facts  existing.  Therefore,  an  assessment  made  upon  an  er- 
roneous theory  or  by  mistake  may  not  be  remitted  or  abated  because 
so  made  if,  at  the  time  its  validity  is  passed  upon  the  Commissioner 
is  in  possession  of  evidence  which  shows  an  equivalent  amount  of  tax 
is  properly  due  in  connection  with  the  income,  transaction  or  matter 
upon  which  the  assessment  is  predicated.  (B.  49-21-1967;  T.  D. 
3251-) 


APPEALS,    REFUNDS,    ABATEMENT  245 

The  validity  of  the  foregoing  riihng  is  questioned.  Under 
the  laws  prior  to  192 1,  interest  did  not  begin  to  run  until  after 
assessment  was  made.  This  ruling  may  subject  taxpayers  to 
interest  charges  from  the  dates  of  the  illegal  assessment,  with- 
out proper  compliance  by  the  Treasury  with  the  sections  of 
the  law  dealing  with  other  assessments  (even  though  meritori- 
ous) barred  by  limitation  of  time,  as  well  as  where  interest 
is  specifically  held  to  conunence  when  collectors  give  notice 
of  assess!::ents. 

Content  of  claim  in  abatement  must  be  supported  by  sworn 
statement. — The  foll<  wing  regulation  sets  forth  the  details  of 
procedure  in  claims  for  abatements  : 

Regulation.  Claims  for  abatement  of  taxes  illegally  or  er- 
ro  icously  assessed  shall  be  made  on  Form  843.  They  must  be  sus- 
tained by  the  affidavits  of  the  parties  against  whom  the  taxes  were 
assessed,  or  of  other  parties  cognizant  of  the  facts.  When  a  tax  has 
been  assessed  and  turned  over  to  the  collector,  the  presumption  is  that 
the  assessment  is  correct.  The  burden  of  proof  in  rebutting  the  pre- 
sumption and  showing  that  it  was  improperly  or  illegally  assessed, 
or  that  relief  should  be  given  under  a  remedial  statute,  rests  upon  the 
applicant  for  abatement.  The  affidavits  must  therefore  contain  full 
and  explicit  statements  of  all  the  material  facts  relating  to  the  claim 
in  support  of  which  they  are  offered  and  to  the  proper  consideration  of 
which  they  are  essential.  The  legality  of  the  claim  is  to  be  determined 
by  the  Commissioner  upon  the  facts  presented  to  him.  The  filing 
of  a  claim  for  abatement  does  not  necessarily  operate  as  a  suspen- 
sion of  the  collection  of  the  tax  or  make  it  any  less  the  duty  of  the 
collector  to  exercise  due  diligence  to  prevent  the  collection  of  the  tax 
being  jeopardized.  He  should,  if  he  considers  it  necessary,  collect 
the  tax  and  leave  the  taxpayer  to  his  remedy  by  a  claim  for  refund. 
Claims  for  abatement  may  not  be  filed  where  the  taxpayer  has  had  the 
benefit  of  the  provisions  of  section  250 (d).^"   ....      (Art.  1032.) 

Provision  has  been  made  in  this  article  for  appeal  under 
section  250   (d)  ;     otherwise  there  is  no  change. 

The  author's  experience  has  been  that  many  claims  for 
abatement  are  denied  because  the  foregoing  reasonable  and 


"  Section  250  (d)  gives  the  taxpayer  the  right,  upon  notice  of  assess- 
ment 4:o  be  made  in  thirty  days,  to  appeal  before  such  assessment  is  finally 


made. 


246  APPLICATION   AND    ADMINISTRATION 

legal  procedure  is  not  followed  by  taxpayers.  It  is  not  enough 
to  make  a  short  affidavit  to  the  effect  that  the  tax  is  illegally 
or  wrongfully  assessed.  It  should  be  remembered  that  the 
additional  assessment  is  often  the  result  of  a  long  and  careful 
audit  of  the  returns.  The  taxpayer  is  entitled  to  and  should 
have  full  particulars  of  the  basis  of  the  assessment. 

The  claim  for  abatement  should  contain  complete  references 
to  the  law  and  regulations  bearing  on  the  matters  in  dispute 
and  should  cite  such  authorities,  precedents  and  business  prac- 
tices as  are  applicable.  The  author  has  never  known  of  a 
case  where  the  presentation  of  a  carefully  prepared  claim  has 
not  received  equally  careful  attention. 

Meaning  of  term  "bona  fide  claim." — Section  250  (e)  of 
the  law  provides  that,  when  the  claim  for  abatement  is  made  in 
good  faith  and  subsequently  denied,  interest  at  the  rate  of  ^ 
o'f  I  per  centum  per  month  shall  be  charged  on  the  tax  from 
the  time  it  was  due  until  the  claim  is  decided.  It  is  therefore 
of  great  importance  not  to  invoke  the  law  unless  the  abate- 
ment can  be  proved  to  be  "the  subject  of  a  bona  fide  claim." 
It  has  been  shown  that  taxpayers  have  an  undoubted  right  to 
question  assessments,  but  the  questioning  of  an  assessment 
must  be  founded  on  more  than  mere  doubt  in  order  to  support 
a  contention  that  a  claim  for  abatement  is  filed  in  good  faith. 

When  the  taxpayer  is  confident  that  his  original  return 
was  properly  prepared  there  can  be  little  doubt  as  to  the  im- 
position of  the  6  per  cent  interest  rate  if  the  claim  for  abate- 
ment is  denied.  The  Commissioner,  in  order  to  impose  the  12 
per  cent  interest  rate,  would  have  to  hold  that  the  claim  was 
made  in  bad  faith.  Taxpayers  should  be  able  to  make  a  good 
showing  in  the  hearing  of  their  cases  and  leave  no  doubt  in 
the  minds  of  the  reviewing  authorities  as  to  the  good  faith 
involved  in  the  claim. 

Collector  may  require  a  bond. — As  it  is  within  the  discre- 
tion of  a  collector  to  accept  or  reject  a  claim  for  abatement 


APPEALS,   REFUNDS,    ABATEMENT  247 

and,  as  he  is  charged  personally  with  the  assessment,  he  may 
require  a  bond  at  the  time  of  accepting  a  claim  for  abatement. 

Ruling While  there  is  no  provision  of  law  expressly  au- 
thorizing the  collector  to  require  a  bond  as  a  condition  of  suspending 
the  collection  of  the  tax,  he  is  personally  charged  with  the  amount  of 
the  assessments  made  against  taxpayers  in  his  district  and  he  is  re- 
quired to  use  due  diligence  in  collecting  such  taxes.  If  he  fails  to  exer- 
cise due  diligence,  it  is  clear  that  he  becomes  personally  liable  for  any 
tax  which  may  be  lost  through  such  failure.  He  may  require  the 
tax  to  be  paid  and  leave  the  taxpayer  to  his  remedy  by  a  claim  for 
refund,  and  if  he  see  fit  to  suspend  the  collection  of  the  tax  in  any 
case  where  a  final  collection  may  thus  be  jeopardized  he  does  it  at 
his  own  risk.  It  is  within  his  discretion  to  protect  himself  by  requir- 
ing the  taxpayer  to  execute  a  bond  in  the  amount  of  the  tax  the  col- 
lection of  which  is  postponed (C.  B.  i,  page  257;  O.  957.) 

Section  1329  provides  that  the  collector  may  accept  as 
security  Liberty  bonds  or  other  bonds  or  notes  of  the  United 
States. 

When  may  a  collector  reject  a  claim  for  abatement? — The 
question  has  arisen  as  to  whether  or  not  a  collector,  after  he 
has  accepted  a  claim  for  abatement  and  has  forwarded  it  to 
the  Commissioner,  may  send  out  a  second  notice  and  demand, 
although  the  Commissioner  has  neither  allowed  nor  rejected 
the  claim,  requiring  payment  within  10  days.  These  second 
notices  and  demands  not  only  include  the  original  amount  of 
the  assessment  but  add  the  5  per  cent  penalty  and  interest  at 
the  rate  of  i  per  cent  a  month.  If  the  tax  is  not  paid  or  if  a 
bond  is  not  filed,  may  the  collector  proceed  to  collect  by  dis- 
traint? 

Since  a  large  number  of  collectors  passed  out  of  office 
with  the  change  in  administration,  the  above  procedure  was 
followed  to  establish  the  requirement  of  due  diligence  in  en- 
deavoring to  collect  the  tax. 

After  a  collector  accepts  a  claim  for  abatement  and  for- 
wards it  to  the  Commissioner  for  consideration,  the  collector 
should  not  send  out  a  second  notice  and  demand  until  the  Com- 
missioner has  notified  him  that  it  has  been  rejected.    If,  how- 


248  APPLICATION   AND   ADMINISTRATION 

ever,  the  second  notice  is  sent,  the  collector  should  be  informed 
that  a  claim  in  abatement  is  already  on  file.  Form  843  can  be 
used  for  this  purpose,  a  copy  of  the  former  claim  being  at- 
tached. By  this  means,  it  is  possible  that  summary  action  by 
the  collector  may  be  prevented. 

At  the  time  when  the  claim  is  accepted  the  collector  must  be 
convinced  that  it  is  a  "bona  fide  claim,''  and  that  the  taxpayer  is 
in  a  position  to  pay  and  will  pay  the  tax  if  the  Commissioner, 
after  consideration,  rejects  it.  Of  course,  if  after  a  claim  has 
been  accepted  some  unforeseen  event  takes  place  which  may 
jeopardize  the  government's  interest,  it  would  be  reasonable 
to  demand  either  a  bond  or  payment.  But  this  certainly  should 
be  done  only  with  the  approval  of  the  Commissioner,  because 
there  are  many  taxpayers  who  have  claims  pending  with  the 
Treasury  which  have  been  on  file  many  months. 

In  any  event,  it  is  improper  to  include  the  5  per  cent  pen- 
alty and  interest  at  the  rate  of  i  per  cent  a  month,  because  the 
penalty  has  been  made  inoperative  by  the  filing  of  the  claim 
for  abatement,  and  interest  can  only  be  collected  on  the  amount 
of  the  claim  disallowed  by  the  Commissioner. 

Claim  for  abatement  filed  by  receivers. — 

Ruling.  Where  the  property  of  a  corporation  is  in  the  hands 
of  a  receiver  who  files  a  claim  for  abatement  of  an  additional  assess- 
ment of  income  and  profits  taxes  for  1917,  no  bond  should  be  required 
as  security  for  the  payment  of  such  taxes.  The  government,  how- 
ever, has  the  right  under  section  3466,  R.  S.,  to  receive  payment  of 
these  taxes  from  the  receiver  in  preference  to  the  creditors  of  the 
corporation.     (B.  47-20-1316;  O.  D.  733.) 

Method  of  calculation  of  interest  under  1918  law  when  a 
claim  for  abatement  or  credit  is  rejected. — 

Ruling.  Where  a  claim  for  abatement  (section  250  (e)  )  or  a 
claim  for  credit  (section  252)  is  rejected,  the  tax  which  is  the  subject 
of  the  claim  is  chargeable  with  interest  at  the  rate  of  one-half  of  I 
per  centum  per  month  from  the  time  the  tax  was  originally  due 
until  the  claim  is  decided  adversely  to  the  taxpayer;  notice  of  the 
adverse  decision  is  sent  to  the  collector  who  must  send  to  the  claim- 


APPEALS,   REFUNDS,    ABATEMENT  249 

ant  a  notice  and  demand  for  payment  of  the  assessment;  if  the  tax 
is  paid  within  the  ten  day  period  following  the  sending  of  the  notice 
the  5  per  cent  penalty  is  not  collectible,  and  the  only  interest  col- 
lectible is  that  at  the  rate  of  one-half  of  i  per  centum  per  month 
from  the  time  the  tax  was  originally  due  until  the  date  of  the  Com- 
missioner's decision;  if  the  tax  covered  by  the  rejected  portion  of 
the  abatement  claim  is  not  paid  within  ten  days  from  the  date  of 
the  notice  and  demand  for  payment,  the  penalty  of  5  per  cent  attaches, 
and  in  addition  thereto,  interest  at  the  rate  of  one-half  of  i  per 
centum  per  month  from  the  original  due  date  to  the  date  of  the 
adverse  decision  by  the  Commissioner  and  at  the  rate  of  i  per  cen- 
tum per  month  from  that  date  to  the  date  of  payment.  (B.  Digest 
31-20-1106;  S.  O.  32.) 

If  some  time  has  elapsed,  as  is  usually  the  case,  between 
the  date  of  the  Commissioner's  adverse  decision  and  the  plac- 
ing of  the  assessment  on  the  list,  and  if  the  taxpayer  pays  the 
tax  within  10  days  after  notice  and  demand  from  the  collector, 
he  is  charged  interest  only  up  to  the  date  of  the  adverse  de- 
cision, which  may  be  a  considerable  time  before  the  taxpayer 
actually  pays  the  taic  without  penalty. 

In  the  detailed  opinion  of  the  solicitor,  it  is  stated: 

....  the  date  of  the  adverse  decision  by  the  Commissioner  be- 
comes a  newly  established  due  date  and  is  subject  to  all  the  provisions 
of  law  relating  to  penalties  and  interest. 

Failure  to  pay  within  10  days  involves  additional  interest 
at  I  per  cent  a  month  from  the  date  of  the  adverse  decision  to 
date  of  payment. 


Actions  to  Restrain  Payment  of  Taxes 

If  no  claim  for  abatement  is  made,  or  if  one  is  not  per- 
mitted because  a  final  decision  has  been  made,  or  if  claim 
is  made  and  denied,  the  tax  imposed  must  ordinarily  be  paid. 

Suits  to  restrain  collection  of  taxes — not  maintainable. — 

Law.  Section  3224.  [Rev.  Stat.]  [Barnes'  Federal  Code,  Sec- 
tion 5123.]  No  suit  for  the  purpose  of  restraining  the  assessment  or 
collection  of  any  tax  shall  be  maintained  in  any  court. 


250  APPLICATION   AND   ADMINISTRATION 

The-  federal  courts  in  construing  this  provision  have  uni- 
formly held  that  no  injunction  will  issue  for  this  purpose. 

It  is  of  interest  to  note,  in  the  case  of  Snyder  v.  Marks/° 
that,  although  it  was  alleged  that  the  "assessment  was  made 
more  than  fifteen  months  after  the  time  which  it  embraced  had 
elapsed,"  a  bill  in  equity  will  not  He  to  enjoin  a  collector  of 
internal  revenue  from  collecting  the  tax.  The  following  lan- 
guage of  the  court  is  of  particular  importance  because  it  relates 
to  section  3224,  which  is  still  in  effect : 

Decision.  The  inhibition  of  section  3224  applies  to  all  assess- 
ments of  taxes,  made  under  color  of  their  offices,  by  internal  reve- 
nue officers  charged  with  general  jurisdiction  of  the  subject  of  assess- 
ing taxes  against  tobacco  manufacturers.  The  remedy  of  a  suit  to 
recover  back  the  tax  after  it  is  paid,  is  provided  by  statute,  and  a 
suit  to  restrain  its  collection  is  forbidden.  The  remedy  so  given  is 
exclusive,  and  no  other  remedy  can  be  substituted  for  it.  Such  has 
been  the  current  of  decisions  in  the  circuit  courts  of  the  United 
States,  and  we  are  satisfied  it  is  a  correct  view  of  the  law. 

It  would  appear  that  if  Congress  says  in  one  section  of 
the  law  that  no  assessment  shall  be  made  after  the  expiration 
of  a  certain  period,  and  says  in  another  that  «o  suit  shall  be 
brought  against  the  government  to  restrain  the  payment  of 
taxes,  the  two  sections  should  be  construed  together.  If  an 
injunction  cannot  be  secured  in  case  the  assessment  is  made 
after  the  limitation  period,  the  intention  of  Congress  cannot 
be  carried  out.  Otherwise  the  section  in  regard  to  the  3  or  5 
years'  limitation  might  as  well  have  been  omitted.  Certainly, 
the  enactments  of  Congress  should  have  some  effect. 

A  more  recent  case,  Markle  v.  Kirkendall,"^  confirms  the 
principle  of  the  Snyder  case.  In  the  Markle  case  an  attempt 
was  made  to  restrain  the  collector  from  collecting  a  tax  which 
the  Commissioner  had  assessed  against  a  taxpayer  as  a  cor- 
poration, whereas  the  taxpayer  was  a  copartnership  when  the 
tax  was  assessed.  The  court  held  that  as  long  as  the  taxpayer 
can  be  brought  within  the  terms  of  the  law  as  taxable,  the  col- 


'  109  U.  S.  i8g;  27  L.  Ed.  901 ;  3  S.  Ct.  157;  decided  November  12,  1883. 
267  Fed.  498. 


APPEALS,   REFUNDS,    ABATEMENT  251 

lector  may  not  be  enjoined,  although  his  proceeding  is  errone- 
ous or  irregular.  The  tax  must  be  paid  and  if  an  appeal  for 
refund  is  disallowed  a  suit  may  then  be  brought  against  the 
collector  for  recovery  of  the  tax  paid. 

In  the  case  of  Dodge  Bros.  v.  Oshorn,^^  Chief  Justice  White 
intimated  that  an  injunction  might  be  secured  in  exceptional 
cases. 

Decision the   statute  plainly   forbids  the  enjoining  of   a 

tax  unless  by  some  extraordinary  and  entirely  exceptional  circum- 
stance its  provisions  are  not  applicable. 

The  cases  which  hold  that  a  stockholder  may  restrain  col- 
lection in  case  of  an  unconstitutional  tax  were  decided  subse- 
quent to  1888,  the  date  of  the  Snyder  case. 

It  may  very  well  be,  therefore,  in  case  it  can  be  shown  that 
a  suit  against  a  collector  to.  recover  the  tax  paid  and  interest 
would  not  afford  the  taxpayer  an  adequate  remedy,  because, 
in  order  to  pay  the  tax  he  would  be  compelled  to  dispose  of 
property  at  a  figure  below  its  real  worth,  for  which,  of  course, 
the  return  of  the  tax  and  interest,  would  not  reimburse  him, 
that  a  court  of  equity,  in  the  exercise  of  its  inherent  juris- 
diction to  afford  relief  where  a  suitor  has  no  adequate  remedy 
at  law,  would  act  by  injunction  to  prevent  the  collection  of  a 
tax  illegally  assessed.  Such  an  injunction  has  recently  been 
applied  for  in  Delaware.  Article  1050  states  that  the  "restrain- 
ing" provision  does  not  apply  to  suits  for  injunctive  relief. 

Stockholders'  suits. — In  cases  where  a  speedy  determina- 
tion of  the  constitutionality  of  the  tax  is  desirable,  a  pro- 
cedure has  been  followed  which  appears  to  be  a  justifiable 
evasion  of  the  statutory  inhibition  against  litigating  the  validity 
of  taxes  before  their  payment.  This  is  done  under  the  color 
of  a  stockholder's  suit,  brought  to  restrain  the  corporation 
from  an  alleged  illegal  use  of  the  corporate  assets.  The  right 
of  a  stockholder  to  maintain  such  a  suit  is  now  well  estab- 


'240  U.  S.  118;  36  S.  Ct.  275;  60  L.  Ed.  557- 


252 


APPLICATION    AND    ADAIINISTRATION 


lished.^^  The  application  of  this  procedure  to  tax  cases  was 
first  resorted  to  in  the  Income  Tax  Cases/*  and  has  been  sub- 
sequently upheld  as  proper  in  view  of  the  confusion  and  in- 
justice which  would  result  if  the  corporation  paid  the  tax."^ 

Refunds 

After  a  tax  has  been  paid  and  a  taxpayer  believes  that 
it  was  unlawfully  or  wrongfully  assessed  or  collected  he  may 
make  claim  for  refund  (on  form  843).  Generally  speaking, 
the  government  imposes  no  restrictions  against  claims  for 
refund  and  such  claims  are  considered  on  their  merits.  This 
practice  must  not  be  confused  with  the  procedure  in  case  of 
suit  against  the  government.  When  suit  is  brought  the  gov- 
ernment interposes  all  the  legal  obstacles  at  its  command. 

Refund  of  taxes  erroneously  collected. — The  following 
regulation  gives  the  details  of  procedure  in  claims  for  refund. 

Regulation.  Claims  by  the  taxpayer  for  the  refunding  of  taxes 
and  penalties  erroneously  or  illegally  collected  shall  be  made  on  form 
843.  In  this  case  the  burden  of  proof  rests  upon  the  claimant. 
All  the  facts  relied  upon  in  support  of  tbe  claim  should  be  clearly  set 
forth  under  oath.  In  tlie  case  of  the  taxpayer's  death,  certified 
copies  of  the  letters  of  administration  or  letters  testamentary, 
or  other  similar  evidence,  must  be  annexed  to  the  claim  to  show 
the  authority  of  the  administrator  or  executor.  The  affidavit  may 
be  made  by  an  agent  of  the  person  assessed,  but  in  such  a  case 
a  power  of  attorney  must  accompany  the  claim.  Checks  in  pay- 
ment of  claims  allowed  will  be  drawn  in  the  names  of  the  per- 
sons entitled  to  the  money  and  shall,  unless  otherwise  directed,  be  sent 
directly  to  the  proper  persons.  The  Commissioner  has  no  authority 
to  refund  on  equital)le  grounds  penalties  legally  collected.-"  .... 
(Art.  1036.) 


''^"  Dodge  v.  Woolsey,  18  How.  331 ;  59  U.  S.  331 ;  i  Miller  284;  15  L.  Ed. 
401;  Halves  v.  Oakland,  104  U.  S.  450;  14  Otto  450;  26  L.  Ed.  827.  (See 
equity  rule  94.) 

"*  Pollock  V.  Farmers'  Loan  &  Trust  Co.,  157  U.  S.  429;  39  L.  Ed.  759. 

"  Brushaber  v.  Union  Pacific  Ry.  Co.,  240  U.  S.  i ;  36  S.  Ct.  233 ;  60 
L.  Ed.  493;  Stanton  v.  Baltic  Mining  Co.,  240  U.  S.  103;  36  S.  Ct.  278; 
60  L.  Ed.  546. 

^  For  cases  in  which  refund  is  made  through  collectors,  see  Income 
Ta.x  Procedure,  1920,  page  217. 


APPEALS,    REFUNDS,   ABATEMENT  253 

It  should  be  noted  that  the  new  regulations  do  not  require 
that  claims  for  refund  must  be  accompanied  by  the  collector's 
receipt  or  by  the  paid  cheque  showing  payment  of  the  tax. 

If  claim  for  abatement  was  not  made  the  claim  for  re- 
fund should  be  supported  by  satisfactory  evidence  as  de- 
scribed on  page  245.  If  claim  for  abatement  was  made  and 
denied  it  cannot  be  expected  that  the  claim  for  refund  will  be 
allowed,  but  the  taxpayer  has  nothing  to  lose  by  attempting 
to  improve  his  case  and  by  securing  any  new  evidence  which 
will  strengthen  it. 

Claims  for  refund  may  not  be  filed  with  Commissioner 
direct. — Prior  to  the  issuance  of  the  following  ruling,  refunds 
could  be  filed  with  the  Commissioner  direct. ^^ 

Ruling.  Claims  for  refund  should  in  all  cases  be  filed  with  the 
collector  of  internal  revenue  to  whom  the  tax  was  paid  or  with  the 
deputy  collector  of  the  division  of  such  district  in  which  the  claimant 
resides.  Warrants  in  payment  of  such  claims  will  be  made  to  the 
order  of  the  claimants  as  provided  in  section  6,  Department  Circular 
230  (not  published  in  the  Bulletin  Service). 

The  Bureau  will  recognize  a  general  power  of  attorney  as  suffi- 
cient authority  for  the  filing  of  more  than  one  claim  for  refund 
on  behalf  of  the  grantor  of  such  power.  It  should  be  noted,  however, 
that  under  the  provisions  of  section  6  of  the  above-mentioned  circu- 
lar special  powers  are  required  in  certain  cases.  In  cases  where 
a  number  of  claims  are  to  be  filed  under  a  general  power  of  attorney 
the  original  power  should  be  attached  to  the  first  claim  filed  on 
behalf  of  the  claimant  granting  the  power,  and  a  copy  thereof  should 
be  annexed  to  each  succeeding  claim,  special  reference  being  made 
in  each  copy  to  the  claims  to  which  the  original  instrument  was  at- 
tached. 

The  Bureau  does  not  require  that  a  power  of  attorney  to  file  a 
claim  for  refund  be  in  any  special  form.  It  is  merely  necessary  that 
the  instrument  meet  the  legal  requirements  of  powers  of  attorney  in 
general. 

A  power  of  attorney  given  by  a  corporation  should  be  signed  by 
the  officers  who  are  duly  authorized  to  execute  such  instrument.  (C. 
B.  4,  page  341;  O.  D.  867.) 


212. 


See  Letter  dated  March  29,  1919,  Income  Tax  Procedure,  1921,  page 


254  APPLICATION   AND   ADMINISTRATION 

Formal  claims  for  refund  may  not  be  necessary  in  some 
cases. — The  Commissioner  may  now  issue  warrants  to  cover 
overpayment  without  requiring  the  taxpayer  to  file  a  formal 
claim  for  refund  or  credit.  Cases  of  this  kind  arise  when  the 
Treasury's  examination  shows  an  overpayment  by  the  tax- 
payer. 

The  following  instructions  have  Ijeen  issued  to  collectors  of 
internal  revenue : 

Ruling.  For  the  more  expeditious  handling  of  refund,  credit, 
and  abatement  claims,  and  to  provide  for  the  refund  or  credit  of 
overpayments  of  revenues  where  no  claims  have  been  filed,  the  follow- 
ing- procedure  is  established  to  become  effective  December  i6,  1921 : 

I.  Reduction  of  internal  revenue  assessments  and  adjustments  of 
overpayments  of  revenues  will  hereafter  be  accomplished  in  one  of 
three  ways : 

(a)  On  the  basis  of  an  application  submitted  by  a  taxpayer 
on  Form  46,  47  or  47A,  together  with  appropriate  supporting 
evidence  to  be  filed  in  the  office  of  the  collector  of  internal  revenue 
of  the  district  in  which  the  tax  is  assessed. 

(b)  On  the  basis  of  a  certificate  of  overassessment  prepared 
by  the  appropriate  administrative  unit  in  the  Bureau  in  each  case 
in  which  an  overassessment  of  tax  is  disclosed  through  the  audit 
of  a  return. 

(c)  On  the  basis  of  a  blanket  claim  (Form  751)  ;  a  schedule 
of  taxes  found  to  be  uncollectible  (Form  53)  ;  or  a  schedule  of 
duplicate  payments  and  overpayments  due  to  obvious  error  on  all 
forms  of  taxable  returns  (blanket  form  47  or  47B)  submitted 
by  a  collector  of  internal  revenue.  Form  751  will  be  used  only 
in  cases  where  credit  balances  exist,  regardless  of  the  class  of 
return  filed.     (T.  D.  3260,  dated  December  8,  1921.) 

Item  (c)  is  of  interest  to  collectors  only.  It  is  the  pro- 
cedure which  must  be  followed  to  clear  their  records. 

Forms  46,  47  and  47A  have  been  consolidated  into  form 
843- 

Claims  for  refunds  by  resident  or  non-resident  aliens. — 

Ruling.  When  a  claim  for  refund  is  filed  by  aliens,  resident  or 
non-resident,  on  Form  46,  a  copy  of  the  form  upon  which  the  alien 
was  assessed  and  taxed  should  loe  attached  to  Form  46.  (C.  B.  i, 
page  258;  O.  D.  472.) 


APPEALS.   REFUNDS,   ABATEMENT  255 

Claims  for  refund  must  be  filed  within  five  years. — The 
government  is  required,  under  the  1918  and  1921  laws  to  make 
any  additional  assessments  arising  from  examinations  within 
five  years  from  the  date  when  the  return  was  due,  unless  fraud 
is  established.  Likewise  taxpayers,  in  order  to  secure  credits 
or  refunds  of  taxes  overpaid,  must  file  their  claims  before  the 
expiration  of  five"  years  from  the  dates  when  the  returns  v/ere 
made. 

Law.  Section  252.  That  if,  upon  examination  of  any  return  of 
income  made  pursuant  to  this  Act,  the  Act  of  August  5,  1909,  entitled 
"An  Act  to  provide  revenue,  equalize  duties,  and  encourage  the  in- 
dustries of  the  United  States,  and  for  other  purposes,"  the  Act  of 
October  3,  1913,  entitled  "An  Act  to  reduce  tariff  duties  and  to  pro- 
vide revenue  for  the  Government,  and  for  other  purposes,"  the  Reve- 
nue Act  of  1916,  as  amended,  the  Revenue  Act  of  1917,  or  the  Revenue 
Act  of  1918,  it  appears  that  an  amount  of  income,  vs^ar-profits  or  excess- 
profits  tax  has  been  paid  in  excess  of  that  properly  due,  then,  notwith- 
standing the  provisions  of  section  3228  of  the  Revised  Statutes,  the 
amount  of  the  excess  shall  be  credited  against  any  income,  war-profits 
or  excess-profits  taxes,  or  instalment  thereof,  then  due  from  the  tax- 
payer under  any  other  return,  and  any  balance  of  such  excess  shall  be 
immediately  refunded  to  the  taxpayer:  Provided,  That  no  such  credit  or 
refund  shall  be  allowed  or  made  after  five  years  from  the  date  when  the 
return  was  due,  unless  before  the  expiration  of  such  five  years  a  claim 
therefore  is  filed  by  the  taxpayer:  Provided  further,  That  if  upon  exam- 
ination of  any  return  of  income  made  pursuant  to  the  Revenue  Act  of 
1917,  the  Revenue  Act  of  1918,  or  this  Act,  the  invested  capital  of  a  tax- 
payer is  decreased  by  the  Commissioner,  and  such  decrease  is  due  to 
the  fact  that  the  taxpayer  failed  to  take  adequate  deductions  in  previous 
years,  with  the  result  that  an  amount  of  income  tax  in  excess  of  that 
properly  due  was  paid  in  any  previous  year  or  years,  then,  notwith- 
standing any  other  provision  of  law  and  regardless  of  the  expiration 
of  such  five-year  period,  the  amount  of  such  excess  shall,  without  the 
filing  of  any  claim  therefor,  be  credited  or  refunded  as  provided  in  this 
section:  And  provided  fiirtlicr,  That  nothing  in  this  section  shall  be 
construed  to  bar  from  allowance  claims  for  refund  filed  prior  to  the 
passage  of  the  Revenue  Act  of  1918  under  subdivision  (a)  of  section 
14  of  the  Revenue  Act  of  1916,  or  filed  prior  to  the  passage  of  this  Act 
under  section  252  of  the  Revenue  Act  of  1918. 


"If  the  claim  for  refund  is  not  occasioned  by  the  fact  that  an  examina- 
tion of  the  taxpayer's  returns  discloses  an  overpayment,  the  claim  for  refund 
must  be  filed  witliin  five  years  from  the  date  tlie  tax  was  paid.  See 
page  263. 


256  APPLICATION    AND   ADMINISTRATION 

The  19 1 8  law  was  changed  by  adding  that  part  which 
starts  with  "Provided  further." 

Under  this  provision  the  Treasury  may  grant  refunds  for 
all  years  subsequent  to  1909  when  based  upon  inadequate  depre- 
ciation or  other  deductions  to  which  the  taxpayer  was  entitled 
in  such  years.  These  refunds  must  be  made  in  connection 
with  examination  of  returns  made  under  the  191 7,  1918  or 
1 92 1  laws. 

Many  concerns  have  paid  additional  taxes  assessed  for 
19 1 6  and  prior  years  which  should  now  be  refunded  unless 
the  procedure  under  memorandum  106'^  and  the  La  Belle  Iron 
Works  case^°  makes  the  application  for  refund  undesirable. 

Ruling.  Reference  is  made  to  a  letter  of  April  7,  1921,  wherein 
the  following  statement  was  made  and  questions  asked: 

The  taxpayer's  books  and  accounts  are  examined  by  a  revenue 
agent.  The  agent  finds  that  for  the  year  1914  the  taxpayer  has  over- 
paid the  amount  of  tax  due.  He  also  finds  that  the  taxpayer  owes 
additional  tax  for  the  year  1916,  and  in  the  adjustment  of  the  agent's 
report  the  overpayment  for  1914  is  applied  as  a  credit  against  the 
additional  tax  found  due  for  1916  and  the  balance  of  the  1914  over- 
payment is  refunded.  It  later  develops  that  the  taxpayer  instead  of 
being  liable  for  additional  tax  for  the  year  1916,  as  found  by  the 
revenue  agent,  has  overpaid  his  tax  for  that  year.  The  taxpayer  files 
a  claim  for  credit  of  this  overpayment  against  tax  due  for  subsequent 
years.  The  question  presented  is,  how  much  tax  may  be  assumed 
to  have  been  paid  by  the  taxpayer  for  the  year  1916,  i.e.,  the  amount 
actually  paid  in  cash  or  the  cash  payment  plus  the  credit' on  account 
of  the  overpayment  for  1914? 

If  it  is  held  in  the  foregoing  that  the  taxpayer  has  paid  the  cash 
payment  plus  the  amount  credited  on  account  of  the  overpayment 
for  1914,  and  a  claim  for  refund  is  filed,  how  should  the  refund  claim 
be  adjusted? 

It  is  to  be  understood  that  in  both  instances  mentioned  above  no 
record  of  a  credit  for  overpayment  of  19 14  tax  against  additional 
tax  originally  found  due  for  the  year  1916  appears  on  the  assessment 
list. 

The  Government  in  the  present  instance  was  expressly  authorized 
to  refund  the  taxes  erroneously  collected  or  to  accept  such  taxes  as  a 
credit.  The  credit  having  been  duly  made,  it  seems  clear  that  if  the 
real  remedial  purpose  of  section  252  is  to  be  effected,  "paid"  must 
be  construed  in  its  broader  sense  as  including  a  credit  duly  made.  It 
is   accordingly   held  that   where   there   has   been   an   overpayment  of 


'See  Aiipeiulix  A,  Chapter  VIII. 
'Advance   opinions  65   L.  Ed.,  page  604. 


I 


I 


APPEALS,   REFUNDS,   ABATEMENT  257 

taxes  on  an  income  return  for  a  certain  year  and  within  five  years 
from  the  date  the  return  was  due  the  overpayment  is  credited  to  taxes 
due  on  an  income  return  for  a  subsequent  year,  such  credit  constitutes 
payment  or  part  payment  of  the  taxes  i'or  the  year  in  which  it  was 
appHed. 

In  reply  to  your  second  question,  you  are  advised  that  the  cash 
payment  plus  the  amount  allowed  as  a  credit  on  account  of  the  over- 
payment for  1914  should  be  adjusted  for  the  year  1916  where  the  tax- 
payer files  a  claim  for  refund  covering  the  latter  year. 

The  fact  that  no  record  of  a  credit  for  overpayment  of  1914  taxes 
appears  on  the  1916  assessment  list  does  not  affect  the  treatment  of 
the  credit  as  a  payment  for  the  year  1916,  where  the  credit  was  in 
fact  made  within  five  years  from  the  date  the  1914  return  was  due. 
(C.  B.  4,  page  336;  Sol.  Op.  107.) 

Section  3228  of  the  Revised  Statutes  was  amended  to 
read  :^^ 

Law.  Section  1316.  [Section  3228,  Rev.  Stat.]  AH  claims  for 
the  refunding  or  crediting  of  any  internal  revenue  tax  alleged  to  have 
been  erroneously  or  illegally  assessed  or  collected,  or  of  any  penalty 
alleged  to  have  been  collected  without  authority,  or  of  any  sum  al- 
leged to  have  been  excessive  or  in  any  manner  wrongfully  collected, 
must  be  presented  to  the  Commissioner  of  Internal  Revenue  within 
four  years  next  after  payment  of  such  tax,  penalty,  or  sum. 

This  section,  except  as  modified  by  section  252,  shall  apply  retro- 
actively to  claims  for  refund  under  the  Revenue  Act  of  191 6,  the 
Revenue  Act  of  1917,  and  the  Revenue  Act  of  1918. 

The  foregoing  section  of  the  ivevised  Statutes  cHffers  from 
the  1918  law  in  two  respects: 

1.  The  period  is  changed  from  two  to  four  years. 

2.  Time  is  computed  from  the  date  of  payment  instead 
of  from  the  date  "after  the  cause  of  action  accrued." 

Generally  speaking,  the  distinction  between  section  252  and 
section  3228  (Revised  Statutes)  is  that  the  former  applies  only 
to  income,  excess  profits  and  war  profits  taxes ;  while  the  latter 
applies  to  all  taxes  specified  in  the  Revenue  iVct.    Furthermore, 


"Before  amendment  this  section  read  as  follows: 

Law.  Section  3228.  [Rev.  Stat.]  "All  claims  for  the  refunding  of 
any  internal  tax  alleged  to  have  been  erroneously  or  illegally  assessed  or 
collected,  or  of  any  jjenalty  alleged  to  have  been  collected  without  authority, 
or  of  any  sum  alleged  to  have  been  excessive  or  in  any  manner  wrongfully 
collected,  must  be  presented  to  the  Commissioner  of  Internal  Revenue 
within  two  years  next  after  the  cause  of  action  accrued " 


258  APPLICATION   AND   ADMINISTRATION 

under  section  3228  relief  is  granted  in  cases  not  covered  by 
section  252.  Section  252  computes  time  "from  the  date  when 
the  return  was  due."  Section  3228  determines  time  from 
the  date  of  payment.  Further,  section  252  relates  to  claims 
for  refund  occasioned  by  examinations  of  a  taxpayer's  income 
and  profits  tax  returns,  whereas  section  3228  refers  to  any 
claim  for  refund  originating  in  any  other  manner. 

Some  time  during  1919,  the  opinion  of  the  Solicitor  was 
requested  as  to  whether  or  not  section  3228  of  the  Revised 
Statutes  permits  the  filing  of  claims  for  refund  of  taxes  paid 
under  any  of  the  acts  specified  in  section  252  of  the  Revenue 
Act  of  1918  after  five  years  from  the  date  return  was  due. 

Ruling The  view  has  been  expressed  that  section  252 

does  not  repeal  section  3228,  but  merely  supplements  the  latter,  and 
whatever  rights  a  taxpayer  may  have  under  section  3228  are  pre- 
served and  further  extended  by  section  252.  In  other  words,  it  is 
said  that  a  claim  for  refund  may  be  filed  under  section  252  within 
five  years  after  the  due  date  of  the  return  for  the  year  involved,  and 
that  a  claim  for  refund  may  also  be  filed  within  two  years  after  pay- 
ment of  the  tax,  or  the  time  when  the  cause  of  action  accrued,  as 
provided  in  section  3228.  This  construction  is  advanced  for  the  reason 
that  taxpayers  would  otherwise  have  no  relief  by  way  of  filing  claims 
for  refund  with  reference  to  assessments  under  the  Revenue  Act  of 
1918,  made  just  prior  to  the  date  when  the  five-year  limitation  ex- 
pired. 

No  suit  may  be  brought  for  the  collection  of  any  taxes  alleged 
to  have  been  erroneously  collected  until  an  appeal  has  been  made  to 
the  Commissioner  of  Internal  Revenue  and  a  decision  of  the  Com- 
missioner has  been  had  therein.  (R.  S.  3226.)  Consequently  if  the 
taxpayer  is  required  to  pay  the  taxes  assessed  agamst  him  at  a  time 
when  the  period  within  which  a  claim  for  refund  may  be  filed  has 
expired  he  could  never  maintain  a  suit  to  recover  the  taxes  paid. 
Nor  could  the  collection  of  the  tax  be  enjoined.  It  is  therefore  held 
that  section  252  of  the  Revenue  Act  of  1918  was  not  intended  to 
take  away  the  right  given  a  taxpayer  under  section  3228  of  the  Re- 
vised Statutes  to  make  a  claim  for  refund  within  two  years  after  the 
cause  of  action  accrued  or  the  date  of  the  payment  of  the  tax 
under  protest.  As  another  has  said,  "perhaps  the  mere  textual 
construction  is  in  favor  of  the  other  view,"  but  a  contrary  con- 
struction would  not  be  harmonious  with  the  spirit  of  the  present 
law,  which  is  designed  to  grant  relief  in  cases  when  Revised  Statutes 
3228  works  injustice (B.  4-19-235;  O.  833.) 


APPEALS,    REFUNDS,   ABATEMENT  259 

The  foregoing  interpretation  also  applies  to  section  252 
of  the  1 92 1  law. 

Interpretation  of  section  252. — The  following  questions 
and  answers  regarding  section  252  of  the  1918  law  were  pre- 
pared for  the  guidance  of  the  Income  Tax  Unit.  These  inter- 
pretations also  apply  to  the  192 1  law. 

Ruling.  Q.  What  is  the  closing  date  governing  the  five-year 
limitation  ? 

A.  Five  years  from  the  date  on  which  the  return  for  the  year  in- 
volved was  due  to  be  filed  (taking  into  consideration  any  extension 
of  time  granted  for  filing  the  original  return). 

(a)  Returns  for  1913  which  were  due  to  be  filed  March  i,  1914, 
have  as  their  closing  date  March  i,  1919.  Does  this  mean  that  the 
warrant  must  be  actually  issued  by  the  Commissioner  before  the 
expiration  date  March  i,  1919,  or  will  the  auditor's  results  of  the  ex- 
amination of  the  return  be  the  governing  date? 

A.  With  respect  to  this  question  there  appears  to  be  an  inaccuracy 
in  statement.  The  question  speaks  of  the  warrant  for  payment  of  a 
claim  for  refund  as  being  issued  by  the  Commissioner.  Such  is  not 
the  practice.  The  Commissioner  signs  the  allowance  schedule,  and 
the  warrant  is  issued  by  the  Division  of  Bookkeeping  and  Warrants 
after  the  allowance  has  been  passed  upon  by  the  Auditor  for  the 
Treasury  Department.  The  correct  answer  to  this  question,  there- 
fore, is  that  the  schedule  authorizing  the  allowance  of  a  claim  for 
refund  must  be  actually  signed  by  the  Commissioner  within  five 
years  from  the  date  when  the  return  was  due,  taking  into  considera- 
tion any  extension  of  time  granted  for  filing  th&  original  return. 

(b)  Does  the  fact  that  a  revenue  agent's  report,  or  a  valuation 
engineer's  report,  determining  an  overpayment  within  the  five-year 
period,  is  not  audited  until  after  the  five-year  limit,  bar  the  auditor 
from  allowing  same  as  an  offset,  it  being  recognized  that  taxpayer  is 
not  in  possession  of  the  valuation  engineer's  finding  and  in  some 
cases  not  in  possession  of  the  revenue  agent's  report,  and,  therefore, 
could  not  have  filed  claim  within  the  five-year  limitation? 

A.  Neither  a  refund  nor  a  credit  claim  could  be  allowed  under 
these  circumstances.  If  a  claim  for  refund  is  filed  and  the  overpay- 
ment considered  in  connection  with  the  refund  claim,  it  would  be 
barred  by  the  five-year  limitation.  If  it  is  proposed  to  allow  credit 
for  the  overpayment,  the  fact  that  an  overpayment  has  been  made  is 
not  conclusively  determined  until  audit  of  the  agent's  or  engineer's 
report  which  is  subsequent  to  the  expiration  of  the  five-year  limita- 
tion. 


26o  APPLICATION   AND   ADMINISTRATION 

(c)  The  auditor  in  auditing  a  case  finds  overpayment  for  1913  and 
offsets  this  overpayment  in  an  A-2  letter  to  taxpayer  dated  February 
25,  1919.  The  taxpayer  takes  exception  to  depletion  allowed  and 
after  several  conferences  with  the  valuation  engineers  a  greater  de- 
pletion for  all  years  is  allowed  and  a  reaudit  of  his  return  is  made 
October  10,  1919.  The  five-year  limitation  on  1913  has  expired  at 
the  time  the  latter  audit  was  made.  Can  this  credit  be  allowed  in 
view  of  the  fact  that  a  portion  was  allowed  in  the  audit  of  February 
25,  1919,  or  is  the  entire  amount  now  barred  by  the  statute?  Had  the 
taxpayer  filed  a  claim  for  abatement  of  the  1913  taxes  prior  to  pay- 
ment thereof,  would  that  have  operated  to  his  advantage? 

A.  The  additional  overpayment  determined  subsequent  to  the  ex- 
piration of  tlie  five-year  limitation  could  neither  be  refunded  nor 
credited. 

Relative  to  the  second  question  in  (c),  it  appears  that  the  prin- 
ciple laid  down  by  the  Supreme  Court  in  the  case  of  the  Rock  Island, 
Arkansas  &  Louisiana  Railroad  Company  versus  The  United  States 
in  a  decision  rendered  November  22,  1920  (Income  Tax  Service  Rul- 
ing 1-21-1380),  is  equally  applicable  to  the  present  case.  As  stated  in 
the  above-cited  case,  the  regulations  have  established  a  procedure  and 
a  form  to  be  used  in  an  application  for  abatement  and  separate  and 
distinct  ones  for  a  claim  for  credit  or  a  claim  for  refund.  A  taxpayer 
must  file  claim  for  the  relief  sought,  i.e.,  a  claim  for  credit,  if  a 
credit  is  what  is  desired  or  is  required.  Section  252  of  the  Revenue 
Act  of  1918  provides  in  part  as  follows: 

No  such  credit  or  refund  shall  be  allowed  or  made  after  five  years 
from  the  date  when  the  return  was  due,  unless  before  the  expiration 
of  five  years  a  claim  therefor  is  filed  by  the  taxpayer. 

The  language  of  the  statute  is  clear.  If  at  the  expiration  of  five 
years  from  the  date  the  return  was  due  no  credit  or  refund  has  been 
allowed  by  the  Commissioner  and  no  claim  for  either  a  credit  or  a 
refund  has  been  filed  by  the  taxpayer,  then  the  taxpayer  is  precluded 
from  relief  under  either  of  the  methods  provided  by  law.  A  claim  for 
abatement  does  not  take  the  place  of  a  claim  for  credit.  These  are 
two  separate  and  distinct  claims,  and  although  the  result  accomplished 
may  be  the  same  in  both  cases,  nevertheless,  the  requirements  of  the 
statute  are  not  satisfied  by  permitting  the  use  of  these  two  claims 
interchangeably. 

(d)  A  taxpayer,  on  April  15,  1918,  filed  amended  returns  for  1913 
and  subsequent  years  which  showed  an  overpayment  for  1913.  The 
amended  returns  were  not  audited  until  July  i,  1919 — four  months 
after  the  expiration  of  the  five-year  limitation  placed  on  the  original 
return.  Does  the  filing  of  an  amended  return  within  the  five-year 
period  act  in  the  same  capacity  as  a  claim,  as  far  as  being  allowed 


APPEALS,    REFUNDS,   ABATEMENT  261 

to  offset  the  overpayment  against  an  additional  tax,  or  is  it  barred 
due  to  the  fact  that  the  final  audit  was  not  reached  before  the  expira- 
tion of  the  five-year  limitation  on  1913  return? 

A.  The  same  principle  applies  as  in  (c).  Amended  returns  do  not 
take  the  place  of  a  claim  for  refund  or  credit,  and  if  filed,  unsup- 
ported by  such  claim  or  claims,  do  not  in  themselves  constitute  a 
sufficient  claim  within  the  meaning  of  the  statute  to  warrant  the 
crediting  or  refunding  of  any  taxes  thereunder  after  the  expiration 
of  the  five-year  period. 

(e)  A  revenue  agent's  report  dated  May  8,  1919,  discovers  addi- 
tional tax  for  the  year  1913,  $150.00.  Waiver  was  secured  and  the 
additional  tax  was  assessed  and  paid  by  taxpayer  November,   1919. 

In  a  reaudit  of  this  case,  based  on  conference  held  in  the  Unit  with 
taxpayer,  additional  depletion  was  allowed  in  which  the  correct  tax 
for  1913  was  determined  to  be  $100.00. 

Thus: 

Original  return  filed No  tax  due 

A-2  letters,  November,  1919 — tax  due $150.00 

Correct  tax  assessable  for  1913 — October,  1920, 
audit 100.00 

Overassessed  and  paid 50.00 

As  the  original  return  as  filed  reported  no  income,  therefore  no 
tax,  the  first  assessment  against  the  taxpayer  appears  in  A-2  letter 
of   November,   1919,  against  the  year   1913   for  $150.00. 

The  final  audit  of  October,  1920,  determines  the  tax  to  be  $100.00. 
Can  the  overpayment  for  1913,  made  by  the  assessment  letter  of  No- 
vember, 1919,  be  offset  against  an  additional  tax  for  subsequent 
years,  due  to  the  fact  that  the  only  assessment  made  for  1913  was 
made  on  a  revenue  agent's  report  dated  May  8,  1919,  in  which  in- 
suflficient  depletion  was  allowed  by  the  revenue  agent? 

A.  No  offset  or  credit  can  be  allowed.  Notwithstanding  the  fact 
that  the  assessment  for  1913  was  made  and  paid  in  1919,  no  credit 
for  overpayment  for  refund  was  allowed  or  made  within  five  years 
from  the  date  when  the  return  was  due,  and  none  can  be  allowed  or 
made  subsequently  under  section  252  of  the  Revenue  Act  of  1918. 
Section  3220  of  the  Revised  Statutes,  however,  authorizes  the  Com- 
missioner of  Internal  Revenue  to  refund  taxes  erroneously  collected, 
but  the  claim  for  refund  thereunder  must  be  presented  to  the  Com- 
missioner within  two  years  next  after  the  cause  of  action  accrued,  as 
required  by  section  3228  of  the  Revised  Statutes.  The  taxpayer  in 
this  case,  therefore,  is  confined  to  his  rights  under  section  3220,  R.  S., 
but  any  claim  for  refund  of  overpayment  of  taxes  based  on  this 
section  must  be  made  within  two  years  after  the  date  of  payment 
thereof.     (C.  B.  4,  page  332;  M.  2764.) 


262  APPLICATION   AND   ADMINISTRATION 

Revival  of  claims  for  refund  for  1914  and  prior  years. — 

The  Treasury  during  1920  issued  a  ruling  holding  that  claims 
for  refund  pending  at  the  time  the  19 18  law  was  passed,  could 
not  be  allowed.^^ 

These  claims  have  been  revived  by  the  following  provision 
of  the  192 1  law : 

Law.  Section  252 nothing  in  this  section  shall  be  con- 
strued to  bar  from  allowance  claims  for  refund  filed  prior  to  the  pas- 
sage of  the  Revenue  Act  of  1918  under  subdivision  (a)  of  section  14 
of  the  Revenue  Act  of  1916,  or  filed  prior  to  the  passage  of  this  Act 
under  section  252  of  the   Revenue  Act  of   1918. 

Payment  of  refunds. — 

Law.  Section  131 5.  That  section  3220  of  the  Revised  Statutes, 
as  amended,  is  reenacted  without  change,  as  follows: 

"Section  3220.  The  Commissioner  of  Internal  Revenue,  subject  to 
regulations  prescribed  by  the  Secretary  of  the  Treasury,  is  authorized 
to  remit,  refund,  and  pay  back  all  taxes  erroneously  or  illegally  assessed 
or  collected,  all  penalties  collected  without  authority,  and  all  taxes 
that  appear  to  be  unjustly  assessed  or  excessive  in  amount,  or  in  any 
manner   wrongfully   collected;  .  .  .  ."^-^ 

The  Solicitor  issued  the  following  opinion  interpreting  the 
1918  law.     It  is  equally  applicable  to  the  1921  law. 

Ruling Section  3220,  Revised  Statutes,  was  amended  by 

Congress  at  the  instance  of  the  Treasury  Department.  Before  amend- 
ment section  3220,  Revised  Statutes,  provided  that  the  Commissioner 
could  remit  or  refund  taxes  subject  to  regulations  made  by  the  Sec- 
retary only  upon  appeal  to  him  made.  The  Treasury  Department 
believed  that  a  taxpayer  should  in  every  case  be  advised  of  every 
overpayment  of  tax  and  that  the  overpayment  should  be  refunded, 
and  it  was  believed  that  it  would  facilitate  the  work  of  the  Internal 
Revenue  Bureau  if  the  Commissioner  could  make  a  refund  without 
the  necessity  of  a  claim  being  filed.  It  was  not  the  intention  of  the 
Treasury  Department  that  the  Commissioner  should  have  authority 
to  allow  claims  which  were  barred  by  any  statute  of  limitation,  or 
to  refund  a  tax  where  the  taxpayer  had  no  right  to  file  a  claim  for 
the  refurfd  therefor.  It  was  apparently  not  the  intention  of  Congress 
to  make  it  possible  for  the  Commissioner,  subject  to  regulations  made 


"C.  B.  3,  page  302;  Sol.  Op.  79.  For  the  author's  criticism  of  this 
opinion,  see  Income  Tax  Procedure,  1921,  pages  214-215. 

"  Section  1323  (section  1316  of  the  1918  law)  re-enacts  section  3225  of 
the  Revised  Statutes  which  limits  refunds  to  cases  in  which  the  return  was 
not  zvilfully  false. 


APPEALS,  REFUNDS,  ABATEMENT         263 

by  the  Secretary,  to  ignore  statutes  of  limitation.  It  must  therefore 
be  held  that  the  Commissioner  has  authority  to  refund  a  tax  only 
in  a  case  where  a  claim  has  been  filed  which  is  not  barred  by  any 
statute  of  limitation  or  where  the  taxpayer  has  a  legal  right  to  file 
a  claim  for  the  refund  of  the  tax.     (C.  B.  3,  page  302;  Sol.  Op.  79.) 

Suits  for  recovery  must  be  started  within  five  years  after 
payment. — An  appeal  to  the  Commissioner  in  the  form  of  a 
claim  for  refund  is  the  first  step  in  seeking  relief  by  a  tax- 
payer. If  the  Commissioner  delays  action  on  claim  for  re- 
fund, suit  may  be  brought  against  the  collector  after  six 
months,   without  awaiting  the   Commissioner's  decision. 

Law.  Section  1318.  That  section  3226  of  the  Revised  Statutes 
is  amended  to  read  as  follows: 

"Section  3226.  No  suit  or  proceeding  shall  be  maintained  in  any 
court  for  the  recovery  of  any  internal-revenue  tax  alleged  to  have 
been  erroneously  or  illegally  assessed  or  collected,  or  of  any  penalty 
claimed  to  have  been  collected  without  authority,  or  of  any  smrK 
alleged  to  have  been  excessive  or  in  any  manner  wrongfully  collected, 
until  a  claim  for  refund  or  credit  has  been  duly  filed  with  the  Com- 
missioner of  Internal  Revenue,  according  to  the  provisions  of  law  in 
that  regard,  and  the  regulations  of  the  Secretary  of  the  Treasury 
established  in  pursuance  thereof.  No  such  suit  or  proceeding  shall 
be  begun  before  the  expiration  of  six  months  from  the  date  of  filing 
such  claim  unless  the  Commissioner  renders  a  decision  thereon  within 
that  time,  nor  after  the  expiration  of  five  years  from  the  date  of  the 
payment  of  such  tax,  penalty,  or  sum." 

This  section  shall  not  affect  any  suit  or  proceeding  instituted  prior 
to  the  passage  of  this  Act,  but  shall  apply  to  all  suits  and  proceedings 
instituted  after  the  passage  of  this  Act,  whether  or  not  barred  by 
prior  Acts  of  Congress. 

The  change  in  the  above  section  reduces  the  time  in  which 
claims  for  refund  may  be  filed  and  suits  instituted.^* 

For  instance,  if  taxpayers  file  claims  for  refund  four  years, 
six  months  and  one  day  after  the  day  the  tax  was  paid  and 
the  Commissioner  does  not  render  a  decision  within  six  months, 
suits  cannot  be  instituted.  No  suit  can  be  instituted  "after  the 
expiration  of  five  years  from  the  date  of  the  payment  of  the 
tax." 


•*  [Former  Procedure]  For  details  of  procedure  under  former  laws, 
see  Income  Tax  Procedure,  1921,  page  220. 


264  APPLICATION    AND   ADMINISTRATION 

The  Treasury  will  probably  not  be  able  to  pass  upon  all 
191 7  and  1918  claims  before  the  expiration  of  five  3^ears. 
Taxpayers,  therefore,  should  be  careful  not  to  permit  the 
period  to  expire  before  instituting  suit. 

Section  3227  of  the  Revised  Statutes  has  been  repealed. 
This  repeal  does  not,  of  course,  affect  any  suit  or  proceeding 
as  described  in  section  3227,  instituted  prior  to  the  192 1  law/^ 

Before  this  section  was  repealed  it  was  possible  to  post- 
pone suit  for  six  years  or  more.""  The  government  in  the  case 
of  Rockefeller  v.  United  States  of  America  (unreported)  as- 
serted that  the  claim  was  barred  two  years  and  six  months 
after  the  appeal  to  the  Commissioner.  The  United  States 
Supreme  Court  considered  this  case  on  its  merits,  hence  this 
decision  may  l)e  accepted  as  finally  disposing  of  this  point. 

Suits  must  now  be  instituted  within  five  years  after  pay- 
ment. 

Proof  of  appeal  to  Commissioner. — The  court  of  claims  of 
the  United  States  has  decided  that  when  suit  is  brought  by  a 
taxpayer  against  the  collector  for  recovery  of  the  tax,  the 
burden  of  proof  is  upon  him  to  show  that  his  appeal  to  the 
Commissioner  has  been  taken  and  decided,  or  else  that  decision 
was  delayed  more  than  six  months  from  the  date  of  appeal. ^^ 

Decision.  The  written  appeal  was  the  best  evidence  of  which 
the  case  was  susceptible  and  if  it  was  not  in  his  power  to  have  pro- 
duced the  original  it  was,  nevertheless,  his  duty  to  have  produced  an 
authentic  copy  thereof,  or  accounted  for  its  absence. ^^ 

Decision.  The  lodging  of  an  appeal  (claim  for  refund)  made 
out  in  due  from  with  tbe  proper  collector  of  internal  revenue,  for  the 
purpose  of  transmission  to  the  commissioner  in  the  usual  course  of 
business  mider  the  requirements  of  the  regulations  of  the  secretary, 
was  in  legal  effect  a  presentation  of  the  appeal  to  the  Commissioner.'-'' 
(Reg.  33,  19 1 8,  Art.  270.) 


"  Section  1319. 

"See  Income  Tax  Procedure.  ig2i.  pages  219  and  220. 
"  Lauer  v.  U.  S.,  5  Ct.  CI.  447. 
''Hubbard  v.  Kellx.  8  W.  Va.  46. 

'■'U.  S.  V.  Savings  Bank,  14  Otto  7^8;  104  C.  S.  728;  26  L.  Ed.  908; 
Int.  Rev.  Rec.  87. 


APPEALS,    REFUNDS,   ABATEMENT  265 

Claim  for  abatement  does  not  constitute  an  appeal  to  the 
Commissioner. — Two  recent  decisions,  one  by  thai  United 
States  Supreme  Court,  the  other  by  the  Circuit  Court  of 
Appeals  for  the  Eighth  Circuit,  conflict  on  the  question  as  to 
whether  or  not  the  filing  of  a  claim  for  abatement  acts  as  an 
appeal  to  the  Commissioner.  Of  course,  the  decision  of  the 
Supreme  Court  controls;  but  since  the  reasoning  of  the  Cir- 
cuit Court  is  more  logical  and  appears  to  be  the  more  reasonable 
interpretation  of  the  law,  both  decisions  are  quoted. 

Decisions.  This  is  a  claim  for  a  sum  paid  as  an  internal  revenue 
tax  under  the  Act  of  August  5,  1909,  c.  6,  §38,  36  Stat.  11,  112.  It 
is  alleged  that  the  claimant  was  not  engaged  in  or  doing  business  in 
the  year  for  which  the  tax  was  collected  and  that  therefore  it  was 
not  due.  The  Court  of  Claims  dismissed  the  petition  on  the  ground 
that  the  claimant  had  not  complied  with  the  conditions  imposed  by 
statute  and  the  claimant  appealed  to  this  court. 

The  facts  are  simple.  After  the  tax  was  assessed  a  claim  for  an 
abatement  was  sent  to  the  Commissioner  of  Internal  Revenue  in  July, 
1913.  On  December  18  of  the  same  year  the  Commissioner  rejected 
the  application,  whereupon  on  December  26  the  claimant  paid  the 
tax  with  interest  and  a  penalty.  So  far  as  appears  there  was  no 
protest  at  the  time  of  payment  and  it  is  found  that  after  it  nothing 
was  done  to  secure  repayment  of  the  tax.  By  Rev.  Stats.,  section 
3226,  amended  by  Act  of  February  27,  1877,  c.  69,  §  i,  19  Stat.  248, 
no  suit  shall  be  maintained  in  any  court  for  the  recovery  of  any  tax 
alleged  to  have  been  illegally  assessed  "until  appeal  shall  have  been 
duly  made  to  the  Commissioner  of  Internal  Revenue,  according  to  the 
provisions  of  law  in  that  regard,  and  the  regulations  of  the  Secretary 
of  the  Treasury  established  in  pursuance  thereof,  and  a  decision  of 
the  Commissioner  has  been  had  therein,  provided,"  etc.  Regulations 
of  the  Secretary  established  a  procedure  and  a  form  to  be  used  in 
applications  for  abatement  of  taxes  and  distinct  ones  for  claims  for 
refunding  them.     The  claimant  took  the  first  step  but  not  the  last. 

By  Rev.  Stats.,  section  3220,  the  Commissioner  of  Internal  Reve- 
nue is  authorized  "on  appeal  to  him  made,  to  remit,  refund,  and  pay 
back"  taxes  illegally  assessed.  It  is  urged  that  the  "appeal"  to  him 
to  remit  made  a  second  appeal  to  him  to  refund  an  idle  act  and  sat- 
isfied the  requirement  of  section  3226.  Decisions  to  that  effect  in 
suits  against  a  collector  are  cited,  the  latest  being  Loomis  v.  Wattles 
(266  Fed.  Rep.  876).  But  the  words  "on  appeal  to  him  made"  mean, 
of  course,  on  appeal  in  respect  of  the  relief  sought  on  appeal — to 
refund  if  refunding  is  what  he  is  asked  to  do.  The  words  of  section 
3226  also  must  be  taken  to  mean  an  appeal  after  payment,  especially 


2r>6  APPLTCATTON    AND    AD^[TNTSTRATION 

in  view  of  section  3228  requiring  claims  of  this  sort  to  be  presented 
to  the  Commissioner  within  two  years  after  the  cause  of  action  ac- 
crued. So  that  the  question  is  of  reading  an  impHed  exception  into 
the  rule  as  expressed,  when  substantially  the  same  objection  to  the 
assessment  has  been  urged  at  an  earlier  stage. 

]Men  must  turn  square  corners  wlieii  they  deal  with  the  Govern- 
ment. If  it  attaches  even  purely  formal  conditions  to  its  consent  to 
be  sued  those  conditions  must  be  complied  with.  Lex  non  praecipit 
inutilia  (Co.  Lit.  127b)  expresses  rather  an  ideal  than  an  accom- 
plished fact.  But  in  this  case  we  cannot  pronounce  the  second  appeal 
a  mere  form.  On  appeal  a  judge  sometimes  concurs  in  a  reversal  of 
his  decision  below.  It  is  possible  as  suggested  by  the  Court  of 
Claims  that  the  second  appeal  may  be  heard  by  a  different  person. 
At  all  events  the  words  are  there  in  the  statute  and  the  regulations, 
and  the  Court  is  of  opinion  that  they  mark  the  conditions  of  the 
claimant's  right.  See  Kings  County  Savings  Institution  v.  Blair  (116 
U.  S.  200).  It  is  unnecessary  to  consider  other  objections  that  the 
claimant  would  have  to  meet  before  it  could  recover  upon  this  claim. ^"^ 

The  right  of  the  plaintiff  to  maintain  this  suit  is  challenged  in 
this  court  for  the  reason  that  the  plaintiff  did  not  appeal  to  the  Com- 
missioner of  Internal  Revenue  after  the  tax  was  paid.  This  conten- 
tion is  based  upon  section  3226,  Rev.  Stat.  U.  S.  (Comp.  Stat.,  section 
5949).  The  object  of  the  statute  requiring  a  party  to  exhaust  his 
remedies  in  the  Internal  Revenue  Department  before  he  shall  bring 
suit  is  to  give  the  department  an  opportunity  to  decide  vi^hether  in 
its  judgment  the  tax  is  legal  or  illegal,  and  thus  save  the  delay  and 
expense  of  litigation.  The  point  under  consideration  was  not  made 
in  the  court  below,  nor  is  it  mentioned  in  the  assignment  of  errors ; 
but,  as  it  may  be  claimed  to  be  jurisdictional,  it  will  be  considered. 
We  had  a  similar  question  before  us  in  Weaver  v.  Ewers  (195  Fed. 
247,  115  C.  C.  A.  219),  and  we  then  held  that,  notwithstanding  section 
3226,  an  appeal  to  the  Commissioner,  before  the  tax  was  paid,  an- 
swered the  purpose  for  which  the  statute  was  enacted.  In  the  case 
cited  we  said : 

"What  the  Commissioner  of  Internal  Revenue  thought  about  the 
assessment  had  been  obtained  upon  full  statement  of  the  facts,  and 
it  would  have  been  a  useless  form  again,  after  the  tax  was  paid,  to 
appeal  to  the  Commissioner  and  obtain  the  same  judgment.  The 
reason  for  the  appeal  did  not  exist,  and  hence  the  appeal  after  tax 
was  paid  was  not  necessary." 

The  following  cases  sustain  our  ruling:  Schwarzchild,  etc.,  Co. 
v.  Rucker  (C.  C,  143  Fed.  656)  ;  San  Francisco  Sav.  &  Loan  Soci- 
ety V.  Carey  (2  Sawy.  333,  Fed.  Cas.  No.  12,317)  ;  Grier  v.  Tucker 


"'Rock  Island,  Arkansas  &  Louisiana  Railroad  Co.  v.  U.  S.,  November 
22,  1920,  254  U.  S.  141. 


APPEALS,    REFUNDS,    ABATEMENT  267 

(C.  C,  150  Fed.  658);  Tucker  v.  Grier  (160  Fed.  611,  614,  615,  87 
C.  C.  A.  513)  ;  De  Bary  et  al.  v.  Dunne  (C.  C,  162  Fed.  961). 

Counsel  for  defendant  cites  Savings  Bank  v.  Blair  (116  U.  S.  200, 
6  Sup.  Ct.  353,  29  L.  Ed.  657)  ;  Stewart  v.  Barnes  (153  U.  S.  456,  14 
Sup.  Ct.  849,  38  L.  Ed.  781);  and  Hastings  v.  Herold  (C.  C,  184 
Fed.  759).  These  cases  have  been  examined,  and  when  the  facts  of 
each  case  are  considered  they  sustain  the  ruHng  of  this  court  in 
Weaver  v.  Ewers,  supra.  We  therefore  see  no  reason  for  departing 
from  the  ruling  heretofore  made,  and  hence  decide  that  the  conten- 
tion is  without  merit.*^ 

It  should  be  noted  that  the  foregoing  case  is  cited  by  the 
Supreme  Court,  but  is  dismissed  with  the  statement  that  the 
words  "an  appeal"  mean  an  appeal  after  payment.  It  is  there- 
fore important  that  taxpayers  file  a  claim  for  refund  after 
a  claim  for  abatement  is  rejected  if  they  wish  to  reserve  their 
legal  rights. 

The  192 1  law  amended  section  3226,  Revised  Statutes, 
making  it  more  specific  as  to  the  nature  of  the  "appeal  .... 
to  the  Commissioner  of  Internal  Revenue,"*^  which  is  a  pre- 
requisite to  bringing  suit  for  refund  and  to  which  reference 
was  made  in  the  Supreme  Court's  opinion  in  Rock  Island, 
Arkansas  and  Louisiana  R.  R.  Co.  v.  United  States.^^  The 
section  as  amended  by  the  192 1  law  states  that  "no  suit  .... 
shall  be  maintained  ....  until  a  claim  for  refund  or  credit 
has  been  duly  filed  with  the  Commissioner "** 

Suit  must  be  brought  against  collector  who  collected  tax 
and  not  against  his  successor. — The  United  States  Circuit 
Court  of  Appeals  for  the  Seventh  Circuit  certified  the  follow- 
ing two  questions  to  the  United  States  Supreme  Court  :*'' 

Decision,  i.  Assuming-  that  the  declaration  states  a  good  cause  of 
action  had  the  suit  been  brought  against  S.  M.  Fitch,  the  internal 
revenue  collector  who  actually  collected  and  received  the  taxes,  does 
it  state  any  cause  of  action  whatever  against  said  S.  M.  Fitch's  suc- 


"  Loomis  V.  Wattles,  266  Fed.  876. 

^'The  text  of  section  3226,  Rev.  Stat.,  as  it  appeared  before  amendment 
by  the  1921  law.  appears  in  Income  Tax  Procedure,  1921,  page  216. 
"254U.  S.  141. 

"  See  page  263  for  text  of  section  3226,  Rev.  Stat.,  as  amended. 
"  Smietanka  v.  Indiana  Steel  Co.,  advance  opinions,  66  L.  Ed.  page  3. 


268  APPLICATION    AND   ADMINISTRATION 

cessor  in  office,  the  plaintiff  in  error,  against  whom  tlic  suit  was 
brought,  but  who  had  no  participation  in  the  collection,  receipt  or  dis- 
bursement of  such  taxes? 

2.  May  suit  in  the  district  court  of  the  United  States  properly 
be  brought  and  maintained  against  a  United  States  collector  of  inter- 
nal revenue  for  the  recovery  of  the  amount  of  a  United  States  in- 
ternal revenue  tax,  unlawfully  assessed  and  collected,  but  in  the  col- 
lection and  disbursement  of  which  such  collector  had  no  agency,  the 
entire  transaction  of  such  assessment,  collection,  and  disbursement  hav- 
ing occurred  during  the  incumbency  of  such  office  of  a  predecessor 
in  office  of  such  collector? 

The  court  answered  both  questions  in  the  negative.*^ 

Suits  where  collector  is  dead. — I'rior  to  the  passage  of  the 
1 92 1  law,  if  the  amount  involved  exceeded  v$io,ooo,  suit  could 
not  be  brought  in  a  federal  district  court  if  the  collector  were 
dead,  but  the  Court  of  Claims  had  sole  jurisdiction.  Section 
1310  (c),  by  an  amendment  of  section  24  of  the  Judicial  Code, 
now  gives  a  district  court  concurrent  jurisdiction  with  the 
Court  of  Claims  in  such  circumstances. 

T>AW.      Section    13 10 (c)   Paragraph   Twentieth   of   section 

24  of  the  Judicial  Code  is  amended  by  adding  at  the  end  thereof  the 
following  new  paragraph: 

"Concurrent  with  the  Court  of  Claims,  of  any  suit  or  proceeding, 
commenced  after  the  passage  of  the  Revenue  Act  of  1921,  for  the 
recovery  of  any  internal-revenue  tax  alleged  to  have  been  erroneously 
or  illegally  assessed  or  collected,  or  of  any  penalty  claimed  to  have 
been  collected  without  authority  or  any  sum  alleged  to  have  been 
excessive  or  in  any  manner  wrongfully  collected,  under  the  internal- 
revenue  laws,  even  if  the  claim  exceeds  $10,000,  if  the  collector  of 
internal-revenue  by  whom  such  tax,  penalty,  or  sum  was  collected  is 
dead  at  the  time  such  suit  or  proceeding  is  commenced." 

State  courts  have  no  jurisdiction  to  determine  federal 
taxes. — Two  interesting  cases'*'  have  been  decided  by  the  Su- 
preme Court  of  Errors  for  the  State  of  Comiecticut. 


"The  District  Court  for  the  Southern  District  of  Ohio,  Western  Divi- 
sion, has  made  a  similar  ruling.  Cincinnati  Gas  &  Electric  Co.  v.  GiUigan 
(not  reported).  See  B.  29-21-1738;  Ct.  D.  16.  See  also  Philadelphia,  Har- 
rishurg  &  Pittsburg  R.  R.  Co.  z'.  Lederer,  242  Fed.  492. 

*'  IVillmann,  ct  al.  v.  Walsh,  1 12  Atl.  804;  and  application  of  Willmann, 
ct  al.  112  Alt.  806. 


APPEALS,   REFUNDS,   ABATEMENT  269 

Ruling.  Under  the  Connecticut  laws  of  1918  (Sections  3446 
and  3447),  upon  voluntary  dissolution  of  a  corporation,  upon  vote  of 
the  stockholders,  the  directors  are  made  trustees  in  the  liquidation 
of  the  affairs  of  the  corporation.  Such  trustees  may  apply  (Section 
3448)  to  the  Superior  Court  for  the  county  in  which  such  corporation 
is  located  for  the  limitation  of  a  period  for  the  presentation  of  claims 
against  the  corporation.  Upon  the  limitation  of  such  a  period  by  the 
court,  it  is  provided  that  such  trustees  shall  proceed  to  wind  up  the 
affairs  of  the  corporation  under  the  direction  of  the  court  in  the  same 
manner  as  if  they  were  receivers.  It  is  provided  (Section  3449)  that 
any  claim  not  presented  within  the  time  limited  shall  be  barred, 
unless  the  owner  thereof  shall  commence  an  action  to  enforce  the  same 
within  four  months  after  notice  from  the  trustees  of  rejection.  (T. 
D.  3166.) 

The  facts  of  the  two  cases  and  the  decision  of  the  lower 
court  appear  in  the  following  ruling: 

Ruling.  On  February  27,  1919,  Joseph  Willmann,  et  al.,  trustees 
in  liquidation,  petitioned  the  court  for  the  issuance  of  an  order  limit- 
ing a  period  within  which  all  claims  against  the  corporation  should 
be  presented  and  for  such  additional  orders  from  time  to  time  relative 
to  the  winding  up  of  the  affairs  of  the  corporation  as  might  be  proper 
and  necessary  in  accordance  with  the  statutes  of  the  State  of  Connec- 
ticut. On  the  same  date  the  Superior  Court  for  New  Haven  County, 
Connecticut,  issued  an  order  providing  that  all  claims  against  the 
Derby  Manufacturing  Company  should  be  presented  to  said  trustees 
witliin  four  months  from  February  27,  19 19.  Among  the  claims 
presented  pursuant  to  this  order  was  one  of  the  United  States,  pre- 
sented by  James  J.  Walsh,  Collector  of  Internal  Revenue  for  the 
District  of  Connecticut  for  additional  income,  excess  profits  and  war 
profits  taxes  for  the  years  1916,  1917  and  1918;  and  also  for  taxes 
not  then  determined  for  that  portion  of  1919- up  to  the  date  of  the 
cessation  of  business  by  such  corporation. 

On  June  i,  1920,  the  trustees  reported  the  claims  of  the  United 
States  wherein  they  disallowed  the  major  portion  thereof.  The 
court  entered  an  order  approving  the  report  and  providing  that  writ- 
ten notice  should  be  given  to  the  United  States,  through  the  Com- 
missioner of  Internal  Revenue,  and  to  James  J.  Walsh,  Collector,  that 
unless  the  disallowed  portion  of  the  claim  was  made  the  subject  of 
application  to  the  court  for  allowance  within  two  weeks,  the  same 
should  be  barred.  Thereafter,  the  United  States  Attorney  for  the 
District  of  Connecticut  filed  a  petition  on  behalf  of  the  United  States 
for  the  allowance  of  the  entire  claim.  On  June  29,  1920,  the  trustees 
in  liquidation  filed  with  the  court  an  application  for  a  restraining 
order   against   the   collector,   asking   that   the   collector   be   restrained 


270 


APPLICATION   AND   ADMINISTRATION 


from  interfering  with  their  possession  of  the  company's  property,  not- 
withstanding the  fact  that  there  was  pending  in  this  office  a  claim  in 
abatement  covering  the  taxes  in  question,  during  the  pendency  of 
which  no  distraint  proceedings  would  have  been  carried  out  by  the 
collector.  It  was  alleged  that  the  trustees  were  officers  of  the  court 
and  that  an  interference  by  the  collector  with  their  possession  would 
be  a  contempt  of  the  court.  Upon  the  hearing  of  this  application, 
the  Superior  Court  of  New  Haven  County  refused  to  grant  the 
restraining  order.  Thereafter,  on  September  20,  1920,  the  trustees 
filed  another  application  for  a  restraining  order  and  for  instructions 
from  the  court  as  to  the  duty  of  the  trustees  in  relation  to  such  claims 
of  the  United  States,  and  for  a  hearing  by  the  court  to  determine 
what  taxes,  if  any,  were  due  the  United  States.  This  application 
was  made  upon  the  theory  that  the  trustees  in  liquidition  were  officers 
of  the  court,  in  view  of  the  fact  that  in  winding  up  the  affairs  of  the 
corporation  they  were  subject  to  the  orders  of  the  court,  and  that, 
in  order  that  proper  instructions  might  be  issued  to  them  in  con- 
nection with  the  Government's  claim  for  taxes,  the  court  should  hear 
and  determine  the  proper  amount  due  and  that  the  collector  should 
be  restrained  from  taking  any  steps  to  distrain  upon  the  company's 
property  in  the  satisfaction  of  any  sum  in  excess  of  the  amount  the 
court  should  allow.  On  October  15,  T920,  upon  hearing  such  appli- 
cation, the  Superior  Court  was  of  the  opinion  that  it  had  no  juris- 
diction to  hear  and  determine  the  claim  of  the  United  States  for  taxes 
and  that  the  assessment  of  the  Commissioner  of  Internal  Revenue 
was  conclusive  upon  it.  The  court  directed  the  trustees  to  pay  the 
Government's  claim  for  taxes,  authorizing  them  to  take  steps  to  pro- 
tect the  estate  of  the  corporation  by  way  of  claim  for  refund  and 
suit  to  recover  back  the  taxes  paid.  Judgment  was  therefore  entered 
in  favor  of  the  United  States.  From  this  order  and  judgment,  and 
from  the  order  denying  the  application  of  the  trustees  dated  June 
29,  1920,  an  appeal  was  taken  to  the  Supreme  Court  of  Errors  for 
the  State  of  Connecticut  as  above  indicated.  (T.  D.  3166,  dated 
May  19,  1921.) 

The  higher  court  affirmed  the  lower  court's  decision  in 
each  case.  In  commenting  upon  the  second  case,  the  higher 
court  said  i*^ 

Decision.  The  facts  found  disclose  that  the  federal  taxes  in- 
volved in  these  proceedings  have  not  been  paid,  and  that  a  claim  for 
the  abatement  of  said  taxes  is  pending  before  the  Commissioner  of 
Internal  Revenue,  under  Section  5949  (Sec.  3226,  R.  S.,  U.  S.)  of 
the  Compilation  of  United  States  Statutes,  1916.  Under  such  facts, 
in  accord  with  the  terms  of  Section  5949  (Sec.  3226,  R.  S.,  U.  S.) 

*'Ib{d. 


APPEALS,    REFUNDS,   ABATEMENT  271 

no  suit,  formal,  or  as  here,  informal,  can  be  maintained  to  recover  back 
or  to  abate  such  federal  taxes  in  any  court,  state  or  federal.  Under 
Section  5947  of  such  Compilation  no  suit,  formal  or  informal,  can  be 
maintained  to  restrain  the  collection  of  federal  taxes.  Therefore  the 
superior  court  had  no  jurisdiction  to  pass  upon  the  legality  of  the 
assessment  of  the  internal  revenue  taxes  in  question,  or  to  issue  a 
restraining  order  relating  thereto,  because  of  the  provisions  of  the 
United   States   Statutes  quoted  above. 

Suit  to  recover  may  include  penalties  improperly  collected. 
— If  an  illegal  tax  is  paid,  the  fact  that  it  was  not  paid  within 
the  time  allowed  by  law  will  not  prevent  any  taxpayer  from 
recovering  the  penalty  of  i  per  cent  a  month  paid  by  him 
for  non-payment;  for  if  the  tax  was  illegal  it  was  never  due 
and  therefore  the  penalty  was  as  much  unauthorized  as  the 
tax  itself.*' 

Interest   allowable   on   refunds,   whether   granted  by   the 

Commissioner  or  the  courts. — Contrary  to  all  previous  laws, 

the   1 92 1   law  provides  that  interest  must  be  paid  upon  all 

claims   for  refund  or  credit  allowed.     The  section  seems  to 

apply  to  refunds  arising  under  all  previous  laws  and  covers  all 

internal  revenue  taxes.     Interest  when  allowed  is  allowable  on 

all  claims,  whether  voluntarily  allowed  by  the  Commissioner  or 

by  the  courts. 

Law.  Section  1324.  (a)  That  upon  the  allowance  of  a  claim 
for  the  refund  of  or  credit  for  internal  revenue  taxes  paid,  interest 
shall  be  allowed  and  paid  upon  the  total  amount  of  such  refund  or 
credit  at  the  rate  of  one-half  of  i  per  centum  per  month  to  the  date 
of  such  allowance,  as  follows:  (i)  if  such  amount  was  paid  under  a 
specific  protest  setting  forth  in  detail  the  basis  of  and  reasons  for 
such  protest,  from  the  time  when  such  tax  was  paid,  or  (2)  if  such 
amount  was  not  paid  under  protest  but  pursuant  to  an  additional 
assessment,  from  the  time  such  additional  assessment  was  paid, 
or  (3)  if  no  protest  was  made  and  the  tax  was  not  paid 
pursuant  to  an  additional  assessment,  from  six  months  after 
the  date  of  filing  of  such  claim  for  refund  or  credit.  The  term  "ad- 
ditional assessment"  as  used  in  this  section  means  a  further  assess- 
ment for  a  tax  of  the  same  character  previously  paid  in  part. 


"Camp  Bird  v.  lioivbrrt,  262  Fed.   114.     Certiorari  denied  March  8, 
1920,  252  U.  S.  579- 


272 


APPLICATION   AND   ADMINISTRATION 


(b)  Section  177  of  the  Judicial  Code  is  amended  to  read  as  fol- 
lows: 

"Section  177.  No  interest  shall  be  allowed  on  any  claim  up  to  the 
time  of  the  rendition  of  judgment  by  the  Court  of  Claims,  unless 
upon  a  contract  expressly  stipulating  for  the  payment  of  interest,  ex- 
cept that  interest  may-  be  allowed  in  any  judgment  of  any  court  ren- 
dered after  the  passage  of  the  Revenue  Act  of  1921  against  the  United 
States  for  any  internal-revenue  tax  erroneously  or  illegally  assessed 
or  collected,  or  for  any  penalty  collected  without  authority  or  any 
sum  which  was  excessive  or  in  any  manner  wrongfully  collected, 
under  the  internal-revenue  laws." 

It  is  important  to  note  that  the  date  when  interest  begins 
to  run  varies  with  certain  conditions.     (See  article  1040.) 

The  JncHcial  ("ode  was  also  amended  so  that  interest  can 
he  paid  on  all  internal  revenue  claims  allowed  by  the  Court  of 
Claims.  I'rior  to  the  passage  of  the  1921  law,  the  courts  had 
held  tJiat  in  suits  against  collectors  interest  was  payable  from 
the  date  of  payment  of  an  illegal  tax."" 

Decision.  The  defendant's  contention  that  interest  was  not 
allowable  we  cannot  uphold.     We  liave  very  lately  been  told  that — 

"Xo  one  could  contend  that  technically  a  judgment  of  a  Dis- 
trict Court  in  a  suit  against  the  collector  was  a  judgment  against 
or  in  favor  of  the  United  States."  (Sage  z'.  U.  S.^  250  U.  S.  33, 
39,  S.  Ct.  415,  63  L.  Ed.  83S,  May  19,  1919). 

Consequently  no  question  of  allowance  of  interest  or  costs  as 
against  the  sovereign  arises  and  the  suit  is  to  be  regarded  ....  as 
against  a  private  person 

It  is  also  urged  that  interest  should  not  have  been  allowed  as 
complained  of,  because  the  Commissioner  signified  his  willingness  to 
return  that  amount  to  plaintiff.  Whether  plaintiff  would  have  preju- 
diced this  suit  by  taking  what  it  could  get  and  suing  for  the  rest  is 
a  matter  not  before  us.  It  is  enough  to  repeat  that  in  this  action 
the  defendant,  even  though  he  has  the  United  States  behind  him,  is 
to  be  treated  as  a  private  person 

The  important  point  to  be  noted  is  that  the  Treasury,  after 
long  delay,  decided  that  the  taxpayer  was  right  and  offered  to 


^  Neiv  York  Life  Insurance  Co.  v.  Anderson,  decided  January  14, 
1920,  263  Fed.  527;  affirmed  2.6g  Fed.  1021.  A  writ  of  certiorari  was  granted 
March  28,  1921  (advance  opinions,  65  L.  Ed.  587;  41  S.  Ct.  449).  Writ  was 
set  aside  on  April  18,  1921  (advanced  opinions,  65  L.  Ed.  591  ;  41  S.  Ct.  534). 
The  application  for  the  writ  was  finally  denied  Maj'  2,  1921  (advance  opin- 
ions, 65  L.  Ed.  699;  4  S.  Ct.  536). 


APPEALS,    REFUNDS,    ABATEMENT  273 

pay  the  claim  without  interest.  Since  the  taxpayer  had  lost  the 
use  of  his  money  for  seven  years  he  very  properly  claimed 
interest.  Upon  refusal  of  the  Treasury  to  pay  he  brought  suit 
and  secured  judgment. 

Any  interest  received,  whether  by  suit  or  not,  should  be 
credited  to  interest.     Such  interest  is  taxable  income. 

When  taxes  are  erroneously  assessed  limitation  does  not 
apply. — It  has  been  held  by  the  Treasury  that,  whereas  suits 
against  the  collector  must  be  brought  within  five  years  after 
the  payment  of  the  tax,  the  limitation  does  not  necessarily 
apply  when  the  tax  has  been  erroneously  assessed  by  the  United 
States.'' 

When  suit  is  brought  may  the  government  open  up  the 
entire  return? — 

Ruling Where  an  action  for  money  had  and  received  is 

brought  against  a  collector  of  internal  revenue  for  the  amount  of  an 
additional  tax  paid  on  net  income,  the  taxpayer  is  entitled  to  recover 
only  such  amount  as  is  in  reality  greater  than  the  tax  which  should 
have  been  assessed  under  the  law  as  properly  interpreted  and  applied. 
The  fact  that  the  Commissioner  in  assessing  the  tax  erroneously 
allowed  some  deductions  for  depreciation  does  not  operate  as  an 
estoppel  against  the  collector  or  against  the  United  States,  as  it  is 
well  settled  that  no  assessment  of  the  Commissioner  is  necessary  for 
the  collection  of  the  tax,  at  least  in  a  direct  action  by  the  United 
States ;  nor  does  it  make  any  difference  that  an  assessment  has  been 
made,  for  in  spite  of  the  assessment  and  of  the  expiration  of  the 
period  within  which  an  amended  assessment  can  be  made,  the  United 
States  may  still  sue  for  the  amount  actually  due.  It  is  immaterial  that 
suit  is  in  form  against  the  collector,  because  the  recovery  in  the  end 
comes  from  the  United  States,  so  that  even  if  the  collector  were  per- 
sonally estopped,  that  estoppel  under  the  circumstances  does  not  apply 
against  the  United  States.  The  conclusion  is  reached  therefore  that 
sums  due  the  United  States  as  determined  by  the  court  in  suit  against 
a  collector  of  internal  revenue  are  a  valid  offset  as  against  the 
amount  found  due  the  taxpayer,  though  such  sums  include  items 
which  the  Commissioner  did  not  claim  to  be  due  the  United  States 
when  considering  the  return  for  purposes  of  assessment.  (C.  B.  i, 
page  258;  T.  D.  2882  (2).) 


See  Income  Tax  Procedure,  1921,  page  322. 


274  APPLICATION   AND   ADMINISTRATION 

This  might  have  been  true  so  far  as  the  laws  prior  to 
the  1918  act  were  concerned,  when  the  government  could 
bring  suit  at  any  time.  Section  250  (d)  of  the  1921  act 
provides  that  no  suit  may  be  brought  by  the  Commissioner 
after  the  expiration  of  a  certain  period. 

If  the  limitation  period  has  run  against  the  government 
before  any  counterclaim  is  made,  it  is  doubtful  if  the  entire 
return  may  be  opened  up.  If  a  taxpayer  filed  a  claim  for 
refund  for  a  certain  item  and  also  instituted  suit  within  the 
limitation  period,  the  government  would  certainly  contend  that 
the  suit  could  include  only  the  specific  item  claimed.  In  other 
words,  after  the  period  had  expired,  the  claim  could  not  be 
amended  to  include  other  items. 

The  District  Court  for  the  Western  Division  of  the  Wes- 
tern District  of  Missouri""  has  held  that  a  suit  may  not  include 
items  which  have  not  been  presented  to  the  Commissioner.  The 
following  statement  is  taken  from  the  Treasury  publications : 

Ruling.  A  taxpayer  can  not  claim  a  deduction  in  court  for  the 
first  time  where,  in  its  claim  for  refund  filed  precedent  to  bringing 
suit,  it  did  not  claim  the  right  to  such  deduction  or  assert  that  it 
had  failed  to  take  it  in  computing  net  income  in  its  return,  or  that  it 
had  failed  to  take  credit  for  it,  and  where,  consequently,  a  claim  for 
the  deduction  was  never  presented  to  the  Commissioner  of  Internal 
Revenue  for  his  decision.  (B.  Digest  18-21-1611;  T.  D.  3164;  Ct. 
D.  II.) 

Claim  for  refund  of  sums  recovered  by  suit. — The  follow- 
ing regulation  sets  forth  the  detailed  procedure  necessary  when 
a  taxpayer  makes  claim  for  the  refund  of  taxes  or  penalties 
erroneously  collected  by  the  government  after  suit  has  been 
brought  and  judgment  secured. 

Regulation,  (o)  Claims  by  taxpayers  for  the  amount  of  a  judg- 
ment representing  taxes  or  penalties  erroneously  collected  should  be 
made  on  form  843.  The  claimant  should  state  the  grounds  of 
his  claim  under  oath,  giving  the  names  of  all  the  parties  to  the  suit,  the 
cause  of  action,  the  date  of  its  commencement,  the  date  of  the  judg- 
ment, the  court  in  which  it  was  recovered,  and  its  amount.     To  this 


^^ Kciiipcr  Military  School  v.  Crulclilcy,  274  Fed.  125. 


APPEALS,  REFUNDS,  ABATEMENT         275 

affidavit  there  should  he  annexed  a  certified  copy  of  the  final  judg- 
ment, a  certificate  of  probable  cause,  and  an  itemized  bill  of  the 
costs  paid  receipted  by  the  clerk  or  other  proper  officer  of  the  court, 
together  with  a  certified  copy  of  the  docket  entries  of  the  court  in 
the  case  or  so  much  thereof  as  may  be  required  by  the  Commissioner. 
When  a  recovery  is  had  in  any  suit  or  proceeding  against  a  collector 
or  other  internal  revenue  officer  for  any  act  done  by  him,  or  for  the 
recovery  of  any  money  exacted  by  or  paid  to  him  and  by  him  paid 
into  the  Treasury,  in  the  performance  of  his  official  duty,  and  the 
court  certifies  that  there  was  probable  cause  for  the  act  done  by  the 
collector  or  other  officer,  or  that  he  acted  under  the  directions  of  the 
Secretary  of  the  Treasury,  or  other  proper  officer  of  the  Govern- 
ment, no  execution  shall  issue  against  such  collector  or  other  officer, 
but  the  amount  so  recovered  ^hall,  upon  final  judgment,  be  provided 
for  and  paid  out  of  the  proper  appropriation  from  the  Treasury. 
....(&)  If  the  judgment  debtor  shall  have  already  paid  the  amount 
recovered  against  him,  the  claim  should  be  made  in  his  name.  There 
should  also  be  a  certificate  of  the  clerk  of  the  court  in  which  the 
judgment  was  recovered  (or  other  satisfactory  evidence),  showing 
that  the  judgment  has  been  satisfied  and  specifying  the  exact  sum 
paid  in  its  satisfaction,  with  a  detail  of  all  items  of  costs  which 
were  paid  by  the  judgment  debtor  or  for  which  he  is  liable.  (Art. 
1 051;  Reg.  45,  Art.  1038.) 

Method  of  paying  refunds. — 

Law.  Section  131 7.  That  the  paragraph  of  section  3689  of  the  Re- 
vised Statutes,  as  amended,  reading  as  follows:  "Refunding  taxes  illegally 
collected  (internal  revenue) :  To  refund  and  pay  back  duties  erro- 
neously or  illegally  assessed  or  collected  under  the  internal  revenue 
laws,"  is  repealed  from  and  after  June  30,  1920;  and  the  Secretary 
of  the  Treasury  shall  submit  for  the  fiscal  year  1921,  and  annually 
thereafter,  an  estimate  of  appropriations  to  refund  and  pay  back 
dudes  or  taxes  erroneously  or  illegally  assessed  or  collected  under  the 
internal-revenue  laws,  and  to  pay  judgments,  including  interest  and 
costs,  rendered  for  taxes  or  penalties  erroneously  or  illegally  assessed 
or  collected  under  the  internal-revenue  laws. 

Validity  of  tax  may  be  determined  by  Bankruptcy  Court. — 
In  the  case  of  In  re  General  Film  Corporation,^'^  the  govern- 
ment filed  proofs  of  claim  against  the  bankrupt  for  additional 
taxes  and  interest.  The  trustee  in  bankruptcy  objected  to  the 
claims  and  the  court  disallowed  them.    The  government  claimed 


U.  S.  V.  Kellogg,  274  Fed.  903. 


276  APPLICATION   AND   ADMINISTRATION 

that  the  only  remedy  open  to  the  trustee  for  correcting  any 
error  was  to  pay  the  taxes  and  then  proceed  under  Rev.  Stat. 
Sec.  3226,  by  appeahng  to  the  Commissioner  for  refund  and 
subsequently  bringing  suit.  It  was  held  that  under  Section  64 
(a)  of  the  Bankruptcy  Act  the  government's  claims  were 
not  to  be  ordered  paid  as  a  matter  of  course  and  the  trustee 
remitted  to  proceedings  for  refund,'  but  that  the  validity  of 
the  tax  was  a  question  to  be  passed  mpon  by  the  Bankruptcy 
Court  in  the  first  instance. 
The  court  said : 

Decision.  We  regard  this  section '(Section  64(a)  of  the  Bank- 
ruptcy Act)  as  binding  upon  the  government  because  it  is  named 
therein  and,  while  conferring  priority,  as  giving  the  bankruptcy  court 
the  power  to  hear  and  determine  any  question  that  arises  as  to  the 
amount  or  legality  of  a  tax  assessed  by  it.  The  provision  applies  to 
taxes  of  all  the  persons  mentioned,  and  w'e  could  not  differentiate  the 
government  from  the  other  persons  in  the  absence  of  language  justi- 
fying it. 

But  section  3226,  U.  S.  Rev.  Stat.,  could  under  no  circumstances 
apply  to  the  case  under  consideration  because  the  trustee  is  not  seek- 
ing to  maintain  a  suit  for  the  recovery  of  internal  revenue  taxes  il- 
legally assessed.  Clinkenbeard  v.  United  States,  21  Wall.  65,  22 
L.  Ed.  477;  United  States  v.  Nebraska  Distilling  Co.,  80  Fed.  285, 
25  C.  C.  A.  418. 

Refunds  will  not  be  entertained  by  either  Commissioner 
or  courts  where  a  final  determination  has  been  had. — Sections 
1312  and  1313  of  the  1921  law  provide  that  the  taxpayer  and 
the  Commissioner  may  by  agreement  finally  close  a  case. 
After  this  agreement  has  been  made,  neither  may  reopen  the 
case. 

These  sections  are  discussed  in  detail  in  Chapter  \TI1, 
pages  210-21 1. 

Action  to  recover  when  government  claims  fraud  or  un- 
derstatement.— 

Law.  Section  1323.  That  section  3225  of  the  Revised  Statutes 
of  the  United  States,  as  amended,  is  reenacted  without  change  as  fol- 
lows: 


APPEALS,    REFUNDS,    ABATEMENT  277 

"Section  3225.  When  a  second  assessment  is  made  in  case  of  any 
list,  statement,  or  return,  which  in  the  opinion  of  the  collector  or 
deputy  collector  was  false  or  fraudulent,  or  contained  any  under- 
statement or  undervaluation,  such  assessment  shall  not  be  remitted, 
nor  shall  taxes  collected  under  such  assessment  be  refunded,  or  paid 
back,  or  recovered  by  any  suit,  unless  it  is  proved  that  such  list, 
statement,  or  return  was  not  willfully  false  or  fraudulent  and  did  not 
contain  any  willful  understatement  or  undervaluation." 

The  foregoing  section  contains  a  very  material  improve- 
ment in  that  understatements  or  undervaluations  must  be 
willfully  false  or  fraudulent.  In  the  19 16  law  the  word  "will- 
fully" in  the  next  to  last  line  and  the  word  "willful"  in  the 
last  line  did  not  appear.^"* 


Credits 

Prior  to  the  passage  of  the  1918  law,  each  year's  taxes 
stood  alone.  A  taxpayer  was  not  allowed  to  offset  one  year's 
taxes  against  overpayment  for  previous  years.  Congress  rec- 
ognized that  this  was  an  injustice;  so  the  claim  for  credit  was 
created. 

When  may  a  claim  for  credit  be  filed? — 

Law.  Section  252.  That  if,  upon  examination  of  any  return  of 
income  made  pursuant  to  this  Act,  the  Act  of  August  5,  1909,  en- 
titled "An  Act  to  provide  revenue,  equalize  duties,  and  encourage  the 
industries  of  the  United  States,  and  for  other  purposes,"  the  Act 
of  October  3,  1913,  entitled  "An  Act  to  reduce  tariff  duties  and  to 
provide  revenue  for  the  government,  and  for  other  purposes,"  the. 
Revenue  Act  of  1916,  as  amended,  or  the  Revenue  Act  of  1917,  or  the 
Revenue  Act  of  1918,  it  appears  that  an  amount  of  income,  war-profits 
or  excess-profits  tax  has  been  paid  in  excess  of  that  properly  due, 
then,  notwithstanding  the  provisions  of  section  3228  of  the  Revised 
Statutes,  the  amount  of  the  excess  shall  be  credited  against  any  income, 
war-profits  or  excess-profits  taxes,  or  installment  thereof,  then  due  from 
the  taxpayer  under  any  other  return,   .... 

Regulation.  Any  amount  of  income,  war  profits  or  excess 
profits  tax  paid  in  excess   of   that  properly  due  shall  be  credited 

"  For  text  of  decisions  under  1916  law,  see  Income  Tax  Procedure, 
1920,  pages  211-212. 


278  APPLICATION   AND   ADMINISTRATION 

against  any  such  taxes  due  from  the  taxpayer  under  any  other  return. 
To  obtain  such  credit  the  taxpayer  should  proceed  as  follows: 

(i)  Where  the  credit  demanded  is  equal  to  or  less  than  any  out- 
standing assessment  of  tax,  a  taxpayer  desiring  to  obtain  such  credit 
shall  file  with  the  collector  for  the  district  in  which  his  original  return 
was  filed  a  claim  on  Form  843,  which  shall  be  sworn  to  and  shall 
contain  the  following  statements:  (a)  business  engaged  in  by  claim- 
ant; (b)  character  of  assessment;  (c)  amount  of  tax  claimed  as  a 
credit;  (d)  unpaid  assessment  against  which  credit  is  asked  and  for 
what  taxable  year;  and  (c)  all  facts  regarding  the  overpayment. 

(2)  Where  the  amount  claimed  as  a  credit  is  greater  than  the 
outstanding  assessment  of  tax,  a  taxpayer  desiring  to  obtain  such 
credit  ^md  the  refund  to  which  he  is  entitled  shall  file,  Form  843,  stat- 
ing thereon  the  respective  amounts  claimed  as  a  credit  or  as  a  re- 
fund. All  the  facts  regarding  the  total  overpayment  should  be  stated 
in  the  claim.     (Art.  1034.) 

Claim  for  credit  may  be  applied  only  against  over-payment 
of  "Income,  War  Profits,  or  Excess  Profits  Tax." — 

Ruling.  Munitions  tax  overpayments  for  one  year  may  not  be 
credited  against  an  additional  assessment  of  munitions  taxes  for  a 
subsequent  or  prior  year. 

Munitions  tax  overpayments  may  not  be  credited  against  addi- 
tional assessments  of  income,  excess  profits  and  war  profits  taxes  for 
the  same  or  for  any  subsequent  or  prior  taxable  year.  (C.  B.  4— »■ 
Digest,  page  330;  A.  R.  M.  123.) 

Collector  must  receive  clearance  before  accepting  claim 
for  credit. — Many  taxpayers  after  having  filed  claims  for 
refund  also  filed  claims  for  credit  against  current  taxes.  The 
result  was  that  the  Treasury  often  had  a  claim  for  credit  and 
refund  covering  the  same  item.  It  is  understood  that  in  many 
cases  both  claims  were  allowed,  which,  of  course,  means  the 
taxpayer  got  more  than  he  was  entitled  to. 

Taxpayers  should  notify  the  Commissioner  to  reject  claim 
for  refund  before  filing  claims  for  credit  with  the  collector  for 
the  same  item.  This  is  a  reasonable  recjuirement.  Taxpayers 
should  not  be  required  to  wait  more  than  a  reasonable  time  for 
the  Commissioner's  rejection  of  the  claim  for  refund. 

Regul.\tiox.  Upon  receipt  by  the  collector  of  a  claim  for  credit 
on  Form  843,  he  will  make  proper  record  thereof  in  his  ofiice  and. 


APPEALS,    REFUNDS,    ABATEMENT  279 

except  in  the  case  of  claims  covering  tax  assessed  on  the  hasis  of 
returns  on  Form  1040  A,  forward  the  claim  inmiediately  to  the  Com- 
missioner irrespective  of  whether  or  not  a  claim  for  refund  of  the 
tax  now  claimed  as  a  credit  has  previously  hcen  filed.  J^ue  notice 
will  be  given  the  collector  and  the  taxpayer  of  the  action  taken  on 
the  claim. 

If  a  claim  is  allowed  against  additional  taxes  due  for  other  years, 
but  such  other  taxes  have  not  yet  been  assessed,  only  the  amount  of  the 
excess  of  such  taxes  over  the  overpayment  shall  be  assessed,  or  the 
excess  of  the  overpayment  over  such  taxes  due  shall  be  refunded  as 
the  case  may  be.  The  effective  date  of  the  filing  of  a  claim  for 
credit  shall  be  the  actual  date  of  presentation  to  the  collector.  The 
filing  of  a  claim  for  credit  against  the  tax  due  under  another  return 
shall  be  subject  to  the  same  rules  with  respect  to  the  addition  of  in- 
terest and  penalties  as  if  the  taxpayer  had  filed  a  claim  for  abatement 
of  the  tax  against  which  credit  is  desired. 

Under  no  circumstances  will  a  taxpayer  be  entitled  to  credit  for 
an  alleged  overpayment  of  tax  prior  to  the  allowance  of  such  credit 
by  the  Commissioner.  An  attempt  to  take  a  credit  prior  to  such  al- 
lowance shall  not  be  held  to  be  the  filing  of  a  claim  under  section  252 
of  the  Revenue  Act  of  192 1.     (Art.  1035.) 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  April  18, 
1921,  stating  that  your  office  has  already  filed  a  number  of  claims  for 
credit  in  connection  with  the  1920  returns  of  your  clients,  in  accord- 
ance with  the  provisions  of  Article  1035  of  Regulations  45.  As  this 
procedure  appears  to  be  in  conflict  with  the  requirements  of  Treasury 
Decision  3154,  dated  April  12,  1921,  however,  you  request  to  be  ad- 
vised whether  Treasury  Decision  3154  was  intended  to  be  retroactive 
and,  if  so,  to  what  extent? 

In  reply,  you  are  advised  that  Treasury  Decision  3154  amending 
Article  1035  of  Regulations  45,  became  effective  on  the  date  of  its 
approval,  April  12,  1921,  and  applies  to  all  claims  for  credit  filed  on 
or  after  'that  date. 

Taxpayers,  however,  who  had  claims  for  refund  on  file  with  the 
Department,  and  converted  these  claims  into  claims  for  credit  in  ac- 
cordance with  the  regulations  in  effect  prior  to  the  issuance  of 
Treasury  Decision  3154,  should  request  the  Commissioner  to  reject 
such  refund  claims  and  consider  only  their  claims  for  credit.  (Letter 
to  Klein,  Llinds  and  Finke,  New  York,  N.  Y.,  signed  by  Acting  Com- 
missioner M.  T.  West,  and  dated  May  9,  1921.) 

Taxpayers  wishing  to  substitute  claims  for  credit  in  place 
of  claims  for  refund  should  direct  their  requests  to  the  Com- 
missioner at  Washington.  Such  requests  are  generally  com- 
plied with  very  promptly. 


28o  APPLICATION   AND   ADMINISTRATION 

Ruling.  Receipt  is  acknowledged  of  your  letter  dated  October 
25,  1921,  relative  to  submitting  claims  for  credit  to  be  considered  in 
lieu  of  claims  for  refund  already  on  file  in  this  office. 

In  reply  you  are  advised  that  in  accordance  with  the  provisions 
contained  in  T.  D.  3154,  it  is  necessary  for  the  claimant  to  request  the 
rejection  of  any  claims  for  refund  covering  the  same  period  and 
including  the  same  items  as  the  credit  claim  which  he  desires  to  file 
before  the  latter  can  be  accepted.  This  substitution  may  be  greatly 
expedited,  however,  if  the  claimant's  request  is  made  direct  to  this 
office.  Steps  have  been  taken  to  insure  the  rejection  of  such  claims 
in  the  shortest  possible  time  and  the  letters  notifying  the  claimants 
of  the  action  taken  are  sent  out  immediately. 

A  copy  of  the  letter  of  rejection  should  be  attached  to  the  claim 
for  credit  and  filed  with  the  Collector  of  Internal  Revenue  for  the 

taxpayer's    District (Letter    to    The    Corporation    Trust 

Company,  signed  by  Deputy  Commissioner  E.  H.  Batson,  by  C.  B. 
Allen,  Head  of  Division,  and  dated  Nov.  9,  1921.) 

Time  when  credit  is  made  or  allowed. — In  response  to 
several  questions  submitted  by  the  Unit,  the  Solicitor  has 
issued  the  following  opinion : 

Ruling.  The  reference,  in  effect,  asks  advice  whether  in  a  case 
where  a  claim  for  credit  has  not  been  filed  by  the  taxpayer  a  credit 
for  an  excess  of  tax  assessed  for  a  prior  year  may  be  made  or  al- 
lowed if  the  examination  of  the  return  was  made  and  the  excess 
amount  determined  upon  within  the  five-year  period  of  limitation 
named  in  section  252,  and  the  taxpayer  within  the  limitation  period 
was  advised  of  the  amount  due  on  subsequent  returns  after  the  credit 
had  been  applied;  but  after  the  limitation  period  has  expired  the 
Department  reconsiders  and  finds  that  a  mistake  was  made  in  the 
amount  of  the  tax  due  on  the  subsequent  returns  and  the  excess 
amount  originally  found  as  a  credit  (a)  has  not  been  changed,  (b) 
should  be  increased,  (c)  should  be  decreased.  It  is  assumed  from 
the  reference  that  the  assessment  represented  by  the  original  letter 
of  advice  to  the  taxpayer  was  not  made.  If  it  was  made  there  would 
seem  no  room  for  doubt,  since  clearly  the  credit  was  made  when 
the  assessment  list  went  out  and  any  reduction  or  increase  of  tax 
would  have  to  be  accomplished  by  abatement  or  refund  or  further 
assessment. 

The  question  presented  depends  for  solution  upon  what  consti- 
tutes the  making  or  allowance  of  a  credit  within  the  meaning  of 
section  252.  A  statement  contained  in  a  letter  from  the  Department 
to  a  taxpayer  that  the  taxpayer  is  entitled  to  a  credit  is  clearly  not  a 
credit  actually  made  or  allowed.  Something  must  be  done  in  a  formal 
way  that  will  amount  to  a  direction  to  the  collector  who  is  charged 


APPEALS,    REFUNDS.    ABATEMENT  281 

with  the  collection  of  internal  taxes.  Prior  to  such  a  direction  lie 
has  nothing  to  do  with  the  taxpayer's  account  since  it  has  not  assumed 
that  status  of  an  accoinit  stated  to  him.  Such  direction  by  the  Com- 
missioner is  usually  made  by  formal  assessment  list  signed  by  him. 
When  such  a  formal  statement  or  direction  to  the  collector  is  signed 
by  the  Commissioner  and  forwarded  to  the  collector,  showing  the 
amount  of  the  tax  to  be  collected  over  and  above  the  credit,  the  Com- 
missioner has  formally  made  or  allowed  the  credit.  When  this  is 
done  the  credit  has  been  made  or  allowed,  but  prior  thereto  anything 
that  is  done  in  the  way  of  stating  the  case  by  employees  of  the  Bureau 
or  in  the  way  of  statements  to  the  taxpayer  in  letters  from  the 
Department  can  be  nothing  more  than  preliminary  to  the  actual  mak- 
ing or  allowance  of  the  credit  by  the  Commissioner. 

This  is  true  where  credits  are  considered  and  passed  upon  formally 
by  the  Commissioner.  Where,  howevei*,  the  collector  because  of  the 
provisions  of  the  statute  and  regulations  made  pursuant  thereto  makes 
the  credit  without  specific  instructions  from  the  Commissioner,  the 
credit  is  actually  made  or  allowed  when  the  collector  so  records  it, 
and  in  such  a  case  subsequent  action  by  the  Commissioner  in  the 
way  of  a  review  of  the  collector's  action,  would  not  operate  to  fix  the 
time  when  the  credit  was  made  or  allowed,  since  in  such  a  case  the 
collector  had  before  him  the  account  of  the  taxpayer  and  is  charged 
by  law  and  the  regulations  to  enter  the  credit. 

It  is  held  that  where  the  allowance  of  a  credit  as  provided  in 
section  252  of  the  Revenue  Act  of  191 8  is  being  considered  by  the 
Commissioner,  the  credit  is  made  or  allowed  only  when  the  Connuis- 
sioner  signs  and  forwards  to  the  collector  a  formal  statement  or  direc- 
tion or  assessment  list  showing  the  amount  of  the  tax  to  be  collected 
over  and  above  the  amount  of  the  credit.  (C.  B.  4.  page  339;  Sol. 
Op.  106.) 

It  is  important  that  the  privilege  of  filing  claims  for  credit 
should  not  be  abused,  and  the  Treasury  is  justified  in  strictly 
interpreting  the  law.  It  is  not  unreasonable  to  require  full 
compliance  with  the  provisions  regarding  claims  for  refund. 

It  should  be  noted,  however,  that  the  Solicitor  did  not 
answer  the  question :  "Did  the  taxpayer  as  a  matter  of  fact 
make  what  might  reasonably  be  deemed  to  be  a  claim  for  re- 
fund within  the  limitation  period?" 

Effect  of  a  claim  for  credit. — The  following  memorandum 
by  the  Committee  on  Appeals  and  Review  very  aptly  describes 
the  function  of  a  claim  for  credit : 


282  APPLICATION    AND    ADMINISTRATION 

Ruling.  A  .  .  .  .  credit  can  not  be  made  until  the  facts  have  been 
carefully  examined  and  the  validity  of  the  credit  approved  by  the 
Commissioner.  That  is  not  to  say,  however,  that  a  claim  for  credit 
has  no  effect  until  approved.  The  claim  for  credit  may  have  pre- 
cisely the  same  effect  as  a  claim  for  abatement;  that  is,  by  forbearance 
of  the  collector  it  may  suspend  collection  until  it  is  acted  upon  by 
the  Commissioner.  If  approved,  credit  is  then  given  relieving  both 
the  collector  and  the  taxpayer  from  any  further  liability.  If  rejected, 
interest  is  to  be  paid  upon  the  amount  suspended  from  the  time  it 
was  due. 

This  view  of  the  law  appears  to  be  entirely  consistent  with  its 
language  and  also  with  the  purpose  which  it  was  believed  Congress 
had  in  mind;  that  is  to  say,  relief  to  the  taxpayer  from  being  re- 
quired to  pay  into  the  Treasury  amounts,  possibly  large,  at  the  same 
time  that  he  is  making  a  bona  fide  claim  that  other  amounts  are 
due  him.  As  held  in  Law  Opinion  No.  957,  it  does  not  prevent  the 
collector,  if  he  so  desires,  from  proceeding  to  collect  at  once  just 
as  he  may  do  in  the  case  of  an  abatement  claim  filed,  but  leaves  it 
optional  with  him  to  suspend  collection  until  such  time  as  credit  is 
given  relieving  both  him  and  the  taxpayer.  (B.  19-20-924;  A.  R.  M. 
46.) 

Law  Opinion  957"  took  the  position  that  in  order  to  credit 
an  amount  of  tax  against  an  overpayment  for  previous  years, 
such  overpayment  must  have  been  actually  ascertained.  The 
above  ruling  is  in  accord  with  the  law  and  is  observed  in  pres- 
ent procedure. 

Place  of  filing  claim  for  credit  when  district  is  changed. — 

Ruling.  Where  a  corporation  filed  a  return  for  1918  with  the 
collector  of  one  district  and  a  return  for  1919  with  the  collector  of 
another  district,  and  subsequently  rendered  an  amended  return  for 
1918,  showing  less  tax  liability,  together  with  a  claim  for  credit 
against  the  outstanding  tax  due  for  1919,  covering  the  overpayment 
to  the  extent  shown  by  the  amended  return,  it  should  file  the  amended 
return  with  the  collector  with  whom  the  original  return  was  filed  for 
the  year  1918. 

The  claim  for  credit  should  be  filed  with  the  collector  with  whom 
the  return  for  1919  was  filed,  who  should  forward  same  to  the  col- 
lector with  whom  the  return  for  1918  was  filed,  for  a  notation  thereon 
of  the  facts  required  by  the  certificate  on  the  reverse  side  as  to  the 
assessment  overpaid  for  1918.  When  this  has  been  done  it  will  be 
returned  by  him  to  the  collector  with  whom  the  1919  return  was 
filed,  who  will  make  a  notation  thereon  as  to  the  1919  assessment  to 

"  C.  B.  I,  page  256. 


APPEALS,    REFUNDS,    ABATEMENT  283 

be  credited,  and  forward  same  to  the  Commissioner  of  Internal  Reve- 
nue for  consideration. 

In  filing  the  amended  return  the  taxpayer  should  call  attention 
to  the  fact  that  a  claim  for  credit  of  the  overpayment  has  been  filed 
with  the  collector  with  whom  the  1919  return  was  filed,  and  the  col- 
lector with  whom  the  claim  for  credit  was  filed  should  be  notified 
that  an  amended  return  has  been  filed.     (B.  48-20-1327;  O.  D,  740.) 

Claim  for  credit  in  case  of  affiliated  companies. — 

Ruling.  Upon  the  audit  of  the  returns  of  several  affiliated  com- 
panies for  the  period  1909-1917,  inclusive,  it  is  found  that  certain 
of  these  companies  are  entitled  to  refund  on  account  of  excess  taxes 
paid  during  that  period.  On  the  basis  of  the  consolidated  return  for 
1918,  covering  these  companies,  it  appears  that  assessment  of  addi- 
tional taxes  will  be  required.  The  question  therefore  arises  whether 
refunds  due  the  subsidiary  companies  may  not  be  used  as  a  credit 
against  the  additional  tax  to  be  assessed  on  the  basis  of  the  consoli- 
dated return. 

For  the  purposes  of  the  income  tax  Acts  each  affiliated  corpora- 
tion is  considered  a  separate  and  distinct  entity  even  though  a  con- 
solidated return  is  submitted  on  behalf  of  all.  A  claim  for  credit  or 
refund  of  excess  tax  paid  by  one  of  the  affiliated  corporations  can  be 
made  only  by  the  corporation  entitled  to  receive  such  credit  or 
refund.  Thus  with  respect  to  refunds,  credits,  and  additional  assess- 
ments each  affiliated  corporation  occupies  a  status  similar  to  that  of 
an  independent  and  unaffiliated  corporation.  The  additional  tax 
assessed  for  the  year  1918,  on  the  basis  of  the  consolidated  return  for 
that  year,  must  be  apportioned  among  the  affiliated  corporations,  and 
to  the  extent  that  each  debtor  corporation  is  entitled  to  receive  back 
a  part  of  the  taxes  paid  in  prior  years,  a  claim  for  credit  may  be 
filed  and  the  amount  of  additional  tax  each  subsidiary  is  required  to 
pay  may  be  reduced  thereby  by  the  amount  it  is  entitled  to  receive. 
In  case  the  amount  payable  to  the  subsidiary  exceeds  its  proportion- 
ate part  of  the  additional  tax  assessed  under  the  consolidated  return, 
it  may  file  a  claim  for  refund  for  the  difiference.  A  subsidiary  which 
is  required  to  pay  additional  tax  and  is  at  the  same  time  entitled  to 
receive  back  in  the  form  of  a  refund  a  portion  of  the  amount  paid 
as  taxes  in  prior  years,  may,  however,  within  its  option  pay  the  entire 
amount  of  the  additional  tax  and  file  a  claim  for  refund  for  the 
entire  amount  it  is  entitled  to  receive.     (B.  41-20-1237;  O.  D.  683.) 

Affiliated  companies  may  apportion  any  tax  assessed 
against  them  on  any  basis  upon  which  they  may  agree;  there- 
fore apportionment  should  be  made  so  as  to  exhaust  the  entire 
amounts  due  from  the  government  for  prior  years. 


284  APPLICATION   AND    ADMINISTRATION 

May  partners  apply  a  credit  against  overpayment  made 
by  a  partnership  under  the  191 7  law? — 

Ruling.  Excess  profits  tax  paid  by  partnership  with  respect  to 
income  received  during  1918  can  not  be  applied  as  credit  to  tax  due 
from  individual  members  for  taxable  year  1918.  In  such  cases 
claim  for  refund  on  Form  46  should  be  filed  by  the  partnership.  (B. 
7-19-310;   O.    D.    180.) 

The  191 7  law  subjected  all  partnerships  to  an  excess 
profits  tax.  As  the  1918  act  was  not  approved  until  1919, 
many  partnerships  with  fiscal  years  ending  in  1918  made  re- 
turns and  paid  such  taxes  for  a  part  of  19 18. 

From  an  administrative  point  of  view,  the  above  ruling  may 
be  correct,  but  legally  the  partners  are  entitled  to  credit  addi- 
tional taxes  against  their  pro  rata  amount  of  the  refund. 

Claim  for  credit  when  a  partnership  was  incorporated  prior 
to  July  I,  1919. — 

Ruling.  Returns  for  1918  were  filed  for  a  partnership  and  its 
members  in  accordance  with  the  Revenue  Act  of  1917,  prior  to  the 
passage  of  the  Revenue  Act  of  1918,  and  tax  paid  accordingly.  The 
partnership  was  incorporated  prior  to  July  i,  1919,  and  elected  to 
be  taxed  as  a  corporation  under  the  provisions  of  paragraph  3,  sec- 
tion 330,  Revenue  Act  of  1918.  Amended  returns  for  1918  showing 
overpayment  of  tax  were  filed  by  the  partners. 

There  is  no  provision  in  the  law  whereby  either  the  tax  by  the 
partnership  or  any  excess  tax  paid  by  the  partners  may  be  credited 
against  any  tax  liability  of  the  successor  corporation  for  any  year. 
Remedy  may  be  sought  only  by  the  partnership  and  the  individual 
members  thereof  filing  claiins  for  the  refunding  of  any  excess  tax 
paid.     (C.  B.  2,  page  247;  O.  D.  457.) 

There  is  no  reason  why  the  above  credit  should  not  have 
been  allowed,  because  the  stockholders  in  the  new  corporation 
were  the  partners  in  the  partnership.  (See  C.  R.  3,  page  310; 
O.  D.  757.) 

When  successor  corporation  may  file  credit  against  over- 
payment of  predecessor. — 

Ruling.  In  view  of  the  fact  that  the  statute  of  New  Jersey  under 
which    a   merger   or   consolidation   of   corporations   resulting   in   the 


APPEALS,    REFUNDS,    ABATEMENT  285 

formation  of  another  corporation  is  accomplished  provides,  in  effect, 
that  the  successor  corporation  shall  represent  predecessor  corporations 
in  the  enforcement  of  their  rights,  it  is  held  that  the  successor  cor- 
poration is  entitled  to  file  claim  for  credit  on  account  of  the  over- 
payment of  tax  by  the  predecessor  corporation.  (C.  B.  4,  page  335; 
O.  D.  950.) 

Claim  of  credit  may  be  filed  by  either  husband  or  wife. — 

Ruling.  Where  claims  for  the  refund  of  taxes  erroneously  paid 
for  1919  and  prior  years  have  been  filed  by  the  husband  as  a  result 
of  the  Attorney  General's  ruling  relative  to  community  property 
under  the  laws  of  Texas  (T.  D.  3071),  such  claims  for  refund  may 
be  converted  into  claims  for  credit  to  be  applied  against  any  taxes 
due  from  the  husband  or  wife  as  shown  by  separate  returns  filed  by 
them  for  the  taxable  year  1920  and  subsequent  years,  subject  to  the 
provisions  of  section  252  of  the  Revenue  Act  of  1918.  Such  claims 
for  credit  must  be  accompanied  by  an  agreement  signed  by  the  hus- 
band and  wife  consenting  to  the  adjustments  therein  demanded.  A 
claim  for  refund  may  be  filed  for  any  excess  of  the  amount  claimed 
as  a  credit  over  taxes  shown  to  be  due.  (C.  B.  4,  page  335;  O.  D. 
854.) 

Claim  for  credit  arising  from  joint  return. — 

Ruling.  The  taxpayer's  wife  in  1918  filed  a  return  showing  a 
substantial  net  income  upon  which  she  paid  the  tax.  Inasmuch  as 
the  taxpayer  had  a  net  loss  for  such  year  he  filed  no  return.  The 
taxpayer  intends  to  file  an  amended  joint  return  for  himself  and 
wife  for  1918  and  a  claim  for  credit  of  the  excess  tax  paid  for  that 
year  to  be  applied  against  any  tax  due  for  the  taxable  year  1921. 

Held,  that  a  single  claim  for  credit  may  be  so  applied  against  any 
outstanding  taxes  due  at  the  time  the  claim  for  credit  is  filed,  pro- 
viding an  agreement  signed  by  the  taxpayer  and  his  wife  consenting 
to  the  adjustments  therein  demanded  accompanies  such  a  claim.  How- 
ever, if  no  outstanding  taxes  are  due  by  the  taxpayer  or  his  wife, 
a  claim  of  refund  of  the  excess  taxes  paid  for  1918  should  be  filed, 
accompanied  by  the  agreement  by  the  taxpayer  and  his  wife  referred 
to.     (I-2-23;  I.  T.  1 162.) 

Claims  for  credit  may  be  applied  against  refunds  due  under 
the  undistributed  profits  tax  of  the  191 7  Act. — 

Ruling.  The  tax  imposed  on  undistributed  net  income  of  cor- 
porations by  section  10  (b)  of  the  act  of  September  8,  1916,  as 
amended  by  the  act  of  October  3,  1917,  is  held  to  be  an  income 
tax  within  the  meaning  of  section  252  of  the  Revenue  Act  of  1918 


286  APPLICATION   AND   ADMINISTRATION 

and  may,  therefore,  be  credited  against  an  additional  amount  of  in- 
come tax  due  from  the  taxpayer  within  the  limitations  of  that 
section.     (B.  Digest  1-20-662;  O.  974.) 


Payment  Under  Protest 

Payment  under  protest  unnecessary  to  support  claim  for 
refund. — In  no  event  is  it  necessary  to  pay  under  protest  to 
secure  a  legal  right  to  demand  a  refund  when  it  is  believed 
that  the  tax  has  been  erroneously  assessed.  Section  3220  of 
the  Revised  Statutes  specifically  covers  this  point.  The  in- 
tention of  the  law  is  that  no  one  shall  be  erroneously  or  ex- 
cessively taxed.  This  intention  is  respected  by  the  Commis- 
sioner of  Internal  Revenue.  Sometimes  his  subordinates  or 
persons  in  the  offices  of  the  collectors,  acting  with  more  or  less 
praiseworthy  zeal,  treat  a  taxpayer's  claim  as  if  it  were  an 
attempt  to  extract  money  from  the  United  States  Treasury 
under  false  pretenses.  Anyone  with  a  legitimate  claim  might 
just  as  well  convey  the  impression  that  the  United  States 
Treasury  retains  some  of  his  money,  collected  under  false 
pretenses. 

Both  positions  are  wrong.  The  claim  and  its  considera- 
tion should  be  as  free  from  technicalities  as  possible  and  be 
made  and  treated  as  impartially  as  a  business  transaction. 
The  whole  matter  should  be  as  simple  as  the  filing  with  a  rail- 
road company  of  a  claim  for  refund  of  an  overcharge.  Busi- 
ness men  do  not  hesitate  to  make  these  claims  against  railroad 
companies,  but  heretofore  they  have  not  been  so  ready  to  go 
after  tax  overcharges.  The  reference  to  railroad  claims  ex- 
cludes the  period  during  which  the  railroads  were  under  gov- 
ernment control. 

It  has  been  recommended  by  some  authorities  that  all  taxes 
reported,  whether  in  any  case  they  are  more  or  less  than  the 
correct  amount,  should  be  paid  under  protest,  not  to  acquire 
any  right  to  claim  a  refund  (that  being  possible  without  ques- 
tion), but  to  establish  a  perfect  foundation  for  a  suit  against 
the  collector  if  the  claim  for  refund  is  rejected.    The  theory 


APPEAT.S,    REFUNDS,    ABATEMENT  287 

is  that  if  payment  is  made  voluntarily,  in  full  knowledge  that 
the  tax  is  erroneous,  the  taxpayer  is  estopped  from  any  right 
to  succeed  in  an  action  at  law. 

If,  as  stated  elsewhere,  payment  has  been  made  without 
any  knowledge  of  the  illegality  of  the  assessment,  an  action 
can  be  maintained  for  that  reason.  Furthermore,  even  where 
a  claim  has  been  made  for  abatement  (before  paying  the  tax) 
and  it  is  refused,  and  notice  is  served  by  the  collector  that  the 
tax  must  be  paid  or  penalties  will  be  enforced,  it  is  evident 
that  the  payment  is  being  made  not  voluntarily,  but  under 
duress,  and  the  courts  hold  that  collections  in  such  circum- 
stances do  not  estop  the  payer  from  subsequent  action  at  law. 

Should  payment  ever  be  made  under  protest? — In  the  case 
of  an  additional  assessment  after  examination,  where  the  facts 
upon  which  the  government  bases  its  claims  are,  in  the  opinion 
of  the  taxpayer,  unfounded  and  illegal,  there  can  be  no  harm, 
when  making  the  payment,  in  attaching  thereto  a  simple  form 
of  protest.  For  instance,  little  trouble  is  involved  in  attaching 
to  the  remittance  this  notice : 

I  hereby  protest  against  the  assessment  of  the  tax  levied  against 

me  as  evidenced  in  notice  dated  ,  on  the  ground  that  it  is 

erroneous  and  illegal,  and  payment  is  hereby  made  solely  to  prevent 
the  imposition  of  penalties  threatened  and  the  attachment  of  my 
property. 

Protest  not  necessary  under  certain  conditions. — In  one 

class  of  cases  it  certainly  is  not  necessary  to  have  paid  under 
protest — that  is,  where  a  taxpayer  prepared  his  returns  in  ac- 
cordance with  Treasury  regulations,  believing  them  to  be 
correct,  and  having  been  assessed  thereon  paid  the  tax  in 
due  course. 

In  the  cases  of  Greenport  Basin  and  Construction  Com- 
pany V.  United  States,  and  Young  v.  United  States,^^'  the 
court  said,  after  quoting  section  252  of  the  1918  law,  that: 

'"269  Fed.  58. 


288  APPLICATION   AND    ADMINISTRATION 

Decision.  Under  the  act,  therefore,  the  refund  is  a  matter  of 
right,  without  proof  of  duress  or  protest.  It  has  been  so  held  under  a 
similar  statute.  U.  S.  v.  Hvo'slef,  237  U.  S.  i,  35  Sup.  Ct.  459,  59 
L,  Ed.  813,  Ann.  Cas.  1916A,  286. 

Even  if  it  were  necessary  to  plead  duress  or  protest,  the  petition 
or  complaint  sets  forth  that  the  defendant  computed  the  tax  under 
compulsion  of  the  regulations  and  filed  a  claim  for  abatement  of  the 
taxes  assessed  before  payment.  This  complies  with  every  requisite 
of  a  payment  under  protest.  Chesebrough  v.  U.  S.,  192  U.  S.  253, 
24  Sup.  Ct.  262,  48  L.  Ed.  432;  City  of  Philadelphia  v.  Collector,  5 
Wall.  720,  18  L.  Ed.  614.  The  government  urges  that  it  is  necessary 
to  make  a  protest  at  the  time  of  actual  payment,  but  it  seems  to  the 
court  that  this  would  be  a  useless  requirement.  The  objects  of  the 
protest  are  to  define  the  taxpayer's  attitude  and  to  notify  the  govern- 
ment thereof.  These  have  been  fully  accomplished  by  the  objection 
of  the  taxpayer  when  the  computation  was  made  and  by  the  filing  of 
his  claim. 

When  payment  should  be  made  imder  protest. — While  in- 
voluntary payment  need  not  be  made  under  protest  in  order 
to  secure  a  refund  in  the  manner  provided  by  the  act,  in  cases 
where  recovery  of  taxes  alleged  to  be  illegally  exacted  is 
sought  by  an  action  at  law,  the  federal  courts  have  held  that 
the  claimant  must  show  involuntary  payment.  In  City  of  Phil- 
adelphia 7'.  the  CoUcctor,^'  the  United  States  Supreme  Court 
said : 

Decision.  Where  the  party  voluntarily  pays  the  money  he  is 
without  remedy;  but  if  he  pays  by  compulsion  of  law,  or  under  pro- 
test, or  with  notice  that  he  intends  to  bring  suit  to  test  the  validity  of 
the  claim,  he  may  recover  it  back,  if  the  assessment  was  erroneous  or 
illegal,  in  an  action  for  money  had  and  received. 

In  the  case  cited,  Elliott  v.  Swartwout,^^  the  court  said : 

Decision.  It  is  therefore  to  be  considered  as  a  voluntary  pay- 
ment by  mutual  mistake  of  law;  and  in  such  case,  no  action  will  lie 
to  recover  back  the  money.  The  construction  of  the  law  is  given  to 
both  parties,  and  each  presumed  to  know  it.  Any  instructions  from 
the  Treasury  Department  could  not  change  the  law  or  affect  the  rights 
of  the  plaintiff.  He  was  not  bound  to  take  and  adopt  that  con- 
struction.   He  was  at  liberty  to  judge  for  himself,  and  act  accordingly. 


'"'■  5  Wall.  720;  7J  U.  S.  720;  18  L.  Ed.  614. 
°'35  U.  S.  137;  12  Curtis  46;  9  L.  Ed.  ^Ji- 


APPEALS,    REFUNDS,    ABATEMENT  289 

....  There  can  be  no  hardship  in  requiring  the  party  to  give 
notice  to  the  collector  that  he  considers  the  duty  illegal,  and  put  him 
on  his  guard,  by  requiring  him  not  to  pay  over  the  money.  The  col- 
lector would  then  be  placed  in  a  situation  to  claim  an  indemnity  from 
the  government.  But  if  the  party  is  entirely  silent  and  no  intimation 
of  an  intention  to  seek  a  repayment  of  the  money;  there  can  be  no 
ground  upon  which  the  collector  can  retain  the  money,  or  call  upon 
the  government  to  indemnify  him  against  a  suit.  It  is  no  sufficient 
answer  to  this  that  the  party  cannot  sue  the  United  States.  The  case 
put  in  the  question  is  one  where  no  suit  would  lie  at  all.  It  is  the 
case  of  a  voluntary  payment  under  a  mistake  of  law,  and  the  money 
paid  over  is  to  the  treasury;  and  if  any  redress  is  to  be  had  it  must 
be  by  application  to  the  favor  of  the  government,  and  not  on  the 
ground  of  a  legal  right. 

Court  held  that  in  case  of  mistake  of  law,  protest  was 
necessary  to  suit.  In  case  of  mistake  of  fact,  such  protest  was 
not  necessary. 

It  should  be  noted  that  the  foregoing  case  was  decided  in 
1836. 

Arguments  in  favor  of  paying  under  protest. — Although 
the  Treasury  unreservedly  states  that  a  tax,  if  excessive, 
need  not  have  been  paid  under  protest  to  be  recovered,  there 
are  certain  cases  which  indicate  that  a  taxpayer  should  pay 
under  protest  to  protect  his  right  to  sue  for  refund.  They  are, 
however,  not  entirely  clear  and  it  will  be  found  that  the  mod- 
ern tendency  is  to  waive  the  formal  protest. 

The  following  cases  are  illustrative  of  past  practice: 

Wright  v.  Blakeslee,  loi  U.  S.  174,  25  L.  Ed.  1048  (1880)  holds 
that,  although  no  written  notice  or  protest  is  required  by  statute  of  a 
party  paying  illegal  taxes  under  the  internal  revenue  laws,  in  order 
to  recover  the  amount  erroneously  paid,  he  must,  however,  pay  under 
protest  in  some  form,  or  his  payment  will  be  deemed  voluntary. 

As  stated  by  Chief  Justice  Fuller,  in  Chesebrough  v.  United 
States.'" 

Decision.  The  rule  is  firmly  established  that  taxes  voluntarily 
paid  cannot  be  recovered  back,  and  payments  with  knowledge  and 
without  compulsion  are  voluntary.     At  the   same  time,  when  taxes 


192  U.  S.  J53;  48  L.  Ed.  432;  24  S.  Ct.  262  (1904). 


290 


ArPLICATION    AND    ADMINISTRATION 


are  paid  under  protest  that  they  are  being  illegally  exacted,  or  with 
notice  that  the  payer  contends  that  they  are  illegal  and  intends  to 
institute  suit  to  compel  their  repayment,  a  recovery  in  such  suit 
may,  on  occasion,  be  had,  although  generally  speaking,  even  a  protest 
or  notice  will  not  avail  if  the  payment  be  made  voluntarily,  with  free 
knowledge  of  all  the  circumstances,  and  without  any  coercion  by  the 
actual  or  threatened  exercise  of  power  possessed,  or  supposed  to  be 
possessed,  by  the  party  exacting  or  receiving  the  payment,  over  the 
person  or  property  of  the  party  making  the  payment,  from  which  the 
latter  has  no  other  means  of  immediate  relief  than  such  payment. 

In  Hei'old  V.  Kahn,^^  the  court  said : 

Decision.  The  proper  administration  of  the  fiscal  afifairs  of  the 
government,  require  that  the  payment  of  taxes  should  not  be  delayed 
by  disputes  as  to  their  legality,  but  that  the  taxes  should  first  be  paid 
and  all  questions  in  regard  to  them  be  determined  in  suits  brought 
for  their  refunding.  It  is  a  wise  policy,  therefore,  that  encourages 
the  payment  under  protest  of  disputed  taxes.  Though  there  is  some 
conflict  in  the  dicta  of  the  Supreme  Court,  we  think  that  the  true 
doctrine  is  that,  when  taxes  are  paid  under  protest  that  they  are 
being  illegally  exacted,  or  with  notice  that  the  payor  contends  that 
they  are  illegal  and  intends  to  institute  suit  to  compel  their  repay- 
ment, a  sufficient  foundation  for  such  suit  has  been  established.*^ 


Procedure  of  Collectors 

The  procedure  of  collectors  regarding  claims  for  abate- 
inent  and  refund  is  not  of  general  interest  to  taxpayers  and  is 
omitted  from  this  book.®^ 


'"IS9  Fed.  608;  86  C.  C.  A.  598. 

®'  The  mandate  was  recalled  and  amended  in  163  Fed.  947 ;  90  C.  C.  A. 
307,  so  as  to  include  interest  from  tiie  date  of  the  judgment  of  the  District 
Court. 

"  See  T.  D.  3260. 


CHAPTER  X 

INFORMATION  AT  THE  SOURCE 

The  provisions  of  the  1918  law  requiring  certain  informa- 
tion returns  have  been  re-enacted  in  the  1921  law  in  identical 
terms. 

The  system  of  information  at  the  source  was  introduced 
in  the  19 17  law  with  a  dual  purpose — to  obtain  an  effective 
method  of  check  regarding  certain  classes  of  income  included 
or  which  should  be  included  in  tax  returns,  and  to  remove  the 
causes  of  complaint  leveled  at  the  provisions  of  the  19 13  and 
1916  laws  regarding  withholding  of  tax  at  the  source. 

"Collection  before  receipt,"  as  withholding  has  been  called, 
was,  and  still  is,  a  salient  feature  of  the  British  income  tax 
law ;  but  its  adoption  in  this  country  proved  too  technical  and 
unsuited  to  American  conditions. 

The  use  of  information  returns,  now  in  force,  provides  a 
method  of  supplying  the  taxing  authority  with  a  vast  amount 
of  accurate  information  regarding  taxable  income  which,  if 
used  intelligently,  will  enable  the  government  to  obtain  almost 
as  definite  a  hold  on  the  income  in  question  as  if  the  tax  had 
been  withheld  by  the  payor. 

It  is  important  that  those  responsible  for  the  filing  of  in- 
formation returns  become  cognizant  of  the  requirements  of 
the  law,  not  only  as  an  assistance  to  the  government  but  also 
in  order  to  prevent  the  infliction  of  penalties  on  themselves 
for  non-compliance.  The  farmer  paying  a  foreman  $90  a 
month  must  be  educated  to  obey  the  law  just  as  much  as  a 
corporation  which  pays  its  president  $9,000  a  month. 

Information  returns  on  all  payments  would  result  in  the 
submission  of  an  immense  amount  of  material,  a  large  part  of 
which  would  be  entirely  valueless.  The  framers  of  the  law 
made  it  discretionary  with  the  Commissioner,  subject  to  cer- 

291 


292  APPLICATION    AND    ADMINISTRATION 

tain  limitations,  as  to  the  type  of  returns  that  may  be  demanded. 
For  this  reason,  the  regulations  make  ver)^  full  provisions  as 
to  the  information  returns  required. 

Classification  of  information  returns. — Returns  of  informa- 
tion may  be  divided  into  the  following  groups: 

1.  Returns  for  all  payments  of  fixed  and  determinable 

income,  such  as  interest  (other  than  bond  interest), 
rent,  wages,  salaries,  fees,  commissions,  etc.,  pay- 
able to  citizens  or  residents  and  to  foreign  partner- 
ships. 

2.  Ownership  certificates  which  must  be  used  in  collecting 

interest  on  foreign  and  domestic  corporation  bonds, 
and  dividends  on  foreign  stocks. 

3.  Withholding  returns  in  the  case  of  all  payments  of 

fixed  and  determinable  annual  or  other  periodical 
income  payable  to  non-resident  alien  individuals  and 
foreign  corporations. 

4.  Returns  of  payments  of  domestic  dividends. 

5.  Returns  of  payments  of  profits  to  clients  by  brokers. 

6.  Returns  disclosing  actual  ownership  of   stock  made 

chiefly  by  foreign  principals. 

The  pages  immediately  following  deal  with  returns  for 
payments  of  fixed  or  determinable  income,  while  the  subject  of 
ownership  certificates  is  covered  in  the  latter  part  of  this  chap- 
ter.    Withholding  returns  are  discussed  in  Chapter  XI. 

Payments  of  Fixed  or  Determinable  Amount 

Who  must  furnish  information  as  to  payments  of  salaries, 
interest,  rent,  etc.,  of  $1,000  or  more. — 

Law.  Section  256.  That  all  individuals,  corporations,  and  part- 
nerships, in  whatever  capacity  acting,  including  lessees  or  mortgagors 

of  real  or  personal  property,  fiduciaries,  and  employers. 

The  classes  to  which  paid. — 
making  payment   to   another  individual,  corporation,^   or  partnership, 

*  Payments  to  corporations  need  not  be  reported  (Art.  1074). 


INFORMATION    AT    THE    SOURCE 


293 


Description  of  payments. — 

of  interest,  rent,  salaries,  wages,  premiums,  annuities,  compensations, 
remunerations,  emoluments,  or  other  fixed  or  determinable  gains, 
profits,  and  income  (other  than  payments  described  in  sections  254 
and  255),  [The  exceptions  are  dividends  and  transactions  by  brokers 
(see  page  302)]. 

The  amount  to  be  reported. — 

of  $1,000  or  more  in  any  taxable  year. 

Employees  of  United  States  government  must  make  re- 
turn.— 

or,  in  the  case  of  such  payments  made  by  the  United  States,  the 
officers  or  employees  of  the  United  States  having  information  as  to 
such  payments  and  required  to  make  returns  in  regard  thereto  by  the 
regulations  hereinafter  provided  for, 

Form  of  returns.- — 

shall  render  a  true  and  accurate  return  to  the  Commissioner,  under 
such  regulations  and  in  such  form  and  manner  and  to  such  extent  as 
may  be  prescribed  by  him  with  the  approval  of  the  Secretary,  setting 
forth  the  amount  of  such  gains,  profits,  and  income,  and  the  name  and 
address  of  the  recipient  of  such  payment 

The  regulation  dealing  with  this  matter   follows : 

Regulation.  All  persons  making  payment^  to  another  person  of 
fixed  or  determinable  income  of  $i,ooo''  or  more  in  a  taxable  year 
must  render  a  return  thereof  to  the  Commissioner  for  the  preceding 
calendar  year  on  or  before  March  15  of  each  year,  except  as  specified 
in  articles  1073,  1074,  1075,  1076,  and  1079.  The  return  shall  be  made 
in  each  case  on  Form  1099,  accompanied  by  a  letter  of  transmittal 
on  Form  1096  showing  the  number  of  returns  filed.     The  street  and 


'  [Former  Procedure]  Under  the  1913  and  1916  laws  there  were  pro- 
visions for  withholding  at  the  source  for  all  classes  of  fixed  and  determin- 
able annual  or  periodical  income.  These  withholding  returns  constituted 
a  source  of  information,  but  "information  at  the  source"  in  the  strict 
sense  was  first  provided  for  in  1917  law.  This  system  was  substituted 
where  withholding  at  the  source  was  abolished.  The  provisions  of  the  1918 
law  regarding  information  are  substantially  the  same  as  those  of  the  1917 
law. 

*  These  returns  are  required  for  actual  amounts  paid  or  credited  and 
made  available  during  the  calendar  year  equal  to  or  exceeding  $1,000. 
(C.  B.  2,  page  249;  O.  D.  428.) 

*  [Former  Procedure]  Under  the  1917  law  the  amount  to  be  reported 
was  an  annual  aggregate  of  $800. 


294  APPLICATION    AND    ADMINISTRATION 

number  where  the  recipient  of  tlic  payment  lives  should  be 
stated,  if  possible.  Where  no  present  address  is  available,  the  last 
known  post-office  address  must  be  given.  Although  to  make  necessary 
a  return  of  information  the  income  must  be  fixed  or  determinable,  it 
need  not  be  annual  or  periodical. '^     (Art.  1071.) 

The  new  article  omits  the  requirement  of  reporting  on  form 
1096  the  aggregate  amottnt  represented  by  the  separate  form 
1099.  The  new  form  only  requires  a  statement  of  the  number 
of  forms  1099  attached  thereto. 

Ruling.  A  receiver  in  partition  proceedings  is  required  to  file 
returns  of  information  covering  payments  of  commissions,  attorney's 
fees,  and  other  fixed  or  determinable  income  of  $1,000  or  more  made 
to  any  person  during  the  taxable  year.    (B.  52-21-1995;  O.  D.  1149.) 

Returns  cover  calendar  year. — 

Law.     Section  256 The  provisions  of  this  section  shall 

apply  to  the  calendar  year  1921  and  each  calendar  year  there- 
after, .... 

The  instructions  on  form  1099  (1920)  state: 

One  of  these  forms  must  be  filled  in  for  each  person  to  whom  in- 
come, as  described  on  this  form,  was  paid  during  the  calendar 
year 

Fixed  and  determinable  income  defined. — The  law  re- 
quires returns  of  information  only  when  the  income  is  fixed 
and  determinable.  It  is  not  necessary  that  the  income  be  an- 
nual or  periodical,  as  stipulated  in  the  requirement  for  with- 
holding. 

Regulation (a)   Income  is  fixed  when  it  is  to  be  paid  in 

amounts  definitely  predetermined.  On  the  other  hand,  it  is  determin- 
able whenever  there  is  a  basis  of  calculation  by  which  the  amount 
to  be  paid  may  be  ascertained (Art.  362,) 

It  has  been  held  that  where  a  lease  provides  for  a  payment 
of  rental  in  crop  shares,  the  landlord  and  tenant  sharing  pro- 
portionately the  expenses  and  dividing  the  proceeds,  such  pay- 


°  Where  withholding  is  required  the  income  must  be  annual  or  periodi- 
cal as  well  as  fixed  and  determinable. 


INFORMATION    AT   THE    SOURCE  295 

merits  are  not  fixed  and  determinable  and  need  not  be  re- 
ported." 

Commission  on  account  of  a  single  transaction  has  been 
held  not  to  be  fixed  or  determinable  annual  income.'  Income 
credited  but  not  paid  is  subject  to  the  provisions  of  article  362.* 
Fees  for  professional  services  should  be  included  in  informa- 
tion returns.®  Earnings  of  lawyers  and  doctors  are  not  usu- 
ally within  the  purview  of  this  provision  of  the  law  (unless 
they  are  paid  a  regular  retainer).^" 

Payments  to  employees. — Returns  of  information  regard- 
ing payments  to  employees,  other  than  those  against  whom 
withholding  is  required,  are  specifically  covered  as  follows : 

Regulation.  The  names  of  all  employees  to  whom  payments 
of  $1,000  or  over  a  year  are  made,  whether  such  total  sum  is  made 
up  of  wages,  salaries,  commissions,  or  compensation  in  any  other 
form,  must  be  reported.  Heads  of  branch  offices  and  subcontractors 
employing  labor,  who  keep  the  only  complete  record  of  payments 
therefor,  should  file  returns  of  information  in  regard  to  such  pay- 
ments directly  with  the  Commissioner.  When  both  main  office  and 
branch  office  have  adequate  records,  the  return  should  be  filed  by  the 
main  office.  In  case  an  employer  has  a  large  number  of  employees 
and  the  computation  of  exact  amounts  paid  during  the  calendar  year 
will  result  in  an  undue  hardship,  careful  estimates  may  be  made  on 
the  basis  of  any  representative  month,  and  unless  the  yearly  payment 
based  on  this  estimate  in  the  case  of  any  employee  amounts  to  $1,000 
or  more,  no  return  of  payments  to  such  employee  is  required.  (Art. 
1072.) 

The  new  regulation  permits  employers  who  have  a  large 
number  of  employees  to  make  returns  on  estimated  payments. 
The  old  regulation  extended  this  privilege  only  to  employers 
having  a  large  number  of  employees  who  were  being  moved 
from  job  to  job. 

To  report  accurately  the  payments  made  to  individual 
employees  occasions  a  great  amount  of  unnecessary  expense 


•Treasury  Bulletin  "B,"  page  38;  also  C.  B.  i,  page  261;  O.  D.  115. 
'C.  B.  4,  page  232;  O.  D.  907. 
'  C.  B.  2,  page  249 ;  O.  D.  428. 
*  C.  B.  2,  page  248;  O.  D.  416. 
"Treasury  Bulletin  "B,"  page  11. 


296  APPLICATION    AND    ADMINISTRATION 

to  many  large  corporations.  It  has  been  ascertained  that  the 
production  of  $1  tax  to  the  government  has  cost  corporations 
in  some  cases  as  much  as  $10.  The  new  regulation  will  reduce 
the  labor  involved  to  some  extent,  but  the  author  is  still  of 
the  opinion  that  the  requirements  of  the  government,  in  so  far 
as  this  particular  form  of  information  is  concerned,  would  be 
amply  met  if  corporations  were  to  report  merely  the  name 
and  address  of  any  employee  paid  at  the  rate  of  $1,000  per 
annum  or  over  without  specifying  the  exact  sum  paid. 

If  an  employer  is  required  under  a  state  law  to  withhold 
a  tax  on  an  employee's  salary,  the  gross  payment  before  de- 
duction should  be  reported. 

Ruling,  In  executing  Form  1099,  ^"  employer  who  is  required 
to  withhold  tax  from  an  employee  under  a  State  income-tax  law, 
should  report  on  such  form  the  amount  of  the  salary  paid  to  the  em- 
ployee plus  the  amount  of  the  tax  withheld.  The  employee  should 
report  the  same  amount  in  his  personal  return  on  Form  1040  or  Form 
1040A  as  the  case  may  be.     (C.  B.  2,  page  249;  O.  D.  401.) 

The  value  of  living  quarters  and  board  furnished  em- 
ployees^^ must  be  considered  by  employers  in  preparing  re- 
turns of  information : 

Rulings A  person  receives  cash  compensation  for  services 

rendered,  and  in  addition  thereto  living  quarters ;  when  such  quarters 
are  furnished  for  the  benefit  and  convenience  of  employees,  the 
amount  of  cash  compensation  plus  the  value  of  living  quarters  must 
be  returned.  When,  however,  Hving  quarters  are  furnished  for  the 
convenience  of  the  employer  only,  the  value  thereof  rreed  not  be 
returned.  Board  and  lodging  furnished  seamen  in  addition  to  their 
cash  compensation  is  held  to  be  supplied  for  the  convenience  of  the 
employer (Treasury  Bulletin  "B,"  page  38.) 

The  value  to  a  domestic  servant  of  the  board  and  lodging  received 
as  part  of  his  compensation  for  services  rendered  is  deemed  to  be 
the  same  amount  which  he  would  be  required  to  pay  for  board  and 
lodging  elsewhere  than  in  his  employer's  household. 

If  the  value  of  the  board  and  lodging  added  to  the  cash  compensa- 
tion equals  or  exceeds  $1,000  an  employer  is  required  to  report  such 
amount  on  Forms  1099  and  1096.    The  value  of  the  board  and  lodging 


"  See  Chapter  XIV.  The  1921  law  specifically  provides  that  the  rental 
value  of  a  minister's  house  is  not  taxable  and  should  therefore  not  be 
reported. 


INFORMATION    AT    THE   SOURCE 


297 


should  be  entered  separately  on  Form  1099,  as  evidence  of  the  fact 
that  such  value  has  been  considered  in  computing  the  total  amount 
received  by  the  servant.     (C.  B.  4,  page  348;  O.  D.  874.) 

In  view  of  the  foregoing,  employees  should  be  advised  by 
employers  regarding  the  tax  to  which  they  are  subject. 

Return  of  information  by  partnerships,  personal  service 
corporations,  and  fiduciaries. — 

Information  returns  on  forms  1099  and  1096  are  required 
in  all  the  above  cases  regardless  of  whether  such  income 
amounts  to  more  or  less  than  $1,000  annually.^"  Salaries  paid 
to  members  of  partnerships  or  personal  service  corporations 
must  also  be  included  in  the  returns  of  information.  Similarly, 
if  a  fiduciary  receives  a  salary  from  an  estate,  an  information 
return  must  be  filed.  All  payments  by  partnerships,  personal 
service  corporations,  and  fiduciaries  to  employees  must  be 
reported  if  such  payments  equal  or  exceed  the  statutory  mini- 
mum. 

Many  taxpayers  object  to  making  information  returns  for 
members  of  partnerships  and  personal  service  corporations 
and  for  beneficiaries,  because  such  information  is  shown  on  the 
partnership  return  1065  dnd  the  fiduciary  return  1041.  This 
duplication  of  information  returns  Vk^as  the  subject  of  a  recent 
conference  at  Washington  between  the  Secretary  of  the  Treas- 
ury and  representative  bankers  and  others.  It  resulted  in  the, 
elimination  of  forms  1096  and  1099  in  these  cases,  as  stated 
in  the  instructions  on  the  new  form  1096. 

Ruling.  A  business  w^hich  had  been  operated  as  a  partnership 
was  incorporated  in  June,  1920,  and  thereafter  operated  as  a  corpora- 
tion. There  was  no  interruption  to  the  business,  and  the  employees  of 
the  partnership  were  retained  by  the  corporation. 


'^  See  Treasury  Bulletin  "B,"  page  3q;  also  C.  B.  4,  page  348;  M.  2708. 

[Former  Procedure] 

Ruling.  "Form  1099  's  required  to  be  filed  for  the  calendar  year.  A 
partnership  which  renders  its  return  on  a  fiscal  year  basis  should  report  on 
Form  1099  the  distributive  share  of  each  member  of  the  partnership  for  the 
fiscal  year  ending  within  the  calendar  year  for  which  the  Form  1099  is 
rendered."     (C.  B.  4,  page  348;  O.  D.  885.) 


298  APPLICATION    AND   ADMINISTRATION 

Held,  that  for  administrative  purposes  it  will  not  be  considered 
that  there  was  a  change  in  employer.  Since  there  was  no  inter- 
ruption to  business,  and  the  employees  of  the  partnership  continued 
to  be  the  employees  of  the  corporation,  only  one  Form  1099  covering 
the  calendar  year  1920  is  required  to  be  filed  in  each  case  where  the 
total  amount  of  payments  made  equalled  or  exceeded  $1,000.  (C. 
B.  4,  page  347;  O.  D.  788.) 

Information  returns  of  bond  interest  and  foreign  dividends 
not  limited  to  payments  of  $1,000. — The  statutory  provision 
as  to  information  returns  in  case  of  bond  interest  and  foreign 
dividends  is  as  follows : 

Law.  Section  256.  .  .  .  .  Such  returns  may  be  required,  regard- 
less of  amounts,  (i)  in  the  case  of  payments  of  interest  upon  bonds, 
mortgages,  deeds  of  trust,  or  other  similar  obligations  of  corpora- 
tions, and  (2)  in  the  case  of  collections^^  of  items  (not  payable  in  the 
United  States)  of  interest  upon  the  bonds  of  foreign  countries  and 
interest  upon  the  bonds  of  and  dividends  from  foreign  corporations 
by  individuals,  corporations,  or  partnerships,  undertaking  as  a  mat- 
ter of  business  or  for  profit  the  collection  of  foreign  payments  of 
such  interest  or  dividends  by  means  of  coupons,  checks,  or  bills  of 
exchange 

Monthly  and  annual  returns  required/* — The  withhold- 
ing agent  is  required  to  make  monthly  and  annual  returns  as 

follows :  • 

Regulation,  (a)  Every  withholding  agent  shall  make  an  an- 
nual return  to  the  collector  of  the  tax  withheld  from  interest  on  cor- 
porate bonds  or  other  obligations  on  or  before  March  i  on  Form  1013. 
He  shall  also  make  a  monthly  return  on  Form  1012  on  or  before 
the  20th  day  of  the  month  following  that  for  which  the  return  is  made. 
The  original  ownership  certificates,  or  the  substitute  certificates 
where  authorized,  must  be  forwarded  to  the  Commissioner  with  the 


"  [Former  Procedure] 

Ruling.  "The  term  'collections'  as  used  in  section  256  of  the  Revenue 
Act  of  1918  includes  the  following: 

"(a)   The  payment  by  the  licensee  of  the  foreign  item  in  cash; 

"(b)  The  crediting  by  the  licensee  of  the  account  of  the  person  present- 
ing the  foreign  item ; 

"(c)  The  tentative  crediting  by  the  licensee  of  the  account  of  the  per- 
son presenting  the  foreign  item  until  the  amount  of  the  foreign  item  is 
received  bj'  the  licensee  from  abroad ; 

"(d)  The  receipt  of  foreign  items  by  the  licensee  for  the  purpose  of 
transmitting  them  abroad  for  deposit."     (I-4-47;  L  T.  1176.) 

"  See  Chapter  XI. 


INFORMATION    AT    THE    SOURCE 


299 


montlily   return    ....    the  tax   withheld  must   be   paid   on   or  be- 
fore June  15  of  each  year  to  the  collector (Art.  371;  Reg. 

45,  Art.  370.) 

The  ownership  certificates  are  now  to  be  sent  to  the  Com- 
missioner and  not  to  the  collector  as  previously. 

If  a  non-resident  alien  claims  exemption  on  tax-free  cove- 
nant bonds  on  or  before  February  i  by  filing  with  the  with- 
holding agent  form  looiB,  the  amount  of  tax  due  from  the 
withholding  agent  as  shown  by  form  1013  may  be  reduced  b)- 
2  per  cent  of  the  aggregate  amount  of  interest  payments  made 
to  such  individual  during  the  calendar  year.^^ 

When  forms  looi  and  lOOiA  are  used  there  is  no  actual 
withholding ,  such  returns  being  simply  information  returns}^ 
Monthly  and  annual  returns  are  nevertheless  required. ^^ 

Regulation.  Where  a  debtor  corporation  or  its  duly  authorized 
withholding  agent  has  made  payments  of  interest  on  its  bonds,  but 
in  certain  instances  has  been  required  to  withhold  no  tax,  the  owner- 
ship certificates  on  Form  looi  filed  in  connection  with  such 
payments  shall  be  transmitted  to  the  Commissioner,  accom- 
panied by  a  return  on  form  1096A  showing  the  number  of  ownership 
certificates  thus  transmitted  and  the  total  amount  of  interest  paid. 
This  return  shall  be  made  by  the  20th  day  of  each  month  following 
that  for  which  the  return  is  made  and  need  not  be  sworn  to.  An 
annual  return  shall  be  forwarded  to  the  Commissioner  not  later  than 
March  15  of  each  year  on  form  1096B,  on  which  shall  be  given  a 
summary  of  the  monthly  returns (Art.  373.) 

Return  of  information  as  to  foreign  items. — 

Regulation.  In  the  case  of  collections  of  foreign  items,  re- 
gardless of  amount,  the  original  ownership  certificates,  when  duly 
filed,  shall  constitute  and  be  treated  as  returns  of  information,  (o) 
In  the  case  of  dividends,  as  to  which  the  first  bank  or  collecting 
agent  is  the  source  of  information,   it  shall   detach  the  ownership 


"  See  Chapter  XXXVI  for  discussion  of  personal  exemption  of  non- 
resident aliens. 

"  It  should  be  noted  that  all  withholding  returns  are  treated  as  informa- 
tion returns  and  are  therefore  mentioned  in  this  chapter.  All  information 
returns,  however,  are  not  withholding  returns  and  this  distinction  should 
be  noted. 

"  The  requirement  as  to  monthly  and  annual  returns  covering  payments 
on  form  lOoiA  are  the  same  as  for  looi.  The  regulation  governing  re- 
turns on  form  lOOiA  is  quoted  in  full  on  page  316. 


300 


APPLICATION    AND   ADMINISTRATION 


certificate  and  indorse  on  the  item  the  words,  "Certificate  detached 
and  information  furnished,"  adding  its  name  and  address.  When 
foreign  items  have  been  indorsed  as  above  prescribed,  the  certifi- 
cates shall  be  forwarded  to  the  Commissioner  on  or  before  the  20th  day 
of  the  month  following  that  during  which  the  items  were  accepted,  ac- 
companied by  a  return  on  form  1096A  showing  the  number  of  cer- 
tificates. An  annual  return  on  form  1096B  shall  be  forwarded  to 
the  Commissioner  not  later  than  IMarch  15  of  each  year,  on  which 
shall  be  given  a  summary  of  the  monthly  returns,  (b)  In  the  case 
of  interest  items,  as  to  which  the  paying  agent  or  the  last  bank  or 
collecting  agent  in  this  country  is  the  source  of  information,  the  own- 
ership certificate  shall  accompany  the  coupon  to  such  agent  or  source 
of  information,  who  shall  forward  the  ownership  certificate  to  the 
Commissioner  in  the  same  manner  as  above  provided  with  respect  to 
dividend  items.  Where  ownership  certificate  Form  1000  is  used, 
a  monthly  return  shall  be  made  on  Form  1012  and  an  annual  return 
on  Form  1013,  as  provided  in  articles  361-375 (Art.  1079.) 

The  name  of  the  paying  agent  should  be  shown  on  forms 
1012  and  1013  when  they  are  used  to  make  returns  of  owner- 
ship certificates  covering  foreign  interest.  The  aggregate 
amount  of  foreign  items  is  no  longer  reported  on  form  1096A. 

The  provisions  of  subdivision  (b)  above  are  appHcable 
also  to  foreign  registered  bonds. ^^ 

Information  regarding  foreign  items. — "Foreign  items" 
and  the  source  from  which  information  is  obtained  are  ex- 
pressly stated  as  follows : 

Definition  of  "foreign  item." — 

Regulation.  The  term  "foreign  item,"  as  here  used,  means  any 
dividend  upon  the  stock  of  a  nonresident  foreign  corporation  or  any 
item  of  interest  upon  the  bonds  of  foreign  countries  or  nonresident 
foreig'n  corporations,  whether  or  not  such  dividend  or  interest  is 
paid  in  the  United  States  or  by  check  drawn  on  a  domestic  bank. 

Source  of  information. — 

(a)   Wherever  a  foreign  country  or  nonresident  foreign  corporation 
issuing  bonds^^  has  appointed  a  paying  agent  in  this  country,  charged 

"C.  B.  3,  page3i3;  O.  D.674; 

"  A  non-resident  corporation  is  defined  as  "a  foreign  corporation  not 
engaged  in  trade  or  business  within  the  United  States  and  not  having  any 
office  or  place  of  business  therein."     "A  foreign  corporation  not  engaged 


INFORMATION    AT   THE    SOURCE  301 

with  the  duty  of  paying  the  interest  upon  such  bonds,  such  paying 
agent  shall  be  the  source  of  information.  If  such  foreign  country  or 
foreign  corporation  has  no  such  agent,  then  the  last  bank  or  col- 
lecting agent  in  this  country  shall  be  the  source  of  information. 
(b)  In  the  case  of  dividends  on  the  stock  of  a  nonresident  foreign 
corporation,  however,  the  first  bank  or  collecting  agent  accepting  such 
item  for  collection  shall  be  the  source  of  information.  No  return  of 
information  is  required  with  respect  to  foreign  items  owned  by  a 
nonresident  alien  individual,  a  foreign  partnership,  or  a  foreign  cor- 
poration, provided  the  first  bank  or  collecting  agent  is  satisfied  as 
to  such  ownership.  In  such  case  the  foreign  item  may  be  stamped 
"foreign  owner."     (Art.  1076;  Reg.  45,  Art.  1077.) 

Returns  of  payments  to   non-resident  aliens.-" — 

Regulation.  In  the  case  of  payments  of  annual  or  periodical 
income  to  nonresident  alien  individuals,  partnerships  composed  in 
whole  or  in  part  of  nonresident  aliens  and  not  having  an  office  or 
place  of  business  within  the  United  States,  or  to  foreign  corporations 
not  engaged  in  trade  or  business  within  the  United  States  and  not 
having  any  office  or  place  of  business  therein,  the  returns  filed  by 
withholding  agents  on  Form  1042  shall  constitute"  and  be  treated 
as  returns  of  information.     (Art.   1075;  Reg.  45,  Art.  1076.) 

Form  1042  is  the  annual  list  return  of  the  withholding 
agent  which  must  be  filed  on  or  before  March  i. 

Ruling.  A  withholding  agent  is  not  relieved  from  obligation  to 
pay  to  the  Federal  Government  the  amount  of  tax  correctly  with- 
held from  the  income  of  a  nonresident  alien  by  reason  of  the  fact 
that  the  nonresident  alien  has  filed  a  return  showing  no  tax  liability. 
(B.  31-21-1756;  O.  D.  985.) 

Return  of  payments  of  dividends. — 

Law.     .Section  254.-^     That  every  corporation  subject  to  the  tax 


in  trade  or  business  within  the  United  States  which  has  a  fiscal  agent  in 
the  United  States,  is  not  a  resident  corporation."  See  Treasury  Bulletin 
"B,"  page  10. 

*  There  is  no  withholding  on  fixed  and  determinable  annual  or  other 
periodical  income  paid  to  foreign  partnerships,  except  in  the  case  of  in- 
terest on  tax-free  covenant  bonds.  Apparently  information  returns  must 
be  filed  on  form  1099,  in  the  case  of  such  payments.  (Bulletin  1-19-10; 
O.  D.  76.)  If  the  income  of  non-resident  aliens  is  not  fixed  or  determin- 
able, no  information  return  is  required.     (C.  B.  3,  page  312;  O.  D.  673.) 

'^  [Former  Procedure]  Reg.  :i^,  1918,  Art.  33,  referred  to  special 
Regulations  40,  governing  returns  to  be  made  by  brokers,  but  these  were 
apparently  never  promulgated. 


302 


APPLICATION   AND   ADMINISTRATION 


imposed  by  this  title  and  every  personal  service  corporation  shall, 
when  required  by  the  Commissioner,  render  a  correct  return  duly 
verified  imder  oath,  of  its  payments  of  dividends,  stating  the  name 
and  address  of  each  stockholder,  the  number  of  shares  owned  by 
him,  and  the  amount  of  dividends  paid  to  him. 

Regulation.  When  directed  by  the  Commissioner,  either  spe- 
cially or  by  general  regulation,  every  domestic  or  resident  foreign 
corporation  and  every  personal  service  corporation  shall  render  a 
return  on  Form  1097  of  its  payments  of  dividends  and  distributions 
to  stockholders  for  such  period  as  may  be  specified,  stating  the  name 
and  address  of  each  stockholder,  the  number  and  class  of  shares 
owned  by  him,  the  date  and  amount  of  each  dividend  paid  him,  and 
when  the  surplus  out  of  which  it  was  paid  was  accumulated.  (Art. 
1060;  Reg.  45,  Art.  105 1.) 

Returns  of  brokers. — 

Law.  Section  255.  That  every  individual,  corporation,  or  part- 
nership doing  business  as  a  broker  shall,  when  required  by  the  Com- 
missioner, render  a  correct  return  duly  verified  under  oath,  under 
such  rules  and  regulations  as  the  Commissioner,  with  the  approval 
of  the  Secretary,  may  prescribe,  showing  the  names  of  customers  for 
whom  such  individual,  corporation,  or  partnership  has  transacted  any 
business,  with  such  details  as  to  the  profits,  losses,  or  other  information 
which  the  Commissioner  may  require,  as  to  each  of  such  customers, 
as  will  enable  the  Commissioner  to  determine  whether  all  income  tax 
due  on  profits  or  gains  of  such  customers  has  been  paid.^^ 

Regulation.  When  directed  by  the  Commissioner,  either  specially 
or  by  general  regulation,  every  person  doing  business  as  a  broker  shall 
render  a  return  on  Form  iioo,  showing  the  names  and  addresses  of 
customers  to  whom  payments  were  made  or  for  whom  business  was 
transacted  during  the  calendar  year  or  other  specified  period  next 
preceding  and  giving  the  other  information  called  for  by  the  form. 
(Art.  1065;  Reg.  45,  Art.  1061.) 

Where  no  return  of  information  on  forms  1099  and  1096  is 
required. — As  previously  stated,  the  statute  gives  the  Com- 
missioner discretionary  powers  as  to  the  class  of  payments  to 
be  reported  on  information  returns  1099  and  1096.  The  list 
of  specific  payments  which  require  no  information  returns 
follows : 


*"  [Former  Procedure]  A  similar  provision  was  in  the  1917  law,  but 
no  return  of  dividends  paid  was  ever  required,  except  in  the  case  of  pay- 
ments to  foreign  corporations — these  being  liable  to  withholding  of  the  tax. 


INFORMATION    AT   THE   SOURCE  303 

Regulation.  Payments  of  the  following  character,  although 
over  $1,000,  need  not  be  reported  in  returns  of  information  on  Form 
1099:  (a)  payments  of  interest  on  obligations  of  the  United  States; 
(b)  dividends  paid  by  domestic  or  resident  foreign  corporations;  (c) 
payments  by  a  broker  to  his  customers;  (b)  payments  of  any  type 
made  to  corporations;  (c)  bills  paid  for  merchandise,  telegrams,  tele- 
phone, freight,  storage,  professional  services,  and  similar  charges; 
(/)  annuities,  representing  the  return  of  capital;  (g)  payments 
of  rent  made  to  real  estate  agents  (but  the  agent  must  report  pay- 
ments to  the  landlord  if  they  amount  to  $1,000  or  more  annually; 
(h)  payments  made  by  branches  of  business  houses  located  in  for- 
eign countries  to  alien  employees  serving  in  foreign  countries;  and 
(i)  payments  made  by  the  United  States  Government  to  sailors  and 
soldiers  and  to  its  civilian  employees.  (Art.  1073;  Reg.  45,  Art. 
1074.) 

The  instructions  on  form  1096  state  that  no  return  on  form 
1099  is  required  in  case  of  "Distributions  to  members  of  a  part- 
nership, personal  service  corporation  and  beneficiaries." 

Ruling.  An  employer  is  not  required  to  report  on  Form  1099  the 
amount  representing  compensation  for  personal  injuries  or  sickness 
paid  to  an  employee.     (C.  B.  4,  page  349;  O.  D.  858.) 

Although  several  types  of  income  paid  by  states  or  political 
subdivisions  thereof  are  exempt  from  tax,  there  are  numerous 
instances  in  vi'hich  taxable  income  is  paid.  Such  taxable  in- 
come must  be  reported: 

Ruling.  A  department  of  municipal  government  is  required  to 
file  a  return  of  information  as  provided  in  section  256  of  the  Revenue 
Act  of  1918,  showing  payments  of  fixed  or  determinable  gains,  profits, 
and  income  of  $1,000  or  over  in  any  taxable  year,  excluding  from 
the  return,  however,  payments  made  as  salary  or  wages  to  officials 
or  employees  of  a  State  or  political  subdivision  thereof,  and  payments 
of  interest  on  the  obligations  of  a  State  or  political  subdivision 
thereof.     (C.  B.  2,  page  249;  O.  D.  470.) 

When  extensions  of  time  for  certain  returns  of  income^* 
have  been  granted  for  a  period  not  exceeding  ninety  days  after 
the  proclamation  of  peace,  such  extension  does  not  authorize 
any  delay  in  filing  returns  of  information." 


'^  Sec  page  61. 

"*  See  article  446,  page  60. 


304 


APPLICATION    AND    ADMINISTRATION 


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INFORMATION    AT    THE    SOURCE  305 

Returns  under  systems  of  "information  at  source"  and 
"payment  at  source." — Returns  by  withholding  agents,  treated 
in  more  detail  later,  are  required  of  the  various  classes  of 
withholding  agents  covered  by  the  regulations. 

Corporations  paying  interest  on  bonds  and  similar  forms 
of  indebtedness  are  required  to  report  the  amount  withheld 
in  any  month  on  or  before  the  20th  day  of  the  following 
month,  using  for  this  purpose  form  1012.  At  the  close  of  the 
year  and  on  or  before  March  i  of  the  following  year,  these 
monthly  returns  are  summarized  on  an  annual  return,  using 
form  1013. 

The  monthly  returns  referred  to  above  are  not  required  by 
the  statute,  but  are  demanded  under  regulations  prescribed  by 
the  Commissioner  as  a  convenience  in  reporting  this  tax. 
Their  purpose  is  to  enable  the  Treasury  to  audit  and  check 
from  month  to  month  the  items  therein  reported,  and  thus 
avoid  congestion  at  the  close  of  the  year.  The  annual  re- 
ports, however,  are  required  by  the  statute,  and  failure  to 
file  them  subjects  the  withholding  agent  to  penalties  the  same 
as  those  for  failure  to  file  the  annual  returns  of  net  income.*^ 
An  extension  of  time  may  be  obtained  for  filing  the  list  returns 
in  the  same  manner  and  for  the  same  reasons  as  those  apply- 
ing to  returns  of  net  income. ^^ 

Tax  withheld  from  income  other  than  bond  interest  will 
be  accounted  for  on  income  tax  form  1042,  and  separate  re- 
ports of  the  payments  entered  in  form  1042  will  be  made  on 
form  1098. 

Employers,  tenants  and  debtors  must  report  annually  on 
form  1099"'  amounts  of  $1,000  or  more,  paid  for  salaries, 
wages,  rents,  interest,  premiums,  etc.,  during  the  year.  In 
the  case  of  payments  of  bond  interest  and  collection  of  for- 
eign dividends  the  report  is  not  limited  to  amounts  in  excess 
of  $1,000.     As  one  person,  firm  or  corporation  may  find  it 


'  Sec  page  132. 
'  See  page  157. 
'For  classes  of  items  lo  be  rcporlcd,  sec  page  293. 


3o6  APPLICATION   AND   ADMINISTRATION 

necessary  to  fill  out  more  than  one  form  1099,  it  will  be  neces- 
sary to  accompany  the  forms  with  a  letter  of  transmittal,  which 
is  known  as  form  1096.  The  form  used  for  non-resident 
aliens  is  form  1098. 

Affiliated  corporations  do  not  make  a  consolidated  report 
for  purposes  of  information.  Form  1099  is  to  be  used  by 
each  corporation  separately  in  reporting  payments.^® 

A  graphic  chart  published  by  the  government  (Treasury 
Bulletin  ''B'")  will  be  found  helpful  (see  page  307). 

The  chart  indicates  in  heavy-faced  type  the  number  of  the 
form  at  its  point  of  origin.  For  instance,  form  1000,  shown 
in  heavy-faced  type  opposite  the  caption  "Individual  or 
Owner,"  is  made  out  by  the  individual  or  other  owner  of  the 
securities,  and  by  him  is  forwarded  to  the  bank  or  collecting 
agent.  Subsequently  form  1000  is  shown  in  light-face  type, 
indicating  its  receipt  and  forwarding,  respectively,  by  the  bank, 
the  payor,  the  collector,  and  finally  the  Commissioner.  Some 
of  the  other  forms  do  not  pass  through  as  many  hands.  For 
instance,  form  1087  goes  directly  from  the  individual  to  the 
Commissioner. 


Ownership  Certificates 

Use  of  ownership  certificates. — Perhaps  no  feature  of  our 
revenue  laws  has  been  more  confusing  to  taxpayers  than  the 
proper  use  of  ownership  certificates.  Such  certificates  are  re- 
quired "for  the  purpose  of  eft'ectuating  the  withholding  re- 
quirements of  the  law  relating  to  the  payment  of  tax  at  the 
source  on  bonds  and  similar  obligations,  and  in  order  to  obtain 
information  at  the  source."*^  The  withholding  requirements 
of  the  statute  regarding  tax-free  covenant  bonds  have  com- 
plicated their  use.^° 

Regulation.     The  owners  of  bonds  or  other  obligations,  except 


See  Appendix   B. 
Treasury  Bulletin   "B,"  paj^c  21. 
'  See  Cliaptcr  X  for  discussion  of  this  subject. 


INFORMATION    AT    THE    SOURCE 


307 


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3o8  APPLICATION   AND    ADMINISTRATION 

domestic  and  resident  corporations,  whether  or  not  such  bonds  or 
other  obhgations  contain  a  free-tax  covenant,  issued  by  domestic  or 
resident  foreign  corporations,  when  presenting  interest  coupons  for 
payment  shall  file  a  certificate  of  ownership  for  each  issue  of  bonds, 
showing  the  name  and  address^^  of  the  debtor  corporation,  the  name 
and  address  of  the  owner  of  the  bonds,  the  nature  of  the  obligations, 
the  amount  of  interest  and  its  due  date,"-  and  the  amount  of  any  tax 
withheld (Art.  365;  Reg.  45,  Art.  364.) 

Domestic  corporations  presenting  interest  coupons  for  pay- 
ment need  no  longer  attach  ownership  certificates.  The  re- 
quirement that  ownership  certificates  should  show  the  marital 
status  of  the  owner  is  eliminated. 

Rulings.  If  banks  and  other  collecting  agents  accept  coupons  for 
collection  to  which  are  attached  incomplete  or  otherwise  improperly 
executed  ownership  certificates,  such  banks  or  collecting  agents  be- 
come a  party  to  the  filing  of  incomplete  returns  of  information  and 
shall  upon  demand  of  the  debtor  furnish  the  name  and  address  of  the 
owner  of  the  coupons  so  that  such  ownership  certificates  may,  when 
filed,  be  accepted  as  returns  of  information  in  accordance  with  the 
provisions  of  the  regulations  issued  under  section  256  of  the  Revenue 
Act  of  1918.     (C.  B.  4,  page  232;  Mim.  2725.) 

Since  the  debentures  of  the  M  Company  are  evidence  of  indebted- 
ness on  the  part  of  the  M  Company  the  payments  made  on  the  de- 
bentures are  not  dividends  but  payment  of  interest.  The  holders 
of  such  debentures  are  therefore  required  to  file  ownership  certificates 
on  Form  looi  when  receiving  payment  made  by  the  corporation  un- 
der the  terms  of  the  debenture.     (C.  B.  4,  page  232;  O.  D.  1060.) 

All  ownership  certificates  should  contain  complete  informa- 
tion, or  payment  should  be  refused.  The  interest  of  the  tax- 
payers and  the  agents  demands  this.  Taxpayers  who  fail 
to  file  the  required  form  automatically  waive  the  credit  which 
they  might  otherwise  claim  for  tax  constructively  withheld  at 
the  source.  Once  a  form  has  been  accepted  by  banks  or  other 
collecting  agencies,  the  responsibility  for  its  corrections  lies 
with  such  banks  or  agents. ^^     They  should  always  bear  the 


^  It  is  not  necessary  to  enter  the  street  address  of  the  debtor  corporation 
on  the  ownership  certificate.     (O.  D.  615.) 

^'  Bondholders  frequently  enter  the  maturity  date  of  the  bond,  instead 
of  the  due  and  payment  date  of  the  coupon. 

'^  See  page  312. 


INFORMATION    AT   THE    SOURCE  309 

signature  of  the  owner  or  his  agent.  Space  is  also  provided  for 
reporting  foreign  dividends.  The  use  of  ownership  certificates 
takes  the  place  of  information  returns  1099  and  1096. 

Regulation.  In  the  case  of  payments  of  interest,  regardless  of 
amount,  upon  bonds  and  similar  obligations  of  domestic  or  resident 
foreign  corporations,  the  original  ownership  certificates,   when  duly 

filed,  shall  constitute  and  be  treated  as  returns  of  information 

(Art.    1074;   Reg.   45,   Art.    1075.) 

The   following  Ownership  certificates  are  now  in  use: 

Form  loofj  (revised)."'  Ownership  certificate — tax  to 
be  paid  at  source.  Interest  on  bonds  and  other  similar 
obligations  of  domestic  and  resident  corporations. 

Form  1 00 1  (revised).  Ownership  certificate — tax  not 
to  be  paid  at  source.  Interest  on  bonds  and  other  similar 
obligations  of  domestic  and  resident  corporations. 

Form  1 00 1 A  (revised).  Ownership  certificate— tax  not 
to  be  paid  at  source.  Dividends  on  stock  of  foreign 
corporations  and  interest  on  bonds  of  foreign  coun- 
tries and  foreign  corporations. 

Form  looiB.^''  Statement  of  income  received  by  non- 
resident alien  from  sources  within  United  States — per- 
sonal exemption  claimed.  Used  by  non-resident  to 
claim  exemption  on  tax-free  covenant  bonds. 

Form  1087  (revised).  Ownership  certificate — disclos- 
ing actual  owner  of  stock.  For  use  of  foreign  prin- 
cipal to  disclose  actual  ownership  of  stock  of  a  domestic 
corporation  registered  in  name  of  representative  in  the 
United  States. 

Form  of  certificate  when  witholding  is  required. — With- 
holding at  the  source  is  discussed  in  detail  in  Chapters  XI  and 
XXX  VT;  but,  inasmuch  as  withholding  returns  are  treated  as 


"When  this   form  is  used  there  is  actual  withholding  at  the  source. 
^°  Few  non-resident  aliens  claim  exemption  on  tax-free  covenant  bond 
interest.    Hence  this  form  is  seldom  used. 


3IO 


APPLICATION    AND    ADMINISTRATION 


information  returns,  it  is  deemed  advisable  to  state  the  regu- 
lation governing  the  use  of  ownership  certificate  form  looo 
(revised).'' 

Regulation.  For  the  purposes  of  article  365  Form  1000 
shall  be  used  (a)  by  citizens  or  residents  of  the  United  States 
when  no  personal  exemption  or  credit  is  claimed  against  interest  on 
bonds  containing  a  tax-free  covenant;  (b)  by  nonresident  alien  in- 
dividuals, by  partnerships  composed  in  whole  or  in  part  of  nonresident 
aliens  and  not  having  an  ofifice  or  place  of  business  within  the  United 
States,  and  by  foreign  corporations  not  engaged  in  trade  or  busi- 
ess  within  the  United  States  and  not  having  any  office  or  place  of 
business  therein,  whether  or  not  such  bonds  contain  a  tax-free  cove- 
nant; (c)  by  partnerships,  resident  or  nonresident,  and  (prior  to  Jan- 
uary I,  1922)  personal  service  corporations,  in  the  case  of  bonds  con- 
taining a  tax-free  covenant;  and  (d)  where  the  owner  is  unknown 
to  the  withholding  agent.     (Art.  366;  Reg.  45,  Art.  365.) 

Partnerships  are  now  included  under  (c)  and  claim  (d) 
is  entirely  new. 

Certificates  required  when  there  is  no  withholding.^" — 

Regulation.  For  the  purposes  of  article  365,  Form  looi 
shall  be  used  (a)  by  citizens  or  residents  of  the  United  States 
when  personal  exemption  is  claimed  against  interest  on  bonds  contain- 
ing a  tax-free  covenant  and  when  presenting  coupons  from  bonds  not 
containing  a  tax-free  covenant;  (b)  by  domestic  and  resident  partner- 
ships, in  the  case  of  bonds  not  containing  a  tax-free  covenant.  In 
case  a  citizen  or  resident  alien  individual  receives  interest  on  bonds 
containing  a  tax-free  covenant  in  excess  of  the  amount  of  personal 
exemption  which  the  individual  may  claim,  any  such  excess  must  be 
reported  on  Form  1000.     (Art.  367;  Reg.  45,  Art.  366.) 

Form  1 00 1  is  no  longer  used  by  domestic  corporations, 
non-resident  partnerships,  nor  by  foreign  corporations. 

Use  of  substitute  certificates.^® — 

Regulation.  Resident  collecting  agents,  including  responsible 
banks  and  bankers  receiving  interest  coupons  for  collection  with 
ownership   certificates   attached,    may   present  the   coupons   with   the 


""For  monthly  and  annual  returns  rcfjuired,  see  pages  298-299. 
"For  monthly  and  annual  returns  required,  see  page  299. 
"  Substitute  certificates  are   favored  by  persons  who  wish  to  conceal 
the  identity  of  bondholders  from  the  debtor  corporation  or  its  paying  agent. 


INFORMATION    AT    THE    SOURCE  311 

original  certificates  to  the  debtor  corporation  or  its  duly  authorized 
withholding  agent  for  collection,  or  may  detach  and  forward  the 
original  certificates  directly  to  the  Commissioner,  provided  each  such 
collecting  agent  shall  substitute  for  such  original  certificates  its  own 
certificates,  Form  1058  or  Form  1059,  and  shall  keep  a  complete 
record  of  each  transaction,  showing  (a)  serial  number  of  item  re- 
ceived; (&)  date  received;  (c)  name  and  address  of  person  from 
whom  received;  (rf)  name  of  debtor  corporation;  (e)  class  of  bonds 
from  which  coupons  were  cut  (whether  containing  a  tax-free  cove- 
nant or  not)  ;  and  (/)  face  amount  of  coupons.  The  original  cer- 
tificate for  which  the  certificate  of  the  collecting  agent  is  substituted 
shall  be  endorsed,  preferably  with  a  rubber  stamp,  by  the  collecting 
agent,  as  follows : 

Owner's  certificate  No 

(Name  of   collecting  agent.) 


,  I9---- 

(Give  date  of  certificate.) 

The  counterpart  of  the  within  certificate  bearing  like  number  was 
attached  to  -the  coupons  within  mentioned  for  delivery  to  the  debtor  or 
withholding  agent,  by  whom  the  coupons  are  payable. 

For  the  purpose  of  identification  the  substitute  certificates  shall 
be  numbered  consecutively,  reverting  to  the  numeral  i  at  the  begin- 
ning of  each  calendar  year,  and  corresponding  numbers  given  the 
original  certificates  of  ownership.  The  use  of  substitute  certificates 
by  collecting  agents,  banks,  and  bankers  is  not  permitted,  however, 
in  the  case  of  ownership  certificates  presented  with  coupons  for  col- 
lection by  nonresident  alien  individuals,  partnerships,  or  corporations. 
(Art.  368;  Reg.  45-  Art.  367.) 

Form  1059  is  used  instead  of  form  1000;  form  1058,  in- 
stead of  form  1 00 1. 


Interest  coupons  presented  without  ownership  certifi- 
cates.— 

Regulation.  When  interest  coupons  are  received  unaccom- 
panied by  certificates  of  ownership,  unless  the  first  bank  be  satisfied 
that  the  owner  is  a  domestic  or  resident  corporation,  the  first  bank 
shall  require  of  the  payee  a  statement  showing  the  naine  and  address  of 
the  payee,  the  name  and  address  of  the  debtor  corporation,  the  date  of 
the  maturity  of  the  interest,  the  name  and  address  of  the  person  from 
whom  the  coupons  were  received,  the  amount  of  the  interest,  and  a 
statement  that  the  owner  of  the  bonds  is  unknown  to  the  payee.    Such 


312  APPLICATION    AND    ADMINISTRATION 

statement  shall  be  forwarded  to  the  Commissioner  with  the  monthly 
return  on  Form  1012.  The  first  bank  receiving  such  coupons  shall 
also  prepare  a  certificate  on  Form  1000,  crossing  out  "ow^ner"'^^ 
and  inserting  "payee"  and  entering  the  amount  of  interest  on  line 
6,  and  shall  stamp  or  write  across  the  face  of  the  certificate  '"State- 
ment furnished,"  adding  the  name  of  the  bank.     (Art.  369.) 

The  affidavit  form  is  no  longer  required,  a  mere  statement 
only  being  necessary.  If  the  first  bank  is  satisfied  that  the 
owner  of  the  coupon  is  a  corporation,  no  statement  is  now 
required. 

Correction  of  ownership  certificates  by  banks  or  other  col- 
lecting agents. — 

Ruling.  Banks  or  other  collecting  agents  receiving  coupons 
attached  to  ownership  certificates  executed  on  the  wrong  form,  in 
order  to  expedite  the  collection  of  the  interest,  are  permitted  to 
transfer  the  necessary  information  from  the  erroneous  to  the  proper 
form,  the  following  notations  being  stamped  in  the  lower  left-hand 
corner : 


(Name  and  address  of  bank  or  collecting  agent.) 

By 


(Name  of  official  executing  certificate.) 

The  original  certificate  should  be  forwarded  with  the  certificate 
executed  on  the  proper  form  by  the  bank  or  collecting  agent,  the 
original  certificate  bearing  the  notation  substantially  as  follows : 
"Superseded  by  ownership  certificate  Form  ....,"  designating  the 
form  of  certificate  executed  bv  the  bank  or  collecting  agent.  (C.  B. 
2,  page  192;  O.  D.  562.) 

The  Treasury  places  the  burden  on  the  bank  or  collecting 
agent  to  see  that  certificates  are  properly  made  out.  By  ac- 
cepting an  ownership  certificate  the  bank  or  agent  becomes 
directly  responsible  for  its  being  made  out  in  accordance  with 
the  requirements  of  the  law  and  regulations. 

Ruling.  The  attention  of  the  Bureau  of  Internal  Revenue  has 
been  invited  to  the  fact  that  in  many  instances  indifference  and  care- 
lessness has  been  shown  by  owners  in  executing  ownership  certificates 


'  Line  6  is  provided  for  unknown  holders. 


INFORMATION    AT    THE    SOURCE  313 

accompanying  coupons  presented  to  banks  and  other  collecting  agents 
for  collection  of  interest  on  bonds  and  other  obligations  of  debtors, 
and  also  that  banks  and  other  collecting  agents  have  been  accepting  in- 
complete and  improperly  executed  ownership  certificates  with  such 
coupons  deposited  for  collection  and  have  been  transmitting  same  to 

debtors  for  payment Banks  and  other  collecting  agents  are 

not  required  by  law  or  regulations  to  accept  interest  coupons  for 
collection.  If,  however,  as  a  matter  of  convenience  to  their  custom- 
ers, they  do  accept  interest  coupons  for  collection,  it  is  their  duty  to  see 
that  the  ownership  certificates  which  are  executed  by  the  owner  of  the 
coupons  are  properly  filled  out.  These  ownership  certificates  cannot 
be  accepted  as  returns  of  information  unless  they  are  properly  filled 
out  and  debtors  receiving  coupons  from  banks  or  collecting  agents 
with  incomplete  or  otherwise  improperly  executed  ownership  certifi- 
cates are,  under  the  foregoing  quoted  provisions  of  Section  256,  au- 
thorized to  demand  that  the  name  and  address  of  the  owner  of  the 
coupons  accompanied  by  incomplete  or  otherwise  improperly  executed 
ownership  certificates  shall  be  furnished  before  the  coupons  are  paid. 
If  banks  and  other  collecting  agents  accept  coupons  for  collection 
to  which  are  attached  incomplete  or  otherwise  improperly  executed 
ownership  certificates,  such  banks  or  collecting  agents  become  a  party 
to  the  filing  of  incomplete  returns  of  information  and  shall  upon  de- 
mand of  the  debtor  furnish  the  name  and  address  of  the  owner  of  the 
coupons  so  that  such  ownership  certificates  may,  when  filed,  be  ac- 
cepted as  returns  of  information  in  accordance  with  the  provisions  of 
the  regulations  issued  under  Section  256  of  the  Revenue  Act  of  1918. 
(C.  B.  4,  page  232;  Mim.  2725.) 

Ownership    certificates    for   bonds   sold   between   interest 

dates. — 

Ruling.  Where  an  interest  coupon  is  presented  for  payment 
of  interest  upon  a  bond  which  has  been  sold  between  interest  dates, 
the  coupon  shall  be  accompanied  by  the  ownership  certificate  of  the 
purchaser  only,  and  the  certificate  should  cover  the  full  amount  of  the 
coupon.  The  purchaser  may,  if  he  does  not  claim  exemption  from 
having  the  tax  paid  at  the  source,  take  credit  in  his  return  for  the 
tax  paid  at  the  source  on  the  entire  amount  of  interest  represented 
by  the  coupon.  The  discrepancy  between  the  amount  of  bond  interest 
reported  in  the  purchaser's  return  in  such  cases,  and  the  amount  of 
interest  shown  by  his  ownership  certificates  to  have  been  collected 
by  him  should  be  explained  by  a  statement  attached  to  and  made  a 
part  of  the  return,  showing  the  total  amount  of  interest  collected 
and  the  amount  of  interest  accrued  on  the  bond  to  the  date  of  pur- 
chase.    (C.  B.  4,  page  232;  O.  D.  830.) 


314  APPLICATION   AND   ADMINISTRATION 

The  foregoing  ruling  is  an  exact  reversal  of  the  Treasury's 
former  procedure*"  which  called  for  certificates  of  ownership 
from  both  vendor  and  purchaser,  the  interest  being  appor- 
tioned between  them.  The  change  in  procedure  does  away 
with  a  needless  duplication  of  certificates  and  still  supplies 
the  required  information  regarding  the  allocation  of  interest. 
It  tends,  however,  to  impose  a  deprivation  on  the  vendor,  where 
such  vendor  is  an  individual  and  not  a  corporation.  Under 
the  ruling  the  vendee  is  entitled  to  take  credit  for  the  tax  paid 
at  source  on  the  entire  amount  of  interest  represented  on  the 
coupon.  The  value  of  the  coupons  is  $ioo,  the  amount 
thereof  accrued  to  the  vendee  is  only  $20,  yet  the  vendee  has 
credit  for  the  whole  of  the  tax  paid  at  source  and  the  vendor 
with  $80  interest  has  credit  for  no  portion  of  that  tax.  In 
view  of  that  fact,  the  vendor,  when  disposing  of  bonds,  where 
tax  on  the  interest  is  paid  at  source,  must  have  this  feature 
of  the  situation  in  mind.  In  arriving  at  the  figure  for  which 
he  would  dispose  of  them,  he  should  recognize  the  value  of 
(i)  the  principal,  (2)  the  interest,  and  (3)  the  loss  arising 
from  inability  to  take  credit  for  the  proportionate  share  of  the 
tax  paid  at  source. 

Ruling.  Certain  bonds  contain  the  privilege  of  being  converted 
into  the  stock  of  the  corporation  which  issued  the  bonds.  If  the 
owner  of  the  bonds  exercises  his  privilege  of  conversion  between 
interest  dates  and  is  allowed  accrued  interest,  he  is  required  to  file  an 
ownership  certificate  covering  such  accrued  interest  when  it  is  paid. 
(C.  B.  4,  page  234;  O.  D.  949.) 

Ownership  certificates  to  be  used  by  fiduciaries  and  joint 

owners. — 

Regulation.  When  fiduciaries  have  the  control  and  custody  of 
more  than  one  estate  or  trust,  and  such  estates  and  trusts  have  as 
assets  bonds  of  corporations  and  other  securities,  a  certificate  of 
ownership  shall  be  executed  for  each  estate  or  trust,  regardless  of 
the  fact  that  the  bonds  are  of  the  same  issue.  ViHien  bonds  are  owned 
jointly  by  two  or  more  persons,  a  separate  ownership  certificate  must 
be  executed  in  behalf  of  each  of  the  owners.     (Art.  374.) 


"See  Incovic  Tax  Procedure,  njzi,  page  250. 


INFORMATION    AT   THE   SOURCE  315 

Use  of  ownership  certificates  for  tax-free  covenant  bond 
interest  by  personal  service  corporations. — 

Ruling.  Personal  service  corporations  are  to  be  treated,  so  far 
as  practicable,  on  the  same  basis  as  partnerships  for  the  purposes  of 
withholding  under  section  221  (b)  of  the  Revenue  Act  of  1918.  Cor- 
porations which  have  received  notice  from  the  Income  Tax  Unit 
that  their  returns  as  personal  service  corporations  have  been  approved 
may  thereafter  and  not  before  issue  Form  1000  in  collecting  interest 
from  bonds  or  other  obligations  of  a  corporation  containing  a  so- 
called  tax  free  covenant  clause  in  the  same  manner  and  to  the  same 
extent  that  partnerships  are  authorized  to  use  that  form.  The  form 
should  bear  the  stamped  or  written  notation  "approved  by  the  Treas- 
ury Department  as  Personal  Service  Corporation  on  (date)."  (C. 
B.  I,  page  186;  O.  D.  339.) 

Ownership  certificates  for  payments  of  registered  in- 
terest.— 

Regulation.  Ownership  certificates,  are  required  in  connection 
with  interest  upon  registered  bonds  the  same  as  interest  upon  any 
other  class  of  bonds.  If  ownership  certificates  are  not  furnished 
by  the  owner  of  the  bonds,  such  certificates  must  be  prepared  by  the 
debtor  corporation  or  its  withholding  agent,  (a)  If  the  bonds  contain 
a  tax-free  covenant  clause,  ownership  certificates  must  be  prepared 
on  Form  1000  for  the  following  classes  of  bondholders :  Citizens  or 
residents  of  the  United  States,  nonresident  alien  individuals,  part- 
nerships, whether  foreign  or  domestic,  foreign  corporations  having 
no  office  or  place  of  business  within  the  United  States,  (b)  If  the 
bonds  do  not  contain  a  tax-free  covenant  clause.  Form  1000  shall  be 
prepared  in  the  case  of  nonresident  alien  individuals,  partnerships 
composed  in  whole  or  in  part  of  nonresident  aliens  and  not  having  an 
office  or  place  of  business  within  the  United  States,  or  in  case  the 
owner  is  a  foreign  corporation  not  engaged  in  trade  or  business 
within  the  United  States  and  not  having  an  office  or  place  of  business 
therein.  If  ownership  certificates  are  not  filed  by  a  citizen  or  resi- 
dent of  the  United  States  or  a  resident  partnership  in  connection 
with  interest  payments  upon  registered  bonds  not  containing  a  tax- 
free  covenant  clause,  Form  looi  should  be  prepared  by  the  debtor 
corporation  or  its  withholding  agent. 

Regardless  of  whether  the  registered  bonds  do  or  do  not  contain  a 
tax-free  covenant  clause,  no  ownership  certificate  is  required  in  con- 
nection with  such  bonds  owned  by  domestic  or  resident  corporations. 
(Art.  370;  Reg.  45,  Art.  369.) 


3i6  APPLICATION    AND    ADMINISTRATION 

Ownership  certificates  for  foreign  items. — 

Regulation.  When  bonds  of  foreign  countries,  or  bonds 
or  stocks  of  nonresident  foreign  corporations,  are  owned  by  citizens  or 
residents  of  the  United  States,  individual  or  fiduciary,  or  by  resident 
partnerships,  ownership  certificate  Form  looiA  shall  be  executed  by 
the  actual  owner  or  by  his  duly  authorized  agent  when  presenting  the 
item  for  collection,  whether  such  item  is  a  dividend  or  an  interest 
payment,  except  in  the  case  of  a  foreign  country  or  a  foreign  corpora- 
tion having  a  fiscal  agent  or  a  paying  agent  in  this  country  and  issuing 
bonds  which  contain  a  tax-free  covenant  clause.  In  such  excepted 
case  the  fiscal  agent  or  paying  agent  is  required  to  withhold  a  tax  of 
2  per  cent  from  the  interest  on  such  bonds  and  ownership  certificate 
Form  1000,  modified  to  show  the  name  and  address  of  the  fiscal  agent 
or  the  paying  agent,  should  be  used,  unless  the  owner  (if  so  entitled) 
desires  to  claim  exemption,  in  which  case  Form  lOOiA  should  be 
filed.-*!     (Art.  1077;  Reg.  45,  Art.  1078.) 

Domestic  corporations  are  no  longer  required  to  execute 
form  1 00 1  A. 

Income  payable  to  a  foreign  government  is  not  subject  to 
federal  income  tax,  but  it  is  held*^  that  it  should  be  reported 
on  hne  6  of  form  looiA  by  crossing  out  the  word  "corpora- 
tion" and  substituting  therefor  "foreign  government."  Ap- 
parently this  conflicts  with  article  365.^^ 

Rulings.  Non-resident  alien  individuals,  partnerships,  and  corpo- 
rations not  engaged  in  trade  or  business  within  the  United  States  and 
having  no  ofiice  or  place  of  business  therein,  should  file  Form  looi-A 
properly  modified,  in  connection  with  interest  coupons  on  bonds  of  a 
corporation  organized  in  the  United  States  but  which  transacts  no 
business  in  the  United  States  and  owns  no  property  therein. 

In  cases  where  Form  1000  has  been  filed  by  non-resident  alien 
bondholders,  the  certificate  should  be  stamped  as  follows  before  be- 
ing forwarded  to  the  Commissioner  of  Internal  Revenue,  Sorting 
Division : 

Exempt — debtor  corporation  owns  no  property  and  does  no  busi- 
ness in  the  United  States.     (C.  B.  i,  page  262;  O.  D.  354.) 

Ownership  certificates  representing  interest  on  bonds  owned  by 
nonresident  aliens,  bearing  addresses  of  domestic  liankers  in  lieu  of 


"  No  attempt  is  made  to  tax  non-resident  aliens  on  income  which  simply 
passes  through  American  banks  for  collection  and  is  not  income  derived 
from  sources  within  the  United  States.     See  Chapter  XXXVI. 

^'  C.  B.  2,  page  191  ;  O.  D.  520. 

"  See  page  306. 


INFORMATION    AT    THE    SOURCE  317 

the  residences  of  the  aliens,  will  be  accepted.     (C.  B.  4,  page  233; 
O.  D.  908.) 

No  ownership  certificates  required  for  certain  foreign  divi- 
dends.— Following  the  principle  in  force  under  the  1918  law, 
it  is  presumed  that  ownership  certificates  will  not  be  required 
in  collecting  dividends  from  foreign  corporations  which  are 
free  from  normal  tax/*  Ownership  certificates  will  be  nec- 
essary in  the  case  of  dividends  from  other  foreign  corpora- 
tions." 

Foreign  items  presented  for  collection  unaccompanied  by 
ownership  certificates. — 

Regulation.  If  the  foreign  item  is  an  interest  coupon  de- 
tached from  bonds  containing  a  tax-free  covenant  clause,  issued  by 
a  foreign  country  or  corporation  having  a  paying  agent  in  the  United 
States,  a  statement  and  ownership  certificate.  Form  1000,  shall  be 
furnished  as  provided  in  article  369. 

In  the  case  of  other  foreign  items  which  are  received  unaccom- 
panied by  an  ownership  certificate  and  the  owner  is  unknown,  a 
statement  shall  be  required  of  the  payee,  showing  the  name  and  ad- 
dress of  the  payee,  the  name  and  address  of  the  debtor  organization, 
the  date  of  the  dividend  check  or  the  maturity  of  the  interest  coupon, 
the  name  and  address  of  the  person  from  whom  the  dividend  check 
or  interest  coupon  was  received,  and  a  statement  that  the  owner  of 
the  securities  is  unknown  to  the  payee.  The  first  bank  receiving  such 
foreign  item  shall  prepare  a  certificate  of  ownership,  Form 
looiA,  crossing  out  the  word  "owner"  and  substituting  therefor  the 
word  "payee."  The  first  bank  shall  stamp  or  write  across  the  face 
of  the  certificate  "statement  furnished,"  adding  the  name  of  the  bank. 
Thereupon  the  statement  and  certificate  shall  be  forwarded  to  the 
Commissioner  as  provided  in  article  1079.     (Art.   1078.) 

Information  as  to  actual  owner. — 

Regulation.  When  the  person  receiving  a  payment  falling 
within  the  provisions  of  the  statute  for  information  at  the  source 
is  not  the  actual  owner  of  the  income  received,  the  name  and  address 
of  the  actual  owner  shall  be  furnished  upon  demand  of  the  indi- 
vidual,  corporation   or  partnership  paying  the   income,   and   in   de- 


See  sections  216  ^(a)  and  234  (a-6). 

For  former  procedure  see  Income  Tax  Procedure,  1921,  page  253. 


3i8  APPLICATION   AND   ADMINISTRATION 

fault  of  a  compliance  with  such  demand  the  payee  becomes  Hable 
to  the  penalties  provided ^^     (Art.  1080.) 

Use  of  form  1087  (revised)  to  disclose  ownership. — The 
proper  use  of  this  ownership  certificate  is  most  conveniently 
summarized  as  follows : 

Ruling.  This  ownership  certificate  [form  1087  (revised)],  is 
designed  primarily  for  the  use  of  a  foreign  principal  to  disclose  the 
actual  ownership  of  stock  of  a  domestic  corporation  registered  in 
the  name  of  his  representative  in  the  United  States.  Unless  the  dis- 
closure is  made  to  the  commissioner  on  this  form,  the  record  owner 
will  be  liable  for  any  additional  tax  on  dividends  on  stock  of  domestic 
corporations  or  resident  foreign  corporations.  In  all  cases  where  the 
actual  owner  is  a  nonresident  alien  individual,  and  the  record  owner 
a  person  in  the  United  States,  the  record  owner  will  be  considered 
for  tax  purposes  to  have  the  receipt,  custody,  control,  and  disposal  of 
the  dividend  income,  and  must  make  return  for  the  actual  owner, 
regardless  of  the  amount  of  income,  and  pay  any  surtax  found  by 
such  return  to  be  due. 

When  a  foreign  corporation  is  the  registered  owner  of  stock  of 
a  domestic  corporation  and  the  actual  owner  is  a  nonresident  alien, 
individual  or  partnership,  disclosure  of  actual  ownership  should  be 
made  on  Form  1087  (Revised).  This  form  should  be  adapted  to 
make  disclosure  in  order  that  a  domestic  corporation  required  to 
render  a  return  of  information  as  to  dividends  in  accordance  with 
section  254  of  the  act,  may  have  at  its  disposal  information  as  to  the 

actual  ownership  of  the  stock (Treasury  Bulletin  "B",  page 

27.) 

Ownership  certificates  not  required  for  interest  on  obliga- 
tions of  the  United  States  and  political  subdivisions  thereof. — 

Law.     Section  256 The  provisions  of  this  section  .... 

shall  not  apply  to  the  payment  of  interest  on  obligations  of  the  United 
States. 

Regulation No    ownership    certificates   need    be    filed 

in  the  case  of  interest  payments  on  bonds  the  income  from  which  is 
not  required  to  be  included  in  gross  income,  nor  in  the  case  of  any 

obligations  of  the  United  States (Art.  365;  Reg.  45,  Art. 

365.) 

Bonds  of  the  War  Finance  Corporation  are  not  obligations 
of  the  United  States.^'     Hence  an  ownership  certificate  is  re- 


'  Sec  page  3J1. 
C.  B.  I,  page  185;  O.  D.  26 


INFORMATION   AT   THE   SOURCE  319 

quired  in  collecting'  interest  on  such  securities.  Ownership 
certificates  arc  not  required  in  case  of  municipal  bonds  and 
such  other  bonds  the  interest  from  which  is  exempt  from  tax. 

General 

Miscellaneous  rulings  regarding  duties  of  banks. — 

Ruling.  Where  a  debtor  corporation  fails  to  withhold  the  2  per 
cent  tax  on  tax-free-covenant  bonds,  and  the  owner  has  filed  Form 
1000,  there  is  no  obligation  on  the  bank  receiving  the  coupons  to  with- 
hold the  tax,  as  assessment  will  be  made  against  the  debtor  or  its 
withholding  agent,  based  on  the  tax  liability  as  disclosed  by  the 
ownership  certificates,  Form  1000. 

A  bank  purchasing  abroad  coupons  of  bonds  issued  by  domestic 
corporations  will  be  held  prima  facie  to  be  the  recipient  of  income. 
Ownership  certificates  should  therefore  be  secured  from  original 
owners  of  bonds  in  order  that  tax  may  be  withheld  as  provided  by 
law. 

Where  a  promissory  note,  signed  by  a  corporation,  is  left  with 
a  bank  or  trust  company  for  collection,  such  bank  or  trust  com- 
pany should  not  require  an  ownership  certificate  to  be  attached. 

Ownership  certificates  are  required  to  be  filed  with  respect  to 
interest  payments  upon  first-mortgage  participation  bonds  issued 
by  a  trust  company  and  secured  by  a  real  estate  mortgage  deposited 
with  the  trustee.  In  cases  where  coupons  of  the  bonds  are  not  ac- 
companied by  ownership  certificates,  the  first  bank  is  required  to  fur- 
nish a  certificate.  Where  no  ownership  certificates  are  filed  in  con- 
nection with  interest  upon  such  registered  bonds,  the  withholding 
agent  will  be  required  to  prepare  certificates.  (Treasury  Bulletin 
"B,"  page  31.) 

It  has  been  held  that  in  the  case  of  interest  payments  on 
overdue  coupon  bonds,  the  interest  coupons  of  which  have  been 
exhausted,  ownership  certificates  must  be  filed  when  collecting 
interest,  in  the  same  manner  as  if  interest  coupons  were  pre- 
sented for  collection.*® 

Use  of  stamps  and  facsimile  signatures  by  banks  and  trust 
companies. — If  proper  authorization  is  obtained  from  the  Com- 
missioner of   Internal  Revenue,   banks  and   trust   companies 


C.  B.  2,  page  191 ;  O.  D.  392. 


320 


APPLICATION    AND    AD^IINISTRATION 


may  use  facsimile  signatures  in  executing  income  tax  certi- 
ficates  (substitute  or  otherwise)   issued  under  their  names. '*^ 

License  required  for  the  collection  of  foreign  items. — 

Law.  Section  259.  That  all  individuals,  corporations,  or  part- 
nerships undertaking  as  a  matter  of  business  or  for  profit  the  collec- 
tion of  foreign  payments  of  interest  or  dividends  by  means  of  cou- 
pons, checks,  or  bills  of  exchange  shall  obtain  a  license  from  the 
Commissioner  and  shall  be  subject  to  such  regulations  enabling  the 
Government  to  obtain  the  information  required  under  this  title  as 
the  Commissioner,  with  the  approval  of  the  Secretary,  shall  pre- 
scribe; and  whoever  knowingly  undertakes  to  collect  such  payments 
without  having  obtained  a  license  therefor,  or  without  complying 
with  such  regulations,  shall  be  guilty  of  a  misdemeanor  and  shall 
be  fined  not  more  than  $5,000,  or  imprisoned  for  not  more  than  one 
year,  or  both. 

Regulation.  Banks  or  agents  collecting  foreign  items,  as  de- 
fined in  article  1076,  and  required  by  article  1079  to  make  returns 
of  information  with  respect  thereto,  must  obtain  a  license  from  the 
Commissioner  to  engage  in  such  business.  Application  Form  1017 
for  such  license  may  be  procured  from  collectors.  The  license 
is  issued  without  cost  on  Form  loio.  Foreign  items  shall  not 
be  accepted  for  collection  by  any  bank  or  collecting  agent  so  licensed 
unless  properly  indorsed  or  accompanied  by  proper  ownership  certifi- 
cates giving  all  the  information  called  for  by  such  certificate.  (Art. 
nil.) 

Payer  has  right  to  demand  name  and  address  of  recipient 
of  income. — 

Law.     .Sectiiin  256 When  necessary  to  make  effective  the 

provisions  of  this  section  the  name  and  address  of  the  recipient  of 
income  shall  be  furnished  upon  demand  of  the  individual,  corpora- 
tion, or  partnership  paying  the  income 

Ruling.  Official  position  of  person  authorized  to  sign  ownership 
certificates  in  behalf  of  corporation  and  identity  of  person  signing 
ownership  certificates  in  behalf  of  partnership  required  to  be  dis- 
closed on  certificates.  (Telegram  to  the  Southern  Pacific  Company, 
New  York,  N.  Y.,  signed  by  Deputy  Commissioner  E.  H.  Batson,  and 
dated  June   16,   1921.) 


"  Either  rubber  stamps  or  printed  signatures  may  be  used.  This  con- 
cession was  made  to  facilitate  collection  uf  coupons  by  banks.  It  avoids 
much  delay  and  inconvenience. 


INFORMATION    AT   THE    SOURCE 


321 


Heavy  penalties  for  failure  to  furnish  information. — The 
specific  penalties  for  failure  or  refusal  to  furnish  information 
were  increased  in  the  1918  law.^° 

Regulation.  A  penalty  of  not  more  than  $1,000  attaches  for 
failure  punctually  to  make  a  required  return,  whether  of  income, 
withholding  or  information,  or  to  pay  or  collect  a  required  tax.  If 
the  failure  is  willful,  however,  or  an  attempt  is  made  to  defeat  or 
evade  the  tax,  the  offender  is  liable  to  imprisonment  and  to  a  fine  of 
not  more  than  $10,000  and  costs.  See  also  the  act  of  July  5,  1884. 
In  addition  to  these  specific  penalties  ad  valorem  penalties  are  im- 
posed in  various  cases.  An  ad  valorem  penalty  is  assessed  and  col- 
lected as  a  part  of  the  tax,  while  a  specific  penalty  is  enforceable 
only  by  suit.     (Art.  1055;  Reg.  45,  Art.  1041.) 


Section  253.  _The  1921  law  re-enacted  this  section  without  any  change. 


CHAPTER  XI 

PAYMENT  OF  TAX  AT  SOURCE^ 

The  framers  of  the  income  tax  laws  of  1913  and  1916 
adopted  the  principle  of  collection  at  the  source^  largely  on 
the  strength  of  its  success  as  a  feature  of  British  income  tax 
administration.  No  attempt  was  made  first  to  test  the  operation 
of  an  income  tax  in  this  country  by  direct  collection  from  the 
taxpayer.  The  withholding  provisions  of  these  two  laws 
proved  burdensome  and  difficult  of  efficient  administration. 
Consequently  the  191 7  law  substituted  a  system  of  "informa- 
tion at  the  source"  and  withholding  was  completely  abolished, 
excepting  only  the  cases  of  non-resident  aliens  and  interest 
on  bonds  containing  a  so-called  tax-free^  covenant  clause.  The 
withholding  provisions  of  the  192 1  law  are  substantial!}'  the 
same  as  those  of  the  two  laws  preceding  it. 

The  suljject  of  withholding  of  tax  at  source  in  connection 
with  non-resident  aliens  is  fully  discussed  in  Chapter  XXXVI. 

So  far  as  citizens  or  residents  of  the  United  States  are 
concerned  there  is  now  no  withholding  or  payment  of  tax  at 
the  source,  except  in  the  case  of  tax-free  covenant  bonds.    Nev- 


'  As  the  subject  of  "Information  at  the  Source"  has  been  treated  in 
Chapter  X.  "Non-Resident  Aliens"  in  Chapter  XXXVI,  "Monthly  and 
Annual  Returns"  in  Chapter  III,  all  questions  as  to  forms  of  owner- 
ship and  information  certificates  required  in  the  various  cases  and  the 
withholding  of  income  paid  to  non-resident  aliens  and  monthly  and  annual 
returns  required  have  been  omitted  from  this  chapter. 

"  This  is  variously  called  "collection  at  the  source,"  "deduction  at  the 
source,"  "withholding  at  the  source,"  and  "stoppage  at  the  source."  Col- 
lection at  the  source  was  early  instituted  in  British  income  tax  administra- 
tion to  prevent  evasion  of  the  law.  In  the  1920  Report  of  the  Royal  Com- 
mission on  the  Income  Tax,  the  opinion  has  been  emphatically  expressed 
that  retention  of  deduction  at  the  source  is  necessary  to  the  efficient  admin- 
istration of  the  revenue.  At  least  70  per  cent  of  the  present  British  income 
tax  is  collected  at  the  source.  The  Commission  has  also  concluded :  "We 
are  not  satisfied  that  any  system  of  'information  at  the  source'  would  be  a 
practical  and  efficient  substitute  for  the  present  system,  and  it  would  be  a 
source  of  trouble  and  irritation  to  the  community  in  general." 

^This  term  should  not  be  confused  with  "tax-exempt,"  which  means 
freedom  from  taxation — state,  local  or  federal,  or  all  three. 

322 


PAYMENT    OF   TAX    AT    SOURCE  323 

ertheless,  there  has  been  considerable  agitation  for  its  com- 
plete abolition  and  this  withholding  feature  of  the  law  would 
doubtless  have  been  abolished  if  it  had  not  been  for  the  opposi- 
tion of  bond  owners  and  investment  banking  houses.  After 
the  enactment  of  the  1913  law  many  bonds  were  issued  which 
contained  tax-free  covenants  whereby  the  debtor  corporations 
agreed  to  pay  interest  in  full  without  deducting  the  amount  of 
tax  required  to  be  withheld  at  the  source.  Bonds  having  such 
covenants  commanded  a  somewhat  higher  price  than  those 
not  having  such  agreements.  Those  who  had  purchased  bonds 
for  this  privilege  were  naturally  opposed  to  any  modification 
of  the  law  which  would  abolish  it.  To  meet  these  objections 
the  1917,  1918.  and  1921  laws  provided  for  restricted  with- 
holding in  the  case  of  tax-free  covenant  bond  interest. 

What  is  a  "tax-free  covenant"?' — The  law  defines  a  tax- 
free  covenant  as  follows : 

Law.  Section  221."'  ....  (b)  In  any  case  where  bonds,  mort- 
gages, or  deeds  of  trust,  or  other  similar  obligations  of  a  corporation 
contain  a  contract  or  provision  by  which  the  obligor  agrees  to  pay  any 
portion  of  the  title  imposed  by  this  title  upon  the  obligor,  or  to  reim- 
burse the  obligee  for  any  portion  of  the  tax,  or  to  pay  the  interest  with- 
out deduction  for  any  tax  which  the  obligor  may  be  required  or  per- 
mitted to  pay  thereon  or  to  retain  therefrom  under  any  law  of  the 
United  States."  ,  ,  .  , 


*  Tax-free  covenants  are  frequently  not  limited  to  federal  taxes,  but 
include  any  state,  county  or  local  taxes  or  impositions  which  the  obligor 
may  be  required  or  permitted  to  deduct  or  retain  under  present  or  future 
laws. 

°  Subsection  (a)  refers  only  to  non-resident  alien  individuals  or  part- 
nerships.    (See  Chapter  XXXVI.) 

"  [Former  Procedure]  Under  the  1913  law  withholding  was  re- 
quired in  the  case  of  interest  on  domestic  and  foreign  bonds  and 
dividends  of  foreign  corporations  regardless  of  amount,  and  on  pay- 
ments of  interest,  rent,  salaries,  wages,  premiums,  annuities,  compen- 
sations, remuneration,  emoluments  or  other  fixed  or  determinable 
gains,  profits  and  income  amounting  to  $3,000  or  over  in  any  taxable 
year.  Exemption  from  the  withholding  provisions  of  the  act  could 
be  obtained  to  the  amount  of  the  personal  exemption,  by  filing  a  cer- 
tificate with  the  withholding  agent,  and  a  further  exemption  was  per- 
mitted by  filing  a  statement  of  the  deductions  to  which  the  taxpayer 
was  entitled. 

Under  the  191G  act  the  withholding  provisions  were  similar  except 
that   the   rate   was  increased   from    1    to  2  per  cent.     However,  under 


324 


APPLICATION    AND    ADMINISTRATION 


By  Treasury  interpretation  Ijonds  issued  under  a  trust  deed 
containing  a  tax-free  covenant  arc  treated  as  if  they  themselves 
contained  such  a  covenant.     It  is  also  held : 

Ruling.  Where  neither  bonds  nor  the  trust  deeds  given  by  the 
obligor  to  secure  them  contain  a  tax-free  covenant,  supplemental 
agreements  executed  by  the  obligor  corporation  and  the  trustee  con- 
taining a  tax-free  covenant  and  which  modify  the  original  trust  deeds 
to  that  extent  are  of  the  same  effect  from  the  date  of  their  proper 
execution  as  if  they  had  been  part  of  the  original  deeds  of  trust,  and 
the  bonds  from  such  date  are  subject  to  the  provisions  of  section 
221(b)  of  the  Revenue  Act  of  1918,  provided  proper  authority  exists 
for  the  modification  of  the  trust  deeds  in  this  manner.  The  authority 
must  be  contained  in  the  original  trust  deeds  or  actually  secured  from 
the  bondholders.      (C.   B.  2,  page   187;  O.   D.  414.) 

Amount  of  tax  to  be  withheld  by  obligor  corporation. — 

Law.  Section  221.  ....  (b)  ....  the  obligee  shall  deduct 
and  withhold  a  tax  equal  to  2  per  centum  of  the  interest  upon  such 
bonds,  mortgages,  deeds  of  trust,  or  other  obligations,  v/hether  such 
interest  is  payable  annually  or  at  shorter  or  longer  periods 

"Withholding  agent"  defined. — 

Law.     Section    200 (3)  The    term    "withholding    agent" 

means  any  person  required  to  deduct  and  withhold  any  tax  under  the 
provisions  of  section  221  or  section  237;   .... 

The  sections  referred  to  in  the  foregoing  relate  to  non- 
resident alien  individuals  or  partnerships  and  foreign  corpora- 
tions, as  well  as  to  domestic  corporations  paying  interest  on 
bonds  having  a  tax-free  covenant. 

The  legal  theory  of  "deduction." — The  tax-free  covenant 
clause  in  bonds  has  long  been  a  prolific  source  of  misunder- 

the  1917  law  withholding  was  abolished  except  in  the  case  of  non- 
resident aliens  and  interest  on  tax-free  bonds,  and  section  1212 
of  that  act  provided  for  refunding  all  tax  that  had  been  withheld  dur- 
ing 1917  except  such  as  had  been  withheld  on.  tax-free  bonds. 

Withholding  agents  did  not  in  all  cases  promptly  release  the 
amounts  in  their  hands,  although  the  law  was  so  clear  that  no  time 
should  have  been  lost  after  October  3,  1917,  in  returning  the  funds. 
If  withholding  agents  did  not  have  in  their  possession  the  informa- 
tion regarding  the  legal  owner  of  the  bonds  to  whom  repayment  was 
due,  they  were  directed  to  communicate  with  the  bank  through  which 
collection  was  made,  secure  the  name  of  the  pa}-ees  and  promptly 
refund  the  amounts  due.     (T.  D.  2635,  January  24,  1918.) 


PAYMENT    OF   TAX    AT    SOURCE  325 

standing"  and  confusion  to  the  average  bondholder,  notwith- 
standing the  effort  of  investment  houses  to  clarify  its  meaning. 
Perhaps  such  covenants  should  be  omitted  from  future  issues 
to  avoid  the  inherent  difficulties  which  attend  their  use. 

Confusion  arises  chiefly  from  the  necessarily  involved  legal 
phraseology  of  such  covenants  and  the  legal  fiction  of  "deduc- 
tion." The  legal  fiction  is  that  a  tax-free  covenant  requires 
the  debtor  corporation  actually  to  deduct  2  per  cent  from  the 
amount  of  the  coupon,  pay  this  sum  to  the  government,  and 
then  pay  the  bondholder  98  per  cent  of  his  coupon  plus  an 
additional  2  per  cent,  if  the  corporation  has  agreed  to  reim- 
burse to  that  extent.  Such  is  the  legal  fiction  of  deduction. 
In  practice  the  corporation  pays  the  coupon  in  full  and  in  addi- 
tion pays  on  behalf  of  the  bondholder  to  the  government 
a  tax  equivalent  to  2  per  cent  of  the  amount  of  the  coupon. 
(See  discussion  of  Massey  v.  Lcdcrcr  in  Chapter  XIX.) 

Under  some  tax-free  covenants  the  debtor  corporation  only 
agrees  to  reimburse  the  bondholder  up  to  i  per  cent  of  the 
amount  of  the  coupon.  In  this  case  the  theory  is  that  2  per 
cent  is  deducted  from  the  coupon  and  the  bondholder  is  paid 
98  per  cent  of  the  coupon  plus  a  reimbursement  of  i  per  cent. 
Practically,  the  bondholder  gets  99  per  cent  of  his  coupon 
and  the  corporation  pays  2  per  cent  to  the  government  for  him. 

Limitation  of  the  debtor  corporation's  liability. — The  con- 
tention that  corporations  having  tax-free  covenants  in  their 
bonds  contracted  to  pay  the  full  normal  income  tax  is  now 
mainly  of  academic  interest. 

When  a  corporation  has  specifically  agreed  to  pay  the 
normal  income  taxes  assessed  against  the  owners  of  its  bonds 
on  the  income  accruing  therefrom,  it  should  be  held  strictly 
to  such  agreement;  but  obviously  such  an  agreement  must 
be  reasonably,  if  not  strictly,  construed.  If  federal  income 
taxes  are  the  only  ones  mentioned,  it  cannot  be  contended  that 
state  income  taxes  are  to  be  paid.     If  the  normal  tax  rate 


326  APPLICATION    AND    ADMINISTRATION 

in  furce  when  the  lionds  were  issued  was  i  per  cent  and  if  the 
rate  is  raised  to  2  per  cent  or  12  per  cent,  the  corporation  must 
pay  the  increased  rate.  But  if  2  per  cent  is  the  "normal"  rate 
and  a  law  specifies  that  in  addition  to  the  "normal"  tax  of  2 
per  cent  an  "additional"  tax  of  4  per  cent  is  imposed,  the  cor- 
poration should  not  pay  more  than  the  2  per  cent  normal  tax/ 

If  a  corporation  has  -not  agreed  to  pay  the  bondholder's 
income  tax,  but  has  agreed  merely  to  pay  such  taxes  as  it  is 
required  to  witJiJwld,  there  is  no  obligation  on  its  part,  moral  or 
legal,  to  pay  any  tax,  normal  or  surtax,  income  or  property, 
federal  or  state,  which  may  be  legally  assessed  against  the 
recipients  of  the  income,  iinless  the  corporation  is  required  by 
the  government  to  withhold  the  tax. 

Corporations  are  ordinarily  obligated  to  rciinburse  bond- 
holders only  for  tJic  amount  zvhicJi  they  arc  required  to  deduct, 
and  in  some  cases  this  reimbursement  is  expressly  limited  by 
contract  to  a  sum  less  than  the  amount  theoretically  deducted 
(e.  g.,  I  per  cent).  Even  though  the  present  normal  tax  is  8 
per  cent,  it  is  lawful  to  zvithJiold  only  to  the  extent  of  2  per 
cent. 

Since  the  imposition  of  a  high  normal  tax  there  has  been 
a  tendency  to  state  the  actual  percentage  of  tax  for  which  the 
corporation  will  make  reimbursement.  Among  such  provisions 
are :  "Both  ])rinci])al  and  interest  payable  in  full  without  de- 
duction for  any  federal  normal  income  tax  ....  not  in  ex- 
cess of  2  per  cent"  and  "both  principal  and  interest  payable  in 
'full  without  deduction  for  any  federal  normal  income  tax 
....  up  to  4  per  cent."  The  first  clause  limits  the  present 
and  future  liabilit}-  to  reimburse  to  2  per  cent.  The  second 
clause  limits  such  future  liability  to  4  per  cent.  In  other 
words,  if  under  a  future  law  6  per  cent  were  the  lawful  de- 
duction, reimburseiuent  would  be  made  to  the  extent  of  2  per 


'  [Former  Procedure]  Normal  taxes  imposed  by  the  Act  of  October 
3.  1917,  were  in  addition  to  those  imposed  bj-  the  Act  of  September  8.  1916. 
The  Revenue  Act  of  1918  contained  no  provision  of  this  kind,  prior  laws 
being  there1)y  repealed.  This,  however,  apparently  does  not  constitute  an 
argument   for   full  payment  of  normal  tax. 


PAYMENT    OF   TAX    AT    SOURCE  327 

cent  under  the  first  clause  or  4  per  cent  under  the  second. 
This  4  per  cent  hmitation  should  not  be  construed  to  render 
corporations  liable  to  4  per  cent  under  the  present  law,  because 
2  per  cent  is  the  maximum  possible  lawful  deduction  in  the 
case  of  a  bond  containing  a  tax-free  covenant  clause. 

From  whom  tax  is  withheld. — The  law  provides  that  in 
making  payments  of  interest  on  tax-free  covenant  bonds,  the 
obligor  shall  deduct  and  withhold  a  tax  equivalent  to  2  per 
cent  of  the  coupon. 

Law.      Section     221 (b)   ....  whether     payable     to     a 

nonresident  alien  individual  or  to  an  individual  citizen  or  resident  of 
the  United  States  or  to  a  partnership:  Froi-idcd,  That  the  Commissioner 
may  authorize  such  tax  to  be  deducted  and  withheld  in  the  case  of  in- 
terest upon  any  such  bonds,  mortgages,  deeds  of  trust  or  other  obliga- 
tions, the  owners  of  which  are  not  known  to  the  withholding 
agent 

Law.  .Section  237.  That  in  the  case  of  foreign  corporations  sub- 
ject to  taxation  under  this  title  not  engaged  in  trade  or  business  within 
the  United  States  and  not  having  any  office  or  place  of  business  therein, 
there  shall  be  deducted  and  withheld  at  the  source  in  the  same  manner 
and  upon  the  same  items  of  income  as  is  provided  in  section  221  a 
tax  equal  to  12^/2  per  centum  thereof  (but  during  the  calendar  year 
1921  only  10  per  centum),  and  such  tax  shall  be  returned  and  paid 
in  the  same  manner  and  subject  to  the  same  conditions  as  provided 
in  that  section:  Provided,  That  in  the  case  of  interest  described  in 
subdivision  (b)  of  that  section  the  deduction  and  withholding  shall  be 
at  the  rate  of  2  per  centum. 

The  Treasury's  interpretation  follows : 

Regulation (c)   of  a  tax  of  2  per  cent    in  the  case  of 

interest  payable  to  an  individual  or  a  partnership,  whether  resident 
or  nonresident,  or  to  a  foreign  corporation  not  engaged  in  trade  or 
business  within  the  United  States  and  not  having  any  office  or  place 
of  business  therein,  upon  bonds  or  other  obligations  of  domestic  or 
resident  foreign  corporations  containing  a  so-called  tax-free  covenant 

clause A  foreign  corporation  having  a  fiscal  agent  or  paying 

agent  in  this  country  is  required  to  withhold  a  tax  of  2  per  cent  upon 
the  interest  on  its  tax-free  covenant  bonds (Art.  361.) 

Ruling.  "Withholding  at  the  liighest  applicable  rate"  as  providefl 
in  article  361  of  Regulations  45,  in  the  case  of  interest  on  bonds  or 
other    securities    where    the   owner    is    unknown    to    the    withholding 


328  APPLICATION   AND    ADMINISTRATION 

agent  is  interpreted  to  mean  the  highest  rate  of  tax  applicable  under 
section  221  of  the  Revenue  Act  of  1918,  viz.,  2  per  cent  in  the  case 
of  tax-free  bonds  and  8  per  cent  in  the  case  of  other  fixed  or  de- 
terminable annual  or  periodical  income.^  (C.  B.  2,  page  188;  O.  D. 
518.) 

When  tax  withheld  is  paid  by  withholding  agent. — 

Law.      Section   221 (c)   Every   individual,   corporation,   or 

partnership  required  to  deduct  and  withhold  any  tax  under  this  section 
shall  make  return  thereof  on  or  before  March  i  of  each  year  and  shall 
on  or  before  June  15  pay  the  tax  to  the  official  of  the  United  States 
government  authorized  to  receive  it.  Every  such  individual,  corpora- 
tion, or  partnership  is  hereby  made  liable  for  such  tax  and  is  hereby 
indemnified  against  the  claims  and  demands  of  any  individual,  cor- 
poration, or  partnership  for  the  amount  of  any  payments  made  in 
accordance  with  the  provisions  of  this  section 

When  no  liability  of  withholding  agent  for  collecting  of 

tax  at  source. — 

Law.     Section   221 (c)  If  any   tax  required  under  this 

section  to  be  deducted  and  withheld  is  paid  by  the  recipient  of  the  in- 
come, it  shall  not  be  recollected  from  the  withholding  agent;  nor  in 
cases  in  which  the  tax  is  so  paid  shall  any  penalty  be  imposed  upon 
or  collected  from  the  recipient  of  the  income  or  the  withholding  agent 
for  failure  to  return  or  pay  the  same,  unless  such  failure  was  fraudulent 
and  for  the  purpose  of  evading  payment. 

No  withholding  against  domestic  and  resident  foreign 
corporations. — The  law  does  not  require  withholding  from 
interest  on  tax-free  covenant  bonds  paid  to  a  domestic  corpora- 
tion or  to  a  foreign  corporation  having  an  office  or  place  of 
business  in  the  United  States  and  engaged  in  a  trade  or  busi- 
ness 'therein. 

Under  the  19 18  law  personal  service  corporations  were 
taxed  like  partnerships,  as  far  as  was  practicable.  Conse- 
quently, under  that  law  it  was  proper  for  debtors  constructively 


*  It  appears  that  the  highest  applicable  rate  of  tax  in  the  case  of  in- 
terest on  bonds  which  do  not  contain  the  tax-free  covenant  clause  would 
be  12I/2  per  cent  after  1921,  or  the  rate  of  withholding  on  non-resident  alien 
corporations.  It  seems  that  for  its  own  protection  the  governrnent  would 
desire  an  additional  withholding  of  loK;  per  cent  in  case  of  interest  on 
tax-free  obligations. 


PAYMENT    OF   TAX   AT    SOURCE  329 

to  withhold  tax  in  making  payment  of  tax-free  covenant  bond 
interest.^  This  is  the  only  exception  to  the  rule  that  there  is 
no  withholding  against  a  domestic  corporation. 

If  the  taxation  of  the  stockholders  of  personal  service 
corporations  is  held  to  be  invalid,  it  is  not  probable  that  any 
readjustments  for  tax-free  covenant  interest  under  the  pro- 
visions of  section  1332  will  follow.  Personal  service  cor- 
porations disappear  as  taxable  entities  after  December  31, 
1 92 1.  Hence,  after  that  date,  debtors  will  not  withhold  against 
such  corporations.  The  tax-free  covenant  no  longer  has  any 
advantage  for  personal  service  corporations. 

As  a  rule,  in  the  case  of  payments  of  tax-free  covenant 
bond  interest  to  domestic  or  resident  corporations,^"  no  pay- 
ment is  made  to  the  government  on  their  behalf ;  hence  the  tax- 
free  covenant  is  of  no  value  to  such  holders.  This  feature 
of  the  law  makes  the  tax-free  covenant  less  costly  to  the  issu- 
ing corporation,  since  large  blocks  of  bonds  are  sold  to  banks, 
insurance  companies,  and  other  corporations. 

Apparently,  in  a  few  isolated  cases,  debtor  corporations 
have,  inadvertently  or  othervv'ise,  paid  tax  on  behalf  of  cor- 
porations owning  their  bonds.  Under  the  1918  regulations, 
such  payment  was  allowed  as  a  credit  against  an  owner's  nor- 
mal tax,  upon  proof  of  payment. ^^ 

Section  221  (b)  of  the  1921  law  provides  that  the  Com- 
missioner may  authorize  the  tax  of  2  per  cent  to  be  deducted 
from  the  interest  on  tax-free  covenant  bonds  the  owners  of 
which  are  not  known  to  the  withholding  agent.  Under  the 
regulation  issued  on  this  point, ^"  it  would  appear  to  be  possible 
for  domestic  corporations  to  obtain  the  benefit  of  having  the 
tax  paid  for  them  by  concealing  their  identity.  This,  how- 
ever, would  be  a  palpable  evasion  of  the  law,  and  is  neither 
recommended   nor   suggested.     Under   the   law    there    is    no 


•Art.  365. 

'"Excepting  personal   service   corporations   during   years    1918  to   1921, 
inclusive. 

"  See  Income  Tax  Procedure,  1920,  page  246. 
"  See  page  327. 


330 


APPLICATION    AND    ADMINISTRATION 


other  way  in  which  domestic  corporations  can  get  the  benefit 
of  tax-free  covenants  in  bonds  owned  by  them. 

Withholding  obligation  on  bond  interest  paid  in  years 
after  the  interest  became  due. — 

Ruling Bond    interest    represents    income    to    taxpayer 

when  due  and  payable  in  accordance  with  article  54,  Regulations  45. 
No  tax  required  to  be  withheld  from  interest  upon  bonds  due  prior 
to  March  i,  1913,  but  paid  subsequent  to  that  date.  Interest  due  on 
and  after  March  i,  1913,  subject  to  withholding  at  rates  in  force  at 
time  of  payment  but  in  case  excess  tax  is  withheld  and  paid  to  gov- 
ernment claim  for  refund  on  form  46  will  be  considered.  (Telegram 
to  A.  Iselin  &  Co.,  New  York,  N.  Y.,  signed  by  P.  S.  Talbert,  Acting 
Assistant  to  the  Commissioner,  and  dated  September  8,   1919.) 

From  the  above  it  would  appear  that  no  withholding  is 
necessary  by  a  debtor  corporation  in  the  case  of  coupons  from 
bonds  containing  a  tax-free  covenant  clause  now  presented 
but  due  prior  to  Marcli  i,  1913;  but  on  any  coupons  matur- 
ing subsequent  to  that  date,  withholding  must  be  made  at  the 
rate  in  existence  at  the  time  of  payment.  The  date  of  ma- 
turity does  not  determine  the  rate  of  withholding.  Of  course, 
if  an  excessive  tax  is  withheld  and  paid,  the  bondholder  may 
secure  relief  by  filing  a  claim  for  refund. 

Withholding  at  the  source  of  interest  on  bonds  having 
no  tax-free  covenant. — 

The  government  has  taken  the  position  that  corporations 
whose  securities  do  not  contain  a  tax-free  covenant  shall  not 
be  permitted  to  pay  the  tax  except  under  supplemental  agree- 
ments. 

Ruling.  Your  telegram  May  29.  Bonds  without  tax-free  cove- 
nant not  permitted  to  be  considered  tax-free  bonds  at  option  of  issu- 
ing corporations.  Corporation  only  allowed  to  withhold  tax  at  rate 
of  8  and  10  per  cent  from  non-resident  alien  individuals  and  non 
resident  alien  corporations  respectively.  Corporation  prohibited 
from  paying  tax  on  interest  derived  from  such  bonds  when  owned 
by  citizens  or  residents  of  United  States.  (Telegram  to  the  Farmers' 
Loan  &  Trust  Company,  New  York,  N.  Y.,  signed  by  Commissioner 
Daniel  C.  Roper,  and  dated  June  2,   1919.) 


PAYMENT    OF   TAX    AT    SOURCE 


331 


Exemption  from  withholding. — Under  the  law  the  debtor 
corporation  or  its  paying  agent  is  required  to  withhold  a  tax 
of  2  per  cent  on  tax-free  covenant  bond  interest  paid  to  indi- 
vidual citizens  or  residents  who  do  not  claun  exemption,  and  in 
the  case  of  resident  partnerships.  (Withholding  on  account 
of  non-resident  alien  individuals,  foreign  partnerships  and 
corporations  is  discussed  in  Chapter  XXXVI.) 

The  statute  provides  that  exemption  from  withholding 
may  be  claimed  in  the  following  manner: 

Law.  Section  221 (b)  ....  Such  deduction  and  with- 
holding shall  not  be  required  in  the  case  of  a  citizen  or  resident  entitled 
to  receive  such  interest,  if  he  files  with  the  withholding  agent  on  or  be- 
fore February  i  a  signed  notice  in  writing  claiming  the  benefit  of  the 
credits  provided  in  subdivisions  (c)  and  (d)  of  section  216;  nor  in  the 
case  of  a  nonresident  alien  individual  if  so  provided  for  in  regulations 
prescribed  by  the  Commissioner  under  subdivision  (g),  section  217. 
....  [.Section  217  gives  the  Commissioner  discretion  in  allowing 
non-resident  alien  individuals  to  claim  exemption  by  means  of  certifi- 
cates of  ownership.] 

This  provision  of  the  law  and  the  use  of  ownership  cer- 
tificates in  its  administration  are  responsible  for  much  of  the 
bondholder's  confusion  regarding  tax-free  covenants.  In  the 
case  of  tax-free  covenant  bonds  interest  is  paid  in  full  regard- 
less of  whether  exemption  is  or  is  not  claimed.  If  exemption 
is  claimed  on  such  coupons,  the  taxpayer  merely  serves  notice 
on  the  debtor  corporation  that  his  income  is  too  small  to  be 
subject  to  tax  and  therefore  nothing  should  be  paid  to  the  gov- 
ernment on  his  behalf.  If  exemption  is  not  claimed,  a  tax  of  2 
per  cent  of  the  amount  of  the  coupon  is  paid  to  the  govern- 
ment by  the  obligor. 

Who  should  claim  exemption  from  withholding? — Individ- 
ual citizens  or  residents  are  privileged  to  claim  exemption  from 
withholding,  but  partners  may  not  claim  such  exemption.  A 
resident  alien  is  required,  in  claiming  such  exemption,  to  file 
in  addition  a  certificate  of  residence  (form  1078,  revised) 
with  the  withholding  agent. 


332 


APPLICATION    AND    ADMINISTRATION 


Individual  citizens  or  residents  should  claim  exemption,  if 
the  total  amount  of  net  taxable  income  does  not  exceed  their 
personal  exemptions,  i.e.,  $i,ooo  for  a  single  person,  $2,000 
or  $2,500  for  a  married  person,  plus  $400  for  each  dependent. ^^ 
By  filing  such  a  claim  the  individual  relieves  the  debtor  cor- 
poration from  paying  a  tax  not  lawfully  due. 

The  debtor  corporation's  liability  under  a  tax-free  covenant 
covers  only  the  portion  of  normal  tax  deductible  at  the  source. 
If,  therefore,  a  taxpayer  is  subject  only  to  surtax,  because  his 
lawful  deductions  exceed  the  amount  of  income,  if  any,  subject 
to  normal  tax,  he  should  relieve  the  debtor  corporation  from 
making  payment  to  the  government  in  his  behalf  by  filing  a 
claim  for  exemption  in  collecting  tax-free  covenant  bond 
interest.  The  situation  is  analogous  to  the  case  mentioned 
in  the  preceding  paragraph. 

If  an  individual  who  has  not  claimed  exemption  at  the  time 
of  collecting  the  interest  afterwards  desires  to  claim  exemption, 
he  may  file  in  writing  with  the  paying  agent,  at  any  time  prior 
to  February  i  of  the  succeeding  year,  his  notice  claiming  ex- 
emption.    Form  1 00 1  may  be  used  for  such  notice. 

Similarly,  an  individual  who  has  claimed  exemption  and 
subsequently  desires  not  to  claim  exemption  must  file  notice 
in  writing  (form  1000)  with  the  paying  agent  on  or  before 
February  i. 

Tax  paid  on  tax-free  covenant  bond  interest  considered 
income.^* — The  Treasury  Department,  in  1919,  ruled  that  any 
tax  paid  pursuant  to  a  tax-free  covenant  clause  on  behalf  of  a 
taxpayer  should  be  considered  in  the  nature  of  additional 
interest  and  should  be  reported  by  the  taxpayer  in  his  return. 
This  ruling  was  a  source  of  great  irritation  to  the  investing 
public  and  aroused  many  protests.  The  192 1  law,  under  sec- 
tion  234   (a-3),  specifically  provides   that   taxes  paid  under 


See  page  31  et  seq  for  discussion  of  personal  exemption. 
For  discussion,  see  Chapter  XIX. 


PAYMENT    OF   TAX    AT    SOURCE 


333 


tax-free  covenants  shall  not  be  included  in  the  gross  income  of 
the  taxpayer. 

Tax  paid  on  tax-free  covenant  bond  interest  not  deductible 
by  corporation.^^ — Under  section  234  (a-3)  of  the  law,  the 
debtor  corporation  is  not  allowed  to  make  deduction  for  federal 
taxes  so  paid  under  the  heading  of  either  interest  or  taxes. 

Credit  for  taxes  paid  on  tax-free  covenant  bond  interest. — 
Taxpayers  are  allowed  to  credit  their  total  normal  and  surtaxes 
with  the  amount  of  any  tax  paid  for  them  at  the  source  by  a 
debtor  corporation  pursuant  to  a  tax-free  covenant  clause.^*' 


'^  For  discussion,  see  Chapter  XIX. 
'*  Section  221   (d). 


PART  II 
INCOME 


CHAPTER  XII 

CREDITS  AND  EXEMPT  INCOME 

111  addition  to  the  deductions  from  gross  income  which 
are  fully  discussed  in  Chapters  XXV  to  XXXIV,  the  tax  laws 
have  provided  other  means  of  reducing  tax  liability.  Tax- 
payers in  receipt  of  large  incomes  are  chiefly  interested  in 
the  various  classes  of  wholly  exempt  income ;  taxpayers  whose 
incomes  are  less  than  $5,000  are  chiefly  interested  in  the  spe- 
cific exemptions.  There  is  a  vast  difference  between  deduc- 
tions and  credits;  the  former  affect  surtaxes  as  well  as  the 
normal  tax;  credits  for  specific  exemptions,  dividends  and 
the  like  reduce  only  the  normal  tax.  Credits  and  exempt  in- 
come are  discussed  at  this  point  because  the  net  effect  of  each  is 
to  reduce  the  amount  of  taxes  which  would  be  due  if  taxpayers 
merely  reported  their  gross  income.  It  is  less  confusing  to 
dispose  of  these  possibilities  in  one  chapter. 

Income  Exempt  from  Normal  Tax  Only — "Credits" 

The  law  imposes  a  normal  tax  of  8  per  cent^  on  the  total 
net  income  of  individuals,  and  graduated  surtaxes  upon  the 
larger  incomes.  It  imposes  a  flat  10  per  cent  rate  (no  sur- 
taxes") upon  the  income  of  corporations,  which  is  raised  to 
12I  per  cent  after  December  31,  1921.  Partnerships  are  not 
taxed  as  independent  units,  the  partners  instead  being  taxed 
upon  their  respective  shares  of  the  profits  whether  or  not  dis- 
tributed.^ Certain  individual  income*  is  exempt  from  the 
normal  tax,  but  is  nevertheless  subject  to  the  surtax  rates,  the 


'  Reduced  to  4  per  cent  on  the  first  $4,000.     See  Chapter  VTI. 

"Up  to  December  31,  1921,  there  was  the  excess  profits  tax  in  addition. 
See  Excess  Profits  Tax  Procedure,  1921. 

'For  a  fnll  statement,  including  a  discussion  of  personal  scrvii-e  cor- 
porations, sec  Chapter  XXIV. 

*  Certain  dividends,  certain  interest,  and  the  personal  exemptions. 

ZZ7 


338  INCOME 

adjustment  being  made  by  "crediting"  (section  216)  these 
items  of  income  for  purposes  of  the  normal  tax  only.  Even 
in  the  case  of  corporations,  where  no  surtax  rates  apply,  there 
are  certain  items"  which,  in  accordance  with  the  practice  in  the 
case  of  individuals,  are  entered  as  "credits"  (section  236) 
rather  than  as  deductions,  the  effect  being  to  make  the  term 
"net  income"  include  these  items  for  excess  profits  tax  pur- 
poses. In  this  chapter  the  exemptions  and  credits  alluded  to 
are  discussed. 

The  personal  exemptions :  wife  and  dependents. — 

Law.     Section   216 (c)   In  the  case  of  a  single  person, 

a  personal  exemption  of  $1,000;  or  in  the  case  of  the  head  of  a  family 
or  a  married  person  living  with  husband  or  wife,  a  personal  exemption 
of  $2,500,  unless  the  net  income  is  in  excess  of  $5,000,  in  which  case 
the  personal  exemption  shall  be  $2,000.  A  husband  and  wife  living 
together  shall  receive  but  one  personal  exemption.  The  amount  of 
such  personal  exemption  shall  be  $2,500,  unless  the  aggregate  net  in- 
come of  such  husband  and  wife  is  in  excess  of  $5,000,  in  which  case 
the  amount  of  such  personal  exemption  shall  be  $2,000.  If  such  hus- 
band and  wife  make  separate  returns,  the  personal  exemption  may  be 
taken  by  either  or  divided  between  them.  In  no  case  shall  the  reduc- 
tion of  the  personal  exemption  from  $2,500  to  $2,000  operate  to  in- 
crease the  tax,  which  would  be  payable  if  the  exemption  were  $2,500, 
by  more  than  the  amount  of  the  net  income  in  excess  of  $5,000;" 

(d)  $400"  for  each  person  (other  than  husband  or  wife)  dependent 
upon  and  receiving  his  chief  support  from  the  taxpayer  if  such  de- 
pendent person  is  under  eighteen  years  of  age  or  is  incapable  of  self- 
support  because  mentally  or  physically  defective 


°  The  specific  exemption  of  $2,000,  on  incomes  of  $25,000  or  less,  and  of 
certain  interest,  excess  and  war  profits  taxes. 

"[Former  Procedure]  Tlic  1013  law  [section  II  (C)]  and  the  1916 
law  [section  7  (a)]  permitted  the  deduction  "for  the  purpose  of  the 
normal  tax  only"  and  made  the  exemption  $3,000,  plus  $1,000  additional 
if  the  person  making  the  return  were  married  with  husband  or  wife  liv- 
ing with  her  or  him.  The  normal  tax,  v.'hich  was  i  per  cent  under  the  1913 
law,  was  made  2  per  cent  in  1916.  The  1917  law  allowed  this  arrangement 
to  remain  in  force,  but  added  what  in  effect  was  a  second  and  distinct 
income  tax  with  an  additional  normal  rate  of  2  per  cent.  For  the  purpose 
of  this  new  2  per  cent  tax  the  exemptions  of  $3,000  and  $4,000  provided 
in  the  1916  law  were  changed  to  $1,000  and  $2,000  (1917  law,  Title  I.  sec- 
tion 3).  Consequently  there  were  two  sets  of  exemptions  in  1017.  one  for 
each  normal  tax  of  2  per  cent.  The  1918  law  provided  for  one  set  of  exemp- 
tions of  $1,000  and  $2,000  [1918  law,  section  216   (c)]. 

'  This  is  an  increase  of  $200  in  the  e.xemption  allowed  for  each  depend- 
ent under  the  1918  law. 


CREDITS    AND    EXEMPT    INCOME 


339 


The  addition  in  the  igji  law  of  $500  to  the  personal 
exemption  for  the  head  of  a  family  or  a  married  person  living 
with  a  spouse,  is  extended  only  to  those  whose  incomes  do  not 
exceed  $5,000.  The  limitation  of  the  higher  exemption  is 
explained  in  the  following  example : 

Example 

Two  taxpayers,  A  and  B,  married,  no  children,  with  net  taxable 
incomes  of  $5,010  and  $5,030  respectively. 

The  computation  of  A's  tax  is  made  in  the  following  manner : 

( 1 )  Net    income    $5,010.00 

Personal  exemption    2,500.00 

Amount  subject  to  tax   $2,510.00 

Tax  at  4% $100.40 

(2)  Net  income  $5,010.00 

Personal  exemption    2.000.00 

Amount  subject  to  tax $3,010.00 

Tax  at  4% 120.40 

Excess  of  computation  (2)  over  ( i ) $20.00 

Since  this  amount  of  $20  is  greater  than  the  excess  of  the  net 
income  over  $5,000,  viz.,  $10,  and  since  the  tax  under  (2)  must  not 
be  greater  than  the  tax  under  (T)  by  more  than  the  excess  of  $5,010 
over  $5,000,  i.  e.,  $10,  the  total  tax  due  by  .A.  is,  therefore,  $100.40 
plus  $io=$i  10.40,   instead  of  $120.40. 

In  the  case  of  B  the  computations  are: 

( 1 )  Net  income $5,030.00 

Personal  exemption    2.500.00 

Amount  subject  to  tax $2,530.00 

Tax  at  4% $101 .20 

(2)  Net  income    $5,030.00 

Personal  exemption 2,000.00 

Amount    subject    to    tax $3,030.00 

Tax  at  4% 121.20 

Excess   of  computation    (2)    over    ( i ) $  20.00 

In  this  instance  the  reduced  exemption  does  not  increase  the  tax 
beyond  the  amount  of  income  over  $5,000,  viz.,  $30.  The  total  tax 
due  by  B  is,  therefore,  $121.20. 


340 


INCOME 


It  will  bo  found  that  the  benefit  of  the  provision  ceases  in  case 
of  taxable  net  incomes  over  $5,020.  The  tax  on  net  incomes,  of  other 
than  single  individuals,  at  and  below  that  figure,  but  in  excess  of 
$5,000,  will  be  computed  on  the  same  basis  as  A  above. 

Test  of  dependency. — 

Regulation.  A  taxpayer  receives  a  credit  of  $400^  for  each  per- 
son (other  than  husband  or  wife),  whether  related  to  him  or  not 
and  whether  living  with  him  or  not,  dependent  upon  and  receiving 
his  chief  support  from  the  taxpayer,  provided  the  dependent  is  either 
(a)  under  eighteen  or  (b)  incapable  of  self-support  because  defective. 
The  credit  is  based  upon  actual  financial  dependency  and  not  mere 
legal  dependency.  It  may  accrue  to  a  taxpayer  who  is  not  the  head 
of  a  family.  But  a  father  whose  children  receive  half  or  more  of 
their  support  from  a  trust  fund  or  other  separate  source  is  not 
entitled  to  the  credit.      (Art.  304.) 

"Head  of  a  family"  defined. — 

Regulation.  A  head  of  a  family  is  an  individual  who  actually 
supports  and  maintains  in  one  household  one  or  more  individuals  who 
are  closely  connected  with  him  by  blood  relationship,  relationship  by 
marriage,  or  by  adoption,  and  whose  right  to  exercise  family  con- 
trol and  provide  for  these  dependent  individuals  is  based  upon  some 
moral  or  legal  obligation.  In  the  absence  of  continuous  actual  resi- 
dence together,  whether  or  not  a  person  with  dependent  relatives  is  a 
head  of  a  family  within  the  meaning  of  the  statute  must  depend  on 
the  character  of  the  separation.  If  a  father  is  absent  on  business  or 
at  war,  or  a  child  or  other  dependent  is  away  at  school  or  on  a  visit, 
the  common  home  being  still  maintained,  the  additional  exemption 
applies.  If,  moreover,  through  force  of  circumstances  a  parent  is 
obliged  to  maintain  his  dependent  children  with  relatives  or  in  a 
boarding  house  while  he  lives  elsewhere,  the  additional  exemption 
may  still  apply.  If,  however,  without  necessity  the  dependent  con- 
tinuously makes  his  home  elsewhere,  his  benefactor  is  not  the  head  of 
a  family,  irrespective  of  the  question  of  support.  A  resident  alien  with 
children  abroad  is  not  thereby  entitled  to  credit  as  the  head  of  a  family. 
(Art.  302.) 

There  are  slight  verbal  changes  in  this  article,  as  com- 
pared with  article  302,  "Regulations  45. 

The  foregoing  regulation  does  not  impair  the  right  of  a 
parent  to  claim  the  $400  for  each  dependent  irrespective  of 


The  credit  for  dependents  under  the  1916,  1917  and  1918  laws  was  $200. 


CREDITS    AND   EXEMPT    INCOME  341 

the  nationality  or  place  of  residence  of  the  dependents.  The 
requirement  of  residence  in  "one  household"  has  been  aban- 
doned.^    It  had  no  justification  under  the  law/" 

When  "without  necessity  the  dependent  continuously 
makes  his  home  elsewhere,"  it  may  be  reasonable  to  hold  that 
the  taxpayer  is  not  to  be  considered  the  head  of  a  family. 
If,  however,  a  resident  alien  has  children  abroad  "with"  neces- 
sity, it  would  seem  that,  in  addition  to  the  credit  of  $400  for 
each  dependent,  the  resident  alien  should  be  classed  as  the 
head  of  a  family  because  every  resident  alien  individual  is 
subject  to  the  income  tax,  even  though  his  income  is  derived 
wholly  from  sources  outside  the  United  States.  ^^ 

If  a  taxpayer  can  qualify  as  the  head  of  a  family  under 
the  definition  formulated  above,  he  can  claim  as  personal 
exemption  the  full  $2,500,  or  $2,000,  as  the  case  may  be,  even 
though  he  be  not  married.  On  the  other  hand,  it  is  no  longer 
necessary  that  he  be  the  head  of  a  family  to  claim  the  $400  for 
each  dependent,  provided  he  supplies  the  "chief  support"  of 
such  dependent.  Practically  every  unmarried  person  who  is 
the  chief  supporter  of  a  dependent  should  be  able  to  qualify  as 
a  head  of  a  family  and  avail  himself  of  the  additional  per- 
sonal exemption  as  well  as  the  $400  deduction.  A  widow 
or  a  widower  supporting  minor  children  is  clearly  a  "head  of 
a  family."  A  child  acting  as  the  main  support  of  a  dependent 
parent  or  a  minor  brother  or  sister  is  entitled  to  the  additional 
exemption,  plus  the  $400  exemption  for  each  minor  child 
or  dependent  person  mentally  or  physically  defective.  An 
uncle  upon  whom  nephews  and  nieces  are  dependent  is  en- 
titled to  the  full  exemption  for  those  under  eighteen  years  of 
age.^"  It  has  been  held  that  a  child  over  eighteen  years  of 
age,  away  at  school,  with  an  income  in  excess  of  $1,000  a  year 
(who  filed  an  income  tax  return  claiming  exemption  of 
$1,000),  but  whose  income  was  insufficient  to  pay  half  the  cost 


'C.  B.  3,  page  194;  O.  D.  665. 

'"  Income  Tax  Procedure,  1920,  pages  31  and  },2. 

"  Section   210. 

"C.  B,  4,  page  215;  A.  R.  R.  551. 


342 


INCOME 


of  its  support,  is  "dependent"  on  its  mother  (a  widow),  who  is 
therefore  entitled  to  exemption  as  the  head  of  a  family. ^^  A 
widower  with  a  daughter  over  eighteen  years  of  age  who  re- 
ceives nominal  income  from  other  sources  and  is  neither 
physically  nor  mentally  incapable  of  self-support,  is  head  of  a 
family." 

In  cases  where  several  persons  combine  to  contribute  to 
the  joint  support  of  several  dependents,  it  may  be  desirable 
to  allocate  their  contributions  to  particular  persons  in  the 
group  of  dependents  to  the  extent  of  making  the  taxpayers 
clearly  the  main  supporters  of  certain  individuals.  By  so 
doing  they  provide  a  basis  for  exemption  claims  which  other- 
wise could  not  be  allowed.  This  principle  has  been  maintained 
in  a  ruling  to  the  effect  that,  where  a  husband  and  wife  both 
contribute  to  the  support  of  a  dependent,  the  credit  must  be 
taken  by  the  one  contributing  the  chief  support  and  may  not 
be  divided  between  them." 

Where,  in  a  family  group,  one  claims  the  exemption  ap- 
plicable to  the  head  of  the  family,  the  income  of  minors  who 
are  dependent  upon  him  should  be  included  in  his  return,  be- 
cause the  law  to  this  extent  contemplates  the  computation  of 
the  tax  upon  the  family  as  a  unit.  The  following  ruling  un- 
der the  19 1 8  law  bears  on  this  point. 

Ruling.  A  father  has  two  sons,  seventeen  and  twenty  years  of 
age,  respectively.  During  1919,  each  son  earned  in  excess  of  $1,000, 
but  both  were  dependent  upon  the  father  since  he  appropriated  their 
entire  earnings. 

In  view  of  the  fact  that  both  sons  were  minors,  and  had  not 
been  emancipated,  and  their  earnings  were  appropriated  by  the  father, 
the  entire  amount  of  such  earnings,  together  with  the  father's  income 
from  all  other  sources,  must  be  reported  in  the  father's  return  for 
1919.  The  credit  of  $200  for  dependents  is  applicable  only  to  the 
son  under  iS  years  of  age.     ( C.  B.  4,  page  214;  O.  D.  797.) 


''C.  B.  2.  page  159;  O.  D.  474;  also  Bulletin  C.  B.  4,  page  214;  O.  D. 
775. 

"  C.  B.  2.  page  159;  O.  D.  422. 

"C.  B.  4,  page  214;  O.  D.  776, 


CREDITS    AND    EXEMPT    INCOME  343 

The  father  was  not  well  advised.  He  should  emancipate 
the  sons,  charge  them  lioard  and  have  them  make  tax  returns. 

Minors  not  exempt. — A  minor  as  such  is  not  exempt. 
If  he  has  a  substantial  income  a  separate  return  should  be 
made  for  him  and  the  $1,000  exemption  should  be  claimed.^* 

Ruling.  Where  a  father  has  made  a  bona  fide  and  absolute  gift 
of  property  to  his  minor  child,  the  income  therefrom  need  not  be 
included  in  the  father's  return  of  gross  income  for  the  purpose  of 
normal  tax  and  surtax,  even  though  the  father  administers  the  prop- 
erty and  collects  the  income  for  the  child.  In  such  a  transaction 
there  is  no  presumption  that  the  gift  is  or  is  not  bona  fide,  but  the 
burden  should  be  upon  the  father  in  each  case  to  show  that  it  is  an 
absolute  gift  to  the  child.     (C.  B.  3,  page  116;  Sol.  Op.  14.) 

Status  at  end  of  year  determines  exemption. — The 
status  of  the  taxpayer  on  the  last  day  of  his  taxable  year  is  the 
significant  factor  in  establishing  his  right  to  the  personal 
exemption. 

Law.  Section  216 (f)  The  credits  allowed  by  subdivi- 
sions (c),  (d),  and  (e),^"  of  this  section  shall  be  determined  by  the 
status  of  the  taxpayer  on  the  last  day  of  the  period  for  which  the  re- 
turn of  income  is  made;  but  in  the  case  of  an  individual  who  dies 
during  the  taxable  year,  such  credits  shall  be  determined  by  his 
status  at  the  time  of  his  death,  and  in  such  case  full  credits  shall 
be  allov/ed  to  the  surviving  spouse,  if  any,  according  to  his  or  her 
status  at  the  close  of  the  period  for  which  such  survivor  makes  re- 
turn of  income. 

The  inclusion  of  the  above  section  is  new  in  the  ])resent 
law\  It  is,  however,  based  on  a  regulation  issued  under  the 
Revenue  Act  of  1918.^^ 

What  constitutes  "living  with  husband  or  wife"? — 

Regulation.  In  the  case  of  a  married  man  or  married  woman 
the  joint  exemption  replaces  the  individual  exemption  only  if  the 
man  lives  with  his  wife  or  the  woman  lives  with  her  husband.  In 
the  absence  of  continuous  actual  residence  together,  whether  or  not 
a  man  or  woman  has  a  wife  or  husband  living  with  him  or  her  within 


'"  See  page  84. 

"See  Chapter  VII,  page  155. 

"  Reg.  45,  Art.  305. 


344 


INCOME 


the  meaning  of  the  statute  must  depend  on  the  character  of  the 
separation.  If  merely  occasionally  and  temporarily  a  wife  is  away  on 
a  visit  or  a  husband  is  away  on  business,  the  joint  home  being  main- 
tained, the  additional  exemption  applies.  The  unavoidable  absence 
of  a  wife  or  husband  at  a  sanatorium  or  asylum  on  account  of  illness 
does  not  preclude  claiming  the  exemption.  If,  however,  the  husband 
voluntarily  and  continuously  makes  his  home  at  one  place  and  the 
wife  hers  at  another,  they  are  not  living  together  for  the  purpose  of 
the  statute,  irrespective  of  their  personal  relations.  A  resident  alien 
with  a  wife  residing  abroad  is  not  entitled  to  the  joint  exemption. 
(Art.  303.) 

Ruling.  The  taxpayer's  wife  was  granted  an  annulment  of  the 
marriage  with  him  by  a  court  composed  of  three  workmen,  known  as 
the  People's  Commission,  under  the  Soviet  regime.  She  later  mar- 
ried a  Russian  subject.  This  marriage  was  under  Soviet  auspices. 
On  or  about  August  — ,  1920,  her  marriage  with  the  Russian  was 
resolemnized  by  a  clergyman. 

Irrespective  of  their  personal  relations  the  above  facts  do  not 
indicate  that  the  separation  was  of  a  temporary  character  or  that  it 
was  unavoidable.  It  is  held  that  the  taxpayer  did  not  have  on  De- 
cember 31,  1920,  the  status  of  a  married  man  living  with  his  wife.  (B 
Digest  49-21-1960;  O.  D.  1 124.) 

The  fact  that  a  husband  has  been  declared  mentally  in- 
competent and  that  his  consequent  confinement  in  an  institu- 
tion may  be  indefinite  has  no  effect  on  the  joint  personal 
exemption. ^^ 

Personal  exemption  valid  for  normal  tax  only. — 
In  computing  the  surtax,  the  personal  exemption  may  not  be 
deducted  from  the  net  income. ^°  Therefore,  if  a  head  of  a 
family  has  more  than  seven  dependents  for  1921  and  more  than 
nine  for  subsequent  years,  or  if  all  of  a  taxpayer's  income 
is  from  dividends  or  from  a  large  amount  of  Liberty  bonds,  it 
is  possible  for  him  to  be  subject  to  a  surtax  while  exempt  from 
the  normal  tax. 

Personal  exemptions  of  resident  aliens.^^ — An  alien 
resident  in  the  United  States  is  in  almost  all  respects  treated 


C.  B.  3,  page  130;  O.  D.  603. 

'  See  section  216.  "For  purposes  of  normal  tax  only " 

For  exemptions  of  non-resident  aliens,  see  Chapter  XXXVI. 


CREDITS    AND    EXEMPT    INCOME  345 

exactly  as  a  citizen.    He  is  permitted  to  take  advantage  of  the 
personal  exemptions  in  the  usual  manner. 

Ruling.  An  alien  residing  in  the  United  States  permanently, 
with  wife  and  children  residing  abroad,  is  entitled  to  a  personal 
exemption  of  only  one  thousand  dollars  since  he  is  not  living  with 
his  wife,  but  is  entitled  to  a  two  hundred  dollar  credit  for  each  child, 
provided  such  child  is  dependent  upon  and  receives  its  chief  support 
from  him  and  is  under  eighteen  or  incapable  of  self-support  because 
defective.     (C.  B.  3,  page  195;  O.  D.  640.) 

Personal  exemptions  of  wards,  beneficiaries  and 
ESTATES. — Wards  and  other  beneficiaries  receiving  their  in- 
come from  estates  are  entitled  to  claim  exemption  according 
to  their  status,  and  the  guardian  or  trustee  when  making  re- 
turns is  allowed  to  deduct  this  personal  exemption  from  the 
amount  of  income  derived  from  the  property  of  which  he 
has  charge  in  favoY  of  each  ward  or  beneficiary  who  has  not 
claimed  a  personal  exemption  independently  or  through  an- 
other trustee  [section  219  (d)].  Where  the  estate  is  sub- 
ject to  a  tax  by  reason  of  income  received  by  it  but  not  dis- 
tributed during  the  year,  a  deduction  of  $1,000  only  (no 
deductions  for  dependents)  is  allowed  in  computing  the  tax 
upon  the  estate  [section  219  (c)].  This  is  the  only  instance 
in  which  the  personal  exemption  may  be  claimed  by  anyone 
other  than  the  individual  taxpayer." 

Regulation,  (a)  An  estate  or  trust  taxed  to  the  fiduciary  is 
allowed  the  same  credits  against  net  income  as  a  single  person,  in- 
cluding a  personal  exemption  of  $1,000,  but  no  credit  for  dependents. 
....  (b)  ....  Each  beneficiary  is  entitled  to  but  one  personal 
exemption,  no  matter  from  how  many  trusts  he  may  receive  income. 
.    .    .    .      (Art.  346.) 

For  a  detailed  discussion  of  the  subject  of  fiduciaries,  see 
Chapter  XXXVII. 


^  [Former  Procedure]  Prior  to  the  enactment  of  the  1917  law  this 
exemption  (but  $3,000  in  amount)  applied  to  all  estates  [section  7  (a)], 
but  as  amended  by  that  law  the  exemption  was  limited  to  citizens  or  resi- 
dents of  the  United  States,  excluding  non-resident  aliens.  The  1918  law 
again  permitted  the  exemptions  in  the  case  of  all  estates,  domestic  and 
foreign. 


346  INCOME 

Specific  Credit  to  Corporations 

Corporations  whose  net  income  does  not  exceed  $25,000 
are  entitled  to  a  specific  credit  of  $2,000.  This  provision  is 
effective  from  January  i,   1921. 

Law.  Section  236.  That  for  the  purpose  only  of  the  tax  imposed 
by  section  230  [income  tax]  there  shall  be  allowed  the  following 
credits:  .... 

(b)  In  the  case  of  a  domestic  corporation  the  net  income  of  which 
is  $25,000  or  less,  a  specific  credit  of  $2,000;  but  if  the  net  income  is 
more  than  $25,000  the  tax  imposed  by  section  230  shall  not  exceed  the 
tax  which  would  be  payable  if  the  $2,000  credit  were  allowed,  plus  the 
amount  of  the  net  income  in  excess  of  $25,000;--    .... 

This  provision,  which  corresponds  closely  to  the  specific 
exemption  from  normal  tax  extended  to  individuals,  has  as  one 
of  its  effects  the  entire  elimination  of  the  payment  of  any  tax 
b}'  a  domestic  corporation  whose  net  income  is  less  than 
$2,000.  In  case  a  consolidated  return  is  filed  for  several 
corporations,  only  one  $2,000  specific  credit  is  allowed,  and 
that  only  if  the  consolidated  net  income  does  not  exceed 
$25,000."*  A  further  analogy  to  the  specific  exemption  allowed 
individuals  appears  in  the  limitation  of  the  credit.  Only  cor- 
porations with  net  incomes  of  $25,000  or  less  reap  the  benefit 
of  this  provision.  The  application  of  the  credit  to  corporations 
whose  net  income  is  but  little  in  excess  of  the  $25,000  is  illus- 
trated by  the  following  computations  : 

Example  I 
Corporation   A   with  net  income  in   1921    (after  deducting  the 

CREDIT   FOR   EXCESS   PROFITS   TAXES)    OF   $25,100 

(a)  The  tax,  without  the  specific  credit,  at  io% $2,510.00 

(b)  Net  income  of   $25,100 

Less :     Credit 2,000 

Tax   at    10%    on $23,100  2.310.00 

Excess  of  (a)  over  (b) $   200.00 

^  [Former  Procedure]  Under  the  igog  law  corporations  received  a 
$5,000  exemption.  Under  tiie  1913.  1916  and  1917  laws  corporations  did  not 
receive  any  specific  exemption.  The  1918  law  reinstated  a  specific  exemp- 
tion (for  income  tax  purposes  only)  to  the  extent  of  $2,000. 

"-*  For  a  discussion  of  the  credit  allowed  corporations  for  excess  profits 
taxes  imposed,  see  Chapter  V,  Excess  Profits  Tax  Procedure,  1921,  and 
Appendix  A  in  this  book. 


CREDITS    AND    EXEMPT    INCOME 


347 


As  the  liinitation  inipused  by  the  section  prcckides  the  tax  cum- 
puted  under  (a),  $2,510,  exceeding  tlie  tax  computed  under  (b), 
$2,310  (an  excess  of  $200),  by  more  than  the  income  in  excess  of 
$25,000  ($100),  the  actual  tax  in  the  case  of  corporation  A  would 
be:  $2,3io+$ioo=$2,4io. 

Example  II 
Corporation   B   with  net  income  in   1921    (after  deducting  the 

CREDIT   for   excess   PROFITS   TAX)    OF   $25,300 

(a)  The  tax,  without  the  specific  credit,  at  10% $2,530.00 

(b)  Net  income  of $25,300.00 

Less :    Credit    2,000.00 

Tax  at   10%   on $23,300.00  2,330.00 

Excess  of   (a)   over   (b) $   200.00 


In  this  example  the  excess  of  (a)  over  (b),  $200,  is  not  more 
than  the  excess  of  the  net  income  over  $25,000,  $300;  the  actual  tax, 
therefore,  of  corporation  B  remains  as  computed  without  the  specific 
credit,  i.  e.,  $2,530. 

The  same  examples  would  hold  good  for  the  taxable  year  1922, 
except  that  the  rate  of  taxation  is  raised  to  12^/2  per  cent.  The  re- 
peal of  the  excess  profits  tax  will  also  mean  that  the  whole  of  the 
taxable  net  income  will  be  subject  to  the  income  tax,  i.  e.,  there  will 
be  no  credit  for  excess  profits  tax.  The  dividing  line  below  and 
above  which  the  specific  credit  of  $2,000  is  effective,  or  otherwise,  is 
$25,200  for  1921  and  $25,250  for  1922. 


Dividends  Which  Are  Exempt  from  Normal  Tax 

Dividends  of  the  classes  referred  to  in  section  216  below 
are  exempt  from  normal  tax  in  the  hands  of  recipients. 

Law.  Section  216.  That  for  the  purpose  of  the  normal  tax  only 
there  shall  be  allowed  the  following  credits: 

(a)  The  amount  received  as  dividends  (i)  from  a  domestic 
corporation  other  than  a  corporation  entitled  to  the  benefits  of  sec- 
tion 262, -'■  or  (2)  from  a  foreign  corporation  when  it  is  shown  to  the 
satisfaction  of  the  Commissioner  that  more  than  50  per  centum  of  the 
gross  income  of  such  foreign  corporation  for  the  three-year  period 
ending  with  the  close  of  its  taxable  year  preceding  the  declaration  of 
such  dividends  (or  for  such  part  of  such  period  as  the  corporation  has 


"°  Refers  to  limitation  of  gross  income  of  certain  corporations  to  that 
derived  from  sources  within  the  United  States.     See  Chapter  XXXVI. 


348  INCOME 

been  in  existence)  was  derived  from  sources  within  the  United  States 
as  determined  under  the  provision  of  section  217;-'^   .... 

The  above  credit  applies  to  individuals  and  its  effect  is  to 
exempt  dividends  from  the  normal  tax  even  though  the  pay- 
ing corporations  are  exempt  from  tax."'  In  the  case  of  corpor- 
ations substantially  the  same  language  is  used  in  a  clause"^ 
included  among  the  deductions,  which  makes  dividends  re- 
ceived from  other  corporations  non-taxable.  The  passage 
of  the  corresponding  section  of  the  1918  act  eliminated  com- 
pletely the  long-standing  discrimination  against  corporations 
which  own  stocks  in  other  corporations.^^ 

Prior  to  1921  the  situation  regarding  dividends  received 
by  citizens  or  residents  from  foreign  corporations  was  anomal- 
ous. As  long  as  the  distributing  corporation  was  "subject  to 
tax"  in  the  United  States,  quite  independent  of  the  fact  that  it 
might  actually  pay  no  tax  in  this  country,  dividends  from  such 
corporations  were  exempt  from  normal  taxes.  The  position  is 
now  clarified  to  the  extent  that  more  than  one-half  of  the  in- 


=^  See  Chapter  XXXVI. 

^  [Former  Procedure]  Under  the  1918  law  the  exemption  was  limited 
to  dividends  received  from  corporations  taxable  under  that  law. 

Dividends  received  by  the  holders  of  the  preferred  stock  of  a  corpora- 
tion, all  of  the  common  stock  being  owned  by  a  town,  the  corporation  fur- 
nishing water,  power,  light  and  heat  to  the  town,  are  not  exempt  from 
normal  tax.     (C.  B.  i,  page  93;  O.  D.  328.) 

■^Section  234  (a-6). 

■■*  [Former  Procedure]  Under  the  1913  and  1916  laws  corporations 
were  not  permitted  to  deduct  dividends  received  from  other  corporations. 
The  1917  law,  which  levied  an  additional  4  per  cent  tax  on  corporations, 
exempted  dividends  received  by  corporations  from  this  rate,  but  not  from 
the  2  per  cent  rate  of  the  1916  law,  which  continued  in  force,  except  as 
to  dividends  out  of  earnings  realized  during  1913,  1914  and  1915,  which 
were  taxable  at  i  per  cent  (see  Chapter  VII).  The  exemption  was  granted 
in  the  form  of  a  "credit"  (1917  law,  war  income  tax,  section  4).  The 
permission  given  corporations  by  the  1918  law  to  deduct  dividends  has 
the  effect  of  automatically  relieving  such  dividends  from  the  exce3s  profits 
tax.  This  was  accomplished  by  special  provision  in  1917.  A  consoli- 
dated return  in  1917  was  permitted  only  for  the  purpose  of  the_  excess 
profits  tax.  For  income  tax  purposes  separate  returns  were  required  for 
each  corporation,  imposing  upon  each  corporation  the  2  per  cent  rate  on 
dividends  under  the  1916  law  which  was  still  in  effect.  In  making  a  con- 
solidated return  for  a  fiscal  year  beginning  in  1917  and  ending  in  1918, 
when  the  computation  was  made  to  determine  the  tax  applicable  to  the 
portion  of  the  year  falling  in  1918,  all  dividends  were  deducted  in  de- 
termining net  income. 


CREDITS    AND   EXEMPT    INCOME 


349 


come  of  the  foreign  corporation  must  have  accrued  from 
sources  within  the  United  States. 

Foreign  corporations  doing  sufficient  business  in  the  United 
States  should  notify  their  stockholders  regarding  the  right  of 
credit.  When  stockholders  do  not  receive  a  notice  the  credit 
should  not  be  claimed.  If  stockholders  have  reason  to  think 
that  they  should  receive  the  credit,  but  have  received  no  notice 
concerning  it  from  the  corporation,  they  should,  of  course, 
ask  the  corporation  for  information  regarding  it. 

It  should  be  noted  that  Porto  Rico  and  the  Philippine 
Islands  are  not  included  in  the  term  "United  States"  for  the 
purposes  of  the  statute.  Dividends  received  from  corporations 
taxed  in  those  countries,  but  having  no  income  from  sources 
within  the  United  States,  are  not  allowed  as  credits  against 
net  income  of  individuals  or  gross  income  of  corporations 
(article  1131). 

Dividends  from  personal  service  corporations  which  were 
specifically  alluded  to  in  this  section  of  the  1918  law  are  not 
included  in  the  present  section.^"  The  status  of  these  corpora- 
tions is  that  of  ordinary  domestic  corporations,  after  Decem- 
ber 31,  192 1. 

A  full  discussion  of  the  situation  created  by  the  1921  law 
in  connection  with  dividends  and  distributive  profits  of  per- 
sonal service  corporations,  is  given  in  Chapter  XXIV. 

Dividends  of  a  personal  service  corporation  paid  on  or 
after  January  i,  19 18,  out  of  earnings  accumulated  prior  to 
January  i,  19 18,  are  exempt  from  the  normal  tax  and  return- 
able the  same  as  dividends  paid  by  ordinary  corporations. 
Dividends  of  a  personal  service  corporation  paid  on  or  after 
January  i,  19 18,  and  prior  to  January  i,  1922,  out  of  earnings 


'"  [Former  Procedurel  Dividends  paid  by  a  personal  service  corpora- 
tion from  earnings  accumulated  prior  to  January  i,  iyi8,  are  exempt  from 
the  normal  tax.  Dividends  paid  by  a  personal  service  corporation  between 
January  i  and  March  i,  igi8  (both  inclusive),  are  deemed  to  have  been 
paid  from  the  earnings  of  1917  [section  201  (e)],  but  were  taxable  at  the 
rates  of  surtax  in  force  in  the  year  in  which  received,  viz.,  igi8.  The  result 
is  that  as  to  the  dividends  received  in  these  two  months  the  stockholders 
nf  a  personal  service  corporation  were  on  the  same  basis  as  the  stockholders 
of  any  other  corporation. 


350 


INCOME 


accumulated  after  January  i,  1918,  have  not  been  subject  to 
any  tax  at  all  in  the  hands  of  the  corporation.  The  entire  net 
income  of  the  corporation  has  been  taxed  to  the  individual 
stockholders  for  both  normal  and  surtaxes,  whether  or  not 
distributed ;  hence  dividends,  as  such,  when  received  are  not 
taxable  and  need  not  be  reported  at  all.  If  the  distributee  is 
not  a  stockholder  at  the  end  of  the  year,  an  accounting  must 
be  made  to  determine  the  tax  liability  for  the  taxable  year. 
[See  section  218   (d).] 

Interest  which  is  exempt  from  normal  tax. — 

Law.  .Section  216.  That  for  the  purpose  of  the  normal  tax 
only  there  shall  be  allowed  the  following  credits:  .... 

(b)  The  amount  received  as  interest  upon  obligations  of  the  United 
States  and  bonds  issued  by  the  War  Finance  Corporation,  which  is 
included  in  gross  income  under  section  213;   .... 

The  foregoing  section  applies  to  individuals.  Corpora- 
tions may  take  credit  under  section  236  (a)  for  similar  in- 
terest. The  interest  here  described  is  that  included  within  the 
definitions  of  gross  and  net  income  by  virtue  of  the  fact  that 
these  particular  public  securities  do  not  fall  within  the  scope  of 
section  213    (b-4-c). 

In  the  case  of  all  the  Liberty  loans  since  the  first,  and  of 
the  Victory  4^/4.  per  cent  issue,  the  interest,  except  that  on  cer- 
tain specified  amounts,  has  been  made  subject  to  the  individual 
surtaxes  and  to  the  excess  and  war  profits  taxes.  The  sections 
quoted  above  provide  the  machinery  for  exempting  the  interest 
from  the  normal  tax  of  individuals  and  the  corporation  10 
per  cent  (12^  per  cent  after  December  31,  1921)  tax  and  yet 
rendering  it  subject  to  the  surtax  and  excess  profits  tax.  For 
a  full  discussion  see  Chapter  XX. 

Income  Exempt  from  Both  Normal  and  Surtaxes 

In  section  213,  which,  it  will  be  recalled,  applies  to  both 
individuals  and  corporations,  certain  items  are  definitely  ex- 
cluded from  the  definition  of  gross  income  and  consequently 


CREDITS    AND    EXEMPT    INCOME  351 

need  not  be  reported  at  all.  These  items  will  be  considered 
separately  in  the  pages  which  follow. 

War  risk  insurance  and  pensions  from  United  States  ex- 
empt.— 

Law.  Section  213.  That  ....  the  term  "gross  income" — 
....  (b)  Does  not  include  the  following  items,  which  shall  be  ex- 
empt from  taxation  under  this  title:  .... 

(g)  Amounts  received  as  compensation,  family  allotments  and 
allov/ances  under  the  provisions  of  the  War  Risk  Insurance  and  the 
Vocational  Rehabilitation  Acts,  or  as  pensions  from  the  United  States 
for  service  of  the  beneficiary  or  another  in  the  military  or  naval  forces 
of  the  United  States  in  time  of  war;   .... 

The  foregoing  provision  is  new.'^^ 

Accident  and  health  insurance  exempt. — 

Law.     Section     213.     That   ....   the     term     "gross     income" — 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title:  .... 

(6)  Amounts  received,  through  accident  or  health  insurance  or 
under  v/orkmen's  compensation  acts,  as  compensation  for  personal 
injuries  or  sickness,  plus  the  amount  of  any  damages  received  whether 
by  suit  or  agreement  on  account  of  such  injuries  or  sickness;^"-   .... 

The  foregoing  exemption  has  been  extended  to  the  estate  or 
other  beneficiaries  in  case  the  insured  is  deceased. 

Regulation (c)      Whether    he    be    alive    or    dead,    the 

amounts  received  by  an  insured  or  his  estate  or  other  beneficiaries 
through  accident  or  health  insurance  or  under  workmen's  compensation 
acts  as  compensation  for  personal  injuries  or  sickness  are  excluded 
from  the  gross  income  of  the  insured,  his  estate  and  other  beneficiaries. 
Any  damages  recovered  by  suit  or  agreement  on  account  of  such 
injuries  or  sickness  are  similarly  excluded  from  the  gross  income  of 
the  individual  injured  or  sick,  if  living,  or  of  his  estate  or  other 
beneficiaries  entitled  to  receive  such  damages,  if  dead (Art.  72.) 


"  Payments  under  the  War  Risk  Insurance  Act  made  since  June  25, 
1918,  were  exempted  by  the  act  under  which  paid  (Reg.  45,  Art.  72).  Pay- 
ments under  the  Vocational  Rehabilitation  Act  were  taxable  (C.  B.  4,  page 
79;  Sol.  Op.  97).  Pensions  were  taxable  under  the  1918  law  (Reg.  45, 
Art.  32). 

■'"This  exemption,  first  introduced  in  1918.  resulted  from  court  inter- 
pretations of  earlier  laws.     See  Income  Tax  Troccdurc,  1920,  page  40. 


352 


INCOME 


Rulings.  The  alienation  of  a  wife's  affections  is  not  such  a 
personal  injury  as  to  entitle  the  recipient  of  damages  therefor  to 
exemption  from  income  tax  as  to  the  amount  received.  (C.  B.  2, 
page  71;  S.  1384.) 

Damages  in  the  form  of  yearly  payments  throughout  the  life  of 
the  injured  party,  recovered  through  the  compromise  of  a  threatened 
suit  for  breach  of  promise  of  marriage,  are  not  regarded  as  a  return 
of  capital,  since  the  benefits  of  which  the  injured  party  was  deprived 
were  merely  anticipatory.  Such  payments  are  within  the  statutory 
definition  of  income  and  accordingly  are  taxable  to  the  recipient. 
(C.  B.  2,  page  70;  O.  D.  501.) 

Life  insurance — extent  to  which  exempt.'^ 

When  paid  to  beneficiaries. — 

Law.     Section    213.     That    ....    the    term    "gross    income" — 
(b)  Does  not  include  the  following  items,  which  shall  be  exempt 

from  taxation  under  this  title: 

(i)  The  proceeds   of  life  insurance  policies  paid  upon  the  death 

of  the  insured;'^   .... 

The  foregoing  provision  definitely  exempts  the  proceeds  of 
all  life  insurance.^* 

Rulings.  A  and  B,  beneficiaries  under  life  insurance  policies 
covering  the  lives  of  their  respective  husbarrds,  accepted  the  option 
of  allowing  the  proceeds  thereof  to  remain  with  the  insurance  com- 
pany to  draw  interest  at  the  rate  of  3  per  cent  per  annum,  plus  the 
amount  of  any  excess  interest  dividends;  the  principal  sum  to  be 
paid  upon  the  death  of  the  beneficiary  to  the  beneficiary's  legal  rep- 
resentatives. In  one  case  the  option  accepted  was  provided  for  in  the 
policy,  and  in  the  other  it  was  offered  by  the  company  independently 
of  the  policy. 

Held,  that  as  the  beneficiary  in  either  case  had  the  option  of  re- 
ceiving the  proceeds  of  the  insurance  or  of  leaving  the  money  with 


^  For  exemption  relating  to  insurance  companies,  see  Chapter 
XXXVIII. 

"*  [Former  Procedure]  The  1913  law  exempted  "the  proceeds  of  life 
insurance  policies  paid  upon  the  death  of  the  person  insured"  [section 
II  (B)].  The  regulations  under  the  1918  law  attempted  to  tax  the  proceeds 
paid  to  the  estate  of  the  insured,  but  this  was  reversed  by  T.  D.  3190, 
July  I,  1921.  The  1918  law  exempted  insurance  paid  to  individual  bene- 
ficiaries or  to  the  estate  of  the  insured,  but  excluded  from  the  exemption 
payments  to  corporations. 

'^  Policies  payable  to  partnerships  (except  limited  partnerships  of  the 
corporate  type)  are  in  effect  payable  to  individual  beneficiaries.  (C.  B.  i, 
page  82;  T.  B.  R.  22.) 


CREDITS    AND   EXEMPT    INCOME 


353 


the  company  to  draw  interest,  she  in  effect  has  loaned  the  money  to 
the  company,  and  the  interest  so  received  thereon  is  taxable  income 
for  the  year  of  its  receipt. 

In  the  policies  covering  the  life  of  C's  husband,  provision  was 
made  that  C  should  receive  only  an  annual  payment  representing 
3  per  cent  of  the  principal  of  the  policy,  together  with  any  excess 
infferest  dividends  apportioned  to  the  policy.  C  may  not  receive  any 
part  of  the  principal,  but  at  her  death  the  entire  sum  is  to  be  paid  to 
certain  named  beneficiaries  of  the  insured. 

Held,  that  the  annual  payment  received  by  C  represents  a  part  of 
the  proceeds  of  an  insurance  policy,  and  is  therefore  exempt  from 
income  tax  in  her  hands.     (C.  B.  3,  page  120;  O.  D.  612.) 

Where  under  a  life  insurance  policy  there  is  payable  to  a  first 
beneficiary  named  6  per  cent  per  annum  of  the  face  value  of  the 
policy  during  the  life,  and,  upon  the  death  of  the  first  beneficiary,  the 
face  value  of  the  policy  is  payable  to  a  second  beneficiary,  the  pay- 
ments to  the  first  beneficiary  are  a  part  of  the  proceeds  of  the  policy 
within  the  meaning  of  section  213  (b)  i  of  the  Revenue  Act  of  1918, 
and  are  not  to  be  included  in  gross  income  for  the  purpose  of  the 
income  tax.     (C.  B.  2,  page  90;  O.  995.) 

Amounts  received  by  an  individual  beneficiary  or  by  the  estate  of 
the  insured  under  the  terms  of  an  ordinary  life,  continuous  installment 
bond  contract  issued  by  a  life  insurance  company  are  exempt  from 
tax  under  the  provisions  of  section  213  (b)  i.  Revenue  Act  of  1918. 
This  applies  not  only  to  the  installment  payments  received  but  also 
to  any  dividends  received  under  the  terms  of  the  bond.  (C.  B.  2, 
page  91;  O.  D.  433.) 

According  to  tlie  nomination  of  the  beneficiary  signed  by  the  in- 
sured the  principal  of  the  policy  is  to  be  held  by  the  insurance  com- 
pany as  trustee  for  the  benefit  of  his  widow  during  her  life  and  upon 
her  death  for  the  benefit  of  his  son  until  he  has  attained  the  age  of 
30  years. 

The  right  of  withdrawal  is  withheld  from  the  widow  during  her 
life  and  his  son  until  he  reaches  the  age  of  30,  unless  the  income  there- 
from for  the  period  of  a  year  falls  below  4^  per  cent  of  the  principal, 
in  which  case  the  beneficiary  has  the  right  to  withdraw  all  that  part 
of  the  principal  on  which  the  beneficiary  may  be  entitled  to  draw 
interest  income. 

Held,  that  any  interest  received  by  the  widow  during  her  life,  or 
by  the  son  prior  to  his  reaching  the  age  of  30,  so  long  as  such  in- 
come is  not  less  than  4I/2  per  cent  of  the  principal,  is  exempt  from 
income  tax.  In  case  the  income  from  the  principal  falls  below  43/2 
per  cent,  the  income  is  taxable  to  the  beneficiary,  regardless  of  whether 
the  principal  is  withdrawn  or  left  in  the  hands  of  the  company,  and 
any  interest  received  thereafter  shall  be  taxable  to  the  beneficiary 


354  INCOME 

whether  more  or  less  than  4^  per  cent  of  the  principal.  The  yearly 
income  from  the  principal  will  be  taxable  to  the  son  upon  his  arriving 
at  the  age  of  30  years.     (  B.  35-21-1790;  O.   D.   loio.) 

The  law  says  "j^rocccds  of  life  insurance  policies'"  are  ex- 
empt. These  interpretations  of  the  Treasury  are  of  interest, 
but  the  courts  may  take  a  different  view. 

When  paid  to  the  insured. — 

Law.     Section  213.    That   ....   the  term  "gross  income"   .... 

(b)   Does   not   include   .... 

(2)  The  amount  received  by  the  insured  as  a  return  of  premium 
or  premiums  paid  by  him  under  life  insurance,  endowment,  or  annuity 
contracts,  either  during  the  term  or  at  the  maturity  of  the  term  men- 
tioned in  the  contract  or  upon  surrender  of  the  contract;   .... 

Dividends  received  on  life  insurance  policies  that  have  not 
matured,  whether  such  dividends  are  drawn  in  cash  by  the 
insured  or  applied  to  the  reduction  of  the  annual  premium 
due,  are  not  considered  items  of  taxable  income  under  the  law 
and  should  be  excluded  from  a  return  of  income.  The  same 
rule  applies  to  dividends  declared  on  endowment  and  other 
policies  until  the  maturity  of  the  contracts. 

Dividends  from  paid-up  policies,  however,  are  considered 
ordinary  dividends,  and  when  the  taxpayer's  net  income  is 
sufficiently  large,  are  subject  to  the  surtax. 

Regulation (b)    During  his   life  only  so  much  of  the 

amount  received  by  an  insured  under  life,  endowment,  or  annuity  con- 
tracts as  represents  a  return,  without  interest,  of  premiums  paid  by 
him  therefor  is  excluded  from  his  gross   income (Art.   72.) 

The  law  does  not  specify  the  method  of  reporting  the 
amount  received  by  the  assured  under  an  endowment  or  can- 
celled policy  in  excess  of  premiums  paid.  As  is  apparent  from 
the  regulations  quoted  above,  the  Treasury  holds  that  the  en- 
tire amount  received  in  excess  of  premiums  paid  is  taxable  in- 
coine  for  the  year  during  which  received.  In  view  of  the  ex- 
pressed purpose  of  the  law  in  other  sections,  that  no  income  or 
gain  which  accrued  prior  to  March  i,  19 13,  is  to  be  taxed, 
it  must  be  assumed  that  the  same  intention  applies  to  this  sec- 


CREDITS    AND    EXEMPT    INCOME 


355 


tion.  Even  if  it  were  not  the  intention,  it  is  not  likely  that  the 
courts  would  uphold  any  attempt  to  tax  amounts  accrued  in 
excess  of  premiums  prior  to  March  i,  191 3.  Therefore  it 
would  seem  to  be  proper  to  value  an  endowment  or  similar 
policy  as  of  March  i,  1913,  and  upon  any  realization  thereof 
account  only  for  the  excess  cash  received  over  the  sum  of  the 
value  at  that  date  and  the  amounts  paid  by  the  policyholder 
between  March  i,  1913,  and  time  of  realization.  It  would  be 
difficult  for  a  policyholder  to  calculate  the  value,  but  the  insur- 
ance company  should  furnish  the  necessary  information. 

Likewise  during  the  years  prior  to  maturity  or  payment, 
if  the  individual  keeps  his  books  upon  the  accrual  basis,  there 
would  seem  to  be  no  objection  to  reporting  each  year's  accrual 
so  that  upon  collection  of  the  principal  sum  there  will  be  no 
necessity  for  reporting  in  one  year  the  entire  excess  above 
premiums  paid.  In  the  case  of  large  endowment  policies  the 
question  is  important. 

Gifts   and  inheritances   exempt."-' — 

Law.     Section  213.    That   ....    the  term  "gross  income" —  .... 

(b)  Does  not  include  the  following  items,  Vi^hich  shall  be  exempt 
from   taxation    under   this   title:   .... 

(3)  The  value  of  property  acquired  by  gift,  bequest,  devise,  or 
descent  (but  the  income  from  such  property  shall  be  included  in 
gross   income),   .... 

Regulation.  Money  and  real  or  personal  property  received  as 
gifts,  or  received  under  a  will  or  under  statutes  of  descent  and  dis- 
tribution, are  exempt  from  tax,  although  the  income  therefrom  de- 
rived from  investment,  sale,  or  otherwi.se  is  not An  amount 

of  principal  paid  under  a  marriage  settlement  is  a  gift (Art. 

7Z-) 

The  foregoing  section  merely  states  that  the  value  of  prop- 
erty ac([uircd  by  gift  need  not  l)e  included  in  gross  income. 
A  lax  on  i)roperty  acquired  l)y  gift  would  ])e  a  ])roperty  tax 
and  could  not  1)e  lield  to  l)c  income  as  income  has  l^een  defined 


""The  iy2i  law  attempts  tn  tax  donees  on  gains  realized  by  sale.  See 
Chapter  XVII.  This  iirovision,  if  valid,  makes  a  radical  change  in  the  con- 
sideration of  gift.s. 


356  INCOME 

by  the  United  States  Supreme  Court,  nor  taxed  as  such,  In 
the  1 92 1  law  appears  for  the  first  time  an  attempt  to  tax  such 
part  of  the  proceeds  of  gifts  as  represents  accrued  gain  at 
the  date  of  the  gift.  It  is  claimed  that  the  gift  itself  is  not 
taxed  but  only  the  untaxed  gain  contained  in  the  gift.  Against 
this  is  the  contention  that  the  imposition  of  a  so-called  income 
tax  on  donees  based  on  a  time  and  a  base  over  which  donees 
have  no  legal  control,  and  usually  no  knowledge  at  all,  is  purely 
and  simply  a  tax  on  the  capital  interest  with  which  donees 
become  seized  at  the  date  of  gift. 

It  should  be  noted  that  no  attempt  is  made  to  tax  gifts  as 
such;  the  tax  referred  to  only  becomes  effective  when,  as  and 
if  donees  sell  or  exchange  the  property  acc[uired  by  gift. 

This  chapter  deals  only  with  exempt  income.  It  may  be 
said  therefore  that,  as  in  all  other  income  tax  laws,  property 
acquired  by  gift  is  exempt  from  the  income  tax. 

If  money  or  other  property  is  acquired  in  a  manner  about 
which  there  is  a  doubt,  the  transaction  may  be  inquired  into. 
If  it  is  determined  that  legal  consideration  is  an  element,  the 
value  of  the  property  may  be  wholly  or  in  part  income,  de- 
pending on  the  circumstances  of  each  case. 

It  is  apparent  that  in  many  cases  the  proper  course  of  ac- 
tion for  the  recipient  of  a  gift  which  might  seem  to  be  some- 
what in  the  nature  of  compensation  for  services  rendered  is 
determined  by  the  action  of  the  person  who  made  the  pay- 
ment. If  the  giver  desires  to  deduct  the  item  as  an  expense, 
the  recipient  can  scarcely  object  to  reporting  any  payment  of 
this  nature  actually  received  as  taxable  income.  Here,  as  in 
so  many  cases,  good  faith  and  a  disposition  to  yield  on  really 
doubtful  points  are  essential  to  the  successful  administration 
of  the  income  tax  law. 

Transactions  in  which  the  element  of  taxability  is  stronger 
than  that  of  exemption  are  discussed  in  the  appropriate  chap- 
ters dealing  with  income   from  services,  gains  or  sales,   etc. 


CREDITS   AND   EXEMPT    INCOME  357 

Gifts  which  have  been  held  to  contain  no  element  of  taxable 
income  are  illustrated  Ijy  the  following  rulings. 

Ruling.  Personal  transportation  passes  issued  by  a  railroad  com- 
pany, to  its  employees  and  their  families,  to  be  used  when  not  engaged 
on  business  for  the  company,  and  which  are  not  provided  for  in  the 
contracts  of  employment,  are  considered  gifts  and  the  value  thereof 
does  not  constitute  taxable  income  to  the  employees.  (C.  B.  4,  page 
no;  O.  D.  946.) 

Ruling.  Held,  that  the  question  as  to  whether  a  gift  from  hus- 
band to  wife  is  bona  fide  must  be  considered  in  the  light  of  the  intent 
of  the  donor,  from  all  available  facts,  and  that  where  a  transfer  is 
made  by  unconditional  endorsement  of  securities,  failure  to  record 
the  transfer  on  the  books  of  the  corporations  and  the  deposit  of  in- 
come from  such  securities  in  a  joint  account,  are  not  conclusive  that 
the  gift  was  colorable.     (C.  B.  4,  page  107;  A.  R.  R.  367.) 

Colorable  gifts. — It  is  reasonable  to  insist  that  gifts  must 
be  irrevocable  and  bona  fide  in  order  that  subsequent  realized 
gains  or  income  will  be  taxed  to  the  donees  instead  of  to  the 
donors.  Usually  the  element  of  consideration  controls.  Where 
there  is  no  family  relation  (where  the  consideration  of  "love 
and  affection"  is  sufficient)  it  should  be  shown  that  the  con- 
sideration is  reasonable. 

In  the  case  of  bequests  the  element  of  consideration  does 
not  enter,  and  no  attempt  has  been  made  to  tax  as  income 
property  acquired  by  bequest. 

Ruling.  The  following  rules  should  be  followed  by  the  Bureau 
of  Internal  Revenue  in  distinguishing  a  case  of  an  actual  gift  and  a 
case  of  a  merely  colorable  gift : 

(a)  Where  it  appears  that  the  owner  of  property  has  purported 
to  transfer  it  without  consideration  to  a  member  of  his  own  family,  or 
to  any  other  person  with  whom  he  is  in  confidential  relations,  and 
that  shortly  thereafter  a  profitable  sale  of  the  security  or  property 
so  transferred  has  occurred,  such  facts  constitute  prima  facie  evi- 
dence that  the  purported  gift  was  not  an  actual  gift  and  that  the 
transfer  was,  in  fact,  merely  colorable.  In  such  case  the  so-called 
gift  should  be  ignored  in  calculating  tax,  and  the  case  should  be 
investigated  for  evidence  on  which  a  charge  of  fraud  could  be  sup- 
ported in  a  contest. 


358 


INCOME 


(b)  The  prima  facie  case  made  out  by  the  facts  mentioned  in 
the  preceding  paragraph  may  be  rebutted  by  proof  which  establishes 
that  it  was  not  a  transaction  primarily  for  the  advantage  of  the  donor, 
and  that  there  was  no  agreement  or  understanding,  tacit  or  other- 
wise, that  the  donor  was  to  receive  back  the  proceeds  or  at  any  time 
control  their  disposition.  Mere  statements  by  the  parties  to  the  effect 
that  the  gift  was  genuine  are  regarded  as  of  little  weight;  the  best 
proof  that  a  gift  was  a  real  gift  would  consist  of  facts  showing  that 
the  position  or  relationship  of  the  parties  is  such  as  to  show  a  rea- 
sonable occasion  for  such  a  gift  being  made,  and  such  as  to  explain 
the  sale  by  the  donee.  Inquiry  should  be  made  as  to  the  disposition 
of  the  proceeds. 

(c)  Where  a  taxpayer  purports  to  make  a  gift  to  a  member  of 
his  family  or  to  a  person  in  a  confidential  relation  to  himself,  but  no 
sale  occurs,  the  question  whether  such  gift  was  real  or  merely  color- 
able is  one  to  be  decided  on  all  of  the  facts.  The  mere  fact  that 
such  conveyance  is  made  may  not  lawfully  be  regarded  as  proof  of 
fraud;  but  if  the  effect  of  the  gift  is  to  diminish  tax  liability,  and  it 
appears,  either  at  the  time  of  the  gift  or  at  any  time  thereafter,  that 
the  donor  is  deriving  advantage  from  the  property  which  he  purported 
to  give  away,  such  facts  constitute  prima  facie  evidence  that  the 
gift  was  only  colorable  and  the  transaction  should  be  treated  as  a 
nullity  unless  other  facts  are  developed  which  show  that  it  was  a 
true  gift.  If  such  a  gift  is  colorable  only  and  made  for  the  purpose 
of  escaping  tax,  the  donor  is  guilty  of  fraud  and  subject  to  penalty 
and  punishment  therefor.     (  C.  B.  i,  page  83;  S.  1022.) 

The  foregoing  is  clear  and  reasonable.  There  is  no  indica- 
tion of  an  intention  to  tax  the  proceeds  of  sales  by  donees  when 
the  gifts  are  bona  fide. 

An  attempt  was  made  in  January,  1921,^'  to  obviate  the 
tax  evasion  made  possible  because  of  the  ''colorable  gifts" 
referred  to  above.  The  bill  in  question  was  not  passed  at  the 
time  but  has  been  enacted  in  substance  into  the  192 1  law.''^ 

The  same  difficulty  was  faced  by  New  York  State  under 
its  personal  income  tax  law.  An  attempt  was  made  to  tax  to 
the  donor  the  appreciation  in  value  at  the  time  of  gift,  but 
the  attempt  was  held  to  be  unconstitutional.^^ 


''  H.  R.  14198. 

'""Section  202   (a-2).  see  Chapter  X\"II. 

"'People  c.v  rel.  Wilson  v.  iVcndcU.  188  N.  Y.  Snpp.  272^  People  ex  rel. 
Brewster  v.  Wendell,  188  N.  Y.  Supp.  510. 


CREDITS    AND   EXEMPT    INCOME  359 

When  a  so-called  pension*"  is  a  gift. — 

Rulings.  The  terms  "pension"  and  "gift"  are  not  nnitually  ex- 
clusive.    A  payment  may  be  both  a  pension  and  a  gift. 

When  a  pension  is  given  by  one  for  whom  services  are  per- 
formed in  consideration  of  such  services,  even  though  it  be  granted 
after  the  services  have  been  rendered,  the  pension  is  not  a  gift  but  in 
the  nature  of  additional  compensation. 

When,  however,  so-called  pensions  are  awarded  by  one  to  whom 
no  services  have  been  rendered,  such  payments  become  mere  gifts  or 
gratuities  and  do  not  constitute  taxable  income.  Payments  by  the 
Carnegie  Foundation  for  the  Advancement  of  Teaching,  made  to 
teachers  and  the  widows  of  teachers,  fall  into  the  latter  class.  Law 
opinion  560  is  modified  to  conform  hereto.  (C.  B.  2,  page  Jt,;  O.  D. 
361,  overruled.)      (C.  B.  3,  page  120;  L.  O.  1040.) 

A  corporation  paid  to  the  widow  of  a  deceased  officer  a  certain 
amount  equal  to  the  salary  he  would  have  earned  in  two  months. 
The  payment  was  without  consideration,  a  gratuity  voted  as  a  com- 
pliment to  the  deceased.  It  is  held  that  the  payment  does  not  con- 
stitute taxable   income.      (B.   36-21-1798;    O.    D.    10 17.) 

Interest  which  is  exempt  from  both  normal  and  surtaxes. — 

Law.     Section  213.    That   ....   the  term  "gross  income" —  .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from   taxation    under   this   title:  .... 

(4)  Interest  upon  (a)  the  obligations  of  a  State,  Territory,  or 
any  political  subdivision  thereof,  or  the  District  of  Columbia  ;^i  or 
(b)  securities  issued  under  the  provisions  of  the  Federal  Farm  Loan 
Act  of  July  17,  1916,^-  or  (c)  the  obligations  of  the  United  States  or 
its  possessions;  or  (d)  bonds  issued  by  the  War  Finance  Corpora- 
tion. In  the  case  of  obligations  of  the  United  States  issued  after  Sep- 
tember I,  1917  (other  than  postal  savings  certificates  of  deposit),  and 
in  the  case  of  bonds  issued  by  the  War  Finance  Corporation,  the  in- 
terest shall  be  exempt  only  if  and  to  the  extent  provided  in  the  respec- 
tive Acts  authorizing  the  issue  thereof  as  amended  and  supplemented, 
and  shall  be  excluded  from  gross  income  only  if  and  to  the  extent  it  is 
wholly  exempt  from  taxation  to  the  taxpayer  from  income,  war-profits 
and  excess-profits  taxes;  .... 


*"  Military  and  naval  pensions  from  the  United  States  are  now  exempt 
[section  213    (9).]      See  page  351. 

"  [Former  Procedure]  The  words  "Territory"  and  "District  of 
Columbia"  were  specifically  included  for  the  first  time  in  the  1918  law. 
Under  the  igi6  law  the  word  "State"  was  defined  to  "include  any  Terri- 
tory, the  District  of  Columbia,"  etc.,  "when  such  construction  is  necessary 
to  carry  out  its  provisions."     (1Q16  law,  section   15.) 

"  [Former  Procedure]  This  clause  was  introduced  i)y  the  1916  law 
(section  4). 


360  INCOME 

Regulation.  Among  income  exempt  from  tax  is  interest  upon 
the  obligations  of  a  State,  Territory,  or  any  political  subdivision 
thereof,  or  the  District  of  Columbia.  Obligations  issued  for  a  public 
purpose  by  or  on  behalf  of  the  State  or  Territory  or  a  duly  organized 
political  subdivision  acting  by  constituted  authorities  duly  empowered 
to  issue  such  obligations,  are  the  obligations  of  a  State  or  Territory 
or  a  political  subdivision  thereof.  The  term  "political  subdivision" 
denotes  any  division  of  the  State  or  Territory  made  by  the  proper 
authorities  thereof  acting  within  their  constitutional  powers  for  the 
purpose  of  carrying  out  a  portion  of  those  functions  of  the  State  or 
Territory  which  by  long  usage  and  the  inherent  necessities  of  gov- 
ernment have  always  been  regarded  as  public.  Political  subdivisions 
of  a  State  or  Territory,  within  the  meaning  of  the  exemption,  include 
special  assessment  districts  so  created,  such  as  road,  water,  sewer, 
gas,  light,  reclamation,  drainage,  irrigation,  levee,  school,  harbor, 
port  improvement,  and  similar  districts  and  divisions  of  a  State  or 
Territory.  The  purchase  by  a  State  of  property  subject  to  a  mort- 
gage executed  to  secure  an  issue  of  bonds  does  not  render  the  bonds 
obligations  of  the  State,  and  the  interest  upon  them  does  not  become 
exempt  from  taxation,  whether  or  not  the  State  assumes  the  payment 
of  the  bonds.     (Art.  74.) 

The  precise  degree  to  whidi  the  interest  on  the  various 
issues  of  United  States  bonds  is  exempt  from  taxation  is  fully 
treated  in  Chapter  XIX.  "Income  from  Interest."  Suffice 
it  here  to  say  that  the  only  totally  exempt  securities  are  state 
and  municipal  bonds  of  any  date,  farm  loan  bonds,  United 
States  securities  issued  prior  to  September  i,  1917,  the  3f 
per  cent  securities  of  the  Victory  Loan,  and  obligations  of 
possessions  of  the  United  States.  Totally  tax-exempt  interest 
need  not  be  included  in  "gross  income"'  at  all.  The  1918  law 
for  the  first  time  required,  purely  for  information  purposes, 
a  statement  concerning  the  taxpayer's  holdings  of  such  se- 
curities.    The  present  law  omits  this  requirement. 

Rulings.  Interest  received  on  certificates  of  indebtedness  known 
as  "Fire  relief  certificates"  issued  in  the  State  of  Minnesota,  is  con- 
sidered interest  upon  the  obligations  of  a  State  and  therefore  not 
taxable.     (C.  B.  i,  page  83;  O.  D.  30.) 

Certificates  of  sale  issued  by  a  county  or  other  political  subdivision 
of  a  State  in  connection  with  the  sale  of  property  for  nonpayment  of 
taxes  do  not  fall  within  that  class  of  obligations  of  a  State,  county, 
or  municipality,  the  income  from  which  is  exempt  from  Federal  in- 
come tax.     (C.  B.  I,  page  83;  O.  D.  327.) 


CREDITS   AND   EXEMPT    INCOME  361 

Interest  on  promissory  notes  of  a  political  subdivision  of  a  State 
or  Territory  is  exempt  from  tax  under  section  213  (b)  4  of  the  Reve- 
nue Act  of  1918.     (C.  B.  4,  page  no;  O.  D.  817.) 

A  municipality  borrows  money  from  a  bank,  issuing  to  the  bank 
its  promissory  notes  at  a  discount.  It  is  provided  that  if  the  notes  are 
not  paid  when  due,  they  will  also  draw  interest  from  maturity  until 
paid. 

Held,  that  both  the  discount  and  the  interest  on  the  notes  after 
maturity  are  exempt  from  income  and  profits  taxes  in  the  hands  of 
the  bank.     (C.  B.  4,  page  no;  O.  D.  856.) 

Interest  paid  by  the  contractor  on  funds  advanced  by  a 
bank  on  certificates  of  indebtedness  of  a  municipality,  and 
discount  charged  by  the  bank  for  cashing  such  certificates,  are 
deductible  from  gross  income.*^ 

Rulings.  The  interest  received  upon  Philippine  4  per  cent  bonds 
of  1914-34  is  exempt  from  the  taxes  imposed  by  the  Revenue  Act  of 
1918.     (C.  B.  4,  page  in;  O.  D.  922.) 

Where  the  executors  under  a  will  hold  property  specifically  be- 
queathed to  a  governmental  agency  of  a  State,  and  other  assets  of 
the  decedent's  estate  are  sufficient  to  pay  all  debts,  income  received 
by  the  executors  during  the  period  of  administration  from  such 
property  is  not  taxable  in  the  hands  of  the  executors  under  section 
2  (b)  of  the  Act  of  1916.    (C.  B.  2,  page  96;  S.  1374.) 

In  the  ruHng  last  quoted  the  question  at  issue  was  the  taxa- 
bility of  income  from  property  specifically  bequeathed  to  a 
state  university,  but  still  held  by  the  executors  during  the 
period  of  administration. 

Certain  dividends  exempt  from  both  normal  and  sur- 
taxes.— 

Federal  land  bank  and  farm  loan  association  divi- 
dends EXEMPT. 

Regulation.  As  section  26  of  the  Federal  Farm  Loan  Act  of 
July  17,  1916,  provides  that  every  federal  land  bank  and  every  na- 
tional farm  loan  association,  including  the  capital  and  reserve  or  sur- 
plus therein  and  the  income  derived  therefrom,  shall  be  exempt  from 
taxation,  except  taxes  upon  real  estate,  and  that  farm  loan  bonds, 
with  the  income  therefrom,  shall  be  exempt  from  taxation,  the  in- 
come derived   from   dividends   on   stock   of   federal   land  banks  and 


'■'B.  Digest  34-21-1778;  O.  D.  999. 


362 


INCOME 


national  farm  loan  associations  and  from  interest  on  such  farm  loan 
bonds  is  not  subject  to  the  income  tax (Art.  75.) 

Federal  reserve  bank  dividends. — 

Regulation.  As  section  7  of  the  Federal  Reserve  Act  of  Decem- 
ber 23,  1913,  provides  that  federal  reserve  banks,  including  the  capital 
stock  and  surplus  therein  and  the  income  derived  therefrom,  shall  be 
exempt  from  taxation,  except  taxes  upon  real  estate,  such  exemption 
attaches  to  and  follows  the  income  derived  from  dividends  on  stock  of 
.federal  reserve  banks  in  the  hands  of  the  stockholders,  so  that  the  divi- 
dends received  on  the  stock  of  federal  reserve  banks  are  not  subject  to 
the  income  tax.  Dividends  paid  by  member  banks,  however,  are 
treated  like  dividends  of  ordinary  corporations.      (Art.  76.) 

Compensation  for  active  war  service  exempt.** — No  exemp- 
tion for  war  service  is  allowed  under  the  192 1  law.  The 
exemption  allowed  under  the  1918  law  expired  automatically 
with  the  Joint  Resolution  of  Congress  dated  March  3,  192 1. 
The  period  of  its  effectiveness  extended  from  January  i,  19 18, 
to  March  3,   1921.*^ 

Dividends  and  interest  from  domestic  building  and  loan 
associations. — The  exemption,  under  the  192 1  law,  of  dividends 
and  interest  from  domestic  building  and  loan  associations  to  a 
maximum  of  $300  per  annum,  is  entirely  new. 

Law.     Section  213.     That  ....  the  term  "gross  income" —  .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from   taxation    under   this   title:  .... 

(10)  So  much  of  the  amount  received  by  an  individual  after  De- 
cember 31,  1921,  and  before  January  i,  1927,  as  dividends  or  interest 
from  domestic  building  and  loan  associations,  operated  exclusively 
for  the  purpose  of  making  loans  to  members,  as  does  not  exceed 
$300;  .... 

The  ambiguity  in  the  amount  of  the  exemption  is  discussed 
in  Chapter  XIX. 

Rental  value  of  minister's  house  not  taxable. — 

Law.     Section  213.     That  ....  the  term  "gross  income" —  .... 


^*  Income  Tax  Procedure,  1921,  page  51  ct  seq.     The  exemption  did  not 
apply  to  the  Public  Heahh  Service   (B.  47-21-1932;  T.  D.  3242). 
"  C.  B.  4.  page  112;  O.  D.  900. 


CREDITS  .AND    EXEMPT    INCOME  363 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from   taxation   under   this   title:.  .  .  . 

(11)  The  rental  value  of  a  dwelling  house  and  appurtenances 
thereof  furnished  to  a  minister  of  the  gospel  as  part  of  his  compen- 
sa'ion;  .... 

This  provision  removes  an  anomaly  that  existed  in  the 
1918  law  under  which  compensation  received  in  this  form 
was  taxable.  Under  the  latter  circumstances  the  property  of 
an  exempt  body,  a  corporation  operated  exclusively  for  re- 
ligious purposes,  was  indirectly  taxed. 

Shipowners'  mutual  protection  and  indemnity  associa- 
tions.— 

Law.     Section  213.     That  ....  the  term  "gross  income" —  .... 
(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title:  .... 

(12)  The  receipts  of  shipowners,  mutual  protection  and  indemnity 
associations,  not  organized  for  profit,  and  no  part  of  the  net  earnings 
of  which  inures  to  the  benefit  of  any  private  stockholder  or  member, 
but  such  corporations  shall  be  subject  as  other  persons  to  the  tax 
upon  their  net  income  from  interest,  dividends,  and  rents 

The  exemption  of  premiums  collected  and  received  by  ship- 
owners' mutual  protection  and  indemnity  associations  is  in- 
cluded for  the  first  time  in  the  1921  law.  Mutual  marine  in- 
surance companies,  as  such,  receive  certain  exemptions.*''  The 
above  specific  provision  brings  shipowners  into  line  with 
farmers  and  other  purely  local  organizations  wherein  protec- 
tion is  sought  without  any  design  to  secure  other  monetary 
benefits  to  the  members. 

Bonus  from  state  not  taxable. — 

Ruling.  A  bonus  paid  by  a  State  to  its  residents  who  served  in 
the  military  or  naval  forces  during  the  war  with  Germany  does  not 
constitute  taxable  income  to  the  recipient.  (C.  B.  i,  page  83;  O.  D. 
286. ) 

The  exemption  is  based  on  the  ground  that  the  bonus  is  a 
gift. 


"Sec  Chapter  XXXVIII. 


364 


INCOME 


Income  of  foreign  governments  exempt. — 

Law.     Section  J 13.  That  ....  the  term  "gross  income"—  .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from   taxation  under   this    title:  .... 

(5)  The  income  of  foreign  governments  received  from  investments 
in  the  United  States  in  stocks,  bonds,  or  other  domestic  securities,  owned 
by  such  foreign  governments,  or  from  interest  on  deposits  in  banks  in 
the  United  States  of  moneys  belonging  to  such  foreign  governments,  or 
from  any  other  source  within  the  United  States;  .... 

Regulation.  The  exemption  of  income  of  foreign  governments 
applies  also  to  their  political  subdivisions.  Any  income  collected  by 
foreign  governments  from  investments  in  the  United  States  in  stocks, 
bonds,  or  other  domestic  securities,  which  are  not  actually  owned  by 

but  are  loaned  to  such  foreign  governments,  is  subject  to  tax 

(Art.  86.) 

This  article  was  heretofore  niinil)ered  83. 

Ruling.  Income  derived  by  a  foreign  corporation  from  sources 
within  the  United  States  is  subject  to  Federal  tax,  regardless  of  the 
fact  that  51  per  cent  of  its  stock  is  owned  by  a  foreign  Government. 
If  such  income  comes  within  the  classes  contemplated  by  sections 
221  and  237,  it  is  subject  to  withholding.  (C.  B.  4,  page  iii;  O.  D, 
958.) 

The  term  "foreign  government"  as  defined  in  article  382 
(see  ChapterXXVIII)  excludes  cities  such  as  Montreal  and 
Paris,  and  it  would  follow  that  any  income  derived  in  the 
United  States  by  such  cities  would  be  subject  to  tax.  The  au- 
thor believes  that  the  Treasury's  definition,  in  this  case,  is  not 
in  accord  with  the  law. 

Income  of  foreign  ambassadors  and  ministers. — 

Regulation The     income     from     investments     in     the 

United  States  in  bonds  and  stocks  and  from  interest  on  bank  balances 
received  by  ambassadors  and  ministers  accredited  to  the  United  States 
and  the  fees  of  foreign  consuls,  are  exempt  from  tax,  but  income  of 
such  foreign  officials  from  any  business  carried  on  by  thein  in  the 
United  States  would  be  taxable.  As  under  international  law  the 
benefits  and  immunities  of  ambassadors  and  ministers  of  foreign 
countries  extend  to  the  members  of  their  households,  including  at- 
taches, secretaries,  and  servants,  the  foregoing  provision  is  likewise 
applicable  to  the  wives  and  minor  children  of  foreign  ambassadors  and 
ministers  and  the  members  of  tlieir  households.     The  compensation 


CREDITS    AND   EXEMPT    INCOME  365 

of  citizens  of  the  United  States  who  are  officers  or  employees  of  a 
foreign  government  is,  however,  not  exempt  from  tax.  (Art.  86; 
Reg.  45.  Art.  83.) 

The  authority  for  this  exemption  is  not  found  in  the  \a.w. 
If  the  ambassadors,  ministers  and  consuls  were  abroad,  their 
income  from  the  United  States  from  the  sources  mentioned 
would  be  subject  to  withholding.  It  is  not  clear  why  the 
usual  "courtesy"  exemption  from  personal  taxes,  such  as  cus- 
toms duties,  should  be  extended  to  withholding  on  account  of 
income  taxes. 

As  an  embassy  is  deemed  to  be  foreign  soil,  those  who 
reside  in  it  should  be  taxed  as  if  they  were  actually  on  foreign 
soil.  If  Great  Britain  followed  our  practice  an  ambassador 
from  the  United  States  to  Great  Britain  would  be  exempt 
from  British  income  tax  on  his  investments  in  that  country. 

Ruling.  Only  foreign  diplomats,  ambassadors,  and  other  diplo- 
matic representatives  in  charge  who  are  accredited  to  the  United 
States  to  represent  their  sovereign  or  country  and  who  reside  here, 
and  the  members  of  their  staff  are  entitled  to  exemption  from  tax  on 
income  from  investments  in  bonds  and  stocks  and  from  interest  on 
bank  balances.  Foreign  consuls  resident  in  the  United  States  are 
not  entitled  to  the  exemption.     (C.  B.  i,  page  91;  O.  D.  336.) 

Although  formerly  ruled  to  the  contrary,'*^  the  privileges 
afforded  foreign  diplomatic  officers  have  been  extended  to 
emijrace  their  wives  and  minor  children.''® 

Compensation  of  the  President  and  United  States  judges 
no  longer  exempt. — The  exemptions  specifically  provided  in 
the  law  are  all  covered  by  the  foregoing  sections.  It  should 
be  particularly  noted,  however,  that  the  exemption  formerly 
extended  to  the  compensation  of  the  President  of  the  United 
States  and  United  States  judges  is  no  longer  contained  in 
the  law.  On  the  contrary,  the  salaries  of  the  President  and 
United  States  judges  are  definitely  declared  to  be  taxable. 
Other  federal  employees  continue  to  be  taxable  as  formerly. 


^'C.  B.  I,  page  90;  O.  D.  153. 
"Bulletin  48-21-1945;  O.  D.  11 15. 


366  INCOME 

Article  32  of  the  regulations  provides  that  the  President 
and  federal  judges  are  not  suljject  to  a  new  tax  or  an  increased 
tax  if  elected  or  appointed  to  office  prior  to  the  passage  of  the 
law. 

\\  hile  the  Supreme  Court  has  decided"''''  that  the  salaries  of 
federal  judges  and  the  President  of  the  United  States  could 
not  be  taxed  because  the  federal  constitution  prohibited  any 
diminution  of  such  salaries  during  continuance  in  office,  the 
Attorney  General  in  an  opinion  dated  June  21,  1920,^°  stated 
he  was  "unable  to  see,  ....  that  there  is  anything  in 
the  recent  opinion  of  the  Supreme  Court  which  relieves  a 
judge  appointed  since  the  enactment  of  tJie  income  tax  law 
from  paying  the  tax  imposed  by  that  law."  This  is  further 
discussed  in  (  hapter  XI\". 

Compensation  of  state  and  municipal  employees  exempt. — 

Regula'iiox.  Compensation  paid  its  officers  and  employees  by 
a  State  or  political  subdivision  thereof,  including  fees  received  by 
notaries  public  commissioned  by  States  and  the  commissions  of  re- 
ceivers appointed  by  State  courts,  is  not  taxable.  Compensation  re- 
ceived for  services  rendered  to  a  State  or  political  subdivision  thereof 
is  included  in  gross  income  unless  the  person  receives  such  compen- 
sation as  an  officer  or  employee  of  a  State  or  political  subdivision. 
An  officer  is  a  person  who  occupies  a  position  in  the  service  of  the 
State  or  political  subdivision,  the  tenure  of  which  is  continuous  and 
not  temporary  and  the  duties  of  which  are  established  by  law  or 
regulations  and  not  by  agreement.  An  employee  is  one  whose  duties 
consist  in  the  rendition  of  prescribed  services  and  not  the  accom- 
plishment of  specific  objects,  and  whose  services  are  continuous,  not 
occasional  or  temporary.  Employees  of  universities  receiving  salaries 
paid  in  part  or  in  whole  from  funds  available  under  the  Smith-Lever 
Act  of  May  8,  1914,  who  are  officers  or  employees  of  a  State,  are 
not  required  to  return  as  taxable  incomes  the  salaries  so  received. 
This  is  also  true  with  respect  to  the  act  of  August  30,  1890,  relating 
to  colleges  for  the  benefit  of  agriculture  and  the  mechanic  arts,  and 
to  the  act  of  ]\Iarch  2,  1887,  relating  to  agricultural  experiment  sta- 
tions in  such  colleges (Art.  88.) 

This  article  was  heretofore  numbered  85.     The  new  article 


'"  Ez'ans  7'.  Gore,  253  U.  S.  245;  64  L.  Ed.  887;  40  Sup.  Ct.  550. 
'"'32  Op.  Att.  Gen.  248. 


CREDITS    AND    EXEMPT    INCOME  367 

contains  a  definition  of  a  state  officer  which  did  not  appear 
in  Regulations  45. 

On  May  6,  19 19.  tlie  .Attorney  General  rendered  an  ojjinion 
that  "salaries  of  state  officials  and  salaries  and  wages  of  em- 
ployees of  a  state  are  not  subject  to  the  income  tax  imposed 
by  the  said  Revenue  Act  of  1918."^^ 

The  author's  understanding  of  the  intention  of  the  fram- 
ers  of  the  1918  law  is  that  state  employees  were  to  be  taxed. 
But  in  view  of  the  foregoing  ruling  there  will,  of  course,  be 
no  judicial  interpretation  of  the  law. 

Rulings.  The  compensation  received  by  the  employees  of  a  cer- 
tain public  library,  a  corporation,  is  not  exempt  from  taxation,  al- 
though the  salaries  and  other  principal  expenses  of  the  corporation 
are  paid  out  of  money  appropriated  by  the  State  or  city  and  the  power 
of  appointment  and  removal  of  the  employees  is  exercised  by  the 
board  of  directors,  three  of  whom  are  officials  of  the  city  and  two 
of  the  remaining  directors  are  appointed  by  the  mayor.  (B.  Digest 
28-21-1725;  O.   D.  973.) 

Salaries  paid  to  teachers  are  exempt  from  income  tax  only  where 
the  educational  institution  is  maintained  wholly  by  the  State,  and  the 
relation  of  employer  and  employee  exists  between  the  State  and  the 
teacher.  They  are  not  exempt  merely  because  engaged  in  educational 
work,  nor  because  thev  are  pensioned  bv  the  State.  (C.  B.  i,  page 
93;  O.  826.) 

This  subject  is  further  discussed  in  Chapter  XIV. 

Alimony  not  taxable. — Although  not  one  of  the  specified 
exemptions,  it  is  important  to  note  here  that  a  person  receiv- 
ing alimony  need  not  take  it  into  account  at  all  in  making  an 
income  tax  return.  Reversing  former  procedure,'^"  the  Su- 
preme Court  of  the  United  States'^^"  in  191 7  held  that  alimony 
is  not  to  be  considered  income  to  the  recipient,  nor  an  item  of 
deductible  expense  to  the  payer.  This,  of  course,  is  tlie  final 
word  on  the  subject. 


"'' T.  D.  2843,  May  17,  1919. 

'"  [Former  Procedurel  T.  D.  2090  (December  14,  1914)  held  that 
alimony  was  a  personal  expense,  not  deductible  by  the  ])erson  paying  but 
taxable  to  the  iicrson  receiving,  (he  tax  being  subject  to  withholding  at 
the  source. 

™  GomW  v.  Gould,  245  U.  S.  151  :  62  L.  L-id.  211  ;  38  Sup.  Ct.  33  (Reg.  ^3. 
1918,  Art.  4). 


368  INCOME 

Regulation Neither  alimony  nor  an  allowance  based  on 

a  separation  agreement  is  taxable  income (Art.  y2)-) 

Territorial  Exemptions 

The  1918  income  tax  applies,  first,  to  individual  citizens  and 
residents  of  the  United  States  and  to  domestic  corporations 
(those  created  or  organized  within  the  United  States)  and, 
second,  to  non-resident  alien  individuals  and  to  foreign  cor- 
porations so  far  as  their  income  arises  from  sources  within 
the  United  States.  A  person  whose  stay  in  the  United  States 
is  only  temporary  is  not  considered  a  resident. 

The  law  states  that  "the  term  'United  States'  when  used 
in  a  geographical  sense  includes  only  the  States,  the  Territories 
of  Alaska  and  Hawaii,  and  the  District  of  Columbia"  (sec- 
tion I ) .  This  definition,  it  will  be  noted,  does  not  include 
Porto  Rico  or  the  Philippine  Islands,^*  where  the  1916  revenue 
law  is  still  in  force  (1921  law,  section  261). 

Regulation,  (o)  A  citizen  of  the  United  States  who  resides  in 
Porto  Rico,  and  a  citizen  of  Porto  Rico  who  resides  in  the  United 
States,  are  taxable  in  both  places,  but  the  income  tax  in  the  United 
States  is  credited  with  the  amount  of  any  income,  war  profits,  and 

excess  profits  taxes  paid  in  Porto  Rico (&)   A  resident  of 

the  United  States,  who  is  not  a  citizen  of  Porto  Rico,  is  taxable  in 
Porto  Rico  as  a  nonresident  alien  individual  on  any  income  derived 
from  sources  within  Porto  Rico,  but  the  income  tax  in  the  United 
States  is  credited  with  the  tax  paid  in  Porto  Rico,  (c)  A  resident 
of  Porto  Rico,  who  is  not  a  citizen  of  the  United  States,  is  taxable 
in  the  United  States  as  a  nonresident  alien  individual  on  any  income 
derived  from  sources  within  the  United  States,  and  receives  no  such 
credit The  same  principles  apply  in  the  case  of  the  Philip- 
pine Islands.     (Art.  1132.) 


"  [Former  Procedure]  The  1916  law  states  "that  the  word  'state'  or 
'United  States'  when  used  in  this  title  shall  be  construed  to  include  any 
territory,  the  District  of  Columbia,  Porto  Rico,  and  the  Philippine  Islands, 
when  such  construction  is  necessary  to  carry  out  its  provisions"  (section 
15).  The  1917  law  imposing  the  war  income  tax  did  not  extend  to  Porto 
Rico  and  the  Philippines,  as  is  shown  by  the  following  section :  "That  the 
provisions  of  this  title  shall  not  extend  to  Porto  Rico  or  the  Philippine 
Islands,  and  the  Porto  Rican  or  Philippine  Legislature  shall  have  power 
by  due  enactment  to  amend,  alter,  modify  or  repeal  the  income  tax  laws 
in  force  in  Porto  Rico  or  the  Philippine  Islands  respectively." 

The  1918  law  continued  this  provision. 


CREDITS    AND   EXEMPT    INCOME  369 

The  same  principle  applies  in  the  case  of  corporations 
similarly  situated  (article  1133). 

It  is  to  be  noted  that  under  the  provisions  of  an  Act  of 
Congress,  known  as  "An  Act  making  appropriations  for  the 
naval  service  for  the  fiscal  year  ended  June  30,  1922,  and  for 
other  purposes,"^^  it  was  "Provided  further,  That  the  income 
tax  laws  now  in  force  in  the  United  States  of  America  and 
those  w'hich  may  hereafter  be  enacted  shall  be  held  to  be  like- 
wise in  force  in  the  Virgin  Islands  of  the  United  States,  ex- 
cept that  the  proceeds  of  such  taxes  shall  be  paid  into  the 
treasuries  of  said  islands."  This  act  has  been  ratified  and 
confirmed  from  and  including  July  i,  1921. 

Exemption  of  profits  from  sales  of  vessels. — The  pro- 
vision in  the  Merchant  Marine  Act  of  1920''"  exempting 
for  ten  years  from  tax  the  gains  arising  from  the  proceeds 
of  certain  vessels  referred  specifically  to  the  taxes  im- 
posed by  the  Revenue  Act  of  1918.  Of  course,  the  "Revenue 
Act  of  1921"  is  not  the  "Revenue  Act  of  1918,"  but  as  the 
Merchant  Marine  Act  is  still  in  force  and  -as  the  exemption 
was  to  be  for  ten  years,  it  should  be  held  that  the  gains  to  be 
exempted  are  the  same  as  those  imposed  by  the  Act  of  1918 
and  that  full  exemption  should  be  granted  for  the  ten-year 
period.  In  any  event,  the  exemption  is  applicable  for  the 
year  1921. 

The  Treasury  has  held  that  the  sale  of  the  entire  capital 


'"'  Public  Law,  No.  35,  67th  Congress. 
^  [Former  Procedure] 

Law.  "That  during  the  period  of  ten  years  from  the  enactment  of  this 
Act  any  person  a  citizen  of  the  United  States  who  may  sell  a  vessel  docu- 
mented under  the  laws  of  the  United  States  and  built  prior  to  January  i, 
1914,  shall  be  exempt  from  all  income  taxes  that  would  be  payable  upon 
any  of  the  proceeds  of  such  sale  under  Title  I,  Title  II  and  Title  III  of  the 
Revenue  Act  of  1918  if  the  entire  proceeds  thereof  shall  be  invested  in  the 
building  of  new  ships  in  American  shipyards,  such  ships  to  be  documented 
under  the  laws  of  the  United  States  and  to  be  of  a  type  approved  by  the 
board  [i.  e.,  the  United  States  Shipping  Board  provided  for  by  Section  3  of 
the  Act.] 

"  'Merchant  Marine  Act,  1920,'  of  which  the  above  is  the  second  para- 
graph of  Section  23,  approved  by  the  President,  June  5,  1920.  (Merchant 
Marine  Act,  1920,  section  23,  paragraph  2.)" 


370  INCOME 


Stock  of  a  company  owning  ships,  even  though  the  proceeds 
of  such  sale  were  reinvested  in  American  ships,  could  not 
be  brought  within  the  privileges  of  the  act  on  the  ground  that 
the  law  specifically  provides  that  the  exemption  applies  only 
to  the  sale  of  ships. 


CHAPTER    XIII 

INCOME  IN  GENERAL 

Plan  of  treatment. — 'The  following  chapters  discuss  in 
detail  the  various  types  of  income  subject  to  the  income  tax. 
Income  from  personal  services,  business,  property,  interest, 
rents,  dividends,  etc.,  are  taken  up  in  regular  order  and  the 
procedure  peculiar  to  them  is  explained.  However,  in  addi- 
tion to  these  particular  subjects  there  are  many  questions  which 
are  general  in  their  nature  and  application.  These  are  brought 
together  for  treatment  in  this  introductory  chapter. 

Variations  according  to  class  of  taxpayer. — It  should  be 
observed  that,  in  the  absence  of  an  indication  to  the  contrary, 
statements  made  in  the  text  are  to  be  accepted  as  applicable 
to  corporations  and  individuals  alike.  So  much  of  the  pro- 
cedure applies  to  all  classes  of  taxpayers  that  it  has  been 
deemed  desirable  to  isolate  only  the  exceptional  points,  indicat- 
ing plainly  in  such  cases  the  limitations  upon  the  application. 

It  is  almost  impossible  to  frame  a  revenue  law  which  will 
distribute  the  tax  burden  with  exact  equality  over  various 
classes  of  taxpayers.  There  are  fundamental  points  of  differ- 
ence between  businesses  operated  by  corporations  and  by  in- 
dividuals, which  cannot  easily  be  equalized.  Partnerships  are 
held  to  be  nothing  more  than  tVk^o  or  more  individuals  acting 
together  for  convenience.  Attempts  have  been  made  to  regard 
partnerships  as  entities,  but  thus  far  the  courts  have  not  de- 
parted from  the  common-law  principle  that  partnerships  enjoy 
no  privileges  and  need  bear  no  burdens  other  than  those  inci- 
dent to  individuals.  This  principle,  however,  is  an  ancient  one 
and  it  is  within  the  range  of  possibilities  that  in  the  near  future 
some  court  will  hold  that  common-law  partnerships  are  in- 
dependent   legal    entities,    taxable    as    such,    and    possessing 

371 


%1^ 


INCOME 


privileges  and  burdens  which  differentiate  them  from  individ- 
uals or  corporations/ 

The  repeal  of  the  inequitable  and  imsatisfactory  excess 
profits  tax  will  require  some  adjustment  of  taxes  upon  busi- 
ness, as  distinguished  from  taxes  upon  income  from  other 
sources.  It  may  be  that  the  best  solution  will  be  to  impose 
the  same  rate  of  tax  upon  business  enterprises,  no  matter  how 
conducted.  This  in  turn  will  require  an  adjustment  of  the 
unduly  high  surtax  rates. 

"Catch-all"  provision.— The  law  states  (section  213)  that 
"gains  or  profits  and  income  derived  from  any  source  what- 
ever" are  subject  to  the  tax.  To  provide  for  possible  lapses 
in  the  law  and  regulations  the  following  "catch-all"  provision 
was  included  in  a  previous  edition  of  the  regulations.  The 
statements  made  are  still  pertinent. 

Regulation.  The  intent  and  purpose  of  the  income  tax  law  is 
that  all  gains,  profits,  and  income  of  a  taxable  class  shall  be  charged 
and  assessed  with  the  corresponding  income  tax,  normal  and  addi- 
tional, and  such  tax  shall  be  paid  by  the  owner  of  such  income  or 
the  proper  representative  thereof  having  the  receipt,  custody,  control, 
or  disposal  of  the  same.  In  any  case  where  the  conditions  which 
obtain  do  not  appear  to  fall  within  the  law  and  regulations  for  the 
assessment  and  collection  of  the  income  tax,  the  proper  tax  shall  be 
assessed  in  the  particular  case  by  the  Commissioner  of  Internal  Rev- 
enue upon  his  findings  concerning  the  same.  Ownership  of  income 
and  liability  for  tax  thereon  shall  be  determined  as  of  the  year  for 
which  the  return  is  required  to  be  rendered.     (Reg.  'i'^,  1918,  Art.  49.) 

Ruling.  A,  upon  becoming  an  officer  of  the  M  Company,  in- 
vested in  the  capital  stock  of  the  company  at  par  and  later  purchased 
additional  shares.    It  appears  that  at  the  time  of  purchase  of  this  stock 


'  See  Massachusetts  Income  Tax  Law,  General  Acts  of  1916,  Chapter 
269,  section  10,  which  reads  in  part  as  follows : 

"The  tax  shall  be  assessed  on  such  a  partnership  by  the  name 
under  which  it  does  business,  and  the  partners  shall  not  be  taxed 
with  respect  to  the  income  derived  by  them  from  such  a  partnership." 

Oliver  V.  Lynn  (130  Mass.  143),  holds  that  the  tax  on  partnership 
property  is  a  separate  tax  against  the  partnership,  and  that  an  individual 
partner  cannot  sue  for  the  recovery  of  such  a  tax  unless  it  is  proved  to  be 
wholly  illegal. 


INCOME   IN    GENERAL  373 

it  was  agreed,  and  so  provided  by  the  by-laws  of  the  company,  that 
should  any  employee  holding  common  stock  sever  connection  with  the 
company,  such  employee  should  sell  to  the  company  all  the  common 
stock  so  held,  receiving  therefor  its  book  value.  In  1918  A  severed 
his  connection  with  the  M  Company,  and  under  the  terms  of  his  agree- 
ment surrendered  his  stock,  receiving  book  value  therefor,  such  book 
value  being  x  dollars  in  excess  of  the  amount  paid  therefor.  A  pro- 
tests against  taxation  of  this  profit  on  the  ground  that  the  sale  was 
not  voluntary. 

This  Committee  is  of  the  opinion  that  this  protest  is  without  merit, 
since  there  is  no  warrant  of  law  for  exempting  profits  actually  realized 

from  tax  because  such  realization  is  involuntary (C.  B.  i, 

page  66;  A.  R.  M.  i.) 

Nature  of  taxable  income, — The  concept  of  income  adopted 
in  the  law  is  not  an  entirely  clear  and  logical  one.  In  general 
it  imposes  the  tax  only  when  the  income  is  reduced  to  money, 
but  in  certain  cases  this  rule  is  not  followed,  the  law  taxing 
some  income  in  forms  other  than  money." 

In  some  respects  the  192 1  law  is  an  improvement  over  past 
laws.  Capital  gains  and  profits  are  still  subject  to  the  tax  (as 
they  should  be)  but  at  a  reduced  rate  for  large  incomes. 

What  is  needed  is  an  authoritative  definition  of  "income." 
This  cannot  be  found  in  the  decisions  of  the  Supreme  Court, 
because  there  are  too  many  differentiations  and  limitations  to 
make  it  clear  what  a  decision  will  be  in  any  future  case. 

The  following  definition  of  income  is  of  interest.  It 
should,  however,  include  the  world  "realized"  when  applied 
to  taxable  income : 

Income  is  the  money  value  of  the  net  accretion  to  one's  economic 
power  between  two  points  of  time^ 

It  appears  from  some  court  decisions  that  doubt  exists  as 
to  the  taxabih'tv  of  certain  transactions  which  involve  so-called 


"The  1917  and  former  laws  pur])orted  to  tax  only  realized  income  but 
the  Treasury  assessed  taxes  on  many  exchanges  in  which  there  was  no 
realized  income.  The  1918  law  contains  a  formula  for  computing  income 
in  the  case  of  exchanges  which  depends  more  on  par  or  face  value  of 
securities  than  on  actual  values. 

"Robert  Murray  Haig.  "The  Concept  of  Income — Economic  and  Legal 
Aspects,"  The  Federal  Income  Tax,  Colinnbia  University,  1921. 


374  INCOME 

capital.  In  a  recent  case*  the  Circuit  Court  of  Appeals,  Second 
Circuit,  held  that  a  gift  to  a  corporation  is  not  taxable  income. 
In  defining  the  word  "income"^  the  court  said:  ".  .  .  .it 
(income)  should  not  include  such  wealth  as  is  honestly  appro- 
priated to  what  would  customarily  be  regarded  as  the  capital 
of  the  corporation."  One  judge,  dissenting,  said:  "I  find 
no  difficulty  in  calling  it  (the  gift  to  the  corporation)  income." 
Under  the  circumstances,  no  apology  is  needed  to  justify 
a  careful  inquiry  into  the  right  of  Congress  or  of  the  Treasury 
to  extend  the  taxation  of  income — which  is  permitted  under 
the  sixteenth  amendment — to  the  taxation  of  capital — which 
is  not  permitted.  Such  an  inquiry  naturally  should  cover  the 
right  to  tax  any  transaction  unless  there  is  an  actual  realiza- 
tion of  income,  as  distinguished  from  the  apparent  income 
which  may  be  and  often  is  the  result  of  temporary  fluctuations 
in  values. 

Income  in  cash  or  equivalent.''— The  use  one  enjoys  of 
his  own  property — as,  for  example,  the  house  in  which  the 
owner  lives — is  not  considered  taxable  income.  Ordinarily 
income,  to  be  taxable,  must  be  in  the  form  of  money.  Thus, 
the  farmer's  crop  is  not  taxable  until  it  has  been  reduced  to 
cash  (if  the  inventory  method  is  not  used)'  and  one  piece 
of  property  exchanged  for  another  when  neither  has  a  "readily 


*  U.  S.  V.  Orcgon-Washingion  R.  &  Nav.  Co.,  251  Fed.  211. 

"  "However,  the  tax,  though  it  includes  income  'from  all  sources.' 
nevertheless  includes  'income'  only,  and  the  meaning  of  that  word  is 
not  to  be  found  in  its  bare  etymological  derivation.  Its  meaning  is 
rather  to  be  gathered  from  the  implicit  assumptions  of  its-  use  in 
common  speech.  The  implied  distinction,  it  seems  to  us,  is  between 
permanent  sources  of  wealth  and  more  or  less  periodic  earnings.  Of 
course,  the  term  is  not  limited  to  earnings  from  economic  capital ; 
i.e.,  wealth  industrially  employed  in  permanent  form.  It  includes  the 
earnings  from  a  calling,  as  well  as  interest,  royalties,  or  dividends, 
though  in  the  case  of  corporations  this  may  be  of  slight  importance. 
Yet  the  word  unquestionably  imports,  at  least  so  it  seems  to  us,  the 
current  distinction  between  what  is  commonly  treated  as  the  increase 
or  increment  from  the  exercise  of  some  economically  productive 
power  of  one  sort  or  another,  and  the  power  itself,  and  it  should  not 
include  such  wealth  as  is  honestly  appropriated  to  what  would  cus- 
tomarily be  regarded  as  the  capital  of  the  corporation  taxed." 

"  See  Arts.  33  and  34,  pages  438  and  437- 

'  See  Chapter  XXXIX. 


INCOME   IN    GENERAL  375 

realizable  market  value, "^  gives  rise  to  no  immediate  taxable 
income.  However,  income  from  personal  services  is  taxable 
"in  whatever  form  paid."^  This  is  true  apparently  on  the 
theory  that  in  these  cases  there  is  some  basis  for  the  determina- 
tion of  the  cash  value  of  the  income  even  though  the  income 
itself  is  in  a  form  other  than  money,  such  as  accounts  receiv- 
aljle  and  mortgages. 

Regulation Items  of  income  and  of  expenditures  which 

as  gross  income  and  deductions  are  elements  in  the  computation  of 
net  income  need  not  be  in  the  form  of  cash.  It  is  sufficient  that  such 
items,  if  otherwise  properly  included  in  the  computation,  can  be 
valued  in  terms  of  money (Art.  22.) 

Sales  proceeds  in  escrow. — 

Ruling.  Where  a  sale  is  made  and  because  of  claimants  for  com- 
missions the  seller  is  required  by  the  purchaser  to  put  a  certain  part 
of  the  purchase  price  in  escrow,  and  thereafter  certain  claimants  are 
paid  directly  out  of  said  funds  in  escrow,  the  seller  is  not  liable  for 
income  tax  upon  any  part  of  the  purchase  price  in  escrow  until  actu- 
ally received  by  him.     (C.  B.  2,  page  82;  S.  1315.) 

A  lease  of  oil  lands  contained  a  clause  that  the  lease  could 
not  be  assigned  without  the  approval  of  the  Secretary  of 
the  Interior.  The  lease  was  assigned  in  December,  19 16, 
and  the  consideration  therefor  deposited  in  a  bank  in  escrow 
pending  the  approval  of  the  assignment,  which  was  obtained 
in  January,  19 17.  The  Treasury  held  that  title  to  the  money 
deposited  in  escrow  did  not  vest  in  the  assignor  until  the  ap- 
proval of  the  assignment  of  the  lease  by  the  Secretary  of  the 
Interior,  and  therefore  was  income  to  the  assignor  in  191 7. 
(I-3-3i;L.  O.  1082.) 

Closed  transactions  in  property. — The  attempt  to  tax 
accretions  of  property  values  has  raised  an  interesting  series 
of  problems  turning  upon  the  question.  What  constitutes  a 
closed  transaction  or  a  realization  definite  enough  to  serve  as 


Section  202   (b). 
Section  213  (a). 


376  INCOME 

the  basis  for  the  imposition  of  a  tax?  This  topic  is  discussed 
in  detail  in  Chapter  XVI. 

"Gross"  and  "net"  income. — The  1921  law  devotes  in  the 
case  of  individuals,  one  section  to  the  enumeration  of  the  items 
included  and  not  included  in  the  term  "gross  income"  (section 
213)  and  another  to  "deductions"  (section  214)  and  by  de- 
claring "net  income"  to  be  the  remainder  obtained  by  deducting 
the  second  from  the  first.  The  items,  such  as  dividends,  per- 
sonal exemptions  and  interest  on  certain  government  securi- 
ties, which  are  subject  to  the  surtaxes  but  not  to  the  normal 
tax,  are  provided  for  by  a  series  of  "credits"  described  in  an- 
other section  (section  216).  As  a  result  "gross"  income  is  a 
special  term  which  excludes  certain  items  such  as  proceeds  of 
insurance  policies  and  gifts  which  are  exempt  from  taxation. 
"Net"  income  is  also  a  special  term  which,  in  the  case  of  in- 
dividuals, includes  personal  exemptions,  dividends,  etc.  The 
same  general  plan  is  followed  in  defining  the  "gross"  and 
"net"  income  of  corporations  (sections  232-236). 

The  explanation  of  the  concepts  of  gross  and  net  income 
provided  in  the  regulations  is  as  follows: 

Regulation.  The  tax  imposed  by  the  statute  is  upon  income. 
In  the  computation  of  the  tax  various  classes  of  income  must  be  con- 
sidered: (a)  Income  (in  the  broad  sense),  meaning  all  wealth  which 
flows  in  to  the  taxpayer  other  than  as  a  mere  return  of  capital.  It 
includes  the  forms  of  income  specifically  described  as  gains  and 
profits,  including  gains  derived  from  the  sale  or  other  disposition  of 
capital  assets.  Income  can  not  be  determined  merely  by  reckoning 
cash  receipts,  for  the  statute  recognizes  as  income-determining  factors 
other  items,  among  which  are  inventories,  accounts  receivable,  prop- 
erty exhaustion,  and  accounts  payable  for  expenses  incurred 

(b)  Gross  income,  meaning  income  (in  the  broad  sense)  less. income 
which  is  by  statutory  provision  or  otherwise  exempt  from  the  tax 
imposed  by  the  statute.^"  .  .  .  .  (c)  Net  income,  meaning  gross 
income  less  statutory  deductions.  The  statutory  deductions  are  in 
general,  though  not  exclusively,  expenditures,  other  than  capital  ex- 
penditures, connected  with  the  production  of  income.^^   .    .    .    .    (d) 


'"  See  page  350  ct  seq. 
"  See  Chapter  XXV. 


INCOME   IN    GENERAL  377 

Net  income  less  credits.^-  ....  The  surtax  is  imposed  upon  net 
income;  the  normal  tax  upon  net  income  less  credits.  Though  tax- 
able net  income  is  a  statutory  conception  it  follows,  subject  to  certain 
modifications  as  to  exemptions  and  as  to  deductions  for  partial  losses 
in  some  cases,  the  lines  of  commercial  usage.  Subject  to  these 
modifications  statutory  "net  income"  is  commercial  "net  income." 
This  appears  from  the  fact  that  ordinarily  it  is  to  be  computed  in 
accordance  with  the  method  of  accounting  regularly  employed  in 
keeping  the  books  of  the  taxpayer (Art.  21.) 

Export  sales. — Ordinarily  there  is  little  difficulty  in  deter- 
mining "gross  income" ;  but  the  question  has  arisen  in  case  of 
exporting  firms,  as  to  whether  or  not  they  should  include  in 
income  the  profit  from  sales  of  goods  shipped  to  customers 
against  open  drafts  before  the  collecting  banks  in  the  foreign 
country  report  payment  of  the  drafts. 

When  it  has  been  the  practice  in  the  past  not  to  include  the 
profit  on  such  sales  until  the  draft  is  met,  it  seems  proper  to 
continue  the  practice. 

In  other  cases  when  definite  advices  are  received  before 
March  15  of  the  succeeding  year  as  to  the  disposition  of 
drafts  against  shipments  made  prior  to  December  31  of  the  pre- 
ceding year,  and  when  it  is  then  known  that  the  drafts  have 
not  been  met,  it  is  proper  not  to  include  the  profit  on  these  sales, 
but  to  include  the  goods  in  the  inventory. 

Ruling.  A  corporation  ships  goods  to  foreign  countries  with  the 
understanding  that  legal  title  docs  not  vest  in  the  purchaser  prior 
to  his  acceptance  of  the  draft  which  accompanies  each  bill  of  lading. 

Held,  that  the  profits  from  the  sale  should  not  be  included  in  the 
gross  income  of  the  corporation  until  the  draft  has  actually  been  ac- 
cepted and  notice  of  that  fact  has  been  received  by  the  corporation. 
Any  goods  shipped,  the  sale  of  which  was  not  actually  consummated 
as  indicated  above  prior  to  the  close  of  the  corporation's  taxable  year, 
should  be  included  in  the  closing  inventory  for  that  year.  (C.  B.  4, 
page  94;  O.  D.  824.) 

Income  accruing  prior  to  March   i,   1913,  not  taxable. — 

Regulation.  Any  claim  existing  unconditionally  on  March  i, 
I9i3>  whether  presently  payable  or  not  and  held  by  a  taxpayer  prior 


See  page  2i2>7  cl  scq. 


378  INCOME 

to  March  i,  1913,  whether  evidenced  by  writing  or  not,  and  all  in- 
terest which  had  accrued  thereon  before  that  date,  do  not  constitute 
taxable  income,  although  actually  recovered  or  received  subsequent 
to  such  date.  Interest  accruing  on  or  after  that  date  is  taxable  income. 
Where  an  interest-bearing  claim  held  on  February  28,  1913,  is  paid 
in  whole  or  in  part  after  that  date,  any  gain  derived  from  the  pay- 
ment of  the  claim  is  taxable.  The  amount  of  such  gain  is  the  excess 
of  the  proceeds  of  the  claim  (both  principal  and  interest)  exclusive 
of  any  interest  accrued  since  February  28,  1913,  already  returned  as 
income,  over  the  cost  thereof  (both  principal  and  interest  then  ac- 
crued). However,  the  gain  to  be  included  in  gross  income 
where  the  fair  market  value  of  the  claim  as  of  March  i, 
I9i3>  is  greater  than  the  cost  thereof,  is  the  excess  of  the  amount  re- 
ceived over  such  value.  No  gain  results  where  the  amount  received 
from  the  claim  is  more  than  the  cost  thereof  but  less  than  its  fair  mar- 
ket value  as  of  March  i,  1913.  In  the  case  of  an  insurance  policy  its 
surrender  value  as  of  March  i,  1913,  may  be  used  as  a  basis  for  the 
purpose  of  ascertaining  the  gain  derived  from  the  sale  or  other  dispo- 
sition of  such  property.  Where  services  were  rendered  prior  to 
March  i,  1913,  but  paid  for  thereafter,  the  amount  received  is  taxable 
income  to  the  extent  of  the  excess  of  such  amount  over  the  fair  mar- 
ket value  on  March  i,  1913,  of  the  principal  of  the  claim  and  any  in- 
terest which  had  then  accrued (Art.  90.) 

When  a  valid  and  valuable  claim  existed,  it  wotild  not  seem 
to  make  mtich  difference  whether  the  right  was  conditional 
or  unconditional. 

Investment  in  non-taxable  securities. — Many  taxpayers 
are  considering  the  relative  advantages  of  investments  in  gov- 
ernment and  other  non-taxable  or  partly  taxable  bonds  as 
compared  with  investments  in  wholly  taxable  securities.  The 
question  arises  both  as  to  investment  of  income  and  as  to 
change  of  investments  held.  Tables  have  been  prepared  by 
investment  bankers  and  others  which  show  the  relative  net 
return  from  taxable  and  non-taxable  securities  to  recipients 
of  income  of  different  amotints.  It  is  often  possible  for  a 
taxpayer  to  reduce  his  tax  burden  by  investing  in  non-taxable 
securities,  but  it  must  be  borne  in  mind  that  tables  which  show 
comparative  returns  can  be  prepared  onh^  with  reference  to 
assumed  conditions  of  investments  and  income.  Each  indi- 
vidual's tax,  however,  depends  on  the  sources  of  his  particular 


INCOME   IN    GENERAL  379 

income,  whether  from  Inisiiiess  activities,  dividends,  interest 
on  bonds  or  other  sonrces.  Moreover,  if  changes  in  invest- 
ments are  made,  there  may  be  losses  upon  sales  which  mate- 
rially affect  the  advantage  of  the  changes.  Consequently,  a 
taxpayer  who  considers  whether  to  invest  in  government 
bonds  or  other  non-taxables  should  realize  that  not  general 
information,  but  a  study  of  his  particular  conditions  of  in- 
vestments and  income,  is  needed  to  determine  what  he  would 
gain,  as  to  taxes,  by  any  investment.  Particularly  is  this  true 
in  view  of  the  contemplated  further  reduction  in  the  upper 
brackets  of  the  surtax. 

Accounting  procedure. — The  1921  law  specifically  pro- 
vides that  for  income  tax  purposes  the  same  methods  of  ac- 
counting shall  be  used  as  are  "regularly  employed  in  keeping 
the  books, "^'^  unless  this  "does  not  clearly  reflect  the  income." 

Law.  Section  212.  ....  (b)  The  net  income  shall  be  computed 
....  in  accordance  with  the  method  of  accounting  regularly  em- 
ployed in  keeping  the  books  of  such  taxpayer ;i^  but  if  no  such  method 
of  accounting  has  been  so  employed,  or  if  the  method  employed  does 
not  clearly  reflect  the  income,  the  computation  shall  be  made  upon  such 
basis  and  in  such  manner  as  in  the  opinion  of  the  Commissioner  does 
clearly  reflect  the  income 

Regulations,  (i)  Approved  standard  methods  of  accounting 
will  ordinarily  be  regarded  as  clearly  reflecting  income.  A  method 
of  accounting  will  not,  however,  be  regarded  as  clearly  reflecting 
income  unless  all  items  of  gross  income  and  all  deductions  are  treated 
with  reasonable  consistency.  See  section  200  of  the  statute  for  defi- 
nitions of  "paid,"  "paid  or  accrued,"  and  "paid  or  incurred."'^  All 
items  of  gross  income  shall  be  included  in  the  gross  income  for  the 
taxable  year  in  which  they  are  received  by  the  taxpayer,  and  deduc- 
tions taken  accordingly,  unless  in  order  clearly  to  reflect  income  such 
amounts  are  to  be  properly  accounted  for  as  of  a  different  period. 
For  instance,  in  any  case  in  which  it  is  necessary  to  use  an  inven- 
tory, no  accounting  in  regard  to  purchases  and  sales  will  correctly 
reflect  income  except  an  accrual  method A  taxpayer  is  deemed 


"  Section  232  makes  section  212  applicable  to  corporations. 

"The  provision  was  the  same  in  the  1918  law.  For  summary  of  the 
provisions  of  former  laws  regarding  the  "accrual"  and  "cash"  bases,  see 
Income  Tax  Procedure,  1918,  pages  67-70. 

"  See  page  383. 


380  INCOME 

to  have  received  items  of  gross  income  which  have  been  credited  to 

or  set  apart  for  him  without  restriction On  the  other  hand, 

appreciation  in  value  of  property  is  not  even  an  accrual  of  income 
to  a  taxpayer  prior  to  the  realization  of  such  appreciation  through 
sale  or  conversion  of  the  property (Art.  23.) 

It  is  recognized  that  no  uniform  method  of  accounting  can  be 
prescribed  for  all  taxpayers,  and  the  law  contemplates  that  each 
taxpayer  shall  adopt  such  forms  and  systems  of  accounting  as  are  in 
his  judgment  best  suited  to  his  purpose.  Each  taxpayer  is  required 
by  law  to  make  a  return  of  his  true  income.     He  must,  therefore, 

maintain  such  accounting  records  as  will  enable  him  to  do  so 

Among  the  essentials  are  the  following: 

(i)  In  all  cases  in  which  the  production,  purchase,  or  sale  of 
merchandise  of  any  kind  is  an  income-producing  factor  inventories 
of  the  merchandise  on  hand  (including  finished  goods,  work  in  proc- 
ess, raw  materials,  and  supplies)  should  be  taken  at  the  beginning  and 
end  of  the  year  and  used  in  computing  the  net  income  of  the 
year ; 

(2)  Expenditures  made  during  the  year  should  be  properly 
classified  as  between  capital  and  income,  that  is  to  say,  that  expendi- 
tures for  items  of  plant,  equipment,  etc.,  which  have  a  useful  life 
extending  substantially  beyond  the  year  should  be  charged  to  a 
capital  account  and  not  to  an  expense  account;  and 

(3)  In  any  case  in  which  the  cost  of  capital  assets  is  being  re- 
covered through  deductions  for  wear  and  tear,  depletion,  or  obso- 
lescence any  expenditure  (other  than  ordinary  repairs)  made  to  re- 
store the  property  or  prolong  its  useful  life  should  be  added  to  the 
property  account  or  charged  against  the  appropriate  reserve  and  not 
to  current  expenses.     (Art.  24.) 

Period  for  which  net  income  is  computed. — 

Regulation.  Net  income  must  be  computed  with  respect  to  a 
fixed  period.  Usually  that  period  is  twelve  months  and  is  known  as 
the  taxable  year.^'^  ....  The  time  as  of  which  any  item  of  gross 
income  or  any  deduction  is  to  be  accounted  for  must  be  determined 
in  the  light  of  the  fundamental  rule  that  the  computation  shall  be 
made  in  such  a  manner  as  clearly  reflects  the  taxpayer's  income.  If 
the  method  of  accounting  regularly  employed  by  him  in  keeping 
his  books  clearly  reflects  his  income,  it  is  to  be  followed  with  respect 
to  the  time  as  of  which  items  of  gross  income  and  deductions  are  to  be 

accounted  for If  the  taxpayer  does  not  regularly  employ  a 

method  of  accounting  which  clearly  reflects  his  income,  the  com- 
putation shall  be  made  in  such  manner  as  in  the  opinion  of  the 
Commissioner  clearly  reflects  it.     (Art.  22.) 


Defined  in  section  200   (i). 


INCOA'IE    IN    GENERAL  381 

Ruling.  Adjustments  made  in  accordance  with  instructions  from 
the  Interstate  Commerce  Commission,  increasing  the  income  of  a 
railroad  corporation  from  transactions  in  prior  years  and  taken  up 
on  the  books  of  the  corporation  during  the  taxable  year  because  neces- 
sary information  was  not  available  prior  to  that  time,  represent  in- 
come for  the  years  during  which  the  transactions  took  place  instead 
of  the  taxable  year.  Corrections  should  be  made  by  means  of 
amended  returns.     (C.  B.  i,  page  58;  O.  D.  9.) 

Regulation.  Each  year's  return,  so  far  as  practicable,  both  as  to 
gross  income  and  deductions  therefrom,  should  be  complete  in  itself, 
and  taxpayers  are  expected  to  make  every  reasonable  effort  to  as- 
certain the   facts  necessai"y  to  make   a  correct   return The 

expenses,  liabilities,  or  deficit  of  one  year  can  not  be  used  to  reduce 

the  income  of  a  subsequent  year -A  taxpayer  has  the  right 

to  deduct  all  authorized  allowances,  and  it  follows  that  if  he  does  not 
within  any  year  deduct  certain  of  his  expenses,  losses,  interest,  taxes, 
or  other  charges,  he  can  not  deduct  them  from  the  income  of  the  next 
or  any  succeeding  year.  It  is  recognized,  however,  that  particularly 
in  a  going  business  of  any  magnitude  there  are  certain  overlapping 
items  both  of  income  and  deduction,  and  so  long  as  these  overlapping 
items  do  not  materially  distort  the  income  they  may  be  included  in 
the  year  in  which  the  taxpayer,  pursuant  to  a  consistent  policy,  takes 
them  into  his  accounts.  Judgments  or  other  binding  adjudication, 
such  as  decisions  of  referees  and  boards  of  review  under  workmen's 
compensation  laws,  on  account  of  damages  for  patent  infringement, 
personal  injuries,  or  other  cause,  are  deductible  from  gross  income 
when  the  claim  is  so  adjudicated  or  paid,  unless  taken  under  other 
methods  of  accounting  which  clearly  reflect  the  correct  deduction,  less 
any  amount  of  such  damages  as  may  have  been  compensated  for  by 
insurance  or  otherwise.  If  subsequently  to  its  occurrence,  however, 
a  taxpayer  first  ascertains  the  amount  of  a  loss  sustained  during  a 
prior  taxable  year  which  has  not  been  deducted  from  gross  income, 
he  may  render  an  amended  return  for  such  preceding  taxable  year 
including  such  amount  of  loss  in  the  deductions  from  gross  income 
and  may  file  a  claim  for  refund  of  the  excess  tax  paid  by  reason  of 
the  failure  to  deduct  such  loss  in  the  original  return.  A  loss  from 
theft  or  embezzlement  occurring  in  one  year  and  discovered  in  an- 
other is  ordinarily  deductible  for  the  year  in  which  sustained 

(Art.  III.) 

The  foregoing  article  sets  forth  good  accounting  practice. 
It  recognizes  that  the  best  test  of  an  adjustment  is  its  relation 
to  the  business  as  a  whole.  It  also  describes  the  proper  method 
of  procedure  when  a  loss  is  discovered  in  a  fiscal  year  succeed- 
ing the  year  in  which  it  should  have  appeared  as  a  deduction. 


382 


INCOME 


Ruling.  A  restraining  order  of  a  court  required  that  a  part  of  the 
commissions  received  by  the  petitioners  should  be  deposited  with  the 
Clerk  of  the  Court,  pending  a  determination  of  the  ownership  thereof, 
upon  which  determination  the  amounts  deposited  were  to  be  refunded 
to  the  petitioners  or  distributed  to  their  patrons  from  whom  they  were 
collected. 

Held,  that  the  commissions  deposited  need  not  be  included  in  gross 
income  until  the  taxable  year  of  the  judicial  determination.  (B.  Digest 
30-21-1743;  O.  D.  980.) 

Amended  returns  required  in  certain  cases. — The 
following  indicates  that  the  Treasury  is  ready  to  accept  ad- 
justments of  returns  of  prior  years,  if  such  adjustments  are 
necessary  to  reflect  the  true  net  income. 

Ruling.  Reference  is  made  to  your  letter  of  June  2,  1920,  in 
which  you  state  that  during  the  years  1915,  1916  and  1917  ....  Com- 
pany paid  customs  duties  on  imported  merchandise  on  the  basis  of 
an  exchange  rate  of  a  franc  at  19.3  cents  instead  of  the  lower  rate 
prevailing  at  the  time  of  importation.  It  appears  that  the  amount  so 
paid  as  duties  were  included  in  the  income  and  profits  tax  returns 
as  part  of  the  cost  of  goods  sold  during  the  years  1915,  1916  and  1917 
and  the  surplus  reduced  each  year  to  the  extent  of  the  duties  paid. 
During  the  year  1919  the  company  received  a  refund  of  the  amount 
so  paid  as  customs  duties  which  was  in  excess  of  the  amount  due  on 
the  basis  of  the  exchange  rate  prevailing  at  the  time  of  importation 
of  the  French  merchandise. 

You  submit  for  consideration  the  following  inquiries  relative  to 
the  treatment  of  the  transaction  for  income  tax  purposes : 

(a)  How   should   the   transaction   be   treated   in   computing   the 

annual  net  income  for  the  years  involved? 

(b)  Is  not  the  amount  allowed  as  a  refund  for  duties  overpaid 

in  each  year  a  credit  to  surplus  for  that  year? 

(c)  Is  not  the  attorney's  fee  and  expense  of  collection  an  item 

of  necessary  business  expense  incurred  in  1919  when  the 
liability  accrued  and  was  paid? 

In  reply  you  are  advised  that  the  law  contemplates  that  each  year's 
return  both  as  to  gross  income  and  deductions  therefrom  shall  be 
complete  in  itself.  The  effect  of  the  Treasury  Decision  under  which 
the  claim  for  refund  of  excess  duties  paid  was  allowed  is  to  indicate 
that  the  excess  revenue,  which  was  paid  during  the  years  191 5,  191 6 
and  1917  and  for  which  the  company  received  a  refund  during  the 
year  1919,  is  an  amount  which  has  been  erroneously  deducted  in  com- 
puting net  income  for  the  years  1915,  1916  and  1917  respectively 
rather  than  an  amount  which  represents  income  for  the  year  1919. 


INCOME    IN    GENERAL  383 

Accordingly  the  company  should  amend  its  returns  t'or  the  years 
1915,  1916  and  1917,  respectively,  excluding  from  the  cost  of  goods 
sold  during  each  year  the  excess  duties  paid  during  such  year.  The 
surplus  account  for  those  years  should  also  be  adjusted  by  restoring 
to  such  account  the  amount  paid  as  revenue  in  excess  of  the  true 
liability  for  those  years. 

The  attorney's  fees  and  cost  of  collection  of  the  refund  are  a 
necessary  business  expense  for  the  year  in  which  the  liability  accrued 
and  was  paid,  which  appears  to  be  the  year  1919.  (Letter  to  S.  D. 
Leidesdorf  &  Company,  New  York,  N.  Y.,  signed  by  Paul  F.  Myers, 
Acting  Commissioner,  and  dated  June  26,  1920.) 

Cash  or  accrual  method  of  computing  net  income. — 
LTnder  ''definitions"  the  law  contains  the  fohowing:" 

Law.  Section  200.  ....  The  term  "paid,"  for  the  purposes 
of  the  deductions  and  credits  under  this  title,  means  "paid  or  accrued" 
or  "paid  or  incurred,"  and  the  terms  "paid  or  incurred"  and  "paid  or 
accrued"  shall  be  construed  according  to  the  method  of  accounting 
upon  the  basis  of  which  the  net  income  is  computed  under  section 
212 

The  foregoing  provisions  are  much  more  positive  in  tone 
than  the  permissive  clauses  included  in  the  191 6  law  and  have 
heen  interpreted  by  the  regulations  to  require  the  accrual  basis 
for  tax  purposes  when  that  method  is  used  in  the  accounts. 

Regulation "Paid"  is  to  be  construed  in  each  instance 

in  the  light  of  the  method  used  in  computing  net  income,  whether 
on  an  accrual  or  a  receipts  basis (Art.   1533.) 

All  well-conducted  business  concerns  attempt  to  make  their 
books  reflect  actual  net  income  for  their  accounting  periods. 
When  this  is  done  in  good  faith  the  income  tax  return  should 
exactly  agree  with  the  books,  subject  to  statutory  provisions. 

Individuals  do  not,  as  a  rule,  keep  books,  and  when  they 
do  their  so-called  accounts  consist  usually  of  cash  records. 
But  when  reasonably  accurate  accounts  are  kept  the  taxpayer 
is  more  than  repaid  for  the  trouble  involved.  They  assist 
economy  and  encourage  thrift.  Without  accurate  accounts 
an  income  tax  cannot  be  satisfactorily  assessed.     The  Com- 


"  Same  in   1918  law. 


384  INCOME 

missioner  will  be  justified  in  directing  that  every  taxpayer  be 
required  to  keep  a  clear  record  of  gross  income  as  it  accrues 
and  of  expenses  as  they  are  incurred. 

Nothing  can  be  more  obvious  than  the  proposition  that 
true  "net  income"  cannot  be  determined  by  looking  over  one's 
cash  account.  Even  day-laborers,  many  of  whom  now  re- 
ceive taxable  incomes,  often  do  not  receive  their  wages  in  the 
period  in  which  they  are  earned.  It  is  not  intended  to  suggest 
that  taxpayers  of  this  class  should  be  required  to  prepare  a 
return  on  the  accrual  basis ;  but  if  the  wage-earner,  whose  wages 
for  December,  1921,  amounting  to  $200,  where  not  received 
by  him  until  January,  1922,  desires  to  include  the  $200  in 
his  192 1  returns,  he  should  be  encouraged  to  do  so. 

Ruling.  Under  the  income  tax  statutes  taxpayers  are  required 
to  render  true  and  accurate  returns  of  annual  net  income  in  manner 
and  form  prescribed  by  the  Commissioner  with  the  approval  of  the 
Secretary  of  the  Treasury.  Any  return  which  in  the  judgment  of 
the  Commissioner  does  not  reflect  the  true  net  income  of  a  corpora- 
tion may  be  rejected  by  him  and  the  taxpayer  required  to  render  a 
return  on  such  basis  as  he  may  prescribe.  Therefore,  the  action  of 
the  Unit  in  requiring  a  corporation  engaged  in  the  mercantile  busi- 
ness, which  made  its  returns  for  1917  and  1918,  on  the  basis  of  re- 
ceipts and  disbursements,  to  file  amended  returns  on  the  accrual  basis 
was  proper  and  is  approved. 

The  general  plan  which  has  been  adopted  with  respect  to  mercan- 
tile corporations  of  requiring  that  both  inventories  and  accounts 
receivable  shall  enter  into  the  computation  of  net  income  is  proper 
and  in  accord  with  the  law  and  regulations.  (C.  B.  3,  page  76; 
A.  R.  R.  217.) 

Profit  on  consignment  sales. — 

Ruling.  Profit  on  goods  sold  by  a  consignee  is  income  to  the 
consignor  for  the  year  in  which  the  sales  are  made,  even  though  the 
consignor  received  no  notification  of  sale  until  a  subsequent  year. 
If  reported  otherwise,  amended  returns  should  be  filed.  (C.  B.  i, 
page  66;  O.  D.  13.) 

Changing  from  cash  to  accrual  method. — If  a  tax- 
payer who  has  kept  his  books  on  a  cash  basis  desires  to  change 
to  an  accrual  basis,  he  must  first  secure  the  consent  of  the 


INCOME   IN    GENERAL  385 

Commissioner.  It  is  most  improper  to  change  more  than 
once  unless  the  reasons  are  extremely  cogent/^ 

In  the  long"  run  the  government  is  not  likely  to  gain  or  lose 
anything  by  permitting  one  change,  but  if  shifting  back  and 
forth  were  freely  permitted  it  might  easily  develop  into  a 
scheme  of  wholesale  evasion. 

It  is  desirable  for  the  taxpayer  who  contemplates  a  change 
in  his  method  of  reporting,  to  restate  his  accounts  as  of  the 
beginning  of  the  taxable  year  as  well  as  at  the  end,  and  thus 
put  all  the  current  year's  earnings  and  expenses  on  an  accrual 
basis. 

Regulation (3)   A  taxpayer  who   changes  the   method 

of  accounting  employed  in  keeping  his  books  for  the  taxable  year  1921 
or  thereafter  should,  before  computing  his  income  upon  such  new  basis 
for  purposes  of  taxation,  secure  the  consent  of  the  commissioner. 
Application  for  permission  to  change  the  basis  of  the  return  shall  be 
made  at  least  30  days  before  the  close  of  the  period  to  be  covered  by 
the  return  and  shall  be  accompanied  by  a  statement  specifying  the 
classes  of  items  differently  treated  under  the  two  systems  and  specify- 
ing all  amounts  which  would  be  duplicated  or  entirely  omitted  as  a 
result  of  the  proposed  change.   .    .    ."  .      (Art.  23.) 

Rulings.  Office  Decision  481,  ruling  18-20-893,  modified  by  Of- 
fice Decision  636,  ruling  34-20-1144,  is  further  modified  so  as  to  pro- 
vide that  where  a  farmer  keeping  his  accounts  on  the  cash  receipts  and 
disbursements  basis  desires  to  change  to  the  accrual  basis,  and  actual 
records  or  definite  proofs  are  submitted  which  establish  to  the  satis- 
faction of  the  Commissioner  of  Internal  Revenue  the  existence  of  an 
animal  or  other  production  asset  on  a  date  previous  to  any  date  on 
which  the  farmer  has  paid  income  tax,  inventory  adjustments  may 
be  made  in  accordance  with  the  instructions  contained  on  page  4  of 
Form  1040-F.     (C.  B.  3,  page  81;  O.  D.  685.) 

A  taxpayer,  having  reported  his  income  prior  to  1920  on  the  basis 
of  cash  receipts  and  disbursements,  is  not  permitted  to  change  from 
that  basis  because  the  books  in  his  publishing  business  are  now  kept 
on  an  accrual  basis,  his  accounts  showing  his  income  from. a  part- 
nership being  still  kept  on  the  cash  basis  and  no  formal  books  of  ac- 
count, being  kept  to  show  his  income  from  miscellaneous  sources. 
(B.  Digest  29-2T-1731;  O.  D.   1731.) 

A  taxpayer  who  had  heretofore  computed  his  income  and  filed 
his   returns  on   the   accrual   basis  changed   bis   method   of  accounting 


I).  24.^3   (January  8,  1917). 


386  INCOME 

to  the  cash  receipts  and  disbursements  basis  on  June  30,  1921,  the 
close  of  his  taxable  year,  and  applied  to  the  Commissioner  for  per- 
mission to  compute  his  income  in  his  return  for  the  1921  fiscal  year 
on  the  cash  basis. 

Held,  that  inasmuch  as  the  change  in  his  method  of  accounting 
was  not  made  until  the  close  of  the  taxable  year,  permission  to  com- 
pute income  in  his  return  for  1921  on  the  cash  receipts  and  disburse- 
ments basis  is  denied.    (B.  48-21-1941 ;  O.  D.  1113.) 

A  taxpayer  who  has  properly  filed  his  return  on  the  cash  receipts 
and  disbursements  basis  can  not  be  granted  permission  to  amend  it 
by  stating  that  it  is  filed  on  an  accrual  basis,  even  though  his  cash 
receipts  and  disbursements  were  the  same  as  his  accrued  income  and 
deductions  except  as  to  the  item  taxes  accrued  to  a  foreign  country. 
(B.  50-21-1971;  O.  D.  1133.) 

Inventories.- — The  provision  of  the  1918  law  regarding 
inventories  marked  a  great  advance  over  the  earlier  laws. 
Under  the  1909  and  191 3  laws  the  tise  of  inventories  was 
permitted  in  certain  cases  without  the  authority  of  any  spe- 
cific permission  in  the  law  and  in  spite  of  some  doubt  as  to 
its  legality.  The  19 18  law  gave  the  Commissioner  power  to 
require  inventories  "whenever  necessary  clearly  to  determine 
the  income  of  any  taxpayer"  and  specified  that  the  basis  should 
"conform  as  nearly  as  may  be  to  the  best  accounting  practice 
in  the  trade  or  business."  The  1921  law  continues  this  re- 
C|uirement. 

Fortunately,  the  determination  of  the  "best  accounting 
practice"  is  not  difficult.  Briefly  defined,  the  term  means  ac- 
counts and  methods  which  correctly  reflect  the  true  financial 
position  of  a  concern  as  to  net  worth  and  earnings  and  which 
make  it  possible  to  secure  advice  which  will  prevent  the  pro- 
prietors or  executives  from  deceiving  themselves.  The  eft"ect 
of  federal  income  tax  legislation  upon  accounting  practice  is 
interesting.  Prior  to  1909,  conservative  business  men  usually 
understated  rather  than  overstated  their  net  earnings,  while 
ignorant  and  dishonest  business  men  overstated  them.  After 
the  enactment  of  the  1909  law,  which  imposed  a  tax  on  net 
earnings,  the  dishonest  men  began  to  understate  their  earnings 
and  the  honest  and  conservative  men  were  inclined  to  overstate 


INCOME   IN    GENERAL  387 

their  earnings  in  their  desire  to  comply  fully  with  the  tax  re- 
quirements. 

Men  cannot  be  made  honest  through  legislation,  but  in- 
come tax  legislation  should  contain  ample  penalties  for  false 
returns.  Those  who  are  honest  can  be  depended  upon  to 
remain  honest.  The  earlier  income  tax  laws  and  regulations, 
in  almost  entirely  ignoring  the  accrual  system  of  accounting 
and  in  forbidding  conservative  methods  of  valuing  inventories, 
actually  reduced  the  revenue  receipts  of  the  government'^  and 
at  the  same  time  attempted  to  impose  upon  taxpayers  impos- 
sible methods  of  accounting  and  valuation.  These  regulations 
bore  most  heavily  upon  honest  and  conservative  business  con- 
cerns but  in  no  way  worried  the  dishonest  ones. 

It  is  very  gratifying  to  note  the  recognition  now  given  to 
good  accounting  practice.  It  does  not  diminish  the  govern- 
ment's revenue  and  it  enables  taxpayers  readily  to  prepare 
returns  from  accounts  which  accurately  reflect  true  net  in- 
come. 

The  subject  of  inventories  is  fully  discussed  in  Chapter 
XV,  "Income  from  Business."     Also  see  Chapter  XXV. 

There  are  some  businesses,  it  seems,  in  which  the  use  of 
inventories  does  not  reflect  true  net  income. 

Ruling.  The  net  income  of  a  person  engaged  in  the  business  of 
propagation  and  culture  of  oysters  can  not  be  properly  computed 
upon  the  basis  of  inventories.  Amended  returns  will  be  required  for 
those  years  for  which  returns  have  been  based  upon  inventories.  The 
net  income  is  the  gross  receipts  for  the  year  less  the  necessary  busi- 
ness expense  and  other  allowable  deductions.  (C.  B.  3,  page  80;  O. 
D.  684.) 

The  Commissioner,  however,  has  no  authority  to  refuse 
permission  to  use  the  inventory  method  when  its  use  (rather 
than  the  cash  basis)  more  clearly  reflects  the  annual  income 
of  the  taxpayer. 

"Constructive"  receipt. — Even  when  the  cash  basis  is 
used,  the  regulations  provide  that  income  must  l)e  reported 


See  Income  Tax  Procedure,  1918,  pages  32-37,  for  concrete  example. 


388  INCOME 

when  it  is  made  available  irrespective  of  whether  or  not  it  is 
actually  reduced  to  possession.  If  an  item  is  a  "constructive" 
receipt  it  is  taxable. 

The  following  regulations  cover  this  matter  fully. 

Regulations.  Income  which  is  credited  to  the  account  of  or 
set  apart  for  a  taxpayer  and  whicli  may  be  drawn  upon  by  him 
at  any  time  is  subject  to  tax  for  the  year  during  which  so  credited 
or  set  apart,  although  not  then  actually  reduced  to  possession.  To 
constitute  receipt  in  such  a  case  the  income  must  be  credited  to  the 
taxpayer  without  any  substantial  limitation  or  restriction  as  to  the 
time  or  manner  of  payment  or  condition  upon  which  payment  is  to 
be  made.  A  book  entry,  if  made,  should  indicate  an  absolute  transfer 
from  one  account  to  another.  If  the  income  is  not  credited,  but  is 
set  apart,  such  income  must  be  unqualifiedly  subject  to  the  demand 
of  the  taxpayer.  Where  a  corporation  contingently  credits  its  em- 
ployees with  bonus  stock,  but  the  stock  is  not  available  to  such 
employees  until  some  future  date,  the  mere  crediting  on  the  books  of 
the  corporation  does  not  constitute  receipt.  (Art.  52;  Reg.  45, 
Art.  53.) 

Where  interest  coupons  have  matured  and  are  payable,  but  have 
not  been  cashed,  such  interest  payment,  though  not  collected  when 
due  and  payable,  is  nevertheless  available  to  the  taxpayer  and  should 
therefore  be  included  in  his  gross  income  for  the  year  during  which 
the  coupons  matured.  This  is  true  if  the  coupons  are  exchanged  for 
other  property  instead  of  eventually  being  cashed.  Defaulted  coupons 
are  interest  for  the  year  in  which  paid.  Dividends  on  corporate 
stock  are  subject  to  tax  when  unqualifiedly  made  subject  to  the  de- 
mand of  the  stockholder,-'^  ....  The  distributive  share  of  the 
profits  of  a  partner  in  a  partnership  is  regarded  as  received-^  by  him 

although  not  distributed Interest  credited  on  savings  bank 

deposits,  even  though  the  bank  nominally  have  a  rule,  seldom  or 
never  enforced,  that  it  may  require  so  many  days"  notice  in  advance 
of  cashing  depositors'  checks,  is  income  to  the  depositor  when 
credited (Art.  53;  Reg.  45,  Art.  54.) 

The  phrase  "unqualifiedly  made  subject  to  the  demand  of 
the  stockholder"  has  been  substituted  for  "set  apart  for,"  and 
the  reference  to  constructive  receipt  of  the  distributive  shares 
of  personal  service  corporations  is  omitted. 

Rulings.  Under  the  by-laws  of  a  cooperative  bank  the  profits 
credited   to   a   shareholder   may   not   be   withdrawn   in   their   entirety 


See  Chapter  XXII. 
See  Chapter  XXIV. 


INCOME   IN   GENERAL  389 

until  five  years  have  elapsed,  but  three-fourths  of  such  profits  may  be 
withdrawn  at  any  time  upon  30  days  notice,  in  which  case  the  other 
fourth  is  forfeited. 

The  question  presented  is  wliether  the  profits  credited  to  a  share- 
holder of  the  bank  are  credited  to  or  set  apart  for  him  without  re- 
striction, and,  if  so,  whether  the  net  amount  which  he  might  imme- 
diately withdraw  or  the  whole  amount  credited  to  him  should  be 
reported  as  income. 

Held,  that  three-fourths  of  the  profits  credited  to  the  shareholder 
are  credited  to  or  set  apart  for  him  without  restriction,  and  as  such 
should  be  included  in  gross  income  for  the  year  in  which  so  credited 
or  set  apart.  The  remaining  one-fourth  becomes  income,  construc- 
tively received,  at  the  end  of  the  five-year  period,  provided  he  has  not 
previously  withdrawn  his  shares.      (B.  44-21-1892;  O.  D.  1081.) 

The  donation  by  assignment  of  partnership  profits  to  be  earned 
in  the  future  does  not  exempt  such  profits,  when  determined,  from 
taxation  as  a  part  of  the  individual  income  of  the  donor.  (C.  B.  i, 
page  80;  O.  912.) 

Where  an  individual  is  employed  as  an  agent  for  a  firm  and  under 
his  contract  is  to  receive  as  compensation  50  per  cent  of  the  profits 
of  the  agency  which  may  be  appropriated  by  him  monthly  as  earned, 
the  amount  actually  appropriated  constitutes  income  of  the  agent  for 
the  year  in  which  appropriated.     ( C.  B.  2,  page  64;  S.  1312. ) 

A  distinction  was  drawn  in  this  case  between  profits 
"credited  or  set  apart"  and  profits  "appropriated"  by  the 
individual  who  was  entitled  to  draw  against  his  share  of  profits. 
On  this  point  the  detailed  opinion  states : 

Ruling.  Attorneys  for  the  claimant  make  the  contention  that  the 
claimant's  portion  of  the  monthly  profits  of  the  agency  constitute  in- 
come of  the  claimant  each  month ;  that  is  to  say,  the  claimant's  share 
of  the  profits  are  received  by  him  during  the  month  in  which  earned. 
This  contention  is  based  upon  the  ruling  of  this  ofiice  contained  in 
article  53  of  regulations  45,  the  wording  of  which  is  "income  which 
may  be  drawn  at  any  time  is  subject  to  the  tax  for  the  year  during 
which  so  credited  or  set  apart,  although  not  then  actually  reduced  to 
possession."  This  contention  is  not  valid  for  the  reason  that  the 
profits  of  the  agency  are  not  credited  to  him  or  set  apart  month  by 
month.  The  contract  of  employment  provides  that  such  profits  "shall 
be  and  are  the  property  of  M." 

This  ruling  is  not  convincing.  Tt  seems  that  an  agent  who 
is  entitled  to  50  per  cent  of  the  profits  of  a  Inisiness  should  be 
required  to  report  all  of  the  earnings  which  accrued  to  him 


390 


INCOME 


during  each  period  rather  than  the  amount  "appropriated." 
If  he  had  not  "appropriated"  any  part  of  the  earnings  it  is 
hardly  Hkely  that  the  Treasury  will  permit  him  to  say  that  he 
had  no  taxable  income. 

Rulings.  Held,  that  commissions  duly  authorized  and  credited 
as  compensation  for  services,  when  under  control  of  the  creditor 
and  subject  to  his  draft,  should  be  treated  as  taxable  income  for  the 
year  in  which  credited,  even  though  not  reduced  to  possession  in  that 
taxable  year.     (C.  B.  4,  page  100;  A.  R.  R.  366.) 

Stockholders  of  a  corporation  were  advised  of  the  decision  of  the 
board  of  directors  to  distribute  a  portion  of  the  assets,  the  distribu- 
tion to  be  made  as  of  December  — ,  191 5)  a-nd  they  were  given  until 
January  — ,  1916,  to  elect  whether  they  would  receive  stock  or  cash. 

Held,  that  there  could  be  no  constructive  receipt  until  the  option 
was  exercised  by  the  stockholders  and  communicated  'to  the  corpora- 
tion.    (C.  B.  4,  page  102;  A.  R.  R.  375.) 

An  amount  received  by  the  lessee  from  the  lessor  of  a  living 
apartment,  upon  the  termination  of  the  lease,  before  its  expiration  for 
the  purpose  of  defraying  storage  charges  upon  the  lessee's  household 
goods,  should  be  included  in  gross  income.  (B.  37-21-1812;  A.  R. 
R.  617.) 

The  foregoing  ruling  is  not  sound.  If  the  tenant  had 
remained  until  the  expiration  of  his  lease  there  would  have  been 
no  storage  charges.  The  tenant  was  merely  reimbursed  for  an 
expense  incurred  for  the  account  of  another.  There  is  no 
legal  or  accounting  precedent  for  calling  such  a  receipt  con- 
structive income.  The  payment  was  authorized  by  the  lessor 
and  the  amount  of  the  expense,  whether  large  or  small,  was 
of  no  more  interest  to  the  lessee  than  is  the  purpose  of  a  cheque 
to  the  bank  on  which  it  is  drawn. 

The  major  element  of  constructive  income  is  that  it  must  be 
actual  income;  when  it  is  taxable  is  another  and  far  different 
question.  Assume  that  two  tenants  were  affected,  neither  of 
whom  derived  any  advantage  in  the  way  of  income  or  reduced 
expenses.  If  the  storage  charges  paid  by  the  lessor  amounted 
to  $500  for  one  tenant  and  $100  for  another,  with  neither 
having  the  slightest  interest  in  the  cost,  could  constructive 
income  of  $500  be  imputed  to  one  and  $100  to  another?    Since 


INCOME   IN    GENERAL  391 

neither  derived  any  advantage  the  residt  to  each  must  be  the 
same.  The  lessor's  expenses  varied,  but  that  concerns  him — 
not  the  lessees.  If  'the  lessor  had  paid  the  moving  expenses 
in  consideration  of  moving  ahead  of  time,  the  element  of  con- 
structive income  would  arise.  In  a  case  dealing  with  a  law 
partnership,  where  an  attempt  had  been  made  to  accrue  fees 
from  professional  services,  it  was  held : 

Ruling.  Numerous  court  decisions  have  been  cited  by  the  ap- 
pellant in  support  of  its  contention  that  the  rendition  of  a  bill  by  a 
lawyer  does  not  constitute  a  binding  account  receivable  until  the 
amount  has  been  assented  to  by  a  client.  It  was  further  argued  that 
the  charges  for  legal  services  entered  on  its  books  were  not  determin- 
able, and  did  not  constitute  income  in  the  sense  contemplated  by  the 
income  tax  laws.  Further,  that  the  charges  were  not  "accounts  re- 
ceivable" as  usually  understood  for  the  reason  that  no  agreement 
existed  between  the  principals  fixing  the  amount  of  compensation 
for  the   services   rendered.  • 

In  view  of  the  foregoing  facts  the  Committee  is  of  the  opinion 
that  the  method  used  by  the  appellant  in  determining  its  net  income 
for  the  taxable  year  1920  is  not  sufficiently  definite  to  be  construed 
as  clearly  reflecting  the  income  of  the  firm,  that  the  method  used  is 
not  an  accrual  method  in  its  acknowledged  sense,  and  that  the  com- 
putation of  net  income  for  the  year  1920  is  more  correctly  determin- 
able on  the  basis  of  cash  receipts  and  disbursements.  Further,  that 
this  conclusion  is  fully  warranted  under  the  provisions  of  section  212, 
Revenue  Act  of  1918,  which  empowers  the  Commissioner  to  make 
the  computation  on  the  basis  and  in  such  manner  as  in  his  opinion 
does  clearly  reflect  the  income.  • 

It  is  therefore  recommended,  in  the  appeal  of  the  M  partnership 
that  the  action  of  the  Income  Tax  Unit  in  denying  permission  to 
change  from  an  accrual  to  a  cash  receipts  basis  in  computing  the 
net  income  of  the  firm  for  the  taxable  year  1920  be  reversed  and  the 
appeal  accordingly  sustained.     (I-3-29;  A.  R.  R.  702.) 

Book  entries.- — -It  is  desirable,  from  many  points  of  view, 
that  income  tax  returns  should  agree  with  the  books  of  the  tax- 
payer; but  the  entries  made  on  the  books  are  not  of  funda- 
mental importance  when  compared  with  the  actual  facts  in  a 
given  situation.""     The  facts,  not  the  l)ook  entries,  control."^ 


'■"See  Reg.  45,  Art.  23,  and  T.  D.  2873. 

"Book  entries,  however,  were  required  by  the  1918  and  carlit-r  laws  if 
deductions  were  claimed  for  bad  debts.  In  the  cases  of  both  individuals 
and  corporations,  debts  to  be  deductible  must  have  been  "ascertained  to  be 
worthless  and  charged  off."     (1918  law,  section  214  (a-7).) 


392  INCOME 

Foreign  exchange. — 

Rate  of  exchange  on  income  accruing  abroad. — 

Ruling.  Income  returnable  for  the  purpose  of  Federal  taxes 
should  be  expressed  in  terms  of  United  States  money.  The  rate  of 
exchange  at  the  time  of  receipt  governs  in  making  the  computa.tion. 
(C.  B.  2,  page  60;  O.  D.  419.)-* 

RuLiNc.  The  Committee  has  reached  the  conclusion  that  under 
the  abnormal  conditions  characterizing  foreign  exchange  during  the 
European  war,  the  taxpayer  may  convert  current  assets  less  current 
liabilities  payable  in  the  foreign  currency  at  the  current  rate  of  ex- 
change or  at  any  rate  less  favorable  to  him.  The  Commissioner 
should  consider  in  any  case  applications  to  adopt  a  rate  more  favor- 
able to  the  taxpayer  or  may  on  his  own  motion  apply  such  a  rate 
where  the  facts  in  the  particular  case  warrant  such  departure. 

This  ruling  should  apply  primarily  to  taxpayers  trading  or  manu- 
facturing in  foreign  countries  and  should  not  be  held  to  apply  to 
isolated  or  collateral  investments  in  foreign  credits  or  securities.  (C. 
B.  2,  f)age  60;  A.  R.  R.  15.) 

....  In  the  case  of  a  domestic  corporation  engaged  in  business  in 
a  foreign  country,  its  assets  and  liabilities  (other  than  capital  assets) 
recorded  on  its  books  in  terms  of  the  foreign  currency,  should  be 
appraised  in  dollars  (whether  actually  converted  or  not)  at  the  close 
of  each  taxable  year  in  which  it  is  engaged  in  active  business  at  the 
current  or  market  rate  of  exchange,  if  any,  then  prevailing.  (C.  B. 
2,  pages  60-61 ;  O.  D.  489.) 

A  domestic  corporation  has  a  branch  office  in  London  which 
keeps  a  separate  set  of  books  in  English  currency  and  renders  a 
report  at  {^e  end  of  the  year  as  to  the  profits.  During  the  year, 
whenever  the  branch  office  has  on  hand  more  money  than  is  needed 
for  regular  expenses,  a  remittance  is  made  to  the  home  office. 

Held,  that  the  net  profits  of  the  London  branch  for  the  year  should 
i)e  computed  in  English  currency.  From  the  total  profits  for  the  year 
should  be  subtracted  the  total  amount  remitted  to  the  home  office 
during  the  year,  all  expressed  in  English  currency.  To  determine  the 
equivalent  of  the  profits  in  terms  of  United  States  money,  the  amounts 
remitted  should  be  converted  into  United  States  money  at  the  rate  of 
exchange  in  effect  at  the  date  such  remittances  were  made.  The 
balance  of  the  net  profits,  expressed  in  English  currency,  should  be 
converted  into  United  States  money  at  the  rate  of  exchange  as  of  the 
end  of  the  taxable  year,  regardless  of  the  fact  that  the  profits  may 
not  have  been  remitted  to  the  home  office.  (C.  B.  2,  page  61;  O.  D. 
550.) 


'*  See  also  B.  42-21-1870;  O.  D.  1066. 


INCOME   IN   GENERAL  393 

Liquidation  of  indebtedness. — The  Treasury  has 
evolved  a  different  procedure  in  cases  in  which  liquidating  lia- 
bilities to  foreign  creditors  appear  on  the  books  in  the  United 
States,  where  remittances  are  made,  not  to  cover  specific  in- 
voices, but  in  a  running  account  which  remains  open  at  the  end 
of  the  year. 

The  rule  laid  down  requires  the  averaging  of  the  rate  of 
exchange  over  the  period,  instead  of  applying  specific  rates 
to  specific  transactions  or  inventorying  at  the  close  of  the 
period."^ 

The  Treasury's  position  in  regard  to  foreign  items  is  not 
entirely  clear  but  the  rulings  indicate  that  no  attempt  will  be 
made  to  enforce  arbitrary  or  unfair  rules. 

Capital  items. — Fluctuations  in  exchange  do  not  justify 
corresponding  changes  in  the  book  values  of  capital  assets  or 
liabilities.  The  expenditure  by  a  corporation ,  of  a  million 
dollars  for  a  building  in  New  York  is  unchanged  on  the  books, 
except  for  depreciation  or  obsolescence,  even  though  the  ap- 
parent market  value  declines  one-half.  If  one  million  dollars 
is  expended  for  a  building  in  Paris  when  francs  cost  8  cents 
and  francs  happen  to  be  6  cents  at  the  end  of  the  year,  the 
apparent  decline  of  $250,000  is  not  an  allowable  deduction. 
Capital  profits  and  losses  must  be  realized  before  they  affect 
income  tax  computations. 

Current  items. — The  author  is  of  the  opinion  that  cur- 
rent items,  such  as  accounts  receivable  and  accounts  payable, 
bank  balances,  etc.,  should  be  inventoried  when  the  books  are 
closed,  as  nearly  as  possible  on  the  basis  of  cost  or  market, 
whichever  is  lower. 

Ruling.  A  corporation  at  the  time  of  closing  its  books  for  the 
taxable  year  had  an  asset  of  x  pounds  sterling  represented  by  ad- 
vances made  in  cash  to  its  London  representative  for  the  purchase 
of  raw  material  in  the  London  market.  The  purchases  liad  not  been 
made  at  the  time  of  the  closing  of  the  books. 


•-■'  C.  B.  3,  page  75 ;  O.  TJ.  590. 


394 


INCOME 


The  rate  of  exchange  at  the  time  of  closing  the  books  was  lower 
than  at  the  date  the  exchange  was  purchased. 

Held,  that  the  taxpayer  did  not  sustain  a  loss  as  contemplated  by 
the  statute 

The  item  of  "sterling  owned"  is  a  current  asset.  Under 
the  ruling  in  C.  B.  2,  page  6i  (see  page  392),  it  should  be 
inventoried  at  the  rate  of  exchange  in  force  at  the  end  of  the 
year.  It  may  not  be  a  technical  loss,  but  if  allowed  as  an  in- 
ventory loss  the  net  result  is  the  same. 

When  current  assets  abroad  exceed  current  liabilities  and 
exchange  is  lower  at  the  end  of  the  year  than  during  the  year, 
a  loss  will  be  shown.  When  exchange  is  higher,  no  profit  or 
loss  will  be  shown. 

When  current  liabilities  exceed  current  assets  and  exchange 
is  lower,  no  profit  or  loss  will  be  shown.  When  exchange  is 
higher  a  loss  will  be  shown. 

The  rule  is  the  same  in  case  of  one  item  of  current  asset 
or  liability  as  it  is  in  the  case  of  branch  houses. 

The  foregoing  is  merely  conservative  business  practice  and 
may  or  may  not  result  in  a  saving  of  taxes.  Based  on  market 
values,  losses  are  taken,  but  profits  are  not  anticipated. 

Official  rates  of  exchange. — During  192 1,  the  Treas- 
ury has  issued  several  rulings  in  which  the  rates  of  exchange 
at  December  31,  1916,  191 7,  1918,  1919  and  1920  which  tax- 
payers should  use  have  been  summarized.  These  rulings  will 
be  found  in  bulletins  as  under : 


c. 

B. 

4,  page  60 

0. 

D. 

772 

c. 

B. 

4,  page  60 

0. 

D. 

803 

c. 

B. 

4,  page  63 

0. 

D. 

876 

c. 

B 

4-  page  63 

0. 

D. 

898 

c. 

B. 

4,   page  63 

0. 

D. 

913 

B 

34-21-1775; 

0. 

D. 

996 

B 

37-21-1811; 

0. 

D. 

1027 

B 

38-21-1826; 

0. 

D. 

1036 

B 

40-21-1852; 

0. 

D. 

1052 

B 

42-21-1869; 

0. 

D. 

1065 

B 

51-21-1977; 

0. 

D. 

^^37 

B 

51-21-1978; 

0. 

D. 

1 138 

INCOME   IN    GENERAL  395 

Community  property. — The  new  type  of  income,  that  from 
"community"  property,  which  first  came  into  prominence  as 
the  result  of  an  opinion  of  the  Attorney  General  dated  Sep- 
tember 10,  1920,-'^  has  been  defined  at  considerable  length  in  a 
further  opinion  of  the  Attorney  Gneral  dated  February  26, 
1921,-^  quoted  below.  It  is  held  that  in  Washington,  Arizona, 
Idaho,  New  Mexico,  Louisiana  and  Nevada,  husband  and  wife 
may  each  report  one-half  of  the  income  arising  from  commun- 
ity property  under  the  laws  of  the  respective  states.  Texas  is 
also  a  community  property  state. -^  This  privilege  is  held  not  to 
be  apphcable  to  California. 

Rulings.  Summarizing,  it  appears  that  in  all  of  the  community- 
property  States  except  California  their  own  courts  have  held  that  the 
wife  has,  during  the  existence  of  the  marriage  relation,  a  vested  in- 
terest in  one-half  of  the  community  property.  Her  rights  in  the 
property  of  the  community  are  perhaps  most  fully  recognized  in  the 
State  of  Washington,  where  both  spouses  have  testamentary  disposi- 
tion over  one-half  of  the  community  property,  and  where  in  the  ab- 
sence of  such  disposition  it  descends  to  their  issue,  or,  in  the  absence 
of  issue,  to  the  survivor;  while  the  husband  is  manager  of  the  com- 
munity estate  in  Washington  he  may  not  sell,  convey,  or  encumber 
real  estate  unless  the  wife  join  with  him  in  the  conveyance;  and  as 
was  held  in  Huyvaerts  v.  Rocdtz,  ante,  and  Schramm  v.  Steele,  ante, 
the  separate  debt  of  the  husband  can  not  be  satisfied  out  of  com- 
munity property  where  it  is  not  incurred  in  connection  with  the 
community  business,  nor  for  the  benefit  of  the  community. 

In  Idaho  it  is  seen  that  the  limitation  upon  the  alienation  of  the 
community  real  property  is  the  same  as  in  Washington.  But  while 
the  wife's  earnings  and  the  rents  and  profits  of  her  separate  estate 
are  community  property  she  is  given  the  management  and  control  of 
same.  The  Idaho  rule  governing  the  disposition  of  conmiunity  prop- 
erty on  the  death  of  either  spouse  is,  with  minor  variations,  the  same 
as  that  of  Washington.  In  neither  State  is  an  inheritance  tax  pay- 
able on  the  one-half  of  the  community  that  goes  to  the  one  spouse 
on  the  death  of  the  other. 

In  Arizona  the  husband  only  may  dispose  of 'community  personal 
property,  but  the  wife  must  join  him  in  deeds  or  mortgages  affecting 
real  estate,  except  unpatented  mining  claims.  One-half  of  the  com- 
munity property  is  subject  to  the  testamentary  disposition  of  either 


'32  Op.  Att.  Gen.  298;  T.  D.  3071. 
32  Op.  Att.  Gen.  435;  C.  B.4.  page  238;  T.  D.  3138. 
'32  Op.  Att.  Gen.  298;  T.  D.  3071. 


396  INCOME 

spouse,  and  in  absence  of  such  disposition  goes  to  his  or  her  de- 
scendants ;  where  there  is  neither  testamentary  disposition  nor  de- 
scendants, it  is  subject  to  distribution  in  the  same  manner  as  the 
separate  property  of  the  husband.  On  decree  of  divorce  the  court 
may  divide  the  property  as  he  sees  fit,  but  in  the  absence  of  provision 
for  the  community  property  the  parties  from  the  date  of  the  decree 
hold  as  tenants  in  common.  The  courts  of  Arizona  hold  that  the  wife 
is  equal  owner  with  her  husband. 

In  Nevada,  the  husband  has  the  entire  management  and  control  of 
the  community  property,  except  that  the  wife  has  entire  control  of 
her  earnings  when  living  separate  from  her  husband.  Upon  her 
death  the  husband  takes  the  whole  community  estate,  except  that 
where  he  has  abandoned  her  without  good  cause  she  may  by  will  dis- 
pose of  half  and  in  absence  of  such  disposition  it  goes  to  her  heirs, 
exclusive  of  her  husband.  On  the  death  of  the  husband  the  wife 
takes  half  and  the  husband  may  dispose  of  the  other  half  by  will,  or 
it  goes  to  his  surviving  children;  if  there  is  no  will  and  no  children 
survive,  the  whole  goes  to  the  wife  without  administration,  subject 
to  certain  provisos.  On  dissolution  of  community  by  divorce  for  any 
other  ground  than  adultery  or  extreme  cruelty,  the  community  prop- 
erty must  be  equally  divided  between  the  parties.  The  wife  pays  no 
inheritance  tax  under  the  inheritance  tax  law  of  Nevada  on  her  in- 
terest in  community  property,  the  courts  holding  that  she  takes  not 
as  heir  but  by  a  right  vested  in  her  at  all  times  during  marriage.  It 
is  to  be  noted  that  the  constitution  of  Nevada  recognizes  the  wife's 
interest  in  community  property. 

In  New  Mexico,  while  the  husband  is  manager  of  the  community 
estate,  he  may  not  transfer  real  property  without  a  valuable  con- 
sideration without  the  written  consent  of  his  wife;  and  under  certain 
circumstances  the  wife  may  be  substituted  as  manager;  prior  to  1915 
he  could  not  transfer  community  personal  property  except  for  a 
valuable  consideration  without  her  written  consent;  on  dissolution  of 
the  community  by  the  death  of  the  wife  the  husband  takes  all  except 
such  portion  as  may  have  been  set  aside  to  the  wife  by  judicial  de- 
cree, which  portion  goes  to  her  heirs  unless  she  has  disposed  of  same 
by  will;  on  death  of  the  husband  one-half  goes  to  the  wife  and  the 
other  half  is  subject  to  testamentary  disposition  by  the  husband.  If 
he  makes  no  will  one-fourth  of  his  one-half  goes  to  the  wife  and  the 
remainder  to  the  chijdren.  On  separation  either  may  petition  for 
division  of  community  property  and  after  divorce  continue  to  hold  as 
tenants  in  common  where  no  disposition  has  been  made  in  the  divorce 
decree.     New  Mexico  has  no  State  inheritance  tax  act. 

In  Louisiana  the  community  property  comprehends  all  property 
acquired  during  the  marriage  by  either  husband  or  wife  except  that 
acquired  with  separate  funds  or  by  inheritance  or  particular  dona- 
tion, and  excepting  the  earnings  of  the  wife  when  she  is  living  sepa- 


INCOME   IN    GENERAL 


397 


rate  from  her  husband;  the  husband  is  manager  of  the  community 
but  he  may  not  convey  community  immovables  by  gratuitous  title, 
and  can  not  dispose  of  movables  in  fraud  of  the  wife;  either  spouse 
may  dispose  of  one-half  the  community  property  by  will  and  the  laws 
governing  the  descent  of  such  property  in  the  absence  of  testamentary 
disposition  apply  equally  to  both  spouses,  the  survivor  taking  the  de- 
ceased spouse's  half  by  inheritance  when  there  is  no  will,  and  neither 
father,  mother,  or  descendants.  As  heretofore  stated,  the  survivor 
pays  no  inheritance  tax  on  his  or  her  one-half  of  the  community 
property  but  does  pay  on  that  part  inherited  from  the  deceased 
spouse. 

In  California  the  wife  has  no  power  of  testamentary  disposition 
of  community  property  except  of  such  as  may  have  been  set  aside  to 
her  by  judicial  decree;  she  takes  one-half  as  heir  on  the  death  of  the 
husband;  but  on  the  death  of  the  wife  the  entire  community  property 
belongs  to  the  husband  without  administration.  The  California 
courts  have  held  that  under  the  law  as  it  stood  prior  to  1917  the  wife 
had  no  vested  interest  in  community  property  prior  to  the  dissolu- 
tion of  the  marriage ;  the  amendment  to  the  inheritance  tax  act  being 
limited  to  the  purposes  of  that  act  could  not  have  had  the  effect  of 
vesting  an  interest  in  her,  and  had  the  addition  of  Sec.  172a  had 
that  effect  any  amendment  of  the  inheritance  tax  act  would  have  been 
unnecessary  to  exempt  her  one-half  from  taxation  thereunder.  In 
the  case  of  Blum  v.  Wardell,  now  pending  before  the  Circuit  Court 
of  Appeals  of  the  Ninth  Circuit,  on  appeal  from  the  District  Court  of 
the  Northern  District  of  California,  the  application  of  the  Federal 
Estate  Tax  Act  of  1916  is  under  consideration. 

As  appears  from  my  opinion  of  September  10,  1920,  in  Texas  the 
control  of  community  property  is  divided  between  the  husband  and 
wife;  in  that  State  on  the  death  of  either  spouse  without  issue  the 
survivor  takes  the  whole  and  where  there  is  issue,  takes  one-half, 
the  other  half  going  to  said  issue  or  their  descendants.  Under  the 
State  inheritance  tax  law  the  wife  pays  no  tax  on  her  half  of  the 
community  property. 

In  Warburton  v.  White.  176  U.  S.  484,  496,  the  principle  was 
enunciated  that  where  State  decisions  have  interpreted  State  laws 
governing  property  or  controlling  relations  that  are  essentially  of 
a  domestic  and  State  nature  the  United  States  Supreme  Court  will 
follow  the  State  decisions,  if  possible  to  do  so,  in  the  discharge  of  its 
duties.  Also  in  De  Vaughn  v.  Hutchinson,  165  U.  S.  566,  570,  it 
was  held  that  to  the  law  of  the  State  in  which  property  is  situated 
we  must  look  for  the  rules  which  govern  its  descent,  alienation,  and 
transfer,  and  for  the  effect  and  construction  of  wills  and  other  con- 
veyances. In  United  States  v.  Crosby,  7  Cranch  115,  it  was  held  that 
the  title  to  land  can  be  acquired  and  lost  only  in  the  manner  pre- 
scribed by  the  law  of  the  place  where  same  is  situated. 


398  INCOME 

In  arriving  at  an  answer  to  the  questions  propounded  by  you  we 
are  called  upon  to  determine  the  rules  of  property  in  the  community 
property  States ;  we  have,  therefore,  pursuant  to  the  rules  of  the 
above  cases,  adopted  the  rules  laid  down  by  the  highest  courts  of 
the  various  States.  There  remains  to  be  determined  the  application 
thereto  of  the  income  and  estate  tax  provisions  of  Federal  statutes. 
In  my  previous  opinion  it  was  stated  that  since  in  Texas  the  owner- 
ship in  one-half  of  all  community  property  vests  in  each  spouse, 
whatever  is  income  to  the  community  is  income  to  both.  This  con- 
clusion applies,  therefore,  to  all  States  in  which  community  prop- 
erty is  held  to  be  vested  equally  in  both  spouses. 

Section  201  of  the  Revenue  Act  of  1916  (39  Stat.  J"]"]^  and  section 
401  of  that  of  1918  (40  Stat.  1096)  impose  a  tax  "upon  the  transfer 
of  the  net  estate  of  every  decedent*'  dying  after  the  passage  thereof, 
to  be  determined  as  is  set  forth  in  the  sections  following,  which  are : 

Revenue  Act  of  19 18. 

Sec.  402.  That  the  value  of  the  gross  estate  of  the  decedent 
shall  be  determined  by  including  the  value  at  the  time  of  his  death  of 
all  property,  real  or  personal,  tangible  or  intangible,  wherever  situ- 
ated— 

(a)  To  the  extent  of  the  interest  therein  of  the  decedent  at  the 
time  of  his  death  which  after  his  death  is  subject  to  the  payment  of 
the  charges  against  his  estate  and  the  expenses  of  its  administration 
and  is  subject  to  distribution  as  part  of  his  estate; 

******* 

(d)  To  the  extent  of  the  interest  therein  held  jointly  or  as  tenants 
in  the  entirety  by  the  decedent  and  any  other  person,  or  deposited  in 
banks  or  other  institutions  in  their  joint  names  and  payable  to  either 
or  the  survivor,  except  such  part  thereof  as  may  be  shown  to  have 
originally  belonged  to  such  other  person  and  never  to  have  belonged 
to  the  decedent.     (40  Stat.  1097.) 

Subdivisions  (a)  and  (c)  of  section  202  of  the  Revenue  Act  of 
1916  are  identical  with  subdivisions  (a)  and  (d)  of  section  402  of 
the  Revenue  Act  of  1918,  quoted  above. 

While  the  community  estate  of  husband  and  wife  has  not  in  the 
strictest  sense  all  the  incidents  of  a  joint  estate  or  an  estate  in  the 
entirety  as  they  were  known  at  common  law,  I  am  convinced  that  the 
community  estate  is  for  all  practical  purposes  within  the  language  of 
subdivision  (d)  of  section  402,  there  being  deductible  therefrom,  in 
arriving  at  the  net  estate  of  decedent,  the  one-half  interest  of  the  sur- 
viving spouse,  which  may  be  shown  to  have  originally  belonged  to 
such  person,  and  never  to  have  belonged  to  the  decedent. 

And  even  though  it  should  be  held  that  the  community  estate  is 
not  a  "joint  estate"  or  an  "estate  in  the  entirety"  within  the  mean- 
ing of  the  Revenue  Acts,  the  one-half  interest  of  the  deceased  spouse 
in  community  property  would  still  be  subject  to  tax  under  the  lan- 
guage of  subdivision   (a)   above. 


INCOME   IN    GENERAL  399 

My  answers  to  your  questions  are  therefore : 

(i)  That  in  Washington,  Arizona,  Idaho,  New  Mexico,  Louisiana, 
and  Nevada  the  husband  and  wife  domiciled  therein,  in  rendering 
separate  income  tax  returns,  may  each  report  as  gross  income  one-half 
of  the  income  which  under  the  laws  of  the  respective  States  becomes, 
simultaneously  with  its  receipt,  community  property. 

(2)  In  the  States  mentioned,  in  answer  to  question  one,  there 
should  be  included  in  gross  estate,  in  computing  the  estate  tax  of  a  de- 
ceased spouse,  one-half  only  of  the  community  property  of  husband 
and  wife  domiciled  therein. 

(3)  Neither  of  the  above  answers  is  based  upon  a  statute  enacted 
subsequent  to  March  i,  1913. 

(4)  My  answers  to  these  questions  apply  under  income  and  estate 
tax  Acts  prior  to  the  Revenue  Act  of  1918.-'' 

A  wife  domiciled  with  her  husband  in  the  State  of  California  may 
not  report  in  her  separate  income  tax  return  salary  and  wages  re- 
ceived by  her.     (B.  Digest  49-21-1964;  O.  D.  1128.) 

In  returns  in  which  community  income  is  divided  between  hus- 
band and  wife  domiciled  in  states  where  such  income  is  divisible  for  in- 
come tax  purposes,  both  husband  and  wife  should  report  in  detail 
the  gross  income  from  such  community  property.  The  deductions 
properly  chargeable  against  such  income  should  be  equally  divided 
between  husband  and  wife.     (C.  B.  4,  page  254;  O.  D.  909.) 

Where  a  husband  and  wife,  domiciled  in  a  State  other  than  a  com- 
munity property  State,  purchase  lands  located  in  Texas  with  the 
separate  funds  of  one  of  the  spouses,  the  rents  and  revenues  there- 
from constitute  the  income  of  the  spouse  whose  funds  purchased  the 
land,  and  are  so  returnable.  Where  a  husband  and  wife,  domiciled  in 
a  State  other  than  a  community  property  State,  purchase  land  located 
in  the  State  of  Texas  with  funds  furnished  in  part  by  the  husband 
and  in  part  by  the  wife,  the  rents  and  revenues  are  income  of  each 
in  proportion  to  their  interest  in  the  land  and  are  so  returnable.  (B. 
28-21-1727;  O.  D.  975.) 

While  domiciled  in  the  State  of  Washington,  husband  and  wife 
acquired  real  property  therein  with  community  earnings.  Subse- 
quent thereto  they  moved  to  another  State,  where  they  have  since 
lived. 

Under  the  laws  of  Washington  the  income  from  such  property  is 
community  property.  During  coverture,  as  well  as  upon  dissolution 
of  the  marriage,  the  wife  has  a  vested  and  definite  interest  and  title 
in  the  community  property  equal  in  all  respects  to  that  of  the  hus- 
band. Such  interest  is  not  affected  by  a  change  of  domicile.  There- 
fore, the  husband  and  wife  may  file  separate   returns  in   which  the 


-"Summary  of  Opinion  of  Attorney  General,  pulilished  as  T.  D.  3138. 
For  full  decision,  see  C.  B.  4,  page  238;  32  Op.  Atty.  Gen.  435,  458. 


400 


INCOME 


income    from    community    property    in    the    State    of    Washington    is 
divided  between  them.     (  B.  47-21-1933:  O.  D.  mo.)-''" 

Interest  and  penalties  on  amended  returns  under 
T.  D.  3071.  - 

Ruling.  Inquiry  is  made  with  respect  to  the  assessment  of  in- 
terest and  penalties  in  cases  where  amended  returns  are  filed  in  ac- 
cordance with  the  provisions  of  Treasury  Decision  3071,  relating  to 
income  from  community  property  in  the  State  of  Texas. 

Held,  that  no  penalties  for  the  understatement  of  tax  may  be 
assessed  against  the  husband  when  the  tax  reported  in  his  original 
return  was  as  large  as  the  tax  actually  due  from  him  after  the  allo- 
cation of  community  income  to  each  spouse  upon  the  basis  of  separate 
returns.  The  Attorney  General  has  held  "that  community  property, 
under  the  laws  of  Texas,  belongs  to  the  husband  and  w-ife''  and  that 
"the  income  therefrom  accrues  to  the  husband  and  wife  in  equal 
shares."  (T.  D.  3071,  C.  B.  3,  p.  221.)  The  husband,  therefore,  in 
reporting  more  than  one-half  of  the  community  income  in  his  return 
(not  a  joint  return  for  himself  and  wife)  was  to  that  extent  reporting 
income  which  technically  was  not  his  at  all.  Penalties  are  provided  for 
the  understatement  of  an  individual's  tax,  as  computed  upon  the  total 
net  income  reported  by  him,  and  it  is  immaterial  that  the  income  from 
one  or  more  sources  is  carelessly  or  intentionally  understated  in 
his  return  if  by  reason  of  an  overstatement  of  income  from  other 
sources  no  understatement  of  his  total  net  income  is  actually  made. 
Therefore,  in  cases  where  the  wife's  share  of  community  income, 
which  was  reported  by  the  husband,  was  equal  to  or  more  than  the 
amount  of  income  received  but  not  reported  by  him,  there  was  no 
understatement  of  the  amount  of  the  husband's  total  net  income  and 
accordingly  no  negligence  or  fraud  penalty  could  be  assessed  against 
him.  Neither  should  a  delinquency  penalty  be  assessed  against  the 
wife  in  cases  where  her  income,  over  and  above  her  share  of  the 
connnunity  income  reported  by  her  husband,  was  insufficient  to  have 
required  her  to  file  a  return  prior  to  the  issuance  of  Treasury  De- 
cision 3071,  and  in  case  she  did  file  a  return  prior  to  the  issuance 
of  that  Treasury  decision,  she  should  not  be  penalized  for  not  report- 
ing her  share  of  the  community  income  which  she  had  reason  to 
believe  was  reported  by  her  husband.    (I-1-13;  I.  T.  1154.) 


'"For  a  similar  ruling  regarding  a  removal  from   Idaho  to  California, 
see  B.  39-21-1845;  Sol.  Op.  121. 


CHAPTER    XIV 

INCOME  FROM  PERSONAL  SERVICES 

Following  the  plan  of  subdividing  the  items  of  income  into 
convenient  groups,  adopting  generally  the  order  and  classifica- 
tion used  in  the  statute,  this  chapter  is  devoted  to  income  from 
personal  services.  This  term  includes  not  only  salaries  and 
wages  but  also  fees  received  from  professions  or  vocations. 

Distributions  by  personal  service  corporations  are  dealt 
with  elsewhere,^  because  the  earnings  of  personal  service  cor- 
porations as  defined  in  the  act  are  not  necessarily  of  the  na- 
ture of  services  as  the  word  "services"  is  usually  understood. 
Salaries,  however,  of  officers  or  other  employees  of  personal 
service  corporations  are  dealt  with  here. 

Law.     Section  213 (a)   Includes  gains,  profits,  and  income 

derived  from  salaries,  wages,  or  compensation  for  personal  service  (in- 
cluding in  the  case  of  the  President  of  the  United  States,  the  judges  of 
the  Supreme  and  inferior  courts  of  the  United  States,  and  all  other 
officfers  and  employees,  whether  elected  or  appointed,  of  the  United 
States,  Alaska,  Hawaii,  or  any  political  subdivision  thereof,  or  the  Dis- 
trict of  Columbia,  the  compensation  received  as  such),  of  whatever  kind 
and  in  whatever  form  paid,  or  from  professions,  vocations,-  .... 

Compensation  of  Certain  Officers  Exempt 

Salaries  of  the  President  and  United  States  judges. — The 

omission  in  the  19 18  law   (the  1921  law  is  the  same)  of  the 


'  See  Chapter  XXIV. 

'[Former  Procedure]  The  language  of  the  1917  law  is  the  same  as 
the  1913  law  except  for  an  immaterial  change  in  the  first  phrase  of  sec- 
tion 4.  In  191 7,  those  who  received  incomes  in  the  form  of  salaries, 
compensation  for  services,  including  all  professional  fees,  commissions, 
and  income  in  general  from  an  occupation,  vocation,  profession  or 
from  a  business  with  no  capital  or  only  nominal  capital  were  com- 
pelled to  pay,  in  addition  to  their  income. tax,  a  tax  of  8  per  cent  upon 
the  income  from  such  sources.  In  other  words,  if  anyone  received  an 
earned  income  of  any  kind  in  excess  of  $6,000  which  had  not  been  subject 
to  the  excess  profits  tax,  he  was  subject  to  this  8  per  cent  tax.  No  tax 
of  this  kind  appears  in  the  1918  or  1921  laws. 

401 


402 


INCOME 


specific  exemption  formerly  granted^  to  the  President  and 
United  States  judges  raised  the  interesting  question  as  to 
whether  or  not  the  salaries  of  these  officers  (whose  compensa- 
tion is  not  supposed  to  be  diminished  during  their  terms  of 
office'*)  may  be  subjected  to  a  federal  income  tax. 

This  question  was  decided  in  a  recent  case,^  the  Supreme 
Court  holding  that  ".  .  .  .  the  fathers  of  the  Constitution  in- 
tended to  prohibit  diminution  by  taxation  as  well  as  other- 
wise—  ....  they  regarded  the  independence  of  the  judges 
as  of  far  greater  importance  than  any  revenue  that  could  come 
from  taxing  their  salaries the  tax  was  imposed  con- 
trary to  the  constitional  prohibition,  and  must  be  adjudged 
invaHd." 

The  (acting)  Attorney  General  in  an  opinion  rendered 
on  June  21,  1920  (32  Op.  Att.  Gen.  248)  stated,  in  part:  "I 
am  unable  to  see,  therefore,  that  there  is  anything  in  the  recent 
opinion  of  the  Supreme  Court  [E.c'aiis  v.  Gore,  supra,']  which 
relieves  a  judge  appointed  since  the  enactment  of  the  income 
tax  law  from  paying  the  tax  imposed  by  that  law." 

Regulation The  salaries  of  Federal  officers  and  em- 
ployees are  subject  to  tax,  except  that,  in  view  of  the  provisions  of 
the  Constitution  of  the  United  States  as  construed  by  the  Supreme 
Court,  the  salaries  of  the  President  of  the  United  States  and  Federal 
judges  are  not  subject  to  a  new  tax  or  an  increased  tax  if  elected 
or  appointed  to  office  prior  to  the  passage  of  the  taxing  statute.  The 
Revenue  Act  of  1921,  however,  imposes  no  new  or  increased  tax 
upon  such  salaries;  hence  the  salaries  of  all  Federal  judges  appointed 


'[Former  Procedure]  The  191",  1916,  and  1913  laws  contained  the 
following  exemption : 

Law.  Section  4.  The  following  income  shall  be  exempt  from 
the  provisions  of  this  title:  ....  the  compensation  of  the  present 
President  of  the  United  States  during  the  term  for  which  he  has  been 
elected,  and  the  judges  of  the  Supreme  and  inferior  courts  of  the 
United  States  now  in  office,  and  the  compensation  of  all  officers  and 
employees  of  a  state,  or  any  political  subdivision  thereof,  except  when 
such  compensation  is  paid  by  the  United  States  government. 

*  Attorney  General  Hoar,  13  Op.  Att.  Gen.  161  (1869).  See  also  Pol- 
lock V.  Farmers'  Loan  and  Trust  Co.,  157  U.  S.  429,  39  L.  Ed.  759;  15  S.  Ct. 
718;  158  U.  S.  601,  39  L-  Ed.  1108,  15  S.  Ct.  912. 

'■Evans  v.  Gore,  253  U.  S.  245,  40  S.  Ct.  550,  64  L.  Ed.  887. 


FROM    PERSONAL   SERVICES 


403 


since    February    24,    1919,    are    subject    to    the    tax    imposed    by   the 
Revenue  Act  of  1921 (Art.  2,^.) 

Compensation  of  federal  officers  in  general  not  exempt. — 
Only  those  federal  salaries  which  were  specifically  designated 
as  not  subject  to  the  income  tax  were  exempt  under  laws  prior 
to  19 18.  All  other  federal  employees,  except  as  noted  below, 
were  taxable  under  former  laws  and  are  taxable  under  the  192 1 
law. 

Compensation  of  referees  in  bankruptcy. — 

Ruling.  The  decision  of  the  United  States  Supreme  Court  in 
Evans  v.  Gore  (T.'D.  3037),  relative  to  the  taxabiUty  of  salaries  of 
judges  of  the  Supreme  Court  and  inferior  courts  of  the  United  States, 
is  not  applicable  to  referees  in  bankruptcy  as  they  are  not  judges  of 
inferior  courts.  The  fees  received  by  referees  in  bankruptcy  are  sub- 
ject to  tax  under  the  provisions  of  section  213(a)  of  the  Revenue 
Act  of  1918.     (C.  B.  3,  page  104;  O.  D.  678.) 

Compensation  of  judges  of  territorial  courts. — 

Ruling.  Judges  of  territorial  courts  are  not  such  judges  as  are 
referred  to  in  article  III  of  the  Constitution  whose  salaries  are  exempt 
from  income  tax  in  accordance  with  the  decision  of  the  Supreme  Court 
of  the  United  States  in  Evans  v.  Gore.     (C.  B.  4,  page  83;  O.  D.  899.) 

Members  of  Board  of  United  States  General  Ap- 
praisers.— 

Ruling.  The  Board  of  United  States  General  Appraisers  is  not 
a  court  nor  are  its  members  Federal  judges.  Therefore,  salaries  paid 
the  members  are  not  exempt  from  tax  under  the  Revenue  Act  of  1918. 
(C.  B.  4,  page  83;  O.  D.  902.) 

Salaries  of  state  officers  and  employees  exempt." — As  a 
result  of  judicial  interpretation  of  the  scope  of  the  federal 
taxing  power,  an  implied  limitation  has  been  placed  upon  the 
power  of  Congress,  prohibiting  it  from  taxing  the  salaries  of 
state  officers.'^  But  there  has  been  no  interpretation  of  that 
power  since  the  passage  of  the  sixteenth  amendment.     The 


"[Former  Procedure]      The  laws  of   19x3,    1916  and    1917  exempted 
such  compensation. 

'Collector  V.  Day,  11  Wall.  113,  78  U.  S.  113,  20  L.  Ed.  122. 


404 


INCOME 


idea  of  abandoning  this  doctrine  has  therefore  found  con- 
siderable support.  If  the  war  had  continued,  it  is  probable 
that  the  employees  formerly  specifically  exempted  would  have 
been  specifically  taxed.  Tlie  1918  bill  as  it  passed  the  House 
of  Representatives  so  provided.  Senator  Simmons,  in  report- 
ing to  the  Senate  the  law  as  it  now  stands,  said :  "The  Com- 
mittee amended  section  213  (a)  so  as  to  require  that  any 
....  salaries  paid  be  subject  to  the  income  tax,  leaving 
the  Constitutional  question  as  to  the  authority  of  Congress  to 
tax  certain  salaries  to  be  settled  by  the  courts  in  any  case 
in  which  the  question  may  be  raised."^ 

The  attitude  of  the  Treasury  under  the  1918  law,  the  lan- 
guage of  which  is  re-enacted  in  the  1921  law,  is  based  on  an 
opinion  of  the  Attorney  General  (31  Op.  Att.  Gen. — )  and  is 
expressed  in  the  following  regulation  and  decision : 

Ruling In  accordance  with  an  opinion  of  the  Attorney- 
General,  dated  May  6,  1919,  and  based  on  the  well-settled  rule  that 
governmental  agencies  of  the  states  are  not  subject  to  taxation  by 
the  federal  government,  it  is  held  that  salaries  of  state  officials  and 
salaries  and  wages  of  employees  of  a  state  are  not  subject  to  the  in- 
come tax  imposed  by  the  said  Revenue  Act  of  1918.  (T.  D.  2843, 
dated  May  17,  1919.) 

Regulation.  Compensation  paid  its  officers  and  employees  by 
a  state  or  political  subdivision  thereof,  including  fees  received  by 
notaries  public  commissioned  by  states  and  the  commissions  of  re- 
ceivers appointed  by  state  courts,  is  not  taxable (Art.  88; 

Reg.  45,  Art.  85.) 

The  issue  is  essentially  constitutional — not  administrative 
— and  the  matter  cannot  be  deemed  to  be  definitely  settled  un- 
til the  courts  have  passed  upon  it.  In  view  of  the  Treasury's 
position,  however,  it  is  difiicult  to  see  how  the  question  will 
be  litigated. 

Since  the  1918  provision  has  been  re-enacted  into  the 
192 1  law,  the  Treasury  should  proceed  to  collect  taxes  from 
state  officers  and  employees.  The  question  would  then  be 
settled  by  the  United  States  Supreme  Court. 


^Report  of  Finance  Committee  to  Senate,  December  6,   1918,  page  6. 


FROM    PERSONAL    SERVICES 


Definition  of  ''^officer"  and  '^'employee. 


405 


Ruling.  An  officer  is  a  person  who  occupies  a  position  in  the 
service  of  the  Government,  the  tenure  of  which  is  continuous  and  not 
temporary,  and  the  duties  of  which  are  established  by  law  or  regula- 
tions and  not  by  agreement. 

An  employee  is  one  whose  duties  consist  in  the  rendition  of  pre- 
scribed services  and  not  the  accomplishment  of  specific  objects,  and 
whose  services  are  continuous,  not  occasional  or  temporary.  (Digest 
45-21-1906;  A.  R.  R.  664;  Sol.  Op.  122.) 

Compensation   of    referee — appointed    by   judge   of 

STATE  judicial  DISTRICT. 

Ruling.  A  referee  in  drainage  is  appointed  by  the  district  judge 
of  the  State  judicial  district  in  which  the  drainage  project  is  located. 
The  judge  is  vested  with  authority  to  provide  for  the  payment  of  the 
referee's  salary,  to  regulate  his  duties,  and  to  discharge  him  at 
pleasure. 

Held,  that  the  referee  is  an  employee  of  a  political  subdivision  of 
the  State  and  that  his  salary  as  such  is  not  subject  to  tax  under  the 
Revenue  xAct  of  1918.     (C.  B.  2,  page  100;  O.  D.  525.) 

Compensation    of    receiver — partly    state,    partly 

FEDERAL. 

Ruling.  A  receiver  was  appointed  by  a  State  court  for  the 
assets  of  a  corporation,  a  part  of  which  were  located  in  the  State 
appointing  the  receiver  and  the  remainder  in  another  State.  The 
Federal  district  court  for  the  latter  State  appointed  the  same  person 
as  receiver  for  the  assets  located  in  that  State.  The  fees  arising  from 
the  receivership  are  allowed  in  a  lump  sum,  such  compensation  being 
fixed  by  the  State  court  and  approved,  by  the  Federal  court. 

Held,  that  the  exemption  from  taxation  as  compensation  of  a  State 
employee  applies  only  to  that  portion  of  the  fee  which, is  attributable 
to  the  appointment  by  the  State  court;  the  portion  attributable  to  the 
appointment  by  the  Federal  court  should  be  reported  as  taxable 
income  by  the  recipient.  The  court  fixing  the  compensation  should 
be  requested  to  allocate  the  portions  reasonably  attributable  to  the 
State  and  Federal  appointments.     (C.  B.  2,  page  99;  O.  D.  503.) 

Compensation  of  engineers  having  contract  with 

state. — 

Ruling.  A  partnership  of  civil  engineers  has  a  contract  with  an 
irrigation  district  of  a  State  for  a  period  of  two  years  as  consulting 
and  supervising  engineers  on  any  question  it  may  be,  called  on  to 


4o6  INCOME 

consider  in  connection  with  development  work  of  the  district.     At 
the  same  time  it  accepts  business  from  the  public  generally. 

Compensation  received  by  the  firm  from  this  source  is  not 
exempt  from  taxation  as  compensation  paid  its  employees  by  a  political 
subdivision  of  a  State.     (C.  B.  2,  page  100;  O.  D.  545.) 

The  ruling  was  based  on  the  following  definition  of  em- 
ployee which  appeared  in  the  detailed  decision: 

The  term  employee  is  ordinarily  understood  to  mean  one  who  is 
in  the  regular  and  continual  service  of  his  employer  and  who  is  sub- 
ject to  the  direction  and  control  of  the  employer,  the  relation  between 
the  employer  and  employee  (as  in  the  relation  between  master  and 
servant),  implying  that  the  employer  not  only  prescribes  to  the  em- 
ployee the  end  of  his  work,  but  directs  or  at  any  moment  may  direct 
the  means  also,  or  retain  the  power  of  controlling  the  work. 

This  is  a  comprehensive  definition  and  should  enable  one 
to  determine  whether  he  could  be  considered  an  "employee  of  a 
state"  or  not. 

In  the  following  case,  however,  it  is  to  be  assumed  that 
the  engineer  was  an  "employee"  as  defined  above. 

Ruling.  A  chief  engineer  appointed  by  a  sewerage  commission 
created  by  the  common  council  of  a  city  under  authority  of  a  State 
statute,  is  considered  to  be  an  employee  of  a  political  subdivision  of  a 
State  and  the  compensation  paid  him  is  not  taxable.  (C.  B.  i,  page 
96;   O.   D.   309.) 

Assistants    to     clerks    of     state     courts — federal 

DUTIES. 

Ruling.  Where  clerks  of  State  courts  employ  clerical  assistants 
in  connection  with  the  administration  of  the  Federal  naturalization 
laws  and  pay  the  salaries  of  such  assistants  out  of  fees  collected  by 
them,  which  fees  are  made  available  for  that  purpose  by  congressional 
appropriation,  the  compensation  received  by  the  assistants  is  income 
subject  to  tax  under  the  provisions  of  the  Federal  income  tax  laws. 
Clerical  assistants  so  employed  are  not  State  employees  by  virtue  of 
such  employment.     (C.  B.  2,  page  99;  O.  D.  484.) 

Employees    of    railway    disbursing    funds    paid    by 

COUNTY. • 

Ruling.  In  constructing  a  causeway,  the  salaries  received  by  the 
individuals  employed  thereon  are  paid  from  the  funds  of  three  railway 
pompanies  and  a  county,  which  is  part  owner  of  the  project.     The 


FROM    PERSONAL   SERVICES  407 

county  pays  its  pro  rata  share  of  the  salaries  to  one  of  the  railway 
companies,  which  by  its  check  pays  the  gross  amount  of  the  salaries. 
Held,  that  as  the  employees  constructing  the  causeway  are  not 
employed  by  and  are  not  under  the  direction  or  control  of  the  State 
or  any  political  subdivision  thereof,  they  do  not  come  within  the 
designations  "State  officers"  or  "Employees  of  a  State"  as  used  in 
article  85,  of  Regulations  45,  and,  therefore,  their  compensation  is 
not  exempt  from  income  tax.     (C.  B.  2,  page  loi ;  O.  D.  553.) 

School  officer— when  not  state  employee. — 

Ruling.  Compensation  received  by  individuals  holding  the  posi- 
tions of  ''State  agent  of  normal  schools  for  whites,"  "State  agent  of 
normal  schools  for  negroes,"  and  "high  school  inspector,"  which 
positions  were  created  by  the  superintendent  of  public  instruction  of 
a  State  without  statutory  authority,  is  not  exempt  from  tax  as  com- 
pensation received  from  a  State  or  a  political  subdivision  thereof, 
when  such  compensation  is  paid  from  an  endowment  fund  no  part  of 
which  is  under  State  control.     (C.  B.  2,  page  98;  O.  D.  449.) 

Notary's  fees  exempt. — 

Ruling.  A  partner  who  turned  over  to  the  partnership  the  fees 
received  by  him  as  notary  public  under  commission  from  the  State, 
may  in  computing  his  distributive  share  of  the  partnership  income 
exclude  from  his  return  an  amount  equal  to  the  fees  so  received  and 
turned  over  to  the  firm.  The  other  partners  are  not  entitled  to  any 
part  of  the  exemption,  however,  and  must  report  their  entire  dis- 
tributive shares  of  the  partnership  income  regardless  of  the  fact 
that  a  portion  of  it  was  derived  from  notarial  fees  received  by  one 
of  the  partners.     (C.  B.  3,  page  125;  O.  D.  648.) 

Compensation  of  executors  and  administrators  not 

EXEMPT. 

Ruling.  An  individual  who  exercises  a  public  function  under 
an  appointment  issued  by  a  court  officer  for  a  particular  transaction 
or  purpose  for  a  limited  time,  and  in  the  exercise  of  such  function 
is  not  invested  with  the  character  of  either  an  officer  or  employee  of 
the  State  or  political  subdivision  thereof,  is  not  considered  to  be 
such  a  State  official  or  employee  whose  compensation  is  exempt  from 
Federal  income  tax  under  the  provisions  of  article  85  of  Regulations 
45  and  Treasury  Decision  2843. 

The  designations  "State  officers"  and  "employees  of  a  State"  refer 
only  to  those  persons  who  are  in  the  regular  and  continual  service 
of  the  State  or  a  political  subdivision  thereof  within  the  ordinary 
acceptance  of  these  terms.  Accordingly,  administrators  and  execu- 
tors, whether  or  not  they  are  considered  to  be  officers  of  the  court 
in  the  performance  of  their  duties,  are  not  exempt  from  Federal  in- 


4o8  INCOME 

come  tax  on  the  compensation  received  for  their  services.    (C.  B.  1, 
page  96;  O.  D.  256.) 

Compensation  of  liquidating  trustees  not  exempt. — 
Ruling.  The  compensation  paid  trustees  of  a  corporation,  who 
have  filed  an  appHcation  for  winding  up  the  affairs  of  said  corpora- 
tion in  accordance  with  the  laws  of  the  State  of  Connecticut,  is  not 
exempt  from  income  tax,  as  the  trustees  are  not  receivers  in  fact 
and  do  not  appear  to  exercise  a  public  function  under  an  appointment 
of  the  court,  nor  are  they  invested  with  the  character  of  an  officer  or 
employee  of  the  State,  although  the  compensation  is  fixed  by  the 
court.     (C.  B.  2,  page  98;  O.  D.  369.) 

Special  counsel  to  city  is  not  an  officer  or  em- 
ployee.— 

Ruling.  A  counsellor  at  law  is  engaged  by  a  municipality  as 
special  counsel,  to  act  in  connection  with  the  regular  city  attorney 
in  handling  a  certain  piece  of  litigation.  Is  he  regarded  as  an  officer 
or  employee  of  a  political  subdivision  of  a  state,  so  that  his  com- 
pensation for  his  services  is  not  taxable  under  article  71  of  Regu- 
lations 45,  sentence  2   [now  Art.  85]  ? 

(Answer.)  In  reply  to  the  first  question,  you  are  advised  that 
under  the  ruling  of  this  office,  the  compensation  paid  by  a  state  to 
"special  counsel,"  such  as  described  above,  is  taxable  income,  and  not 
exempt  from  income  tax.  (Part  of  letter  from  Collins  &  Corbin, 
Jersey  City,  N.  J.,  and  the  answer  thereto,  signed  by  J.  H.  Callan, 
Assistant  to  the  Commissioner,  and  dated  April  15,  1919.) 

Special  counsel  for  state  comptroller — commissions 
exempt.— 

Ruling.  The  New  York  transfer  (inheritance)  tax  law  provides 
for  the  appointment  of  an  attorney  in  each  county  to  look  after  the 
State's  interests  in  the  collection  of  inheritance  taxes.  In  1914  A 
was  appointed  by  the  State  comptroller  as  attorney  in  a  certain  county 
and  has  since  then  continued  in  that  position.  He  receives  as  com- 
pensation a  commission  upon  the  transfer  of  most  of  the  estates ;  in 
other  cases  he  is  paid  such  fees  and  allowances  as  the  comptroller 
decides  are  reasonable  and  proper.  It  is  stated  that  in  the  service 
of  all  papers  upon  him  reliating  to  transfer-tax  proceedings,  service 
is  recognized  as  being  upon  the  comptroller  and  further  that  all  of 
his  official  acts  are  representative  of  the  comptroller,  being  so  recog- 
nized by  the  courts. 

Held,  that  the  compensation  received  by  A  in  the  capacity  of 
attorney  for  the  State  comptroller  is  not  subject  to  Federal  income 
tax  under  the  provisions  of  article  85  of  Regulations  45.  (C.  B.  2, 
page  99;  O.  D.  494.) 


FROM    PERSONAL   SERVICES 


409 


It  is  difficult  to  see  any  essential  difference  between  the  two 
cases  above,  the  compensation  the  attorneys  receive  being  in 
fact  received  from  a  state  or  poHtical  suljdivision  thereof. 

Compensation  of  National  Guard  exempt — when? — - 

Ruling.  The  compensation  paid  by  a  State  to  an  officer  of  the 
National  Guard  of  the  State  is  exempt  from  the  taxes  imposed  by  the 
Revenue  Act  of  1918. 

The  compensation  paid  by  the  Federal  Government  to  an  officer 
of  the  National  Guard  for  services  while  engaged  in  field  training 
or  at  instruction  camps  is  not  exempt.     (C.  B.  4,  page  112;  O.  D.  942.) 

Confederate  state  pensions  not  exempt. — 

Ruling.  Pensions  paid  by  the  State  of  Kentucky  to  Confederate 
Civil  War  veterans  are  not  exempt  from  tax  under  the  Revenue  Act 
of  1918.  These  veterans  can  not  be  said  to  be  "officers"  or  "em- 
ployees" of  a  State  within  the  ordinary  and  usual  meaning  of  those 
words.     (C.  B.  4,  page  112;  O.  D.  903.) 

Attorneys  employed   by   state  exempt — when? — 

Ruling.  The  certified  copy  of  the  order  of  the  court  approving 
the  employment  of  A,  an  attorney  at  law,  by  the  collector  of  revenues 
in  a  certain  county,  states  that  the  employment  is  for  the  term  of  office 
of  the  collector;  that  is,  for  a  period  of  four  years.  The  taxpayer  states 
that  this  has  been  the  practice  for  many  years. 

A  State  statute  provides  that  the  collector  may  employ  such  at- 
torneys as  he  may  deem  necessary  to  file  such  suits  as  may  be  re- 
quired for  the  collection  of  delinquent  taxes 

Since  the  collector  is  responsible  for  the  institution  and  prosecu- 
tion of  such  actions  and  has  a  right  to  employ  such  attorneys  for 
such  purposes  as  he  may  deem  necessary,  he  would  have  the  right 
to  discharge  any  attorney  for  failure  to  carry  out  his  instructions. 
The  employment  of  the  attorney  consists  in  the  agreement  to  render 
personal  services  as  directed  by  the  collector.  The  relation  of  em- 
ployer and  employee  exists.  It  is  therefore  the  opinion  of  this  office 
that  the  taxpayer  is  an  employee  of  the  county  and  that  his  com- 
pensation received  as  such  is  exempt  from  the  income  tax.  (B. 
46-21-1919;  O.  D.  1099.) 

Pilots  employed  by  a  state  commission  held  not  ex- 
empt.— 

Ruling.  A  taxpayer  is  a  pilot  for  a  port  in  the  State  of  Florida, 
appointed  by  the  Board  of  Pilot  Commissioners  after  qualifying  bv 
required  examination.     This  board  is  appointed  by  the  Governor  of 


4IO  INCOME 

the  State  of  Florida.  The  taxpayer  claims  his  compensation  as  pilot 
is  exempt  from  tax  as  compensation  paid  an  officer  or  employee  of  a 
State. 

Held,  that  inasmuch  as  the  taxpayer  receives  his  compensation  as 
pilot  from  fees  paid  by  the  steamship  companies  to  the  Board  of 
Pilot  Commissioners,  rather  than  from  funds  of  the  State,  such  com- 
pensation is  not  exempt  from  the  tax  imposed  by  the  Revenue  Act 
of  1918.  (C.  B.  4,  page  112;  O.  D.  916.) 

District  of  Columbia,  territories,  etc.,  are  not  "states." — 

The  191 7  law  (section  23)  declares  that  "nothing  in  this 
title  shall  be  held  to  exclude  from  the  computation  of  net  in- 
come the  compensation  paid  any  official  by  the  governments  of 
the  District  of  Columbia,  Porto  Rico,  and  the  Philippine 
Islands,  or  the  political  subdivisions  thereof."  No  definite 
ruling  appears  to  have  been  made  regarding  the  status  of  ter- 
ritories, but  apparently  the  former  exemption  extended  to 
state  employees  did  not  extend  to  the  employees  of  territories. 

Ruling.  Compensation  of  teachers  of  the  Territory  of  Hawaii  is 
subject  to  income  tax  under  section  213  (a).  (C.  B.  i,  page  66; 
O.  D.  12.) 

Pay  of  soldiers  and  sailors. — The  special  exemption  for 
soldiers  and  sailors  which  appeared  in  the  1918  law  is  not 
re-enacted  in  the   192 1  act.^ 


°  [Former  Procedure]     The  918  law  reads  as  follows : 

Law.  Section  213.  ".  .  .  .  'gross  income' —  ....  (b)  Does  not  in- 
clude the  following  items,  which  shall  be  exempt  .... 

(8)  So  much  of  the  amount  received  during  the  present  war  by  a  per- 
son in  the  military  or  naval  forces  of  the  United  States  as  salary  or  com- 
pensation in  any  form  from  the  United  States  for  active  services  in  such 
forces,  as  does  not  exceed  $3,500 " 

Supplementing  the  above  section  of  the  law,  the  regulations  pro- 
vided: 

Regulation.  ".  .  .  .  this  exemption  does  not  apply  to  compensation 
received  either  before  or  after  the  present  war.  The  date  of  the  termina- 
tion of  the  war  for  the  purpose  of  the  statute  will  be  fixed  by  proclamation 
of  the  President.  The  military  and  naval  forces  of  the  United  States 
include,  among  others,  army  contract  surgeons  and  the  individuals  named  in 
section  i  of  the  statute.  A  person  is  in  active  service  if  he  is  actually  serving 
in  such  forces,  not  necessarily  in  the  field  or  in  the  theatre  of  war,  and  is  not 
merely  on  the  retired  or  reserve  list.  Accordingly,  if  such  a  person  receives 
compensation   from  the  United  States  of  $3,500  or  less  and  has  no  other 


FROM    PERSONAL    SERVICES  41 1 

The  Treasury  has  held  (C.  B.  4,  page  112;  O.  D.  900) 
that  for  the  purpose  of  this  section  of  the  law  the  war  termin- 
ated March  3,  192 1. 

Ruling.  The  following  items  are  to  be  included  in  the  $3,500 
exemption  provided  in  section  213  (b)  8,  Revenue  Act  of  1918,  for 
salary  or  compensation  received  by  persons  in  the  military  or  naval 
forces  of  the  United  States  during  the  "present  war" : 

Bonus  payable  upon  discharge. 

Mileage  from  point  of  discharge  to  point  of  enlistment. 

Ration  money  covering  periods  of  absence  from  camp  on  fur- 
lough.   (C.  B.  2,  page  loi ;  O.  D.  370.) 

Pensions  and  all  payments  under  war  risk  or  vocational 
rehabilitational  act   are   exempt. — 

Law.      Section    213 (b)  Does    not    include    the    following 

items,  which  shall  be  exempt  from  taxation  under  this  title:  .... 

(9)  Amounts  received  as  compensation,  family  allotments  and 
allowances  under  the  provisions  of  the  War  Risk  Insurance  and  the 
Vocational  Rehabilitation  Acts,i"  or  as  pensions  from  the  United  States 
for  service  of  the  beneficiary  or  another  in  the  military  or  naval  forces 
of  the  United  States  in  time  of  war;     .... 

Pensions  received  from  a  state  have  also  been  held  to  be 
exempt." 

Contractor  for  public  work  not  a  public  employee. — 

Regulation,  Any  profit  received  from  a  State  or  political  sub- 
division thereof  by  an  independent  contractor  is  taxable  income. 
Where  warrants  are  issued  by  a  city,  town,  or  other  political  sub- 
division of  a  State,  and  are  accepted  by  the  contractor  in  payment 
for  public  work  done,  the  fair  market  value  of  such  warrants  should  be 
returned  as  income.  If  for  any  reason  the  contractor  upon  conversion 
of  the  warrants  into  cash  does  not  receive  and  can  not  recover  the 
full  value  of  the  warrants  so  returned,  he  may  allowably  deduct 
from  gross  income  for  the  year  in  which  the  warrants  are  converted 
into  cash  any  loss  sustained,  and  if  lie  realizes  more  than  the  value 


income  of  an  amount  sufficient  in  itself  to  require  him  to  render  a  return 
of  income,  he  need  make  no  return.  Members  of  draft  boards  are  not  as 
such  entitled  to  this  cxt'ni]>tion."     (Reg.  45,  Art.  86.) 

'"  [Former  Procedure]  Under  the  iyi8  law  payments  under  this  act 
were  taxable.  Pensions  were  also  taxable  under  the  1918  law.  (C.  B.  4, 
page  79;  Sol.  Op.  97.) 

"  C.  B.  2,  page  98;  O.  D.  434. 


412 


INCOME 


of  the  warrants  so  returned  he  should  include  such  amount  in  his 
gross  income  of  the  year  in  which  realized.     (Art.  37.) 

If  a  contractor  accepts  payment  in  warrants  which  are  sell- 
ing in  the  market  at  less  than  par  he  need  not  account  for 
the  amount  received  at  any  value  above  the  market.  If  the 
contractor  collects  the  warrants  at  par  he  will  be  accountable 
for  the  excess  when  received.  If  sold  for  more  or  less  than 
their  market  value  when  received,  adjustment  would  have  to 
be  made  at  time  of  sale. 

Income  from  jury  fees. — Fees  paid  to  jurors  serving  in 
United  States  courts  are  taxable  income.  Fees  paid  by  states 
are  not  taxable. 

Mileage  paid  to  jurors  should  be  applied  against  expenses 

paid.     If  there  is  a  surplus  it  is  taxable,  if  a  deficit  it  should 

be  deducted  from  the  fees  as  a  necessary  expense  incident  to 

the  earning  of  the  income. 

Ruling Persons  serving  on  the  jury  of  a  State,  county,  or 

municipal  court  are  held  to  be  employees  of  a  State  or  a  political  sub- 
division thereof,  and  fees  and  compensation  received  by  them  are 
accordingly  exempt  from  tax.     (C.  B.  i,  page  98;  O.  D.  434.) 

Fees  of  witnesses  summoned  by  a  state  attorney  are  held 
to  be  taxable.^" 

Salaries  in  "land-grant"  colleges. — Through  acts  passed 
in  1862,  1890  and  1914,  the  last  known  as  the  Smith-Lever 
Act,  Congress  deeded  certain  lands  and  granted  certain  funds 
to  the  states  for  the  support  of  colleges.  The  taxability  of 
the  salaries  of  the  professors  in  such  colleges  turns  upon  the 
point  as  to  whether  or  not  these  teachers  are  employees  of  the 
state.  If  they  are,  their  salaries  are  not  taxable"  even  though 
they  are  received  in  whole  or  in  part  from  Smith-Lever  funds, 
for  such  funds  "lose  their  identity  as  funds  of  the  United 
States  by  being  paid  to  the  states.'"* 


"C.  B.  I,  page  67;  O.  D.  105. 

"  With  regard  to  their  possible  tax  liability  under  the  1918  and  1921  laws, 
see  page  403- 

'*T.  D.  2668,  March  9,  1918. 


FROM    PERSONAL    SERVICES  413 

Regulation Employees  of  universities  receiving  salaries 

paid  in  part  or  in  whole  from  funds  available  under  the  Smith-Lever 
Act  of  May  8,  1914,  who  are  officers  or  employees  of  a  State,  are  not 
required  to  return  as  taxable  incomes  the  salaries  so  received.  This 
is  also  true  with  respect  to  the  Act  of  August  30,  1890,  relating  to 
colleges  for  the  benefit  of  agriculture  and  the  mechanic  arts,  and  to 
the  Act  of  March  2,  1887,  relating  to  agricultural  experiment  sta- 
tions in  such  colleges.      (Art.  88;  Reg.  45,  Art.  85.) 

Salaries  of  civil  service  employees. — 

Rulings.  The  amounts  deducted  and  withheld  from  the  basic 
salary,  pay,  or  compensation  paid  to  employees  in  the  civil  service  of 
the  United  States,  in  accordance  with  the  provisions  of  the  Act  ap- 
proved May  22,  1920,  should  be  reported  by  such  employees  for  in- 
come tax  purposes.  The  total  compensation  of  the  employees  should 
be  reported  in  gross  income  and  no  corresponding  deduction  can  be 
taken  for  the  amounts  withheld,  inasmuch  as  such  amounts  are  pay- 
ments made  toward  the  purchasQ  of  annuities  provided  for  in  the 
Act  and  are  not  allowable  deductions  for  income  tax  purposes. 

The  annuities  paid  to  retired  employees  are  subject  to  tax  to  the 
extent  that  the  aggregate  amount  of  the  payments  exceeds  the  amounts 
withheld  from  the  compensation  of  the  employees.  (C.  B.  i,  page 
76;  T.  D.  3112.) 

If  an  employee  leaves  the  civil  service  of  the  United  States  before 
he  is  eligible  to  retirement  under  the  Act  of  May  22,  1920,  and  re- 
ceives the  amount  of  salary  withheld,  together  with  interest,  he 
should  report  only  the  amount  of  interest  received  by  him  as  income 
for  the  year  in  which  received.     (C.  B.  4,  page  Tj;  O.  D.  823.) 

Accounting  Procedure 

Receipt  or  accrual  method. — Salaries  and  wages  need  not 
be  accounted  for  in  the  return  until  payment  is  made  and  re- 
ceived.^^  Unquestionably  this  is  the  most  convenient  method 
of  dealing  with  salaries  and  wages,  because  comparatively 
few  recipients  of  incomes  of  this  nature  keep  books,  and  it 
would  require  some  adjustments  of  accounts  to  report  the 
salary  earned  within  a  calendar  year  but  partly  paid  prior  or 
subsequent  thereto.  But  anyone  desiring  to  keep  books  on  an 
accrual  basis   (that  is,  entering  all  income  as  earned  and  all 


"  See  Chapter   XXVI  as  to  deductions  of  compensation   for  personal 
services  in  carrying  on  a  trade  or  business. 


414  INCOME 

expenses  as  incurred)  is  permitted  and  encouraged  to  do  so. 
For  a  full  discussion  of  the  accrual  method,  see  page  383.  If 
any  part  of  the  accrued  income  so  reported  becomes  uncol- 
lectible, the  regulations  permit  credit  to  be  taken  therefor  as 
an  allowable  deduction. 

The  so-called  receipt  method  cannot  be  used  if  it  serves 
to  obscure  the  taxpayer's  actual  net  income  for  the  taxable 
period.  Section  212  (b)  defines  "net  income"  and  states  that 
"if  the  method  [of  accounting]  employed  does  not  clearly 
reflect  the  income,  the  computation  shall  be  made  upon  such 
basis  and  in  such  manner  as  in  the  opinion  of  the  Commis- 
sioner does  clearly  reflect  the  income." 

If  the  taxpayer  prefers  to  prepare  his  income  tax  return 
from  his  cheque  book  or  cash  book,  no  fault  will  be  found,  if 
the  result  clearly  reflects  his  actual  net  income.  In  such  cases 
it  is  suggested  that  if  the  taxpayer's  income  arises  from  fees, 
etc.,  a  cash  book  with  several  columns  will  be  most  useful. 
On  the  receipt  side  all  items  of  receipts  from  fees,  etc.,  should 
be  entered  in  a  column  reserved  for  the  particular  purpose,  so 
that  at  the  end  of  the  year  the  aggregate  of  such  column  will 
be  the  proper  amount  to  include  in  the  return.  If  at  all  feas- 
ible, however,  the  accrual  system  should  be  adopted.  No 
other  method  accurately  reflects  net  income,  except  in  the  case 
of  wage-earners  who  have  no  investments. 

Regulation.  Where  no  determination  of  compensation  is  had 
until  the  completion  of  the  services,  the  amount  received  is  ordinarily 
income  for  the  taxable  year  of  its  determination,  if  the  return  is 
rendered  on  the  accrual  basis,  or,  for  the  taxable  year  in  which  re- 
ceived, if  the  return  is  rendered  on  a  receipts  and  disbursements 
basis (Art.  32.) 

Many  professional  men,  when  closing  their  books  for 
their  taxable  years,  enter  as  accrued  income  an  estimate  of 
what  has  been  earned  to  such  date,  and  report  such  estimate 
as  taxable  income.    This  they  have  a  right  to  do  under  the  law. 

Ruling.  A  performed  certain  services  in  1909  under  an  agree- 
ment that  he  was  to  receive  as  compensation  a  percentage  of  the 
net  income  of  a  business  enterpri-se,  the  time  of  payment,  however, 


FROM    PERSONAL   SERVICES  415 

to  be  within  the  discretion  of  the  individuals  in  control  of  the  business 
enterprise.  The  amount  of  A's  compensation  was  determined  in  1916 
but  not  paid  until  1919.  Held  that  as  A  kept  his  books  on  the  cash 
receipts  and  disbursements  basis,  the  entire  amount  received  con- 
stitutes income  for  the  year  1919.     (C.  B.  2,  page  85;  O.  D.  460.) 

In  this  case  the  business  was  disposed  of  in  1916,  and  A 
could  not  have  earned  the  compensation  after  that  time.  It 
might  also  be  said  that  on  the  principle  of  "constructive  re- 
ceipt" he  received  the  coinpensation  in  19 16.  Certainly  A 
could  not  be  taxed  on  any  income  which  had  accrued  to  him 
at  March  i,  1913.^'' 

Ruling.  A  taxpayer  who  keeps  no  books  of  account,  and  to 
whom  is  paid,  upon  the  termination  of  services  extending  over  a 
period  of  years,  a  lump  sum  in  amount  not  previously  agreed  upon, 
as  compensation  for  such  services,  must  return  as  income  in  the  year 
in  which  received  the  entire  amount  so  paid  him,  even  when  such 
payment  is  accompanied  by  a  statement  proportioning  the  compensa- 
tion over  the  years  in  which  the  services  were  rendered.  (C.  B.  2, 
page  80;  T.  D.  2960.)^" 

In  the  foregoing  case  the  service  did  not  begin  until  May 
27,  1913. 

The  following  court  decision  is  also  of  interest.^* 

Decision.  (Syl.) Where,  relying  on  the  unofficial  prom- 
ises of  a  majority  of  the  board  of  directors  that  additional  salary 
would  be  voted  him  for  past  years,  the  president  of  a  corporation  over- 
drew his  account  with  the  corporation,  additional  salary,  subsequently 
voted,  was  income  to  him  for  the  year  in  which  the  amount  thereof 
was  finally  settled  upon  and  segregated  by  an  order  of  the  board,  al- 
though he  had  actually  received  and  spent  the  money,  as  overdrafts, 
prior  to  that  year. 

This  procedure,  as  well  as  the  principle  laid  down  in  the 
Jackson  case,  works  an  injustice  to  the  taxpayer. 

If  the  Supreme  Court  adopts  the  principle  that  income 
cannot  be  taxed  unless  and  until  it  is  realized  in  cash,  or  the 


"See  page  2,77-  See  also  Art.  90,  page  417;  and  C.  B.  4,  page  83; 
O.  D.  956. 

"  This  statement  was  issued  with  an  extract  of  the  decision  in  the  case 
of  Jackson  v.  Smictanka,  267  Fed.  932.  The  Circuit  Court  of  Appeals  for 
the  Seventh  Circuit  has  recently  affirmed  this  decision    (272  Fed.  970). 

"  Holbrook  v.  Moore,  United  States  District  Court,  February  8,  1921 
(not  reported).     See  T.  D.  3 161. 


4i6  INCOME 

equivalent  of  cash,  the  Treasury  wiU  have  to  recede  from  its 
position  in  Regulations  45  and  many  rulings.  Its  former  prin- 
ciples, however,  regarding  uncertain  and  undetermined  claims, 
resulting  in  realizations  in  later  years  have  been  overruled  in 
Regulations  62/" 

"Back  pay"  awarded  by  railroad  board  taxable  in 

year  of  receipt. 

Ruling.  A  taxpayer  who  had  been  discharged  from  the  em- 
ploy of  a  railroad  company  was  reinstated  by  order  of  the  Railroad 
Board  and  paid  for  all  time  lost  during  a  period  of  over  two  years. 
It  is  contended  that  the  sum  received  by  the  taxpayer,  for  which  he 
rendered  no  service,  is  in  reality  a  gift  and  not  taxable. 

Held,  that  the  payment  can  not  be  treated  as  a  gift  for  the  reason 
that  it  was  not  made  voluntarily.  It  is  income  within  the  ordinary 
acceptation  of  the  word  and  not  being  such  income  as  is  expressly 
exempt  under  the  Act,  should  be  included  in  the  return  of  the  tax- 
payer for  the  year  in  which  it  was  received  by  him.  (C.  B.  2,  page  71 ; 
O.  D.  512.) 

Compensation  of  trustee  taxable  when  received. — 

Regulation.  If  no  determination  was  made  as  to  the  amount 
due  the  trustee  of  an  estate  as  compensation  for  his  services  over  a 
period  of  years  until  the  trust  was  terminated,  the  amount  allowed 
him  should  be  returned  in  full,  subject  to  allowable  deductions,  as 
income  for  the  year  in  which  paid ;  and  should  not  be  prorated  over 
the  length  of  time  during  which  he  served  as  trustee.  (T.  D.  2135, 
January  23,   1915.) 

The  question  here  arises  as  to  what  constitutes  a  "deter- 
mination." This  ruling,  of  course,  would  not  be  applicable  if 
it  could  be  shown  that  a  definite,  or  an  approximately  definite, 
portion  of  the  fee  had  been  earned  and  had  accrued  prior  to 
March  i,  1913.  The  trustee  could  not  legally  be  taxed  on  in- 
come which  accrued  prior  to  the  date  when  the  law  went  into 
effect.^" 

Otherwise  the  ruling  is  fair,  because  the  trustee  could 
have  reported  the  accruing  income  annually.     If  he  did  not 


"■'  See  page  532. 
'"  See  page  },77. 


FROM    PERSONAL   SERVICES 


417 


do  so  and  was  compelled  to  return  a  large  amount  in  a  year 
when  there  was  in  force  a  tax  rate  higher  than  during  the 
years  when  the  income  accrued,  he  had  only  himself  to  blame 
for  not  having  adopted  the  accrual  basis. 

Compensation  for  services  rendered  before  March  i,  1913 — 
How  far  taxable. — 

Regulation Where    services    were    rendered    prior    to 

March  i,  1913,  but  paid  for  thereafter,  the  amount  received  is  tax- 
able income  to  the  extent  of  the  excess  of  such  amount  over  the 
fair  market  value  on  March   i,   1913,  of  the  principal  of  the  claim 

and  any  interest  whicli  had  then   accrued (Art.  90;   Reg. 

45,  Art.  87.) 

This  is  logical.  The  accrual  before  March  i,  191 3,  was 
not  taxable,  because  in  effect  it  became  capital  at  that  date. 
If  it  was  found  to  be  bad  after  that  date,  it  was  properly  an 
allowable  deduction.  If  the  income  accrued  after  March  i, 
1 91 3,  and  v^as  not  returned  for  taxation,  it  would  be  improper 
to  claim  the  loss  as  a  deduction. 

Compensation   for   Services    Distinguished    from 
Gifts,  Dividends,  etc. 

The  establishment  of  a  clear  distinction  between  compen- 
sation for  personal  services,  on  the  one  hand,  and  gifts,  dis- 
tributions of  profits  or  assets  and  payments  for  property,  on 
the  other,  is  one  of  the  very  difficult  tasks  in  income  tax 
procedure.  In  the  case  of  bonuses,  Christmas  gifts,  "profit- 
sharing"  distributions,  and  other  payments  of  a  like  nature, 
it  is  sometimes  almost  impossible  to  determine  the  exact  ex- 
tent to  which  they  contain  other  elements  than  that  of  mere 
remuneration  for  services  rendered.  The  Treasury  has  faced 
this  problem  squarely'"^  and  has  issued  regulations  laying 
down  the  principles  in  accordance  with  which  these  distinctions 


"The  subject  was  first  treated  in  a  very  inadequate  fashion  in  Reg. 
33,  1918,  Art.  138.  In  T.  D.  2696  (April  10,  1918)  the  subject  was  clearly 
and  accurately  presented. 


4i8  INCOME 

are  to  be  made.  These  regulations  (articles  105-107)  are 
quoted  in  full  in  Chapter  XXVI. 

Briefly  it  is  held  that  "the  test  ....  is  whether  they  are 
reasonable  and  are  in  fact  payments  purely  for  services." 
Even  though  the  payment  is  determined  on  a  contingent  basis 
and  is  greater  than  the  amount  which  would  ordinarily  be  paid, 
it  may  still  be  considered  pure  compensation  if  the  basis  is  de- 
termined ''pursuant  to  a  free  bargain  between  the  enterprise 
and  the  individual  made  before  the  services  are  rendered 
.  .  .  . "  In  case  of  compensation  determined  after  services 
have  been  rendered,  reasonableness  is  ordinarily  the  controlling 
test." 

The  Treasury  held,  in  the  following  case,  that  the  pay- 
ments made  were  for  services  which  had  been  rendered  and 
were  not  a  gift : 

Ruling.  A  was  an  employee  of  the  M  Company  under  contract 
for  a  period  of  21  years,  such  contract  being  terminable  at  the  will  of 
the  company.  The  company  sold  its  assets  and  discontinued  business 
during  1920,  and  at  the  time  A's  employment  ceased  in  1921  he  re- 
ceived 6y  dollars  from  the  M  Company  as  an  expression  of  its  appre- 
ciation of  his  long  and  faithful  service.  A  had  no  interest  in  the 
company,  received  nothing  in  the  way  of  bonuses  or  extra  commis- 
sion, and  had  no  agreement  with  the  company  for  anything  further 
than  his  salary. 

This  office  has  held  that  pensions  and  bonuses  are  in  the  nature 
of  additional  compensation  to  the  recipient  and  must  be  included  in 
computing  net  income.  In  a  like  manner,  any  lump  sum  received  by 
an  employee  from  a  former  employer  upon  the  termination  of  his 
employment  has  in  it  a  large  element  of  compensation  for  services 
previously  rendered. 

It  is  held,  therefore,  that  the  amount  received  by  A  is  in  the  nature 
of  additional  compensation  and  must  be  included  by  A  in  computing 
his  net  income  for  the  year  in  which  it  was  received.  (B.  37-21-1814; 
O.  D.  1814.) 

In  cases  such  as  the  above,  the  assumption  is  that  the  pay- 
ments are  for  services,  but  if  intended  as  a  gift  the  recipient 
is  not  taxable  thereon.  The  facts  of  the  foregoing  case  are 
not  stated  in  detail,  but  it  appears  that  the  payment  was  made 


See  Chapter  XXVI. 


FROM    PERSONAL   SERVICES  419 

as  an  expression  of  the  company's  appreciation  of  the  em- 
ployee's long  and  faithful  service.  There  would  appear  to  be 
strong  evidence  to  support  a  gift. 

The  following  arrangement  was  held  to  constitute  a  gift: 

Ruling.  Subsequent  to  February  28,  1913,  the  M  Company  issued 
to  A  an  endowment  life  insurance  policy  on  his  life.  A  made  a  sin- 
gle payment  of  Sx  dollars  in  consideration  of  which  the  M  Company 
agreed  to  pay  as  an  endowment  the  sum  of  6x  dollars.  The  insured 
placed  the  policy  on  the  accelerative  endowment  plan  so  that  the 
policy  became  payable  in  1920.  It  was  agreed  when  the  policy  was 
written  that  the  proceeds  should  be  paid  in  two  hundred  and  forty 
monthly  payments,  one-half  of  which  should  be  paid  to  B,  a  son  of 
the  insured,  and  the  remaining  one-half  to  C^  a  daughter  of  the  in- 
sured, provisions  being  made  for  payment  in  the  event  of  the  death 

of  the  beneficiaries  named.     The  installments  beginning  with  the  

were  to  be  increased  by  such  dividends  as  might  be  apportioned 
thereto.    A  is  still  living. 

Held,  that  the  endowment  policy  in  question  was  a  gift  by  A  to 
B  and  C  and  that  that  part  of  each  installment  paid  under  the  policy 
to  B  and  C  which  represents  a  return  of  the  capital  value  received 
by  them,  that  is,  the  cost  of  the  policy  to  the  donor,  is  not  taxable 
income,  but  that  that  part  of  each  installment  which  represents  the 
gain  derived  by  them  or  dividends  apportioned  to  the  installment, 
should  be  returned  as  taxable  income.     (B.  47-21-1931 ;  O.  D.  1108.) 

Gifts  or  bonuses  to  employees. — The  interest  of  the  re- 
cipient of  a  bonus  or  similar  kind  of  income  is  centered  upon 
the  taxes  which  he  may  properly  be  called  upon  to  pay  on  ac- 
count of  the  item.  If  it  is  adjudged  an  expense,  he  is  fully 
taxable  upon  the  amount  received,  because  the  employer  has 
not  paid  any  tax  on  the  sum.  Certain  employers,  however, 
prefer  to  make  these  payments  tax-free  to  the  recipients  and 
to  treat  them  as  distributions  of  profits.  In  some  cases  such 
payments  were  made  in  good  faith  and  charged  as  expenses, 
only  to  be  subsequently  disallowed  by  income  tax  inspectors. 
Naturally  the  recipients,  in  reporting  the  amounts  received, 
should  not  have  had  to  pay  again  the  tax  which  had  been 
paid  in  their  behalf. 

The  regulations  prescribe  in  detail  the  procedure  to  be 
followed  by  the  recipient  of  such  income. 


420 


INCOME 


Commissions,  fees  and  tips  are  taxable. — 

Regulation Commissions  paid  salesmen,  compensation 

for  services  on  the  basis  of  a  percentage  of  profits,  commissions  on 
insurance  premiums,  tips,  ....  are  income  to  the  recipients ;  as 
are  also  marriage  fees,  baptismal  offerings,  sums  paid  for  saying 
masses  for  the  dead,  and  other  contributions  received  by  a  clergyman. 

evangelist  or  religious  worker  for  services  rendered (Art. 

32.) 

Christmas  gifts,  however,  are  not  considered  income  with- 
in the  meaning  of  the  law  and  are  not  supposed  to  be  inchided 
in  a  return,"^  but  if  deducted  by  employers  as  additional  com- 
pensation (as  is  usually  the  case)  the  amounts  received  are 
taxable. 

Ruling.  Commissions  advanced  in  payment  for  services  of  an 
advertising  solicitor  should  be  reported  as  gross  income  for  the  tax- 
able year  in  which  received.  Any  portion  of  the  commissions  thus 
received,  which  are  paid  back,  owing  to  failure  of  payment  for  ad- 
vertising, may  be  deducted  as  a  loss  for  the  year  in  which  payments 
are  returned.     (C.  B.  i,  page  67;  O.  D.  19.) 

The  question  arises  as  to  the  year  in  which  the  bonus 
should  be  reported.  It  is  customary  tor  many  concerns  to  set 
apart  bonuses  at  the  end  of  the  year  and  pay  them  a  few 
days  after  the  close  of  the  year. 

Ruling.  In  accordance  with  its  annual  practice,  a  company  on 
December  31,  1916,  set  aside  on  its  books  a  lump  sum  representing 
a  part  of  its  net  profits  for  1916  for  the  purpose  of  distributing  the 
same  to  its  employees  as  additional  compensation  for  services  ren- 
dered during  that  year.  The  actual  disbursement  of  this  fund  was 
made  on  January  2,  1917. 

Held,  that  this  additional  compensation  was  taxable  in  the  hands 
of  the  recipient  employees  at  1917  rates,  since  the  setting  aside  of 
the  amount  to  be  distributed  on  the  company's  books  on  December  31, 
1916,  was  not  a  sufficient  compliance  with  the  regulations  to  warrant 
treating  it  as  income  constructively  received  in  1916.  (C.  B.  3,  page 
III;  A.  R.  R.  182.)-* 

The  Treasury  also  said  in  this  case  that  "the  amount  set 
apart"   was   not   subject   to   demand   by  the   employees,   and 


'T.  D,  2090  (December  14,  1914). 
Issued  under  Revenue  Act  of  1917. 


FROM    PERSONAL    SERVICES  421 

therefore  in  effect  the  bonus  could  not  be  said  to  be  "construc- 
tively" received"'"'  in  19 16. 

Government  pensions  to  widows  are  gifts. — 

Ruling.  Held,  that  pensions  paid  by  the  United  States  Govern- 
ment to  widows  of  soldiers,  as  such,  are  not  taxable  income  for  the 
reason  that  such  pensions  are  not  awarded  as  compensation  for  ser- 
vices rendered  to  the  United  States  Government  by  the  widows  and 
are  mere  gifts  or  gratuities.     (C.  B.  4, 'page  84;  O.  D.  857.) 

Remuneration  to  executor  provided  by  will  held  taxable. — 

In  the  case  of  United  States  v.  J\iiidcrbilt,-''  the  late  Alfred  G. 
Vanderbilt,  by  his  w^ill,  bequeathed  sums  varying  from  $200,- 
000  to  $500,000  to  men  named  by  him  as  executors  and 
trustees  under  his  will  in  "lieu  of  all  compensation  or  commis- 
sions" for  their  services  as  such.  These  executors  and  trustees 
claimed  that  these  sums  were  becjuests  and  therefore  not  tax- 
able, and  did  not  include  them  in  their  income  tax  returns. 
The  Internal  Revenue  Bureau  took  the  view  that  the  entire 
sums  were  in  payment  for  services,  and  therefore  were  taxable 
income.  Suit  was  brought  and  the  court  sustained  the  view  of 
the  Bureau. 

Compensation  of  the  clergy. — 

The  Treasury  has  held  that  a  pension  paid  to  a  retired 
clergyman  is  taxable  income. 

Ruling.  The  fact  that  the  pensions  are  paid  through  the  govern- 
ing body  instead  of  by  each  individual  church  direct  to  the  pensioners . 
is  immaterial,  as  the  churches  and  the  governing  body  are  part 
of  the  same  religious  organization  and  the  fund  out  of  which  the 
pensions  are  paid  is  contributed  by  the  churches  by  whom  the  retired 
clergymen  were  formerly  employed.     (I-2-17;  I.  T.   1157.) 

Ruling.  A  clergyman  is  not  liable  for  any  income  tax  on  the 
amount  received  by  him  during  the  year  from  the  parish  of  which 
he  is  in  charge,  provided  that  he  turns  over  to  the  religious  order  of 
which  he  is  a  member,  all  the  money  received  in  excess  of  his  actual 
living  expenses,  on  account  of  the  vow  of  poverty  which  he  has  taken. 


'  Sec  page  387. 

'275  Fed.     Advance  Opinions,  page   log. 


422  INCOME 

Members  of  religious  orders  are  subject  to  tax  upon  taxable  in- 
come, if  any,  received  by  them  individually,  but  are  not  subject  to 
tax  on  income  received  by  them  merely  as  agents  of  the  orders  of 
w^hich  they  are  members.    (C.  B.  i,  page  82;  O.  D.  119.) 

Rental  value  of  residence  occupied  by  clergy  is  not 
taxable  income. 

Law.     Section  213 the  term   "gross  income" —  .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title:  .... 

(11)  The  rental  value  of  a  dwelling  house  and  appurtenances  there- 
of furnished  to  a  minister  of  the  gospel  as  part  of  his  compensa- 
tion; .... 

This  exemption  appears  for  the  first  time  in  the  192 1  law. 

Should  taxes  be  eliminated  from  profits  in  computing 
bonus? — In  calculating  the  amount  of  tax  to  be  paid  by  re- 
cipients of  commissions,  bonuses,  etc.,  which  are  based  upon 
the  profits  of  a  business  or  a  department  thereof,  the  question 
arises  as  to  the  obligation,  if  any,  of  such  recipients  to  assume 
a  share  of  the  tax  paid  by  the  business.  Payments  of  such 
commissions,  etc.,  are  expenses  of  the  business  and  should 
be  treated  as  such  by  deducting  them  from  gross  income  be- 
fore stating  the  net  profits  subject  to  excess  profits  and  in- 
come taxes.  It  follows,  therefore,  that  since  the  payments  re- 
ferred to  are  reported  as  allowable  deductions,  no  tax  of  any 
kind  has  been  paid  thereon  by  the  business,  but  the  recipients 
must  personally  pay  income  taxes''  on  any  amounts  they  may 
receive,  subject,  of  course,  to  statutory  exemptions,  other 
income,  etc.  Obviously,  then,  in  the  absence  of  any  specific 
agreement  to  the  contrary,  it  would  be  unfair  to  the  recipients 
to  compute  such  commissions,  etc.,  on  the  income  of  the  busi- 
ness after  deducting  excess  profits  and  income  taxes. -^ 


^  [Former  Procedure]  For  any  part  of  the  year  1917,  the  8  per  cent 
excess  tax  had  also  to  be  paid. 

'"Decision  Edgar  W.  S.  Recdcr  v.  G.  IVinthrop  Coffin  and  Qn'mcy  A. 
Gillmore,  individually  and  as  copartners,  trading  as  Coffin  &  Gillmore, 
Court  of' Common  Pleas  No.  3  (Philadelphia),  June  Term,  1918,  No.  3268 
(not  reported).     Extract   from  opinion:    McMichael,   P.  J.,   November   15, 

1918. 

"We  have  considered  the  question  of  deduction  of  income  taxes  before 


FROM    PERSONAL   SERVICES 


423 


This  position  is  subject  to  modification  in  cases  where 
there  may  be  said  to  exist  an  understanding  with  an  employee 
that  federal  income  and  excess  profits  taxes  are  to  be  de- 
ducted before  ascertaining  the  amount  available  for  distribu- 
tion to  an  employee  who  is  on  a  profit-sharing  basis  and  to  the 
partners  or  stockholders.  If  an  employee  were  on  a  salary 
basis  the  full  amount  of  the  salary,  no  matter  how  large, 
would  be  paid  to  the  employee  without  deduction  for  federal 
taxes.  Many  employees  who  change  from  a  salary  to  a  so- 
called  profit-sharing  basis  contend  that,  as  they  are  held  re- 
sponsible for  their  income  taxes  (and  in  19 17  for  the  8  per 
cent  excess  profits  tax),  employers  have  no  right  to  transfer 
to  them  any  part  of  a  burden  which  fortuitously  has  been  laid 
solely  or  chiefly  upon  the  employer.  In  claiming  the  amount 
paid  to  the  employee  as  a  deductible  business  expense,  the 
employer  may  be  said  to  assent  to  the  position  that  the  em- 
ployee is  not  liable  to  a  tax  based  on  net  income.  In  view  of 
the  very  high  income  and  other  taxes  imposed  upon  corpora- 
tions in  the  years  prior  to  1922,  the  whole  matter  becomes  one 
of  expediency.  Employers  and  employees  should  come  to  an 
understanding  and  amend  existing  contracts  by  adding  a  clause 
setting  forth  the  agreement  which  may  be  reached.  In  any 
event  it  is  incorrect  to  calculate  the  taxes  which  would  be  pay- 
able if  the  employee  had  no  interest  in  the  business,  and  then 
charge  the  employee  with  a  proportion  of  such  amount  equal  to 
the  percentage  of  profits  to  which  he  is  entitled.  This  method 
is  sometimes  followed,  but  it  imposes  upon  the  employee  part 
of  a  tax  which  is  not  paid  to  the  government. 

If  it  is  decided  that  the  employee  is  to  bear  a  proportionate 
share  of  federal  taxes  on  the  net  income  remaining  after  his 
compensation  has  been  charged  as  an  expense,  it  wall  be  neces- 
sary to  use  a  somewhat  complicated  formula  for  determining 
the  amount  of  net  income  remaining  after  deducting  from 


allowing  the  plaintiff  5  per  cent  of  the  net  profits  as  salary.  We  do  not 
think  this  deduction  should  be  made,  as  it  is  not  in  any  way  contcmpUtcd 
by  the  contract." 


424 


INCOME 


earnings  the  contf)ensation  due  to  the  employee;  because  the 
compensation  due  cannot  be  determined  until  taxes  are  al- 
lowed for — and  taxes  cannot  be  allowed  for  until  the  com- 
pensation due  to  the  employee  is  determined.  The  following 
illustrations  set  forth  as  simple  a  formula  as  can  be  devised 
for  reaching  the  desired  result: 


FROM    PERSONAL   SERVICES 


425 


o  a  bD     ^ 


^^ 


w    "^ 


O      o 

(M         y_ 


^2 


rt   C^       ~ 


^     t: 


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W 
-I 

m 
o 

Oh 


Et 


^•5  c 


bo 


<u 


cj 


O   c;  -D 


■     0) 


03    aj  +j 


<U          3  i5    _>  *^   O 

•S.2  rt  .. 


lU 


c  ^  o 


J2   o 


(„        o  o  "^  o  >« 

^    <U   O   n!   <u    ^, 
O   o  -a   O        -C   rt 


§.rt  rt  ^  o  «  ^ 

(u  w  y  rt  g  >• 
•*-  bo  i2  5  ^       .^ 


^  ^  P  O  J3  bo  C 
*-  ■'^  _o  **^  rt  C  — 
-=■:=   S   OJ:^    O   '•«•" 

H  g,     -^H  ^<^ 
E  u       bo     _2 

«  3   O       13       "T 
U3    M  ^<->  <U  S 


^B 


u 


C  M-. 

o  o 

CCO<. 
aj 
X 
W 


-r  U 


O     w 


^  ^ 


8  o 


w 


426 


INCOME 


^       HH 


s 

(5 


o 


^1  ►= 

+ 

o 


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X 

+ 


o   o 


&H 


H 


X 

■^ 

u 

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< 

L> 

a. 

X 

c 

H 

o 

E 

4.> 

u 

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u 

o 

X 

2 

c 

H^  H 


—  IT)      O 


Cl. 


"" 

O 

(A 

ID 

U 

E 

<u 

o 

bfl  <J 

a 

c 

<  o 


■^  IT) 

00  oo" 


X  X 


FROM    PERSONAL   SERVICES 


427 


0  0 

„ 

9  t 

10 

d  10 

■* 

5    Tj- 

10 

5  On 

q^ 

dco 

»-( 

tM 

0 

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o  CO 
d  w 


o  o 


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0 

0  0 

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rt 

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rf  IT) 

d\ 

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ro 

m  Tl" 

0 

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0   "0 

ir> 

On  "^ 

K! 

>-•  0 

<s 

00'  0' 

00 

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00 

09 

W- 

t«- 

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<«- 

H 


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(-U  Eoo<. 


t/} 


u 


— <  a 


'^ 


H 


e  "> 
..J,     '.2  iJ  — 

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C/2 


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w 

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0 

So 


428  INCOME 

In  the  following  illustration,  a  knowledge  of  algebra  is  not 
necessary."^ 

Method  of  Calculating  Federal  Taxes  and  Bonus  When  Bonus 
IS  Based  on  Net  Profits  after  Deducting  Federal  Taxes 

Given:  A  corporation  with  an  invested  capital  of  $840,000  makes 
a  profit  of  $470,000  before  calculating  taxes  and  has  an  agreement 
with  its  manager  to  pay  him  10  per  cent  bonus  on  net  profits  after 
paying  taxes.  In  this  case  the  entire  bonus  comes  out  of  the  40  per 
cent  bracket.     Taxes  before  applying  bonus  amount  to  $173,124. 

The  change  in  taxes  as  result  of  allowing  bonus  would  be  as 
follows : 

Decrease  in  excess  profits  tax 40%  of  bonus 

Decrease  in  normal  tax 10%    "       " 

Total  decrease   50%    "        " 

Increase  in  normal  tax  as  result  of  decreased  credit  account 

less  excess  profits  paid,  10%  of  40%,  or 4%    "        " 

Net   decrease   in   tax    46%    "        " 

As  result  of  decrease  in  taxes  there  is  more  profit  in  which  the 
manager  would  participate  to  extent  of  10  per  cent,  or  4.6  per  cent 
of  the  bonus. 

Calculation  of  Bonus 

Profits  before  taxes  $470,000.00 

Taxes — before  applying  bonus 173,124.00 

Balance   $296,876.00 

10%  bonus  on  above $  29.687.60 

4.6%  of  $29,687.^10  =   1,365.63 

4.6%  of       1,365.63  =   62.82 

4.6%  of           62.82  =    2.89 

4.6%  of             2.89  =   .13 

Total  bonus $31,119.07 


Calculation  of  Tax 
Profits  $470,000.00  less  $31,119.07  =  $438,880.93 

20%  Bracket 

20%    of   invested   capital $168,000.00 

Excess  profits  credit  8%  of  invested  capital  plus 

$3,000    70,200.00 

20%  tax  on  balance $97,800.00      $19,560.00 


"From  Journal  of  Accountancy,  September,  1920, 


FROM    PERSONAL   SERVICES  429 

40%  Bracket 

Profit $438,880.93 

20%   on   invested   capital 168,000.00 

Balance  taxable  at  40% $270,880.93       108,352.37 

Total  excess  profits  taxes $127,912.37 

Income  Tax 

Profit    $438,880.93 

Credits : 
Excess  profits  taxes  plus  $2,000 129,912.37 

Balance  taxable   at    10% $308,968.56        30,896.86 


Total  tax  $158,809.23 

Proof 

Profit  before  tax  and  bonus $470,000.00 

Taxes  158,809.23 

Balance    $311,190.77 

10%  bonus  to  manager 31,119.07 


In  case  the  bonus  came  out  of  the  20  per  cent  bracket  the  decrease 
in  taxes  would  be  28  per  cent  and  the  additional  bonus  to  manager 
would  be  10  per  cent  of  that  amount,  or  2.8  per  cent  of  the  bonus. 

When  the  bonus  comes  out  of  the  40  per  cent  bracket  the  amount 
of  bonus  before  figuring  taxes  plus  4.8217813  per  cent  of  itself  will 
give  the  final  bonus. "'^  If  it  comes  out  of  20  per  cent  bracket,  use 
2.880656  per  cent. 

In  case  part  of  the  bonus  comes  out  of  the  40  per  cent  bracket 
and  the  balance  out  of  20  per  cent  bracket,  the  calculation  would  be 
as  follows : 

A  corporation  with  an  invested  capital  of  $100,000  makes  a  profit 
of  $21,000,  and  has  agreed  to  pay  its  manager  10  per  cent  of  net 
profits  after  calculating  tax.  The  tax,  before  deducting  bonus,  would 
be  $3,880. 

Calculation  of  Bonus 

Profit  before  bonus  and  taxes $21,000.00 

Tax  before  deducting  bonus 3,880.00 

Balance    $17,120.00 

10%  bonus  on  above 1,712.00 


Before  deducting  bonus  there  was  a  profit  of  $1,000  in  the  40 
per   cent  bracket,   but   after   deducting  bonus   the   entire   tax   would 


'"  This  statement   i.s  erroneous.     The  sentence   should   read : 
"When  the  bonus  comes   out  of  the  40  per  cent  bracket,   the  amount 
of   bonus    (after   figuring   taxes   as   though   bonus   were  not   an   allowable 
deduction)  plus  4.8217813  per  cent  of  itself  will  give  the  final  bonus." 


430  INCOME 

fall  in  the  20  per  cent  bracket.     The  reduction  in  taxes  as  result  of 
allowing  the  tentative  bonus  of  $1,712  would  be  as  follows: 

46%  of  $1,000.00  in  40%   bracket $   460.00 

28%  of  $712.00  in  20%  bracket 199-36 

Total  saving  in  taxes  on  first  calculation  of  bonus $   659.36 

Manager  gets  10%  of  this  amount 65.94 

2.8%   of  $65.94 1.85 

2.8%   of  $1.85 .05 

Total  additional  bonus $     67.84 

Tentative  bonus 1,712.00 

Total   bonus $1,779.84 

The  proof  works  out  as  illustrated  in  the  first  example. 

Compensation  "of  Whatever  Kind  and  in  Whatever 
Form  Paid" 

The  law  specifies  that  compensation  for  personal  services 
shall  be  reported  as  income  even  if  received  in  some  form 
other  than  cash.  Taxable  income  is  to  include  compensation 
"of  whatever  kind  and  in  whatever  form  paid."  The  regula- 
tions governing  the  valuation  of  services  not  paid  for  in  cash 
read  as  follows: 

Regulation.  Where  services  are  paid  for  with  something  other 
than  money,  the  fair  market  value,  if  readily  realizable,  of  the  thing 
taken  in  payment  is  the  amount  to  be  included  as  income.  If  the 
services  were  rendered  at  a  stipulated  price,  in  the  absence  of  evidence 
to  the  contrary  such  price  will  be  presumed  to  be  the  fair  value  of 
the  compensation  received (Art.  33.) 

Recision  of  salary  contract. — 

Ruling.  A  contract  was  entered  into  between  A  and  the  M 
Company,  whereby  the  compensation  of  A  for  the  year  191 8,  in  addi- 
tion to  his  salary,  was  fixed  at  a  certain  per  cent  of  the  net  income 
from  the  business.  This  contract  was  later  modified  and  a  stated 
amount  agreed  upon  as  the  maximum  liability  of  the  corporation, 
which  sum  was  paid  to  A  in  1919,  in  full  settlement  of  the  contract 
for  1918,  and  was  reported  by  A  in  his  income  tax  return  for  1919. 
Owing  to  dissatisfaction  on  the  part  of  some  of  the  stockholders 
over  the  second  contract,  an  agreement  was  reached  whereby  the 
money  received  by  A  thereunder  in  1919  was  returned  to  the  com- 
pany on  March  — ,  1921,  and  all  rights  under  the  contract  waived. 


I 


FROM    PERSONAL   SERVICES  431 

The  contracts  of  employment  were  fully  performed  in  19 19  when 
the  amount  agreed  upon  was  paid  by  the  company  to  A  in  full  settle- 
ment of  the  contracts.  As  there  can  be  no  recision  of  an  executed 
contract  there  was  no  obligation  upon  A  to  refund  any  of  the  money 
so  received.  The  transfer  of  the  amount  to  the  company  on  March  — , 
1921,  was  purely  a  voluntary  act  on  his  part  and  for  income  tax  pur- 
poses the  amount  transferred  must  be  considered  a  gift.  (B.  43-21- 
1882;  O.  D.   1073.) 

A  contract  can  be  legally  rescinded  by  mutual  consent.  It 
is  not  necessary  to  support  this  statement  by  legal  decisions. 
It  is  established  business  practice.  If  the  foregoing  ruling 
was  decided  on  that  point  alone,  it  is  not  good  law. 

Premiums  paid  by  employer  on  group  life  insurance — 
not  income  to  employee. — 

Regulation Premiums  paid  by  an  employer  on  policies 

of  group  life  insurance  covering  the  lives  of  his  employees,  the  bene- 
ficiaries of  which  are  designated  by  the  employees,  are  not  income  to 
the  employees (Art.  33.) 

Prior  to  March  20,  1920,  the  Treasury  held  payments  of 
this  character  to  be  additional  income  of  the  employee.  The 
employer,  however,  may  deduct  such  premiums  paid  as  "ordi- 
nary and  necessary  expenses. "^^ 

Compensation  received  in  the  form  of  stock. — 

Regulation Compensation  paid  an  employee  of  a  cor- 
poration in  its  stock  is  to  be  treated  as  if  the  corporation  sold  the 

stock   for  its  market  value  and  paid  the  employee  in  cash 

(Art.  33.) 

The  proper  valuation  of  such  stock  is  often  a  matter  of 
considerable  difficulty  and  its  true  worth  for  purposes  of 
taxation  in  many  cases  is  not  the  same  as  the  sum  shown  on 
the  books  of  the  company.^"  When  there  is  an  actual  market 
price  for  the  stock  such  price  is  the  proper  one  to  use.     The 


''Bulletin  12-20-793;  O.  1014. 

'''  [Former  Procedure]  The  "actual  value"  of  such  stock  charged  on 
the  books  of  the  corporation  as  an  expense  was  the  basis  used  previously. 
(Reg.  33.  Art.  139.) 


432  INCOME 

problem  is  complicated  when  there  is  no  market  value  be- 
cause the  stock  is  not  bought  and  sold  on  an  exchange  or 
when  the  directors  have  placed  an  "optimistic"  value  upon 
the  shares.  In  case  the  recipient  of  the  stock  is  one  of 
the  directors  and  as  such  has  been  a  party  to  a  formal 
determination  that  the  services  performed  were  equal  in 
value  to  the  par  value  of  the  stock,  he  would  have  dif- 
ficulty in  discussing  this  valuation  with  a  revenue  agent.  If 
he  was  not  a  party  to  the  valuation  placed  upon  the  stock  by 
the  corporation  he  should  return  the  stock  at  the  value  which 
in  his  best  judgment  represents  its  actual  worth,  which  would 
also  represent  the  cash  value  of  his  services.  He  would  not 
be  bound  by  a  nominal  quotation  for  the  stock  on  an  exchange 
or  by  sales  prices  which  might  not  represent  "fair"  prices. 
The  principles  followed  by  the  Treasury  in  fixing  the  value 
to  be  placed  on  stock  received  in  payment  for  services,  when 
the  value  at  the  date  of  issuance  is  unknown,  are  stated  in  the 
following : 

Ruling It   being    an    entirely    new    venture,    the    market 

price  for  the  stock  at  the  time  of  the  incorporation  and  the  issuance 
of  stock  was  not  known.  Shortly  thereafter,  the  taxpayer,  as  a  part 
of  the  agreement,  proceeded  to  make  a  market  for  the  stock.  That  is 
to  say,  he  had  it  listed  on  the  curb  and  arranged  for  bringing  it  to 
the  attention  of  the  public.  For  his  services  the  taxpayer  received  in 
payment  shares  of  the  stock  of  the  corporation  and  voting  trust  cer- 
tificates (  non-negotiable ) . 

No  stipulated  cash  value  appears  to  have  been  placed  on  the  tax- 
payer's services. 

Where  services  are  paid  for  in  something  other  than  money,  the 
fair  market  value  of  the  thing  taken  in  payment  is  the  amount  to  be 
included  as  income.  If  stock  of  a  corporation  is  received  in  payment 
for  services  rendered,  such  stock  must  be  considered  as  equivalent  to 
cash,  providing  it  has  any  actual  money  value.  It  is  to  be  treated  as 
if  the  corporation  sold  the  stock  for  its  market  value  and  paid  the 
employee  in  cash.  (See  art.  33  of  Regulations  45.)  To  constitute 
taxable  income,  however,  the  value  of  the  stock  received  must  be  so 
fixed  as  to  be  capable  of  measurement  at  the  time  of  receipt.  If  its 
value  can  not  be  measured  in  terms  of  cash  or  money's  worth,  then  it 
can  not  be  considered  income  for  income-tax  purposes.     (19-19-494.) 

The  value  of  stock  which  has  no  market  price  may  be  estimated  by 
resort  to  the  value  of  the  assets  capitalized  and  attendant  circum- 


FROM    PERSONAL    SERVICES 


433 


stances  which  may  affect  the  value  of  such  assets.  (Goodwin  v.  Wil- 
bur, 104  111.  App.,  45;  Collins  V.  Denny,  89  N.  W.,  1012;  Virginia  v. 
West  Virginia,  238  U.  S.,  202.)  In  the  case  of  inventions,  their  value 
is  dependent  upon  proven  utility  or  the  likelihood  of  practical  use- 
fulness and  therefore  stock  issued  thereon  will  have  a  corresponding 
value.  If  an  inventor  should  sell  a  recently  patented  invention  to  a 
manufacturer  before  its  use  has  been  tested,  but  simply  upon  its 
apparent  usefulness,  it  may  be  said  that  the  invention  at  that  time  is 
worth  what  is  paid  for  it,  because  a  price  has  been  offered  and  paid. 
The  measure  of  value  is  the  price  paid.  {Burke  Hollow  Coal  Co.  v. 
Lawson,  151  S.  W.,  657;  Johnson-Brinkman  Commission  Co.  v. 
Wabash  R.  Co.,  64  Mo.  App.,  590.)  Stock  issued  upon  such  invention 
would  be  worth  the  value  of  the  invention,  measured  by  the  price 
which  the  manufacturer  has  paid  for  it. 

Where  the  inventor  himself  forms  a  company  and  issues  stock 
upon  his  invention  and  there  are  dealings  in  said  stock  at  or  within 
a  reasonable  time  after  the  issuance  thereof,  prices  then  paid  may 
be  said  to  be  evidence  of  the  value  of  the  invention  capitalized  and 
therefore  of  the  stock  at  the  time  of  its  issuance.  This  is  upon  the 
principle  that  a  subsequently  existing  fact  is  evidence  of  some  pro- 
bative value  of  the  prior  existence  of  the  same  fact.  (See  Hum- 
phreys V.  Minnesota  Clay  Co.,  103  N.  W.,  338;  Atwood  v.  Bears,  8 
N.  W.,  55.) 

The  taxpayer  has  received  something  which  he  did  not  have  be- 
fore. If  what  he  has  received  is  of  value  and  that  value  is  capable 
of  measurement,  he  has  received  income.  (19-19-494,  supra.)  The 
fact  that  the  stock  received  sold  in  the  open  market  within  a  very 
short  time  after  the  date  of  its  issue  and  receipt  by  the  taxpayer  is 
strong  evidence  that  it  had  value  at  such  date  and  the  prices  received 
in  such  sales  are  evidence  of  the  measure  of  its  value  within  the 
principles  above  laid  down.    However — 

In  the  case  of  subsequent  existence  as  evidence  at  the  time  in 
issue,  there  is  the  disturbing  contingency  that  some  circumstance  oper- 
ating in  the  interval  may  have  been  the  source  of  the  subsequent 
existence,  and  the  propriety  of  the  inference  will  depend  on  the  likeli- 
hood of  such  intervening  circumstance  having  occurred  and  been  the 
true  origin.  (Sec.  437,  Wigmore  on  Evidence.  See  also  Doll  v. 
Henne'ssy  Merc.  Co.,  81  Pac,  625.) 

Consequently,  even  though  the  inference  is  strong  that  the  first 
prices  brought  in  the  sale  of  the  stock  in  question  represent  its  true 
market  value  at  the  date  of  issue  and  receipt  by  the  taxpayer,  still 
the  activities  of  the  taxpayer  in  bringing  the  stock  to  the  attention 
of  the  public  in  a  favorable  light  might  have  been  the  cause  for  a 
large  portion  of  the  prices  so  received.  Such  activities  can  not,  how- 
ever, be  said  to  account  for  all  of  such  prices.  It  is  therefore  fair 
and  reasonable  to  conclude,  in  view  of  the  range  of  prices  over  a 


434  INCOME 

period  of  two  years,  that  the  price  received  over  and  above  the  stated 
par  value  was  due  to  the  taxpayer's  efforts  at  publicity,  and  that  the 
value  of  the  stock  when  received  by  him  was  its  par  value.  (See 
Mojfitt  V.  Hereford,  34  S.  W.  (Mo.)' 252.)   .... 

It  is  therefore  held,  in  the  peculiar  circumstances  of  this  case, 
that  stock,  based  upon  a  new  and  untried  invention,  received  in  pay- 
ment for  services  is  income  to  the  person  receiving  the  stock  to  the 
extent  of  its  market  value.  The  market  value  at  the  time  of  receipt 
is  to  be  fixed  by  taking  into  consideration  the  first  prices  brought  for 
such  stock  w-hen  placed  on  sale  within  a  reasonable  time  after  such 
receipt,  due  allowance  being  made  for  intervening  circumstances 
affecting  such  value.      (B.   1-20-656;   O.  962.)^^ 

The  foregoing  ruling  is  quoted  in  full  because  it  describes 
the  Treasury's  method  of  determining  gain.  When  a  loss  is 
claimed  the  Treasury  does  not  use  the  same  formula.  When 
an  inventor  endeavors  to  fix  the  value  of  his  patents  at  March 
I,  191 3,  he  is  not  given  the  benefit  of  such  statements  in  the 
ruling  as  this :  "In  the  case  of  inventions,  their  value  is  de- 
pendent upon  proven  utility  or  the  likelihood  of  practical  use- 
fulness." ^  In  no  part  of  the  ruling  is  there  any  mention  of  the 
formula  of  the  Supreme  Court  in  defining  income.^*  It  must 
be  remembered  that  only  income  can  be  taxed,  and  only  income 
which  has  been  realized  to  such  an  extent  that  it  is  the  equiva- 
lent of  cash.  The  Supreme  Court  has  never  approved  the 
principle  that  income  can  be  imputed  to  a  transaction  when  the 
stock  or  other  property  received  has  no  market  value. 

Stock  purchase  schemes  for  employees. — 
Ruling.  Where  a  corporation  offers  its  employees  the  oppor- 
tunity to  purchase  shares  of  its  stock,  and  the  title  to  the  stock  re- 
mains in  the  corporation  until  it  is  fully  paid  for,  it  is  held  that  the 
so-called  dividends  credited  to  the  account  of  the  employee  purchas- 
ing the  stock  as  part  payment  for  the  stock  are  not  in  fact  dividends, 
as  dividends  can  not  legally  be  declared  on  unissued  or  treasury 
stock.  The  amounts  so  credited,  which  are  measured  by  the  dividends 
declared  on  the  outstanding  stock,  constitute  additional  compensation 
to  the  employees  and  taxable  as  such. 

Where  other  amounts  in  the  nature  of  special  allowances  are. 
upon  the  fulfillment  of  certain  conditions,  credited  to  the  account  of 


'See  Chapters  XVI  and  XVII. 
'See  page  533,  ct  scq. 


FROM    PERSONAL   SERVICES 


435 


such  subscriber  as  part  of  the  payment  for  his  stock,  and  where  pro- 
vision is  made  for  the  payment  of  certain  amounts  in  the  event  the 
subscriber  does  not  default  in  any  payment  on  the  stock  being  pur- 
chased and  complies  with  certain  other  conditions,  it  is  held  that  such 
amounts  are  in  the  nature  of  additional  compensation. 

It  is  held,  further,  however,  that  as  the  interest  of  the  subscriber 
is  merely  a  contingent  interest  which  may  be  defeated  by  failure  to 
execute  the  terms  of  the  agreement  upon  which  the  stock  is  issued, 
the  so-called  dividends  and  special  allowances  credited  to  the  account 
of  the  subscriber  do  not  constitute  taxable  income  to  such  subscriber 
until  the  terms  of  the  agreement  have  been  completed.  (C.  B.  4,  page 
76;  O.  D.  763.) 

In  the  foregoing  ruling,  what  are  called  dividends  are  held 
to  be  additional  compensation  to  employees,  in  which  case  the 
payments  are  allowable  deductions  to  the  corporation ;  whereas 
dividends  are  not.  In  order  to  carry  out  the  purpose  of  the 
corporation,  stock  equal  to  the  aggregate .  accruing  credits 
should  be  issued  to  trustees  who  can  receive  and  disburse  the 
dividends  in  behalf  of  the   beneficial  owners. 

In  the  following  case  the  corporation  issued  the  stock  to 
trustees,  but  the  result  was  a  contingent  rather  than  a  vested 
beneficial  interest  in  the  employees. 

Rulings.  A  corporation  issued  in  the  name  of  its  employees  shares 
of  its  stock  as  compensation  for  services  rendered.  The  employees 
executed  the  certificate  of  transfer  on  each  share  of  stock  purporting 
to  transfer  the  stock  to  the  principal  owners  of  the  stock  of  the  cor- 
poration, designated  trustees.  The  conditions  of  the  purported  is- 
suance and  transfer  of  the  stock  were  that  it  should  be  held  by  the 
trustees  until  the  dividends  thereon,  paid  regularly  to  the  trustees, 
should  equal  the  par  value  of  the  stock,  after  which  the  dividends 
and  stock  were  to  become  the  property  of  the  employees.  In  case  of 
resignation  or  discharge  of  an  employee  prior  to  the  time  of  receiv- 
ing title  to  the  stock,  he  was  to  receive  the  dividends  paid  to  the 
trustee  on  account  of  the  stock  issued  in  his  name,  and  in  case  of  his 
death  they  were  to  be  paid  to  his  next  of  kin. 

Held,  that  title  to  the  stock  and  to  the  so-called  dividends  did  not 
vest  in  the  employees  until  the  conditions  imposed  by  the  agreement 
between  the  corporation  and  employees  were  fulfilled.  Consequently 
the  payments  made  to  the  principal  owners  of  the  stock  of  the  corpora- 
tion, the  amount  of  which  was  measured  by  the  dividends  paid  on 
the  outstanding  stock,  are  not  dividends  as  defined  by  section  201  (a) 
of  the   Revenue   Act  of   1918,   but  the  amount  thereof  is  additional 


436  INCOME 

compensation  for  services  rendered,  and  constitutes  income  to  the 
employees  in  the  year  in  which  the  title  vested  in  them,  subject  both 
to  normal  tax  and  surtax. 

When  title  to  the  stock  vests  in  the  employees  they  should  return 
as  taxable  income  the  fair  market  value  of  such  stock  at  that  time. 
Any  dividends  thereafter  paid  by  the  corporation  would  be  true  divi- 
dends as  defined  by  section  201  (a)  and  subject  only  to  surtax.  (C. 
B.  4,  page  76;  O.  D.  791.) 

Where  the  members  of  a  firm  establish  an  employees'  profit- 
sharing  fund  by  transferring  a  given  sum  of  money  to  certain 
employees  in  trust,  such  fund  being  invested  in  the  business  of  the 
firm  and  the  interest  paid  annually  to  a  certain  class  of  employees, 
who  hold  certificates  entitling  them  to  participate  in  the  profits  of  the 
fund,  such  certificates  being  subject  to  cancellation  at  the  pleasure  of 
the  firm,  the  income  from  the  fund  is  taxable  as  a  part  of  the  firm's 
income.    (C.  B.  2,  page  76;  S.  1329.) 

There  are  many  forms  of  profit-sharing  funds  and  plans. 
The  Treasury  holds  that  income  from  such  funds,  although 
paid  to  the  employees,  is  in  the  first  instance  income  of  the 
owner  of  the  fund  and  that  such  owner  is  the  firm  when 
"such  fund  is  neither  a  separate  business  venture  nor  an  irre- 
vocable trust."  The  ruling  is  sound.  The  actual  payments 
to  employees  are  an  allowable  deduction.  The  restriction  on 
the  deduction  applies  only  when  the  transfer  of  funds  is  in 
name  only.^^ 

Ruling.  Bonuses  paid  by  a  corporation,  partly  in  cash  and 
partly  in  stock  of  the  corporation,  which  stock  was  purchased  by  the 
corporation  on  the  open  market,  in  accordance  with  a  plan  laid  down 
by  its  board  of  directors,  to  the  most  deserving  of  its  employees 
(which  must  be  recognized  as  meaning  most  deserving  on  account 
of  services  rendered),  represent  additional  compensation  to  the  em- 
ployees and  as  such  are  deductible  by  the  corporation  and  taxable 
to  the  recipients.  The  fact  that  the  corporation  did  not  deduct  the 
amount  representing  these  bonuses  from  gross  income  in  its  return 
would  not  affect  the  taxability  of  the  bonuses  in  the  hands  of  the 
employees.  The  amount  to  be  considered  as  taxable  income  is  the 
actual  amount  of  cash,  plus  the  market  value  of  the  stock,  when 
received  by  the  employees.    (C.  B.  3,  page  144;  O.  D.  570.) 


See   also  section  219   (f). 


FROM    PERSONAL   SERVICES  437 

Compensation  received  in  the  form  of  notes. — 

Regulation.  Notes  or  other  evidences  of  indebtedness  received 
in  payment  for  services,  and  not  merely  as  security  for  such  payment, 
constitute  income  to  the  amount  of  their  fair  market  value.  A  taxpayer 
receiving  as  compensation  a  note  regarded  as  good  for  its  face  value  at 
maturity,  but  not  -bearing  interest,  shall  treat  as  income  as  of  the 
time  of  receipt  the  fair  discounted  value  of  the  note  at  such  time. 
Thus,  if  it- appears  that  such  a  note  is  or  could  be  discounted  on  a 
6  or  7  per  cent  basis,  the  recipient  shall  include  such  note  in  his 
gross  income  to  the  amount  of  its  face  value  less  discount  computed 
at  the  prevailing  rate  for  such  transactions.  If  the  payments  due 
on  a  note  so  accounted  for  are  met  as  they  become  due,  there  should 
be  included  as  income  in  respect  of  each  such  payment  so  much 
thereof  as  represents  recovery  for  the  discount  originally  deducted. 
(Art.  34.) 

That  is  to  say,  if  on  October  i,  1921,  A  received  in  pay- 
ment for  services  rendered  a  promissory  note  for  $1,000  pay- 
able in  6  months,  without  interest,  he  would  return  the  dis- 
counted value  (assuming  the  current  rate  to  be  6  per  cent), 
approximately  $970,  as  income  for  192 1.  When  the  note  is 
collected  in  1922,  he  would  return  $30  as  income.  The  maker 
of  the  note,  however,  is  permitted  to  deduct  in  192 1  the  full 
$1,000. 

If  the  note  bears  interest,  say  at  6  per  cent,  A  would  return 
in  1921  the  discounted  value,  viz.,  $1,015,  and  for  1922  he 
would  return  $15.  The  maker  of  the  note  would  deduct 
$1,000  in  1 92 1,  and  $30  in  1922. 

If  the  note  could  not  be  discounted  no  return  need  be  made 
for  1920.  This  privilege  is  extended  to  instalment  houses  and 
it  cannot  be  withheld  from  others  similarly  situated. 

Ruling.  A  corporation  keeping  its  accounts  on  the  basis  of 
actual  receipts  and  disbursements  loans  money,  the  loans  being  se- 
cured by  first  mortgages  on  property  of  the  borrowers.  The  cor- 
poration receives  as  commission  second  mortgages  on  the  property 
payable  in  5  or  10  annual  installments  without  interest. 

The  second  mortgage  notes  received  as  compensation  for  services 
should  be  reported  as  income  at  their  fair  discounted  value  as  at  the 
date  of  receipt.  If  the  notes  are  not  marketable  at  a  fair  discount 
value,  each  installment  payment  should  be  included  in  gross  income 
in  its  entirety  by  the  corporation  in  the  year  in  which  received.  (B. 
46-20-1302;  O.  D.  728.) 


438  INCOME 

Although  notes  may  be  regarded  as  "good  for  face  value 
at  maturity,"  as  stated  in  article  34,  if  not  "marketable  at  a 
fair  discount,"  the  income  need  not  be  reported  until  payment 
is  made. 

In  the  business  of  architects,  contractors  -and  banks,  sec- 
ond mortgage  bonds  are  often  taken  as  part  payment  for 
services  rendered.  These  securities  usually  have  no  market 
value.  If  books  are  kept  on  an  accrual  basis  the  income  to  be 
reported  should  be  on  an  estimated  market  or  discounted 
value  of  the  second  mortgages.  When  the  books  are  closed  an 
inventory  may  be  taken  since  the  mortgages  are  part  of  the 
stock-in-trade.  If  books  are  kept  on  a  cash  basis,  the  bonds 
should  not  be  reported  as  income  until  realized  in  cash. 

Compensation  for  services  received  by  partnership. — 

Ruling.  Shares  of  stock  and  cash  received  by  a  partnership  for 
underwriting  the  reorganization  of  an  insolvent  concern  in  which 
a  deceased  partner  owned  stock,  the  transaction  being  undertaken  in 
order  to  protect  the  interests  of  the  decedent's  estate  and  the  entire 
amount  received  therefrom  being  turned  over  to  his  estate,  represent 
taxable  income  to  the  partnership  regardless  of  the  fact  that  no  dis- 
tribution was  made  to  the  individual  partners  and  irrespective  of  the 
reasons  for  which  the  partnership  entered  into  the  transaction.  (C. 
B.  2,  page  72;  O.  D.  542.) 

The  foregoing  is  apparently  based  on  the  assumption  that 
although  the  partnership  was  practically  engaged  in  a  chari- 
table undertaking,  it  received  income  for  services  and  made  a 
gift  to  the  deceased  partner's  estate. 

Compensation  received  in  the  form  of  rent  and  board. — 

Regulation When   living   quarters   such   as   camps   are 

furnished  to  employees  for  the  convenience  of  the  employer,  the 
ratable  value  need  not  be  added  to  the  cash  compensation  of  the 
employees,  but  where  a  person  receives  as  compensation  for  services 
rendered  a  salary  and  in  addition  thereto  living  quarters,  the  value  to 
such  person  of  the  quarters  furnished  constitutes  income  subject  to 
tax (Art.  33.) 

Many  factory  superintendents,  as  part  consideration  for 
their  services  and  not  necessarily  for  the  convenience  of  the 


FROM    PERSONAL   SERVICES 


439 


employers,  are  permitted  to  live,  rent  free,  in  houses  belong- 
ing to  their  employers.  Under  this  ruling  they  are  required 
to  ascertain  the  rental  value  thereof  and  report  it  as  taxable 
income.  The  rental  value  of  a  minister's  house  is  exempt 
from  taxation."** 

While  the  rules  laid  down  on  this  point  are  in  themselves 
equitable,  they  can  scarcely  be  considered  consistent  with  the 
rule  under  which  persons  owning  their  own  houses  are  not  tax- 
able on  the  rental  value.  In  other  words,  there  is  a  discrimina- 
tion between  the  man  who  pays  no  rent  because  he  lives  in  the 
house  he  owns  and  the  man  who  pays  no  rent  because  he  lives 
in  his  employer's  house,  rent  free,  because  of  his  services. 
In  the  latter  case  income  tax  is  collected  on  the  rental  value. 
In  the  former  case  no  income  tax  is  assessed  on  the  rental 
value. 

Rulings.  Board  and  lodging  furnished  seamen  in  addition  to  their 
cash  compensation  is  held  to  be  supplied  for  the  convenience  of 
the  employer  and  the  value  thereof  is  not  required  to  be  reported  in 
such  employees'  income  tax  returns.    (C.  B.  i,  page  71;  O.  D.  265.) 

Where  the  employees  of  a  hospital  are  subject  to  immediate  ser- 
vice on  demand  at  any  time  during  the  twenty-four  hours  of  the  day 
and  on  that  account  are  required  to  accept  quarters  and  meals  at  the 
hospital,  the  value  of  such  quarters  and  meals  may  be  considered  as 
being  furnished  for  the  convenience  of  the  hospital  and  does  not 
represent  additional  compensation  to  the  employees.  On  the  other 
hand,  where  the  employees  are  on  duty  a  certain  specified  number  of 
hours  each  day  and  could,  if  they  so  desired,  obtain  meals  and  lodg- 
ing elsewhere  than  in  the  hospital  and  yet  perform  the  duties  re- 
quired of  them  by  such  hospital,  the  ratable  value  of  the  board  and 
lodging  furnished  is  considered  additional  compensation.  (C.  B.  4, 
page  85;  O.  D.  915.) 

The  following  rule  differs  from  the  foregoing. 

Ruling.  The  fair  rental  value  of  buildings  occupied  by  em- 
ployees of  the  Indian  service  should  be  included  in  the  compensation 
of  such  employees  if  the  rental  value  has  been  charged  to  the  appro- 
priation from  which  the  compensation  of  the  employees  is  paid  and 
the  amount  covered  into  the  Treasury  as  miscellaneous  receipts.  (C.  B. 
4,  page  85;  O.  D.  914.) 


""Law,   section  213    (b-'i).     See  page  422.     Prior  to   1921,  the  rental 
value  had  to  be  included  in  gross  income. 


440 


INCOME 


Even  though  the  rental  is  charged  to  an  appropriation  it 
would  seem  that  the  quarters  furnished  are  for  the  con- 
venience of  the  employees. 

Ruling.  The  regulations  of  the  Public  Health  Service  provide 
that  officers  of  such  service  are  entitled  to  quarters,  heat,  and  light, 
and  that  employees,  such  as  attendants,  dietitians,  internes,  nurses,  and 
reconstruction  aids,  are  entitled  to  quarters,  subsistence,  and  laundry. 
These  items  are  furnished  to  such  persons  in  respect  of  a  service 
which  they  render  and  as  an  inducement  to  them  to  enter  the  Public 
Health   Service. 

It  is  held,  therefore,  that  the  value  of  the  quarters,  subsistence, 
laundry,  heat,  and  light  furnished  the  officers  and  employees  referred 
to  constitutes  income  to  such  officers  and  employees  and  must  be  re- 
turned by  them  as  income  for  the  year  in  which  received.  (C.  B. 
4,  page  112;  O.  D.  904.) 

"Supper  money"  not  taxable. — 

Ruling.  "Supper  money"  paid  by  an  employer  to  an  employee, 
who  voluntarily  performs  extra  labor  for  his  employer  after  regular 
business  hours,  such  payment  not  being  considered  additional  com- 
pensation and  not  being  charged  to  the  salary  account,  is  considered 
as  being  paid  for  the  convenience  of  the  employer  and  for  that  rea- 
son does  not  represent  taxable  income  to  the  employee.  (C.  B,  2, 
page  90;  O.  D.  514.) 

Compensation  received  in  the  form  of  heat  and  light,  tele- 
phone, automobile  and  other  service. — 

Regulatton.  Amounts  received  by,  or  paid  for,  an  officer  for 
heat  and  light  shall  be  returned  as  income.  (T.  D.  2079,  November 
24,   1914.) 

This  applies  to  army  officers  who  receive,  in  addition  to 
their  salaries  and  allowances  for  rent,  a  further  allowance  for 
heat  and  light. ^'     Since  the  amounts  paid  are  readily  ascertain- 


^'  Copy  of  Office  Memorandum  No.  17,  issued  by  General  Staff,  U  .5. 
A.,  March  3,  1919. 

"i.  The  following  letter  from  the  office  of  the  Commissioner  of  the 
Bureau  of  Internal  Revenue  is  published  for  the  information  and  guidance 
of  all  concerned : 

'With  a  view  to  assisting  persons  in  the  military  and  naval  forces 
of  the  United  States  in  preparing  their  income  tax  returns  for  the  year 
1918,  attention  is  called  to  the  holdings  of  this  office  under  previous  income 
tax  acts  and  to  the  provisions  of  the  revenue  bill  as  passed  by  Congress 

'It   has   been   held   that  interest   on    deposits   made   with   disbursing 


FROM    PERSONAL   SERVICES 


441 


able,  it  may  be  assumed  that  all  army  officers  whose  aggregate 
incomes  exceed  the  exemption  pay  the  tax  thereon.  There 
are  many  other  individuals  who  receive  allowances  of  a  simi- 
lar nature  and  should  be  taxed  thereon.  For  instance,  many 
corporation  officers,  particularly  those  who  live  near  indus- 
trial plants,  receive  or  enjoy  telephone  service,  fuel,  use  of 
automobiles  and  many  other  perquisites  which  under  the  rul- 
ing cited  are  taxable.  It  is  usual  for  officers  of  automobile 
concerns,  manufacturers  and  dealers  to  have  the  full  use  of 
motor  cars  for  pleasure  and  business  purposes.  Officers  of 
railroad  companies  receive  passes  good  over  their  own  and 


officers  after  September  i,  1917,  under  authority  of  section  1305  Rev. 
Stat.,  as  amended  by  the  act  of  July  i,  1906,  on  deposits  made  under 
authority  of  section  203  of  the  Act  of  October  6,  1917,  and  on  amounts  of 
compensation  not  drawn,  represents  taxable  income;  and  that  the  follow- 
ing items  represent  compensation  for  services  rendered  and  should  be 
returned  as  income: 

'Quarters  furnished  within  the  allowance  provided  by  law;  or  a  room 
furnished  as  quarters  only,  that  is,  a  room  other  than  barracks 
to  which  several  men  are  assigned. 

'Heat  and  light  furnished  within  the  allowance  provided  by  law. 

'Allowance  drawn  from  the  government  as  tlie  equivalent  of  cloth- 
ing not  drawn. 

'The  commutation  .of  rations. 

'Markmanship  pay  or  extra  duty  pay. 

'Traveling  pay  to  discharged  officers  or  enlisted  men. 

'Mileage  allowance,  claiming  as  a  deduction  the  actual  necessary 
traveling  expenses. 

'Allowance  in  lieu  of  subsistence  while  traveling  under  orders,  claim- 
ing as  a  deduction  the  actual  necessary  traveling  expenses. 

'On  the  other  hand,  it  has  been  held  that  the  following  items  are 
furnished  by  the  government  for  its  own  purposes  rather  than  as  com- 
pensation to  the  officer  or  enlisted  man  and  the  money  equivalent  thereof 
should  not  be  returned  as  income : 

'Clothing  and  rations   furnished  in  kind. 
'Gratuitous  medical  and  hospital  treatment. 
'Tent  or  other  temporary  shelter. 

'Room  furnished  at  a  permanent  military  post  used  for  sleeping 
quarters  and  office  combined. 

'The  family  allowance  provided  for  under  article  2  of  the  War  Risk 
Insurance  Act  was  held  to  be  subject  to  tax  prior  to  the  amendment  of 
June  25,  1918.  In  view  of  this  amendment,  allotments,  family  allowances, 
compensation  and  death  or  disability  insurance  payable  under  the  War 
Risk  Insurance  Act  of  September  12,  1914,  as  amended,  were  held  to  be 
exempt  from  tax  and  the  former  ruling  was  made  to  apply  only  in  the 
case  of  assessments  made  prior  to  the  date  of  the  amendment,  June  25, 
1918.'" 


442  INCOME 

Other  lines.  These  are  used  for  personal  as  well  as  business 
purposes.  An  individual,  for  instance,  may  use  a  pass  to  go 
to  and  from  his  golf  club  or  on  pleasure  trips. 

Should  emoluments  of  this  kind  be  reduced  to  their  equiva- 
lent in  money  and  be  reported  as  taxable  income?  The  point 
is  really  an  important  one,  for  the  income  tax  to  be  success- 
ful must  be  administered  impartially  and  equitably.  If  army 
officers,  who  are  not  overpaid,  are  required  to  pay  the  tax  on 
the  money  equivalent  of  rent,  light  and  heat,  then  other  in- 
dividuals, most  of  whom  are  better  able  to  pay,  ought  to  pay 
on  similar  income.  "Compensation  for  personal  service  of 
whatever  kind  and  in  whatever  form  paid"  is  hardly  subject 
to  doubt  as  to  its  meaning. 

One  difficulty  which  will  arise  is  that  of  drawing  the  dis- 
tinction between  compensation  which  takes  the  form  of  re- 
duced living  expenses  (taxable  because  not  allowable  as  de- 
ductions) and  the  receipt  of  similar  privileges  which  do  not 
reduce  the  living  expenses  of  the  recipient.  For  instance, 
automobiles  are  frequently  furnished  to  salesmen  exclusively 
for  business  use.  Here,  of  course,  no  return  would  be  made. 
If  the  salesman  is  permitted  to  employ  a  car  for  personal  or 
family  use,  should  he  ascertain  the  rental  value  for  the  time  so 
used  and  include  such  amount  as  taxable  income?  The  an- 
swer is  "yes"  only  in  case  the  salesman  would  purchase  a 
car  himself  were  this  car  not  furnished  free  of  charge.  Only 
then  would  the  item  be  the  equivalent  of  a  reduction  of  "per- 
sonal, living  or  family  expenses."  Or,  stated  another  way, 
return  should  be  made  of  an  amount  representing  the  worth 
of  the  automobile  service  to  him  personally  and  individually. 
If,  on  the  other  hand,  an  officer  of  an  automobile  concern  has 
the  exclusive  use  of  a  car  and  does  use  it  for  other  than  busi- 
ness purposes,  and  if  it  is  a  fair  assumption  that  he  would 
own  and  operate  a  car  even  if  he  had  to  pay  for  it,  then  he 
should  ascertain  the  total  cost  of  operation  for  a  year  and 
prorate  such  cost  equitably,  reporting  as  taxable  income  the 
estimated  saving  of  expense  arising  from  the-  use  of  the  car 


FROM    PERSONAL    SERVICES 


443 


as  additional  compensation.  Of  course,  he  would  report  on 
the  basis  of  what  the  actual  cost  to  him  would  be,  taking  the 
benefit  of  manufacturers'  or  wholesale  prices,  rather  than  what 
he  would  have  had  to  pay  if  he  had  not  been  in  a  position  to 
secure  such  concessions. 

There  may  be  in  some  cases  a  question  as  to  whether  or 
not  some  items  like  those  discussed  above  are  compensation 
or  gifts.  This  probably  depends  legally  upon  the  contractual 
relation  between  the  one  who  pays  and  the  recipient.  If  the 
rent,  fuel,  automobile  and  similar  privileges  are  part  of  the 
employment  contracts,  express  or  implied,  and  thus  show  on 
their  face  that  more  or  less  value  attaches  thereto,  the  cash 
equivalent  of  the  items  is  taxable.  If,  however,  the  privileges 
are  not  part  of  a  contract  and  are  pure  gifts,  and  if  no  diminu- 
tion of  cash  compensation  results  therefrom,  they  do  not  con- 
stitute taxable  income. 

Compensation  received  in  the  form  of  per  diem  allowances 
and  mileage. — The  19 18  regulations^®  specifically  provided  that 
congressmen,  army  officers  and  others  who  received  stated  al- 
lowances per  mile  or  per  diem  to  cover  traveling  or  living  ex- 
penses, and  allowances  for  stationery,  secretarial  services,  etc. 
should  return  as  income  any  excess  of  such  allowances  over 
actual  expenses.  Article  loi  (a)  of  the  1921  regulations 
provides,  in  effect,  for  the  same  procedure.  In  the  case 
of  liberal  allowances  such  as  congressmen  receive,  part  of 
the  allowance  obviously  is  taxable  and  the  regulation  calls 
attention  to  this  case  specifically.  In  other  cases,  such 
as  that  of  army  officers,  the  allowance  closely  approximates 
the  expenditure  and  it  may  not  be  worth  while  to  attempt  an 
exact  accounting.  There  is,  however,  a  definite  obligation 
imposed  upon  the  recipient  to  keep  such  a  record  as  will  indi- 
cate at  the  close  of  taxable  periods  whether  or  not  return  should 
be  made.  The  record  of  deposits  in  one's  cheque  book  usually 
is  sufficient. 

'' Regulati(jns  45,  Art.  292. 


444  INCOME 

The  Treasury  has  held  that  transportation  charges  paid 
by  the  government  on  account  of  the  transportation  of  the 
famihes  of  army  ofificers  are  in  the  nature  of  additional  com- 
pensation.^^ 

Ruling.  A  person  in  the  service  of  the  American  Red  Cross 
receiving  maintenance  but  no  pay  should  return  as  income  any  excess 
of  the  amount  receive'd  for  maintenance  over  his  actual  Hving  ex- 
penses.    (C.  B.  I,  page  66;  O.  D.  ii.) 

Compensation  received  in  the  form  of  deductions  for  pen- 
sion funds^  etc. — When  deductions  are  made  from  the  salaries 
or  wages  of  employees  (other  than  public)  to  cover  com- 
pulsory or  voluntary  contributions  to  pension,  sick  or  insur- 
ance funds,  such  payments  or  deductions  should  be  added  to 
the  amounts  received  in  reporting  income  which  is  subject  to 
tax. 

Regulation pensions     or     retiring    allowances    paid    by 

private  persons  ....  are  income  to  the  recipients ;  ....     (Art.  32.) 

Proceeds  of  accident  insurance  and  damages  not  taxable. — 

Law.  Section  213.  That  ....  "gross  income" —  .  .  .  .  (b) 
Does  not  include   .... 

(6)  Amounts  received,  through  accident  or  health  insurance  or 
under  workmen's  compensation  acts,  as  compensation  for  personal 
injuries  or  sickness,  plus  the  amount  of  any  damages  received  whether 
by  suit  or  agreement  on  account  of  such  injuries  or  sickness.""*   .... 

Insurance  proceeds,  when  taxable  and  not  taxable. — 

Regulation,  (a)  Upon  the  death  of  an  insured  tlie  proceeds 
of  his  life  insurance  policies,  whether  paid  to  his  estate  or  to  any 
!)eneficiary    (individual,    partnership,    or   corporation),    directly   or   in 

trust,  are  excluded  from  the  gross  income  of  the  beneficiary 

(b)  During  his  life  only  so  much  of  the  amount  received  by  an  in- 
sured under  life,  endowment,  or  annuity  contracts  as  represents  a  re- 
turn, without  interest,  of  premiums  paid  by  him  therefor  is  excluded 
from  his  gross   income (r)   \^'hether   he  be   alive  or  dead. 


'"Bulletin  50-21-1975;   O.  D.  1135. 

*"  [Former  Procedure]  Payments  made  to  injured  employees  by 
corporations  under  the  accident  compensation  laws  of  the  several  states 
constitute  taxable  income  of  the  employees.  (T.  D.  2570,  November  6, 
1917.)  This  was  reversed  by  T.  D.  2747  (July  12,  1918),  the  principles  of 
which  are  adopted  in  the  present  law. 


FROM    PERSONAL   SERVICES  445 

the  amounts  received  by  an  insured  or  his  estate  or  other  beneficiaries 
through  accident  or  health  insurance  or  under  workmen's  compensa- 
tion acts  as  compensation  for  personal  injuries  or  sickness  are  ex- 
cluded from  the  gross  income  of  the  insured,  his  estate  and  other 
beneficiaries.  Any  damages  recovered  by  suit  or  agreement  on  ac- 
count of  such  injuries  or  sickness  are  similarly  excluded  from  the 
gross  income  of  the  individual  injured  or  sick,  if  living,  or  of  his  es- 
tate or  other  beneficiaries  entitled  to  receive  such  damages,  if  dead. 
....  Since  June  25,  1918,  no  assessment  of  any  federal  tax  may 
be  made  on  any  allotments,  family  allowances,  compensation,  or  death 
or  disability  insurance  payable  under  the  War  Risk  Insurance  Act 
of  September  2.,  1917,  as  amended,  even  though  the  benefit  accrued 
before  that  date (Art.  ']2..') 

Article  72  of  Regulations  45  is  amended  as  above  to  ex- 
empt the  proceeds  of  insurance  paid  to  a  corporation  bene- 
ficiary, thus  complying  with  the  new  law. 

The  above  regulation  explains  the  provisions  of  the  statute, 
which  includes  in  the  exemption  amounts  paid  either  to  the  in- 
sured or  his  estate,  together  with  allotments,  allowances,  and 
war  risk  insurance  and  compensation.'*^ 

Ruling.  Where  an  individual  takes  out  a  policy  of  insurance  in 
favor  of  his  estate  which  is  assigned  to  a  corporation  as  security  for 
money  advanced  without  interest  or  other  charge  to  pay  a  premium 
thereon,  and  upon  the  death  of  the  insured  the  corporation  deducts 
the  amount  of  the  indebtedness  from  the  proceeds  of  the  policy  paid 
to  it  as  assignee,  and  turns  the  balance  over  to  the  executor  of  the 
estate,  the  corporation  should  not  for  income  tax  purposes  include 
the  proceeds  of  the  policy  in  its  gross  income.  The  function  of  the 
corporation  was  merely  that  of  an  intermediary  in  the  collection  of 
the  proceeds  of  the  policy.     (C.  B.  4,  page  72;  O.  D.  804.) 

Premiums  paid  by  corporation — income  to  officer  in 
certain  cases. 

Ruling.  If  a  corporation  pays  the  premiums  on  an  individual 
life  insurance  policy  carried  on  the  life  of  one  of  its  officers  or  em- 
ployees who  is  permitted  to  designate  the  beneficiary  and  in  which  the 
corporation  is  not  in  any  way  a  beneficiary,  premiums  so  paid  will, 
in  the  absence  of  satisfactory  evidence  to  the  contrary,  be  presumed 
to  constitute  taxable  income  to  such  officer  or  employee.  (C.  B.  3, 
page   104;   O.   D.   627.) 


"  See  page  350  ct  scq. 


CHAPTER     XV 

INCOME  FROM  BUSINESS 

The  line  between  the  profits  resulting  from  business,  dealt 
with  in  this  chapter,  and  the  profits  resulting  from  appre- 
ciation of  property,  discussed  in  Chapter  X\"II,  must  be  some- 
what arbitrarily  drawn.  Most  business,  of  course,  consists 
of  dealing  in  property,  while  all  dealings  in  property  are  usu- 
ally thought  of  as  "business"  transactions. 

An  attempt  is  made  to  distinguish  between  income  from 
the  purchase  and  sale  of  merchandise,  securities  and  other 
property  by  dealers,  and  income  or  profits  realized  by  in- 
vestors and  others  who  are  not  dealers.  General  principles 
regarding  the  nature  and  taxation  of  appreciation  of  fixed 
assets  and  investment  securities,  real  estate,  etc.,  are  discussed 
in  Chapter  X\^II.  Sales  and  exchanges  of  property  (not  form- 
ing part  of  a  dealer's  stock-in-trade)  are  discussed  in  Chap- 
ter X\T.  The  discussion  of  inventories  and  other  "current" 
assets  is,  consequently,  retained  in  this  chapter. 

Law.      Section   213 the  term   "gross  income" — 

(a)  Includes  gains,  profits,  and  income  derived  from  .... 
trades,  businesses,  commerce,  or  sales,  or  dealings  in  property,  whether 
real  or  personal,  growing  out  of  the  ownership  or  use  of  or  interest 
in  such  property;  also  from  ....  securities,  or  the  transaction  of  any 
business  carried  on  for  gain  or  profit,   .... 

Gross  income  from  business  defined. — 

Regulation.  In  the  case  of  a  manufacturing,  merchandising  or 
mining  business  "gross  income"  means  the  total  sales,  less  the  cost 
of  goods  sold,  plus  any  income  from  investments  and  from  incidental 
or  outside  operations  or  sources.  In  determining  the  gross  income 
subtractions  should  not  be  made  for  depreciation,  depletion,  selling 
expenses  or  losses,  or  for  items  not  ordinarily  used  in  computing 
the  cost  of  goods  sold.^     (Art.  35.) 


This    statement    of    course    does    not    modify   those    sections    of    the 

446 


FROM    BUSINESS  447 

Business  need  not  be  lawful. — The  law  of  191 3  (section 
II  B)  provided  that  the  tax  was  levied  on  the  gains  from 
"any  law^ful  business  carried  on  for  gain  or  profit."  In  the 
law  of  1916,  the  word  "lawful"  is  omitted  and  it  does  not 
reappear  in  either  the  19 18  or  1921  law.  This  would  seem 
to  indicate  a  direct  intention  on  the  part  of  Congress  to  make 
"stealings"  and  "winnings"  taxable  as  well  as  "earnings." 
Income  from  gambhng  and  bootlegging  would,  of  course,  come 
under  this  head. 

In  this  country  there  is  not  a  large  class  of  professional 
gamblers  or  others  transacting  an  unlawful  business,  but  such 
as  can  be  reached  should  be  taxed.  Occasional  betting,  how- 
ever, is  frequent,  millions  of  dollars  being  wagered  on  the 
results  of  political  campaigns,  athletic  contests,  etc.  The  win- 
nings are  subject  to  tax.  What  they  win  cannot  be  termed  a 
gift  or  any  other  item  specifically  exempt  from  taxation,  and 
"gains  derived  from  any  source  whatever"  are  taxable.  One 
should,  therefore,  include  all  receipts  from  bets  in  his  income 
tax  return.  This  in  some  cases  would  be  a  considerable  item 
in  the  year  of  a  presidential  election.  It  would  seem  that  net 
losses  should  be  deducted  when  the  transactions  were  entered 
into  for  profit.  It  would  not  be  wise  to  claim  credit  for  a  net 
loss  arising  from  betting,  but  there  is  a  clear  obligation  to 
return  a  net  gain. 

British  practice. — In  England  it  has  been  held  that  a 
professional  bookmaker  is  liable  to  assessment  under  the  in- 
come tax  law.    The  court  decided  that : 

Decision.  (Syl.)  Persons  receiving  profits  from  betting  sys- 
tematically ca-rried  on  by  them  throughout  the  year,  are  chargeable 
with   income  tax   on  such  profits  in   respect  of  a   "vocation. "- 

In  France,  also,  the  government  is  taxing  income  from 
gambling,  as  stated  in  a  press  dispatch.     However,  in  France, 


law  and  regulations  which  permit  the  use  of  recognized  accounting 
practices.  A  taxpayer  will  not  be  required  to  change  his  method  of 
accounting  merely  to  ascertain   items  of   "gross   income." 

' i'arlridgc  v.  M allandainc ,  L.  R.  18  Q.  B.  Div.  276  (1886). 


448  INCOME 

gambling  is  not  "illegal"  when  conducted  under  government 
license. 

Those  who  patronize  the  lotteries  on  a  large  scale  and  whose 
quarterly  winnings  may  amount  to  1,000,000  francs  have  learned  to 
their  dismay  that  the  new  taxes  strike  a  double  blow  at  them. 

First  they  must  pay  20  per  cent  outright  to  the  city  of  Paris  as 
the  tax  on  unforeseen  revenues.  Then  when  they  have  deposited  the 
balance  of  their  winnings  in  a  bank  it  becomes  a  part  of  their  gen- 
eral yearly  revenue  and  is  taxable  another  15  per  cent.^ 

Speculation  in  "futures/'  etc. — The  purchase  and 
sale  of  ''futures,'"  which  chiefly  concern  those  who  deal  in 
cotton  and  other  commodities  on  exchanges,  are  often  called 
gambling  and  those  who  indulge  in  such  transactions  do  not 
always  consider  that  their  gains  are  taxable  income.  It  is 
immaterial  whether  the  transactions  are  called  business  deal- 
ings, speculation  or  gambling.  If  they  result  in  net  gain,  the 
profit  must  be  returned  as  taxable  income.* 

Accounting  Procedure 

Fiscal  year  for  individuals. — The  1921^  law  provides 
that  an  individual  may  compute  his  net  income  on  the  basis 
of  his  "annual  accounting  period  (fiscal  year  or  calendar 
year,  as  the  case  may  be).'"^  An  individual  business  man  or  a 
partner  may  simply  make  his  personal  tax  year  coincident  wnth 
his  business  fiscal  year;  or  if  he  desires  to  make  his  personal 
return  on  the  basis  of  the  calendar  year,  he  may  report  his 
income  from  a  business  to  the  end  of  its  fiscal  year  only,  with- 
out attempting  to  restate  the  accounts  as  of  December  31. 

It  is,  however,  difiicult  and  annoying  to  make  tax  returns 
for  a  period  other  than  the  accounting  period  adopted  by  an 
individual.  The  end  of  December  is  a  very  inconvenient  time 
for  many  taxpayers  to  state  their  accounts.     Under  the  pres- 


'  New  York  Herald,  November  21,  1920. 

*  For  discussion  of  deductibility  of  losses,  see  Chapter  XXIX. 

°  The  provision  was  first  inserted  in  the  1918  law. 

°  Section  212   (b),  see  page  64. 


FROM    BUSINESS 


449 


ent  law  it  is  possible  to  select  and  report  for  a  year  ending 
on  the  last  day  of  any  month  most  convenient  for  the  taxpayer. 
The  receipt  or  accrual  basis  and  the  proper  accounting 
procedure  for  each  are  fully  discussed  in  Chapters  XIII  and 
XIV. 

Computation    of    business    income    of    contractors. — The 

business  of  contracting  offers  some  peculiar  difficulties  in  the 
calculation  of  income.  The  regulations  deal  with  them  as 
follows : 

Regulation.  Income  from  long-term  contracts  is  taxable  for  the 
I^eriod  in  which  the  income  is  determined,  such  determination  depend- 
ing upon  the  nature  and  terms  of  the  particular  contract.  As  used 
herein  the  term  "long  term  contracts"  means  building,  installation, 
or  construction  contracts  covering  a  period  in  excess  of  one  year. 
Persons^  whose  income  is  derived  in  whole  or  in  part  from  such 
contracts  may,  as  to  such  income,  prepare  their  returns  upon  the 
following  bases : 

(o)  Gross  income  derived  from  such  contracts  may  be  reported 
upon  the  basis  of  percentage  of  completion.  In  such  case  there 
should  accompany  the  return  certificates  of  architects  or  engineers 
showing  the  percentage  of  completion  during  the  taxable  year  of  the 
entire  work  to  be  performed  under  the  contract.  There  should  be  de- 
ducted from  such  gross  income  all  expenditures  made  during  the  tax- 
able year  on  account  of  the  contract,  account  being  taken  of  the  mate- 
rial and  supplies  on  hand  at  the  beginning  and  end  of  the  taxable 
period  for  use  in  connection  with  the  work  under  the  contract  but  not 
yet  so  applied.  If,  upon  completion  of  a  contract,  it  is  found  that 
the  taxable  net  income  arising  thereunder  has  not  been  clearly  re- 
flected for  any  year  or  years,  the  Commissioner  may  permit  or  re- 
quire an  amended  return. 

(b)  Gross  income  may  be  reported  in  the  taxable  year  in  which 
the  contract  is  finally  completed^  and  accepted  if  the  taxpayer  elects 
as  a  consistent  practice  to  so  treat  such  income,  provided  such  method 


_  '  [Former  Procedure]  Under  the  old  regulations  this  special  pro- 
vision for  contractors  applied  only  to  corporations  (Reg.  33,  1918,  Art.  121). 
The  term  "person,"  as  used  in  the  1918  and  1921  laws,  includes  individuals 
and  corporations. 

'  A  contractor  keeps  books  on  an  accrual  basis.  When  the  contract  is 
completed  the  final  income  must  be  completed  and  returned  in  accord  with 
the  regulations  whether  the  work  is  paid  for  in  full  or  in  part.  (B.  52-21- 
1991;  O.  D.  1147.) 


450 


INCOME 


clearly  reflects  the  net  income.  If  this  method  is  adopted  there 
should  he  deducted  from  gross  income  all  expenditures  during  the 
life  of  the  contract  which  are  properly  allocated  thereto,  taking  into 
consideration  any  material  and  supplies  charged  to  the  work  under 
the  contract  but  remaining  on  hand  at  the  time  of  completion. 

Where  a  taxpayer  has  filed  his  return  in  accordance  with  the 
method  of  accounting  regularly  employed  by  him  in  keeping  his 
books  and  such  method  clearly  reflects  the  income,  he  will  not  be 
required  to  change  to  either  of  the  methods  above  set  forth.  If  a 
taxpayer  desires  to  change  his  method  of  accounting  in  accordance 
with  paragraphs  (a)  and  (b)  above,  a  statement  showing  the  com- 
position of  all  items  appearing  upon  his  balance  sheet  and  used  in 
connection  with  the  method  of  accounting  formerly  employed  by 
him,  should  accompany  his  return.^     (Art.  36.) 

This  regulation  is  in  substance  identical  with  the  similarly 
numbered  article  in  Regulations  45.  However,  the  last  para- 
graph is  new  and  permits  a  contractor  to  use  his  own  account- 
ing method,  if  such  method  clearly  reflects  the  income,  or  to 
change  to  one  of  the  bases  designated  by  making  the  neces- 
sary adjustments  in  his  accounts. 

It  has  been  held  that  having  elected  to  report  on  the  basis 
of  completed  work,  amended  returns  \\ill  not  be  accepted  on 
another  basis.  A  change  of  basis  was  allowed,  however,  as  to 
subsequent  years.  For  Treasury  ruling,  see  C.  B.  4,  page  86; 
O.  D.933. 

A  foreign  corporation  having  a  long-term  contract  from 
which  it  had  no  net  income  from  the  United  States  but  re- 
ceiving gross  income  therefrom  in  1919,  was  rec^uired  to  file 
a  return  showing  ''its  election  to  report  any  profit  derived 
from  the  contract  in  the  )-ear  in  which  it  would  be  completed." 
( 1-3-36;  I.  T.  1 1 70.) 

Contractors  should  be  able  to  prepare  their  accounts  on 
the  accrual  basis.  Their  dif^culties  are  by  no  means  insur- 
mountable. 


*  [Former  Procedure]  Regulations  33  and  T.  D.  2161  (February  19, 
1915)  did  not  provide  for  the  adjustment  of  income  of  any  year  which 
had  been  overstated  or  understated,  by  the  filing  of  amended  returns  for 
such  period,  whereas  such  provision  was  contained  in  Reg.  45,  Art.  36. 


FROM    BUSINESS 


451 


Reserves  for  discounts. — In  certain  industries,  notably  tex- 
tiles and  leather,  it  is  a  general  custom  to  allow  high  rates  of 
discount  for  payment  in  thirty  days.  These  rates  may  be  as 
high  as  4,  6,  7  or  10  per  cent.  Manifestly  customers  cannot 
afford  not  to  avail  themselves  of  discounts  at  these  high  rates; 
in  fact  a  manufacturer  would  decline  to  do  business  very  long 
with  any  customer  who  did  not  make  it  a  practice  to  pay  such 
bills  within  thirty  days.  When  the  rate  of  discount  is  only  i  or 
2  per  cent,  the  issue  is  not  of  very  great  importance,  but  when 
the  rates  are  higher  the  amount  of  tax  may  be  materially 
affected  by  whether  deduction  is  claimed  for  the  amount  of 
discount  actually  taken  by  customers  or  for  the  amount  of  dis- 
count accrued. 

The  manufacturer  recognizes  that  the  face  amount  of 
the  invoice  carrying  a  high  rate  of  discount  should  be  re- 
duced by  the  amount  of  discount  in  order  that  his  accounts 
may  reflect  true  income.  This  is  ordinarily  accomplished  by 
establishing  a  reserve  both  at  the  beginning  and  at  the  end 
of  the  fiscal  year  to  offset  the  amount  of  discount  included  in 
the  accounts  receivable.  A  manufacturer  who  determines  his 
income  on  the  basis  of  discounts  actually  taken  without  al- 
lowance for  the  increase  or  decrease  in  the  discounts  on  out- 
standing accounts  receivable  is  misleading  himself. 

The  amount  reserved  at  the  end  of  a  taxable  year  for  dis- 
counts which  it  is  expected  will  be  deducted  by  customers  is, 
in  effect,  regarded  by  the  Treasury  as  an  allowable  deduction. 

Ruling.  A  corporation  keeping  its  accounts  on  an  accrual  basis 
will  not  be  permitted  to  deduct  from  gross  income  a  sum  in  anticipa- 
tion of  the  amount  the  corporation  may  be  required  to  allow  as  cash 
discount  on  accounts  due  and  payable  in  the  succeeding  year.  But 
any  amounts  so  allowed  in  the  succeeding  year  before  the  return  is 
filed  may  be  deducted  from  gross  sales  for  the  previous  taxable 
year.     (C.  B.  i,  page  221 ;  O.  D.  146.) 

The  following  regulation,  providing  for  the  determination 
of  deductions  for  bad  debts,  confirms  the  procedure  suggested, 
and  in  effect  permits  the  setting  aside  of  the  discount  which 
is  expected  to  be  allowed  on  each  sale. 


452 


INCOME 


Regulation If  a  taxpayer  computes  his  income  upon  the 

basis  of  valuing  his  notes  or  accounts  receivable  at  their  fair  market 
value  when  received,  which  may  be  less  than  their  face  value,  the 
amount  deductible  for  bad  debts  in  any  case  is  limited  to  such  original 
valuation.     (Art.   151.) 

In  a  ruling  on  the  valuation  of  goods  on  hand,  the  Treas- 
ury has  held  that  "taxpayers  who  as  a  matter  of  settled  prac- 
tice do  not  deduct  cash  discounts  from  purchases"  may  not 
deduct  "the  average  amount  of  discount  received."^"  It  may 
be  inferred,  however,  that  if  the  taxpayer  adopts  the  practice 
of  deducting  cash  discounts  from  purchases,  and  adheres  to 
it,  the  deduction  will  be  allowed. 

Inventories 

When  a  concern  maintains  a  stock  of  any  kind  of  prop- 
erty which  it  periodically  renews  as  it  exhausts  it,  the  proper 
procedure  in  order  to  determine  profit  or  loss  is  to  inventory 
the  stock.     Regarding  inventories  the  law  provides : 

Law.  Section  203.  That  whenever  in  the  opinion  of  the  Com- 
missioner the  use  of  inventories  is  necessary  in  order  clearly  to  deter- 
mine the  income  of  any  taxpayer,  inventories  shall  be  taken  by  such 
taxpayer  upon  such  basis  as  the  Commissioner,  with  the  approval  of 
the  Secretary,  may  prescribe  as  conforming  as  nearly  as  may  be  to 
the  best  accounting  practice  in  the  trade  or  business  and  as  most 
clearly  reflecting  the  income. 

The  19 18  law  for  the  first  time  gave  the  Commissioner 
specific  authority  to  require  inventories,  although  they  have 
as  a  matter  of  fact  been  used  under  regulations  of  the  Treas- 
ury ever  since  the  passage  of  the  1909  law.^^ 


'"C.  B.  I,  page  56;  O.  D.  326. 

"  [Former  Procedure]  Even  under  the  regulations  issued  to  con- 
trol the  procedure  under  the  1913  law  and  in  spite  of  the  doubtful 
authority  in  the  law  for  the  use  of  the  accrual  method,  the  Treasury 
specified  that  inventories  should  be  used  in  certain  cases. 

Regulation.  "In  order  that  certain  classes  of  corporations  ma^ 
arrive  at  their  correct  income,  it  is  necessary  that  an  inventory,  or  its 
equivalent,  of  materials,  supplies  and  merchandise  on  hand  for  use  or 
sale  at  the  close  of  each  calendar  (or  fiscal)  year  shall  be  made  in 
order  to  determine  the  gross  income  or  to  determine  the  expense  of 
operation. 


FROM    BUSINESS  453 

Regulation.  In  order  to  reflect  the  net  income  correctly,  in- 
ventories at  the  beginning  and  end  of  each  year  are  necessary  in 
every  case  in  which  the  production,  purchase,  or  sale  of  merchandise 
is  an  income-producing-  factor (Art.   1581.) 

Estimated  inventories  are  not  permitted. — 

Ruling.  A  taxpayer  who  for  many  years  has  elected  to  take 
inventory  only  every  two  years,  and  used  an  estimated  inventory  in 
the  return  for  the  intermediate  year,  making  any  necessary  adjust- 
ments in  the  return  for  the  following  year  when  an  actual  inventory 
was  taken,  may  not  apportion  his  total  earnings  for  the  two  years 
1917  and  1918  equally  between  such  years  for  income  tax  purposes. 
(C.  B.  I,  page  62;  O.  D.  133.) 

It  would  seem,  however,  that  if  an  estimated  inventory 
which  can  be  verified  by  the  "gross  profit"  test  has  been  used 
in  former  years,  and  there  is  no  material  fluctuation  in  the  rate 
of  gross  profit  to  the  date  when  an  actual  physical  inventory 
is  taken,  such  estimate  must  be  acceptable. 

Inventory  must  be  taken  as  of  one  fixed  date  for  entire 

business. — 

Ruling.  Taxpayers  will  not  be  permitted  to  adopt  one  period  for 
inventorying  and  closing  their  books  applicable  to  one  part  of  their 
business  and  a  different  period  applicable  to  another  part  thereof. 
(C.  B.  I,  page  62;  O.  D.  289.) 

Inventories  in  the  case  of  amended  returns. — 

Ruling.  Where  amended  returns  are  filed  it  is  not  permissible  to 
value  the  inventories  in  the  amended  returns  on  a  basis  different  from 
that  employed  in  the  original  returns,  unless  the  audit  of  the  returns 
in  this  office  reveals  the  necessity  for  employing  a  different  basis.  (B. 
50-21-1970;  O.  D.  1 132.) 


"A  physical  inventory  is  at  all  times  preferred,  but  where  a  phys- 
ical inventory  is  impossible  and  an  equivalent  inventory  is  equally 
accurate,  the  latter  will  be  acceptable. 

"An  equivalent  inventory  is  an  inventory  of  materials,  supplies 
an-d  merchandise  on  hand  taken  from  the  books  of  the  corporation." 
(Art.  161,  Reg.  33,  January  5,  1914.) 

Regulations  33,  1918,  article  120,  contained  this  direction  regard- 
ing inventories:  "and  they  must  be  taken  where  the  business  con- 
sists of  buying  and  selling  commercial  commodities." 


454  INCOME 

If  inventories  have  been  taken  on  any  basis  other  than 
that  of  "cost"  or  "cost  or  market,  whichever  is  lower,"  amended 
returns  may  be  filed  and  either  one  of  the  two  bases  mentioned 
above  may  be  used.  In  a  specific  case  in  which  revenue  agents 
at  first  refused  to  recognize  change  from  "cost"  basis  to  "cost 
or  market,  whichever  is  lower,"  they  assented  when  an  analysis 
of  the  method  originally  used  by  the  taxpayer  showed  that  the 
basis  was  not  strictly  one  of  "cost." 

What  inventory  includes/- — 

Regulation The  inventory  should  include  raw  materials 

and  supplies  on  hand  that  have  been  acquired  for  sale,  consumption, 
or  use  in  productive  processes,  together  with  all  finished  or  partly 
finished  goo^s (Art.   1581.) 

The  regulation  refers  to  goods  "on  hand"  which  is  synony- 
mous with  a  physical  inventory.  Physical  inventories  or 
their  equivalent  are  absolutely  necessary  in  every  concern 
handling  materials  or  goods;  but  recognized  accounting  prin- 
ciples do  not  require  that  a  physical  inventory  be  taken  of 
everything  on  hand  on  a  specific  date.  If  a  book  inventory 
is  trustworthy  and  the  entire  stock  is  actually  verified  in 
whole  or  in  part  at  various  times  during  the  year,  taxpayers 
need  have  no  hesitancy  in  stating  that  article  1581  has  been 
complied  with. 

The  Treasury  has  ruled  that  advances  to  a  foreign  cor- 
poration by  an  American  firm  may  not  be  inventoried,  even 
though  a  considerable  decline  in  the  exchange  rate  has  oc- 
curred. 

Ruling.  In  taking  inventory  for  the  purpose  of  determining 
taxable  net  income  in  accordance  with  article  1581  of  Regulations  45, 
it  is  not  permissible  to  include  claims  which  the  taxpayer  may  have 
against  other  persons  and  which  have  depreciated  in  value  on  ac- 
count of  a  decline  in  exchange  rates  or  for  any  other  reason.  (C. 
B.  2,  page  50;  O.  D.  541.) 

In  view  of  the  tremendous  decline  in  the  principal  foreign 
exchanges,  any  conservative  balance  sheet  would  show  such 


''  See  page  458,  "Goods  purchased  but  not  delivered." 


FROM    BUSINESS  455 

assets  ''inventoried"  at  the  current  rate  of  exchange/^  Strictly 
speaking,  the  word  "inventory"  does  not  include  accounts 
receivable,  but  a  fall  in  exchange  rates  is  equivalent  to  a  fall 
in  the  market  value  of  goods.  The  accrued  loss  should  be 
claimed.  Under  the  1921  law  it  can  be  included  in  the  reserve 
for  bad  debts.  Goods  of  a  certain  value  have  been  exchanged 
for  other  property,  viz.,  a  chose  in  action.  When  valued  at  the 
equivalent  of  cash  the  chose  in  action  is  worth  less  than  the 
sales  value  of  the  goods.  True  net  income  cannot  be  deter- 
mined unless  the  resulting  loss  is  taken  into  account. 

Bailments — when  included  in  inventory. — In  some 
branches  of  business  it  is  customary  to  send  material  to  other 
concerns  for  certain  processing,  for  instance,  bleaching  or  dye- 
ing. At  the  date  of  the  inventory  such  items  are  included  in 
the  inventory  if  they  are  to  be  returned  in  kind;  but  some 
firms  have  varying  arrangements  for  the  return  of  the  "prod- 
ucts of  the  property,"  such  as  flour  for  wheat.  In  such  cases 
the  Treasury  holds  that  this  exchange  amounts  to  a  sale,  and 
the  goods  returnable  under  such  arrangements  cannot  be  in- 
cluded in  the  inventory. 

Ruling.  The  delivery  of  copper  bullion  to  a  smelting  and  re- 
fining company  where  it  is  mixed  with  other  bullion  and  concentrates 
of  different  metallic  contents  under  a  contract  by  which  the  smelting 
and  refining  company  is  to  return  the  equivalent  of  the  metallic  con- 
tents of  such  ore  previously  determined  by  assay,  less  commissions 
and  other  allowable  charges,  constitutes  a  sale  and  not  a  bailment. 
Only  so  much  of  the  metals  as  had  been  redelivered  by  the  refining 
company  at  the  close  of  the  taxable  year  belonged  to  and  should 
have  been  included  in  the  inventory  of  the  taxpayer  as  of  that  date. 
(C.  B.  2,  page  45;  S.  1373.) 

In  the  detailed  opinion  of  the  solicitor  the  general  rule  is 
stated. 

But  the  rule  is  well  settled  that  when,  by  the  terms  of  the  contract 
under  which  property  is  delivered  by  an  owner  to  another,  the  latter 
is  under  no  obligation  to  return  the  specific  property  either  in  its 
identical  form  or  in  some  other  form  in  which  its  identity  may  be 

"Sec  Chapter  Xlll. 


456 


INCOME 


traced,  but  is  authorized  to  substitute  something  else  in  its  place, 
either  money  or  some  other  equivalent,  the  transaction  is  not  a  bail- 
ment, but  is  a  sale  or  exchange.  {Austin  v.  Seligman,  i8  Fed.,  519, 
520.) 

The  effect  of  this  ruling  is  to  permit  concerns  to  anticipate 
the  profit  or  loss  upon  products  which  have  been  converted  but 
not  dehvered  to  the  actual  customers.  It  would  apply  only  to 
concerns  which  adopt  such  practice  as  a  settled  policy. 

The  refined  copper  returnable  to  the  M  Company  on  December 
31,  1917,  and  December  31,  1918,  should,  in  each  instance,  have  been 
set  up  in  an  account  receivable,  and  if  returns  were  made  on  an 
accrual  basis,  should  have  been  so  returned.  There  is  this  difference, 
however,  between  such  an  account  and  an  ordinary  account  receivable, 
namely,  that  it  is  an  account  receivable  in  metal  and  not  in  money. 
Under  Treasury  Decision  2609  and  article  1582  of  Regulation  45  the 
copper  actually  returned  to  the  corporation  prior  to  the  dates  stated 
should  have  been  included  in  the  respective  inventories  as  of  those 
dates  at  cost,  or  cost  or  market,  whichever  was  lower,  and  it  would 
seem  clear  that  the  copper  receivable  could  not  have  had  a  different 
value  for  the  purpose  of  inventory  than  that  which  the  copper,  if 
actually  received,  would  have  had.  For  the  purpose  of  determining 
the  value  of  such  account,  therefore,  the  copper  receivable  should 
be  priced  at  cost,  or  cost  or  market,  whichever  was  lower.^* 

The  Treasury  in  the  foregoing  case  has  departed  from  its 
usual  position  and  has  required  receivables  to  be  inventoried 
as  if  no  sale  had  been  made. 

General  basis  for  valuation  of  inventories.^^ — 

Law.  Section  202.  (a)  That  the  basis  for  ascertaining  the  gain 
derived  or  loss  sustained  from  a  sale  or  other  disposition  of  property, 


•  "Art.  1582  permits  the  inventory,  under  certain  conditions,  to  be  taken 
at  less  than  cost  or  market.     See  page  458. 

"  [Former  Procedure]  Cost  price  was  prescribed  by  the  directions 
printed  on  the  corporation  return  No.  1031,  as  revised  October,  1916. 
This  is  the  statement  which  appeared: 

"In  case  the  annual  gain  or  loss  is  determined  by  inventory,  mer- 
chandise must  be  inventoried  at  the  cost  price,  as  any  loss  in  salable 
value  will  ultimately  be  reflected  in  the  sales  during  the  year  when 
the  goods  are  disposed  of." 

This  direction  was  ignored  by  those  who  desired  to  have  their  ac- 
counts reflect  their  actual  financial  condition.       The  general  Treasury 


FROM    BUSINESS 


457 


real,  personal,  or  mixed,  acquired  after  February  28,  1913,  shall  be  the 
cost  of  such  property;  except  that — 

(i)  In  the  case  of  such  property,  which  should  be  included  in  the 
inventory,  the  basis  shall  be  the  last  inventory  value  thereof;  .... 

Regulation.  The  Act  provides  two  tests  to  which  each  inven- 
tory must  conform:  (i)  It  must  conform  as  nearly  as  may  be  to  the 
best  accounting  practice  in  the  trade  or  business,  and  (2)  it  must 
clearly  reflect  the  income.  It  follows,  therefore,  that  inventory  rules 
can  not  be  uniform  but  must  give  effect  to  trade  customs  which  come 
within  the  scope  of  the  best  accounting  practice  in  the  particular 
trade  or  business.  In  order  to  clearly  reflect  income,  the  inventory 
practice  of  a  taxpayer  should  be  consistent  from  year  to  year,  and 
greater  weight  is  to  be  given  to  consistency  than  to  any  particular 
method  of  inventorying  or  basis  of  valuation  so  long  as  the  method 
or  basis  used  is  substantially  in  accord  with  these  regulations.  An 
inventory  that  can  be  used  under  the  best  accounting  practice  in  a 
balance  sheet  showing  the  financial  position  of  the  taxpayer  can,  as 
a  general  rule,  be  regarded  as  clearly  reflecting  his  income. 

The  basis  of  valuation  most  commonly  used  by  business  con- 
cerns and  which  meets  the  requirements  of  the  Revenue  Act  is  (a) 
cost  or  (b)  cost  or  market,  whichever  is  lower 

In  respect  to  normal  goods  whichever  basis  (a)  or  (b)  is  adopted 
must  be  applied  with  reasonable  consistency  to  the  entire  inventory. 
Taxpayers  were  given  an  option  to  adopt  the  basis  of  either  (o) 
cost  or  (b)  cost  or  market,  whichever  is  lower,  for  their  1920  inven- 


decision  dealing  with  inveiiitories  in  force  at  the  time  of  the  passage 
of  the  1918  law  was  as  follows: 

Regulation,  "i.  For  the  purposes  of  income  and  excess  profits 
tax  return,  inventories  of  merchandise,  etc.,  and  securities,  will  be 
subject  to  the  following  rules: 

"A.  Inventories  of  supplies,  raw  materials,  work  in  process  of 
production  and  unsold  merchandise  must  be  taken  either  (a)  at  cost, 
or  (b)  at  cost  or  market  price  whichever  is  lower,  provided  that  the 
method  adopted  must  be  adhered  to  in  subsequent  years  unless  an- 
other be  authorized  by  the  Commissioner  of  Internal  Revenue. 

"B.  A  dealer  in  securities  who  in  his  books  of  account  regularly 
inventoried  unsold  securities  on  hand  either  (a)  at  cost,  or  {b)  at 
cost  or  market  price  whichever  is  lower,  may,  for  the  purposes  of  in- 
come and  excess  profits  taxes,  make  his  return  upon  the  basis  upon 
which  his  accounts  are  kept;  provided  that  a  description  of  the 
method  employed  shall  be  included  in.  or  attached  to  the  return, 
that  all  the  securities  must  be  inventoried  by  the  same  method,  and 
that  that  method  must  be  adhered  to  in  subsequent  years  unless  an- 
other be  authorized  by  the  Commissioner  of  Internal  Revenue. 

"C.  Gain  or  loss  resulting  from  the  sale  or  disposition  of  assets 
inventoried  as  above  must  be  computed  at  the  difference  between  the 
inventory  value  and  the  price  or  value  at  which  sold  or  disposed  of. 

"2.  In  all  other  cases  inventories  must  be  taken  at  cost  or  at  value 
as  of  March  i,  1913,  .  .  .  ."   (T.  D.  2609,  December  19,  1917.) 


458 


INCOME 


tories,  and  the  basis  adopted  for  that  year  is  controlling  and  a  change 
can  now  be  made  only  after  permission  is  secured  from  the  Commis- 
sioner. Goods  taken  in  the  inventory  which  have  been  so  inter- 
mingled that  they  can  not  be  identified  with  specific  invoices  will  be 
deemed  to  be  either  (o)  the  goods  most  recently  purchased  or  pro- 
duced, and  the  cost  thereof  will  be  the  actual  cost  of  the  goods  pur- 
chased or  produced  during  the  period  in  which  the  quantity  of  goods 
in  the  inventory  has  been  acquired,  or  (b)  where  the  taxpayer  main- 
tains book  inventories  in  accordance  with  sound  accounting  sys- 
tem in  which  the  respective  inventory  accounts  are  charged  with  the 
actual  cost  of  the  goods  purchased  or  produced  and  credited  with 
the  value  of  goods  used,  transferred,  or  sold,  calculated  upon  the 
basis  of  the  actual  cost  of  the  goods  acquired  during  the  taxable  year 
(including  the  inventory  at  the  beginning  of  the  year)  the  net  value 
as  shown  by  such  inventory  accounts  will  be  deemed  to  be  the  cost 
of  the  goods  on  hand.  The  balances  shown  by  such  book  inventories 
should  be  verified  by  physical  inventories  at  reasonable  intervals  and 
adjusted  to  conform  therewith. 

Inventories  should  be  recorded  in  a  legible  maner,  properly  com- 
puted and  summarized,  and  should  be  preserved  as  a  part  of  the 
accounting  record  of  the  taxpayer.  The  inventories  of  taxpayers 
on  whatever  basis  taken  will  be  subject  to  investigation  by  the  Com- 
missioner, and  the  taxpayer  must  satisfy  the  Commissioner  of  the 
correctness  of  the  prices  adopted. 

The  following  methods,  among  others,  are  sometimes  used  in  tak- 
ing or  valuing  inventories,  but  are  not  in  accord  with  these  regula- 
tions, viz. : 

(a)  Deducting  from  the  inventory  a  reserve  for  price  changes, 
or  an  estimated  depreciation  in  the  value  thereof. 

(b)  Taking  work  in  process,  or  other  parts  of  the  inventory,  at 
a  nominal  price  or  at  less  than  its  proper  value. 

(c)  Omitting  portions  of  the  stock   on  hand. 

(d)  Using  a  constant  price  or  nominal  value  for  a  so-called  nor- 
mal quantity  of  materials  or  goods  in  stock. 

(e)  Including  stock  in  transit,  either  shipped  to  or  from  the  tajt- 
payer  the  title  of  which  is  not  vested  in  the  taxpayer.       (Art.  1582.) 

The  foregoing  regulation  is  an  admirable  exposition  of 
good  accounting  practice  and  is  a  vast  improvement  over  some 
of  the  former  regulations  dealing  with  inventories.  It  will  be 
found  that  balance  sheets  properly  prepared  reflect  good  ac- 
counting practice  in  the  taxpayers'  trade  or  business.  The 
law  gives  the  Commissioner  wide  discretion  in  the  matter  of 
inventories  and  it  is  to  be  hoped  that  many  of  the  irritating 


FROM    BUSINESS  459 

differences  of  opinion  which  grew  out  of  former  regulations 
will  disappear. 

The  five  methods  which  are  specifically  disapproved  are 
in  themselves  technical  departures  from  good  accounting  prac- 
tice. In  practice  the  necessary  writing  down  of  inventory 
values  to  meet  actual  market  conditions,  adhering  strictly  to 
the  new  regulations,  will  in  many  cases  produce  the  same  net 
result  as  if  one  or  more  of  the  methods  disapproved  had  been 
used. 

Early  in  1920,  the  Treasury  held: 

Ruling If  inventories  have  been  taken  in  the  past  on  the 

basis  of  cost  and  the  request  is  now  made  to  change  to  "cost  or  market, 
whichever  is  lower,"  the  reasons  for  the  request  should  be  carefully 
scrutinized  and  the  request  refused  if  it  appears  that  the  principal 

reason  therefor  is  to  reduce  the  tax  payable  for  1919 (C.  B. 

2,  page  54;  A.  R.  M.  38.) 

Later,  but  prior  to  T.  D.  3108,^'^  this  position  was  reconsid- 
ered on  the  ground  that  in  "many  instances  the  taxpayer  has 
had  no  real  election,  but  has  been  forced  to  take  his  inventory 
on  either  basis  at  cost,  since  cost  was  lower  than  market " 

Ruling The  Committee  therefore  recommends  that  Memo- 
randum No.  38  be  modified  to  the  extent  that  where  it  can  be 
shown  that  market  at  the  close  of  1918  and  1919  was  above  cost  the 
taxpayer  may  now  elect  to  take  his  inventory  upon  a  cost  or  market 
basis,  whichever  is  lower,  provided  that  such  practice  is  consistently 
adhered  to  in  the  future,  but  that  the  memorandum  in  question  stand 
so  far  as  it  applies  to  those  cases  where  there  was  an  opportunity  to 
take  inventories  at  a  figure  lower  than  cost  because  market  was 
lower  than  cost  at  the  close  of  1918  or  1919,  and  consequently  there 
was  a  real  election  to  continue  upon  a  cost  basis.  (Ruling  13-20-804, 
modified.)    ....      (C.  B.  3,  pages  65,  66;  A.  R.  M.  85.) 

"Cost  or  market  price"  is  not  illegal. — The  regulations 
quoted  above  reiterate  and  amplify  the  principles  originally  laid 
down  in  T.  D.  2609,  the  legality  of  which  was  questioned;  but 
the  Attorney  General,  to  whom  the  question  was  referred,  "ad- 


'  December,  1920. 


46o  INCOME 

vised  upon  the  basis  of  a  decision  of  the  Supreme  Court/^  that 
the  methods  of  taking  inventories  authorized  by  T.  D.  2609  are 
])crmissible."^^ 

Inventories  at  cost. — 

Regulation.    Cost  means : 

(i)  In  the  case  of  merchandise  on  hand  at  the  beginning  of  the 
taxable  year,  the  inventory  price  of  such  goods. 

(2)  In  the  case  of  merchandise  purchased  since  the  beginning 
of  the  taxable  year,  the  invoice  price  less  trade  or  other  discounts 
except  strictly  cash  discounts  approximating  a  fair  interest  rate, 
which  may  be  deducted  or  not  at  the  option  of  the  taxpayer,  pro- 
vided a  consistent  course  is  followed.  To  this  net  invoice  price 
should  be  added  transportation  or  other  necessary  charges  incurred 
in  acquiring  possession  of  the  goods. 

(3)  In  the  case  of  merchandise  produced  by  the  taxpayer  since 
the  beginning  of  the  taxable  year  (a)  the  cost  of  raw  materials  and 
supplies  entering  into  or  consumed  in  connection  with  the  product, 
{b)  expenditures  for  direct  labor,  (c)  indirect  expenses  incident  to 
and  necessary  for  the  production  of  the  particular  article,  including 
in  such  indirect  expenses  a  reasonable  proportion  of  management  ex- 
penses, but  not  including  any  cost  of  selling  or  return  on  capital, 
whether  by  way  of  interest  or  profit. 

(4)  In  any  industry  in  which  the  usual  rules  for  computation  of 
cost  of  production  are  inapplicable,  costs  may  be  approximated  upon 
such  basis  as  may  be  reasonable  and  in  conformity  with  established 
trade  practice  in  the  particular  industry (Art.  1583.) 

Purchase  discounts  actually  earned  are  treated  by  some 
as  a  financial  gain  and  by  others  as  a  reduction  of  cost. 

Rulings.  Taxpayers  who  as  a  matter  of  settled  practice  do  not 
deduct  cash  discounts  from  purchases,  but  who  take  the  merchandise 
purchased  into  their  inventories  at  invoice  price  (less  trade  or  other 
discounts  other  than  strictly  cash  discounts),  carrying  the  discounts 
in  a  discount  account,  may  not,  in  valuing  their  closing  inventories 
for  income  tax  purposes,  deduct  from  the  invoice  price  of  the  mer- 
chandise on  hand  at  the  close  of  the  taxable  year  the  average  amount 
of  cash  discount  received  on  such  merchandise;  neither  may  the 
amount  of  cash  discount  earned,  to  be  reported  as  income,  be  de- 
creased by  an  amount  representing  the  estimated  cash  discount  re- 
ceived on  merchandise  on  hand  at  the  close  of  the  year.  (C.  B.  i, 
page  56;  O.  D.  326.) 


"Doyle  V.  Mitchell  Brothers,  247  U.  S.  179,  38  S.  Ct.  467,  62  L.  Ed.  1054. 
"31  Op.  Att.  Gen.  — ;  T.  D.  2744,  July  3,  1918.    See  page  482. 


FROM    BUSINESS  461 

Held,  tliat  a  wholesale  liquor  dealer  who,  for  years  prior  to 
1918,  exercised  the  option  of  including  excise  taxes  in  cost  of  mer- 
chandise in  calculating  inventory  may  not  amend  such  inventory  and 
treat  such  taxes  as  business  expenses  for  1918.  (C.  B.  4,  page  41; 
A.  R.  M.  121.) 

Allocated  cost  method  permitted. — 

Regulation.  A  taxpayer  engaged  in  mining  or  manufacturing 
who  by  a  single  process  or  uniform  series  of  processes  derives 
a  product  of  two  or  more  kinds,  sizes,  or  grades,  the  unit 
cost  of  which  is  substantially  alike,  and  who  in  conformity  to  a 
recognized  trade  practice  allocates  an  amount  of  cost  to  each  kind, 
size,  or  grade  of  product  which  in  the  aggregate  will  absorb  the  total 
cost  of  production,  may  use  such  allocated  cost  as  a  basis  for  pricing 
inventories,  provided  such  allocation  bears  a  reasonable  relation  to 
the  respective  selling  values  of  the  different  kinds  of  products. 
(Art.  1587.) 

The  foregoing  regulation  is  in  accord  with  the  law  which 
permits  any  inventory  method  which  accords  with  good  ac- 
counting practice.  Special  procedure  has  been  prescribed  in 
the  cases  of  the  tobacco  and  lumber  industries  and  may  be 
extended  to  any  other  industry  in  which  conditions  justify  a 
departure  from  the  general  rule. 

Average  cost  method  permitted — tobacco  industry. — 

Ruling Tobacco    companies    taking    inventory    on    the 

monthly  average  cost  method,  no  method  more  nearly  approaching 
theoretical  accuracy  being  practically  possible,  may  continue  to  use 
such  method  in  reporting  for  income  tax. 

The  method  followed,  as  understood  by  the  Committee,  is  an  aver- 
age cost  method  and  not  an  average  cost  or  market  method.  Accord- 
ingly, if  the  market  should  be  below  the  average  cost  at  the  close  of 
a  given  year,  the  average  cost  shall  be  the  basis  of  valuation  and  not 
the  lower  market  price.  Companies  adopting  average-cost  methods 
of  inventorying  for  income-tax  purposes  should  be  required  to  adhere 
to  that  method  in  future  years.     (C.  B.  2,  page  50;  A.  R.  R.  18.) 

If  average  cost  represents  as  nearly  as  can  be  determined 
actual  cost,  and  market  prices  are  lower  at  the  end  of  any 
year,  taxpayers  cannot  be  denied  the  right  to  value  inventories 
at  market  prices. 


462  INCOME 

Average  market  price  not  permitted/" — 

Ruling.  A  company  taking  its  inventory  upon  the  basis  of  the 
average  of  the  market  prices  prevailing  over  a  period  of  years  does 
not  conform  to  the  method  of  computing  inventories  in  accordance 
with  articles  1 581-1585,  Regulations  45,  and  it  should  therefore  be 
required  to  file  amended  returns.     (C.  B.  i,  page  55;  T.  B.  M.  31.) 

Average  cost  method — lumber  manufacturers. — 
The  following  illustration  shows  the  importance  of  the 
method  referred  to  in  article  1587.-°  The  point  is  that  each 
grade  is  assigned  a  cost  relative  to  all  other  grades.  If  most 
of  the  high  grade  is  sold,  the  low  grade  remaining  in  the  in- 
ventory will  not  be  given  an  average  cost  value  inflated  in 
effect,  by  taking  in  high  grade  not  on  hand. 

The  computation  is  based  on  the  following : 


"For  discussion  of  farm  price  method,  see  Chapter  XXXIX. 

™  "Lumber  Costs,"  by  Edmund  M.  Meyer,  Journal  of  Accountancy," 
August,  1921. 

Regulation,  "i.  Because  of  the  impracticability  of  determining  accu- 
rately the  costs  properly  assignable  to  each  species,  grade,  and  dimension  of 
lumber  making  up  the  product  of  the  mill,  lumber  manufacturers  may  use 
as  a  basis  for  pricing  inventories  the  average  cost  to  the  manufacturer  of 
producing  the  inventoried  products  during  the  taxable  year  for  which  the 
return  of  net  income  is  made. 

"2.  If  the  quantity  of  lumber  on  hand  at  the  time  of  inventory  is 
greater  than  the  total  quantity  of  lumber  produced  during  the  current  tax- 
able year,  it  is  evident  that  the  excess  stock  has  been  carried  over  from 
the  previous  year's  production,  and  such  excess  shall  be  valued  at  the 
average  cost  of  production   for  the  preceding  taxable  year. 

"3.  A  taxpayer  who  regularly  allocates  in  his  books  of  account  such 
average  cost  to  the  different  kinds  and  grades  of  lumber  in  proportion  to 
the  selling  value  of  such  kinds  and  grades  may.  subject  in  each  case  to  the 
approval  of  the  commissioner  upon  audit  of  the  return,  make  his  returns 
of  net  income  on  that  basis. 

"4.  The  term  lumber  manufacturer  as  used  in  this  article  means  a  per- 
son who  manufactures  lumber  from  logs,  as  distinguished  from  a  remanu- 
facturer  of  lumber."     (Reg.  45,  Art.  1587.) 


FROM    BUSINESS 


463 


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464  INCOME 

~  Inventories  at  market. — 

Regulation.-^  Under  ordinary  circumstances  and  for  normal 
goods  in  an  inventory,  "market"  means  the  current  bid  price  prevail- 
ing at  the  date  of  the  inventory  for  the  particular  merchandise  in  the 
volume  in  which  usually  purchased  by  the  taxpayer,  and  is  applicable 
in  the  cases  (a)  of  goods  purchased  and  on  hand,  and  (b)  of  basic 
elements  of  cost  (materials,  labor,  and  burden)  in  goods  in  process 
of  manufacture  and  in  finished  goods  on  hand;  exclusive,  however, 
of  goods  on  hand  or  in  process  of  manufacture  for  delivery  upon 
firm  sales  contracts  (i.e.,  those  not  legally  subject  for  cancellation  by 
either  party)  at  fixed  prices  entered  into  before  the  date  of  the  in- 
ventory, which  goods  must  be  inventoried  at  cost.  Where  no  open 
market  exists  or  where  quotations  are  nominal,  due  to  stagnant  mar- 
ket conditions,  the  taxpayer  must  use  such  evidence  of  a  fair  mar- 
ket price  at  the  date  or  dates  nearest  the  inventory  as  may  be  avail- 
able, such  as  specific  purchases  or  sales  by  the  taxpayer  or  others  in 
reasonable  volume  and  made  in  good  faith,  or  compensation  paid  for 
cancellation  of  contracts  for  purchase  commitments.  Where  the 
taxpayer  in  the  regular  course  of  business  has  offered  for  sale  such 
merchandise  at  prices  lower  than  the  current  price  as  above  defined, 
the  inventory  may  be  valued  at  such  prices  less  proper  allowance 
for  selling  expense,  and  the  correctness  of  such  prices  will  be  de- 
termined by  reference  to  the  actual  sales  of  the  taxpayer  for  a  rea- 
sonable period  before  and  after  the  date  of  the  inventory.  Prices 
which  vary  materially  from  the  actual  prices  so  ascertained  will  not 
be  accepted  as  reflecting  the  market.     (Art.  1584.) 

The  foregoing  regulation  accords  with  good  accounting 
practice. 

The  Treasury  now  recognizes  that  the  current  bid  price 
may  not  represent  what  a  purchaser  might  have  to  pay  if  he 
attempted  to  buy  in  quantities ;  what  the  taxpayer  would  prob- 
ably pay  is  a  much  fairer  test  of  the  market  value  than  apparent 
bid  prices  in  abnormal  markets  such  as  obtained  at  the  end  of 
192 1. 

The  foregoing  regulations,  in  recognizing  abnormal  con- 
ditions, throw  a  considerable  amount  of  responsibility  on  the 
good  judgment  and  good  faith  of  the  taxpayer. 

Probably  the  most  important  factor  in  fixing  market  prices 


"  See  Chapter  XXIX,  where  claims  for  shrinkage  in  inventory  losses 


are  discussed. 


FROM    BUSINESS  465 

is  qtiantity.^^  If  the  quantity  on  hand  is  in  excess  of  the  reason- 
able requirements  of  the  taxpayer,  the  nominal  market  price 
for  a  small  quantity  usually  is  not  the  market  price  for  larger 
quantities.  In  a  declining  market  it  is  proper  to  assume  that 
replacement  market  prices  for  large  quantities  are  considerably 
below  ruling  market  prices. ^^ 

At  the  end  of  1920  many  users  of  steel  products  had  placed 
large  orders  for  steel.  When  the  general  price  decline  came, 
the  demand  for  their  finished  product  vanished  overnight, 
particularly  in  the  automobile  industry,  yet  the  price  of  forg- 
ings  and  other  raw  material  showed  no  decline  because  the 
steel  mills  had  large  accumulated  orders  on  their  books.  Using 
the  nominal  "bid"  prices  prevailing  at  the  date  of  the  in- 
ventory would  have  compelled  these  manufacturers  to  pay 
taxes  at  the  high  rate  on  enormous  inventories  which  they  were 
not  able  to  liquidate  for  some  very  considerable  time. 

In  connection  with  an  interpretation  of  the  terms  (a)  cost, 
and  (b)  cost  or  market,  whichever  is  lower,  questions  have 
arisen  as  to  whether  certain  items  in  an  inventory  may  be  priced 
at  cost  (which  is  less  than  market)  and  other  items  of  exactly 
the  same  kind,  which  cost  more,  may  be  reduced  to  market. 
For  illustration,  certain  lots  of  pig  iron  may  have  cost  $20  per 
ton.  Other  lots  may  have  cost  $25  and  additional  lots  may 
have  cost  $30.  When  inventory  is  taken  the  market  price  is 
$25.  Where  the  lots  can  be  readily  identified  the  first  lot 
should  be  kept  at  cost,  viz.,  $20  per  ton,  the  second  lot  should 
be  kept  at  market,  viz.,  $25  per  ton,  and  the  third  lot  should 
be  marked  down  to  market,  viz.,  $25  per  ton. 

Article  1582  implies  that  in  the  same  inventory  some  items 
may  be  taken  at  cost  and  some  (when  the  market  has  dropped) 
at  less  than  cost.  No  other  method  would  properly  interpret 
the  term  "cost  or  market,  whichever  is  lower,"  nor  conform  to 
good  accounting  practice. 


'"See  R.  H.  Montgomery,  Auditing,  Theory  and  Practice  (1921  edition), 
page  127. 

"'  See  page  468. 


466 


INCOAIE 


Ruling.  This  office  acknowledges  receipt  of  your  letter  of  Sep- 
tember 7,  1921,  making  inquiry  as  to  whether  Article  1582,  Regula- 
tions 45,  1920  edition,  provides  for  a  change  in  the  method  of  apply- 
ing the  basis  of  cost  or  market  whichever  is  lower,  in  valuing  an 
inventory. 

In  reply  you  are  informed  that  the  change  of  wording  in  Article 
1582,  Regulations  45,  1920  edition,  is  not  intended  to  change  the 
former  method  of  applying  the  basis  of  cost  or  market  to  each  item 
of  the  inventory.  In  employing  the  basis  of  cost  or  market  whichever 
is  lower,  the  lower  value  of  each  item  listed  in  the  inventory  must  be 
placed  upon  the  particular  item.  You  will  note  that  one  item  may  be 
valued  at  cost  while  another  may  be  valued  at  market.  The  valua- 
tion to  be  placed  on  the  item  is  determined  by  the  fact  that  either  cost 
or  market  value  is  the  lower.  (Letter  to  Prentice-Hall,  Inc.,  signed 
by  E.  H.  Batson,  Deputy  Commissioner,  dated  September  20,  1921.) 

There  seems  to  have  been  some  confusion  in  the  minds  of 
taxpayers  as  to  the  practical  appHcation  of  the  "cost  or  market, 
whichever  is  lower''  method.  Ordinarily  it  is  not  feasible  to 
segregate  or  identify  the  various  lots  which  were  sold  or  still 
remained  in  stock.  To  do  so  involves  a  minute  segregation 
of  accounts,  such  as  is  found  in  a  comprehensive  cost  system. 
In  the  ordinary  course  the  stock  purchased  first  must  be  as- 
sumed to  be  the  stock  sold  first,  and  the  stock  to  be  inventoried 
would  be  that  last  purchased.  The  cost  of  these  last  lots  is 
compared  with  the  market  price,  and  the  lower  of  the  two  is 
taken. 

Net  selling  prices. — A  further  recognition  by  the  Treas- 
ury that  apparent  market  prices  are  often  not  real,  particularly 
in  the  case  of  goods  that  are  shopworn,  obsolete,  or  that  have 
deteriorated  from  some  other  cause,  is  found  in  the  new  regu- 
lation. The  author  has  contended  in  the  past  that  "for  many 
reasons  merchandise  may  have  to  be  valued  below  cost ;  over- 
stock; damage  or  deterioration;  changes  in  styles  and  shapes; 
obsolescence — going  out  of  date;  sizes  and  qualities  seldom 
used;  broken  lots.'""*  The  new  regulations  give  effect  to  this 
contention. 


'"Income  Tax  Procedure,  1921,  page  349. 


FROM    BUSINESS  467 

Regulations Any  goods  in  an  inventory  which  are  unsal- 
able at  normal  prices  or  unusable  in  the  normal  way  because  of  damage, 
imperfections,  shop  wear,  changes  of  style,  odd  or  broken  lots,  or  other 
similar  causes,  including  second-hand  goods  taken  in  exchange, 
should  be  valued  at  bona  fide  selling  prices  less  cost  of  selling  whether 
basis  (a)  or  (&)  is  used,  or  if  such  goods  consist  of  raw  materials 
or  partly  finished  goods  held  for  use  or  consumption,  they  should 
be  valued  upon  a  reasonable  basis,  taking  into  consideration  the 
usability  and  the  condition  of  the  goods,  but  in  no  case  shall  such 
value  be  less  than  the  scrap  value.  Bona  fide  selling  price  means 
actual  offerings  of  goods  during  a  period  ending  not  later  than  30 
daj^s  after  inventory  date.  The  burden  of  proof  will  rest  upon  the 
taxpayer  to  show  that  such  exceptional  goods  as  are  valued  upon  such 
selling  basis  come  within  the  classifications  indicated  above,  and 
he  shall   maintain   such   records   of  the  disposition   of   the   goods  as 

will  enable  a  verification  of  the  inventory  to  be  made (Art. 

1582.) 

The  foregoing  article  assumes  that  the  goods  inventoried 
would  not  be  replaced  and  that  they  are  worth  the  gross  sales 
price  subsequently  realized  less  expense  of  selling.  It  is  the 
most  reasonable  method  of  inventorying  such  goods.  It  does 
not,  however,  give  to  a  new  fiscal  period  any  element  of  profit. 
If  the  merchandise  is  of  such  a  nature  that  the  market  price 
can  be  obtained,  it  is  more  conservative  to  use  market  prices 
than  net  selling  prices."^ 

Are  the  inventory  regulations  in  accord  with  accounting 
procedure? — The  regulations  quoted  are  in  accord  with  sound 
commercial  practice  assuming  that  "market  price"  will  be  con- 
strued to  mean  a  fair  and  reasonable  price. 

Inventories  should  be  valued  at  "cost  or  market,  whichever 
is  lower,"  except  when  trade  conditions  or  long-continued 
custom  calls  for  a  still  lower  basis.^''  Apparent  market  prices 
may  not  be  true  market  prices.  This  is  particularly  the  case 
in  a  falling  market,  but  may  be  equally  true  when  a  rising 
market  indicates  speculative  prices  arising  out  of  shortages 
(which  may  be  only  temporary).     In  such  cases,  goods  pur- 


"'  See  page  464. 
-'Art.  1584. 


_^es  INCOME 

chased  at  the  speculative  prices  may  at  inventory  time  appear 
to  be  worth  cost  and  the  apparent  market  price  may  be  even 
higher,  but  a  conservative  concern  would  hesitate  before  rec- 
ognizing  such  values  as  real.  Therefore,  no  matter  how^  staple 
or  salable  the  goods  may  be,  if  the  market  price  has  declined 
the  inventory  should  be  reduced  to  correspond.  As  stated 
in  the  new  regulations,  merchandise  may  for  various  reasons 
have  to  be  inventoried  below  cost.^^ 

Portions  of  inventories  usually  priced  at  less  than  either 
cost  or  market. — In  some  cases  it  will  be  necessary  to  con- 
tinue to  price  portions  of  an  inventory  at  less  than  either  cost 
or  market.  Businesses  such  as  those  of  agricultural  imple- 
ment and  automobile  manufacturers  frequently  find  that  they 
have  on  hand  large  stocks  of  spare  parts  which  are  not  worth 
cost  or  the  nominal  market. 

As  a  matter  of  fact,  small  quantities  may  be  selling  freely 
and  at  a  very  high  rate  of  profit.  But  inventories  must  not 
be  taken  on  the  supposition  that  an  entire  stock  is  worth  as 
much  proportionately  as  a  small  part.  A  hatter  has  in  stock 
100  perfectly  good  hats.  He  may  sell  50  of  them  at  a  good 
profit.  If  he  then  takes  stock,  and,  from  experience  knows 
that  the  most  the  future  market  will  absorb  is  40,  ordinary 
business  practice  requires  him  to  inventory  40  at  cost  or 
market,  whichever  is  the  lower,  or  50  at  the  same  aggregate 
price,  but  at  a  less  unit  price.  This  is  not  a  departure  from, 
but  is  an  adherence  to,  the  principle  of  inventory  valuation 
which  conforms  "to  the  best  accounting  practice."  Future 
demand  is  one  of  the  controlling  factors  in  the  determination 
of  market  prices. 

If  on  December  31,  1921,  it  were  known  that  the  future 
demand  was  decreasing,  that  factor  would  have  its  influence 
on  market  prices  of  that  date,   but  no  one  would  be  war- 


"  For  full  discussion  of  factors  which  influence  inventory  valuations, 
see  Auditing,  Theory  and  Practice  (1921  edition),  by  R.  H.  Montgomery, 
pages  117  to  172. 


FROM    BUSINESS  469 

ranted  in  assuming  that  further  declines  would  take  place 
thereafter  unless  in  preinous  years  it  had  been  customary  to 
carry  stock  at  less  than  cost  or  the  market.  It  is  obvious  that 
if  such  a  custom  were  an  old  one  the  government  might  not 
lose  through  its  continuance,  because  a  change  in  policy  would 
result  in  the  adjustment  of  the  returns  of  previous  years, 
which  would  in  most  cases  leave  the  net  result  for  1921 
unchanged. 

The  Treasury,  however,  has  gone  on  record  as  being  op- 
posed to  the  so-called  "base  stock,"  "minimum"  or  "  cushion" 
method.     As  stated  by  the  Treasury: 

Ruling.  According  to  the  base-stock  method  of  taking  inven- 
tories a  manufacturer  or  dealer  values  at  the  same  price  year  after 
year  the  minimum  quantity  of  goods  which  he  must  have  on  hand 
at  all  times.     (C.  B.  i,  page  51 ;  T.  B.  R.  65.) 

In  the  detailed  opinion  it  was  held  that : 

The  base  stock  method  of  taking  inventories  is  not  warranted 
by  the  law  or  the  Regulations. 

The  Treasury's  arguments  against  this  method  are : 

1.  The  method  has  not  been  widely  adopted. 

2.  To  sanction  its  use  would  be  discriminatory. 

3.  It  is  not  the  "accounting  practice"  followed  by  a  ma- 
jority of  manufacturers. 

4.  It  assigns  profits  and  losses  on  the  minimum  inventory 
to  the  year  in  which  such  inventory  is  liquidated,  by  ignoring 
sales  of  individual  items  in  the  inventory  and  treating  the 
minimum  inventory  as  a  unit. 

5.  It  disregards  gains  that  may  be  considered  quasi- 
capital  gains  and  are  taxable  under  American  (as  distinguished 
from  British)  income  tax  laws. 

6.  In  substance,  it  results  in  offsetting  an  inventory  gain 
of  one  year  against  an  inventory  loss  of  another. 

Goods  purchased  but  not  delivered. — In  all  cases  when 
goods  have  been  shipped  the  consignee  should  consider  the 


470 


INCOME 


goods  as  part  of  his  inventory  and  include  the  full  purchase 
price  among  his  liabilities.  If  the  market  price  of  the  goods 
at  closing  time  is  less  than  cost  the  inventory  will  be  reduced. 

Regulation Only  merchandise  title  to  which  is  vested 

in  the  taxpayer  should  be  included  in  the  inventory.  Accordingly 
the  seller  should  include  in  his  inventory  goods  under  contract  for 
sale  but  not  yet  segregated  and  applied  to  the  contract  and  goods 
out  upon  consignment,  but  should  exclude  from  inventory  goods  sold, 
title  to  which  has  passed  to  the  purchaser.  A  purchaser  should  in- 
clude in  inventory  merchandise  purchased,  title  to  which  has  passed 
to  him,  although  such  merchandise  is  in  transit  or  for  other  reasons 
has  not  been  reduced  to  physical  possession,  but  should  not  include 
goods  ordered  for  future  delivery  transfer  of  title  to  which  has  not 
yet  been  effected.     (Art.  1581.) 

The  proper  taking  of  **in  transit"  and  other  parts  of  the 
inventory  is  facilitated  by  planning  ahead  of  the  inventory 
date.  Careful  segregation  and  compilation  of  information  on 
the  following  points  will  avoid  neglect  of  matters  which  are 
often  overlooked: 

1.  Invoices  received  for  goods  not  yet  received. 

2.  Goods  received  but  no  invoices. 

3.  Goods  returned  by  customers  but  credit  not  yet  passed. 

4.  Goods  returned  and  billed  back  by  customers  but  not 

yet  received. 

5.  Goods  on  consignment. 

6.  Goods  at  other  plants  for  processing  or  which  are  held 

on  order. 

7.  Goods  sold  awaiting  shipment  but  not  yet  billed. 

When  contracts  have  been  entered  into  for  future  delivery, 
and  such  contracts  are  not  subject  to  cancellation,  it  may 
be  important  to  consider  whether  or  not  any  loss  has  arisen 
in  respect  thereto.  If  the  purchases  were  set  aside  by  the 
seller  and  charged  on  the  seller's  books  to  the  purchaser,  the 
latter  should  also  reflect  the  transaction  in  his  books.  Other- 
wise the  profit  to  the  seller  would  have  appeared  in  his  tax 
returns  for  192 1,  but  the  shrinkage  in  value,  if  any,  to  the 


FROM    BUSINESS 


471 


purchaser  would  not  have  appeared  in  the  latter's  returns  until 
after  1921. 

If  the  goods  are  not  dealt  with  as  sales  by  the  seller,  the 
purchaser  can  hardly  expect  to  take  up  any  loss  on  his  books. 

It  may  be  urged  that  if  a  purchaser  contracts  in  November, 
1921,  for  cotton  goods  to  be  delivered  in  January,  1922,  and 
at  December  31,  1921,  the  market  price  is  10  cents  a  yard  less 
than  the  purchase  price,  he  should  be  able  to  deduct  the  10 
cents  a  yard  loss  in  his  192 1  returns  as  reflecting  the  market 
price  on  December  31,  192 1.  The  answer  is  that  goods  not 
received  may  never  be  received;  that  before  the  goods  are 
received  the  market  may  again  advance,  and  that  no  loss  has 
been  realized. 

On  the  other  hand,  a  true  balance  sheet  of  the  purchaser 
would  show  a  reserve  for  the  loss  accrued  to  December  31."* 
If  the  loss  must  be  set  up  to  reflect  actual  conditions,  there 
must  be  some  merit  in  the  contention  that  true  net  income 
for  the  year  1921  cannot  be  determined  unless  and  until 
what  has  taken  place  in  1921  is  reflected  in  the  tax  returns. 

When  there  is  a  considerable  shrinkage  in  prices  and  it 
is  desired  to  reflect  in  the  current  year  the  accrued  losses  on 
forward  orders,  it  is  legal  and  proper,  prior  to  the  closing  date, 
to  cancel  orders,  pay  the  loss  due  to  cancellation,  and  reinstate 
the  orders  at  the  current  market  prices. 

In  some  trades  it  is  customary  to  place  orders  for  future 
delivery  on  the  books.     In  such  cases  the  inventory-at-market 


""  "The  balance  sheet,  for  instance,  might  show  stock  on  hand  large 
enough  or  too  large  for  the  normal  requirements  of  the  business.  Unful- 
filled contracts  outstanding  at  the  date  of  the  balance  sheet  which  call  for 
the  receipt  of  additional  stock,  which  may  not  be  readily  salable,  will  result 
in  an  actual  liability,  whereas  the  offset,  the  stock  to  arrive,  will  be  an  asset 
of  doubtful  value. 

"In  every  audit,  therefore,  the  auditor  should  call  for  copies  of  all 
orders  for  future  delivery.  If  such  orders  call  for  stock  in  excess  of  the 
current  and  reasonable  prospective  demand,  mention  thereof  should  be  made 
in  the  balance  sheet.  The  details  reported  should  depend  on  the  circum- 
stances of  each  particular  case."  [Auditing,  Theory  and  Practice  (3rd  edi- 
tion), by  R.  H.  Montgomery,  page  260.] 


472  INCOME 

basis  would  enable  credit  to  be  taken  for  the  loss  in  1921, 
If  such  a  custom  has  been  followed  for  a  period  of  years  or 
is  general  in  a  trade,  it  may  be  continued.  Otherwise  the  prac- 
tice should  not  be  initiated  as  at  December  31,  1921.  Tax- 
payers are  on  notice,  however,  that  the  Treasury  has  ruled  that 
goods  to  which  title  has  not  passed  cannot  be  inventoried. 

A  question  arose  from  a  claim  for  loss  under  section 
204,^^  due  to  decline  in  value  of  the  inventory,  as  to  w^hether 
or  not  the  material  covered  by  contracts  for  future  delivery 
could  properly  be  included  in  the  inventory.^" 

Ruling On  September  30,  1918,  none  of  the  X  material 

on  account  of  which  losses  were  subsequently  sustained  had  been 
delivered  to  the  company,  and  hence  none  was  included  in  the  inven- 
tory on  which  the  assessment  for  1918  was  made.  The  company  did 
not  at  that  time  own  this  X  material,  and  presumably  much  of  it  had 
not  even  been  produced.  The  company  did  not  own  it  but  only  had 
a  contract  for  its  purchase.  It  could  not,  therefore,  have  properly 
been  included  in  an  inventory  of  the  company's  property  as  of  that 
date (C.  B.  3,  page  88;  T.  D.  3044.) 

Futures.^^ — During  the  year  1921,  the  Treasury  removed 
its  inhibition  against  the  inclusion  in  the  inventory  of  such 
futures  as  constitute  "hedges"  against  actual  spot  or  cash 
transactions.  Prior  to  the  issue  of  A.  R.  M.  135,  the  Treas- 
ury had  consistently  refused  to  permit  the  inclusion  of 
"hedges"  in  the  inventories  of  dealers  in  cotton,  grain  and 
similar  commodities.  The  author  has  contended  for  many 
years  that  such  disregard  for  recognized  accounting  practice 
is  not  in  accordance  with  the  law. 

Ruling.  The  leading  cotton  and  grain  exchanges  of  the  country 
and  some  of  the  leading  individual  dealers  in  these  commodities  ap- 
peared by  counsel  or  in  person  before  the  Internal  Revenue  Bureau  to 
urge  that  "hedge"  transactions  in  "futures"  shall  be  accorded  recogni- 
tion in  the  taxpayer's  balance  sheet  at  the  close  of  each  taxable  year 

"'  1918  law. 

"  See  Chapter  XXIX. 

"  [Former  Procedure]  Prior  to  1921  the  Treasury  held  that  "trans- 
actions in  'futures'  unclosed  at  the  end  of  the  taxable  year  form  no  integral 
part  of  the  cost  of  the  commodity  included  in  the  taxpayer's  inventory." 
(C.  B.  3,  page  66;  A.  R.  \[.  100.) 


FROM    BUSINESS  473 

and  shall  be  thus  taken  into  consideration  in  computing  taxable  in- 
come. Such  consideration  h^s  been  heretofore  denied  by  the  Internal 
Revenue  Bureau  to  taxpayers  engaged  in  these  lines  of  business  for 
the  reason  that  transactions  in  "futures"  have  been  held  not  to  be 
"closed  transactions"  within  the  meaning  of  the  regulations,  where 
such  transactions,  entered  into  in  one  taxable  year,  had  been  carried 
forward  into  the  year  following. 

In  thus  holding  the  Bureau  appears  to  have  relied  very  largely 
upon  its  previous  decision  [A.  R.  M.  100,  Dec.  1920  Cum.  Bull.  p.  661 
in  which  decision  there  was  considered  nothing  more  than  inventories 
of  cotton  and  grain  merchants,  no  other  aspects  of  the  case  being  at 
that  time  under  consideration,  and  what  was  said  referred  only  to  the 
valuation  of  such  inventories  and  to  the  proposal  to  determine  profit 
or  loss  by  treating  such  transactions  either  as  additions  to  or  de- 
ductions from  the  taxpayers'  inventories. 

At  the  hearing  the  Bureau  was  deeply  impressed  with  the  force 
lit  the  arguments  presented  by  counsel  and  with  the  seriousness  of 
the  situation  that  would  unquestionably  develop  in  the  cotton  and 
grain  trades  should  the  present  practice  in  denying  to  taxpayers  the 
right  of  including  in  their  balance  sheets  their  liabilities  or  assets 
under  these  "hedges,"  be  confirmed  and  established  as  the  recognized 
practice  of  the  Bureau. 

From  its  previous  opinion  the  Bureau  now  finds  no  cause  to  deviate 
and  holds  it  to  be  self-evident  without  reference  to  the  legal  question 
involved,  that  any  proposition  to  add  to  an  inventory  the  value  of  a 
commodity,  the  title  to  which  is  not  at  the  time  actually  vested  in 
the  taxpayer  or  to  deduct  from  an  inventory  the  value  of  a  commodity, 
the  title  to  which  may  or  may  not  be  vested  in  the  taxpayer,  but 
which  is  to  be  delivered  only  at  some  time  in  the  future,  cannot  by 
any  correct  system  of  reasoning  or  logic  be  maintained. 

The  case  now  presented  for  consideration  involves  quite  a  differ- 
ent principle  and  the  proposition  is  not  identical  with,  nor  in  fact 
in  any  degree  parallel  to  the  previous  decision  of  the  Bureau.  In 
the  present  decision  there  is  involved  firm  contracts  entered  into  in 
good  faith  for  a  consideration  and  enforceable  under  the  law,  the 
•value  of  which  (and  consequently  the  profit  or  loss  resulting  there- 
from) can  be  absolutely  fixed  and  determined  at  any  minute  of  any 
business  day.  To  deny  to  these  contracts  at  any  time  during  their  life 
Governmental  recognition  as  actual  liabilities  or  actual  assets  (as 
the  case  may  be)  would  be  futile,  nor  could  such  a  contention  be 
sustained  in  the  courts  where  recognition  has  heretofore  been  fully 
accorded  them. 

The  Bureau  accordingly  holds  that  dealers  in  cotton  and  grain, 
and  in  such  other  commodities  as  are  dealt  in  in  a  similar  manner,  may 
for  the  purpose  of  determining  taxable  income,  incorporate  in  their 
balance  sheets  at  the  close  of  any  taxable  year,  such  open  "future" 


474 


INCOME 


contracts  to  which  they  arc  parties  as  are  "hedges"  against  actual 
"spot"  or  cash  transactions:  provided,  that  no  purely  speculative  trans- 
actions in  "futures"  not  off-set  by  actual  "spot"  or  cash  transactions, 
may  be  so  included  or  taken  into  the  taxpayer's  account  in  any  manner 
until  such  transactions  are  actually  closed  by  liquidation;  and  pro- 
vidcd  further,  that  the  values  of  the  commodity  covered  by  such  open 
"future"  contracts  shall  not  be  added  to  nor  deducted  from  the  in- 
ventory of  the  taxpayer.  ( Special  summary  of  Memorandum  No. 
135,  May  23,  1921,  prepared  by  the  Committee  on  Appeals  and  Re- 
view, for  release  July  15,  I92i.)32 

It  has  been  held  that  the  ruHng  made  in  A.  R.  M.  135  is 
appHcable  to  all  dealers  in  commodities  "as  are  dealt  in  in  a 
manner  similar  to  that  outlined  in  such  ruling,"  and  particu- 
larly to  millers  who  hedge  future  contracts  for  wheat  against 
unfilled  flour  sales. ^" 

Obsolete  stock  may  be  written  down  or  off. — The  prin- 
ciple of  cost  or  market,  wdien  applied  to  inventory  items 
which  have  become  obsolete  or  nearly  so,  is  feasible.  If 
there  were  a  reasonable  demand  for  the  items  they  would 
not  be  classed  as  obsolete.  If  the  demand  has  definitely  fallen 
off  or  has  ceased,  the  market  value  has  correspondingly  de- 
clined and  such  stock  may,  in  accordance  with  the  principle, 
be  written  down  to  its  market  value  or  marked  off  entirely 
if  it  has  no  market  value. 

In  many  lines  of  industry,  notably  the  automobile  indus- 
try, new  designs  have  rendered  obsolete  much  of  the  finished 
goods  carried  in  the  inventory.  When  this  is  known  before 
the  end  of  the  year,  the  obsolescence  is  certainly  definite  and 
should  be  reflected  in  the  inventory  values.^* 

Income  from  sales  of  small  quantities  which  form  part  of  a 
large  lot. — When  a  stock  of  materials  or  goods  consists  of  a 
number  of  units  it  is  sometimes  difficult  to  determine  the 
measure  of  profit  or  loss  which  should  be  assigned  to  the  dis- 


"'For  complete  ruling,  including  extracts  from  briefs  filed,  see  B.  31-21- 
1750;  A.  R.  M.  135. 

'' 1-3-30;  J.  T.  1 166. 

"'  For  discussion  of  "marked  selling  price"  valuation  applicable  to  obso- 
lete stock,  see  page  468. 


FROM    BUSINESS  475 

position  of  a  part  of  the  stock  pending  the  sale  of  the  entire 
lot.  In  theory  the  aggregate  of  the  cost  or  inventory  price 
can  be  distributed  to  each  unit  and  thus  the  profit  or  loss  on 
each  sale  would  be  easily  determined,  but  in  practice  it  is  well 
known  that  it  may  be  easy  to  dispose  of  part  of  a  large  stock 
whereas  the  remainder  may  never  be  sold. 

It  is  claimed  by  some  that  the  entire  proceeds  of  first  sales 
should  be  credited  against  the  entire  lot  and  that  no  profit 
should  be  taken  until  the  purchase  or  inventory  price  is  ex- 
ceeded or  it  is  known  that  it  will  be  exceeded. 

In  other  cases  profit  or  loss  is  shown  in  each  item  as  it  is 
sold. 

This  is  one  of  the  questions  which  must  be  settled  accord- 
ing to  good  accounting  practice.  It  requires  that  where  unusual 
conditions  obtain,  the  item  should  receive  special  treatment. 
This,  in  turn,  must  be  controlled  by  the  good  judgment  and 
good  faith  of  those  in  charge  of  the  business. 

The  foregoing  reasoning  is  applied  to  stocks  of  liquor, 
since  the  difficulty  of  disposing  of  them  has  recently  increased. 
The  Treasury  seems  to  feel,  however,  that  such  stocks  have 
a  "market  value." 

Ruling The  prohibition  law,  as  understood  by  the  com- 
mittee, permits  the  use  of  distilled  liquors  and  wines  in  the  manu- 
facture of  medicines  and  in  the  filling  of  prescriptions  for  medicinal 
use.  The  provision  for  these  legitimate  demands,  therefore,  gives 
to  the  goods  available  to  supply  them  some  value,  and  it  is  presumed 
that  there  can  be  readily  established  the  market  value  for  the  supply- 
ing of  such  demands.  It  is  true  that  the  demand  is  not  sufficient  to 
create  a  market  for  all  the  goods  held  in  stock,  and  that  an  attempt 
to  sell  for  this  purpose  at  one  time  very  considerable  part  of  the 
stocks  on  hand  would  doubtless  flood  the  market  and  break  it  down 
to  a  very  low  figure.  In  a  measure,  however,  this  was  true  before 
the  enactment  of  prohibition  laws,  as  the  supply  of  liquor  on  hand 

was    always    in    excess    of    any    immediate    demand    therefor 

(C.  B.  2,  page  53;  A.  R.  M.  33.) 

Inventories  by  retail  dry  goods  and  other  retail  dealers. — 
Among  the  specific  classes  of  taxpayers  to  whom  special  meth- 
ods of  inventorying  have  been  allowed  are  "retail  merchants." 


476 


INCOME 


It  is  noteworthy  that  the  Treasury  is  recognizing  trade  prac- 
tices in  various  trades  and  that  where  they  are  long  established 
taxpayers  are  allowed  to  adhere  to  them. 

Regulation.  Retail  merchants  who  employ  what  is  known  as 
the  "retail  method"  of  pricing  inventories  may  make  their  returns 
upon  that  basis,  provided  that  the  use  of  such  method  is  designated 
upon  the  return,  that  accurate  accounts  are  kept,  and  that  such 
method  is  consistently  adhered  to  unless  a  change  is  authorized  by 
the  commissioner.  Under  this  method  the  goods  in  the  inventory  are 
ordinarily  priced  at  the  selling  prices,  and  the  total  retail  value  of 
the  goods  in  each  department  or  of  each  class  of  goods  is  reduced  to 
approximate  cost  by  deducting  the  percentage  which  represents  the 
difference  between  the  retail  selling  value  and  the  purchase  price. 
This  percentage  is  determined  by  departments  of  a  store  or  by  classes 
of  goods,  and  should  represent  as  accurately  as  may  be  the  amounts 
added  to  the. cost  prices  of  the  goods  to  cover  selling  and  other  ex- 
penses of  doing  business  and  for  the  margin  of  profit.  In  computing 
the  percentage  above  mentioned,  proper  adjustment  should  be  made  for 
all  mark-ups  and  mark-downs. 

A  taxpayer  maintaining  more  than  one  department  in  his  store  or 
dealing  in  classes  of  goods  carrying  different  percentages  of  gross 
profit  should  not  use  a  percentage  of  profit  based  upon  an  average 
of  his  entire  business,  but  should  compute  and  use  in  valuing  his  in- 
ventory the  proper  percentages  for  the  respective  departments  or 
classes  of  goods.     (Art.  1588.) 

While  this  method  in  the  article  quoted  is  limited  to  "retail 
merchants,"  it  w'ill  be  noted  from  the  following  letter  of  the 
Commissioner  that  the  method  will  be  permitted  to  those  stores 
which  follow  essentially  the  practices  of  such  retail  merchants 
as  retail  dry  goods  stores. 

Ruling.  Reference  is  made  to  your  letter  of  January  13,  1921, 
relative  to  T.  D.  3058,  issued  August  16,  1920  (Article  1588  of  Reg- 
ulations 45. — Inventories  of  retail  dry  goods  dealers)  asking  for  further 
details  as  to  prope'r  procedure  within  the  meaning  of  the  regulations. 
Your  questions  are  taken  up  and  answered  in  the  order  in  which 
you  presented  them. 

1.  The  use  of  the  retail  method  is  by  the  decision  confined  to  retail 
dry  goods  dealers.  Other  organizations  and  individual  stores  who 
conduct  retail  establishments  and  follow  essentially  the  retail  method 
of  dry  goods  stores,  may  be  allowed  this  method  upon  application  to 
the  Bureau  of  Internal  Revenue. 

2.  The  designation  of  the  method  as  a  "cost"  method.    It  was  not 


FROM    BUSINESS  477 

intended  that  the  apparent  limitation  should  be  inflexible.  It  is  rec- 
ognized that  on  a  constant  or  rising  market  the  retail  method  is  ap- 
proximately a  "cost"  basis,  and  that  on  a  falling  market  it  results  in 
a  reduction  to  "cost  or  market  whichever  is  lower." 

3.  Preserving  records.  There  must  be  a  permanent  form  of  re- 
cording by  departments,  purchases  showing  the  firm  name,  date  of 
invoice,  invoice  cost  and  retail  sales,  stock,  etc.  It  must  be  borne  in 
mind  that  under  no  circumstances  will  arbitrary  standard  percentages 
of  purchase  mark-up  be  allowed  in  the  determination  of  the  "cost" 
or  "cost  or  market"  value  of  retail  inventories;  but  that  such  per- 
centages must  be  the  purchase  mark-up  percentage  disclosed  by  the 
department  records  of  the  fiscal  period  for  which  the  return  is  made. 

4.  Opening  inventory.  In  Section  "A"  the  words  "the  value  of  all 
merchandise  as  received"  is  inclusive  of  inventory  at  the  beginning 
of  the  period.    The  purchase  mark-up  must  be  computed  as  follows: 

Cost:     Inventory  at  cost  at  beginning:  purchases  at  cost; 
transportation. 

Retail:  Inventory  at  sales  price:  purchases  at  sales  price. 

5.  Appreciation  in  retail  values  of  goods  on  hand.  Within  the 
meaning  of  the  Article,  it  is  proper  to  include  as  a  part  of  "original 
retail  sales  price"  the  actual  increase  in  the  original  sales  price  which 
has  been  brought  about  by  market  conditions  or  by  incorrect  pricing 
when  the  goods  were  put  into  stock.  For  the  convenience  of  the  ex- 
amining officer,  a  special  form  should  be  provided;  complete  informa- 
tion by  items  of  the  increase  from  the  original  retail  must  be  shown ; 
reference,  if  possible,  must  be  made  to  the  original  invoice;  entry  and 
the  reason  for  the  increase  freely  explained.  All  such  amended  retail 
increases  must  be  approved  by  the  buyer  of  the  department  and  mer- 
chandise manager  or  other  responsible  official  and  they  should  be  sO' 
filed  that  quick  reference  to  them  may  be  made.  Entry  of  such  in- 
creased retail  prices  properly  belongs  in  department  purchase  books,  al- 
though it  may  be  set  up  as  a  separate  item  in  the  accumulated  records  of 
the  department.  The  same  forms  that  are  used  to  record  such  price 
increases  should  not  be  used  for  mark-downs  and  in  no  instances  will 
a  store  be  allowed  to  include  as  retail  increases  a  mark-up  which 
has  been  taken  as  a  correction  or  cancellation  of  a  mark-down ;  such 
mark-up  must  be  regarded  and  treated  in  all  cases  as  opposite  to 
mark-down. 

6.  Proper  vmrk-dozvns  substantiated  by  record  of  facts  mill  be 
permitted.  The  decision  is  not  intended  to  disturb  the  procedure  in 
stores  which  have  properly  handled  mark-downs,  but  instances  where 
arbitrary  reductions  from  retail  values  have  been  made  because  of 
the  desire  to  provide  for  depreciation  and  obsolescence  with  no  actual 
offering  to  the  public  of  the  goods  on  which  the  mark-downs  were 
claimed,  cannot  be  recognized.   Under  no  circumstances  will  a  store  be 


478  INCOME 

allowed  to  depreciate  its  stock  in  any  way  except  by  the  offering  of 
it  to  its  customers  at  such  reduced  prices.  The  procedure  of  stores 
in  regard  to  mark-downs  will  be  deemed  proper  if  in  any  fiscal  year 
or  period  of  that  year  the  goods  so  marked  down  are  in  proportion 
to  current  sales,  stock  on  hand,  to  mark-downs  of  preceding  months 
of  preceding  year,  or  if  evidence  can  be  submitted  as  to  market  changes 
which  have  forced  a  reduction  in  retail  prices  necessary  to  bring 
about  a  parity  with  the  selling  price  of  the  same  goods  which  have 
been  purchased  or  could  be  purchased  at  a  reduced  cost. 

In  conclusion  it  should  be  noted  that  a  store  which  has  employed 
this  retail  method  in  the  past,  may  now  specify  in  the  return  that  such 
method  is  used,  as  a  basis  of  valuing  inventories,  regardless  of  the 
fact  that  in  past  years  it  reported  on  a  "cost''  or  "cost  or  market, 
whichever  is  lower"  basis.  However,  the  use  of  the  retail  method 
will  not  be  recognized  unless  it  has  been  correctly  followed  through- 
out the  entire  fiscal  or  calendar  year  period  for  which  the  return  is 
made.  (Letter  to  the  National  Retail  Dry  Goods  Association,  New 
York,  N.  Y.,  signed  by  Commissioner  Wm.  M.  Williams,  and  dated 
January  21,  192 1.) 

Market  value  of  goods  in  process  and  finished  goods. — 

One  of  the  most  difficult  problems  of  manufacturers  arises 
from  work  in  process  and  finished  goods. 

This  question  is  of  major  importance  in  a  time  of  demoral- 
ized markets,  such  as  have  confronted  so  many  industries  at 
the  close  of  1920  and  192 1. 

The  following  comparison  illustrates  the  problem : 

Finished  Goods 

Replacement  Cost, 
Actual  Cost  i.  e.,  Actual  Market 

Material  $100  $  50 

Labor   200  120 

Overhead    200  200 

Totals  $500  $370 

This  assumes  that  material  has  declined  50  per  cent  and 
labor  40  per  cent.  Overhead  may  remain  at  the  same  figure 
or  be  changed. 

Work  in  process  should  be  valued  by  applying  the  ratios 
of  decline  thus  obtained  to  the  actual  cost  of  the  inventory  of 
goods  in  process.  Different  stages  of  completion  will  require 
adjustment. 


FROM    BUSINESS 


479 


The  Treasury  permits  the  foregoing  adjustment  of  mate- 
rial prices  and  also  permits  the  replacement  basis  in  labor  and 
expense!  items.  The  physical  property  which  is  inventoried  is 
goods  in  process  (or  finished  goods).  If  goods  and  wages 
have  declined,  the  product  of  goods  and  wages  declines  in 
value.  An  inventory  is  not  at  "market"  unless  it  is  adjusted 
to  what  is  practically  a  replacement  basis  as  at  the  date  of  the 
inventory. 

In  addition  to  the  present  cost  of  replacement,  considera- 
tion should  be  given  to  the  selling  prices  in  effect  for  such 
goods,  goods  in  process  and  finished  goods  at  the  present  time, 
which  for  inventory  purposes  should  be  valued  at  not  more 
than  their  selling  value  less  shipping  or  other  costs  yet  to  be 
incurred. 

The  selling  price  of  goods  is  a  measure  of  the  demand  for 
them  and  a  supplemental  indication  of  their  present  market 
value,  even  when  market  value  is  considered  from  a  replace- 
ment rather  than  from  a  sales  point  of  view. 

Goods  sold  for  future  delivery. — Article  1584'"'  provides 
that  goods  sold  for  delivery  at  fixed  prices  already  agreed  upon 
and  op  hand  at  date  of  inventory,  must  be  inventoried  at  cost. 
If  sold  at  prices  which  yield  a  normal  profit,  the  requirement 
is  sound  if  there  is  no  possibility  of  cancellation  and  if  the 
credit  of  the  buyer  is  beyond  c^uestion. 

When  goods  for  future  delivery  have  been  sold  at  a  loss, 
they  should  be  inventoried  at  market,  as  if  they  were  not  sold. 

The  following  authoritative  statement  has  been  made  pub- 
lic by  the  American  Institute  of  Accountants.^*' 

The  treatment  of  inventories  by  companies  having  contracts  for 
sale  of  goods  at  prices  yielding  a  profit  above  cost  was  considered. 
It  was  agreed  that  where  goods  have  been  bought  specifically  for  such 
contracts,  they  should  be  taken  at  cost  even  if  that  be  higher  than 
market,  both  for  general  accounting  and  tax  purposes.  This  should 
apply  only  if  the  contracts  are  enforceable  contracts  with  responsible 

'"^  .Sec  page  464. 

'"  Special  Bulletin  No.  7,  December,  1920. 


48o 


INCOME 


people — not  in  cases  where  enforcement  would  involve  such  risk  of 
a  bad  debt  as  to  be  unwise.  It  was  recognized  that  the  question  as 
to  applying  goods  on  hand  to  such  contracts  where  they  were  not 
earmarked  was  difficult,  and  the  firm  (of  accountants)  should  not  be 
disposed  to  question  any  reasonable  course  adopted  by  any  client  in 
this  matter. 

Ruling In  the  contracts  involving  the  delivery  of  goods 

in  the  future  the  company  at  no  time  makes  any  particular  appropria- 
tion of  any  particular  goods  to  fill  any  particular  order  or  portion 
thereof  until  the  time  specified  for  the  delivery  of  the  goods  to  the 
carrier.  At  the  time  of  entering  into  the  contract,  in  a  majority  of 
the  cases  the  purchaser  gives  his  promissory  note  in  settlement  for 
the  goods.  The  notes  do  not  bear  interest  until  maturity,  and  gener- 
ally the  due  date  of  the  note  is  fixed  at  the  time  of  the  delivery  of 
the  bulk  of  the  order  if  that  time  is  determinable  at  the  time  of  enter- 
ing into  the  contract.  The  nature  of  the  goods  is  such  that  they 
deteriorate  rapidly,  consequently  only  such  goods  are  manufactured 
at  any  particular  time  as  are  necessary  to  fill  and  complete  shipments 
of  orders  for  delivery  at  the  particular  time  the  goods  are  manu- 
factured. 

Held,  that  under  the  provisions  of  section  213  (a)  of  the  Revenue 
Act  of  1918,  the  M  Company  is  not  required  to  treat  its  contracts 
covering  unfilled  and  undelivered  orders  for  its  goods  as  gross  sales 
for  the  year  in  which  the  order  is  taken  and  the  contract  entered  into, 
but  that  the  sale  of  the  goods  can  not  be  properly  considered  as  hav- 
ing taken  place  until  the  goods  are  delivered  to  the  carrier  for  ship- 
ment to  the  buyer,  or  in  those  cases  in  which  the  purchaser  is  to  call 
for  the  goods  at  the  place  of  business  of  the  company,  until  there 
is  a  specific  identification  of  the  goods  manufactured  and  they  are 
put  in  a  deliverable  state.     (C.  B.  4,  page  95;  O.  D.  826.) 

Where  no  specific  goods  are  appropriated  to  the  contract, 
but  dehveries  are  made  from  regular  stock,  such  goods  should 
be  inventoried  on  the  basis  of  cost,  or  cost  or  market,  which- 
ever is  lower,  depending  on  which  of  these  two  methods  is 
employed  by  the  taxpayer. 

Notice  to  Treasury  of  method  adopted. — When  the  peculiar 
conditions  of  any  business  make  a  literal  compliance  with  the 
regulations  difficult  or  impossible,  it  is  advisable  to  attach  a 
statement  to  the  return  to  the  effect  that  inventories  were 
taken  at  what  the  taxpayer  believed  to  be  market  values,  but 
that  owing  to  the  difficulty  of  ascertaining  trustworthy  mar- 


FROM    BUSINESS  481 

ket  values  the  taxpayer  reserves  the  right  to  amend  the  return 
if  it  subsequently  be  found  that  the  information  was  inac- 
curate. 

Dealers  in  securities  may  use  inventory  method.^^ — 

Regulation.  A  dealer  in  securities  who  in  his  books  of  account 
regularly  inventories  unsold  securities  on  hand  either  (a)  at  cost  or 
(b)  at  cost  or  market,  whichever  is  lower,  or  (c)  at  market 
value,  may  make  his  return  upon  the  basis  upon  which  his  accounts 
are  kept;  provided  that  a  description  of  the  method  employed  shall 
be  included  in  or  attached  to  the  return,  that  all  the  securities  must  be 
inventoried  by  the  same  method,  and  that  such  method  must  be  ad- 
hered to  in  subsequent  years,  unless  another  be  authorized  by  the 
commissioner.  For  the  purpose  of  this  rule  a  dealer  in  securities  is  a 
merchant  of  securities,  whether  an  individual,  partnership,  or  corpora- 
tion, with  an  established  place  of  business,  regularly  engaged  in  the 
purchase  of  securities  and  their  resale  to  customers;  that  is,  one  who 
as  a  merchant  buys  securities  and  sells  them  to  customers,  with  a 
view  to  the  gains  and  profits  that  may  be  derived  therefrom.  If 
such  business  is  simply  a  branch  of  the  activities  carried  on  by  such 
person,^^  the  securities  inventoried  as  here  provided  may  include  only 
those  held  for  purposes  of  resale  and  not  for  investment.  Taxpayers 
who  buy  and  sell  or  hold  securities  for  investment  or  speculation,  and 
not  in  the  course  of  an  established  business,  and  officers  of  corpora- 
tions and  members  of  partnerships,  who  in  their  individual  capacities 
buy  and  sell  securities,  are  not  dealers  in  securities  within  the  mean- 
ing of  this  rule.  A  dealer  in  securities  is  not  entitled  to  the  benefits 
of  section  206^'-*  with  reference  to  the  gain  from  the  sale  of  securities. 
(Art.  1585.) 

Many  "dealers  in  securities"  are  partnerships.  Securities 
which  are  really  investments  may  have  been  carried  in  the  in- 
ventory. If  it  is  desired  to  secure  the  benefits  of  section  206 
(capital  gains),  there  seems  to  be  no  reason  why  such  secur- 
ities should  not  be  taken  out  of  the  inventory  and  carried  as 
investments,  if  they  are  such  in  fact. 

Prior  to  issuance  of  T.  D.  2609  (December  19,  191 7),  those 


'■  [Former  Procedure]  Dealers  in  securities  were  included  in  the  pro- 
vision entitling  taxpayers  to  adopt  "cost  or  market,  wliich  is  lower"  as  a 
basis  for  1920  inventories.     (C.  D.  4,  page  52;  M.  2703.) 

^°  Banks  and  other  institutions  having  established  departments  for  the 
merchandising  of  securities. 

'"Section  206  refers  to  capital  gains.     See  Chapter  XVII. 


482  INCOME 

who  dealt  in  things  other  than  "materials,  supplies  and  mer- 
chandise" were  not  permitted  by  the  regulations  to  calculate 
their  losses  or  gains  by  the  usual  methods,  but  were  required 
to  keep  an  accurate  record  of  each  item  (even  if  these  items  ran 
up  into  the  tens  of  thousands),  its  cost  and  the  date  and  its 
sale  and  the  date  (even  though  many  years  subsequent).  Most 
taxpayers  were  unable  to  comply  with  these  requirements  and 
therefore  their  modification  became  necessary.  The  Treasury 
announced  that  the  authority  for  T.  D.  2609  and  for  the  gen- 
eral extension  of  the  inventory  method  to  dealers  in  securities 
was  an  opinion  of  the  Attorney  General,*"  viz. : 

Ruling.  The  Attorney-General  has  advised  upon  the  basis  of 
a  recent  decision  of  the  Supreme  Court  [Doyle  v.  Mitchell  Brothers. 
decided  May  20  last  (247  U.  S.  179)  ]  that  the  methods  of  taking 
inventories  authorized  by  T.  D.  2609  are  permissible.  That  decision, 
supplemented  by  the  last  paragraph  of  T.  D.  2649  defining  "a  dealer 
in  securities,"  therefore  continues  to  stand  as  a  regulation  of  the 
Department.     (T.  D.  2744,  July  3,  1918.) 

T.  D.  2649  (January  30,  1918)  agrees  substantially  with 
article  1585  as  regards  the  definition  of  a  "dealer  in  securities." 

Since  the  case  of  Doyle  r.  Mitchcll,^^  relied  upon  by  the  At- 
torney General,  arose  under  the  1909  law,  and  since  all  Su- 
preme Court  interpretations  of  a  revenue  law^  are  retroactive 
to  the  date  of  the  law,  it  follows  that  dealers  in  securities  have 
had  full  power  to  inventory  their  securities  under  all  income 
tax  laws  since  1909. 

The  privilege,  extended  to  taxpayers  by  article  1582  (as 
amended  in  December.  1920,  by  T.  D.  3108),  of  changing  from 
the  "cost"  basis  of  valuation  to  "cost  or  market,"  is  applicable 
to  dealers  in  securities. *- 

^^'ho  may  or  may  not  use  inventories  is  clearly  indicated, 
in  so  far  ^s  the  Treasury  is  concerned,  by  reference  to  T.  D. 
2649,  referred  to  above.  "An  individual,  partnership,  or  cor- 
poration, with  an  established  place  of  business  and  whose  prin- 


"'31  Op.  Alt.  Gen. 

"247  U.  S.  179,  38  S.  Ct.  467,  62  L.  Ed.  1054 

*-Q.  B.  4,  page  52;  Mim.  2703. 


FROM    BUSINESS  483 

cipal  business  is  the  purchase  of  securities,  and  their  resale  to 
customers,"  impHes  a  general  definition.  For  "securities"  sub- 
stitute merchandise,  stock-in-trade  generally,  or  any  other 
commodity  forming  the  essential  productive  factors  in  the 
principal  business  of  the  taxpayer,  and  those  commodities 
are  subject  to  the  process  of  inventorying.  The  test  is  legi- 
timate dealing  and  manufacturing  as  against  spasmodic  or 
"on-the-side"  dealing. 

There  is  not  much  difference  between  a  "dealer"  who  buys 
and  sells  securities  and  a  "speculator"  or  an  investor  who 
buys  and  sells  securities.  In  man}^  cases  taxpayers  who  claimed 
that  they  were  "dealers"  and  who  were  denied  the  classification 
by  the  Treasury,  will  now  benefit  by  the  capital  gains  privilege. 

Inventory     method — when     applicable    to     "short 

SALES." — 

Ruling.  Where  a  taxpayer  has  "borrowed"  stock  in  order  to 
make  a  "short  sale"  the  gain  or  loss  arising  from  such  transaction 
can  not  be  accrued  upon  the  books  of  the  taxpayer  at  the  close  of  his 
taxable  year  by  treating  as  an  offsetting  obligation  the  market  value 
of  the  stock  sold  "short"  as  of  that  date;  the  gain,  or  loss  is  deter- 
mined when  the  amount  of  stock  sold  "short"  is  repurchased  for 
return  to  the  lender  and  the  transaction  closed.  (C.  B.  i,  page  62; 
S.  1 179.) 

The  Treasury  holds  that  "the  short  sale  dealer  in  open 
short  sales,  having  no  stock  in  his  possession  to  which  he 
has  title,  consequently  has  no  stock  which  he  can  inventory." 

When  applied  to  one  who  is  not  a  dealer  in  securities  the 
ruling  is  sound,  but  there  is  no  good  reason  why  a  dealer  in 
securities  should  not  inventory  all  his  trades,  at  least  to  the 
same  extent  as  is  permitted  in  the  case  of  "hedges."  (See 
page  472.)  The  case  is  not  analogous  to  dealing  in  futures  or 
to  the  forward  business  of  dealers  in  merchandise.  Short 
sales  are  not  usually  made  as  "hedges"  but  in  the  ordinary 
course  of  business  as  individual  transactions.  The  dealer  does 
have  physical  property  to  inventory,  viz.,  the  cash  proceeds  of 
the  sale.     But  the  cash  proceeds  are  worth  more  or  less  than 


484 


INCOME 


their  face  value,  depending  on  fluctuations  in  the  price  of  the 
stock  or  other  property  which  must  be  replaced  in  kind.  There- 
fore the  cash  reserve  must  be  increased  or  decreased  at  inven- 
tory time  or  the  accounts  will  not  reflect  the  results  of  the 
dealer's  business  on  an  accrual  basis. 

The  author  is  of  the  opinion  that  a  dealer  in  securities 
should  be  permitted  to  inventory  short  sales  on  the  basis  of 
cost  or  market,  whichever  is  lower. 

The  inventory  method  is  supposed  to  make  unnecessary 
the  closing  of  trades  to  establish  closed  transactions.  What 
can  be  done  indirectly  should  be  permitted  if  done  directly. 
A  dealer  can  readily  cover  all  his  short  sales  before  the  end 
of  the  year  and  arrange  to  resell  the  same  or  similar  classes 
of  stocks,  etc.,  immediately  thereafter,  l)ut  he  should  not  be 
required  to  go  through  a  foolish  form  when  the  inventory 
regulations  provide  a  more  reasonable  method. 

Returns  of  dealers  in  securities. — In  preparing  returns 
on  form  1040,  the  taxpayer  who  has  c[ualified  as  a  dealer  in  se- 
curities is  not  required  to  enter  the  items  of  his  business  in 
schedule  D,*"  but  should  use  schedule  B.  On  line  i  of  schedule 
B  there  should  be  entered  the  sales  price  of  all  securities  sold, 
and  on  line  4  there  should  be  entered  the  cost  price  of  securi- 
ties purchased.  When  the  dealer  has  kept  his  books  on  an 
accrual  basis  and  has  taken  inventories,  lines  6  and  8  should 
be  used  to  record  the  inventories  at  the  beginning  and  end  of 
the  year.  If  it  is  not  feasible  for  a  dealer  in  securities  to  enter 
the  gross  sales  price  in  line  i,  because  his  books  show  only 
gross  profits,  he  should  then  enter  the  item  of  gross  profits  on 
line  I  and  not  attempt  to  set  up  the  cost  of  securities  held  on 
line  4.  This  method  is  permissible  because  it  accords  with 
accepted  accounting  principles. 

But  schedule  B  is  not  intended  to  be  used  by  those  who  are 
not  dealers  in  securities.  Speculators  or  investors  who  may 
carry  on  many  hundreds  of  transactions  during  the  year  must 


'AH  references  in  this  chapter  are  to  1921  forms. 


FROM    BUSINESS  485 

either  qualify  as  dealers  in  securities  or  they  must  report 
under  schedule  D.  It  has  been  urged  that  an  active  trader  can- 
not readily  prepare  schedules  which  show  the  sales  price  and 
cost  of  all  securities  dealt  in.  If  such  trader  keeps  books  show- 
the  details  of  each  transaction  and  if  he  keeps  an  account  show- 
ing the  gross  profit  or  gross  loss  on  each  transaction,  it  may 
be  permissible  to  use  such  totals  in  schedule  D  with  an  explan- 
ation that  those  figures  agree  exactly  with  the  regular  books 
of  accounts  kept  by  the  taxpayer  and  open  to  the  income  tax 
inspectors.  On  the  other  hand,  if  such  taxpayer  does  not  keep 
regular  sets  of  books  which  can  readily  be  verified,  the  Treas- 
ury is  fully  justified  in  requiring  the  detail  of  every  transaction 
during  the  taxable  year.  If  some  such  compilation  is  not 
made,  the  taxpayer  himself  does  not  know  what  his  profits  or 
losses  have  been  and,  if  a  compilation  is  made,  there  is  no 
reason  why  a  copy  of  it  should  not  be  attached  to  form  1040 
in  support  of  schedule  D  totals. 

Inventories  of  securities  by  a  bank  maintaining  a 
department  for  dealing  therein. 

Ruling.  Reference  is  made  to  your  letter  of  May  26,  1919, 
wherein  you  ask  whether  a  bank  that  maintains  a  branch  for  the 
purpose  of  buying  and  selling  securities  has  the  full  status  of  a  recog- 
nized dealer  in  securities. 

In  reply,  you  are  advised  that  a  bank  or  other  institution  having 
a  regularly  established  department  for  the  merchandising  of  securities, 
even  though  that  department  is  subordinate  in  importance  to  other 
departments,  is  entitled  to  the  same  benefit  of  using  the  basis  provided 
for  in  Article  i'585  of  inventorying  securities  acquired  and  held  for 
resale,  as  one  who  is  solely  a  dealer  in  securities. 

In  so  far  as  the  bank  or  other  institution  carry  on,  with  an  es- 
tablished place  of  business  a  department  for  the  merchandising  of 
securities,  it  is  in  respect  of  such  department  treated  in  the  same  way 
as  any  other  security  merchant.  It  should  be  noted,  however,  that  the 
method  of  inventorying  provided  for  in  Article  1585  has  no  application 
and  can  not  be  extended  to  taxpayers  simply  buying  and  selling  secur- 
ities for  investment  or  speculation.  (Letter  to  The  Corporation 
Trust  Company,  signed  by  Commissioner  Daniel  C.  Roper,  dated  June 
28,  1919.) 


486 


INCOME 


Dealers  in  foreign  exchange  may  use  inventory  method. — 

Ruling.  A  dealer  in  foreign  exchange — that  is,  one  who  regu- 
larly engages  in  the  purchase  and  resale  to  customers  of  foreign  money 
with  a  view  to  the  gains  and  profits  that  may  be  derived  therefrom — 
who,  in  his  books  of  account  regularly  inventories  unconverted  for- 
eign money  on  hand  either  (a)  at  cost  or  (b)  at  cost  or  market  value 
whichever  is  lower,  may  make  his  return  upon  the  basis  upon  which 
his  accounts  are  kept. 

A  taxpayer  who  is  not  a  dealer  in  foreign  exchange  but  merely 
purchases  foreign  money  on  his  own  account  or  as  an  incident  of  his 
principal  business  may  not  inventory  such  unconverted  foreign  money 
at  the  close  of  his  taxable  year.  The  realization  of  the  gain  or  loss 
is  postponed  until  the  foreign  money  is  disposed  of  or  converted. 
(C.  B.  4,  page  6i ;  O.  D.  834.) 

When  foreign  exchange  is  purchased  incident  to  the  busi- 
ness such  as  that  of  an  importer,  there  would  seem  to  be  no 
good  reason  why  the  amount  held  at  the  end  of  the  year  should 
not  be  inventoried.  It  is  as  to  such  importer  an  asset  used  in 
trade,  and  should  therefore  be  subject  to  the  usual  rules  for 
valuing  trade  assets. 

Dealers  in  second-hand  automobiles  may  use  inventory 
method.— 

Ruling.  A  dealer  may  value  used  or  second-hand  automobiles 
included  in  a  closing  inventory  on  the  basis  of  cost  or  market  which- 
ever is  lower,  in  accordance  with  article  1582  of  Regulations  45,  if 
he  can  furnish  satisfactory  evidence  of  the  market  value  of  such 
second-hand  automobiles  at  the  date  of  the  inventory.  (C.  B.  4, 
page  49;  O.  D.  888.) 

Real  estate  dealers  not  permitted  to  use  inventories. — 

Ruling.  A  taxpayer,  engaged  in  the  real  estate  business,  is  not 
permitted  to  inventory  real  estate  which  is  held  for  sale  for  the  pur- 
pose of  calculating  net  income  subject  to  Federal  income  tax.  (C. 
B.  4,  page  47;  O.  D.  848.) 

Method  of  valuing  inventories  when  a  partnership  is  suc- 
ceeded by  a  corporation.— The  question  arises  as  to  how  an 
opening  inventory  should  be  taken  when  a  corporation  suc- 
ceeds a  partnership,  the  latter  having  taken  its  closing  inven- 


FROM    BUSINESS  487 

tory  at  cost,  and  the  market  value  now  being  greater  than  cost. 

If  the  transfer  constitutes  a  closed  transaction  (and  the 
partners  have  paid  a  tax  on  the  appreciation),  the  opening 
inventory  of  the  corporation  for  tax  purposes  would  be  the 
increased  value.  If  the  transfer  is  a  continuing  transaction, 
the  basis  used  by  the  partnership  should  be  continued. 

Under  the  1921  law,**  however,  such  a  transfer  would 
not  be  a  closed  transaction  if  the  control  of  the  corporation  is 
in  the  former  partners  and  "the  amounts  of  stock,  securities, 
or  both,  received  by  such  persons  are  in  substantially  the  same 
proportion  as  their  interests  in  the  property  before  such  trans- 
fer." It  would  appear  that,  on  the  one  hand,  the  partners 
need  not  pay  a  tax  on  such  appreciation  at  the  time  of  the 
transfer,  and  that,  on  the  other  hand,  the  corporation  may 
take  up  the  inventory  at  its  present  value  as  the  corpora- 
tion is  a  separate  entity  and  therefore  may  properly  value  any 
property  acquired  by  it  at  the  value  it  had  at  time  of  acquisi- 
tion and  for  which  its  securities  are  issued. 

At  first  glance  it  might  appear  that  some  income  is  escap- 
ing taxation  but  this  is  more  apparent  than  real.  The  corpora- 
tion as  such  pays  no  tax  on  the  appreciation,  as  it  occurred 
prior  to  its  acquisition  of  the  property.  The  members  of  the 
former  partnership,  however,  would  pay  on  the  appreciation 
if,  as,  and  when  realized  by  the  sale  of  their  holdings  of  the 
corporation's  stock.  Under  the  1921  law"  their  investment 
in  the  corporation's  stock  is  in  such  a  case  deemed  to  be  the 
same  as  their  investment  in  the  partnership  which  had  valued 
the  inventory  at  cost. 

Income  from  Sale  of  Property  on  the  Instalment  Plan 

Under  T.  D.  3082,  October  20,  1920,  amending  article  42 
of  Regulations  45,  the  Treasury  made  it  possible  for  instal- 


"  Section  202   (c-3). 
"  Section  202  (d). 


488  INCOME 

nient  dealers,  under  the  1918  law,  to  report  only  profits  realized 
in  cash  collections. 

The  same  procedure  is  permitted  under  the  1921  law. 

Law.  Section.  202.  .  .  .  .  (f)  Nothing  in  this  section  shall  be 
construed  to  prevent  (in  the  case  of  property  sold  under  contract  pro- 
viding for  payment  in  installments)  the  taxation  of  that  portion  of  any 
installment  payment  representing  gain  or  profit  in  the  year  in  which 
such  payment  is  received. 

Generally  speaking,  the  regulations  consider  sales  to  be  on 
the  instalment  basis  when  less  than  25  per  cent  of  the  purchase 
consideration  passes  to  the  vendor  at  the  time  the  sale  is  ef- 
fected, and  when  the  balance  of  the  consideration  is  payable 
in  specific  instalments.  Such  a  condition  obtains  whether  the 
title  rests  with  the  vendor  until  purchase  is  completed,  whether 
the  title  passes  to  the  vendee  under  a  lien  agreement,  whether 
the  title  be  reconveyed  to  vendor  by  a  chattel  mortgage,  or 
whether  title  be  conveyed  to  trustees  pending  performance  of 
contract. 

Regulation.  Dealers  in  personal  property  ordinarily  sell  either 
for  cash,  or  on  the  personal  credit  of  the  buyer,  or  on  the  installment 
plan.  Occasionally  a  fourth  type  of  sale  is  met  with,  in  which  the 
buyer  makes  an  initial  payment  of  such  a  substantial  nature  (for 
example,  a  payment  of  more  than  25  per  cent)  that  the  sale,  though 
involving  deferred  payments,  is  not  one  on  the  installment  plan. 
Dealers  in  personal  property  who  sell  on  the  installment  plan 
usually  adopt  one  of  four  ways  of  protecting  themselves  in  case  of 
default:  (a)  through  an  agreement  that  title  is  to  remain  in  the 
seller  until  the  buyer  has  completely  performed  his  part  of  the  trans- 
action ;  (b)  by  a  form  of  contract  in  which  title  is  conveyed  to  the 
purchaser  immediately,  but  subject  to  a  lien  for  the  unpaid  portion 
of  the  purchase  price;  (c)  by  a  present  transfer  of  title  to  the  pur- 
chaser, who  at  the  same  time  executes  a  reconveyance  in  the  form  of 
a  chattel  mortgage  to  the  seller;  or  (d)  by  conveyance  to  a  trustee 
pending  performance  of  the  contract  and  subject  to  its  provisions. 
The  general  purpose  and  effect  being  the  same  in  all  of  these  plans, 
it  is  desirable  that  a  uniformly  applicable  rule  be  established.  The 
rule  prescribed  is  that  in  the  sale  or  contract  for  sale  of  personal 
property  on  the  installment  plan,  whether  or  not  title  remains  in  the 
vendor  until  the  property  is  fully  paid  for,  the  income  to  be  returned 
by  the  vendor  will  be  that  proportion  of  each  installment  payment 
which  the  gross  profit  to  be  realized  when  the  property  is  paid  for 


FROM    BUSINESS  489 

bears  to  the  gross  contract  price.  Such  income  may  be  ascertained 
by  taking  as  profit  that  proportion  of  the  total  cash  collections  re- 
ceived in  the  taxable  year  from  installments  sales,  (such  collections  be- 
ing allocated  to  the  year  against  the  sales  of  which  they  apply),  which 
the  annual  gross  profit  to  be  realized  on  the  total  installment  sales 
made  during  each  year  bears  to  the  gross  contract  price  of  all  such 
sales  made  during  that  respective  year.  In  any  case  where  the  gross 
profit  to  be  realized  on  a  sale  or  contract  for  sale  of  personal  property 
has  been  reported  as  income  for  the  year  in  which  the  transaction 
occurred,  and  a  change  is  made  to  the  installment  plan  of  computing 
net  income,  no  part  of  any  installment  payment  received  subsequent 
to  the  change,  representing  income  previously  reported  on  account  of 
such  transaction,  should  be  reported  as  income  for  the  year  in  which 
the  installment  payment  is  received;  the  intent  and  purpose  of  this 
provision  is  that  where  the  entire  profit  from  installment  sales  has 
been  included  in  gross  income  for  the  year  in  which  the  sale  was  made, 
no  part  of  the  installment  payments  received  subsequently  on  account 
of  such  previous  sales  shall  again  be  subject  to  tax  for  the  year  or 
years  in  which  received.  Where  the  taxpayer  makes  a  change  to  this 
method  of  computing  net  income  his  balance  sheet  should  be  adjusted 
conformably.  If  for  any  reason  the  vendee  defaults  in  any  of  his  in- 
stallment payments  and  the  vendor  repossesses  the  property,  the  entire 
amount  received  on  installment  payments,  less  the  profit  already  re- 
turned, will  be  income  of  the  vendor  for  the  year  in  which  the  prop- 
erty was  repossessed,  and  the  property  repossessed  must  be  included 
in  the  inventory  at.  its  original  cost  to  himself,  less  proper  allowance 
for  damage  and  use,  if  any.  If  the  vendor  chooses  as  a  matter  of  con-' 
sistent  practice  to  treat  the  obligations  of  purchasers  as  the  equivalent 
of  cash,  such  a  course  is  permissible.     (Art.  42.) 

When  can  sales  of  personal  property  be  deemed  to  be  on 
the  instalment  plan? — 

Rulings.  If  a  stockholder  of  a  corporation  sells  stock  to  em- 
ployees of  the  company  for  consideration  of  10  per  cent  cash  and 
the  balance  in  installment  payments,  secured  by  notes  covering  a 
period  of  10  years,  that  proportion  of  each  installment  payment  re- 
ceived during  the  taxable  year  which  the  gross  profit  to  be  realized 
bears  to  the  gross  contract  price  should  be  reported  as  income  for  the 
year  during  which  installment  payments  were  received.  (C.  B.  i,  page 
75;0.  D.  134.) 

Where  the  stockholders  of  a  corporation  sell  their  shares  in  the 
corporation  for  a  price  in  excess  of  cost  and  receive  a  cash  payment 
not  in  excess  of  20  per  cent  of  the  total  price,  the  purchasers  agreeing 
to  pay  the  balance  in  a  number  of  semiannual  installments  and  deposit 
collateral  with  trustees  as  security  for  the  faithful  performance  of 


490 


INCOME 


the  contract,  the  transaction  is  not  an  installment  sale  within  the 
meaning  of  article  42,  Regulations  45.  The  entire  consideration  in- 
volved in  the  sale  must  be  treated  as  the  equivalent  of  cash  in  the 
year  when  the  sale  is  consummated.     (C.  B.  i,  page  75;  O.  D.  290.) 

The  last  ruling  may  or  may  not  be  sound,  depending  on 
the  circumstances  of  the  case.  If  the  deferred  payments  (80 
per  cent)  are  not  m  fact  the  equivalent  of  cash,  no  tax  can  be 
imposed.  Under  the  law  no  income  arises  until  the  actual 
equivalent  of  cash  is  realized.  Many  deferred  payments  are 
not  discountable  on  any  reasonable  basis.  In  such  cases  the 
following  ruling  governs. 

Ruling.  In  the  case  of  sales  of  personal  property  where  sub- 
stantial initial  payments  are  made  (more  than  25  per  cent  of  sale 
price),  obligations  of  the  purchasers  need  not  be  regarded  as  the 
equivalent  of  cash  if  it  is  shown  clearly  that  such  obligations,  even 
though  represented  by  notes  or  other  paper  in  negotiable  form,  can 
not  be  discounted  or  otherwise  converted  into  cash  without  material 
loss  because  of  lack  of  credit  on  the  part  of  the  buyer  and  the  nature 
of  the  property  involved.  In  such  cases  profit  may  be  reported  as 
provided  for  sales  on  the  installment  plan.  (C.  B.  3,  page  107;  O.  D. 
7150 

The  foregoing  is  sound  and  in  strict  accord  with  the  law. 

The  author  has  been  unable  to  ascertain  why  instalment 
houses  should  receive  consideration  not  extended  to  any 
other  class  of  taxpayers  and  wholly  unjustified  by  any  reason- 
able interpretation  of  the  regulations  regarding  closed  trans- 
actions. 

Other  businesses  in  changing  from  one  method  of  account- 
ing to  another  have  always  been  required  to  file  amended  re- 
turns as  far  back  as  may  be  necessary  to  protect  the  govern- 
ment's interests.  Other  businesses  in  which  accounts  and  notes 
receivable  have  been  less  liquid  than  the  notes  receivable  taken 
by  instalment  houses  have  been  required  io  return  the  entire 
profit  on  the  accrual  basis.  The  instalment  house  sells  goods 
for  a  substantial  cash  payment  and  often  takes  promissory 
notes  for  the  balance.  The  latter  are  more  readily  discountable 
in  ninety  cases  out  of  one  hundred  than  are  the  securities  re- 


FROM    BUSINESS  491 

ceived  in  exchanges  of  other  property;  but  under  the  regula- 
tions no  tax  is  imposed  until  the  notes  are  collected  at  maturity. 
The  treatment  of  instalment  houses  is  not  too  liberal;  the 
injustice  lies  in  the  refusal  of  the  Treasury  to  interpret  the 
1918  and  prior  laws  with  half  as  much  liberality  in  thousands 
of  cases  in  which  taxpayers  were  far  less  able  to  pay  the  tax. 

Method  of  computing  taxable  profit  by  instalment  houses. 

— The  detailed  procedure  outlined  in  the  following  ruling 
serves  to  give  effect  to  two  principal  changes  in  the  Treasury's 
former  requirements.**^ 

First.  Any  collections  applicable  to  instalment  sales  already 
reported  as  income  are  credited  to  accounts  receivable.  No 
part  of  such  items  is  used  in  computing  realized  profits  for 
the  taxable  year.     This  avoids  double  taxation. 

Second.  Collections  as  made  are  segregated  according  to 
the  years  in  wiiich  the  sales  were  made.  Segregation  is  also 
made  in  the  books  for  each  year  of — 

(a)  Sales 

(b)  Gross  profit  (unrealized) 

Ratio  of  (b)  for  each  year  to  (a)  for  each  year  for  which 
cash  is  collected  in  current  year  applied  to  the  collections  in 
current  year  gives  income  to  be  reported  as  realized  profits 
of  current  year. 

To  illustrate,  assume : 


C  u 

0  3  " 
■Z'O  '» 
0       o\ 
«  n  « 

^  te  M 
UE.S 

$2,000 

8,000 

Instalment 
^  ^  sales  con- 
p  p  tracts  (Sale 
g  g   made  durin 
0  0   respective 

years) 

"0 1>  0 

01    (U_^ 

m  °-      ^ 

-0  u  ">  ■" 

°  c  IJ  « 

$24,000 
37,500 

"«  «  S  " 

$6,000 
12,500 

(b) 

^  0 

l£ 

in  0 

fn    be 

20% 
25% 

$10,000 

$80,000  (a) 

$61,500 

$18,500 

The  problem  is  to  compute  the  realized  profits.     The  rul- 


See  Income  Tax  Procedure,  1920,  pages  309-314. 


492 


INCOME 


ing  says  that  such  profits  should  be  computed  by  taking  the 
same  percentage  of  the  cash  collections  made  during  the  tax- 
able year  on  account  of  instalment  sales  contracts  of  either  that 
or  prior  years,  as  the  total  unrealized  profits  on  instalment 
sales  contracts  for  the  year  against  which  the  collection  ap- 
plies, bear  to  the  total  instalment  sales  made  during  that  re- 
spective year. 

Applying  the  gross  profit  for  each  year  to  the  collections 
applicable  to  the  respective  years,  we  have : 

1920,  20  per  cent  of  $2,000  =  $   400 

1921,  25  per  cent  of  $8,000  =   2,000 

Realized   profits   for   1921 $2,400 


Rur.iNGS.  The  procedure  outlined  in  T.  P).  R.  24'^  has  been  recon- 
sidered and  as  a  result  of  such  reconsideration  the  following  has  been 
adopted  where  a  taxpayer  engaged  in  merchandising  upon  the  install- 
ment plan  has  heretofore  made  returns  upon  the  basis  of  treating  the 
profit  upon  installment  sales  as  realized  as  at  the  date  of  sale  and  now 
wishes  to  change  to  the  basis  of  reporting  the  profit  as  being  realized 
as  at  the  date  of  collection  of  the  outstanding  accounts. 

1.  In  accordance  with  the  provisions  of  article  42  (as  amended) 
of  Regulations  45,  the  balance  sheet  as  at  the  beginning  of  the  tax- 
able year,  which  shall  be  filed  as  a  part  of  the  return,  shall  carry  the 
installment  sales  contracts  unliquidated  and  remaining  in  force  as  at 
the  date  that  this  system  of  accounting  is  adopted  and  made  efifective 
by  the  taxpayer,  as  accounts  receivable,  such  unliquidated  installment 
sales  contracts  having  been  inventoried  and  determined  as  at  that 
date.  Cash  collections  on  account  of  such  contracts  will  be  credited 
directly  to  such  accounts  receivable  and  no  part  of  such  collections 
will  be  included  in  computing  realized  profits  for  the  taxable  year. 

2.  As  from  the  beginning  of  the  taxable  year,  the  following 
accounts  should  be  set  up : 

(a)  Goods  purchased,  which  will  be  charged  with  the  amount  of 
inventory  of  the  goods  on  hand  at  the  beginning  of  the  taxable  year 
and  with  the  expenditures  for   goods  purchased  during  the  year. 

(b)  Goods  sold  (cost  value),  which  will  be  credited  with  the  cost 
value  of  all  goods  sold  during  the  year. 

(c)  Installment  sales  contracts  (year  date),  which  will  be 
charged  only  with  the  amount  of  installment   sales   contracts  made 


"  Under  the  former  ruling,  when  a  change  was  made  in  the  instalment 
method,  cash  collections  applying  to  sales  already  reported  were  included 
in  the  new  computation. 


FROM    BUSINESS 


493 


during  the  year  specified.  This  account  for  each  year  will  be  credited 
with  all  cash  collected  during  that  year,  or  in  subsequent  years,  upon 
installment  sales  contracts  for  that  year  only,  and  with  the  unpaid 
installments  of  defaulted  or  canceled  contracts  for  that  year. 

(d)  Unrealised  gross  profits  on  installment  'sales  contracts  (year 
date),  which  will  be  credited  only  with  the  amount  of  unrealized 
gross  profits  upon  installment  sales  contracts  made  during  the  year 
specified.  This  amount  will  be  the  total  of  the  installment  sales  con- 
tracts for  that  year  reduced  by  the  cost  or  inventory  value  (as  car- 
ried in  account  (a)  goods  purchased),  of  the  actual  goods  sold  and 
covered  by  the  contracts;  the  balance  remaining  being  the  amount  of 
the  unrealized  gross  profits.  The  proforma  monthly  (or  annual) 
journal  entry  would  be : 

Dr.        Cr. 

Installment  sales  contracts    (year  date) $ 

To  goods  sold    (cost  value) $ 

Unrealized  gross  profits  on  installment  sales  contracts 

(year  date)    $ 

(e)  Realized  profits  on  installment  sales  contracts,  which  will  be 
credited  from  month  to  month  (or  at  the  end  of  the  year),  with  the 
profits  realized  by  cash  collections  upon  all  installment  sales  con- 
tracts of  any  year.  Such  profits  should  be  computed  by  taking  the 
same  percentage  of  the  cash  collections  made  during  the  taxable 
year  on  account  of  installment  sales  contracts  of  either  that  or  prior 
years,  as  the  total  unrealized  profits  on  installment  sales  contracts  for 
the  year  against  which  the  collection  applies,  bear  to  the  total  install- 
ment sales  made  during  that  respective  year.  Corresponding  debits 
should  be  made  to  unrealized  gross  profits  on  installment  sales  con- 
tracts for  the  year  affected  by  such  collections.  If  adjustments  to 
any  or  all  of  these  various  accounts  become  necessary  in  order  that 
it  or  they  may  accurately  reflect  the  facts,  such  adjustments  may  be 
made  either  monthly  or  as  at  the  end  of  the  taxable  year. 

It  is  believed  that  sufficient  has  been  said  above  to  indicate  the 
use  that  is  to  be  made  of  these  special  accounts  and  it  is  not  necessary 
to  discuss  any  of  the  other  accounts  which  would  normally  be  main- 
tained. 

It  will  be  noted  that  the  foregoing  plan  which  will  be  permitted 
upon  an  explicit  statement  of  facts  made  to  the  Commissioner  of 
Internal  Revenue  by  a  taxpayer  engaged  in  merchandising  upon  the 
installment  plan  is  not  a  change  from  an  accrual  basis  to  a  cash 
received  and  paid  basis.  In  the  opinion  of  this  office,  the  income  of 
a  merchandising  concern  can  not  be  correctly  reflected  upon  the  lat- 
ter basis,  as  the  use  of  inventories  is  absolutely  essential.  The  plan 
herein  outlined  is,  therefore,  merely  such  a  modification  or  adapta- 
tion of  the  ordinary  accrual  method  of  accounting  as  in  the  opinion 
of  this  office  will  enable  the  accounts  of  the  taxpayer  clearly  to  reflect 


494  INCOME 

his  net  income.  Where  in  the  past  another  method  has  been  used 
that  has  failed  to  reflect  the  taxpayer's  net  income  an  amended  return 
or  returns  for  such  year  may  be  made. 

In  cases  where  the  taxpayer  has  in  the  past  exercised  the  option 
of  reporting  the  profit  as  realized  as  at  the  date  of  sale  and  now 
wishes  to  change  to  a  basis  of  reporting  the  profit  as  realized  as  at 
the  date  of  collection  of  the  outstanding  installments,  either  of  which 
method  is  allowable  under  article  42  of  Regulations  45,  amended  re- 
turns for  years  prior  to  the  date  that  the  above  outlined  system  of 
accounting  is  adopted  and  made  effective  by  the  taxpayer,  will  not 
be  required  or  allowed  unless  in  the  opinion  of  the  Commissioner 
such  former  method  has  failed  to  reflect  the  net  income.  (C.  B.  3, 
page  105;  O.  D.  623.) 

O.  D.  623  does  not  contemplate  that  where  a  change  is  made  to 
the  basis  of  reporting  the  profit  from  installment  sales  as  being 
realized  as  at  the  date  of  the  collection  of  the  outstanding  accounts, 
any  part  of  the  unliquidated  installment  sales  contracts  at  the  date  the 
new  basis  is  adopted,  which  are  to  be  carried  as  accounts  receivable 
on  the  balance  sheet  at  the  beginning  of  the  taxable  year  in  which 
the  change  is  made,  should  be  excluded  from  surplus  in  computing 
invested  capital  for  the  taxable  year.     (C.  B.  4,  page  87;  O.  D.  793.) 

If  books  have  been  so  kept  that  the  cost  of  each  article  sold  was 
not  shown,  gross  profit  may  be  determined  by  taking  the  average  per- 
centage of  gross  profit  on  gross  sales.  If  several  different  lines  of 
merchandise  are  handled,  on  which  the  average  percentages  of  profit 
differ,  the  gross  profit  on  total  sales  of  each  different  class  of  mer- 
chandise should  be  computed  separately.     (C.  B.  i,  page  75;  O.  D.  25.) 

Where  a  taxpayer  is  engaged  in  business  making  cash,  personal 
credit,  and  installment  sales,  the  percentage  of  gross  profit  to  be  re- 
ported on  the  installment  sales,  as  provided  in  article  42  of  Regula- 
tions 45,  is  the  percentage  of  gross  profit  on  all  sales  made  during  the 
year  in  which  the  installment  sale  was  made,  regardless  of  whether 
they  were  cash,  personal  credit,  or  installment  sales.  (B.  47-21-1930; 
O.  D.  1 107.) 

The  two  preceding  rulings  are  confusing.  In  O.  D.  25 
taxpayers  are  required  to  make  separate  computations  where 
the  percentage  of  gross  profit  on  different  classes  of  goods 
sold  on  the  instalment  plan  differs  materially,  whereas  in 
O.  D.  1 107  taxpayers  are  required  to  compute  gross  profit  on 
all  classes  of  sales. 

In  the  case  of  instalment  houses  which  have  adequate  cost 
records,  the  latter  ruling  does  not  give  accurate  results  and  is 


FROM    BUSINESS  495 

contrary  to  the  principle  laid  down  in  article  42  of  Regulation 
62,  that  the  income  "may  be  ascertained  by  taking  as  profit 
that  proportion  of  the  total  cash  collections  received  in  the 
taxable  year  from  instalment  sales  ....  which  the  annual 
gross  profit  to  be  realized  on  the  total  instalment  sales  made 
during  each  year  bears  to  the  gross  contract  price  of  all  such 
sales  made  during  that  respective  year."  As  a  practical  mat- 
ter it  may  apply  to  a  concern  which  can  not  segregate  the  cost 
of  items  sold  on  the  instalment  basis  from  other  sales. 

Application  of  instalment  payments. — Since  collections 
made  in  one  year  may  apply  to  sales  made  in  different  years, 
each  showing  a  different  rate  of  gross  profit,  the  following 
rules  for  applying  the  cash  payments  made  by  customers  are 
important  in  determining  the  proportion  of  such  payments  to 
be  reported  as  income. 

Rulings.  When  income  from  sales  of  personal  property  on  the 
installment  plan  is  reported  as  provided  in  article  42  of  Regulations  45, 
the  payments  made  by  a  purchaser  having  several  accounts  should  be 
allocated  to  the  particular  account  or  accounts  to  which  under  the 
terms  of  the  contracts  of  sale  such  payments  are  to  be  applied.  (B. 
39-21-1838;  O.  D.  1045.) 

In  cases  of  continuous  accounts  covering  sales  of  personal  prop- 
erty, the  income  from  which  is  reported  on  the  installment  plan  as  pro- 
vided in  Treasury  Decision  3082,  the  cash  payments  received  should 
be  allocated  in  accordance  with  the  generally  recognized  principle  of 
law  governing  such  cases,  that  is,  that  failing  application  by  the 
vendee,  the  cash  payments  should  be  applied  to  the  earliest  items  of 
the  account.     (C.  B.  4,  page  88;  O.  D.  815.) 

Computation  of  bad  debts  in  case  of  instalment  sales. — 

Ruling.  The  amount  to  be  deducted  from  gross  income  as  a  bad 
debt  in  cases  of  sales  of  personal  property  on  the  installment  plan. in 
which  the  unpaid  installment  obligations  of  the  purchaser  become 
worthless  and  are  charged  off  and  the  property  is  not  recovered  by  the 
vendor  is  such  proportion  of  the  defaulted  payments  as  represents  the 
capital  investment,  that  is,  the  cost  of  the  goods  sold,  and  this  amount 
must  be  deducted  for  the  year  in  which  the  default  occurred. 

Let  it  be  assumed  that  the  taxpayer's  installment  sales  (contracts) 
for  the  year  1919  were  $300,000  and  that  the  cost  of  the  goods  sold 


496 


INCOME 


and  covered  by  such  contracts  was  $100,000;  then  the  unrealized  gross 
profits  would  be  $200,000  and  the  rate  of  profit  for  that  year  would  be 
established  at  66^i  per  cent. 

Let  it  be  assumed,  further,  that  during  the  years  1919  and  1920 
the  cash  collections  on  account  of  such  contracts  were  $266,700;  then 
the  entries  covering  these  transactions  would  be  as  follows : 

Installments  sales  contracts,  1919 $300,000 

To  goods  sold  (cost  value) $100,000 

To   unrealized  gross   profits   on   installment  sales 
contracts,  1919  200,000 

Rate  of  gross  profit — J^  or  66J/3  per  cent. 

Unrealized    gross    profits    on    installment    sales 

contracts,  1919   177,800 

To   realized   profits   on   installment    sales 

contracts    177,800 

Cash  collections  during  1919  and  1920  for  ac- 
count of  1919  $266,700 

Yi  thereof    177,800 

At  the  close  of  1920  the  accounts,  as  affected  by  the  above  trans- 
actions, would  stand  as  below  : 


DEBITS 

Cash   $266,700 

Installment  sales  contracts, 
1919    33-300 


$300,000 


CREDITS 

Goods  sold  (cost  value)  . . .  $100,000 
Unrealized  gross  profits,  etc.  22,200 
Realized  profits,  etc 177,800 


$300,000 


Of  the  above  balance  of  $33,300  to  the  debit  of  installment  sales 
contracts,  two-thirds,  or  $22,200  (shown  as  a  balance  to  the  credit  of 
unrealized  gross  profits),  is  to  be  accounted  for  and  taxed  as  profit  as, 
when,  and  if  collected.  The  remaining  one-third  is  the  capital  invest- 
ment representing  the  cost  of  goods  sold. 

But  let  it  be  assumed  that  the  whole  or  any  part  of  the  balance  of 
the  installment  sales  contracts,  amounting  to  $33,300,  was  defaulted  in 
1919  or  at  any  later  time;  then  the  question  arises:  How  should  the 
loss  occasioned  by  such  defaults  be  treated  for  purposes  of  determining 
the  income  and  excess  profits  tax  ? 

The  answer  is  that  the  proper  portion  (two-thirds  in  this  case) 
of  the  amount  of  the  defaulted  payments  should  be  charged  against 
the  unrealized  profits  and  the  balance  (in  this  case  one-third),  repre- 
senting the  cost  of  the  goods  sold,  should  be  allowed  to  the  taxpayer  as 
a  deduction  for  losses  actually  sustained  during  the  taxable  year. 

This  method  of  treatment  should  be  followed  wdiether  the  goods 
are  or  are  not  recovered.  If  the  goods  are  not  recovered,  it  correctly 
reflects  the  facts  without  further  entries  upon  the  books.  If  the  goods 
are  recovered,  their  fair  market  value  at  the  time  of  recovery  should 
be  credited  as  realized  profits  for  that  year,  with  a  corresponding  debit 


FROM    BUSINESS  497 

to  the  account  of  goods  purchased.  The  difference  (debit  balance) 
between  the  two  accounts  of  goods  purchased  and  goods  sold  should 
reflect  the  value  of  the  physical  inventory  at  any  given  date.  (C.  B.  4, 
page  86;  O.  D.  792.) 

Reserves  for  unearned  interest,  collection  expenses,  etc., 
good  accounting  practice. — 

Ruling.  A  taxpayer  who  sells  merchandise  on  the  installment 
plan  may  not  allocate  the  expenses  incident  to  producing  the  income 
to  the  year  in  which  the  profits  on  the  sale  of  the  goods  are  realized, 
but  should  deduct  such  expenses  in  his  income-tax  return  as  for  the 
year  in  which  incurred  and  paid  or  accrued.  (C.  B.  4,  page  123  > 
O.  D.  844.) 

When  goods  are  sold  on  the  instalment  plan  there  is  in- 
cluded in  the  sales  price  an  adequate  allowance  for  bad  debts, 
for  the  costs  of  collection,  interest  and  other  carrying  charges. 
No  specific  segregation  of  the  selling  price  is  made,  but  the 
items  are  there  nevertheless.  There  can  be  no  net  income  until 
provision  is  made  for  costs  and  expenses.  Usually  collection 
and  similar  expenses  are  relatively  small,  but  in  the  instalment 
business  such  expenses  are  high.  At  the  end  of  each  accounting 
period  (or  oftener),  if  accounts  are  kept  on  the  accrual  basis, 
there  should  be  taken  out  of  gross  sales  on  the  instalment  plan 
such  part  thereof  as  may  be  said  to  represent  the  actual  cost 
of  carrying  and  collecting  the  accounts.  If  the  future  costs 
and  charges  can  be  segregated  with  reasonable  accuracy  into 
interest,  collection  charges,  and  similar  expenses,  the  separ- 
ation should  be  made. 

It  is  somewhat  doubtful  whether  reserves  of  this  kind  were 
allowable  deductions  heretofore,  but  since  the  19 18  and  1921 
laws  call  for  the  use  of  the  best  accounting  practice  in  each 
trade,  there  should  be  no  question  about  the  propriety  of  set- 
ting up  such  reserve  accounts  to  provide  for  interest  and  ex- 
penses charged  to  customers,  but  not  collected  from  the  cus- 
tomers and  not  yet  expended  for  these  purposes.  When  re- 
turns are  made  on  the  cash  basis  now  permitted,  these  reserves 
cannot  be  claimed  as  deductions. 


498  INCOME 

Income  from  the  sale  of  real  estate  on  the  instalment 
plan. — 

Regulation.  Deferred  payment  sales  of  real  estate  ordinarily 
fall  into  two  classes  when  considered  with  respect  to  the  terms  of 
sale,  as  follows : 

(i)  Installment  transactions,  in  which  the  initial  payment  is  rela- 
tively small  (generally  less  than  one-fourth  of  the  purchase  price) 
and  the  deferred  payments  usually  numerous  and  of  small  amount. 
They  include  (o)  sales  where  there  is  immediate  transfer  of  title 
when  a  small  initial  payment  is  made,  the  seller  being  protected  by  a 
mortgage  or  other  lien  as  to  deferred  payments,  and  (b)  agreements 
of  purchase  and  sale  which  contemplate  that  a  conveyance  is  not  to 
be  made  at  the  outset,  but  only  after  all  or  a  substantial  portion  of 
the  agreed  installments  have  been  paid. 

(2)  Deferred  payment  sales  not  on  the  installment  plan,  in 
which  there  is  a  substantial  initial  payment  (ordinarily  not  less  than 
one-fourth  of  the  purchase  price),  deferred  payments  being  secured 
by  a  mortgage  or  other  lien.  Such  sales  are  distinguished  from  sales 
on  the  instalment  plan  by  the  substantial  character  of  the  initial 
payment  and  also  usually  by  a  relatively  small  number  of  deferred 
payments. 

In  determining  how  these  classes  shall  be  treated  in  levying  the 
income  tax,  the  question  in  each  case  is  whether  the  income  to  be 
reported  for  taxation  shall  be  based  only  on  amounts  actually  re- 
ceived in  a  taxing  year,  or  on  the  entire  consideration  made  up  in 
part  of  agreements  to  pay  in  the  future.     (Art.  44.) 

When  obligations  of  purchasers  are  not  the  equiva- 
lent OF  CASH. 

Regulation.  In  the  two  kinds  of  transactions  included  in  class 
( I )  in  the  foregoing  article,  installment  obligations  assumed  by  the 
buyer  are  not  ordinarily  to  be  regarded  as  having  a  readily  realizable 
market  value, ■'^  and  the  vendor  may  report  as  his  income  from  such 
transactions  in  any  year  that  proportion  of  each  payment  actually  re- 
ceived in  that  year  which  the  gross  profit  to  be  realized  when  the 
property  is  paid  for  bears  to  the  gross  contract  price.  If  the  return 
is  made  on  this  basis  and  the  vendor  repossesses  the  property  after 
default  by  the  buyer,  retaining  the  previous  payments,  the  entire 
amount  of  such  payments,  less  the  profit  previously  returned,  will  be 


^'  [Former  Procedure]  Permission  to  calculate  a  proportion  only  of 
instalments  received  as  realized  income  was  conditioned  upon  "title  re- 
maining in  the  vendor  until  fully  paid  for."   (Reg.  33,  IQ18.  Art.  T17.) 

In  the  regulations  covering  the  1918  law  the  expression  "equivalent  of 
cash"  was  used  instead  of  "readilv  realizable  market  value."  (Reg.  45, 
1 918,  Art.  45-) 


FROM    BUSINESS  499 

income  to  the  vendor  and  will  be  so  returned  for  the  year  in  which  the 
property  was  repossessed,  and  the  property  repossessed  must  be  in- 
cluded in  the  inventory  at  its  original  cost  to  himself  (less  any  depre- 
ciation as  defined  in  articles  161  and  162).  If  the  taxpayer  chooses  as 
a  matter  of  settled  practice  consistently  followed  to  treat  the  obliga- 
tions of  the  purchaser  as  having  a  readily  realizable  market  value 
and  to  report  the  profit  derived  from  the  entire  consideration,  cash 
and  deferred  payments,  as  income  for  the  year  when  the  sale  is  made, 
this  is  permissible.  If  so  treated  the  rule  prescribed  in  article  46  will 
apply.*»     (Art.  45.) 

Ruling.  In  February,  1917,  A  purchased  land  and  improvements 
for  a  consideration  of  46.r  dollars.  On  September  — ,  1917,  an  agree- 
ment for  the  sale  of  the  property  was  entered  into  between  A  and  his 
wife,  parties  of  the  first  part,  and  B,  party  of  the  second  part,  for  a 
consideration  of  yox  dollars,  payable  as  follows : 

%.r  dollars  cash,  receipt  of  which  is  acknowledged, 

9^x  dollars  cash,  to  be  paid  on  or  before  November  — ,  1917, 

3}i-r        "  "         "         "        "  "  December  — ,  1919, 

3^,r        '  "         "         "        "  "  December  — ,  1920, 

3}ix       "  "         "         "        "  "  December  — ,  1921, 

3}ix       "  "         "         "        "  "  December  — ,  1922, 

3x        "  "         "         "        "  "  December  — ,  1923, 

and  the  balance  thereof,  to  wit :    The  sum  of  42,r  dollars  to  be  paid 

on  or  before  the day  of  June,  1927,  in  accordance  with  the  note 

and  mortgage  executed  by  the  parties  of  the  first  part  to  C,  which 
mortgage  is  of  record,  all  deferred  payments  to  draw  interest  at  y  per 
cent  per  annum,  interest  payable  annually,  and  the  party  of  the  sec- 
ond part  reserves  the  right  to  pay  said  sums  at  the  due  date  thereof 
or  any  part  thereof  in  multiples  of  $100  at  any  time,  and  upon  re- 
ceipt of  the  payment  of  any  such  sum,  interest  on  such  sums  so  paid 
shall  thereupon  cease. 

In  determining  the  amount  of  the  initial  payment  it  has  been  the 
practice  to  consider  as  the  equivalent  of  cash  mortgages  assumed  by 
the  purchaser.  In  the  present  case,  however,  it  does  not  appear  that 
the  purchaser  assumes  the  mortgage  on  the  property  referred  to  above. 
He  merely  agreed  to  pay  an  amount  to  the  seller  equal  to  the  amount 
of  the  mortgage  on  or  before  June  — ,  1927,  as  the  final  payment  on 
the  property.  That  the  seller  was  not  released  by  this  agreement  from 
liability  on  the  mortgage  is  indicated  in  the  statement  in  the  letter 
from  the  taxpayer's  representative  that  "the  holder  of  the  original 
mortgage  against  the  property  refused  to  release  the  taxpayer  until 
payment  of  his  obligation  has  been  made  in  full."  The  amount  of  the 
mortgage,  42.r  dollars,  should  not,  therefore,  be  considered  as  the 
equivalent  of  cash  in  determining  the  amount  of  the  initial  payment 
in  this  transaction.     (B.  46-21-1918;  A.  R.  M.   140.) 

"  Sec  page  500. 


200  INCOME 

Even  if  the  mortgage  had  been  assumed  in  the  foregoing 
case,  the  sale  would  still  be  one  of  an  instalment  nature,  since 
the  down  payment  was  small. 

Where  lien  notes  are  given  to  cover  future  payments  for 
property  purchases,  such  notes  are  considered  as  cash  to  the 
extent  of  their  discountable  value. ^°  When  land  is  sold  for 
part  cash  and  part  oil,  if  oil  is  found,  the  right  to  receive  oil 
has  not  a  "definitely  ascertainable  value"  and  no  income  is 
realized  until  the  total  payments  received  by  the  vendor  exceed 
the  cost  or  March  i,  1913,  value  of  his  land.^^ 

When  obligations  of  purchasers  are  the  equiva- 
lent OF  CASH. 

Regulation.  In  class  (2)  in  article  44  the  obligations  assumed 
by  the  buyer  are  much  better  secured  because  of  the  margin  afforded 
by  the  substantial  first  payment,  and  experience  shows  that  the  greater 
number  of  such  sales  are  eventually  carried  out  according  to  their 
terms.  If  these  obligations  have  a  readily  realizable  market  value,  as 
defined  by  article  1564,  they  are  to  be  considered  as  the  equivalent  of 
cash  and  the  profit  realized  from  the  transaction  is  taxable  income 
for  the  year  in  which  the  initial  payment  was  made  and  the  obli- 
gation assumed.  If  the  buyer  defaults  and  the  seller  regains  title  to 
land  by  agreement  or  process  of  law,  retaining  payments  previously 
made,  he  may  deduct  from  his  gross  income  as  a  loss  in  the  year  of  re- 
possession any  excess  of  the  amount  previously  reported  as  income 
over  the  amount  actually  received,  and  must  include  such  real  estate 
in  his  inventory  at  its  original  cost  to  himself  (less  any  depreciation 
as  defined  in  arts.  161  and  162.)  If  the  obligations  have  no  readily 
realizable  market  value,  the  amount  of  the  initial  payment  shall  be 
applied  against  and  reduce  the  basis,  as  provided  in  section  202  and 
articles  1561-1564,  of  the  property  sold  and  if  in  excess  of  such  basis, 
shall  be  taxable  to  the  extent  of  the  excess.  (See  art.  1658.)  Gain 
or  loss  is  realized  when  the  obligations  are  disposed  of  or  satisfied, 
the  amount  being  the  difference  between  the  basis  as  provided  above 
and  the  amount  realized  therefor.  (See  arts.  153,  1561,  and  1568.) 
(Art.  46.) 

Even  though  the  first  payment  is  substantial  in  amount, 
if  it  is  made  in  some  form  (note,  property,  etc.)  that  has  not 


C.  B.  4,  page  89;  O.  D.  842. 
C.  B.  4,  page  89;  O.  D.  889. 


FROM    BUSINESS 


501 


a  readily  realizable  market  value,  the  transaction  is  not  closed 
and  no  income  is  realized. ^^ 

The  two  foregoing  articles  (45  and  46)  must  be  reasonably 
construed.  If  transactions  in  class  (2)  are  substantially  the 
same  as  those  in  class  (i)  the  Treasury  could  not  hold  that 
one  is  the  equivalent  of  cash  and  the  other  not. 

Initial  payment  includes  all  payments  during  tax- 
able YEAR. 

Ruling.  An  individual  who  sold  a  parcel  of  real  estate  in  1918 
for  60X  dollars  received  a  payment  of  5.1-  dollars  on  March  i,  1918, 
the  date  on  which  the  sale  was  consummated,  a  payment  of  2y^x 
dollars  on  July  i,  1918,  and  a  payment  of  lo.r  dollars  on  December 
I,  1918,  or  a  total  of  173^-r  dollars  during  the  year  1918.  It  was 
provided  that  the  balance  of  the  selling  price  would  be  paid  in  install- 
ments falling  due  on  December  i  of  each  year  thereafter,  including 
the  year  1922,  such  deferred  payments  being  secured  by  crop  mort- 
gages and  additional  collateral  security. 

In  order  to  ascertain  whether  this  sale  comes  within  the  ruling 
in  article  45  of  Regulations  45  under  wbich  a  taxpayer  is  permitted 
to  report  only  the  proportionate  part  of  each  installment  payment 
representing  profit  as  income  for  the  year  in  which  received,  the 
entire  amount  of  the  selling  price  received  in  cash  during  the  taxable 
year  in  which  the  sale  was  made  is  to  be  taken  into  consideration  in 
determining  whether  or  not  the  initial  payment  was  a  substantial  one. 
Since  in  this  case  the  sum  of  the  payments  received  in  1918  was  more 
than  one-fourth  of  the  selling  price,  the  vendor  should  have  included 
the  entire  profit  realized  on  the  sale  in  his  return  for  1918.  (C.  B.  3, 
page  108;  O.  D.  569.) 

It  IS,  however,  reasonable  to  assume  that  the  security  for 
the  deferred  payments  was  not  the  equivalent  of  cash,  in  which 
case  the  entire  profit  should  not  have  been  held  to  be  taxable 
in  1918. 

•  Payment  in  notes  not  readily  discountable. — 

Ruling.  In  the  case  of  real  estate  sales  involving  deferred  pay- 
ments, even  though  substantial  first  payment  is  made,  if  the  notes 
given  by  buyers  of  real  estate  can  not  be  discounted  nor  sold  on 
account  of  lack  of  credit  of  the  buyers,  such  notes  need  not  be  re- 


"  For  full  discussion,  see  Chapter  XVI. 


502 


INCOAJE 


garded  as  the  equivalent  of  cash,  and  the  vendors  may  report  as  their 
income  from  the  proposed  transaction  for  each  year  only  the  propor- 
tion of  each  payment  actually  received  in  that  year  which  the  gross 
profit  to  be  realized  when  the  property  is  paid  for  bears  to  the  gross 
contract  price.     (C.  B.  i,  page  76;  O.  D.  181.) 

If  because  of  decline  in  value  and  curtailment  of  credit, 
notes  given  for  property  cannot  be  marketed,  the  sale  of  the 
property  may  be  treated  as  one  made  for  deferred  payments. 

RuLiNc inasmuch    as    the    notes    covering    the    unpaid 

balance  of  the  purchase  price  are  not  merchantable  because 
of  lac'k  of  credit  on  the  part  of  the  purchasers  and  the  decrease  in  the 
value  of  farm  land  since  the  date  of  the  original  sale  agreement,  it  is 
held  that  the  transactions. in  question  should  be  treated  for  income  tax 
purposes  as  deferred  payment  sales  of  real  estate  on  the  installment 
plan.  The  administrators  of  the  estate  of  ...  .  should,  therefore, 
include  in  the  income  tax  return  of  the  decedent  for  the  period  from 
the  beginning  of  his  taxable  year  to  the  date  of  his  death,  that  pro- 
portion of  each  installment  payment  received  by  the  decedent  during 
such  period  which  the  gross  profit  to  be  realized  when  the  prop- 
erty is  paid  for  bears  to  the  gross  contract  price.  (Extract  from  letter 
to  John  E.  Hughes,  Chicago,  111.,  signed  by  Acting  Deputy  Commis- 
sioner E.  H.  Batson,  by  M.  E.  Stickley,  Head  of  Division,  dated  April 
27,  1921.) 

Payment  in  u.sed  cars. — 

Ruling.  A  dealer  in  automobiles  who  takes  used  machines  as 
part  payment  on  sales  of  new  cars  is  required  to  report  the  entire 
profits  realized  on  the  new  cars  for  the  year  in  which  received  regard- 
less of  the  fact  that  part  of  the  payments  received  are  in  the  form  of 
used  machines.  The  fair  market  value  of  the  used  cars  takeji  as  part 
payment  is  deemed  to  be  the  value  at  which  they  were  taken  in  on  the 
sales. 

In  case  the  used  cars  are  later  sold,  the  basis  for  determining  gain 
or  loss  will  be  the  value  placed  on  them  for  income  tax  purposes  when 
received,  or  if  inventories  are  employed  and  the  cars  were  on  hand 
at  the  beginning  of  the  taxable  year  in  which  sold,  the  value  at  which 
they  were  included  in  the  inventorv  at  that  date.  (C.  B.  4,  page  3.1; 
O.  D.  782.) 

Under  the  192 1  law  the  term  "readily  marketable"  would 
be  substituted  for  the  words  "fair  market  value."  It  is  prob- 
able that  in  the  automobile  trade  the  former  term  is  more  ac- 
ceptable. 


FROM    BUSINESS 


Sale  of  real  estate  in  lots. 


503 


Regulation.  Where  a  tract  of  land  is  purchased  with  a 
view  to  dividing  it  into  lots  or  parcels  of  ground  to  be  sold  as  such 
the  cost  shall  be  equitably  apportioned  to  the  several  lots  or  parcels 
and  made  a  matter  of  record  on  the  books  of  the  taxpayer,  to  the 
end  that  any  gain  derived  from  the  sale  of  any  such  lots  or  parcels 
which  constitutes  taxable  income,  may  be  returned  as  income  for  the 
year  in  which  the  sale  vi-as  made.  This  rule  contemplates  that  there 
will  be  a  measure  of  gain  or  loss  on  every  lot  or  parcel  sold,  and  not 
that  the  capital  invested  in  the  entire  tract  shall  be  extinguished  be- 
fore any  taxable  income  shall  be  returned.  The  sale  of  each  lot  or 
parcel  will  be  treated  as  a  separate  transaction  and  the  gain  or  loss 
will  be  accounted  for  as  provided  in  article  1561. "'■'     (Art.  43.) 

The  new  regulation  refers  to  any  gain  "which  constitutes 
taxable  income."  For  discussion  of  those  transactions  in 
which  no  gain  is  deemed  to  be  realized,  see  Chapter  XVI. 

Ruling For  income  tax  purposes  the  sale  of  a  per- 
petual easement  on  a  specified  number  of  acres  of  land  to  a  railroad 
company  is  to  be  treated  as  though  it  were  an  outright  sale  of  land 
where  legal  title  passes  at  the  time  of  sale,  unless  for  some  reason  the 
fee  of  the  owner  has  more  than  a  merely  nominal  value,  as  for  ex- 
ample, where  the  land  is  underlaid  by  a  mine.  (B.  43-21-1881 ; 
O.  D.  1072.) 

Estimated  development  work  may  be  included  in 
cost. — 

Ruling.  Profit  realized  on  the  sale  of  lots,  the  selling  price  of 
which  includes  the  cost  of  certain  development  work  already  made 
or  to  be  made  in  accordance  with  the  contract  of  sale,  should  be 
based  on  the  cost  of  the  land  to  the  vendor,  or  its  fair  market  value 
as  of  March  i,  1913,  if  acquired  prior  to  that  date,  plus  the  actual 
and  estimated  future  expenditures  for  development.  If  the  estimated 
future  expenditures  should  be  subsequently  ascertained  to  be  incor- 
rect, amended  returns  should  be  filed  as  the  basis  for  an  adjustment 
of  the  tax  for  the  years  affected.  The  cost  of  such  development 
having  been  taken  into  consideration  in  determining  profit,  expendi- 
tures for  this  purpose  can  not  be  deducted  from  gross  income  in  sub- 
sequent returns.     (C.  B.  3,  page  108;  O.  D.  567.) 

Repossession  of  real  estate  sold  on  instalment 
PLAN. — The  foregoing  regulation  states  that  in  case  of  repos- 


See  Chapter  XVI. 


504 


INCOME 


session  ''the  property  repossessed  must  be  included  in  the  in- 
ventory at  its  original  cost." 

Under  another  ruling,  real  estate  dealers  are  not  permit- 
ted to  inventory  real  estate.^*  Article  46,^^  which  refers  to 
real  estate  sales  not  on  the  instalment  plan,  uses  similar 
language,  as  does  article  42,  which  deals  with  sales  of  per- 
sonal property  on  the  instalment  plan.  Since  the  Treasury  has 
held  that  real  estate  dealers  may  not  use  the  inventory  method, 
this  gives  them  the  benefits  of  the  capital  gains  provisions.^® 
The  foregoing  ruling  merely  provides  that  the  cost  of  real  es- 
tate sold  and  returned  must  not  be  written  down.  The  net 
proceeds  arising  from  the  sale  and  return  are  of  course  tax- 
able. 

Proceeds  of  Property  Requisitioned  or  Destroyed^^ 

Special  provision  has  been  made  to  prevent  excessive  taxa- 
tion in  cases  where  compensation  is  received  for  property 
lost  or  destroyed  through  fire,  storm,  shipwreck  or  where 
property  is  taken  under  right  of  eminent  domain,  or  requisi- 
tioned by  the  government  for  war  purposes,^^  which  is  tem- 
porarily not  replaceable.  In  such  cases  "replacement  funds" 
may  be  established  and  the  tax  accounting  postponed  "for  a 
reasonable  period  of  time." 

Law.  Section  214.  (a)  ....  (12)  If  property  is  compul- 
sorily  or  involuntarily  converted  into  cash  or  its  equivalent  as  a  result 
of  (A)  its  destruction  in  whole  or  in  part,  (B)  theft  or  seizure,  or  (C) 
an  exercise  of  the  power  of  requisition  or  condemnation,  or  the  threat 


^  See  page  486. 

"  See  page  500. 

"  Section  206. 

"  [Former  Procedure]  T.  D.  2706  (April  25.  1918)  provided  relief 
only  in  cases  of  property  lost  through  war  hazards.  It  also  provided  for 
the  deduction  of  any  mortgage  obligation  on  such  property  from  the 
replacement  fund.  Further,  it  permitted  the  valuation  of  the  replaced 
property  at  an  amount  greater  than  that  at  which  the  old  property  was 
carried  "to  the  extent  that  such  new  or  restored  property  has  an 
increased  productive  capacity." 

Some  of  the  provisions  now  incorporated  in  the  1921  law  were  hereto- 
fore included  in  Reg.  45,  Arts.  49  and  50,  but  without  specific  provision  of 
law.     See  Income  Tax  Procedure,  1921,  pages  374-377. 

"C.  B.  4,  page  43;  O.  D.  897. 


FROM    BUSINESS  505 

or  imminence  thereof;  and  if  the  taxpayer  proceeds  forthwith  in  good 
faith,  under  regulations  prescribed  by  the  Commissioner  with  the  ap- 
proval of  the  Secretary,  to  expend  the  proceeds  of  such  conversion  in 
the  acquisition  of  other  property  of  a  character  similar  or  related  in 
service  or  use  to  the  property  so  converted,  or  in  the  acquisition  of 
80  per  centum  or  more  of  the  stock  or  shares  of  a  corporation  owning 
such  other  property,  or  in  the  establishment  of  a  replacement  fund, 
then  there  shall  be  allowed  as  a  deduction  such  portion  of  the  gain  de- 
rived as  the  portion  of  the  proceeds  so  expended  bears  to  the  entire 
proceeds.  The  provisions  of  this  paragraph  prescribing  the  conditions 
under  which  a  deduction  may  be  taken  in  respect  of  the  proceeds  or 
gains  derived  from  the  compulsory  or  involuntary  conversion  of  prop- 
erty into  cash  or  its  equivalent,  shall  apply  so  far  as  may  be  practicable 
to  the  exemption  or  exclusion  of  such  proceeds  or  gains  from  gross  in- 
come under  prior  income,  war-profits  and  excess-profits  tax  acts 

Law.     Section     202 (d)     ....    (2)  Where     property 

is  compulsorily  or  involuntarily  converted  into  cash  or  its  equivalent 
in  the  manner  described  in  paragraph  (12)  of  subdivision  (a)  of  section 
214  and  paragraph  (14)  of  subdivision  (a)  of  section  234,  and  the  tax- 
payer proceeds  in  good  faith  to  expend  or  set  aside  the  proceeds  of 
such  conversion  in  the  form  and  in  the  manner  therein  provided,  the 
property  acquired  shall,  for  the  purpose  of  this  section,  be  treated  as 
taking  the  place  of  alike  proportion  of  the  property  converted;     .... 

The  192 1  law  permitting  the  estabhshnieiit  of  a  "replace- 
ment fund"  has  several  new  features. 

1.  The  acquisition  of  80  per  cent  or  more  of  the  stock 
of  a  company  owning  property  similar  to  that  lost  is  deemed 
a  replacement.  Under  the  old  regulations  it  was  necessary  to 
"replace  the  property"  lost  or  destroyed. 

2.  Under  the  192 1  law  an  amount  of  the  gain  resulting 
from  recovery  may  be  deducted,  based  on  the  proportion  of  such 
proceeds  expended  for  replacement  to  total  proceeds. 

Assume  the  following: 

Cost  of  asset  destroyed  $200,000 

Less:  Depreciation  to  date  of  conversion 50,000 

Depreciated   cost    $150,000 

Amount  recovered  250,000 

Profit  deferred $100,000 

Amount  expended  in  replacing  assets  substantially  in  kind.   $150,000 


5o6 


INCOME 


Amount  of  profit  allowed  as  deduction  from  income: 
150,000 

of  100,000  = 60,000 

250,000 


Taxable   profit    $  40.000 

The  old  regulation  dealing  with  the  profits  to  be  reported 
reads :  "the  excess  of  the  amount  received  over  the  amount 
actually  and  reasonably  expended  to  replace  or  restore  the 
property.  "^^ 

The  foregoing  regulation  was  drafted  at  a  time  when  re- 
placement costs  were  greatly  in  excess  of  normal,  and  un- 
doubtedly it  was  not  expected  that  replacement  would  be  made 
at  an  amount  less  than  original  cost  or  March  i,  1913,  value. 
Hov/ever,  if  property  was  replaced  in  1920  at  less  than  cost, 
the  gain  would  be  measured  by  the  excess  of  the  amount  re- 
covered over  cost  or  March  i,  1913,  value.  In  other  words, 
the  higher  basis  would  be  used  in  computing  the  profit. 

3.  The  property  acquired  takes  the  place  of  a  like  propor- 
tion of  the  property  converted.  In  the  illustration  above, 
the    property    acquired    would    be     assigned     a     "cost"     of 

1 50,000 

X  $iSO,ooo,  or  $90,000,   for  the  purpose  of  com- 

250,000     /^  ^  ^   '       '         ^^  i     i 

puting  gain  or  loss  on  subsequent  sale,®°  and  for  depreciation. 

4.  The  provisions  of  the  192 1  law  are  made  retroactive  to 
all  prior  income  and  profits  tax  laws  as  regards  exemption 
from  tax. 

Accounting  for  proceeds  of  conversion. — 

Regulations.  In  the  case  of  pronerty  which  has  been  compul- 
sorily  or  involuntarily  converted  into  cash  or  its  equivalent  as  a  re- 
sult of  (a)  its  destruction  in  whole  or  in  part,  (b)  theft  or  seizure, 
or  (c)  an  exercise  of  the  power  of  requisition  or  condemnation  or  the 
threat  or  imminence  thereof,  that  amount  received  by  the  owner  as 
compensation  for  the  property  which  is  in  excess  of  the  cost  of  the 
property  (or  other  basis)  should  be  included  in  gross  income.  How- 
ever, the  gain  to  be  included  in  gross  income  in  the  case  where 
the    property    was    acquired    before    March    i,    1913,    and    its    fair 


Reg.  45,  Art.  49. 
Section  202  (d). 


FROM    BUSINESS  507 

market  value  as  of  that  date  was  greater  than  its  cost,  is  the 
excess  over  such  value  of  the  amount  received.  No  taxable  gain  re- 
sults when  the  amount  received  is  more  than  the  cost  but  less  than 
the  fair  market  value  of  the  property  as  of  March  i,  1913.  In  any  case 
proper  provision  shall  be  made  for  depreciation  to  the  date  of  the  loss, 
damage,  or  transfer.  However,  if  the  taxpayer  proceeds  forthwith 
in  good  faith  to  replace  the  property,  as  provided  in  Section  214  (a) 
(12),  see  Articles  261-263 (Art.  49.) 

Sections  214  (a)  (12)  and  234  (a)  (14)  of  the  statute  deal  with 
cases  where  property  is  compulsorily  or  involuntarily  converted  into 
cash  or  its  equivalent  as  a  result  of  fire,  shipwreck,  theft,  condemna- 
tion or  similar  causes  enumerated  in  the  statute.  Under  regulations 
prescribed  by  the  Commissioner  with  the  approval  of  the  Secretary, 
the  taxpayer  is  permitted  to  deduct  gains  which  may  be  thus  invol- 
untarily realized  (through  insurance  or  otherwise)  when  he  proceeds 
forthwith  in  good  faith  to  expend  the  proceeds  of  such  conversion  (i) 
in  the  acquisition  of  other  property  of  a  character  similar  or  related 
in  service  or  use  to  the  property  so  converted,  (2)  in  the  acquisition 
of  80  per  cent  or  more  of  the  stock  or  shares  of  a  corporation  owning 
such  other  property,  or  (3)  in  the  establishment  of  a  replacement  fund. 
When  only  part  of  the  proceeds  of  such  conversion  is  thus  expended 
(for  example,  one-third)  a  corresponding  part  of  the  gain  (in  the 
example  given,  one-third)  may  be  deducted.  The  statute  also  pro- 
vides that  for  the  purpose  of  determining  gain  or  loss  the  property 
acquired  takes  the  place  of  a  like  proportion  of  the  property  con- 
verted (in  the  example  given,  one-third).  (See  Sec.  202  (d)  (2)  and 
art.  1567.)"^  The  or  restored  property,  to  the  extent  of  the  re- 
placement, shall  not  be  valued  in  the  accounts  of  the  taxpayer  at  an 
amount  in  excess  of  the  cost  of  the  old  property  (or  of  its  value  as  of 
March  i,  1913,  if  acquired  before  that  date  and  such  value  is  higher 
than  the  cost)  after  making  proper  provision  in  either  case  for  de- 
preciation of  the  original  property,  plus  the  cost  of  any  actual  addi- 
tions and  betterments. 

This  provision  relating  to  the  involuntary  conversion  of  property 
applies,  so  far  as  may  be  practicable,  to  the  exemption  or  exclusion 
of  the  proceeds  thereof  or  the  gains  derived  therefrom  from  gross 
income  under  prior  income,  war  profits,  and  excess  profits  tax  acts. 
Articles  261,  262,  and  263  have  no  application  to  property  which  is 
voluntarily  sold  or  disposed  of.  As  to  replacement  funds,  see  article 
263.     (Art.  261.) 

The  law  gives  the  taxpayer  three  Hnes  of  procedure. 

I.  To  replace  the  property  with  property  similar  in  char- 
acter or  related  in  service. 


See  Chapter  XVII. 


5o8 


INCOAIE 


2.  To  acquire  a  minimum  interest  of  80  per  cent  in  the 
stock  of  a  corporation  owning  such  property. 

3.  To  establish  a  replacement  fund.  ' 

If  a  shipping  company  suffers  the  loss  of  one  of  its  ships 
and,  to  obtain  the  use  of  another,  purchases  80  per  cent  or 
more  of  the  stock  of  another  company  owning  a  ship  which 
can  be  used  to  replace  its  loss,  such  purchase  of  stock  is  deemed 
a  replacement. 

Should  the  taxpayer  not  elect  to  follow  any  of  the  three 
courses  of  procedure  outlined  in  article  261,  any  gain  accruing 
from  the  transaction  is  taxable. 

Regulation.  In  cases  of  involuntary  conversion  of  property 
within  the  provisions  of  sections  214  (a)  (12)  or  234  (a)  (14)  the 
gain  must  be  included  in  income  and  no  deduction  will  be  allowed 
unless  the  taxpayer  proceeds  forthwith  in  good  faith  to  expend  the 
proceeds  of  such  conversion  in  any  of  the  three  ways  described  in 
article  261.  If  the  taxpayer  does  not  elect  so  to  expend  the  proceeds 
of  the  conversion,  the  gain,  if  any,  shall  be  ascertained  as  provided  in 
article  49.     (Art.  262.) 

Replacement  substantially  in  kind. — 

Ruling.  Where  a  taxpayer  elects  to  replace-  a  vessel  by  one 
somewhat  larger,  so  long  as  the  general  type  of  the  boat  is  the  same 
as  the  boat  lost  or  destroyed,  it  may  fairly  be  taken  as  a  replacement 
in  kind  within  the  meaning  of  article  49  of  Regulations  45,  in  so  far 
as  it  equals  the  tonnage  of  the  original  vessel.  There  should  be 
charged  against  the  replacement  fund  only  such  portion  of  the  cost  of 
the  new  vessel  as  would  represent  the  cost  of  a  boat  of  the  carrying 
capacity  of  the  old  vessel,  with  allowance  for  depreciation.  The 
period  during  which  the  replacement  fund  may  be  maintained  may 
properly  be  limited  to  one  year  with  the  privilege  of  the  taxpayer  to 
apply  at  the  end  thereof  for  a  further  extension  of  time.  (C.  B.  i, 
page  76;  T.  B.  M.  61.) 

When,  however,  the  replacement  is  another  type  of  ves- 
sel, such  as  a  barge  in  place  of  a  tug,  the  Treasury  denies  the 
rehef. 

Ruling.  Where  the  owner  of  a  requisitioned  tug  uses  the  pro- 
ceeds to  buy  barges,  this  is  not  a  replacement  in  kind  as  to  come 
within  the  provisions  of  articles  49  and  50  of  Regulations  45.  (C.  B.  i, 
page  y-j;  O.  914.) 


FROM    BUSINIiSS 


509 


Corporation  purchasing  replacement  property  from  sub- 
sidiary.— 

Ruling.  Where  one  of  an  affiliated  group  of  corporations  which 
file  a  consolidated  return  established  a  replacement  fund  in  accordance 
with  the  provisions  of  article  50,  Regulations  45,  the  expenditure  of  the 
replacement  fund  so  established  to  replace  a  steamship  in  kind  is  not 
a  replacement  within  the  meaning  of  that  term,  when  the  steamship 
acquired  to  replace  the  one  lost  was  acquired  from  another  of  the 
affiliated  corporations.     (B.  48-21-1942;  A.  R.  M.  142.) 

Replacement  funds. — 

Regulation.  In  any  case  where  the  taxpayer  elects  to  replace  or 
restore  the  converted  property,  but  where  it  is  not  practicable  to  do 
so  immediately,  he  may  obtain  permission  to  establish  a  replacement 
fund  in  his  accounts  in  which  part  or  all  of  the  compensation  so  re- 
ceived shall  be  held,  without  deduction  for  the  payment  of  any 
mortgage,  and  pending  the  disposition  thereof  the  deduction  shall  be 
tentatively  allowed.  In  such  a  case  the  taxpayer  should  make 
application  to  the  Commissioner  on  Form  11 14  for  permission 
to  establish  such  a  replacement  fund  and  in  his  application  should 
recite  all  the  facts  relating  to  the  transaction  and  undertake 
that  he  will  proceed  as  expeditiously  as  possible  to  replace  or  restore 
such  property.  The  taxpayer  will  be  required  to  furnish  a  bond  with 
such  surety  as  the  Commissioner  may  require  for  an  amount  not  less 
than  the  estimated  additional  income  and  war-profits  and  excess- 
profits  taxes  assessable  by  the  United  States  upon  the  income  so  car- 
ried to  the  replacement  fund.  (See  Sec.  1329  of  the  statute.)  The 
estimated  additional  taxes,  for  the  amount  of  which  the  claimant  is 
required  to  furnish  security,  should  be  computed  at  the  rates  at  which 
the  claimant  would  have  been  obliged  to  pay,  taking  into  consideration 
the  remainder  of  his  net  income  and  resolving  against  him  all  matters 
in  dispute  affecting  the  amount  of  the  tax.  Only  surety  companies 
holding  certificates  of  authority  from  the  Secretary  of  the  Treasury 
as  acceptable  sureties  on  Federal  bonds  will  be  approved  as  sureties. 
The  application  should  be  executed  in  triplicate,  so  that  the  Commis- 
sioner, the  applicant,  and  the  surety  or  depositary  may  each  have  a 
copy.     (Art.  263.) 

The  principal  change  in  the  foregoing  article  is  that  "part 
or  all  of  the  compensation"  may  be  held  in  the  replacement 
fund,  instead  of  the  "entire  amount." 

The  replacement  fund  may  consist  of  compensation  in 
cash  and  proceeds  of  property  returned  to  taxpayer,  when 
such  property  has  been  materially  damaged. 


5IO 


INCOME 


Rulings.  Where  the  Government  having  requisitioned  vessels 
from  a  taxpayer  for  use  in  the  war,  returns  the  same  vessels  in  an 
unfit  condition  for  their  former  use,  giving  the  taxpayer  a  sum  of 
money  in  lieu  of  restoration,  the  vessels  are  deemed  to  be  substantially 
different  property  from  that  taken  from  the  taxpayer,  and  the  taxpayer 
may  elect  to  sell  the  vessels  returned  and  place  the  proceeds,  together 
with  the  money  paid  him  in  lieu  of  restoration,  in  a  replacement  fund 
established  under  Articles  49  and  50,  Regulations  45.  (C.  B.  i,  page 
78;  T.  B.  R.  41.) 

Where  business  property  was  destroyed  by  fire  and  the  taxpayer 
immediately  replaced  such  property  with  property  of  substantially 
the  same  kind,  the  excess  of  the  cost  of  replacement  over  the  amount 
of  insurance  received  as  compensation  for  the  property  destroyed  can 
not  be  taken  as  a  loss.  It  is  treated  as  a  capital  expenditure,  which 
is  recoverable  through  depreciation  deductions.  (C.  B.  3,  page  no; 
O.  D.  697.) 

The  principle  of  the  foregoing  rulings  may  be  best  illus- 
trated by  the  following  examples : 

Ruling,     i.  When  recovery  '"is  less  than  damage  sustained:" 

Cost  of  asset    $5,000.00 

Replacement  cost    $5,000.00 

Recovery    $4,000.00 

Loss    ---  $1,000.00 

2.  When  recovery  is  "less  than  an  amount  necessary  to  make  good 
the  damage :" 

Cost  of  asset  • $5,000.00 

Replacement   cost     $11,000.00 

Recovery    $10,000.00 

Loss    (?)    - $1 ,000.00 

The  investment,  at  cost,  as  indicated  in  each  of  the  above  illustra- 
tions is  $5,000.  This  is  the  capital  sum  that  may  be  returnable  through 
depreciation  or  claimed  as  a  loss  if  the  asset  is  damaged  or  destroyed. 
In  the  recovery  for  loss  or  damage  there  is  necessarily  a  conversion. 
In  this  conversion  there  would  ordinarily  be  an  immediate  profit  or 
loss  determined  by  the  amount  of  recovery.  But  under  Treasury  De- 
cision 2706  the  determination  of  the  profit  or  loss  is  deferred. 

This  decision  provides  that  an  amount  so  recovered  (b)^  requisition 
of  property  for  war  purposes  or  because  lost  or  destroyed  in  whole 
or  in  part  through  war  hazard)  may  be  set  aside  in  a  "replacement 
fund"  and  "pending  the  disposition  thereof  tlie  accounting  for  ga'n 
or  loss  thereupon  may  be  deferred  for  a  reasonable  period  of  time." 
The  excess  of  the  amount  so  recovered  "over  the  value  or  cost  of  the 
property,  except  so  far  as  actually  used  for  the  replacement  of  the 


FROM    BUSINESS  511 

property  in  kind,  is  subject  to  the  income,  war  income^  and  excess 
profits  taxes.'*  This  decision,  therefore,  provides  for  the  determina- 
tion of  gain  by  use  of  the  replacement  fund.  If  the  entire  fund  is 
expended  to  replace  in  kind  there  is  no  profit  or  loss  because  an  asset 
of  no  greater  or  lesser  value  has  been  acquired.  Substantially  there 
is  no  conversion — merely  a  substitution. 

The  substitution  of  the  asset  "in  kind''  is  only  one  transaction  and 
the  profit  or  loss  is  measured  by  the  use  of  all  or  a  part  of  the  replace- 
ment fund — not  by  an  amount  in  excess  of  the  replacement  fund. 
Thus,  if  the  recovery  (as  in  illustration  No.  i)  was  $4,000  on  an 
asset  valued  at  $5,000  and  it  cost  $5,000  to  replace  the  asset,  the  de- 
ductible loss  is  $1,000.  But  if  the  recovery  (as  in  illustration  No.  2) 
was  $10,000  the  immediate  profit  of  $5,000  can  not  be  converted  into 
a  loss  of  $1,000  if  it  cost  $11,000  to  replace  the  asset.  Any  expenditure 
in  addition  to  the  amount  recovered  and  held  in  the  replacement  fund 
represents  the  conversion  of  a  current  asset  (cash)  into  a  fixed  asset. 

The  Committee  accordingly  concludes  that  an  amount  in  excess 
of  recovery  for  loss  expended  for  replacement  of  an  asset  "in  kind" 
is  not  deductible  as  a  loss  when  the  entire  fund  so  recovered  is  equal 
to  or  greater  than  the  book  value  of  the  asset.  (C.  B.  4,  page  92; 
extract  from  A.  R.  M.  122.) 

The  foregoing  ruling  would  work  out  as  follows:  A  con- 
cern owned  a  ship  which  was  carried  on  its  books  at  cost  (or 
value  March  i,  1913),  less  normal  depreciation,  viz.,  $100,000. 
In  1 9 19  it  was  lost  or  destroyed.  Insurance  amounting  to 
$300,000  (its  insurable  value)  was  collected.  Under  the  reg- 
ular practice  income  and  excess  profits  taxes  would  be  collected 
on  $200,000.*^-  On  the  assumption  that  it  would  cost  $300,000 
to  replace  the  old  ship  with  a  new  one  no  better  than  the  old, 
the  1 92 1  law  (retroactive  in  this  respect  to  taxes  under  pre- 
vious income  and  profits  tax  laws)  permits  the  taxpayer  to 
credit  the  entire  amount  received  to  a  replacement  fund,  and 
to  withhold  the  payment  of  any  tax  on  the  excess  received, 
provided"^  bond  is  filed  for  the  tax  which  would  be  due  if  im- 
mediately assessed.  If  a  new  ship,  which  is  "substantially"  the 
same  as  the  old,  is  purchased  out  of  the  replacement  fund,  at 
a  cost  of  $300,000,  no  tax  will  be  payable  if  the  new  ship 


"^If  the  ship  is  not  replaced  income  tax  would  be  assessed  on  $200,000, 
but  relief  might  he  granted  as  t(j  the  excess  profits  tax  in  certain  circum- 
stances.    See  Appendix  A,  Chapter  XV. 

"'Art.  263. 


512 


INCOME 


is  carried  in  the  accounts  of  the  taxpayer  at  an  amount  not 
greater  than  that  at  which  the  old  ship  was  carried. 

If  the  replacement  is  made  at  a  cost  of  less  than  $300,000, 
say  for  $150,000,  the  gain  to  be  reported  is  that  proportion  of 
the  proceeds  in  excess  of  cost  which  the  amount  expended  for 
replacement  bears  to  the  amount  recovered,  viz., 

150,000        /         T/N       r  c^  o  64 

"^    (or  ^)  of  $200,000,  or  $100,000."^ 

300,000 

Under  the  192 1  law  [section  202  (d-2)]  a  new  prorated 
"cost"  ($50,000)  would  be  assigned  to  the  replaced  property, 
viz.,  that  proportion  of  the  cost  of  the  property  converted 
($100,000)  that  the  amount  expended  for  replacement 
($150,000)  bears  to  the  amount  recovered  ($300,000),  that 
is,  one-half.  If  the  replacement  cost  is  $350,000,  the  excess 
of  cost  over  compensation  received,  viz.,  $50,000,  must  be 
added  to  the  book  cost,  and  must  not  be  taken  as  a  loss. 

The  provision  that  the  new  ship  must  not  be  valued  on 
the  books  at  more  than  the  book  value  of  the  old  one  is  equi- 
table, because  if  it  were  so  valued  there  would  be  an  amount 
credited  to  profit  and  loss  account  upon  which  no  tax  had 
been  assessed. 

Cash  received  from  Alien  Property  Custodian. — The 
amount  of  cash  received  from  the  Alien  Property  Custodian 
as  a  return  of  property  seized''^  by  him  may  be  placed  in  a  re- 
placement fund.  The  provision  is  broad  enough  to  include 
property  seized  by  him  under  the  law  and  converted  into 
money. 


"  [Former  Procedure]  T.  D.  2706,  approved  April  25,  1918,  read  in 
part :  "This  excess  of  the  amount  received  oivr  the  value  or  cost  of  the 
property,  except  so  far  as  actually  used  for  the  replacement  of  the  property 
in  kind,  is  subject  to  ...  .  taxes." 

Art.  49,  Reg.  45,  (promulgated  January  28,  1921)  reads,  in  part,  as 
follows:  "the  gain,  if  any,  is  measured  by  the  excess  of  the  amount  received 
over  the  amount  actually  and  reasonably  expended  to  replace  or  restore  the 
property."     But  see  text  on  page  506. 

"  Section  214   (a-12)   reads  "as  a  result  of  ...  .  seizure." 


FROAI    BUSINESS  513 

Recoveries   for    Damages,    Patent    Infringement, 
Claims,  Bad  Debts,  etc. 

Regulation.     Gains,  profits  and  income  are  to  be   included  in 

the  gross  income  for  the  taxable  year  in  which  they  are  received^*  by 
the  taxpayer,  unless  they  are  included  when  they  accrue  to  him  in 
accordance   with  the   approved  method   of   accounting   followed   bj 

him A  person  may  sue  in  one  year  on  a  pecuniary  claim  or 

for  property,  but  money  or  property  recovered  on  a  judgment  there- 
for rendered  in  a  later  year  would  be  income  in  that  year,  assuming 
that  it  would  have  been  income  in  the  earlier  year  if  then  received. 
This  is  true  of  a  recovery  for  patent  infringement.  Bad  debts  or  ac- 
counts charged  off  subsequent  to  March  i,  1913,  because  of  the  fact 
that  they  were  determined  to  be  worthless,  which  are  subsequently  re- 
covered, whether  or  not  by  suit,  constitute  income  for  the  year  in 
which  recovered,  regardless  of  the  date  when  the  amounts  were 
charged    off (Art.    51.) 

The  foregoing  article  is  a  fair  interpretation  of  the  legal 
definition  of  income  even  though  in  many  cases  it  has  resulted 
inequitably.  When  accounts  are  kept  on  an  accrual  basis  and 
an  obvious  error  has  been  made,  the  returns  of  prior  years 
may  be  reopened  and  corrected.  When  income  is  not  reported 
for  taxation  because  it  is  not  deemed  at  the  time  to  be  taxable 
income,  no  just  criticism  can  be  imputed  to  a  regulation  which 
holds  that  if  income  was  not  reported  when  it  appeared  to 
accrue  it  must  be  reported  when  it  is  realized. 

When  items  which  have  never  been  included  in  gross  in- 
come or  which  have  been  charged  off  as  bad  are  collected, 
they  are  pruna  facie  taxable  income  (jf  the  year  of  realization. 
The  courts  carry  this  theory  to  an  extreme  not  warranted  by 
business  practice.  Good  accounting  practice  requires  that 
there  be  taken  up  as  accrued  and  taxable  transactions,  those 
which  are  the  equivalent  of  cash.^'  x^ccounts  and  notes  receiv- 
able due  from  and  recognized  by  solvent  debtors  are  deemed 
to  be  the  equivalent  of  cash.  Only  in  exceptional  ca'^c^  vyov.ld 
accruals  of  tmcertain  or  indeterminate  items  be  sanctioned  by 


"Postponement  of  collection  by  reason  of  moratorium  does  not  entitle 
taxpayer  to  omit  income  from  accounts  so  affected  from  return  for  year  in 
which  received.     (C.  B.  4,  page  98;  O.  D.  869.) 

"•  See  page  t,^t,. 


5H 


INCOME 


good  accounting  practice.  The  definitions  of  income  in  the 
law  and  regulations  are  strictly  limited  by  the  decisions  of  the 
United  States  Supreme  Court.  These  decisions  do  not  require 
the  payment  of  tax  on  transactions  which  are  not  the  equiv- 
alent of  cash.  Any  regulation  which  attempts  to  set  aside  this 
theory  is  not  sound. 

Ruling.  The  United  States  brought  suit  against  the  M  Corpora- 
tion for  the  recovery  and  possession  of  oil  lands.  A  receiver  was  ap- 
pointed to  take  possession  of  the  lands  and  retain  the  proceeds  of  the 
sales  of  oil  and  gas  produced  thereon,  pending  a  final  judgment, 
which  was  rendered  in  1919  in  favor  of  the  United  States.  Pursuant 
to  an  Act  of  Congress  the  United  States  in  1920  leased  the  land  that 
was  involved  to  the  same  corporation.  Later,  pursuant  to  the  same 
Act,  the  Department  of  Justice  proceeded  with  the  settlement  and  ad- 
justment of  the  judgment  against  the  company,  whereupon  by  a  decree 
of  the  court  rendered  in  1921,  the  receiver  was  directed  to  pay  a  part 
of  the  impounded  money  to  the  M  Company,  which  is  held  to  be  tax- 
able income  for  the  year  1921,  when  it  was  paid.  (B.  39-21-1839; 
O.  D.  1046.) 

Award  of  damages  by  arbitration  board. — 

Ruling.  The  award  in  the  year  1918  by  a  board  of  arbitration  of 
X  dollars  to  the  M  Company  on  its  unliquidated  claim  to  a  portion  of 
the  proceeds  arising  out  of  transactions  which  took  place  in  1917  is 

income  to  the  corporation  for  the  year  1918  rather  than  1917 

(C.  B.  2,  page  82;  S.  1335.) 

In  computing  damages  the  element  of  value  at  March  i, 
19 1 3,  must  not  be  forgotten.  In  the  case  of  damages  for 
infringement  of  patents,  etc.,  it  is  quite  possible  that  suits 
not  yet  settled,  or  those  which  have  been  settled  during  recent 
years,  include  payments  which  properly  apply  to  the  period 
prior  to  March  i,  1913. 

Ruling.  Certain  property  owned  by  an  estate  was  in  1906  listed 
by  a  city  to  be  condemned  for  public  purposes.  The  property  was 
not  destroyed  until  191 7.  During  that  year  a  verdict  was  rendered 
awarding  the  estate  x  dollars,  with  interest  at  the  rate  of  6  per  cent 
per  annum  from  1906,  the  date  the  property  was  listed  for  condemna- 
tion. Mandamus  proceedings  were  instituted  to  enforce  the  settle- 
ment of  this  award,  and  in  1920  the  estate  received  payment  of  the 


FROM    BUSINESS 


515 


face  value  of  the  claim,  together  with  interest  accrued  since   1906, 
and  costs. 

Held,  that  the  measure  of  taxable  income  is  the  excess  of  the  sum 
of  the  principal  and  accrued  interest  actually  received  over  the  fair 
market  value  of  the  claim  representing  such  principal  and  interest 
accrued  as  at  March  i,  1913.  Such  excess  as  regards  the  principal 
of  the  claim  is  taxable  as  of  the  year  1920,  in  which  it  was  received. 
The  amount  of  the  interest  received  is  exempt  from  income  tax  as 
interest  on  the  obligation  of  a  political  subdivision  of  a  State  within 
the  meaning  of  section  213   (b)  4  of  the  Revenue  Act  of  1918. 

The  cost  of  mandamus  proceedings  was  a  replacement  of  the 
amount  expended  by  the  estate  in  the  collection  of  a  debt  and  should 
not  be  included  in  gross  income  of  the  estate.  Nor  should  it  be 
taken  as  a  deduction  in  computing  net  income  for  the  year  in  which 
expended.    (C.  B.  3,  page  113;  O.  D.  591.) 

A  taxpayer  sued  in  1908  to  recover  damages  for  patent 
infringement  and  in  191 1  a  United  States  circuit  court  ren- 
dered a  decision  in  his  favor.  The  case  was  referred  to  a  mas- 
ter, v^ho  filed  a  final  report  with  the  court  early  in  1918.  In 
the  latter  part  of  1918,  the  case  was  compromised,  and  an 
amount  agreed  upon  was  paid  to  the  taxpayer.  The  Treasury 
held:  ".  .  .  .  the  amount  received  in  1918  does  not  con- 
stitute taxable  income  for  that  year,  for  the  reason  that  the 
right  to  receive  this  amount  existed  and  was  a  part  of  the 
assets  of  the  X  Company  on  March  i,  191 3." 

Claims. — The  word  "claims"  indicates  that  liability  is  dis- 
puted. If  claimants  do  not  accrue  the  claims  as  income  and 
if  those  against  whom  claims  are  made  deny  liability,  it  can 
hardly  be  held  that  taxable  income  arises  unless  and  until  there 
is  realization  of  the  equivalent  of  cash. 

It  is  now  well  settled  that  proceeds  from  claims,  judgments, 
contracts,  etc.,  definitely  ascertained  and  vested  before  March 
I,  191 3,  although  received  during  some  subsequent  year,  are 
not  taxable  net  income."''' 

Bad  debts. — When  accounts  or  notes  receivable  have  been 


Sec  Arts  51  and  151,  Cliaptcr  XXX. 


5i6 


INCOME 


charged  off  because  they  are  deemed  to  be  worthless,  it  is 
proper  to  include  any  subsequent  collections  on  account  thereof 
as  taxable  income  of  the  year  in  which  realization  occurs.  It 
is  not  good  accounting  practice  to  reopen  the  accounts  of  \)rt- 
vious  years  under  such  circumstances;  nor  is  it  proper  to  re- 
open tax  returns  under  similar  conditions.  Even  if  it  develops 
subsequently  that  poor  judgment  is  used  and  some  accounts 
which  were  charged  off  should  not  have  been  charged  off,  it 
would  bring  about  indescribable  confusion  in  accounting  and 
tax  matters  if  it  were  permissible  to  reopen  the  accounts  except 
under  extraordinary  circumstances.  Business  is  conducted 
under  ordinary  conditions  and  superhuman  knowledge  is 
not  imputed  to  business  men.  Under  the  accrual  system  books 
of  account  must  be  closed  and  income  statements  prepared 
periodically;  when  reasonable  care  is  taken  in  closing  books, 
subsequent  adjustments  must  be  made  in  subsequent  accounts. 

Types  of  Business  Income  Taxable  and  Non-Taxable 

Taxable  income  can  only  arise  from  dealings  with  the 
public. — The  types  of  business  dealings  here  considered  are 
with  the  public  generally.  For  purposes  of  convenience  or- 
ganizations are  sometimes  set  up  which  operate  as  separate 
entities,  but  are  entirely  owned  by  one  interest.  Reference 
is  not  made  to  the  relationship  which  exists  between  parent 
and  subsidiary  corporations  or  between  affiliated  corporations. 
Such  relationships  are  discussed  elsewhere. ®®  But  there  are 
other  cases  in  which  a  firm  or  an  individual  establishes  branch 
houses  or  agencies  which  keep  separate  sets  of  books  and 
prepare  independent  profit  and  loss  statements.  If  the  separa- 
tion is  in  form  and  not  in  substance  income  tax  returns  should 
not  be  made  except  by  the  sole  owner. 

An  English  firm  had  an  agency  in  the  United  States  which 
purchased  cotton  in  the  United  States  and  shipped  it  to  Eng- 
land.    The  cotton  was  billed  to  the  head  office  at  market 


See  Chapter  XXII  and  page  196. 


FROM    BUSINESS  517 

prices  on  the  day  of  shipment.  A  book  profit  of  several  hun- 
dred thousand  dollars  was  shown  on  the  books  kept  in  this 
country.  No  cotton  was  shipped  to  any  one  except  the  actual 
purchasers.  Not  a  dollar  of  actual  profit  was  realized  in  this 
country.  An  income  tax  examiner  held  that  a  taxable  profit 
was  realized  because  it  was  shown  on  the  books.  The  profit 
was  a  book  profit  only.  No  net  income  was  realized.  Upon 
appeal  the  inspector  was  overruled. 

Charging  or  crediting  oneself  at  high  or  low  prices  can- 
not produce  a  profit  or  a  loss.  Dealing  with  the  public  is 
necessary  to  produce  profit  or  loss. 

Ruling.  Coal  purchased  by  a  company  on  bona  fide  contracts 
entered  into  prior  to  October  30,  1919,  and  shipped  to  tidewater  for 
export  on  contracts  entered  into  prior  to  that  date  was  diverted  by  a 
Government  agency  for  the  use  of  certain  railroads  and  the  company 
is  carrying  these  accounts  on  its  books  awaiting  a  decision  by  the 
Government  as  to  the  final  settlement  of  the  bills. 

Held,  that  the  principle  laid  down  in  the  last  two  sentences  of 
article  52,  Regulations  45,  is  applicable  in  this  case,  although  these 
sentences  refer  to  the  unusual  conditions  prevailing  at  the  close  of 
1918.  The  M  Company  should  set  up  these  accounts  in  a  "Suspense 
Account"  and  eliminate  them  from  their  returns  for  1919  and  1920, 
pending  final  settlement.  There  should  be  attached  to  such  returns  a 
full  statement  of  the  facts  relative  to  the  claims  of  the  company  on 
account  of  the  diversion  of  the  coal.  When  final  settlement  has  been 
made,  amended  returns  for  the  years  1919,  and  1920,  should  be  filed, 
including  therein  the  income  found  to  be  due  upon  such  final  settle- 
ment.  (C.  B.  4,  page  93;  O.  D.  816.) 

The  foregoing  riding  attempts  to  apply  the  very  doubtful 
provision  of  article  52^*^  of  Regulations  45  to  an  imrelated  mat- 
ter. In  the  foregoing  case  the  shijjpers  had  accounts  receivable 
at  the  end  of  191 9  and  1920.  If  the  accounts  were  not  bad  at 
the  end  of  these  years  they  could  not,  under  the  regulations, 
be  charged  off.  There  is  no  basis  in  the  19 18  regulations  for 
''eliminating"  doubtful  accounts.  A  proper  interpretation  of 
the  laws  would  have  permitted  charging  off  bad  debts,"  but 
the  regulations  specifically  forbade  it.    The  invoking  of  article 


'"  See  page  513. 
"  Cliapter  XXX. 


5i8  INCOME 

52  is  versatile  l)nt  unsound.  If  permitted  to  stand  it  will  bring 
about  a  vast  number  of  amended  returns  and  the  inclusion  in 
the  accounts  of  subsequent  years  of  the  amount,  if  any,  re- 
covered. 

Ruling.  In  1914  the  United  States  Government  took  over  a  cer- 
tain business  of  the  M  Company  and  held  it  until  March,  1920,  at 
which  time  it  was  returned  to  private  ownership.  In  1919,  following 
the  settlement  of  a  dispute  as  to  the  corporation  entitled  to  receive  the 
income  from  the  operation  of  the  business,  the  United  States  Govern- 
ment paid  the  M  Company  the  sum  of  2.r-dollars  representing  earnings 
from  1914  to  April  6,  1917.  In  1920  it  paid  the  company  x  dollars  as 
rental  from  April  6,  1917,  to  March,  1920. 

The  question  arises  as  to  how  this  income  should  be  reported  and 
also  the  manner  and  extent  a  claim  for  depreciation  in  value  of  the 
property  may  be  made. 

Held,  that  inasmuch  as  the  M  Company  kept  its  books  on  the  cash 
receipts  and  disbursements  basis,  the  amounts  received  in  1919  and 
1920  must  be  treated  as  income  for  these  vears.  (C.  B.  4.  page  180; 
O.  D.  948.) 

The  foregoing  ruling  is  not  consistent  with  the  Treasury's 
contention  that  unusual  conditions  are  sufficient  to  modify 
general  rules.  It  may  be  assumed  that  if  the  government 
"took  over"  and  "held"  the  business  from  1916  to  1920,  failure 
during  such  period  to  keep  accounts  on  an  accural  basis  is  the 
failure  of  the  government  and  not  of  the  taxpayer.  The  gov- 
ernment cannot  take  advantage  of  its  own  negligence  to  keep 
accounts  of  property  held  in  trust  according  to  good  accounting 
methods. 

Gifts  received  by  corporations  not  taxable  as  income.'- — 

Law.  Section  213.  [Individuals]  ....  "gross  income" — 
.  .  .  .  (b)  Does  not  include  ■  •  •  •  (3)  The  value  of  property  ac- 
quired by  gift,  bequest,  devise,     .... 

Section  233.  [Corporations]  ....  "gross  income"  means  the 
gross  income  as  defined  in  section  213,     .... 

The  foregoing  section  of  the  law  applies  to  corporations 
as  well  as  to  individuals.  The  interesting  question  arises : 
How   shall  a  corporation   enter  gifts  on  its  books?     If   the 


"■  [Former  Procedure]     For  procedure  under  1909  and  1913  laws,  see 
Income  Tax  Procedure,  1920,  pages  322-323. 


FR(3M    BUSINESS  519 

values  at  date  of  gift  are  set  up  in  the  books,  subsequent  gains 
based  on  book  vakies  may  or  may  not  be  taxable.  It  would 
seem  to  be  necessary  in  all  of  such  cases  to  ascertain  from  the 
donors  the  cost  to  them  of  the  property  donated  and  to  note 
the  cost  in  the  ledger  account.  The  maximum  tax  which  can 
be  imposed  upon  the  net  income  of  corporations  after  January 
I,  1922,  is  12 V2  per  cent.  Individuals  who  own  property  for 
less  than  two  years  and  who  desire  to  sell  it,  apparently  can 
donate  the  property  to  a  corporation.  When  the  corporation 
sells  it  the  gain  can  be  taxed  only  at  the  I2>^  per  cent  rate. 

The  Treasury  has  held  that  upon  the  recision  of  a  con- 
tract and  repayment  to  the  corporation  by  an  employee  of  com- 
pensation paid  under  the  contract  in  a  prior  year,  such  pay- 
ment was  a  gift  to  the  corporation.  (See  O.  D.  1073,  cpoted 
on  page  430. ) 

Sale  by  corporation  of  property  acquired  by  gift. — 

Law.  Section  20J.  (a)  .  .  .  .  (2)  In  the  case  of  such  prop- 
erty, acquired  by  gift  after  December  31,  1920,  the  basis  shall  be  the 
same  as  that  which  it  would  have  in  the  hands  of  the  donor  or  the  last 
preceding  owner  by  whom  it  was  not  acquired  by  gift.  If  the  facts 
necessary  to  determine  such  basis  are  unknown  to  the  donee,  the  Com- 
missioner shall,  if  possible,  obtain  such  facts  from  such  donor  or  last 
preceding  owner,  or  any  other  person  cognizant  thereof.  If  the  Com- 
missioner finds  it  impossible  to  obtain  such  facts,  the  basis  shall  be  the 
value  of  such  property  as  found  by  the  Commissioner  as  of  the  date 
or  approximate  date  at  which,  according  to  the  best  information  the 
Commissioner  is  able  to  obtain,  such  property  was  acquired  by  such 
donor  or  last  preceding  owner.  In  the  case  of  such  property  acquired 
by  gift  on  or  before  December  31,  1920,  the  basis  for  ascertaining  gain 
or  loss  from  a  sale  or  other  disposition  thereof  shall  be  the  fair  market 
price  or  value  of  such  property  at  the  same  time  of  such  acquisition; 


Forgiveness  of  indebtedness. — 

Regulation.  The  cancellation  and  forgiveness  of  indebtedness 
is  dependent  on  the  circumstances  for  its  effect.  It  may  amount  to 
a  payment  of  income  or  to  a  gift  or  to  a  capital  transaction.  If, 
for  example,  an  individual  performs  services  for  a  creditor,  who 
in  consideration  thereof  cancels  the  debt,  income  to  that  amount  is 


t^2o  INCOME 

realized  by  the  debtor  as  compensation  for  his  services.  If,  how- 
ever, a  creditor  merely  desires  to  benefit  a  debtor  and  without  any 
consideration  therefor  cancels  the  debt,  the  amount  of  the  debt  is 
a  gift  from  the  creditor  to  the  debtor  and  need  not  be  included  in 
the  latter's  gross  income.  If  a  stockholder  in  a  corporation  which 
is  indebted  to  him  gratuitously  forgives  the  debt,  the  transaction 
amounts  to  a  contribution  to  the  capital  of  the  corporation.'^  .... 
(Art.  50.) 

One  of  the  United  States  circuit  courts  of  appeals  has 
decided  in  a  recent  case  that  a  debt  forgiven  is  not  income 
to  the  debtor.'*  The  court  said :  "Now,  it  seems  to  us  hardly 
arguable  that  the  cancellation  of  the  debt  in  question  was  not  in 
the  category  of  capital  ....  The  cancellation  of  the  debt  was 
a  means  of  contribution  to  its  capital  account,  quite  as  though 
the  money  had  been  contributed  by  the  stockholder  only  to 
enhance  the  value  of  his  stock." 

It  is  suggested  that  when  stockholders  or  bondholders 
contemplate  making  good  a  deficit,  attention  should  be  given 
to  both  sides  of  the  transaction.  The  creditor  may  desire  to 
claim  credit  for  the  transaction  as  a  bad  debt  deduction. 

Outlawed  accounts  held  to  be  taxable  income. — 

Decision.  (Syl.)  I'he  amount  of  obligations  of  a  railroad  cor- 
poration carried  on  the  books  as  liabilities,  which  became  outlawed 
and  were  therefore  written  off  during  the  taxable  years  1910  and 
1911,  represented  profit  to  the  company  which  was  properly  included  in 
its  net  income  for  the  year  in  which  so  written  off.'^^ 

Voluntary  assessments  paid  by  stockholders  not  taxable. — 

Regulation.  Where  a  corporation  requires  additional  funds  for 
conducting  its  business  and  obtains  such  needed  money  through  vol- 
untary pro  rata  payments  by  its  stockholders,  the  amounts  so  re- 
ceived being  credited  to  its  surplus  account  or  to  a  special  capital 
account,  such  amounts  will  not  be  considered  income,  although  there 


''  [Former  Procedure]  Tlie  last  st'iucncc  of  the  corresponding  article 
(51)  in  Reg.  45  (1919  Edition)  reads:  "If.  however,  a  corporation  to  which 
a  stockholder  is  indebted  forgives  the  debt,  the  transaction  has  the  effect 
of  the  payment  of  a  dividend." 

'*  U.  S.  V.  Oregon-W ashvujtnn  R.  cr  Xai'.  Co.,  Circ.  Ct.  of  App..  251 
Fed.  211   (April  24,  1918). 

"'Great  Northern  Ry.  Co.  :■.  Lyncli,  U.  S.  Disl.  Ct.,  Dist.  of  Minnesota, 
3rd  Div.,  January  10,  i<j2i.  (not  reported).     See  T.  D.  3147. 


FROM    BUSINESS  521 

is  no  increase  in  the  outstanding  shares  of  stock  of  the  corporation. 
The  payments  in  such  circumstances  are  in  the  nature  of  voluntary 
assessments  upon,  and  represent  an  additional  price  paid  for,  the 
shares  of  stock  held  by  the  individual  stockholders,  and  will  be 
treated  as  an  addition  to  and  as  a  part  of  the  operating  capital  of 
the  company (Art.  544.) 

If  the  payments  are  made  as  indicated  the  stockholders 
must  consider  the  payments  as  capital  investments.  If  the 
corporation  is  losing  money  and  the  stockholders  are  merely 
advancing  funds  with  which  to  pay  its  debts  or  losses  it  might 
be  better  to  arrange  the  payments  in  the  form  of  advances. 
Failure  of  the  corporation  to  repay  would  entitle  the  stock- 
holders to  charge  off  the  advances  as  bad  debts. 

Taxes  paid  by  vendee  for  vendor  on  profits  from  sale  of 
property  are  income  to  vendor. — 

Ruling.  A  vendee  of  a  business  agrees  that  in  addition  to  the 
purchase  price  of  the  business  he  will  pay  the  income  and  excess 
profit  taxes  of  the  vendor  arising  from  the  sale  of  said  business. 
(Query.)  Does  the  payment  of  the  said  taxes  by  the  vendee  con- 
stitute income  to  the  vendor  which  the  vendor  would  have  to  report 
on  his  income  tax  statement  and  pay  a  tax  thereon? 

(Answer.)  Income,  excess  profits  and  war  profits  taxes  paid 
by  vendee  for  vendor  on  profits  from  sale  of  property  to  vendee  con- 
stitute additional  taxable  income  to  vendor.  (Telegram  of  inquiry 
from  The  Corporation  Trust  Company,  and  the  reply  thereto  signed 
by  Commissioner  Daniel  C.  Roper,  and  dated  May  2,   1919.) 

An  agreement  to  pay  an  additional  sum  to  a  vendor  equal 
to  the  tax  payable  by  him  is  an  enforceable  contract,  but  the  cal- 
culation is  a  somewhat  involved  one.  The  amount  payable 
must  be  sufficient  to  pay  the  tax  on  the  profit  plus  such  addi- 
tional sum  as  will  enable  the  vendor  to  pay  the  tax  on  the 
amount  received  in  excess  of  the  original  sales  price. ^^  The 
vendee  would  properly  consider  that  the  tax  which  is  paid 
for  the  vendor  is  a  part  of  the  purchase  price  of  the  prop- 
erty. 


For  computations,  see  Income   Tax  Procedure,  1921,  pages  382,  383. 


-22  INCOME 

It  is  inulerstood  thai  ihe  'J'reasury  has  not  in  all  cases 
aillicred  to  the   foregoing  position." 

Net  proceeds  of  "business"  life  insurance  are  not  income. — 
The  proceeds  of  "business"  life  insurance  are  not  to  be  included 
in  gross  income. 

Law.     Section  213 the  term  "gross  income" —     .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title: 

(i)  The  proceeds  of  life  insurance  policies  paid  upon  the  death 
of  the  insured ;'"'     .... 

Law.  Section  233.  (a)  That  in  the  case  of  a  corporation  .... 
the  term  "gross  income"  means  the  gross  income  as  defined  in  section 
213 

Regulation Under  the  revenue  act  of  1921.  the  pro- 
ceeds of  life  insurance  policies  paid  upon  the  death  of  the  insured 
to  any  beneficiary  (corporate  or  otlierwise)  are  not  to  be  included  in 
the  l)eneficiary's  gross  income (Art.  541.) 

Although  the  premiums  paid  on  "business"  life  insurance 
are  still  not  deductible  when  the  taxpayer  is  a  beneficiary,'^ 
the  entire  proceeds  of  such  policies  may  be  excluded  from 
gross  income. 

Reserve  fund  to  carry  own  insurance. — Premiums 
collected  from  customers  and  placed  in  a  reserve  fund  by  an 
automobile  dealer  to  provide  for  losses  through  confiscation, 
under  the  Volstead  Act,  of  automobiles  sold  by  him  on  term 
contracts,  are  income  in  the  taxable  year  in  which  they  are 
received  or  accrued.^" 

Of  course  payments  made  or  liabilities  contracted  in  respect 
of  such  premiums  are  allowable  deductions. 


"  A.  R.  M.  16,  C.  B.  2,  page  62  is  reversed. 

■*  [Former  Procedure]  Under  all  laws  prior  to  1921,  the  proceeds  of 
life  insurance  collected  by  corporations  were  included  in  gross  income. 
Section  213  (b-i)  of  the  1918  law  contains  the  limiting  clause,  "to  individual 
beneficiaries  or  to  the  estate  of  the  insured."  Under  the  1918  law  the 
])rimiums  paid  on  "business"  life  insurance  were  offset  against  the  gross 
amount  received  on  the  policies,  and  the  remainder  was  required  to  be 
reported  as  taxable  income. 

"  Section  215   (a-4). 

'"Bulletin  47-21-1929;  O.  D.  1106. 


FROM    BUSINESS 


523 


Income  from  instalment  proceeds  of  "business"  life 

insurance. 

Ruling.  The  option  exercised  by  a  corporation  beneficiary  in 
allowing  the  proceeds  of  an  insurance  policy  to  be  paid  in  installments 
represents  in  fact  an  investment  of  such  proceeds.  Any  interest  or 
profits  received  over  and  above  the  face  value  of  each  installment 
represents  taxable  income  to  the  corporation  for  the  year  in  which 
received.    (C.  B.  i,  page  211 ;  O.  D.  66.) 

Bonus  received  in  stock. — 

Regulation Where    common    stock    is    received   as    a 

bonus  with  the  purchase  of  preferred  stock  or  bonds,  the  total  pur- 
chase price  shall  be  fairly  apportioned  between  such  common  stock 
and  the  securities  purchased  for  the  purpose  of  determining  the  por- 
tion of  the  cost  attributable  to  each  class  of  stock  or  securities,  but  if 
that  should  be  impracticable  in  any  case,  no  profit  on  any  subsequent 
sale  of  any  part  of  the  stock  or  securities  will  be  realized  until  out  of 
the  proceeds  of  sales  shall  have  been  recovered  the  total  cost.^^ 
•    •    ■    •      (Art.  39.) 

This  article  is  equitable  and  accords  with  good  accounting 
practice. 

Purchase  by  corporation  of  its  own  bonds  at  a  discount. — 

When  a  corporation  purchases  its  own  bonds  at  a  discount  it 
is  clear  that  the  retirement  of  the  bonds  discharges  a  HabiHty 
at  less  than  book  value,  with  a  resulting  credit  to  surplus. 

Regulation.  (i)  («)  If  bonds  arc  issued  by  a  corpora- 
tion at  their  face  value,  the  corporation  realizes  no  gain  or  loss. 
....  (c)  If,  however,  the  corporation  purchases  and  retires  any  of 
such  bonds  at  a  price  less  than  the  issuing  price  or  face  value,  the 
excess  of  the  issuing  price  or  face  value  over  the  purchase  price 
is  gain  or  income  for  the  taxable  year. 

(2)  (a)  If  bonds  are  issued  by  a  corporation  at  a  premium,  the 
net  amount  of  such  premium  is  gain  or  income  which  should  be  pro- 
rated or  amortized  over  the  life  of  the  bonds (c)  If,  how- 
ever, the  corporation  purchases  and  retires  any  of  such  bonds  at  a 
price  less  than  the  issuing  price  minus  any  amount  of  premium 
already  returned  as  income,  the  excess  of  the  issuing  price  minus 
any  amount  of  premium  already  returned  as  income  (or  of  the  face 


"  [Former  Procedure]  Reg.  3i,  Art.  44,  pruvidcd  that  "the  entire 
proceeds  derived  from  the  sale  or  transfer  of  such  (bonus)  stock  is  income 
subject  to  the  normal  and  additional  tax." 


5 -'4 


INCOME 


value  plus  any  amount  of  premium  not  yet  returned  as  income)  over 

the  purchase  price  is  gain  or  income   for  the  taxable  year 

(Art.  545.) 

It  will  be  noted  that  the  conditions  precedent  in  the  fore- 
going are  purchase  and  retirement.  A  corporation  which  buys 
some  of  its  bonds  in  the  open  market  at  less  than  par  and 
carries  them  at  cost  as  marketable  investments  and  has  no 
intention  of  retiring  them  cannot  be  held  to  have  realized  a 
profit.  The  burden  of  proof  is  on  the  corporation  to  show 
that  the  bonds  were  not  retired.  If  the  bonds  were  resold  at 
a  profit,  it  would  be  taxable;  if  resold  at  a  loss  it  would  be 
deductible. 

It  has  been  held  that  taxpayers'  own  obligations  in  the 
form  of  corporate  bonds  are  not  susceptible  of  valuation  at 
March  i,  1913,  for  the  purposes  of  establishing  gain  or  loss 
from  sale  or  exchange.^" 

Profit  on  purchase  by  corporation  of  its  own  stock  not 
taxable. — Corporations  sometimes  purchase  their  own  stock  at 
a  price  less  than  par  value.  If  the  stock  is  retired  or  if  it  is 
carried  as  an  asset  on  the  corporation's  books  at  par,  the  dif- 
ference between  par  value  and  cost  should  be  credited  to  sur- 
plus account.  On  this  point  the  regulations  provide  as  fol- 
lows : 

Regulation If,  for  the  purpose  of  enabling  a  corpora- 
tion to  secure  working  capital  or  for  any  other  purpose,  the  stock- 
holders donate  or  return  to  the  corporation  to  be  resold  by  it  certain 
shares  of  stock  of  the  company  previously  issued  to  them,  or  if  the 
corporation  purchases  any  of  its  stock  and  holds  it  as  treasury  stock, 
the  sale  of  such  stock  will  be  considered  a  capital  transaction  and 
the  proceeds  of  such  sale  will  be  treated  as  capital  and  will  not 
constitute  income  of  the  corporation.  A  corporation  realizes  no  gain 
or  loss  from  the  purchase  of  its  own  stock. ^-^    ....      (Art.  543.) 


"Bulletin  27-21-1717;  A.  R.  R.  545. 

"  [Former  Procedure] 

Regulation.  "Treasury  stock,  wherever  and  whenever  that  term  is 
used  in  connection  with  the  accounts  of  the  corporation  or  for  income 
tax  purposes,  will  be  held  to  mean  stock  which  had  been  previously  issued 


FROM    BUSINESS 


525 


Ruling.  When  a  corporation  transferred  certain  assets  having  a 
book  value  in  excess  of  the  book  value  on  the  same  date  of  its  capital 
stock  acquired  by  such  transfer  and  carried  to  treasury  stock  account, 
there  took  place  a  capital  transaction  and  not  one  in  which  there  re- 
sulted a  loss  from  the  sale,  exchange,  or  other  disposition  of  property. 
(B.  51-21-1984;  A.  R.R.693.J 

Criticism  of  foregoing  regulation. — If  a  corporation 
were  to  resell  treasury  stock  at  a  profit,  as  is  frequently  done, 
there  would  be  no  real  difference  between  this  transaction 
and  one  involving  the  purchase  and  sale  of  the  shares  of  an- 
other corporation.  When  stock  is  donated  or  sold  to  a  cor- 
poration at  a  nominal  price  to  enable  the  corporation  to  secure 
working  capital  the  resale  of  the  treasury  stock  may  in  fact 
represent  capital  and  if  so  the  proceeds  of  the  sale  are  not 
properly  taxable.  But  if  the  stock  is  purchased  as  an  invest- 
ment any  resale  at  a  profit  should  be  held  to  be  a  taxable 
transaction. 

Treasury  stock — accounting  procedure. — In  order 
that  stock  may  be  considered  as  full-paid  and  non-assessable, 
and  thus  provide  a  means  whereby  it  may  be  legally  sold  by  the 
corporation  at  less  than  its  par  value  without  liability  attach- 
ing to  the  purchaser  for  the  difference  between  the  price  paid 
and  par,  arrangements  are  frequently  made  to  issue  capital 
stock  for  property  or  services  in  an  amount  in  excess  of  the  ac- 
tual cash  value  of  such  property  or  services.  A  part  of  such 
stock  is  then  "donated"  to  the  corporation  and  is  thereafter 
dealt  Vk'ith  as  "treasury  stock."  When  sold,  the  proceeds  are 
sometimes  treated  as  income,  but  the  usual  and  proper  dis- 
position is  to  credit  an  account  called  "Capital  surplus"  or 


by  the  corporation  and  which  had  been  repossessed  by  it  through  purchase 
or  otherwise  and  then  carried  on  its  books  as  an  asset.  If  such  stock  is 
resold  at  a  price  in  excess  of  its  cost  upon  repossession,  such  excess  shall 
be  returned  as  income  for  the  year  in  which  resold.  Unissued  stock,  which 
had  been  retained  by  the  corporation  for  the  purpose  of  future  sale,  will 
not,  for  the  purpose  of  the  income  tax,  be  considered  'Treasury  stock' 
and  when  sold  no  part  of  the  proceeds  of  such  sale  will  be  considered 
taxable  income.  Nor  will  there  be  any  deductible  loss  if  such  stock  is 
sold  at  a  price  less  than  par."     (Reg.  33,  1918,  Art.  98.) 


t;26  INCOME 

"Working  capital,"  or,  better  still,  to  credit  the  proceeds  di- 
rectly to  the  property  or  asset  account. 

Of  course,  the  amount  realized  for  the  donated  stock  is 
capital.  By  a  fiction,  induced  by  improper  incorporation  laws, 
it  is  made  to  appear  that  on  one  side  the  stock  is  issued  for 
value  received  at  $ioo  per  share,  and  that  on  the  other  side 
someone  who  has  paid  the  alleged  full  value  for  it  hands  it  back 
to  the  corporation  as  a  gift,  pure  and  simple.  The  courts  are 
supposed  to  go  to  the  substance  of  a  matter  and  to  ignore  the 
form;  but  it  is  questionable  if  they  should  he  asked  to  declare 
as  capital  what  a  corporation  itself  denominates  as  income. 
Therefore,  the  corporation  should  be  careful,  in  handling  the 
proceeds  of  the  sale  of  treasury  stock  on  its  1)Ooks,  to  indicate 
clearly  the  fact  that  the  so-called  income  is  actually  capital. 

Accounting  practice  is  as  follows: 

If  purchased  by  the  corporation  for  resale,  cost  price  is  the  cor- 
rect basis  of  book  entry;  if  purchased  without  specific  intention  to 
resell  and  more  than  par  is  paid,  the  premium  should  be  charged  to 
surplus.  In  effect,  part  of  the  surplus  is  paid  to  the  retiring  stock- 
holder. The  par  value  of  the  stock  purchased  should  be  deducted  on 
the  balance  sheet  from  the  total  stock  issued.  When  the  cost  is  less 
than  par,  the  purchase  price  should  be  carried  in  the  books  and  in  the 
balance  sheet  as  an  asset,  but  the  item  must  not  be  included  among 
any  other  assets.  It  is  desirable  that  the  number  of  shares  should  be 
stated.  It  is  information  which  should  be  revealed.  Many  published 
balance  sheets  do  show  all  details,  but  the  practice  is  not  uniform. 

If  acquired  by  gift,  opinions  dift'er  as  to  the  form  of  entry.  Be- 
cause of  the  legal  formalities  required  to  show  that  the  stock  has 
l)een  issued  full-paid,  the  best  authorities  sanction  the  setting  up  of 
the  stock  as  an  asset  at  par  value,  offsetting  this  entry  by  the  creation 
of  a  reserve  or  surplus  account  which  is  designated  as  a  capital  item, 
and  which  is  clearly  differentiated  from  the  surplus  which  arises  out 
of  profits  or  which  is  available  for  dividends.  It  is  never  proper  to 
include  any  part  of  the  book  value  of  treasury  stock  among  the  cur- 
rent profits  or  as  a  part  of  the  surplus  available  for  dividends.  This 
does  not  apply,  however,  if  stock  had  been  resold  at  a  profit  and  the 
profit  is  realized  in  cash.  As  treasury  stock  is  sold  or  otherwise  dis- 
posed of,  the  asset  account  is  credited  and  an  adjustment  is  made  be- 
tween this  account  and  the  reserve  or  surplus  account  for  the  differ- 
ence between  the  book  value  and  the  proceeds  of  the  sale.** 

^* Anditiii;!,  Tlieury  ami  Practice  (1921  edition),  by  R.  H.  Montgomery, 
pages  206-207. 


FROM    BUSINESS  527 

The  Treasury  now  requires  "copies  of  the  journal  entries 
covering  the  original  issuance,  repossession  and  any  subse- 
quent adjustments,"  if  treasury  stock  was  "on  hand  at  any 
time  during  the  taxable  period.""**^ 

Discount  for  cash  not  taxable. — 

Ruling.  Reference  is  made  to  your  letter  of  the  15th  instant,  in 
which  you  state  that  a  corporation  has  purchased  a  large  quantity  of 
equipment  and  in  consideration  of  making  a  prompt  payrrient  there- 
for has  been  allowed  a  cash  discount.  You  ask  to  be  advised  whether 
or  not  this  discount  should  be  reported  as  income. 

In  reply  you  are  informed  that  the  discount  allowed  to  the  cor- 
poration purchasing  this  new  equipment  need  not  be  reported  as 
income,  but  the  cost  of  the  equipment  as  charged  to  capital  must 
represent  only  the  net  cost  after  making  allowance  for  the  discount 
in  question.  (Letter  to  E.  G.  Shorrock  &  Co.,  Seattle,  Washington, 
signed  by  Deputy  Commissioner  L.  F.  Speer,  and  dated  November 
26,  1918.) 

This  ruling  is  in  accord  with  what  the  author  believes  to 
be  good  accounting  practice,®"  but  opinion  on  the  point  is 
divided. 

Income  from  Export  Business 

A  domestic  corporation  chiefly  engaged  in  buying  goods  in 
the  United  States  and  shipping  them  to  foreign  countries  and 
there  selling  them,  having  been  taxed  upon  its  corporate  income 
from  all  sources,  sued  to  recover  that  proportion  of  the  tax 
compulsorily  paid  which  its  foreign  business  bore  to  its  whole 
trade,  upon  the  ground  that  a  tax  on  income  derived  from  the 
profitable  sale  of  exported  articles  was  a  taj^  on  the  articles 
so  exported,  and  therefore  unconstitutional.  The  Supreme 
Court  of  the  United  States  (May  20,  1918),  in  holding  that 
the  corporation  was  taxable  upon  its  entire  income,  used  the 
following  language.^' 


""^  Instructions  page  2,  schedule  E  10,   form   luo. 

"Auditing,  Theory  and  Practice  (19.21  edition),  by  R.  H.  Montgomery, 
page  587. 

'"  Peck  and  Co.  v.  Lowe,  247  U.  S.  165,  38  S.  Ct.  43J,  62  L.  Ed.  1049. 


5-^« 


INCOME 


Decision It  (the  income  tax)  is  not  laid  on  articles  in 

course  of  exportation  or  on  anything  which  inherently  or  hy  the  usages 
(if  commerce  is  embraced  in  exportation  or  any  of  its  processes.  On  the 
contrary,  it  is  an  income  tax  laid  generally  on  net  incomes.  And 
while  it  cannot  be  applied  to  any  income  which  Congress  has  no 
power  to  tax  (see  Stanton  v.  Baltic  Mining  Co.),  it  is  both  nominally 
and  actually  a  general  tax.  It  is  not  laid  on  income  from  exportation 
because  of  its  source,  or  in  a  discriminative  way,  but  just  as  it  is 
laid  on  other  income.  The  words  of  the  act  are  "net  income  arising 
or  accruing  from  all  sources."  There  is  no  discrimination.  At  most, 
exportation  is  affected  only  indirectly  and  remotely.  The  tax  is 
levied  after  exportation  is  completed,  after  all  expenses  are  paid  and 
losses  adjusted,  and  after  the  recipient  of  the  income  is  free  to  use 
it  as  he  chooses. 

Sales  covered  by  open  drafts. — Many  exporting  firms  at 
the  close  of  1920  had  made  sales  to  customers  in  foreign  coun- 
tries. In  view  of  many  cases  of  refusal  to  accept  shipments, 
the  question  arises  whether  or  not  to  report  the  profit  on  such 
sales  as  taxable  income  when — 

1.  Drafts  are  due  but  consignee  has  not  accepted. 

2.  The  goods  are  in  transit  and  advices  are  not  due. 

Proper  procedure  is  to  treat  the  sales  as  not  completed  and 
to  inventory  such  goods  at  cost  or  market  value,  whichever 
is  lower,  on  the  spot  where  they  happen  to  be.  However, 
drafts  accepted  and  advices  received  up  to  the  time  of  filing 
the  tax  return  should  be  included  as  sales  and  deducted  from 
the  inventory. 

Income  from  Government  Contracts 

The  1 92 1  law  re-enacts  the  provision  of  the  19 18  law 
which  differentiates  in  several  particulars  between  net  income 
from  business  in  general  and  net  income  derived  from  govern- 
ment contracts.     The  latter  term  is  defined  thus : 

Law.  Section  2.  ....  (11)  The  term  "Government  contract" 
means  (a)  a  contract  made  with  the  United  States,  or  with  any  depart- 
ment, bureau,  officer,  commission,  board,  or  agency,  under  the  United 
States  and  acting  in  its  behalf,  or  with  any  agency  controlled  by  any 


FROM    BUSINESS 


529 


of  the  above  if  the  contract  is  for  the  benefit  of  the  United  States,  or 
(b)  a  subcontract  made  with  a  contractor  performing  such  a  contract 
if  the  products  or  services  to  be  furnished  under  the  subcontract  are 
for  the  benefit  of  the  United  States.  The  term  "Government  contract 
or  contracts  made  between  April  6,  1917,  and  November  11,  1918,  both 
dates  inclusive"  when  applied  to  a  contract  of  the  kind  referred  to  in 
clause  (a)  of  this  subdivision,  includes  all  such  contracts  which,  al- 
though entered  into  during  such  period,  were  originally  not  enforce- 
able, but  which  have  been  or  may  become  enforceable  by  reason  of 
subsequent  validation  in  pursuance  of  law.^^ 

The  purpose  in  earmarking  income  from  government  con- 
tracts was  to  place  upon  it  in  years  after  1918  a  heavier  burden 
of  tax  than  that  imposed  upon  income  not  derived  from  war 
activity.  The  1918  profits  tax  rates  apply  to  such  income 
if  received  in  1921. 

Most  of  the  rulings  issued  by  the  Treasury  on  specific  cases 
have  involved  the  question  of  time,  i.  e.,  was  there  a  contract 
in  force  between  the  dates  specified  in  the  law,  viz.,  April  6, 
1917,  and  November  11,  1918?  This  is  a  legal  question,  and 
the  Treasury's  conclusions  in  each  case  are  susceptible  to  re- 
vision by  the  courts. 

The  Treasury  has  also  ruled^''  that  so-called  "order  con- 
tracts" on  which  the  work  was  done  by  order  of  the  President 
under  the  Naval  Appropriation  Acts  of  March  4,  191 7,  and 
July  I,  1918,  are  "government  contracts."  This  ruHng,  how- 
ever, is  open  to  serious  question, °°  and  will  no  doubt  be  con- 
tested in  the  courts. 

Ruling.  A  corporation  which  contracted  with  another  corpora- 
tion to  manufacture  and  deliver  machinery  to  be  used  in  manufac- 
turing ammunition,  but  did  not  produce  or  furnish  ammunition  or 
any  component  part  thereof,  nor  perform  any  direct  service  in  con- 
nection with  tlie  production  of  ammunition  manufactured  by  another 
corporation  under  contract  for  the  United  States  Government,  is  not  a 
subcontractor  within  the  meaning  of  Section  i.  Revenue  Act  of  1918. 
(C.  B.  2,  page  12;  O.  D.  359.) 


*'  For   method   of   allocating   income    from   government   contracts,  and 
computation  of  tax  thereon,  see  Excess  Profits  lax  Procedure.  1921. 
"  C.  B.  2,  page  13 ;  O.  D.  477. 
•"See  Excess  Profits  Tax  Procedure,  1921. 


330  INCOME 

Supplemental  contracts  held  to  be  government 
contracts. 

Ruling.  Supplemental  contracts  made  with  a  department  of  the 
United  States  Government  after  November  ii,  1918,  modifying  orig- 
inal contracts  entered  into  between  April  6,  1917,  and  November  li, 
1918,  between  the  same  parties,  are  "Government  contracts"  entered 
into  between  April  6,  1917.  and  November  11,  1918,  within  the  meaning 
of  the  Revenue  Act  of  1918  and  the  income  therefrom  is  taxable  under 
section  301  (c)  of  the  above  Act.    (I-2-16;  Sol.  Op.  128.) 

Form  of  contract  not  enforcible. — 

Ruling.  A  contract  between  the  Government  and  a  corporation 
which  was  entered  into  and  enforceable  against  the  corporation  prior 
to  April  6,  1917,  but  which  was  not  executed  in  the  form  prescribed 
by  section  3744,  Revised  Statutes,  so  as  to  become  enforceable  against 
the  Government  until  after  that  date,  is  not  a  "Government  contract" 
within  the  meaning  of  that  term  as  defined  in  the  Revenue  Act  of 
19 18,  and  the  corporation  will  not  be  required  to  compute  its  tax 
upon  the  profits  arising  therefrom  in  accordance  with  section  301  (c) 
of  that  act.     (C.  B.  2.  page  13:  O.  D.  412.) 

Corporations  subsidiary  to  or  affiliated  with  others. — The 

1 92 1  law  provides  that  corporations  which  are  affihated  shall 
make  consolidated  returns^^  for  192 1  "subject  to  the  same 
conditions  as  provided  by  the  Revenue  Act  of  1918."  Under 
the  1918  law  [section  240  (b)]  an  affiliated  corporation,  50 
per  cent  of  whose  gross  income  was  derived  from  government 
contracts,  is  denied  the  privilege. 

1 9 18  Law.  Section  240.  (a)  That  corporations  which  are  af- 
filiated ....  shall  ....  make  a  consolidated  return  .  .  .  .  : 
Provided,  That  there  shall  be  taken  out  of  such  consolidated  net  income 
and  invested  capital,  the  net  income  and  invested  capital  of  any  such 
affiliated  corporation  organized  after  August  i,  1914,  and  not  successor 
to  a  then  existing  business,  50  per  centum  cr  more  of  whose  gross  in- 
come consists  of  gains,  profits,  commissions,  or  other  income,  derived 
from  a  Government  contract  or  contracts  made  betv/een  April  6,  1917, 
and  November  11,  1918,  both  dates  inclusive.  In  such  case  the  cor- 
poration so  taken  out  shall  be  separately  assessed  on  the  basis  of  its 
own  invested  capital  and  net  income  and  the  remainder  of  such  affil- 
iated group  shall  be  assessed  on  the  basis  of  the  remaining  consolidated 
invested    capital    and   net   income 

"  Section  240  (c). 


FROM    BUSINESS 


531 


Corporations  in  great  numbers  placed  their  facilities  un- 
reservedly at  the  disposal  of  the  government.  Because  cer- 
tain corporations  were  guilty  of  actual  and  despicable  profi- 
teering, there  is  no  justification  for  a  general  penalty  which  will 
reach  many  corporations  which  deserve  credit  rather  than  pun- 
ishment. The  guilty  ones  should  be  punished  in  some  other 
way. 

Ruling.  The  income  of  affiliated  corporations  which  is  derived 
from  Government  contracts  is  taxable  (except  as  provided  in  sec. 
240(a)  of  the  Revenue  Act  of  1918)  upon  the  basis  of  the  total 
sum  received  from  that  source  by  the  group  and  not  upon  the  basis  of 
the  separate  amount  received  by  each  corporation.  (Also  Art.  635.) 
(C.  B.  2,  pag-e  226;  O.  D.  415.) 

Beginning  with  January  i,  1922,  affiliated  corporations 
may  make  either  separate  returns  or  a  consolidated  return. 
Since  the  higher  rate  of  tax  imposed  on  government  contract 
income  is  for  excess  and  war  profits  tax  only,  and  the  profits 
tax  is  repealed  as  of  December  31,  1921,  the  "government  con- 
tract" provisions  will  not  affect  income  received  in  1922  and 
subsequent  years. 

May  not  qualify  as  a  personal  service  corporation. — The 
privilege  of  qualifying  as  a  personal  service  corporation  (which 
means  reporting  as  a  partnership)  is  denied  to  a  corporation, 
under  certain  circumstances. 

Law.  Section  200 (5)  The  term  "personal  service  cor- 
poration" ....  does  not  include  ....  any  corporation  50  per 
centum  or  more  of  whose  gross  income  consists  ....  (2)  of  gains, 
profits,  commissions,  or  other  income,  derived  from  a  Government  con- 
tract, or  contracts  made  between  April  6,  191 7,  and  November  11,  1918, 
both  dates  inclusive 

Amortization  allowances  should  be  credited  to  plant  ac- 
counts.®'— 

Regulation iVU   allowances   made  to  a  taxpayer  by  a 

""  [Former  Procedure]    Article  181  of  Rogulatioiis  45  reads  as  follows: 
Regulation.  "  .  .  .  .  All    allowances    made   to   a   taxpayer   by   a    con- 
tracting department   of   the   Government,   or   by   any   other   contractor,   for 


532  INCOME 

contracting  department  of  the  Government,  or  by  any  other  con- 
tractor, for  amortization,  specifically  as  such,  shall  be  treated  as  a 
reduction  of  the  cost  of  the   taxpayer's   plant   investment.     Further 

amortization  is  allowable  only  in  respect  of  such  reduced  cost 

(Art.  i8i.) 

The  foregoing  regulation  is  sound  and  is  in  accord  with 
good  accounting  and  business  methods.  It  reflects  the  actual 
procedure  of  most  taxpayers. 

The  method  of  determining  the  proper  deduction  for 
amortization  is  fully  discussed  in  Chapter  XXXII,  "Deduc- 
tions for  Extraordinary  Obsolescence  and  Amortization." 

Former  procedure  has  been  materially  modified  by  the  new 
regulations.  Such  items  as  claims  for  compensation  under 
canceled  government  contracts  constitute  income  for  the  year 
in  which  they  are  allowed  or  their  value  is  otherwise  definitely 
determined. 

Regulation.  Gains,  profits  and  income  are  to  be  included  in  the 
gross  income  for  the  taxable  year  in  which  they  are  received  by  the 
taxpayer,  unless  they  are  included  when  they  accrue  to  him  in  ac- 
cordance with  the  approved  method  of  accounting  follow^ed  by  him. 
A  person  may  sue  in  one  year  on  a  pecuniary  claim  or  for  property, 
but  money  or  property  recovered  on  a  judgment  therefor  rendered  in 
a  later  year  would  be  income  in  that  year,  assuming  that  it  would 
have  been  income  in  the  earlier  year  if  then  received.  This  is  true 
of  a  recovery  for  patent  infringement.  Bad  debts  or  accounts 
charged  off  subsequent  to  March  i,  1913,  because  of  the  fact  that  they 
were  determined  to  be  worthless,  which  are  subsequently  recovered, 
whether  or  not  by  suit,  constitute  income  for  the  year  in  which  re- 
covered, regardless  of  the  date  when  the  amounts  were  charged  off. 
Such  items  as  claims  for  compensation  under  canceled  Government 
contracts  constitute  income  for  the  year  in  which  they  are  allowed 
or  their  value  is  otherwise  definitely  determined.      (Art.   51.) 

The  foregoing  procedure  now  accords  with  practice  re- 
garding similar  claims. 


amortization,  or  fall  in  the  value  of  property,  whether  such  allowances  were 
made  as  a  part  of  the  price  of  the  product  or  in  settlement  of  claims  aris- 
ing out  of  the  cancellation  or  termination  of  contracts,  shall  be  included  in 

gross  income "     (Reg.  45,  Art.  181.) 

The  regulation  was  misunderstood  and  occasioned  much  difficulty. 


FROM  businp:ss 


533 


[Former  Procedure] 

Government  contract  adjustments. — 

Regulation.  ".  .  .  .  In  view  of  the  unusual  conditions  prevailing  at 
the  close  of  the  year  1918  it  is  recognized  tliat  many  items  of  gross  income, 
such  as  claims  for  compensation  under  cancelled  contracts,  together  with 
claims  against  contracting  departments  of  the  Government  for  amortiza- 
tion and  other  matters,  while  properly  constituting  gross  income  for  the 
taxable  year  1918  were  undecided  and  not  suflficiently  definite  in  amount  to 
be  reported  in  the  original  return  for  that  year.  In  every  such  case  the 
taxpayer  should  attach  to  his  return  a  full  statement  of  such  pending  claims 
and  other  matters,  and  when  the  correct  amount  of  such  items  is  ascertained 
an  amended  return  for  the  taxable  year  1918  should  be  filed."  (Reg.  45, 
Art.  52.) 

At  the  end  of  1918,  many  taxpayers  having  claims  against  the  gov- 
ernment were  unable  to  evaluate  such  claims  because  of  the  inability 
of  government  representatives  to  state  the  basis  of  settlement.  This 
does  not  refer  to  claims  wliich  were  disputed  by  the  government,  but  to 
claims  which  were  admitted  to  be  due. 

If  a  contractor  included  in  gross  income  for  1918  a  larger  or  smaller 
amount  as  due  from  the  government  than  has  been  actually  collected, 
the  book  profit  or  loss  shown  in  1919  is  in  soine  cases  not  an  actual 
profit  or  loss,  but  represents  a  mere  adjustment  of  an  estimate  as  of 
December  31,  1918.  In  such  cases  tlie  proper  procedure  is  to  file  an 
amended  return  for  1918. 

The  Treasury,  however,  must  be  consistent.  If  it  insists  on  reopen- 
ing returns  for  1918  in  order  to  write  back  additional  profits,  when  such 
profits  have  been  determined  in  subsequent  years,  it  must  also  allow 
the  reopening  of  19^7,  iQiS  or  1919  returns  when  subsequent  determina- 
tion proves  that  excessive  profits  were  returned  in  one  or  more  of 
those  years.  It  is  of  course  obvious  that  there  is  a  limit  to  the  reopen- 
ing of  old  returns,  otherwise  taxpayers  and  the  government  would 
indulge  in  a  never-ending  competition.  Books  of  account  are  closed, 
and  always  have  been  closed,  on  estimates  which  are  more  or  less  in- 
accurate. A  reopening  is  justified  only  when  a  mistake  has  been  made. 
and  the  obligation  upon  a  taxpayer  to  reopen  when  a  mistake  is  dis- 
covered is  the  same  whether  it  means  additional  tax  or  less  tax.  The  reopen- 
ing of  accounts  for  the  purpose  of  recomputing  inventories  is  much  more  rea- 
sonable than  a  requirement  that  accounts  for  1918  be  reopened  in  order  to 
include  as  income  disputed  claims  against  the  government. 

It  may  be  expected  that  the  foregoing  procedure  will  be  modified  in 
the  light  of  article  51,  Regulations  62,  although  many  additional  assess- 
ments have  been  made  on  the  basis  of  the  old  regulations.  Taxpayers 
should  ask  for  reconsideration  when  excessive  assessments  have  been  made. 

In  a  recent  case,  the  Treasury  at  first  denied  a  loss  in  1919  because  of 
a  government  contract  adjustment  made  in  1920,  but  subsequently  permitted 
the  reopening  of  the  1919  return  and  the  reduction  of  the  1919  income  from 
Government  contract  because  of  its  "tentative"  character. 

Ruling.  "  .  .  .  .  The  Committee  is  of  the  opinion  that  the  loss  result- 


534  INCOME 

ing  from  the  company's  claim  was  due  more  to  an  overestimated  charge 
tentatively  set  up  on  the  books  of  the  company,  and  that  any  subsequent 
loss  sustained  on  the  account  was  more  properly  a  charge  to  surplus  when 
the  amount  of  the  settlement  was  fmally  decided.  In  this  case  it  would 
seem  that  the  company  would  have  been  perfectly  within  its  rights  in 
accordance  with  article  52,  Regulations  45,  if  it  had  withheld  from  its 
return  for  the  fiscal  year  ended  June  30,  1919.  the  full  amount  of  its  claim 
against  the  Government  pending  a  final  settlement,  which  it  was  known 
would  be  definitely  decided  at  a  later  date  by  the  District  Claims  Board.  It 
would  seem,  therefore,  that  the  disallowance  of  the  loss  resulting  from  an 
erroneous  charge  in  191 8  would  be  a  discrimination  against  the  company 
and  a  penalty  for  the  apparent  good  faith  displayed  in  including  as  a  tax- 
able profit  an  amount  which  at  the  lime  of  filing  its  return  was  unquestion- 
ably in  doubt "     (B.  48-21-1948:  A.  R.  R.  685.) 

The  Treasury  also  stated  that  "all  claims  in  the  final  analysis  were  more 
or  less  tentative  and  subject  to  a  revision  by  the  government. 


CHAPTER    XVI 

INCOME  FROM  SALES  AND  EXCHANGES   OF 
SECURITIES  AND  OTHER  PROPERTY 

To  determine  the  amount  subject  to  tax  in  the  case  of 
an  appreciation  of  property,  a  comparison  must  be  made  be- 
tween the  value  as  established  at  the  beginning  of  the  period, 
and  the  value  at  the  end  of  the  period  as  established  by  the 
price  for  which  the  property  is  sold  or  exchanged. 

If  an  exchange  of  property  for  other  property  results  in 
a  continuing  transaction,  no  gain  or  loss  occurs  at  the  time; 
if  the  transaction  is  closed  it  is  taxable  or  not  taxable,  depend- 
ing on  the  bases  of  value  and  their  application  to  the  closed 
transactions;  these  bases  will  be  discussed  in  Chapter  XVII. 
The  following  sections  of  the  192 1  law  deal  with  exchanges 
of  property  for  other  property. 

Law.     Section  202 (c)  For  the  purposes  of  this  title,  on 

an  exchange  of  property,  real,  personal  or  mixed,  for  any  other  such 
property,  no  gain  or  loss  shall  be  recognized  unless  the  property  re- 
ceived in  exchange  has  a  readily  realizable  market  value;  but  even 
if  the  property  received  in  exchange  has  a  readily  realizable  market 
value,  no  gain  or  loss  shall  be  recognized — 

(i)  When  any  such  property  held  for  investment,  or  for  produc- 
tive use  in  trade  or  business  (not  including  stock-in-trade  or  other 
property  held  primarily  for  sale),  is  exchanged  for  property  of  a  like 
kind  or  use; 

(2)  When  in  the  reorganization  of  one  or  more  corporations  a 
person  receives  in  place  of  any  stock  or  securities  owned  by  him, 
stock  or  securities  in  a  corporation  a  party  to  or  resulting  from  such 
reorganization.  The  word  "reorganization,"  as  used  in  this  para- 
graph, includes  a  merger  or  consolidation  (including  the  acquisition 
by  one  corporation  of  at  least  a  majority  of  the  voting  stock  and 
at  least  a  majority  of  the  total  number  of  shares  of  all  other  classes 
of  stock  of  another  corporation,  or  of  substantially  all  the  properties 
of  another  corporation),  recapitalization,  or  mere  change  in  iden- 
tity, form,  or  place  of  organization  of  a  corporation  (however  ef- 
fected) ;  or 

535 


536  INCOME 

(3)  When  (A)  a  person  transfers  any  property,  real,  personal  or 
mixed,  to  a  corporation,  and  immediately  after  the  transfer  is  in  con- 
trol of  such  corporation,  or  (B)  two  or  more  persons  transfer  any  such 
property  to  a  corporation,  and  immediately  after  the  transfer  are  in 
control  of  such  corporation,  and  the  amounts  of  stock,  securities,  or 
both,  received  by  such  persons  are  in  substantially  the  same  propor- 
tion as  their  interests  in  the  property  before  such  transfer.  For  the 
purposes  of  this  paragraph,  a  person  is,  or  two  or  more  persons  are, 
"in  control"  of  a  corporation  when  owning  at  least  80  per  centum  of 
the  voting  stock  and  at  least  80  per  centum  of  the  total  number  of 
shares  of  all  other  classes  of  stock  of  the  corporation 

What  Constitutes  a  Closed  Transaction? 

When  an  outright  sale  is  made  for  cash  no  problem  exists ; 
but  transactions  vary  by  imperceptible  degrees  from  the  out- 
right sale  for  cash  through  various  sorts  of  trades  and  ex- 
changes to  the  transaction  in  which  the  property  is  too  indefi- 
nitely valued  to  afford  a  basis  for  claiming  that  a  "realization" 
has  been  made.  It  is  here  that  serious  problems  of  procedure 
arise.  When  is  a  sale  a  true  sale  in  the  sense  oi  being  a 
closed  transaction  rather  than  merely  a  continuing  one? 

Previous  attempts  of  the  Treasury  to  answer  this  question 
have  been  conspicuously  unsuccessful.  The  1921  law  pro- 
vides two  definite  tests.  In  order  to  constitute  a  closed  and 
taxable  transaction  the  property  received  in  exchange  must 
have : 

1.  A  readily  realizable  market  value,  and 

2.  A  different  form  or  use. 

Therefore,  exchanges  of  like  property,  or  of  securities  in 
the  reorganization^  of  corporations,  are  continuing  transac- 
tions, in  which  there  is  as  yet  no  taxable  gain  or  deductible  loss. 

Regulation.  Gain  or  loss  arising  from  the  acquisition  and  sub- 
sequent disposition  of  property  is  realized  only  when  as  the  result  of 
a  transaction  between  the  owner  and  another  person  the  property  is 
converted  into  other  property  (a)  that  is  essentially  different  from 
the  property  disposed  of,  and  (b)  that  has  a  readily  realizable  market 
value (Art.   1564.) 


'  For   full  discussion  of  reorganizations,  see  page  557. 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       537 

(i)   Property   received  in  exchange   must  have   a  readily 

reaHzable  market  value. — The  exchange  of  property  sections 

of  the  1 92 1  law  may  be  regarded  as  interpretative  of  former 

laws  rather  than  as  expressing  new  principles   of   taxation. 

In  the  1918  law^  appear  the  words:     "The  equivalent  of  cash 

to  the  amount  of  its  fair  market  value,  if  any."     The  average 

man  sees  no  distinction  between  these  words  and  the  language 

of  the  new  law. 

Law.  Section  202.  .  .  .  .  (c)  For  the  purposes  of  this  title, 
on  an  exchange  of  property,  real,  personal  or  mixed,  for  any  other 
such  property,  no  gain  or  loss  «hall  be  recognized  unless  the  property 
received   in   exchange   has   a   readily   realizable   market  value;  .... 

Reciui.ation Property  has  a   readily   realizable  market 

value  if  it  can  be  readily  converted  into  an  amount  of  cash  or  its 
equivalent  substantially  equal  to  the  fair  value  of  the  property.  In 
other  words,  the  property  received  in  exchange  must  be  readily 
marketable  at  substantially  its  fair  value  in  order  that  a  gain  or  loss 
he  recognized.  Property  which  is  regularly  traded  in  in  a  public 
market  has  a  readily  realizable  market  value  in  the  quantities  reg- 
ularly traded  in.  Property  may  be  salable,  as  in  the  case  of  a  forced 
sale  or  in  exceptional  quantities,  without  having  a  readily  realizable 
market  value.  Stock  in  a  close  corporation  may  or  may  not  have  a 
readily  realizable  market  value,  depending  upon  all  the  facts  in  each 
particular  case.  The  question  whether  property  has  a  readily  realiz- 
able market  value,  and  if  so  the  amount  thereof,  is  one  of  fact  to  be 
determined  in  each  case  in  the  light  of  all  the  surrounding  circum- 
stances ;  and  attention  should  be  called  in  the  return  to  each  exchange 
effected  during  the  taxable  year  about  which  there  could  be  any 
doubt.     (Art.  1564.) 

The  first  test  stated  in  the  law  is  a  simple  one,  and  the 
words,  "readily  realizable  market  value,"  should  be  strictly 
construed  in  favor  of  the  taxpayer  as  w'ould  reasonably  have 
been  expected  under  the  1918  law.^ 

Some  of  the  court  decisions  go  so  far  as  to  say  that  gains 
or  income  must  be  realized  in  cash  before  they  can  be  taxed, 


^  See  section  202   (b),  page  569. 

'  [Former  Procedure]  Under  the  1918  and  prior  laws  the  Treasury 
held  that  many  transactions  were  closed  (and  therefore  taxable)  which 
were  not  so  under  any  reasonable  interpretations  of  the  laws.  For  prior 
laws,  regulations  and  rulings,  and  comments  thereon,  see  Income  Tax  Pro- 
cedure, 1921,  pages  434-485. 


538 


INCOME 


but  it  is  not  necessary  to  go  so  far.  Taxpayers  will  be  content 
if  the  actual  income  and  not  the  unrealized  income  should  be 
taxed.  It  might  be  urged  that  if  a  taxpayer  were  permitted  to 
continue  to  exchange  or  trade  securities  which  are  not  readily 
realizable  without  being  required  to  report  such  transactions 
for  income  tax,  he  might  in  the  course  of  time  run  up  a  "shoe- 
string" to  a  million  dollars  without  having  paid  a  cent  of  tax 
thereon.  This  is,  of  course,  true,  but  such  a  person  would  be 
in  no  more  favorable  position  than  the  person  whose  property 
appreciates  to  a  like  degree  without  being  exchanged  back  and 
forth  from  hand  to  hand. 

The  1 92 1  law  effects  a  compromise  and  taxes  gains  when 
the  property  exchanged  has  "a  readily  realizable  market  value," 
and  is  not  "of  a  like  kind."  An  exception  is  also  made  in  the 
case  of  reorganization.*  The  author's  contention  is  that  this 
value  should  be  something  more  definite  than  a  guess  or  even  a 
value  imputed  from  an  occasional  market  quotation  for  similar 
property.     The  tax  should  rest  upon  a  suljstantial  foundation. 

Stating  the  rule  affirmatively,  it  is  held  that  an  exchange 
will  be  taxable  (if  the  securities  or  other  property  received 
are  worth  more  than  cost  or  March  i,  191 3.  value)  when 
(a)  the  exchange  is  into  property  essentially  different  from 
the  property  disposed  of,  and  (b)  where  there  is  a  readily 
realizable  market  value.     Both  factors  must  he  present.'^ 

In  discussing  additional  articles  of  the  regulations  it  is 
most  important  to  keep  in  mind  the  basic  principles  involved. 
Unless  readily  realizable  market  value  can  be  ascribed  to  what 
is  received,  the  property  received  need  not  be  evaluated  at  the 
time  of  exchange.  An  account  receivable,  contract,  agree- 
ment, option  or  similar  undertjlking  ui)t)n  which  a  suit  at  law 
can  be  maintained,  if  it  has  a  market  value,  as  options  fre- 
quently have,  might  be  taxable.  If  it  could  not  be  transferred 
or  hypothecated,  it  could  hardly  be  said  to  have  a  readily 
realizable  market  value. 


I  See  page  557. 
"  Section  202. 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY 


539 


Meaning  of  "readily  realizable  market  value." — A  full  dis- 
cussion of  the  meaning  of  the  term  "fair  market  value  or  value 
March  i,  1913,""  appears  elsewhere  and  need  not  be  repeated 
here. 

In  article  1564,  the  term  "fair  value"  is  used  as  a  measure 
by  which  to  determine  whether  a  conversion  is  into  property 
having  a  "readily  realizable  value."  The  terms  "fair  value," 
"market  value"  and  "fair  market  value"  have  been  used  by 
the  Treasury  in  many  cases  interchangeably. 

In  dealing  with  the  problem  under  the  1918  law  the  obvious 
purpose  of  the  successive  changes  in  the  regulations  dealing 
with  exchanges  of  property  has  been  to  make  as  many  closed 
transactions  as  possible.' 

The  use  of  the  term  "readily  realizable  market  value"  pre- 
supposes an  actual  market.  Property  may  be  of  great  value, 
but  there  may  be  no  "market"  for  it.  Central  Park  in  New 
York  and  the  Treasury  Department  Building  in  Washington 
certainly  are  valuable,  but  there  is  -no  market  for  them.  There 
is  no  willing  buyer  and  no  walling  seller. 

The  framers  of  the  law  do  not  intend  that  a  tax  shall  be 
imposed  in  respect  of  the  "value"  of  the  property  received,  but 
only  in  respect  of  its  fair  market  value  when  determined  in 
the  usual  way  which  must,  however,  also  be  readily  realizable. 
Only  in  case  there  are  both  willing  buyers  and  willing  sellers  is 
there  a  fair  market  value. 

The  following  interpretation  by  the  Treasury  of  the  term 
"fair  market  value"  throws  some  light  on  what  we  may  expect 
when  it  comes  to  the  interpretation  of  "readily  realizable 
market  value." 

Ruling.  In  the  absence  of  reason  to  the  contrary  the  words,  "fair 
market  value"  must  be  given  their  ordinary  meaning.  The  expression 
■'market  value,"  either  with  or  without  adjective  "fair,"  is  a  familiar 
one  and  has  frequently  been  defined  and  explained.  Without  attempt- 
ing in  this  recommendation  to  collate  these  definitions,  it  may  be 
said  that  they  amount  in  substance  to  this,  that  the  "market  value" 


"  Sec  page  396. 

^Income  Tax  Procedure,  1921,  page  461. 


"40  INCOME 

of  property  is  the  fair  value  of  the  property  in  money  as  between 
one  who  wishes  to  purchase  and  one  who  wishes  to  sell.  It  is  not, 
however,  what  can  be  obtained  for  the  property  when  the  owner  is 
under  peculiar  compulsion  to  sell  or  the  purchaser  to  buy;  nor  is  it  a 
purely  speculative  value  which  an  owner  could  not  reasonably  expect 
to  obtain  for  the  property  although  he  might  possibly  be  fortunate 
enough  to  do  so.  "Market  value"  is  the  price  at  which  a  seller  will- 
ing to  sell  at  a  fair  price  and  a  buyer  willing  to  buy  at  a  fair  price, 
both  having  reasonable  knowledge  of  the  facts,  will  trade.  It  im- 
plies the  existence  of  a  public  of  possible  buyers  at  a  fair  price.  The 
adjective  "fair"  emphasizes  the  idea  of  fairness  inherent  in  this 
conception  of  market  value,  and  excludes  any  possibility  of  a  con- 
struction of  the  words  "market  value"  with  reference  to  a  market  in 
which,  or  to  circumstances  of  sale  under  which,  for  any  reason  a 
fair  price  could  not  be  obtained.  Under  this  interpretation  property 
received  in  exchange  for  other  property  has  no  "fair  market  value" 
for  the  purpose  of  determining  gain  or  loss  resulting  from  such 
exchange  when,  owing  to  the  condition  of  the  market,  there  can  be 
no  reasonable  expectation  that  the  owner  of  the  property,  though 
wishing  to  sell,  and  any  person  wishing  to  buy  will  agree  upon  a 
price  at  which  to  trade  unless  one  or  the  other  is  under  some  peculiar 
compulsion;  that  is,  property  has  no  "fair  market  value"  when  mar- 
ket conditions  are  such  that  there  would  be  no  trading  in  the  prop- 
erty in  question  at  a  fair  price.  It  does  not  follow,  however,  that 
property  has  no  "fair  market  value"  merely  because  there  is  no  price 
therefor  established  by  public  sales  or  sales  in  the  way  of  ordinary 
business.  The  fact  that  there  is  no  "market  price"  or  "current  price" 
so  established  does  not  indicate  that  the  property  may  not  readily  be 
sold  at  a  fair  price,  and  the  meaning  of  "market  value"  is  not  ordi- 
narily so  restricted.  The  courts  have  recognized,  not  only  that  there 
are  cases  in  which  property  has  no  "market  value,"  or  more  properly 
"market  price,"  in  this  restricted  sense,  but  also  that  there  are  cases 
in  which  property  has  no  "market  value"  in  the  broader  sense  in 
which  the  words  are  used  in  the  statute  as  herein  construed.  See 
Wall  V.  Piatt  (169  Mass.,  398);  Montgomery  County  v.  Schuylkill 
Bridge  Co.  (no  Pa.  St.,  54). 

A  construction  of  the  statute  in  which  the  words  "fair  market 
value"  are  defined  as  above  indicated  is  in  accord  with  its  theory 
and  purpose.  A  fundamental  consideration  in  income  taxation  is 
to  determine  when  income,  or  elements  essential  to  the  computation 
of  income,  such  as  gain  and  loss,  are  realized.  Clearly,  gain  or  loss 
is  realized  upon  the  sale  of  property  for  cash.  It  seems,  moreover, 
that  even  apart  from  express  statutory  provision  gain  or  loss  is 
realized  from  the  exchange  of  property  for  other  property  which 
may  fairly  be  said  to  be  the  equivalent  of  cash.  See  California  Cop- 
per Syndicate  v.  Harris  (41  Scot.  L.  R.,  691;  5  Tax  Cas.  159).    Such 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       541 

was  the  ruling  of  the  Bureau  under  the  Revenue  Acts  of  1913  and 
1916  (see  Law  Opinion,  434),  and  the  Revenue  Act  of  1918  expressly 
recognizes  this  principle  in  the  language  now  under  consideration  in 
providing  that  "the  property  received  in  exchange  shall  ....  be 
treated  as  the  equivalent  of  cash."  It  is  reasonable  to  regard  prop- 
erty which  has  a  "fair  market  value,"  as  the  words  are  herein  defined, 
as  "the  equivalent  of  cash."  A  taxpayer  receiving  such  property 
can  determine  the  amount  of  his  gain  or  loss  in  terms  of  cash  with 
a  reasonable  degree  of  certainty  and  can,  if  necessary,  without  undue 
sacrifice  obtain  by  the  sale  of  such  property  cash  with  which 
to  pay  his  taxes.  It  is,  however,  unreasonable  to  regard  property 
which  has  no  "fair  market  value,"  in  this  sense,  as  "the  equivalent 
of  cash."  A  taxpayer  receiving  such  property  can  neither  determine 
the  amount  of  his  gain  or  loss  with  certainty  nor  obtain  cash  by 
sale  of  the  property  without  sacrifice. 

It  may  be  argued  against  the  construction  here  given  to  the  words 
"fair  market  value"  that  these  words  are  used  in  other  parts  of  the 
statute  in  such  a  way  as  to  imply  that  property  always  has  a  "fair 
market  value"  and  that  the  same  meaning  should  be  given  to  the 
words  throughout  the  statute.  Thus,  in  ascertaining  gain  or  loss 
upon  the  sale  or  other  disposition  of  property  acquired  before  March 
I,  1913,  the  basis  is  "the  fair  market  price  or  value  of  such  property 
as  of  that  date"  (sec.  202(a(i)),  or,  where  stock  or  securities  ac- 
quired before  March  i,  1913,  are  exchanged  for  other  stock  or  securi- 
ties in  connection  with  a  reorganization,  merger,  or  consolidation, 
"the  fair  market  value  as  of  that  date"  (sec.  202(b)).  So  in  ascer- 
taining the  amount  of  depletion  in  the  case  of  property  acquired 
before  March  i,  1913,  the  basis  is  the  "fair  market  value  .... 
on  that  date,"  and  in  the  case  of  property  having  a  discovery  value 
the  basis  is  the  "fair  market  value  of  the  property  at  the  date  of  the 
discovery,  or  within  30  days  thereafter."  (Sec.  214(a)  (10)  ; 
234(a)    (9)-) 

The  provisions  above  quoted  raise  no  necessary  implication  that 
property  always  has  a  "fair  market  value."  The  resort  to  "fair 
market  value"  in  the  case  of  discovery  can  be  made  only  where  the 
"fair  market  value  of  property  is  materially  disproportionate  to  the 
cost";  that  is,  it  must  appear  that  the  property  has  a  "fair  market 
value"  and  that  such  value  is  materially  disproportionate  to  cost. 
There  is  no  presumption  that  either  fact  exists.  In  the  case  of  deple- 
tion of  property  acquired  before  March  i,  1913,  "fair  market  value" 
is  to  "be  taken  in  lieu  of  cost  up  to  that  date."  The  natural  con- 
struction of  this  language  is  that  "fair  market  value"  is  to  be  taken 
wherever  possible,  otherwise  "cost  up  to  that  date."  In  ascertaining 
the  gain  or  loss  resulting  from  the  sale  or  other  disposition  of  prop- 
erty the  purpose  of  valuing  such  property  on  March  i,  1913,  is  to 
determine  the  amount  which  must  be  withdrawn  from  the  sale  price 


-_^2  INCOME 

in  order  to  keep  the  capital  intact.  In  the  case  of  a  sale  or  other 
disposition  of  property,  not,  however,  including  depletion  (see  Stan- 
ton V.  Baltic  Mining  Co.,  240  U.  S.,  103),  it  would  be  necessary  to 
so  withdraw  the  value  of  the  property  on  March  i,  19 13,  even  if 
there  was  no  statutory  provision  therefor.  See  Doyle  v.  Mitchell 
Bros.  (247  U.  S.,  179)  ;  Lynch  v.  Turrish  (247  U.  S.,  221)  ;  Southern 
Pacific  Co.  V.  Lowe  (247  U.  S.,  330).  The  present  statute  must  be 
construed  as  authorizing  the  withdrawal  of  such  value.  This  result 
can  be  reached  either  by  holding  that  all  property  had  a  "fair  market 
price  or  value"  on  March  i,  1913,  or  by  holding  that  "fair  market 
price  or  value"  is  the  statutory  measure  of  the  value  to  be  with- 
drawn in  any  case  in  which  the  property  has  a  "fair  market  price  or 
value,"  but  that  where  it  has  no  such  "fair  market  price  or  value" 
other  means  of  measuring  value  must  be  resorted  to.  The  latter 
interpretation  gives  to  the  words  "fair  market  ....  value"  their 
ordinary  meaning,  and,  while  recognizing  that  they  have  the  same 
meaning  throughout  the  statute,  gives  effect  to  the  words  "if  any"  in 
the  paragraph  under  consideration.  It  seems,  therefore,  the  more 
reasonable. 

(Since  "fair  market  price,"  if  not  synonymous  with  "fair  market 
value"  is  narrower  in  its  scope,  it  seems  unnecessary  to  distinguish 
between  the  expression  "fair  market  price  or  value"  and  "fair  market 
value."  While  it  is  possible  to  construe  the  words  "fair  market"  as 
modifying  only  the  word  "price"  and  not  the  word  "value"  in  sec- 
tion 202(2),  the  use  of  the  phrase  "fair  market  value"  in  other  parts 
of  the  statute  seems  to  indicate  that  this  is  not  the  proper  construc- 
tion. It  may  be  noted,  however,  that  if  this  construction  were 
adopted  the  same  result  would  be  reached  as  is  reached  on  the  lines 
developed  in  this  recommendation.) 

Some  practical  bearings  of  the  construction  herein  given  to  the 
statute  should  be  noted.  Statements  herein  made  are,  however,  far 
from  exhaustive  of  a  subject  of  special  difficulty  in  the  application 
of  a  general  principle  to  specific  cases.  In  determining  whether 
property  has  a  "fair  market  value"  all  available  evidences  must  be 
considered.  A  case  in  which  property  has  no  "fair  market  value" 
should  be  regarded  as  unusual,  and  a  determination  that  property  has 
no  "fair  market  value"  should  not  be  made  lightly.  Property  is  not 
without  "fair  market  value"  merely  because  there  is  a  considerable 
divergence  of  opinion  as  to  its  value.  "Fair  market  value"  is  to 
a  large  extent  a  matter  of  opinion  and  men  of  equally  wise  judg- 
ment will  differ  widely  in  their  opinions.  Frequently  excellent  evi- 
dence as  to  the  "fair  market  value"  of  property,  especially  that  which, 
though  not  ordinarily  traded  in,  has  a  value  in  use,  is  found  in  its 
cost,  or  in  the  cost  of  reproducing  it,  with  adjustments  for  deprecia- 
tion and  the  like.  (It  should  be  noted,  however,  that  while  cost  is 
frequently  excellent  evidence  of  "fair  market  value,"  "fair  market 


FROM    SALES    AND    EXCHANGES    OF    PROPERTN'       343 

value"  may  be  either  greater  or  less  than  cost  and  must,  wherever 
made  the  statutory  test,  be  taken  regardless  of  its  relation  to  cost.) 
As  already  pointed  out,  property  can  not  be  said  to  have  no  "fair 
market  value"  merely  because  no  price  therefor  is  established  by  pub- 
lic sales  or  sales  in  the  way  of  ordinary  business.  Of  course  it  is  not 
essential  that  property  be  listed  or  traded  in  on  any  exchange  in 
order  that  it  may  have  a  "fair  market  value."  For  example,  stock  in 
a  small  closely  held  corporation  does  not  ipso  facto  lack  "fair  market 
value,"  nor  does  article  1563  of  Regulations  45  so  hold.  Evidence  as 
to  the  assets  and  liabilities  of  such  a  corporation  and  as  to  its  earn- 
ings may  furnish  very  definite  indications  as  to  its  "fair  market  value." 
Even  if  a  corporation  is  newly  organized  and  has  never  done  business 
as  such,  but  has  succeeded  to  the  business  of  an  individual  or  partner- 
ship, its  stock  will  ordinarily  have  a  "fair  market  value"  ascertainable 
by  reference  to  its  assets  and  liabilities,  the  history  of  the  specific 
business,  and  the  history  and  conditions  of  the  industry  in  general. 
Similar  considerations  apply  to  other  kinds  of  property. 

In  any  case  in  which  it  is  found  that  property  received  in  ex- 
change has  no  "fair  market  value"  and  that,  consequently,  no  gain 
or  loss  results  from  the  exchange,  the  property  received  in  exchange 
is  to  be  treated  as  taking  the  place  of  the  property  exchanged  therefor 
and  takes  as  its  value  for  the  purpose  of  computing  depreciation, 
depletion  and  gain  or  loss  resulting  from  sale  or  other  disposition, 
the  cost,  or  the  market  value  on  March  i,  1913,  or  on  the  date  of 
discovery,  as  the  case  may  be,  of  the  property  exchanged  for  it. 
Property  which  has  no  "fair  market  value"  for  the  purpose  of  deter- 
mining gain  or  loss  under  section  202  (b)  has  no  "fair  market  value" 
for  any  of  the  purposes  of  the  Revenue  Act  of  1918.^ 

It  is  held,  therefore,  that  section  202  (b)  of  the  Revenue  Act  of 
1918  must  be  construed  as  recognizing  that  there  are  exchanges  of 
property  for  other  property  which  do  not  result  in  taxable  gain  or 
deductible  loss  for  the  reason  that  the  property  received  in  exchange 
has  no  "fair  market  value."  A  general  statement  as  to  the  circum- 
stances under  which  this  is  true  is  made  in  the  body  of  this  recom- 
mendation.    (C.  B.  I,  page  40;  T.  B.  R.  57.) 

The  foregoing  ruling  was  issued  in  1919  at  a  time  when 
the  Treasury  was  interpreting  1918  and  prior  laws  very 
strictly.  The  provisions  of  the  192 1  law  regarding  exchanges 
are  not  essentially  different  from  the  1913,  1916  and  1917 
laws,  but  are  more  detailed.     The  ruling  is  inserted  at  this 


"  This  statement  need  not  be  considered  as  changing  the  procedure  as 
to  values  at  March  i,  1913,  because  the  law  specifically  provides  that 
"value"  at  that  date  may  control,  whereas  in  exchanges  there  must  be 
"readily  realizable  market  value." 


544  INCOME 

point  as  indicating  the  position  of  the  Treasury  under  the 
provision  of  prior  laws. 

Illustration  of  a  closed  transaction. — 

Regulation (4)   A    owns   certain   property   which   he 

transfers  to  corporation  X,  a  going  concern,  in  which  A  owns  no 
stock,  in  exchange  for  common  stock  of  the  corporation  of  the  par 
value  of  $170,000.  The  X  corporation  has  outstanding  immediately 
after  the  transfer  common  stock  of  the  par  value  of  $200,000  and 
nonvoting  preferred  stock  of  the  par  value  of  $50,000.  A  realized  a 
gain  or  loss  from  this  exchange  measured  by  the  difference  between 
the  basis  of  the  property  exchanged  and  the  fair  market  value,  if  read- 
ily realizable,  of  the  stock  received  in  the  exchange.  If  the  property 
exchanged  was  acquired  prior  to  March  i,  1913,  see  article  1561.® 
(Art.  1566.) 

Example  4 — Gain  or  Loss  Is  Imputed 

Preferred 
Common  Non-voting 

Stock  owned  before  transfer 

Stock  received  for  property   $170,000  


Total  stock  owned  after  transfer $170,000  (a)  (c) 

Total  stock  outstanding  after  transfer $200,000  (b)  $50,000  (d) 

Percentage    (a)    is  of    (b)    Ss'-.x 

Percentage    (c)    is   of    (d) 


In  the  last  illustration,  if  only  $100  of  preferred  stock 
were  outstanding,  and  the  taxpayer  owned  that  one  share,  no 
gain  or  loss  would  be  imputed  to  the  transfer  of  his  property 
to  the  corporation,  because  he  would  then  own  at  least  80  per 
cent  of  all  classes  of  stock  outstanding.  The  requirement 
that  in  addition  to  owning  80  per  cent  of  the  voting  stock  the 
taxpayer  must  also  own  "at  least  80  per  centum  of  the  total 
number  of  shares  of  all  other  classes  of  stock  of  the  corpora- 
tion," in  this  case  seems  rather  absurd.  The  language  of 
the  law  is,  however,  explicit  on  this  point  and  must  obviously 
be  complied  with  if  the  benefit  of  the  section  is  to  be  had. 

'  Sec  page  570. 


FROM  SALES  AND  EXCHANGES  OF  PROPERTY 


545 


(2)  Property  of  a  different  kind  or  use. — Congress  may  be 
said  to  have  gone  the  Hmit  in  freeing  from  tax  all  exchanges 
which  do  not  result  in  realized  income.  The  language  of  the 
law  suspending  the  determination  of  taxable  gain  or  deductible 
loss  in  the  case  of  exchanges  until  there  has  been  a  change  in 
both  form  and  substance  of  the  taxpayer's  investment,  is  broad 
and  susceptible  of  very  liberal  interpretation. 

Law.     Section  202 (c)    For  the  purposes  of  this  title,  on 

an  exchange  of  property,  real,  personal  or  mixed,  for  any  other  such 
property,  no  gain  or  loss  shall  be  recognized  unless  the  property  re- 
ceived in  exchange  has  a  readily  realizable  market  value;  but  even  if 
the  property  received  in  exchange  has  a  readily  realizable  market  value, 
no  gain  or  loss  shall  be  recognized — 

(i)  When  any  such  property  held  for  investment,  or  for  produc- 
tive use  in  trade  or  business  (not  including  stock-in-trade  or  other 
property  held  primarily  for  sale),  is  exchanged  for  property  of  a  like 
kind  or  use;  .... 

The  Treasury  regulation  construing  the  words  "like  kind" 
reads  as  follows : 

Regulation.  Where  property  is  exchanged  for  other  property, 
even  if  the  property  received  in  exchange  has  a  readily  realizable 
market  value,  no  gain  or  loss  is  recognized ; 

(a)  Where  property  held  for  investment  is  exchanged  for  other 
property  of  a  like  kind,  or  where  property  held  for  productive  use  in 
trade  or  business  is  exchanged  for  other  property  of  a  like  use, 
the  words  "like  kind"  are  defined  as  having  reference  to  the  nature 
or  character  of  the  property  and  not  its  grade  or  quality.  Therefore 
under  this  paragraph  no  gain  or  loss  is  realized  by  one  other  than  a 
dealer  from  the  exchange  of  real  estate  for  real  estate,  or  from  the 
exchange  of  evidences  of  indebtedness  (such  as  bonds  and  notes)  for 
evidences  of  indebtedness,  or  from  the  exchange  of  shares  of  stock 
for  other  shares  of  stock,  but  one  kind  or  class  of  property  may  not, 
under  this  paragraph,  be  exchanged  for  property  of  a  different  kind 
or  class,  as  shares  of  stock  for  bonds,  or  real  estate  for  personal 
property.  Where  evidences  of  indebtedness  are  exchanged  for  other 
evidences  of  indebtedness,  the  fact  that  any  of  the  evidences  of 
indebtedness  involved  in  such  exchange  are  secured  by  mortgage  or 
other  lien,  or  the  fact  that  any  real  estate  involved  in  an  exchange 
is  improved  or  unimproved  makes  no  difference,  for  such  facts  re- 
late only  to  grade  or  quality  of  the  property  and  not  to  its  kind  or 
class.  There  is  excluded  from  the  provisions  of  this  paragraph 
stock-in-trade  or  other  properly  held  primarily  for  sale.     Unproduc- 


54(3 


INCOME 


tive  real  estate  held  by  one  other  than  a  dealer,  for  future  use  or 
future  realization  of  the  increment  in  value,  is  held  for  investment 
and  not  primarily  for  sale.     (Art.  1566.) 

It  will  be  observed  from  the  foregoing  article  that  a  most 
liberal  interpretation  is  given  of  the  property  of  "like  kind" 
which  may  be  made  without  either  party  to  the  transaction 
realizing  any  taxable  income.  Taking  the  regulation  at  its 
face  value,  it  would  appear  that  United  States  Steel  stock,  for 
instance,  might  be  exchanged  for  shares  of  Pennsylvania  Rail- 
road without  any  taxable  income  resulting  therefrom,  even  if 
the  Steel  stock  had  been  purchased  years  before  at  a  very  low 
figure. 

Unsecured  notes  may  apparently  be  exchanged  for  mort- 
gage bonds  without  any  taxable  profit  (or  deductible  loss) 
arising  from  the  exchange.  Again,  unimproved  real  estate 
may  be  exchanged  for  improved  real  estate,  and  vice  versa. 

It  will  be  observed,  however,  that  the  Treasury  distin- 
guishes sharply  between  classes  of  securities,  stocks  and  evi- 
dences of  indebtedness  (bonds,  notes,  etc.)  not  being  deemed 
to  be  property  of  "like  kind."  Therefore,  an  exchange  of 
United  States  Steel  stock  for  Pennsylvania  Railroad  bonds 
would,  under  the  Treasury's  regulation,  be  deemed  a  closed 
transaction.  The  author  fails  to  see  the  logic  of  the  inhibition. 
If  it  is  not  a  taxable  transaction  to  exchange  Steel  stock  for 
Pennsylvania  Railroad  stock,  it  is  certainly  not  a  taxable 
transaction  to  exchange  certain  kinds  of  stocks  for  certain 
kinds  of  bonds.  The  distinction,  however,  would  not  apply 
in  cases  of  reorganizations  where  stock  might  be  received  in 
exchange  for  bonds  or  vice  versa,  even  though  the  securities 
received  might  have  "a  readily  realizable  market  value."  Re- 
organizations are  covered  by  a  different  subdivision  of  sec- 
tion 202  than  exchanges  of  property  of  a  "Hke  kind  or  use."^" 

The  Treasury  regulation  already  quoted  defines  only  the 
words  "hke  kind"  but  makes  no  reference  to  the  words  "or 

•"  See  page  557. 


FROM    SALES   AND    EXCHANGES    OF   PROPERTY       547 

use"  which  also  appear  in  section  202  (c-i)  of  the  law  in  the 
same  connection.  For  instance,  would  the  exchange  of  an 
automobile  for  a  horse  be  deemed  to  be  a  continuing  and  not 
a  closed  transaction  because  both  pieces  of  property  are  for 
"like   ....    use"? 

It  would  defeat  the  whole  purpose  of  an  income  tax  law 
if  taxpayers  could  exchange  readily  marketable  securities  or 
property  of  one  class  for  wholly  different  property.  The 
adoption  of  such  a  principle  would  in  such  cases  result  in  the 
disappearance  of  money  as  a  medium  of  exchange  and  the 
substitution  of  trading  or  bartering  "in  kind,"  such  as  goes  on 
in  Russia. 

Article  1566  intimates  that  real  estate  dealers  are  not 
permitted  to  exchange  one  piece  of  property  for  another 
and  to  consider  that  the  transaction  is  continuing.  This  is 
equivalent  to  stating  that  real  estate  dealers  should  inventory 
their  properties.  But  real  estate  dealers  have  not  been  per- 
mitted to  inventory  their  stock-in-trade  as  are  other  mer- 
chants; therefore  the  Treasury  is  estopped  from  treating  them 
as  dealers.^^ 

Real  estate  dealers,  like  all  other  owners  of  investment 
property,  will  be  taxed  or  not  taxed  on  exchanges,  depending 
on  the  factors  which  have  been  discussed.  The  exchange  of 
one  city  lot  for  another  city  lot  should  be  deemed  to  be  a  closed 
transaction,  when  the  property  received  has  a  readily  realiz- 
able value.  It  should  not  be  held  to  be  property  of  a  like  kind 
or  use,  any  more  than  the  shares  of  two  steel  companies  or 
two  railroad  companies  are  held  to  be  of  the  same  kind  or  use. 

One  of  the  controlling  factors  in  all  such  transactions  is 
the  intention  of  the  parties;  in  almost  all  cases  the  question: 
"Is  it  a  continuing  or  closed  transaction?"  can  be  settled  by 
easily  ascertainable  facts.  Section  202  is  eminently  fair  and  a 
reasonable  administration  of  its  provisions  will  not  result 
inequitabl}^ 


"  See  pages  486  and  545. 


548 


INCOME 


Sales  Which  May  or  May  Not  Result  in  Taxable  Gains 

In  addition  to  completed  transactions  which  are  clearly 
taxable,  there  are  other  transactions  which  may  or  may  not 
immediately  be  taxable,  depending  on  their  nature.  Some 
transactions  are  on  the  border  line,  as  discussed  in  article 
1566/"  The  following  classes  of  transactions  may  or  may 
not  be  taxable. 

When  sale  is  made  on  instalment  plan  can  tax  be  deferred? 

— In  many  cases  of  sales  of  property  the  seller  attempts  to 
arrange  that  the  proceeds  of  the  sale  shall  be  received  in  in- 
stalments over  a  period  of  years,  thus  deferring  the  imposition 
of  the  tax.  It  is  not  feasible  to  discuss  at  length  in  this 
book  arrangements  of  this  nature.  If  the  purchaser  is  not 
in  good  financial  standing,  or  the  seller  retains  title  to  his 
property,  or  the  cash  payments  are  distributed  over  a  long 
period  of  years,  the  transaction  certainly  cannot  be  considered 
as  closed.  If  the  purchaser  delivers  his  obligations  to  pay 
in  such  form  as  to  render  them  the  equivalent  of  cash,  the 
transaction  is  a  closed  one  and  a  tax  will  be  imposed  on  the 
realized  profit. 

The  owner  of  several  magazines,  who  is  said  to  have  a  net 
income  of  a  million  dollars  a  year,  purchased  a  newspaper  and 
gave  five  promissory  notes  in  payment.  The  notes  were  for 
$100,000  each  and  matured  annually  for  five  years.  The 
seller,  who  kept  his  books  on  the  accrual  basis,  entered  the 
notes  as  the  equivalent  of  cash.  In  submitting  his  balance 
sheet  to  a  federal  reserve  bank  he  was  informed  that  he 
should  not  have  included  the  notes  as  current  assets.  In  the 
circumstances  the  Treasury  could  hardly  hold  that  the  notes 
were  the  equivalent  of  cash.  In  view  of  the  rulings  appli- 
cable to  instalment  houses  and  to  sales  of  property  on  an  instal- 
ment basis,^^  taxpayers  need  not  consider  that  notes  and  other 


''See  page  545- 
'=See  Chapter  XV. 


FROM  SALES  AND  EXCHANGES  OF  PROPERTY 


549 


securities  are  the  equivalent  of  cash  unless  they  can  readily  be 
discounted  at  a  reasonable  rate  of  interest. 

If  shares  of  stock  are  sold  and  delivery  of  part  (and  pay- 
ment therefor)  are  postponed,  the  transaction  should  be 
deemed  to  be  closed  or  not  closed  depending  on  the  terms  of 
the  contract  of  sale. 

Proceeds  of  sale  of  goodwill  may  be  taxable. — When  an 
individual  or  a  partnership  sells  a  business  and  its  goodwill  is 
an  element,  part  of  the  purchase  price  i§  paid  for  goodwill, 
and  the  question  arises  as  to  the  taxable  status  of  the  vendor. 
The  question  is  not  the  same  whether  cash  or  securities  are 
received,  because  in  the  former  case  there  is  a  realization  and 
the  question  settles  down  to  the  basis  of  the  tax;  in  the  latter 
case  no  actual  realization,  as  a  rule,  takes  place. 

Assume  that  in  1921,  A  sold  his  business  to  B  for  $100,000 
cash.  The  value  of  the  net  tangible  assets  was  $50,000;  the 
balance  represented  goodwill.  A  established  the  business  in 
1913,  so  no  question  of  March  i,  1913,  value  arises.  The 
Treasury  would  certainly  tax  A  upon  a  basis  of  $50,000  real- 
ized profits,  taxable  at  1921  rates. 

If  A  sells  to  a  corporation  for  its  stock  it  can  hardly  be  ex- 
pected that  the  stock  he  receives  will  be  worth  par  value. 
Goodwill  usually  is  valued  on  a  hoped-for  basis.  Hopes  are 
not  taxable  subjects.  If  A  sells  out  to  others,  under  the  regu- 
lations he  will  be  required  to  account  for  the  fair  value  of  the 
stock  he  receives.  If  he  incorporates  his  own  business  he 
cannot  be  charged  with  receiving  something  he  did  not  have 
before.  Under  the  1921  law  [section  202  (c-3)]  the  transac- 
tion would  be  deemed  a  continuing  one  if  A  immediately  after 
the  transfer  had  80  per  cent  control  in  the  new  corporation.^^ 
The  regulations  provide  as  follows : 

Regulation.  Any  profit  or  loss  resulting  from  a  sale  of  good 
will  can  be  taken  only  when  the  business,  or  a  part  of  it,  to  which  the 
good  will  attaches  is  sold,   in   which  case  the  profit  or  loss  will   be 

'*  See  page  536. 


550 


INCOME 


determined  upon  the  basis  of  the  cost  of  the  assets,  including  good 
will.  If  the  good  will  was  acquired  prior  to  March  I,  1913,  the  tax- 
able gain  or  deductible  loss  should  be  ascertained  in  accordance  with 
the  provisions  of  article  1561.  If  specific  payment  was  not  made  for 
good  will  acquired  after  February  28,  1913,  there  can  be  no  deductible 
loss  with  respect  thereto,  but  profit  may  be  realized  from  the  sale 
of  good  will  built  up  through  expenditures  which  have  been  cur- 
rently deducted.  It  is  immaterial  that  good  will  may  never  have  been 
carried  on  the  books  as  an  asset,  but  the  burden  of  proof  is  on  the 
taxpayer  to  establish  the  cost  or  fair  market  value  on  March  i,  1913, 
of  the  good  will  sold.     (Art.  41.) 

Are  profits  on  sale  of  rights  to  subscribe  to  stock  tax-i 
able? — One  form  in  which  appreciation  in  the  value  of  prop- 
erty sometimes  asserts  itself,  is  the  privilege  given  to  a  stock- 
holder to  subscribe  to  a  new  issue  of  stock  upon  particularly 
favorable  terms.  These  "rights"  in  some  cases  undoubtedlv 
represent  an  increase  in  the  vakie  of  the  stockholder's  interest 
in  the  company,  and  under  the  19 18  regulations  the  Treasury 
attempted  to  tax  the  proceeds  of  the  sale  of  such  rights  as 
income. 

Regulation The  entire  amount  realized  from  the  sale 

of  rights  to  subscribe  for  stock  is  income.     (Art.  39.) 

The  Treasury  in  a  lengthy  opinion^^  relied  upon  the  case 
of  Tax  Commissioner  zk  Putnam,^^  but  in  a  recent  case  the 
court  pointed  out  that  that  case  was  based  on  the  theory  that 
stock  dividends  were  income  and  that  under  the  federal  law  the 
gross  proceeds  from  the  sale  of  rights  are  not  taxable." 

Decision.  There  is  apparently  only  one  case  which  has  passed 
upon  the  precise  question  here  raised.  Tax  Commissioner  vs.  Put- 
man,  227  Mass.  522.  There  the  Government's  position  was  squarely 
sustained,  as  was  natural  if  not  inevitable  after  the  Court  had  held 
that  stock  dividends  were  taxable  income,  for  while  the  returns  from 


'"C.  B.  I,  page  72. 

''227  Mass.  522. 

"  Safe  Deposit  &  Trust  Co.  of  Baltimore,  Guardian  of  Frank  R.  Brown, 
V.  Miles,  Collector,  237  Fed.  822,  U.  S.  Dist.  Ct.  for  the  Dist.  of  Maryland, 
May  26,  1921.  The  position  taken  by  the  author  had  been  that  the  proceeds 
from  sale  of  rights  was  not  all  income.  Income  Tax  Procedure,  1921, 
page  449. 


FROM    SALES    AND    EXCHANGES   OF   PROPERTY       551 

rights  are  different  things  and  may  be  income  although  such  dividends 
are  not,  the  reverse  is  scarcely  possible. 

If  the  stockholder  must  pay  an  income  tax  upon  the  full  nominal 
amount  of  a  stock  dividend,  he  can  hardly  escape  from  paying  upon 
all  he  gets  from  the  sale  of  stock  rights.  It  is  impossible  to  be  sure 
that  the  Supreme  Judicial  Court  v^^ould  have  held  the  latter  taxable, 
had  it  not  first  reached  the  conclusion  that  the  former  were.  The 
express  refusal  of  the  United  States  Supreme  Court  to  accept  the 
ruling  that  stock  dividends  were  income,  necessarily  deprives  the 
Massachusetts  case  of  persuasive  force  in  the  Federal  Courts.  Eisner 
V.  Macomber,  252  U.  S.  189-216.  The  question  must  therefore  be 
dealt  with  as  one  upon  which  there  is  no  direct  authority.  The 
reiterated  declarations  of  the  Supreme  Court  have,  however,  it  is 
believed,  made  plain  the  principles  which  should  govern  its  decision. 
What  is  taxable  is  the  gain,  profit  or  income  derived  from  the  sale 
or  dealing  in  property,  whether  real  or  personal.  39  Stat.  757;  40 
Stat.  300-307;  Goodrich  v.  Edwards,  decided  March  28,  1921. 

Congress,  it  is  true,  has  very  ample  authority  to  adjust  its  income 
taxes  according  to  its  discretion,  and  the  rules  it  prescribes  for  the 
ascertainment  of  taxable  income  are  binding  upon  the  Courts  unless 
they  are  palpably  arbitrary  and  unjust.  LaBelle  Iron  Works  v. 
The  United  States,  decided  May  16,  1921.  The  net  revenue  from  some 
peculiar  kind  of  property,  such  as  mines,  may  include  not  only  profit 
from  operation,  but  a  portion  of  the  capital  as  well.  The  problems  of 
apportionment  may  be  too  difficult  and  some  of  their  factors  too  un- 
certain for  adjustment  by  the  Courts,  and  the  tax  may  have  to  be 
assessed  upon  the  entire  net  proceeds  with  such  deductions  only  if 
any  as  Congress  may  have  authorized.  Von  Baumbach  v.  Sargent 
Land  Co.,  242  U.  S.  503.  Nevertheless  by  and  large  the  statute 
means  what  it  says,  and  that  is  that  the  tax  is  to  be  levied  on  nothing 
else  except  gains,  profits  and  income,  and  upon  them  only  when 
actually  realized  in  money  or  in  money's  worth,  and  in  determining 
what  is  included  therein,  the  Courts  will  look  through  form  to  sub- 
stance. Doyle  V.  Mitchell  Bros.  Co.,  247  U.  S.,  179;  Eisner  v.  Ma- 
comber (Supra). 

What  are  the  facts  to  which  these  general  rules  are  to  be  applied  ? 

The  shares  of  the  Hartford  Fire  Insurance  Company  were  worth 
on  March  i,  1913,  $760  apiece.  At  the  time  of  the  death  intestate  of 
the  ward's  father,  the  Government  said  that  for  the  purpose  of  the 
estate  tax,  they  were  each  of  the  value  of  $710  and  that  may  be 
taken  as  their  cost  to  the  plaintiff.  The  Insurance  Company  deter- 
mined to  double  the  numl^er  of  its  shares  and  to  give  each  of  its 
stockholders  the  right,  upon  payment  of  $150  a  share,  to  obtain  as 
many  new  shares  as  he  held  old. 

The  plaintiff  in  tlie  right  of  every  share  it  held  and  which  had 
cost  it,  as  just  mentioned,  $710,  could,  by  paying  $150  a  share  more 


552 


INCOME 


get  another,  so  that  it  would  have  two,  which  in  the  aggregate  would 
have  cost  it  $860  or  $430  apiece.  There  would  be  no  way  of  dis- 
tinguishing between  the  old  and  the  new.  If  the  latter  was  some- 
thing which  had  not  before  existed  almost  the  same  might  as  truth- 
fully be  said  of  the  former.  Its  characteristics  had  undergone  a  great 
change.  Before  the  issue  of  the  new  stock,  it  represented  one  twenty- 
thousandth  of  the  capital  of  the  company;  afterwards  it  stood  for 
but  one  forty -thousandth.  Moreover,  if  the  plaintiff  had  in  person 
taken  the  new  stock,  and  had  had  its  old  and  new  consolidated  into 
one  certificate,  and  had  subsequently  sold  a  part  of  its  holdings 
it  could  not  say  that  that  with  which  it  parted  was  out  of  the  old 
or  out  of  the  new,  or  partly  out  of  both.  In  determining  the  cost  of  its 
shares  for  the  calculation  of  the  profit  or  loss  upon  resale,  it  would  be 
necessary  to  assume  that  they  had  one  and  all  cost  the  holder  an  equal 
amount,  which  in  the  case  of  the  plaintiff  here  was  $430  a  share. 

It  certainly  could  make  no  difference  that  without  waiting  until 
the  stock  was  issued,  and  then  selling,  it  sold  the  right  to  the  new 
stock,  and  made  it  a  part  of  the  consideration  that  the  buyer  should 
assume  for  it  the  payment  of  the  $150  per  share  exacted  by  the  com- 
pany. All  that  would  have  to  be  borne  in  mind  in  comparing  the 
two  ways  of  reaching  the  same  end,  is  that  if  the  right  was  sold,  the 
price  really  received  for  the  new  share  was  $150  more  than  the  sum 
paid  to  the  seller,  which  in  the  case  at  bar  was  $358.48.  That  was 
equivalent  to  $508.48  for  a  fully-paid-for  share,  and  the  $78.48  by 
which  it  exceeded  the  $430  which  the  share  cost  the  plaintiff,  was 
the  gain  or  profit  it  made  out  of  the  transaction. 

That  is  the  whole  story.  If  $78.48  be  multiplied  by  35.  the  num- 
ber of  shares  of  rights  sold  by  the  plaintiff,  the  product  will  be 
$2,746.80,  and  upon  that  it  was  properly  taxable  and  upon  nothing 
more. 

It  still  retains  thirty-five  shares.  When,  if  ever,  they,  or  any  of 
them  are  sold,  there  must  be  returned  as  profit  in  the  year  in  which 
the  price  is  received  for  them,  the  amount,  if  any,  by  which  that  price 
exceeds  $430. 

It  is  of  course  immaterial  that  if  the  plaintiff  had  chosen  at  the 
time  it  parted  with  the  rights  to  the  other  thirty-five,  to  sell  any 
of  those  it  still  held,  it  would  have  made  a  taxable  profit  of  nearlv 
$80  a  share  upon  those  so  disposed  of.  There  is  no  tax  upon  a  profit 
until  that  profit  is  realized. 

Is  an  option  taxable? — When  a  taxpayer  receives  a  "right" 
to  subscribe  to  stock  or  other  securities  and  sells  the  right, 
the  proceeds  are  held  by  the  Treasury  to  be  income. 

When  the  right  is  not  sold  and  the  security  is  purchased 


FROM  SALES  AND  EXCHANGES  OF  PROPERTY 


553 


*io  income  is  deemed  to  accrue,  even  though  the  actual  mar- 
ket value  of  the  new  security  is  greatly  in  excess  of  the  op- 
tion price,  unless  and  until  the  security  is  subsequently  sold 
at  a  profit.  The  theory  is  that  no  gain,  profit  or  income  has 
been  realised,  and  that  the  accrual  to  the  original  investor 
is  merely  appreciation  in  value.  There  are,  however,  other 
kinds  of  rights  or  options  which  are  in  a  different  class.  If  a 
valuable  option  is  received  for  services  rendered,  it  could 
hardly  be  deemed  to  be  a  continuing  transaction. 

If  a  stockholder  sold  his  stock  for  part  in  cash  and  part 
in  an  option  to  buy  other  property  at  a  price  considerably 
less  than  its  fair  market  value,  the  option  being  assignable, 
it  might  or  might  not  be  a  closed  transaction. 

It  may  be  claimed  that  if  an  option  is  not  exercised  no 
profit  can  accrue,  and  so  long  as  the  option  has  not  been  exer- 
cised there  has  been  no  realization  and  it  is  not  a  closed  trans- 
action as  defined  by  the  regulations.  The  case  is  somewhat 
analogous  to  the  receipt,  as  the  proceeds  of  a  sale,  of  a  Liberty 
bond  or  currency, ,  which  later  was  lost  or  stolen.  The  pro- 
ceeds or  gain  of  the  sale  would  never  be  realized  in  the  sense 
of  any  permanent  advantage  to  the  taxpayer.  He  had  the 
cash,  but  he  lost  it;  and  he  had  the  option,  which  he  might 
have  sold,  but  did  not. 

Therefore,  if  an  option  can  freely  be  sold  at  the  date  of 
receipt,  it  is  probable  that  it  will  be  taxed.  Most  options, 
however,  cannot  be  deemed  to  be  the  equivalent  of  cash,  and 
the  exercise  thereof  constitutes  a  continuing  rather  than  a 
closed  transaction. 

Exchange  of  insurance  policies — calculation  of  profit. — 

Ruling.  In  determining  the  taxable  gain  arising  where  a  policy- 
holder in  a  life  insurance  company  relinquishes  a  policy  held  by 
him  and  takes  a  policy  of  another  kind  in  exchange,  it  is  held: 

Where  the  second  policy  at  the  time  of  issuance  has  no  readily 
determinable  cash  value,  no  taxable  gain  arises  from  the  exchange. 

Where  the  second  policy  at  the  time  of  issuance  has  a  readily 
determinable  cash  value,  and  the  value  of  the  surrendered  policy  as  of 


554 


INCOME 


March  i,  1913,  is  greater  than  the  gross  premiums  charged  prior  to 
that  date,  less  amounts  returned,  deducted  or  abated  therefrom,  the 
taxable  gain,  if  any,  arising  from  the  exchange  is  the  amount  whereby 
(i)  the  sum  of  the  value  of  the  surrendered  policy  as  of  March  i, 
1913,  plus  the  gross  premiums  subsequently  charged,  less  amounts 
returned,  deducted,  or  abated  therefrom,  is  exceeded  by  (2)  the 
cash,  if  any,  received  upon  surrender  of  the  first  policy,  plus  the 
cash  value  of  the  second  policy. 

Where  the  second  policy  at  the  time  of  issuance  has  a  readily 
determinable  cash  value,  but  the  value  of  the  surrendered  policy  as 
of  March  i,  1913,  is  not  greater  than  the  gross  premiums  charged 
prior  to  that  date,  less  amounts  returned,  deducted  or  abated  there- 
from, the  taxable  gain,  if  any,  arising  from  the  exchange  is  the 
amount  whereby,  (i)  the  gross  premiums  charged  at  any  time  either 
before,  on,  or  after  March  i,  1913,  less  sums  returned,  deducted,  or 
abated  therefrom,  are  exceeded  by  (2)  the  cash,  if  any,  received  upon 
the  surrender  of  the  first  policy,  plus  the  cash  value  of  the  second 
poHcy.     (C.  B.  3,  page  54;  Sol.  Op.  55.) 

Sale  of  tax-exempt  securities. — 

Ruling.  Profit  derived  from  State  and  municipal  securities  pur- 
chased at  a  discount  is  not  taxable  in  the  hands  of  the  person  holding 
such  obligations  at  maturity  except  that  in  no  case  may  such  exemp- 
tion exceed  the  total  discount  at  which  the  securities  were  originally 
sold  by  the  State  or  municipality. 

Inasmuch  as  no  person  other  than  the  municipality  can  pay  the 
interest  borne  by  the  obligations  of  the  municipality  (whether  such 
interest  is  paid  at  a  specified  rate  or  in  the  form  of  realized  dis- 
count), any  person  selling  municipal  bonds  for  an  amount  in  excess 
of  the  cost  of  the  bonds  to  him  (or  their  fair  market  value  as  of 
March  i,  1913,  if  they  were  acquired  prior  to  that  date)  realizes  a 
taxable  profit  to  the  extent  of  such  excess  amount  even  though  the 
bonds  were  issued  at  a  discount.     (C.  B.  3,  page  49;  O.  D.  737.)'^^ 

No  fault  can  be  found  with  the  foregoing  ruHng,  since  the 
law  exempts  only  the  interest  from  tax-exempt  securities  and 
not  the  profit  derived  from  the  sale  thereof. 

Sale  of  capital  assets  by  a  corporation. — When  a  corpora- 
tion sells  its  assets  for  an  amount  in  excess  of  their  book 
value  the  corporation  will  be  taxed  on  the  excess.  In  turn 
the  stockholders,   when   distribution  is  made,   will  be  taxed 


'"Also  see  C.  B.  4,  page  31;  O.  D.  762;  and  C.  B.  4,  page  31;  O.  D. 
774- 


FROM  SALES  AND  EXCHANGES  OF  PROPERTY 


555 


on  the  same  amount,  less  the  tax  paid  by  the  corporation. 
In  order  to  avoid  this  double  taxation  the  individual  stock- 
holders of  the  selling  corporation  should  sell  their  stock  to  the 
new  owner.  When  the  purchaser  acquires  all  the  stock  he  or 
it  may  cause  all  of  the  assets  of  the  corporation  to  be  turned 
over  for  a  nominal  consideration.  Thus  the  books  of  the  cor- 
poration will  not  show  any  profit  on  the  sale.^^ 

Ruling.  If,  upon  the  sale  of  the  capital  assets  of  a  corporation 
to  another  corporation,  shares  of  stock  are  surrendered  by  the  old 
stockholders  to  the  vendee  corporation,  the  nature  of  the  transaction 
is  not  changed  from  one  of  the  sale  by  the  corporation  to  one  of  sale 
of  stock  by  the  stockholders.     (C.  B.  2,  page  81 ;  A.  R.  M.  21.) 

The  ruling  is  highly  technical.  If  the  vendee  corporation 
purchased  the  old  shares  directly  from  the  stockholders  or 
arranged  an  exchange  with  such  stockholders,  it  could  not  be 
held  that  the  vendor  corporation  made  the  sale.  If  the  vendor 
corporation  as  a  corporation  foolishly  arranged  and  made  the 


"  [Former  Procedure]  The  provision  in  the  1918  law  (section  202) 
that  the  receipt  of  securities  in  a  reorganization  of  a  greater  aggregate  par 
value  than  that  of  the  securities  exchanged  would  be  deemed  to  result  in  a 
closed  transaction,  has  not  been  re-enacted. 

Regulation.  In  a  case  wherein  a  corporation  acquires  from  stock- 
holders the  stock  of  another  corporation,  giving  in  exchange  therefor  its 
own  stock,  it  is  held  that  the  transaction  is  one  by  which  the  corporation 
acquiring  the  stock  becomes  the  sole  stockholder  of  the  other  corporation. 
As  a  result  of  this  transaction  no  income  accrues  to  the  corporation  whose 
stock  is  thus  acquired.  Neither  will  any  income  accrue  to  this  corpora- 
tion if  later  the  holding  corporation  should  cause  the  assets  of  the  under- 
lying company  to  be  transferred  to  it  for  mere  nominal  consideration. 
(Reg.  23,  1918,  Art.  124.) 

Although  this  regulation  does  not  discuss  the  case  of  the  individual 
shareholders  who  receive  the  stock  of  the  purchasing  company,  it  appar- 
ently holds  that  they  are  taxable  on  the  basis  of  the  "fair  cash  value"  of 
the  securities  received.  This  situation  is  altered  by  the  1918  act  in  case 
the  exchange  is  made  "in  connection  with  the  reorganization,  merger,  or 
consolidation  of  a  corporation,"  and  in  case  the  new  stock  is  "of  no 
greater  aggregate  par  or  face  value"  than  the  old.     [Section  202  (b)]. 

The  second  edition  of  Regulations  45  stated  that  if  less  than  50  per  cent 
of  the  stock  of  a  new  corporation  were  acquired  in  exchange  for  other 
property,  the  transaction  would  be  deemed  to  be  a  closed  one.  Later,  Art. 
1566  of  Reg.  45  was  modified,  holding  that  the  exchange  was  a  closed 
transaction  only  if  the  stock  received  had  a  market  value. 


556  INCOME 

sale  and  the  stockholders  merely  surrendered  their  stock  the 
old  corporation  would  be  subject  to  tax. 

Reorganizations,     Mergers    and     Consolidations    or 

Exchanges   which   Are    Not   Closed   and 

Taxable  Transactions 

The  192 1  law  in  effect  provides  that  taxable  income  does 
not  arise  from  reorganizations, "°  even  if  the  property  received 
in  exchange  has  a  readily  realizable  market  value,  unless  the 
security  holders  dispose  of  the  securities  received  by  them  in 
the  reorganization. 

Law.    Section  202 (c)  For  the  purposes  of  this  title,  on  an 

exchange  of  property,  real,  personal  or  mixed,  for  any  other  such 
property,  no  gain  or  loss  shall  be  recognized  unless  the  property  re- 
ceived in  exchange  has  a  readily  realizable  market  value;  but  even  if 
the  property  received  in  exchange  has  a  readily  realizable  market  value, 
no  gain  or  loss  shall  be  recognized. 

(2)  When  in  the  reorganization  of  one  or  more  corporations  a 
person  receives  in  place  of  any  stock  or  securities  owned  by  him,  stock 
or  securities  in  a  corporation  a  party  to  or  resulting  from  such  re- 
organization  

Securities  exchanged  in  reorganization. — 

Regulation.  Where  property  is  exchang'ed  for  other  property, 
even  if  the  property  received  in  exchange  has  a  readily  realizable 
market  value,  no  gain  or  loss  is  recognized :   .    .    .    . 

(b)  When  in  the  reorganization  of  one  or  more  corporations  a 
person  receives  in  place  of  any  stock  or  securities  owned  by  him, 
stock  or  securities  in  a  corporation  a  party  to  or  resulting  from 
such  reorganization.  The  word  "reorganization"  as  used  in  this 
paragraph  includes  a  merger  or  consolidation  (including  the  acquisi- 
tion by  one  corporation  of  at  least  a  majority  of  the  outstanding  vot- 
ing stock  and  at  least  a  majority  of  the  total  number  of  outstanding 
shares  of  all  other  classes  of  stock  of  another  corporation,  or  of  sub- 
stantially all  the  properties  of  another  corporation),  recapitalization, 
or  mere  change  in  identity,  form,  or  place  of  organization  of  a  cor- 
poration, however  effected.  Under  this  paragraph  it  makes  no  dif- 
ference whether  the  stock  or  securities  received  are  or  are  not  of  a 


^^  [Former  Procedure]  The  taxation  of  gains  or  alleged  gains  arising 
from  reorganizations  prior  to  January  i,  1922,  is  a  highly  complicated  and 
technical  subject.  For  full  discussion  see  Income  Tax  Procedure,  1921,  etc. 
For  rulings  during  1921  see  end  of  this  chapter. 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       557 

like  kind  or  class.  So  long  as  the  property  received  in  the  reorganiza- 
tion consists  of  stock  or  securities  within  the  usual  meaning  and 
acceptation  of  these  terms,  no  gain  or  loss  is  recognized.  Where 
two  or  more  corporations  unite  their  properties,  by  either  (i)  the 
dissolution  of  corporation  B  and  the  sale  of  its  assets  to  corporation 
A,  or  (2)  the  sale  of  its  property  by  B  to  A,  or  (3)  the  sale  of  the 
stock  of  B  to  A,  or  (4)  the  merger  of  B  into  A,  or  (5)  the  con- 
solidation of  A  and  B,  or  (6)  the  acquisition  by  A  of  a  majority 
of  the  voting  stock  and  a  majority  of  the  total  number  of  shares 
of  all  other  classes  of  stock  of  B  or  of  substantially  all  of  the  prop- 
erties of  B,  no  taxable  income  is  received  from  the  transaction  by  A 
or  B  or  by  the  stockholders  of  either  corporation  A  or  corporation  B, 
provided  the  sole  consideration  received  by  the  stockholders  is  stock 
or  securities  of  corporations  A  or  B  or  any  corporation  a  party 
to  or  resulting  from  the  reorganization.  Where  in  connection  with 
an  internal  adjustment  of  the  affairs  of  a  corporation,  either  by 
recapitalization  or  a  change  in  identity,  form,  or  domicile  (however 
effected),  a  person  receives  in  place  of  the  stock  or  securities  owned 
by  him  new  stock  or  securities  of  the  corporation,  no  gain  or  loss  is 
realized.     (Art.  1566.) 


Definition  of  term  "reorganization." — 

Law.  Section  202 (c)  ....  (2)  ...  .  The  word  "re- 
organization," as  used  in  this  paragraph,  includes  a  merger  or  consoli- 
dation (including  the  acquisition  by  one  corporation  of  at  least  a  ma- 
jority of  the  voting  stock  and  at  least  a  majority  of  the  total  number 
of  shares  of  all  other  classes  of  stock  of  another  corporation,  or  of 
substantially  all  the  properties  of  another  corporation),  recapitalization, 
or  mere  change  in  identity,  form,  or  place  of  organization  of  a  cor- 
poration,   (however   effected) ;  .  .  .  , 

llie  foregoing  section  means  that  exchanges  are  continuing 
transactions  in  the  following  cases : 

1.  Merger. 

2.  Consolidation. 

3.  Acquisition  by  one  corporation  of  a 

majority  of  the  voting,  stock 
Plus 
Majority  of  all  other  classes  of  stock 

4.  Acquisition  of  substantially  all  the  properties  of  an- 

other corporation. 


558  INCOME   ■ 

5.  Recapitalization. 

6.  Change  in  identity. 

7.  Change  in  form. 

8.  Change  in  place  of  organization. 

Simply  stated,  if  a  taxpayer  in  a  "reorganization"  receives 
in  exchange  nothing  but  new  securities,  the  transaction  is  not 
a  closed' one. 

The  foregoing  may  be  summarized  into  two  main  groups, 
viz. : 

1.  Changes  in  substance  and  form  which  include  classes 

I  to  5 ;  and 

2.  Changes  only  in  form,  which  include  classes  6  to  8. 

Mergers  and  other  forms  of  reorganizations. — The 
terms  used  in  section  202  (c-2),  viz.,  ''merger  or  consolidation 
(including  the  acquisition  by  one  corporation  of  at  least  a 
majority  of  the  voting  stock  and  at  least  a  majority  of  the 
total  number  of  shares  of  all  other  classes  of  stock  of  another 
corporation,  or  of  substantially  all  the  properties  of  another 
corporation),  recapitalization,"  include  financial  transactions 
in  which  usually  there  are  changes  in  substance  as  well  as  in 
form.  There  is  a  loss  and  mingling  of  identity  which  may 
or  may  not  assume  a  taxable  status.  As  heretofore  stated, 
no  tax  will  be  imposed  if  there  is  no  readily  realizable  market 
value  for  the  new  securities  or  other  property.  No  tax  will 
be  imposed  if  one  corporation  when  it  acquires  an  interest  in 
another  corporation  secures  at  least  a  majority  interest.  No 
tax  will  be  imposed  when  (a)  transfers  of  property  are  made 
by  an  individual  or  a  corporation  to  a  corporation,  or  (b) 
when  two  or  more  individuals  jointly  or  two  or  more  corpora- 
tions jointly  convey  property  to  a  corporation,  provided  in  the 
case  of  (a)  the  previous  owner  is  in  control  and  owns  at  least 
80  per  cent  of  all  of  the  voting  shares  plus  80  per  cent  of  all 
other  shares  of  the  new  corporation.  In  case  of  (b)  it  is 
sufficient  if  the  same  affiliated  group  (individuals  or  corpora- 

.     ^  See  page  592. 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       559 

tions)  who  conveyed  the  property,  jointly  own  and  control  the 
80  per  cent  interest. 

Changes  in  substance  and  form. — The  1921  law  makes  it 
clear  that  exchanges  of  securities  or  other  property,  even 
though  the  securities  received  have  a  readily  realizable  market 
value,  may  not  be  taxable  in  cases  where  there  is  a  change  in 
substance.  These  cases  depend  almost  entirely  on  the  per- 
centage of  ownership  in  the  properties  which  is  retained  by 
the  old  owners.  "When  there  is  a  change  in  substance,  and  the 
old  owners  do  not  retain  a  substantial  interest  in  the  new 
property,  and  there  is  a  readily  realizable  market  value  for  the 
new  securities,  it  is  entirely  reasonable  to  consider  the  transac- 
tion a  closed  one. 

New  property  must  have  readily  realizable  value. — 
Section  202  (c)  provides  that  no  tax  will  be  imposed  in  any 
case  when  the  property  received  has  no  readily  realizable 
market  value. 

What  constitutes  ""like  kind  or  use." — iVrticle  1566 
defining  the  words  "like  kind"  has  already  been  quoted  and 
commented  upon  on  page  545  et  seq.  in  connection  with  the 
subject  of  closed  transactions.  Further  comment  on  this  point 
seems  unnecessary,  except  that  it  should  be  noted  that  the 
exchange  must  be  a  100  per  cent  one  in  order  to  avoid  the 
possibiHty  of  tax.  If  part  cash  is  received  there  may  or  may 
not  be  any  tax,  depending  on  the  basis  prescribed  in  section 
202   (e)." 

Transfer  of  property  to  a  corporation. — 

Law.     Section  202 (c)  For  the  purposes  of  this  title,  on 

an  exchange  of  property,  real,  personal  or  mixed,  for  any  other  such 
property,  no  gain  or  loss  shall  be  recognized  unless  the  property  re- 
ceived in  exchange  has  a  readily  realizable  market  value;  but  even  if 
the  property  received  in  exchange  has  a  readily  realizable  market 
value,  no  gain  or  loss  shall  be  recognized. 


56o 


INCOME 


(3)  When  (A)  a  person  transfers  any  property,  real,  personal  or 
mixed,  to  a  corporation,  and  immediately  after  the  transfer  is  in  con- 
trol of  such  corporation,  or  (B)  two  or  more  persons  transfer  any  such 
property  to  a  corporation,  and  immediately  after  the  transfer  are  in 
control  of  such  corporation,  and  the  amounts  of  stock,  securities,  or 
both,  received  by  such  persons  are  in  substantially  the  same  proportion 
as  their  interests  in  the  property  before  such  transfer.  For  the  pur- 
poses of  this  paragraph,  a  person  is,  or  two  or  more  persons  are,  "in 
control"  of  a  corporation  when  owning  at  least  80  per  centum  of  the 
voting  stock  and  at  least  80  per  centum  of  the  total  number  of  shares 
of  all  other  classes  of  stock  of  the  corporation 

It  will  be  asked,  "What  happens  if  in  case  of  a  transfer 
described  in  the  foregoing  section  of  the  law  the  continuing 
interest  is  only  79  per  cent?"  The  answer  is  not  easy.  If  the 
new  shares  have  no  readily  realizable  market  value,  there  is 
no  tax.  If  the  new  shares  have  a  readily  marketable  value, 
it  means  that  ownership  to  the  extent  of  21  per  cent  has  been 
disposed  of  and  must  be  accounted  for  under  section  202  (e). 
and  it  is  deemed  to  be  proper  to  consider  the  other  79  per  cent 
the  equivalent  of  cash.  If  there  is  a  ready  market,  cash  can 
be  raised  to  pay  the  tax.  In  any  event,  any  gain  would  no 
doubt  be  a  capital  gain  and  the  rate  of  tax  on  capital  gains  is 
not  excessive. 

There  will  not  be  many  instances  of  this  kind  to  which 
tax  liability  will  attach.  The  element  of  readily  realizable 
market  value  is  enough  to  eliminate  from  possible  taxation  99 
per  cent  of  such  transactions. 

In  any  event,  the  80  per  cent  provision  applies  only  to  the 
time  "immediately  after  the  transfer."  Subsequent  sales  are 
not  taxable  unless  the  proceeds  exceed  the  cost  or  March  i, 
191 3.  value  of  the  old  securities. 

It  is  difficult  to  reconcile  the  procedure  laid  down  in  section 
202  (c-3)  with  section  202  (c-i).  Under  the  latter  section, 
when  property  is  exchanged  for  other  property  of  a  like  kind 
or  use  no  tax  is  imposed.  It  would  seem  that  when  property 
is  transferred  to  a  corporation  and  79  per  cent  ownership  is 
retained,  the  conditions  of  section  202  (c-i)  are  fulfilled  and 
that  no  taxable  income  can  accrue  (unless  the  proceeds  from 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       561 

the  sale  of  the  21  per  cent  interest  exceed  the  cost  or  March  i, 
1913,  vaKie),  because  the  proceeds  will  be  credited  against 
cost  or  value  as  provided  in  section  202  (e).  Furthermore, 
section  202  (c-3)  seems  to  conflict  with  section  202  (c-2). 
The  latter  deals  with  reorganizations,  etc.  It  would  seem  to 
be  possible  for  those  who  desire  to  form  a  new  corporation, 
[section  202  (c-3)],  to  arrange  to  own  and  control  at  least  80 
per  cent  of  its  stock  "immediately  after"  its  organization.  The 
next  step  would  be  to  consolidate  with  another  corporation 
under  section  202  (c-2),  in  which  case  it  is  only  necessary  to 
retain  a  majority  interest  in  the  new  corporation.  Even 
though  the  securities  of  the  new  corporation  arc  readily  mar- 
ketable, no  tax  can  be  imposed. 

Illustrations  of  continuing  transactions. — 

Regulation (0  ^"^  ^"^1  ^  each  own  an  undivided  one- 
half  interest  in  certain  property.  Corporation  X  is  created,  to  which 
A  and  B  transfer  the  property,  each  receiving  in  exchange  therefor 
50  per  cent  of  the  stock  of  the  corporation  X.  No  gain  or  loss  is 
realized  from  this  exchange. 

(2)  A,  who  owns  common  stock  in  the  X  corporation  of  the  par 
value  of  $70,000,  transfers  certain  property  to  the  corporation,  for 
which  he  received  additional  common  stock  of  the  par  value  of 
$15,000.  The  X  corporation  has  outstanding  immediately  after  the 
transfer  only  common  stock  of  the  par  value  of  $100,000.  No  gain 
or  loss  is  realized  from  this  exchange. 

(3)  A  owns  certain  property  which  he  transfers  to  the  corpora- 
tion X,  a  going  concern,  in  which  he  owns  common  stock  of  the  par 
value  of  $280,000  and  class  A  nonvoting  preferred  stock  of  the  par 
value  of  $190,000.  A  receives  in  exchange  for  the  property  common 
stock  of  the  par  value  of  $70,000.  The  X  corporation  immediately 
after  the  transfer  has  outstanding  common  stock  of  the  par  value  of 
$400,000,  class  A  nonvoting  preferred  stock  of  the  par  value  of 
$200,000  and  class  B  nonvoting  preferred  stock  of  the  par  value  of 

$25,000.     No  gain   or   loss   is   realized    from   this   exchange 

(Art.   1566.) 

In  ( I )  there  is  no  gain  because  the  old  interests  own  and 
control  more  than  80  per  cent  of  the  new  corporation. 
In  (2)  the  continuing  interest  is  85  per  cent. 
In  (3)  the  continuing  interest  is  86.4  per  cent. 


562 


INCOME 


In  statement  form,  examples   (2)   and   (3)   given  in  the 
foregoing  regulation  appear  as  follows : 


Example  2 — No  Gain  or  Loss  Is  Imputed 


Common 
(par  value) 

Stock  owned  by  individual   before 

transferring  property    $  70,000 

Stock  received  by  individual  for 
property  transferred  15,000 


Preferred, 

Class  A 

Non-voting 

(par  value) 


Preferred, 

Class  B 
Non-voting 
(par  value) 


Total    stock    owned    by    individual 
after  transfer    $  85,000  (a) 


Total      stock      outstandnig      after 
transfer  $100,000  (b) 


Percentage  (a)  is  of   (b) 


85% 


Example  3 — No  Gain  or  Loss  Is  Imputed 

Stock  owned  before  transfer $280,000  $190,000 

Stock  received   for  property 70,000  


Total  stock  owned  after  transfer..   $350,000  (a)     $190,000  (c) 


Total      stock      outstanding      after 
transfer    $400,000  (b)     $200,000  (d)     $25,000  (e) 


Percentage   (a)   is  of   (b) 87.570 

Pencentage  (c)   is  of   (d)  plus  (e) 


84.4% 


In  the  foregoing  illustration,  if  the  taxpayer  held  $175,000 
of  class  A  preferred  stock,  instead  of  $190,000,  he  would  be 
denied  the  benefit  of  the  reorganization  provision.  He  would 
control  87.5  per  cent  of  the  common  stock,  and  92.5  per  cent 
of  the  class  A  preferred,  "but  his  preferred  holding  would  be 
only  77.8  per  cent  of  the  total  of  both  classes  of  preferred 
outstanding. 

Purchase  of  assets  by  bondholders. — It  frequently 
happens  that  bondholders,  in  order  to  protect  themselves,  pur- 
chase outright  the  property  represented  by  their  bonds,  or 
exchange  their  bonds  for  stock  in  a  reorganized  company 
which  purchases  the  assets  of  the  old  corporation.  In  such 
cases  the  assets  may  be  transferred  to  a  new  corporation  and 


FROM    SALES   AND    EXCHANGES    OF   PROPERTY       563 

no  tax  will  be  imposed  if  the  assignors  retain  more  than  80 
per  cent  of  the  stock  of  the  new  corporation. 

Disposition  of  surplus  of  dissolved  corporation. — 
Practically  all  reorganizations  and  consolidations  result  in  the 
dissolution  of  pre-existing  corporations.  Taxpayers  who  re- 
ceive cash  or  securities  arising  from  the  dissolution  of  a  cor- 
poration should  inquire  as  to  whether  or  not  the  old  corpora- 
tion had  an  undistributed  surplus  account  on  its  books.  If  so, 
such  surplus  as  and  when  distributed  to  stockholders  in  divi- 
dends (or  the  equivalent  of  dividends)  was  free  from  all  tax 
as  to  the  part  accumulated  prior  to  March  i,  191 3,  and  free 
from  the  normal  tax  as  to  the  part  earned  after  March  i, 
1913.'^ 

Dissolution  of  limited  partnerships. — The  procedure 
in  the  case  of  dissolution  of  limited  partnerships  of  the  cor- 
poration type'^  is  the  same  as  that  for  corporations.  When 
there  is  a  large  surplus  at  the  date  of  distribution,  it  must  be 
borne  in  mind  that  the  normal  income  tax  has  been  paid  on  all 
accumulations  since  March  i,  191 3.  If  securities  in  a  new 
corporation  or  limited  partnership  are  received  in  exchange, 
it  would  be  regarded  as  a  distribution  in  kind  and  no  tax 
would  be  imposed  unless  and  until  the  securities  were  subse- 
quently disposed  of  by  the  individual  partners.^* 

If  the  old  partnership  distributes  the  new  securities  to  its 
shareholders,  the  transaction  will  be  deemed  a  continuing  one, 
under  section  202  (c-3).^^ 

Changes  in  form. — Section  202  (c-2)  of  the  1921  law 
groups  changes  in  identity,  form  and  place  of  organization 
with  reorganizations  generally,  which  are  not  taxable  even 
though  the  new   securities  have  a  readily  realizable  market 


"  See  Chapter  XXII  as  to  dividends. 
"  See  Chapter  XXIV. 
='See  Chapter  XXIV. 
■'  See  page  560. 


564  INCOME 

value.  The  requirement  that  a  substantial  interest  be  retained 
in  the  new  securities,  hardly  applies  to  mere  changes  in  form, 
since  the  new  ownership  is  usually  precisely  the  same  as  the 
old. 

Under  previous  laws  the  Treasury  has  held  that  very 
slight  changes  in  corporate  entities  result  in  closed  transac- 
tions and  subject  the  owners  of  the  so-called  new  securities  to 
tax.  The  1921  law  definitely  settles  the  question  for  the 
future  and  may  be  used  as  interpretative  of  the  past. 


[Former  Procedure] 

Under  the  1918  law  an  exchange  of  property  was  regarded  as  a  closed 
transaction  (a)  if  the  property  received  was  the  "equivalent  of  cash,"  ex- 
cept that  (b)  if  securities  were  received  in  a  reorganization  of  "no  greater 
aggregate  par  or  face  value"  than  those  exchanged,  the  transaction  was 
deemed  not  to  be  closed;  (c)  if  the  aggregate  par  of  the  securities  received 
in  a  reorganization  was  greater  than  the  par  of  those  exchanged,  the 
transaction  was  deemed  to  be  closed. 

The  gain  in  (a)  was  the  excess  of  the  "fair  market  value"  of  the 
property  received  over  the  cost  or  March  i,  1913,  value  of  the  property 
exchanged. 

The  gain  in  (c)  was  (i)  the  excess  par  value  of  the  securities  received 
in  exchange  over  the  par  of  those  exchanged,  or  (2)  the  excess  "fair  market 
value"  over  the  cost  or  March  i,  1913,  value,  respectively.  That  is,  the 
taxable  profit  is   (i)  or  (2),  whichever  is  lower. 

The  subject  is  treated  at  great  length  in  Income  Tax  Procedure,  1921, 
in  Chapters  XIV  and  XV.  Space  does  not  permit  the  inclusion  of  old 
rulings  and  comments  in  this  volume.  The  following  rulings  were  issued 
in  1921. 

Ruling.  The  provisions  of  section  202  (b)  of  the  Revenue  Act  of 
1918,  relating  to  reorganizations,  consolidations,  and  mergers,  are  new. 
These  provisions  are  not  contained  in  any  of  the  prior  income  tax  Acts 
and  they  are  not  declaratory  of  the  rule  existing  under  the  previous  Acts. 
They  apply  to  the  determination  of  gain  or  loss  from  exchanges  of  stock 
or  securities  in  connection  with  reorganizations,  consolidations,  or  mergers, 
occurring  only  in  1918  and  subsequent  years.  It  has  been  the  uniform 
practice  of  the  Department  under  the  prior  income  tax  statutes  in  dealing 
with  all  exchanges  of  stock  in  one  corporation  for  stock  in  another  cor- 
poration to  recognize  the  different  entities  and  to  regard  the  stock  received 
in  exchange  as  essentially  different  property  from  that  disposed  of.  Under 
those  statutes  this  office  has  consistently  held  that  gain  or  loss  arises  from 
such  transactions  if  the  stock  received  in  the  exchange  has  a  market  value 
even  though  the  aggregate  par  value  of  the  stock  received  in  the  exchange 
is  not  greater  than  the  aggregate  par  value  of  the  stock  parted  with. 
(C.  B.  4,  page  45;  O.  D.  783.) 

The  foregoing  ruling  sets  forth  the  separate  entity  theory  of  the  Treas- 


FROM    SALES    AND    EXCHANGES    OF    PROPERTY       565 


[Former  Procedure — Continued] 
ury  as  applied  to  1917  and  prior  laws.  The  courts  have  not  yet  decided 
the  issue  squarely.  In  the  Phellis  (U.  S.  v.  Phcllis,  advance  opinions,  66 
L.  Ed.,  page  69),  Rockefeller  {Rockefeller  v.  U.  S.,  advance  opinions,  66 
L.  Ed.,  page  74),  and  other  cases  the  new  securities  were  held  to  be  of  a 
different  character  than  the  old.  On  the  whole,  the  trend  of  the  court 
decisions  seems  to  support  the  principle  that  an  exchange  of  securities 
results  in  a  taxable  transaction  when  there  is  a  real  market  value  for  the 
new  securities. 

Effect  of  the  receipt  of  cash  and  stock  of  greater  par  value. — 

Ruling.  Upon  the  liquidation  of  a  corporation  in  1919  and  the  forma- 
tion of  a  new  one  a  taxpayer  exchanged  stock  of  the  old  corporation  pur- 
chased subsequent  to  February  28,  1913,  for  a  certain  amount  in  cash  and 
stock  of  the  new  corporation  having  an  aggregate  par  value  in  excess  of 
the  aggregate  par  value  of  the  old  stock.  The  old  stock  cost  the  taxpayer 
more  than  the  fair  market  value  of  the  new  stock  plus  the  cash  received. 

It  is  held  that  the  exchange  of  stock  may  be  treated  as  a  closed  trans- 
action and  tliat  the  taxpayer  may  take  as  a  loss  the  difference  between 
tl;e  cost  of  the  old  stock  and  the  fair  market  value  of  the  new  stock  plus 
the  cash  received.     (B.  28-21-1722;  O.  D.  970.) 

Income  from  common  stock  exchanged  for  preferred. — 
Ruling.  An  individual  traded  his  common  stock  purchased  since 
February  28,  1913,  to  another  individual  for  preferred  stock  in  the  same 
company.  Gain  or  loss  was  realized  by  reason  of  the  exchange.  This  gain 
or  loss  was  measured  by  the  difference  between  cost  of  the  common  stock 
and  the  fair  market  value  of  the  preferred  stock  as  at  the  date  of  ex- 
change.    (B.  35-21-1788;  O.  D.  1008.) 

Par  value  of  stock  in  foreign  corporation  as  determined  by  rate 
of  exchange. — 

Ruling.  Where  in  connection  with  a  reorganization,  consolidation  or 
merger,  stock  in  a  domestic  corporation  is  exchanged  for  stock  in  an  Eng- 
lish corporation,  the  par  value  of  the  latter  being  expressed  in  pounds,  in 
order  to  determine  whether  the  stock  received  is  of  a  greater  par  value 
than  the  stock  exchanged,  the  par  value  of  the  stock  in  the  English  cor- 
poration should  be  expressed  in  terms  of  United  States  money  based  on  the 
rate  of  exchange  in  effect  at  the  date  of  such  reorganization,  consolidation 
or  merger.     (B.  41-21-1859;  O.  D.  1058.) 

Ruling.  In  1917  a  domestic  corporation  purchased  tangible  property 
in  a  foreign  country  for  a  stated  sum  in  the  currency  of  that  country  at 
an  exchange  rate  of  $0.20.  Later  in  the  same  year  the  property  was  trans- 
ferred to  a  newly  organized  corporation  of  the  same  foreign  country  in 
exchange  for  its  capital  stock  of  a  total  par  value  equal  to  the  same  amount 
as  the  cost  of  the  tangible  property,  the  rate  of  exchange  at  the  time  of 
the  transfer  being  $0.30. 

Held,  that  gain  or  loss  was  realized  by  the  domestic  corporation 
through  the  exchange  of  the  property  for  stock  of  the  new  foreign  cor- 
poration in  the  amount  that  the  fair  market  value  of  such  stock  in  American 
money  at  the  time  of  such  exchange  was  greater  or  less  than  the  cost  of 
the  property  in  American  money.     (C.  B.  4,  page  46;  O.  D.  1670.) 

The  foregoing  ruling  carries  a  temporary  fluctuation  in  exchange  rates 


566 


INCOME 


fFormer  Procedure — Continued] 
into  a  transaction  in  fixed  assets.     It  is  doubtful  if  a  loss  would  have  been 
allowed  under  similar  circumstances. 

For  effect  of  fluctuation  of  exchange  rate  on  par  value  in  case  of 
exchange  of  stock  of  a  domestic  corporation  for  that  of  a  foreign  com- 
pany, see  B.  41-21-1859;  O.  D.  1058. 

Par  value  imputed  to  subscriptions  to  joint-stock  company. — 

Ruling.  The  M  Company,  organized  pursuant  to  a  State  statute,  is 
a  joint-stock  company.  The  net  value  of  its  assets  on  March  i,  1913,  was 
approximately  x  dollars.  Its  net  assets  on  December  31,  1920,  were  ap- 
proximately S^  dollars.  The  company  proposes  to  incorporate  and  to 
transfer  all  of  the  property  and  assets  of  the  joint-stock  company  to  a  cor- 
poration which  would  assume  all  liabilities.  The  corporation  will  issue  to 
the  members  of  the  joint-stock  company  shares  of  stock  of  a  par  value 
equal  to  the  value  of  the  net  assets  transferred  to  the  corporation. 

Advice  was  requested  as  to  whether  the  members  of  the  joint-stock 
company  would  be  subject  to  a  tax  on  the  difference  between  the  value 
of  their  respective  interests  in  the  joint-stock  company  as  of  March  i, 
1913,  and  the  value  of  the  shares  of  stock  of  the  new  corporation,  issued 
in  exchange  therefor.  Held,  that  section  202  (b)  and  article  1567,  Regu- 
lations 45,  are  applicable  in  the  case  of  a  reorganization  into  a  corporation 
of  a  joint-stock  company  which  is  taxable  under  the  Revenue  Act  of  1918 
as  a  corporation. 

Held  further,  that  if  the  par  value  of  the  shares  of  stock  of  the 
corporation  so  received  is  in  excess  of  the  par  value  of  the  stock  or  sub- 
scriptions to  the  joint-stock  company,  such  excess  will  be  taxable  gain  to 
the  recipient  to  the  extent  that  the  fair  market  value  of  the  new  stock 
received  by  him  is  in  excess  of  the  cost  of  his  stock  or  subscriptions  (or  if 
acquired  prior  to  March  i.  1913,  the  fair  market  value  as  of  that  date  if 
greater  than  cost).     (B.  40-21-1851 ;  O.  D.  1051.) 


CHAPTER  XVII 

COMPUTATION    OF    TAX    ON    EXCHANGES    OR 
SALES  OF  CAPITAL  ASSETS 

The  Supreme  Court  of  the  United  States  has  decided  that 
appreciation  of  property,  accrued  since  March  i,  1913,  and 
realised,  is  taxable  under  an  income  tax  law/  The  192 1  law 
provides,  however,  that  capital  net  gains^  realized  after  De- 
cember 31,  1 92 1,  may  be  taxed  at  only  12)^  per  cent. 

Just  prior  to  the  passage  of  the  192 1  law,  the  Treasury 
ruled  that  appreciation  accrued  prior  to  March  i,  1913,  but 
realized  in  a  subsequent  year,  is  income  (although  not  taxable) 
of  the  year  in  which  realized,  and  is  not  the  realization  of  tax- 
payers' capital  at  March  i,  1913.^  This  interpretation  did 
not  result  in  the  taxation  of  the  realization  by  a  corporation, 
but  it  did  result  in  the  taxation  of  dividends  paid  out  of  such 
gains.  The  1921' law,  however,  contains  a  provision  which 
specifically  states  that  "any  ....  increase  in  value  of 
property  accrued  prior  to  March  i,  191 3,  may  be  distributed 
exempt  from  tax   .    .    .    ."to  the  recipients  of  such  dividends.* 

The  chief  defect  in  the  past  procedure  governing  the 
taxation  of  these  gains  was  the  attempt  to  tax  profits  which 
were  not  definitely  realized.  The  Treasury  stated  that  gains 
or  profits  would  not  be  taxed  until  realized.^  Of  course  it  so 
stated,  otherwise  the  levy  would  have  amounted  to  a  direct 
tax  on  property — not  an  income  tax — and  such  a  direct  tax 
is  unconstitutional  unless  apportioned  according  to  population. 


'  Walsh  V.  Brewster,  advance  opinions,  65  L.  Ed.  451. 

*  [Former  Procedure]  Under  all  laws  prior  to  that  of  1921,  capital 
gains  were  taxed  at  the  same  rates  as  other  net  income.  For  full  discussion 
of  capital  net  gains  see  page  627. 

^The  interpretations  also  affect  invested  capital.  The  rulings  are  over- 
ruled by  the  new  regulations,  see  page  715  et  scq. 

*  Section  201   (b). 
°  See  page  536. 


568 


INCOME 


Having  decided  that  gains  or  profits  arising  from  capital 
transactions  are  taxable,  the  tendency  of  the  Treasury  under 
laws  prior  to  1921  was  to  tax  every  such  gain,  both  those  ac- 
tually realized  and  those  which  were  merely  apparent.''  This 
tendency  is  illustrated  by  the  Treasury  rulings  dealing  with 
the  question  whether  or  not  the  exchange  of  securities  con- 
stitutes a  closed  transaction/  As  a  matter  of  fact,  most  of 
such  exchanges  do  not  result  in  realizations.  It  may  be  readily 
admitted  that  if  a  man  buys  a  share  of  inactive  stock  for  $10 
and  later  exchanges  it  for  a  share  of  United  States  Steel  stock 
which  is  selling  at  $100,  there  is  so  near  a  realization  of  $90 
in  cash  that  there  can  be  little  objection  to  assessment  of  the 
tax.  The  theory  that  a  newly  acquired  security  can  always  be 
sold  at  current  market  quotations  is  sometimes  fallacious, 
however,  even  when  applied  to  listed  stocks  or  bonds.  In  the 
case  of  unlisted  or  closely  held  securities  the  lack  of  a  free 
market  usually  makes  it  unfair  if  not  impossible  to  consider  an 
exchange  a  closed  transaction.  Moreover,  it  is  fallacious  to 
assume  that  the  transfer  or  sale  of  a  few  shares  (out  of  many) 
constitutes  a  free  market. 

The  changes  in  the  1921  law  are  not  as  radical  as  they 
appear  to  be.  They  are  radical  when  compared  with  the  regu- 
lations under  which  prior  laws  were  administered.  The  author 
beheves  that  the  inhibitions  in  the  1921  law  against  taxing- 
apparent  gains  arising  from  exchanges,  reorganizations,  etc., 
should  be  looked  upon  as  interpretations  of  the  meaning  of 
the  term  ''closed  transactions."  If  this  is  a  correct  inference, 
many  of  the  rulings  prior  to  1922  defining  the  term  must  be 
revised.      Taxpayers   who   actually   continued   their   interests 


°  [Former  Procedure]  In  the  1921  and  prior  editions  of  this  book  the 
author  exhaustively  commented  on  the  propriety  of  taxing  capital  gains. 
Numerous  American  and  British  authorities  were  cited.  The  author  con- 
sistently supported  the  position  that  capital  gains  accruing  after  March  i, 
1913,  were  taxable.  In  view  of  the  decision  in  Walsh  v.  Brewster  (advance 
opinions  65  L.  Ed.  451)  and  other  cases  the  matter  is  now  of  only  academic 
interest.  Those  who  are  interested  in  the  development  of  the  subject 
should  consult  Income  Tax  Procedure,  1921,  pages  .394-402. 

'  See  page  536  ct  seq. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         569 

ill  capital  assets  but  who  have  been  taxed  under  the  theory 
that  they  sold  and  repurchased  the  assets,  have  legal  claims 
for  refund  of  taxes  assessed  and  paid. 

Basis  for  Ascertaining  Gain  or  Loss  When  Appreciation  of 
Property  Values  Is  Realized 

The  new  law  makes  numerous  changes  in  the  basis  for 
determining  gain  or  loss  when  appreciation  is  realized.^  The 
two  main  bases  are  cost  ( for  property  acquired  after  February 
28,  1913)  and  fair  market  value  at  March  i,  1913,  (for 
property  acquired  prior  thereto).  The  various  exceptions 
are  succinctly  stated  in  the  law  under  the  two  main  classifica- 
tions of  property  acquired  after  and  before  March  i,  1913. 

When  property  is  acquired  after  February  28,   1913. — 

Law.  Section  202.  (a)  That  the  basis  for  ascertaining  the  gain 
derived  or  loss  sustained  from  a  sale  or  other  disposition  of  property, 
real,  personal,  or  mixed,  acquired  after  February  28,  1913,  shall  be  the 
cost  of  such  property;  .... 

The  exceptions  noted  in  the  statute  are : 

1.  Property  which  is  properly  subject  to  inventory.® 

2.  Gifts,  after  December  31,  1920.^° 

3.  Property  acquired  by  bequest,  devise  or  inheritance.^^ 

When  property  is  acquired  before  March  i,  1913. — 

Law.     Section  202 (b)  The  basis  for  ascertaining  the 

gain  derived  or  loss  sustained  from  the  sale  or  other  disposition  of 
property,  real,  personal,  or  mixed,  acquired  before  March  i,  1913,  shall 
be  the  same  as  that  provided  by  subdivision  (a)  [that  is  to  say,  cost  is 
the  basis] ;  but — 

(i)  If  its  fair  market  price  or  value  as  of  March  i,  1913,  is  in  excess 
of  such  basis,  the  gain  to  be  included  in  the  gross  income  shall  be 
the  excess  of  the  amount  realized  therefor  over  such  fair  market  price 
or  value; 


'  [Former  Procedure]  For  text  of  1918  and  prior  laws,  regulations 
thereunder  and  criticisms  of  the  regulations,  see  Income  Tax  Procedure, 
1 92 1,  pages  404-425. 

"Section  202  (a-i).    See  page  457. 

'"Section  202  (a-2).     See  page  622. 

"Section  202  (a-3).     See  page  625. 


570 


INCOME 


(2)  If  its  fair  market  price  or  value  as  of  March  i,  1913,  is  lower 
than  such  basis,  the  deductible  loss  is  the  excess  of  the  fair  market 
price  or  value  as  of  March  i,  1913,  over  the  amount  realized  therefor; 
and 

(3)  If  the  amount  realized  therefor  is  more  than  such  basis  but  not 
more  than  its  fair  market  price  or  value  as  of  March  i,  1913,  or  less 
than  such  basis  but  not  less  than  such  fair  market  price  or  value,  no 
gain  shall  be  included  in  and  no  loss  deducted  from  the  gross  in- 
come  

The  foregoing  follows  the  decision  of  the  Supreme  Court/^ 
retroactive  to  1913.  If  an  excessive  tax  has  been  paid  on  a 
basis  other  than  that  indicated  by  the  above  quoted  section  of 
the  law,  claim  for  refund  should  be  made. 

For  discussion  of  gains  arising  from  exchanges  [section 
202   (c)],  see  Chapter  XVI. 

Regulation.  For  the  purpose  of  ascertaining  the  gain  or  loss 
from  the  sale  or  exchange  or  property,  the  basis  is  the  cost  of  such 
property,  or  in  the  case  of  property  which  should  be  included  in  the 
inventory,  its  latest  inventory  value.  But  in  the  case  of  property 
acquired  before  March  i,  1913,  when  its  fair  market  value  as  of  that 
date  is  in  excess  of  its  cost,  the  gain  to  be  included  in  gross  income 
is  the  excess  of  the  amount  realized  therefor  over  such  fair  market 
value.  Also  in  the  case  of  property  acquired  before  March  i,  1913, 
when  its  fair  market  value  as  of  that  date  is  lower  than  its  cost,  the 
deductible  loss  is  the  excess  of  such  fair  market  value  over  the  amount 
realized  therefor.  No  gain  or  loss  is  recognized  in  the  case  of  prop- 
erty sold  or  exchanged  (a)  at  more  than  cost  but  at  less  than  its  fair 
market  value  as  of  March  i,  1913,  or  (&)  at  less  than  cost  but  at 
more  than  its  fair  market  value  as  of  March  i,  1913.  In  any  case 
proper  adjustment  must  be  made  in  computing  gain  or  loss  from  the 
exchange  "or  sale  of  property  for  any  depreciation  or  depletion  sus- 
tained and  allowable  as  a  deduction  in  computing  net  income;  the 
amount  of  depreciation  previously  charged  off  by  the  taxpayer  shall 
be  deemed  to  be  the  true  depreciation  sustained  unless  shown  by 
clear  and  convincing  evidence  to  be  incorrect.  What  the  fair 
market  value  of  property  was  on  March  i,  1913,  is  a  question 
of  fact  to  be  established  by  any  evidence  which  will  reasonably  and 
adequately  make  it  appear.  In  the  case  of  property  traded  in  on 
public  exchanges,  evidence  of  actual  sales  at  or  about  March  i, 
1913,  or  other  basic  date,  affords  evidence  of  value,  but  it  must  not 
be  regarded  as  conclusive.     The  nature  and  extent  of  the  sales  and 


"  Goodrich  v.  Edzvards,  U.  S.  Sup.  Ct.,  March  28,  1921,  advance  opin- 
ions, 65  L.  Ed.  450. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         571 

the  circumstances  under  which  they  were  made  should  be  considered. 
Prices  received  at  forced  sales  or  for  small  lots  of  property  may  be 
and  often  are  no  real  indication  of  the  value  of  the  amount  of  property 
in  question.  For  instance,  sales  from  time  to  time  of  a  small  number 
of  shares  of  stock  is  little  indication  of  the  value  of  a  large  or  con- 
trolling interest  in  the  corporation.  As  to  inventories,  see  section  203 
of  the  statute  and  articles  1581-1588.  As  to  sale  of  stock  upon 
which  dividends  have  been  declared,  see  articles  1543,  1544,  and  1546. 
The  fair  market  value  as  of  March  i,  1913,  has  no  bearing  on  the 
determination  of  the  invested  capital  of  a  corporation  for  the  pur- 
pose of  the  war  profits  and  excess  profits  tax If  the  taxpayer 

can  not  determine  the  cost  of  securities  purchased  prior  to  March  i, 
1913,  because  of  the  loss,  destruction  or  failure  to  keep  records,  the 
value  of  the  securities  at  the  date  or  approximate  date  of  acquisition 
may  be  used  in  determining  the  cost  basis  for  purposes,  of  computing 
the  gain  or  loss  from  the  sale  of  the  securities.  When  the  date  or 
approximate  date  of  acquisition  is  unknown,  no  general  rule  can 
be  stated  for  determining  the  cost  value  of  such  securities.  Each 
case  must  be  considered  separately  upon  its  own  facts.     (Art.  1561.) 

The  following  illustrative  examples,  given  in  article  1561, 
indicate  the  application  of  the  law  quoted  above : 


Market  Value  at 

Taxable  Profit  or 

Case 

Cost 

March  i,  1913 

Sale  Price 

Deductible  Loss 

I 

$10,000 

$15,000 

$20,000 

$5,000  profit 

II 

10,000 

5,000 

3,000 

2,000  loss 

III 

10,000 

30,000 

20,000 

IV 

10,000 

3,000 

5,000 

.... 

V 

10,000 

5,000 

20,000 

10,000  profit 

VI 

10,000 

15,000 

5,000 

S,ooo  loss 

The  following  rules  for  determining  taxable  profit  and  de- 
ductible loss  on  property  sold  after  March  i,  1913,  which 
had  been  acquired  prior  to  that  date,  are  of  interest : 

1.  There  is  neither  a  taxable  gain  nor  a  deductible  loss 

when  the  selling  price  lies  between  cost  and  market 
value  as  of  March  i,  1913. 

2.  When  selling  price  is  greater  than  both  cost  or  market 

value,  or  when  less  than  both  cost  or  market  value, 
the  taxable  gain  or  deductible  loss  is  the  lesser 
amount  by  which  the  selling  price  differs  from  cost 
or  market  value  as  of  March  i,  1913. 
The  chart  reproduced  below  shows  in  graphic  form  how 
the  appreciation  is  measured. 


572 


INCOME 


,$20,000 
$15,000 


Profit  $5,000 


$3,000 


$30,000 


— {MV 


K'ojjrolit  or  loss 


51 0.000  ^7-%z7^z7^ 


7M^///////////M/A 

lyjirofit  oj  loss 


Prolii  $10,000 


$15,000 


$10,000  — <c;^^- \       '/'y/' 

|loss  $5.000 


$5,000 


CASE 


CASE  II 


CASE 


CASE  IV 


CASEV 


CASE  VI 


EXPLANATION 

C=COST  PRICE.  M  =  FAIR  MARKET  VALUE  AS  OF  MAR.  1,  1913,  AND 
S=  SELLING  PRICE 

THE  OIFFERENCE  BETWEEN  C  AND  M  IS  A  ZONE  OF  NO  PROFIT  OR  LOSS. 
AND  HAS  BEEN  SHADED  IN  THE  DIAGRAMS  ABOVE. 

IF  THE  SELLING  PRICE  FALLS  VI/ITHIN  THIS  AREA.  THERE  IS  NO  TAXABLE    GAIN  OR  LOSS. 

IF  THE  SELLING  PRICE  IS  OUTSIDE  THE  SHADED  AREA,  THE  GAIN  OR  LOSS  IS  MEASURED 
ONLY  FBflJH  TH£  NEARER  MARGIN  OF  91ICJ1  AREA. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS 


573 


The  official  illustrations  given  above,  however,  do  not 
show  the  effect  of  depreciation  accrued  from  March  i,  1913, 
to  date  of  sale,  which  must  always  be  considered. 

Regulation In  every  case,  however,  in  ascertaining  the 

gain,  the  cost  of  the  assets,  including  any  expenditures  properly 
charged  to  capital  account,  or  the  fair  market  value  as  of  March  i, 
1913,  of  the  assets  acquired  prior  thereto,  should  first  be  reduced  by 
the   amount   of   depreciation,   obsolescence,   depletion    sustained   and 

allowable,  as  a  deduction   in   computing  net   income (Art. 

546.) 

It  is  necessary  to  compare  cost  depreciated  to  date  of  sale 
with  selling  price,  as  well  as  to  compare  value  at  March  i,  19 13, 
depreciated  to  date  of  sale  with  selling  price. 

With  these  two  elements  to  be  subtracted  from  selling 
price  taken  into  consideration,  the  general  rule  laid  down 
in  the  law,  and  indicated  by  the  recent  decision  of  the  Supreme 
C'ourt,^^  viz.,  that  there  can  be  no  taxable  gain  unless  selling 
price  exceeds  cost,  is  applied.  Application  of  this  rule  means 
that  there  is  no  taxable  gain  unless  selling  price  exceeds  cost 
depreciated  to  date  of  sale;  i.e.,  there  cannot  be  any  gain  unless 
the  seller  gets  more  than  the  value  he  would  be  assumed  to 
have  if  there  is  taken  into  account  depreciation  upon  cost  to 
the  date  of  sale. 

Value  at  March  i,  191 3,  depreciated  to  date  of  sale,  how- 
ever, offers  a  check  upon  the  possible  gain,  in  that  if  the  excess 
of  selling  price  over  March  i,  191 3  value  depreciated  to  date 
of  sale,  is  less  than  the  excess  of  selling  price  over  cost 
depreciated  to  date  of  sale,  the  taxable  gain  will  be  the  smaller 
difference.  If  value  at  March  i,  1913,  is  greater  than  cost 
depreciated  to  March  i,  1913,  then,  since  the  normal  course 
of  depreciation  from  value  at  March  i,  1913,  and  from  cost 
will  bring  the  value  to  zero  at  the  same  date  in  both  cases,  the 
lines  representing  the  theoretical  decline  in  value  due  to  depre- 
ciation with  reference  to  cost  and  with  reference  to  value  at 


^^  Walsh  V.  Btczvster,  U.  S.  Sup.  Ct.,  March  28,  1921.  advance  opinions, 
65  L.  Ed.  451. 


574 


INCOME 


March  i,  191 3,  must  always  occupy  the  same  relation  to  each 
other  during  the  remaining  life  of  the  asset  after  March  i, 
191 3.  Hence,  if  the  line  from  value  at  March  i,  19 13,  to  value 
at  the  end  of  the  useful  life  of  the  property  is  above  the  line 
representing  decline  in  value  as  measured  by  depreciation  of 
cost,  the  inference  is  proper  that  some  part  of  the  gain  repre- 
sented by  the  excess  of  selling  price  over  cost  depreciated  to 
date  of  sale  is  due  to  the  appreciation  that  had  brought  the 
value  at  March  i,  1913,  above  cost  depreciated  to  that  date. 
Consequently,  such  part  of  the  total  gain  represented  by  the 
excess  of  selling  price  over  cost  must  be  eliminated  from  pos- 
sible taxable  gain. 

The  results  as  to  taxable  gains  and  deductible  losses,  and  as 
to  cases  in  which  there  is  no  taxable  gain,  are  worked  out  in 
the  following  charts : 


EXCHANGES   OR   SALES   OF  CAPITAL  ASSETS        575 


•—     O  ^   OJ  — 


5/6 


INCOME 


EXCHANGES    OR    SALES    OE   CAPITAL   ASSETS         577 

(  J^ifc  of  asset,  20  years  from  1908) 
(Life  of  asset,  15  years  from  1913) 

Case  i 

1908  Cost    $10,000 

Less:    Depreciation  on  cost  igo8-i(j2i 7,000    $  3,000 

1921    Sales   price    $20,000 

March,    1913,  value    $15,000 

1913-1921  Less:  Depreciation  on  March,  1913,  value..       9,000*       6,000 

1921  Net  gain   $14,000 

*Iii  the  illustrations   1913  has  been  considered  as  a  full  year,  to  make  them  simpler. 

The  foregoing  .shows  the  advantage  of  revaluation  at 
March  i.  1913.  The  net  gain  based  on  depreciated  cost  wotild 
l)e  $17,000;  i.e..  $20.000 — ($10,000 — $7,000). 

Case  2 

1908  Cost ". . .  $10,000 

Less:    Depreciation  on  cost   1908-1921 7.000     $  3,000 

1921  Sales  price  $20,000 

March  i,  1913,  value  $  9,000 

Less:  Depreciation  1913-1921    5,400        3,600 

1921  Taxable  gain   $16,400 

The  foregoing  sho\v.s  the  advantage  of  using  March  i,  1913, 
net  vahie.  The  original  cost  is  greater  than  the  March  i.  1913, 
value,  but  the  depreciated  value  at  March  i,  191 3.  is  greater 
than  the  depreciated  cost.  Therefore  the  higiier  bgure  is  used. 
1-Jad  the  depreciated  cost  been  used,  the  net  gain  would  ])e 
$17,000;  i.e.,  $20,000 — ($10.000 — $7,000). 

Case  3 

March,  1913,  value  $  5,000 

Less:     Depreciation    1913-1921    3,000     $  2,000 

1921  Sales  price   $20,000 

1908   Cost    $10,000 

Less:   Depreciation  on  cost  1908-1921 7,000        3,000 

1921  Taxable  gain   $17,000 

The  foregoing  shows  ihe  ad\antagc  of  ignoring  March  i. 
KJ13,  value  when  it  is  lower  than  cost,     'riie  net  gain,  Ijased  on 


578  INCOME 

depreciated  Alarch  i,  191 3,  value,  would  be  $18,000;  i.e.,  $20,- 
000 —  (  $5 ,000 — $3 ,000  ) . 

■  It  might  be  urged  that  the  only  depreciation  which  need 
be  deducted  is  on  cost  to  February  28,  1913,  and  on  the  March 
I,   19 1 3,  value  subsequently. 

In  case  3  the  depreciation  to  February  28,  1913,  on  cost  is $  2,500 

Depreciation   1913-1921  on  depreciated  value 3,ooo 

Total  depreciation   $  5,500 

Original  cost   10,000 

Net  cost    $  4,500 

Sales  price   20,000 

Net  gain   $15,500 

In  the  opinion  of  the  author,  the  foregoing  method  is  not 
sound.      It  is  true  that 

The  depreciation  deduction  for  income  tax  purposes  is $  3,000 

Instead  of  on  cost  4,500 

An  apparent  loss  of   $  1,500 

The  law  states  that  taxpayers  may  invoke  the  original 
cost  basis  instead  of  March  i,  19 13,  value,  provided  such  basis 
prevents  the  imposition  of  the  tax  on  unrealized  gains.  But 
there  is  nothing  in  the  laW'  which  states  that  the  privilege  of 
ignoring  the  March  i,  1913,  value  may  be  invoked  to  reduce 
an  unjust  tax  and  at  the  same  time  there  may  be  ignored  the 
inevitable  depreciation  which  is  going  on.  If  cost  w^as  $10,- 
000  and  the  effective  life  is  tw'enty  years,  at  the  end  of  four- 
teen years  there  is  a  reduction  in  the  capital  of  $7,000.  The 
taxpayer  receives  that  benefit  annually  as  a  return  of  his  capital 
invested.  If  he  wishes  to  ignore  the  March  i,  1913,  revalu- 
ation in  order  to  reduce  his  tax  from  $18,000  to  $17,000,  he 
should  not  also  be  able  to  partially  use  the  March  i,  191 3, 
value  and  reduce  the  tax  from  $17,000  to  $15,500. 

In  1908  there  was  no  federal  tax  law.  From  1909  to  1912 
corporations  would  have  been  able  to  deduct  depreciation  on 
$10,000.  Individuals  ivoiild  not.  After  1913  individuals 
and  corporations  could  deduct  depreciation  on  $5,000.     There- 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         579 

fore  the  factor  of  the  depreciation  allowance  granted  under 
federal  laws  can  hardly  be  a  factor  when  the  sole  question 
involved  is  to  secure  the  benefit  of  a  departure  from  the 
March  i,  19 13,  value. 

Case  4 

1908  Cost   $10,000 

Less:  Depreciation  1908-1921    7,000      $3,000 

1921    Sales   price    $8,000 

March  i,  1913,  value  $15,000 

Lf'.yj;  Depreciation  1913-1921   9,000        6,000 

1921  Taxable  gain  $2,000 

As  in  case  i,  the  foregoing  shows  the  advantage  of  using 
March  i,  1913,  value  even  though  the  sales  price  is  less  than 
the  original  cost  and  also  less  than  the  value  at  March  i,  1913. 
The  depreciated  March  i,  1913,  value  at  date  of  sale  being 
greater  than  the  depreciated  cost,  the  higher  figure  is  used  in 
computing  the  profit.  Had  depreciated  cost  been  used  the 
profit  would  be  $5,000;  i.e.,  $8,000 — ($10,000— $7,000). 

The  foregoing  case  is  illustrated  in  a  February,  1922, 
ruling : 

Ruling.  A  died  intestate  before  1913.  At  the  time  of  his  death 
lie  owned  an  unimproved  lot  located  upon  the  principal  street  of 
a  city  and  also  carried  life  insurance.  The  estate  descended  equally 
to  the  widow  and  children  in  fee  simple.  Before  1913  the  heirs  used 
the  life  insurance  money  and  additional  money  inherited  from  A 
in  erecting  a  building  upon  the  land  to  be  used  for  business  purposes. 
On  March  i,  1913,  the  land  and  building  were  worth  loo.v  dollars, 
and  during  the  year  1920  were  sold  for  i2ox  dollars. 

Inquiry  is  made  whether  (i)  in  determining  the  profit,  if  any, 
made  on  the  sale,  the  land  should  be  valued  as  of  the  date  of  decedent's 
death,  that  being  the  date  on  which  the  heirs  acquired  title  by  opera- 
tion of  law,  or  whether  the  value  should  be  fixed  as  of  March  i,  1913; 
(2)  in  view  of  the  fact  that  the  improvement  was  made  by  the  heirs 
and  paid  for  with  money  inherited  from  A,  and  money  received  from 
life  insurance  which  was  nontaxable,  the  land  and  improvements 
should  be  appraised  separately  or  as  an  entirety. 

Held,  that  in  computing  the  cost  of  the  building  and  land  in  ques- 
tion, they  should  be  treated  as  an  entirety — the  cost  of  the  land  to  be 
determined  by  its  fair  market  value  at  the  time  of  the  decedent's 
death  and  the  cost  of  the  building  by  its  actual  cost  of  construction. 


58o  INCOME 

The  sum  of  these  figures  will  represent  the  cost  of  the  improved  real 
estate,  and  the  difference  between  the  cost  so  arrived  at,  less  deprecia- 
tion sustained  after  March  i,  1913,  and  the  selling  price,  will  repre- 
sent the  gain  from  the  transaction.  However,  if  the  fair  market  value 
of  the  improved  real  estate  as  of  March  i,  1913,  w^as  in  excess  of  the 
value  of  the  land  at  the  date  of  decedent's  death  plus  the  actual  cost 
of  construction  of  the  building,  then  the  profit  subject  to  tax  will  I^e 
the  difference  between  the  value  of  the  improved  real  estate  as  of 
March  i,  1913,  less  depreciation  thereafter  sustained,  and  the  selling 
price.     (I-5-49;  I-  T.  1 178.) 

Case  5 

March  i,  1913,  value $15,000 

Less:  Depreciation  1913-1921    9,000      $6,000 

1921  Sales  price  $5,000 

1908  Cost $10,000 

Less:  Depreciation   1908-1921    7,000        3.000 

Realization  of  March,  1913,  value,  not  taxable $2,000 


111  the  foregoing  case  there  is  no  gain  or  loss  because  sales 
price  lies  between  depreciated  cost  and  depreciated  March  i, 
1913,  value.  'In  this  case  the  book  profit  of  $2,000  is  not  tax- 
able. The  sales  price,  $5,000,  is  more  than  depreciated  cost, 
$3,000  ($10,000 — $7,000)  ;  Ijut  less  than  depreciated  March 
I,   1913,  value,  $6,000   ($15,000 — $9,000). 

Case  6 

March  i,  1913,  value  $  4.500 

Less:  Depreciation   2.700       $1,800 

1908  Cost    $10,000 

Less:   Depreciation   1908-1921    7.000      $3,000 

1921  Sales  price 2,500 

Loss  sustained  based  on  March  i,  1913,  \alue   (not  deduc- 
tible )    $    500 


The  foregoing  is  similar  to  case  5  in  that  the  sales  price 
lies  between  depreciated  cost  and  depreciated  IVIarch  i,  191 3, 
value,  hence  there  is  no  taxable  gain  or  loss.  In  case  6  the 
depreciated  cost  is  higher  than  the  dejireciated  March  i,  191 3. 
value^ — the  converse  of  case  5. 


EXCHANGES    OR    SAEES    OF    CAPITAE    ASSETS         581 

Cask  7 

iyo8   Cost    $i(),aau 

Less:   Depreciation    KjoM-iyji    7,(joo       $3,000 

March  i,  1913,  value  $  5,000 

Less:  Depreciation   3,000      $2,000 

1921    Sales   price    1,000 

Deductible  loss   $1,000 

The  foregoing"  is  the  same  as  case  3,  except  the  selHng 
price  is  less  tJian  dei)reciate(l  cost  and  less  than  the  depreciated 
March  i,  1913,  vahie.  The  lesser  vahie  is  used  in  computing 
the  loss.  If  comi)ute(l  on  depreciated  cost,  the  loss  under 
1916,  191 7  and  1918  laws  would  l)e  $2,000;  i.e.,  ($10,000 — 
$7,000) — $1,000. 

Case  8 

March  i,   1913,  value    $15,000 

J^ess:  Depreciation   iyi3-ig2i    9,000      $6,000 

1908   Cost    $10,000 

Less:  Depreciation  1908-1921   7,000      $3,000 

1921   Sales  price   1,000 

Deductible  loss   $2,000 

The  foregoing-  is  the  converse  of  case  7,  in  that  the  depre- 
ciated cost  is  less  than  the  depreciated  March  1,  1913,  value. 
As  in  case  7,  the  lesser  value  is  used  in  computing"  the  loss. 
If  computed  on  depreciated  March  i,  19 13,  value,  the  loss  under 
1916,  1917  and  1918  laws  would  be  $5,000;  i.e.,  ($15,000 — 
$9,000) — $1,000. 

No  ADJUSTMENT  FOl^  UlCl'KECIATION  WHEN  RESIDENCE  OF 
TAXPAYER  IS  SOLD. 

Ruling.  A  taxpayer  occupied  as  a  residence  a  part  of  a  building 
he  purchased  before  1913  and  rented  the  other  part.  In  determining 
the  gain  from  a  sale  in  accordance  with  article  1561,  the  amount  repre- 
senting depreciation  to  be  added  to  the  selling  price  is  that  sustained 
on  the  part  of  the  property  used  for  rental  purposes.  No  depreciation 
may  be  considered  with  respect  to  that  portion  of  the  property  used 
for  residential  purposes  hv  the  tax])aver.  (  15.  Digest  37-21-1810; 
O.  D.  1026.) 


582  INCOME 

The  foregoing  ruling  works  out  in  favor  of  taxpayers  who 
sell  their  residences.  The  deduction  of  depreciation  decreases 
the  book  value  of  the  asset  and  correspondingly  increases  the 
gain. 

Application  of  "tax-free"  distributions. — If  distributions 
have  been  received  from  earnings  accumulated  prior  to  March 
I,  1 91 3,  or  from  appreciation  at  that  date,  the  basis  prescribed 
by  section  202,  as  set  forth  in  this  chapter,  must  be  reduced 
by  such  ''tax-free"  distribution  in  case  of  loss."  In  case  of 
gain,  however,  the  "tax-free"  distributions  are  ignored. ^^ 

Surplus  arising  from  reappraisals  is  not  taxable  income. 
— Increased  valuations  arising  from  the  writing  up  of  book 
values  are  not  subject  to  income  or  excess  profits  taxes,  un- 
less the  taxpayer  has  adopted  the  inventory  method  as  pre- 
scribed by  sections  202  (a-i)^*'  and  203.  In  certain  cases 
it  is  customary  and  desirable  for  dealers  in  securities  and  sim- 
ilar property  to  inventory  their  assets  annually.  When  secur- 
ities, etc.,  are  stock-in-trade,  the  best  accounting  practice  re- 
quires inventories.  But  it  is  not  good  accounting  practice  to 
consider  that  revaluations  of  capital  assets  are  equivalent  to 
inventories.  This  is  demonstrated  by  the  practice  of  ac- 
countants who  refuse  to  credit  the  surplus  arising  from  revalu- 
ations of  capital  assets  to  the  current  income  or  earnings  ac- 
count. 

Revaluations  as  of  March  i,  1913,  should,  however,  be 
used  as  bases  for  depreciation  and  depletion  charges,  and 
this  requires  that  the  appraisals  be  entered  in  the  books.  Prop- 
erty accounts  will  be  debited  and  "surplus  arising  from  re- 
appraisement  of  property"  will  be  credited.  The  latter  account 
is  equivalent  to  a  capital  surplus  account,  excepting  that  part 
of  the  appreciation  which  may  subsequently  be  realized  and 


"  Section  201    (b). 

'°  For  full  discussion,  see  Chapter  XXIX. 

"See  page  457. 


EXCHANGES    OR    SALES    OF    CAPITAL    ASSETS         583 

which  should  then  be  transferred  to  an  account  which  on  a 
balance  sheet  and  for  excess  profits  tax  purposes  would  be 
called  "earned  surplus."  In  order  to  avoid  its  inclusion  as 
income  for  the  taxable  year,  the  amount  on  the  books  should 
be  credited  to  "surplus  earned  prior  to  March  i,  1913." 

Written-up  book  values  as  of  effective  date  of  law  never 
taxable. — The  courts  have  consistently  held  that,  under  both 
the  1909  and  the  191 3  laws,  increases  in  the  value  of  property, 
to  be  subject  to  the  tax,  must  have  occurred  during  the  period 
when  the  law  was  effective.  The  1916,  1917,  1918  and  1921 
laws,  it  will  be  recalled,  specifically  designate  March  i,  1913, 
as  the  date  from  which  appreciation,  which  is  taxable  when 
realized,  shall  be  measured. 

Supreme  Court  decisions  regarding  taxation  of  apprecia- 
tion in  property  values. — We  now  have  a  satisfactory  line  of 
decisions  of  the  Supreme  Court  bearing  on  the  question  of 
the  taxation  of  increases  in  property  values,  and  the  fixing 
of  March  i,  1913,  as  the  date  for  the  revaluation  of  all  prop- 
erty, tangible  and  intangible,  for  income  tax  purposes. 

Cases  under  the  1909  law. — The  case  of  Doyle  v.  Mit- 
chell Brothers  Company,^'  decided  by  the  Supreme  Court  of 
the  United  States,  May  20,  1918,  turns  upon  the  question  of 
the  taxability  of  the  increased  value  of  certain  timber  lands: 

Decision.  Plaintiff  acquired  certain  timber  lands  at  its  organi- 
zation in  1903,  and  paid  for  them  at  a  valuation  approximately 
equivalent  to  $20  per  acre.  Owing  to  increases  in  the  market  price 
of  stumpage  the  market  value  of  the  timber  land,  on  December  31, 
1908,  had  become  approximately  $40  per  acre.  The  company  made 
no  entry  upon  its  books  representing  this  increase,  but  each  year 
entered  as  a  profit  the  difference  between  the  original  cost  of  the 
timber  cut  and  the  sums  received  for  the  manufactured  product,  less 
the  cost  of  manufacture.     After  the  passage  of  the  excise  tax  act, 


''247  U.  S.  179,  38  S.  Ct.  467,  62  L.  Ed.  1054.  See  also  U.  S.  v.  Gug- 
genheim Exploration  Co..  238  Fed.  231  ;  also  Baldivin  Locomotive  Works  7'. 
McCoach  (U.  S.  Circuit  Court  of  Appeals  for  the  Third  Circuit),  221  Fed. 
59,  136  C.  C.  A.  660. 


584  INCOME 

and  preparatory  to  making  a  return  of  income  for  the  year  1909,  the 
company  revalued  its  timber  stumpage  as  of  December  31,  1908,  at 
approximately  $40  per  acre.  The  good  faith  and  accuracy  of  this 
valuation  are  not  in  question,  but  the  figures  representing  it  never 
were  entered  in  the  corporate  books. 

The  Commissioner  declined  to  recognize  the  deduction  on 
the  basis  of  the  valuation  of  December  31,  1908.  The  court 
refused  to  sustain  the  Treasury,  its  position  being  shown  by 
the  following  quotations  from  the  decision : 

Decision.  When  the  act  took  effect,  plaintiff's  timber  lands,  with 
whatever  value  they  then  possessed,  were  a  part  of  its  capital  assets, 
and  a  subsequent  change  of  form  by  conversion  into  money  did  not 
change  the  essence.  Their  increased  value  since  purchase,  as  that 
value  stood  on  December  31,  1908,  was  not  in  any  proper  sense  the 
result  of  the  operation  and  management  of  the  business  or  property 
of  the  corporation  while  the  act  was  in  force.  Nor  is  the  result 
altered  by  the  mere  fact  that  the  increment  of  value  had  not  been 
entered  upon  plaintiff's  books  of  account.  Such  books  are  no  more 
than  evidential,  being  neither  indispensable  nor  conclusive.  The  de- 
cision must  rest  upon  the  actual  facts,  which,  in  the  present  case,  are 
not  in  dispute. 

Occasionally  reference  is  made  to  appreciation  arising  from 
revaluations  of  corporate  assets  as  of  January  i,  1909.  It 
should  be  noted  that  revaluations  as  of  that  date  are  of  in- 
terest only  when  there  was  a  realization  of  such  appreciation 
prior  to  Fel:)ruary  2(S,  1913.^^    The  court  also  said: 

Yet  it  is  plain,  we  think,  that  by  the  true  intent  and  meaning  of 
the  act  the  entire  proceeds  of  a  mere  conversion  of  capital  assets 
were  not  to  be  treated  as  income.  Whatever  difficulty  there  may  be 
about  a  precise  and  scientific  definition  of  "income,"  it  imports,  as 
used  here,  something  entirely  distinct  from  principal  or  capital  either 
as  a  subject  of  taxation  or  as  a  measure  of  the  tax;  conveying  rather 
the  idea  of  gain  or  increase  arising  from  corporate  activities 

Understanding  the  term  in  this  natural  and  obvious  sense,  it 
cannot  be  said  that  a  conversion  of  capital  assets  invariably  produces 
income.  If  sold  at  less  than  cost,  it  produces  rather  loss  or  outgo. 
Nevertheless,  in  many  if  not  in  most  cases  there  results  a  gain  that 
properly  may  be  accounted  as  a  part  of  the  "gross  income"  received 
"from  all  sources;"  and  by  applying  to  this  the  authorized  deductions 
we  arrive  at  "net  income."  In  order  to  determine  whether  there  has 
been  grain  (jr  loss,  and  the  amount  of  the  s::un.  it  anv,  we  must  with- 


EXCHANGES    OR    SALES    OF    CAPITAL    ASSETS         585 

draw  from  the  gross  proceeds  an  amount  sufficient  to  restore  the 
capital  value  that  existed  at  the  commencement  of  the  period  under 
consideration. 

The  same  points  are  reiterated  in  Hays  v.  Gauley  Moun- 
tain Coal  Coinpany,^^  decided  by  the  Supreme  Court  on  the 
same  day. 

Decision.  The  expression  "income  received  during  said  year," 
employed  in  the  act  of  1909,  looks  to  the  time  of  realization  rather 
than  to  the  period  of  accrument,  except  as  the  taking  effect  of  the 
act  on  a  specified  date  (January  i,  1909)  excludes  income  that  ac- 
crued before  that  date 

As  we  construe  the  latter  act,  it  measured  the  tax  by  the  in- 
come received  within  the  year  for  which  the  assessment  was  levied, 
whether  it  accrued  within  that  year  or  in  some  preceding  year  while 
the  act  was  in  effect;  but  it  excluded  all  income  that  accrued  prior 
to  January  i,  1909,  although  afterwards  received  while  the  act  was 
in  effect.''-* 

Case  under  1913  law. — The  principle  enunciated  in  the 
cases  arising  under  the  1909  law  was  extended  to  the  19 13 
law  in  the  case  of  Lynch  v.  Turrish,~"  decided  l)y  the  Supreme 
Court  of  the  United  States,  June  3,  1918.  In  this  case  the 
plaintiff  received  in  cash  double  the  par  value  of  stock  held 
by  him  in  a  lumber  company,  the  distribution  being  made 
upon  the  surrender  of  the  stock,  after  which  the  company 
went  out  of  business.  The  sum  thus  distributed  represented 
an  "increase  due  to  the  gradual  rise  in  the  market  value  of 
the  lands"  owned  by  the  company  before  March  i,  1913.  The 
following  are  the  most  pertinent  paragraphs  of  the  decision : 

Decision.  And  in  determining  the  application  of  the  statute  to 
Turrish  we  must  keep  in  mind  that,  on  the  admitted  facts,  the  dis- 
tribution received  by  him  from  the  Payette  Company  manifestly  was 
a  single  and  final  dividend  in  liquidation  of  the  entire  assets  and 
business  of  the  company,  a  return  to  him  of  the  value  of  his  stock 


'"247  U.  S.  189,  38  S.  Ct.  470,  62  L.  Ed.  1061. 

"Again  in  the  case  of  U.  S.  v.  C.  C.  C.  &  St.  L.  Raihmy  Co.  (247 
U.  S.  195,  38  S.  Ct.  472,  62  L.  Ed.  1064,  decided  May  20,  1918)  the  Supreme 
Court  declared:  "We  concur  in  tlie  view  that  the  defendant  was  not  tax- 
able except  with  respect  to  so  much  of  the  profit  upon  the  stock  as  accrued 
after  December  31,  1908." 

"'247  U.  S.  221,  38  S.  Ct.  537,  62  L.  Ed.  1087. 


-86  INCOME 

upon  the  surrender  of  his  entire  interest  in  the  company,  and  at  a 
price  that  represented  its  intrinsic  value  at  and  before  March  i, 
1913,   when  tlie  act  took  effect. 

The  district  court  and  the  circuit  court  of  appeals  decided-^ 
that  the  amount  so  distributed  to  Turrish  was  not  income  within  the 
meaning  of  the  statute,  basing  the  decision  on  two  propositions,  as 
expressed  in  the  opinion  of  the  circuit  court  of  appeals,  by  San- 
born, Circuit  Judge: — (a)  The  amount  was  the  realization  of  an  in- 
vestment made  some  years  before,  representing  its  gradual  increase 
during  those  years,  and  which  reached  its  height  before  the  effective 
date  of  the  law,  that  is,  before  March  i,  1913,  and  the  mere  change 
of  form  of  the  property  "as  from  real  to  personal  property,  or  from 
stock  to  cash,"  was  not  income  to  its  holders  because  the  value  of 
the  property  was  the  same  after  as  before  the  change;  (b)  The  tim- 
ber lands  were  the  property,  capital,  and  capital  assets  of  their  legal 
and  equitable  owner,  and  the  enhancement  of  their  value  during  a 
series  of  years  "prior  to  the  effective  date  of  the  income  tax  law, 
although  divided  or  distributed  by  dividend  or  otherwise  subsequent 
to  that  date,  does  not  become  income,  gains,  or  profits  taxable  under 
such  an  act."  .... 

If  increase  in  value  of  the  lands  was  income,  it  had  its  particular 
time,  and  such  time  must  have  been  within  the  time  of  the  law  to 
be  subject  to  the  law;  that  is,  it  must  have  been  after  March  i,  1913. 
But,  according  to  the  fact  admitted,  there  was  no  increase  after  that 
date,  and  therefore  no  increase  subject  to  the  law.  There  was  con- 
tinuity of  value,  not  gain  or  increase.  In  the  first  proposition  of  the 
court  of  appeals  we,  therefore,  concur. 

After  considering  the  contentions  of  the  government  in 

the  case  of  Gray  i'.  Darlington  (15  Wall.  63,  82  U.  S.  63, 
21  L.  Ed.  45),  the  court  indicated  its  concurrence  with  the 
second  proposition  of  the  Circuit  Court  of  Appeals  as  well." 


''236  Fed.  653. 

'^  In  a  series  of  decisions  the  Supreme  Court  has  interpreted  the 
law  as  it  affects  the  taxability  of  dividends  received  when  such  dividends 
represent  in  part  surplus  accumulated  or  assets  increased  in  value 
before  March  i,  1913.  This  matter  is  fully  discussed  in  Chapter  XXII, 
"Income  from  Dividends."  It  should  be  pointed  out  here,  however,  that 
the  court  has  established  a  distinction  depending  upon  the  nature  of  the 
transaction.  Dividends  from  such  funds  were  declared  not  taxable  in  the 
Turrish  case,  discussed  above,  where  there  was  a  single  final  dividend ;  in 
the  case  of  Southern  Pacific  Co.  v.  Lowe  (247  U.  S.  330,  38  S.  Ct.  540. 
62  L.  Ed.  1 142,  June  3,  1918).  where  the  dividend  was  a  mere  paper  trans- 
action the  holding  company  itself  doing  the  business  of  the  subsidiary  and 
having  possession  of  the  property ;  and  in  the  case  of  the  Gulj  Oil  Cor- 
poration V.  LewcUyn  (248  U.  S.  71,  39  S.  Ct.  35,  6t,  L.  Ed.  133,  December 
9,  1918)  where  the  holding  company  owned  all  the  shares  in  the  subsidiary 
except  the  directors'  qualifying  shares.     In  the  case  of  Lynch  v.  Hornby 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS 


0°/ 


Basis  when  shares  of  same  issue  are  bought  and  sold  at 
different  dates. — Securities  owned  by  a  dealer  may  be  inven- 
toried"^ and  profits  may  be  ascertained  on  the  basis  of  the  valu- 
ations thus  determined.  Other  securities  are  to  be  valued  in 
accordance  with  the  following  procedure : 

Regulation.  When  shares  of  stock  in  a  corporation  are  sold 
from  lots  purchased  at  different  dates  and  at  different  prices  and  the 
identity  of  tlie  lots  can  not  be  determined  the  stock  sold  shall  be 
charged  against  the  earliest  purchases  of  such  stock.  The  excess 
of  the  amount  realized  on  the  sale  over  the  cost  of  the  stock  will  con- 
stitute gain.  However,  the  gain  to  be  included  in  gross  income  in  the 
case  where  the  stock  was  acquired  before  March  i,  1913,  when  its 
fair  market  value  as  of  that  date  is  in  excess  of  its  cost,  is  the  excess 
of  the  amount  realized  by  the  sale  over  such  value.  No  gain  is  recog- 
nized when  stock  is  sold  at  more  than  its  cost  but  at  less  than  its  fair 
market  value  as  of  March  i,  1913.  In  the  case  of  stock  in  respect  of 
which  any  stock  dividend  was  paid,  the  cost  of  each  share  of  such 

stock    shall    be    ascertained    as     specified     in    article     1548 

(Art.  39.) 

The  theory  of  this  regulation  is  wrong.  When  different 
purchases  of  the  same  issue  of  stock  are  made  the  actual  re- 
sult is  an  average  cost.  When  a  taxpayer  buys  100  shares  of 
a  stock  at  80  and  later  buys  100  shares  at  60,  he  owns  200 
shares  at  70  and  any  subsequent  accounting  should  be  based 


(247_U.  S.  339,  38  S.  Ct.  543,  62  L.  Ed.  1149,  June  3,  1918)  a  sharp  dis- 
tinction is  drawn  between  the  type  of  dividend  discussed  in  the  foregoing 
decisions  and  the  case  of  the  "ordinary  stockholder  receiving  dividends 
declared  in  the  ordinary  course  of  .business."  The  court  declared  that 
"under  the  1913  act  dividends  declared  and  paid  in  the  ordinary  course  by 
a  corporation  to  its  stockholders,  after  March  i,  1913,  whether  from 
current  earnings  or  from  a  surplus  accumulated  prior  to  that  date,  were 
taxable  as  income  to  the  stockholder."  The  case  of  Pcabody  v.  Eisner 
(247  U.  S.  347.  38  S.  Ct.  546,  62  L.  Ed.  1 152,  June  3,  1918),  (also  brought 
under  the  1913  law)  was  declared  to  be  controlled  by  Lynch  v.  Hornby, 
supra.  The  same  rule  was  applied  in  ['nio)i  Pacific  Coal  Co.  1'.  Skinner, 
249  Fed.  152,  161  C.  C.  A.  204;  affirmed,  252  U.  S.  570.  40  S.  Ct.  392,  64 
L.  Ed.  721. 

It  can  hardly  be  said,  therefore,  that  the  Supreme  Court  has  decided 
that  all  values  existing  at  March  i,  1913,  are  capital,  but  the  1916,  1917 
and  1918  revenue  laws  are  quite  definite-on  the  point  that  dividends  de- 
clared out  of  surplus  accrued  prior  to  March  i,  1913,  are  not  taxable,  so 
that  the  case  of  Lynch  v.  Hornby,  supra,  has  no  bearing  on  dividends  re- 
ceived after  January  i,  1916. 

'^  See  page  485.  Banks  and  financial  institiUions  are  required  to  ac- 
count for  profits  on  securities  in  the  same  fashion  as  individuals,  except 
where  the  bank  maintains  a  branch  or  department  for  dealing  in  securities. 


588  INCOME 

on  the  average.  There  are  difficuhies  in  the  appHcation  of  the 
average  rule  when  the  certificates  for  the  shares  can  be  iden- 
tified because  there  may  be  an  actual  intention  on  the  part 
of  the  taxpayer  to  separate  the  transactions.  Even  here  the 
right  to  select  the  certificates  to  be  sold  is  used  by  some  tax- 
payers to  evade  the  intention  of  the  law  even  though  thev 
follow  the  regulations. 

Inventory  method  not  applicable. — The  measurement  of 
gain  in  the  case  of  property  subject  to  inventory  has  been 
adequately  discussed  in  the  preceding  chapter."^  As  to  other 
property,  the  law  plainly  designates  cost  as  the  base  from 
which  to  measure  appreciation  in  the  case  of  property  accjuired 
on  or  after  March  i.  1913,  and  the  value  on  that  date  for 
property  acquired  prior  thereto,  with  the  exceptions  previously 
noted. 

Section  203  of  the  law  grants  to  the  Commissioner 
full  authority  to  require  taxpayers  to  inventory  their  assets, 
so  long  as  the  basis  prescriljed  conforms  "to  the  best  ac- 
counting ])ractice  in  the  trade  or  business''  and  "as  most 
clearly  reflecting  the  income."  It  would  seem  that  there  is  a 
very  definite  limitation  upon  the  power  of  the  Commissioner 
because  it  is  not  customary  in  any  trade  or  business  to  inven- 
tory annually  or  periodically  the  capital  assets.  The  inven- 
tory method  is  used  only  with  trading  assets.  Although  it 
might  be  highly  desirable,  no  specific  authority  is  given  to 
prescribe  inventories  for  those  not  engaged  in  trade  or  busi- 
ness. 

Basis  for  Ascertaining  Gain  or  Loss  When  Property  Dis- 
posed of  Was  Received  in  a  Continuing  Transaction 

In  the  preceding  chapter  the  determination  of  whether  a 
transaction  is  closed  or  continuins:  has  l)een  treated. ^^ 


;■'  See  page  457  <'/  -'•yy- 

""For   full   discussion   of   transactions   deemed   not   to   be   "closed,"   see 
Chapter  XVI. 


EXCHANGES    OR    SALES    OF    CAPITAL    ASSETS         589 

When  the  transaclidn  is  (lecniccl  to  he  continuing,  the  1921 
law  specifies  how  the  l)asis  for  computing  proht  on  subsequent 
resale  is  to  be  ascertained,  as  folhnvs:  -" 

1.  The  general  rule  is  that  the  cost  or  March   i,   19 13, 

value  of  the  old  property  exchanged  is  assigned  to 
the  new  property  received  [section  202   (d-i)]. 

2.  Property  "replaced"  is  assigned  a  proportionate  part 

of  the  cost  of  the  old  property  destroyed  in  the  ratio 
of  amount  expended  to  amount  recovered  [section 
202  (d-2)]."' 

3.  In  the  case  of  "wash  sales"  the  cost  or  March  i,  1913, 

value  of  the  securities  sold,  or  a  pro  rata  part  where 
only  a  part  of  the  transaction  is  deemed  to  be  a 
"wash  sale,"  is  assigned  to  the  securities  purchased 
[section  202  (d-3)].-- 

4.  When  part  cash  and  part  property  having  no  readily 

realizable  market  value  are  received,  the  amount  of 
cash  serves  to  reduce  the  original  cost  or  March  i, 
1913,  value  of  the  old  property  exchanged  [section 
202  (e)],  except  that 

5.  When  property  of  the  following  class  is  received  even 

though  it  may  have  a  readily  realizal)le  market  value, 
viz., 

(a)  Property  of  a  like  kind  or  use. 

(b)  Securities  received  in   a   "reorganization." 

(c)  Securities  received   from  an  80  ])er  cent  con- 

trolled corporation. 

(d)  Cash  or  property  ( «jther  than  mentioned  under 

(a),  (b)  and  (  c  )  )  having  a  readily  realizable 
market  value. 
Only  the  items  in    (d)    serve  to  reduce  the  basis  of  the 
original  cost  or  March  1,   1913,  value. 


■"Section  202   (d)   and  202   (c). 

'■'  For  discussion  and   illu.stratiun  see   Chapter  XV.  and  page   S91. 
"^The  deductibility  of  losses   on   "wasli   sales"   is   discussed  in  Chapter 
XXIX,  and  at  page  591. 


590 


INCOME 


Property  received  takes  the  place  of  the  property  ex- 
changed.— 

Law.  Section  202.  ....  (d)  (i)  Where  property  is  ex- 
changed for  other  property  and  no  gain  or  loss  is  recognized  under 
the  provisions  of  subdivision  (c),  the  property  received  shall,  for  the 
purposes  of  this  section,  be  treated  as  taking  the  place  of  the  prop- 
erty exchanged  therefor,  except  as  provided  in  subdivision  (e) ;   .    .    .    . 

K()  prol:)lem  arises  when  a  transaction  is  deemed  not  to  be 
closed  except  that  taxpayers  who  exchange  property  for  other 
proi)erty  sometimes  neglect  to  preserve  the  records  which 
show  the  original  cost.  These  records  are  particularly  valu- 
able when  losses  are  claimed.  Revenue  agents  are  justified  in 
demanding  trustworthy  records. 

Regul.\tion.  (a)  Where  property  is  exchanged  for  other  prop- 
erty and  no  gain  or  loss  is  recognized  under  articles  1564  or  1566  the 
property  received  shall  for  the  purpose  of  determining  gain  or  loss 
from  its  subsequent  sale  be  treated  as  taking  the  place  of  the  prop- 
erty    exchanged     therefor For     exchange     of     property 

acquired  prior  to  March  i.  1913.  see  article  1561.  If  prop- 
erty is  exchanged  for  two  kinds  of  property  and  no  gain  or  loss  is 
recognized  under  articles  1564  or  1566  the  cost  of  the  original  prop- 
erty should  be  apportioned,  if  possible,  between  the  two  kinds  of  prop- 
erty received  in  exchange  for  the  purpose  of  determining  gain  or  loss 
upon  subsequent  sale.  If  no  fair  apportionment  is  practicable,  no 
profit  on  any  subsequent  sale  of  any  part  of  the  property  received  in 
exchange  is  realized  until  out  of  the  proceeds  of  sale  shall  have  been 
recovered  the  entire  cost  of  the  original  property.  When  securities 
of  a  single  class  are  exchanged  for  new  securities  of  different  classes 
so  that  no  gain  or  loss  is  realized  under  the  provisions  of  paragraph 
ib)  of  article  1566,  for  the  purpose  of  determining  gain  or  loss  on 
the  subsequent  sale  of  any  of  the  new  securities  the  proportion  of  the 
original  cost,  or  other  basis,  to  l)e  allocated  to  each  class  of  new 
securities  is  that  proportion  which  the  market  value  of  the  particular 
class  bears  to  the  market  value  of  all  securities  received  on  the  date 
of  the  exchange.  For  example,  if  100  shares  of  common  stock,  par 
value  $100,  are  exchanged  for  50  shares  of  preferred  and  50  shares 
of  common  each  of  $100  par  value,  and  the  cost  of  the  old  stock  was 
$250  per  share,  or  $25,000,  but  the  market  value  of  the  preferred 
on  the  date  of  the  exchange  was  $110  per  share,  or  $5,500  for  the 
50  shares,  and  the  market  value  of  the  common  was  $440  per  share 
or  $22,000  for  the  50  shares  of  common,  one-fifth  of  the  original 
cost,  or  $5,000,  would  be  regarded  as  the  cost  of  the  preferred  and 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         591 

four-fifths,  or  $20,000  as  the  cost  of  common.  The  same  method  of 
computation  should  be  used  in  the  case  of  stock  acquired  prior  to 
March  i,  191 3,  in  order  to  ascertain  the  proportion  of  such  value  to 
be  allocated  to  each  class  of  new  securities  on  that  date  and  the  tax- 
able gain  or  deductible  loss  should  thereafter  be  computed  in  accord- 
ance with  article  1561 (Art.  1567.) 

Basis  when  "replacement  funds"  are  established  and  prop- 
erty lost  or  destroyed  is  replaced. — 

Regulation {b)  Where  property  is  compulsorily  or  in- 
voluntarily converted  into  cash  or  its  equivalent  in  the  manner  de- 
scribed in  sections  214  (a)  (12)  and  234  (a)  (14)  and  the  taxpayer 
proceeds  in  good  faith  to  expend  or  set  aside  the  proceeds  of  such 
conversion  in  the  form  and  in  the  manner  therein  provided,  the  prop- 
erty acquired  shall  for  the  purpose  of  determining  gain  or  loss  from 
its  subsequent  sale  be  treated  as  taking  the  place  of  a  like  proportion 
of  the  property  converted.     (Art.  1567.) 

Full  discussion  of  "replacement  funds"  and  the  treat- 
ment of  property  replaced  thereunder,  with  an  illustration  of 
the  manner  in  which  the  deferment  of  profit  thereon  serves  to 
reduce  the  basis  of  cost  proportionately,  will  be  found  in 
Chapter  XV. 

Basis  when  loss  on  "wash  sales"  is  denied. — 

Law.     Section  202 (d)    ....    (3)  Where  no  deduction 

is  allowed  for  a  loss  or  a  part  thereof  under  the  provisions  of  para- 
graph (5)  of  subdivision  (a)  of  section  214  and  paragraph  (4)  of  sub- 
division (a)  of  section  234,  that  part  of  the  property  acquired  with 
relation  to  which  such  loss  is  disallowed  shall  for  the  purposes  of  this 
section  be  treated  as  taking  the  place  of  the  property  sold  or  disposed 
of 

Assimie  that  securities  costing  in  1915  $100,000,  were  sold 
in  1922  for  $60,000,  registering  a  loss  of  $40,000.  If  $20,000 
of  this  loss  were  disallowed  as  arising  from  a  "wash  sale" 
(due,  for  instance,  to  a  partial  repurchase),  then  the  "cost" 
of  one-half  of  the  securities  repurchased  would  be  deemed  to 
be  one-half  of  the  cost  of  the  securities  disposed  of,  viz., 
$50,000. 

For  discussion  of  losses  on  "w^ash  sales"  and  similar  trans- 
actions, see  Chapter  XXIX,  "Deductions  for  Losses." 


592 


INCOME 


Effect  of  the  receipt  of  cash  (or  property  other  than  cash) 
by  former  owners. — The  following  section  gives  effect  to  the 
new  provisions  of  the  1921  law  holding  certain  transactions 
not  to  be  closed,  but  for  purpose  of  computing  profit  on  a  sul> 
sequent  sale  certain  adjustments  of  the  original  cost  or  March 
I,  19 1 3,  value  have  to  be  made. 

I, AW.     Section    202 (e)   Where    property    is    exchanged 

for  other  property  which  has  no  readily  reaHzable  market  value,  to- 
gether with  money  or  other  property  which  has  a  readily  realizable 
market  value,  then  the  money  or  the  fair  market  value  of  the  prop- 
erty having  such  readily  realizable  market  value  received  in  exchange 
shall  be  applied  against  and  reduce  the  basis,  provided  in  this  section, 
of  the  property  exchanged,  and  if  in  excess  of  such  basis,  shall  be 
taxable  to  the  extent  of  the  excess;  but  when  property  is  exchanged 
for  property  specified  in  paragraphs  (i),  (2),  and  (3)  of  subdivisions 
(c)  as  received  in  exchange,  together  with  money  or  other  property 
of  a  readily  realizable  market  value  other  than  that  specified  in  such 
paragraphs,  the  money  or  the  fair  market  value  of  such  other  property 
received  in  exchange  shall  be  applied  against  and  reduce  the  basis, 
provided  in  this  section,  of  the  property  exchanged,  and  if  in  excess 
of  such  basis,  shall  be  taxable  to  the  extent  of  the  excess 

The  rule  laid  down  in  the  foregoing  section  of  the  law  may 
be  stated  as  follows :  \Vhen  the  transaction  is  not  closed,  the 
cash  or  other  property  having  a  readily  realizable  market 
value  (other  than  the  three  exceptions  stated)  received  in  ex- 
change is  regarded  as  a  return  ( in  whole  or  in  part,  as  the 
case  may  be)  of  the  taxpayer's  investment. 

The  following  illustrations  show  the  two  applications  of 
the  rule,  when  the  transaction  is  regarded  as  a  continuing 
one. 

Case  I 

Land   costing   in    1915  I    is  exclianged  in   \   Securities     (having    no-  readily 
$25,000  I  1921    for         "/       realizable  market  value) 

'  '   Cash  $10,000 

In  the  above  case  the  securities  are  regarded  as  taking  the  place 
of  the  land,  but  the  cash  received  $10,000  is  applied  against  the  $25,000, 
so  that  the  "cost"  of  the  securities,  upon  resale,  is  deemed  to  be 
$15,000. 


EXCHANGES    OR    SALES    OF    CAPITAL    ASSETS 


593 


Land   costing  in    1915 
$25,000 


is  exchanged  in 
1921   for 


Case  II 

(a)  Land  '"^  or 

(b)  Securities  in  an  80  per  cent 
controlled  corporation  *" 

or 

(c)  Either  one  or  both  of  the 
above  two  clashes,  all 
having  a  readily  reali- 
zable market  value ;  and 

(d)  Cash,  or  securities  of  a 
kind  different  from  those 
in  (b)  or  (c)  above,  hav- 
ing a  readily  realizable 
market   value   of   $10,000 

In  the  second  case,  while  any  or  all  of  the  two  specific 
classes  of  property  (a)  and  (b)  above  may  have  a  readily 
realizable  market  value,  the  receipt  thereof  is,  under  section 
202  (c),  deemed  to  be  a  continuing  transaction  in  which 
neither  gain  nor  loss  is  recognized.  Therefore,  only  the  value 
of  property  (d)  in  the  illustration  above,  $10,000,  is  regarded 
as  a  return  on  account  of  the  original  investment  of  $25,000, 
and  thus  serves  to  reduce  the  basis  to  $15,000  for  purpose  of 
computing  profit  on  any  subsequent  sale  of  property  (a) 
or   (b). 

If,  in  the  foregoing  illustration,  property  (d)  had  an 
aggregate  value  of  $30,000  instead  of  only  $10,000,  a  profit 
of  $5,000  would  have  to  be  reported  for  the  ])eriod  during 
which  the  transaction  occurred,  and  upon  the  sale  of  any  of 
the  property  (c)  or  (b)  the  full  amount  realized  would  have 
to  be  reported  as  taxable  income. 


Case  III 


Stocks  and  bonds  in 
company  costing  in 
1915  $25,000 


a  r  e   exchanged 
in  I 92 I  for 


Securities  in  B  Company,  in  a 
"reorganization"  ''  of  A  Com- 
pany, having  a  readily  reali- 
zable market  value;  and 

Cash  $10,000 


^  For  discussion  of  property  of  a  "like  kind  or  use"  [section  202  (c-i)], 
see  page  545- 

'"Transfers  of  property  to  a  corporation  in  which  the  transferors  con- 
trol 80  per  cent  or  more  of  the  stock  [section  202  (c-3)]  is  discussed  at 
page  560. 

""  "Reorganizations"    [section   202    (r-2)]    are  treated  at  page   557. 


594  INCOME 

The  third  case  above  is  also  deemed  to  1)e  a  continuing 
transaction,  under  section  202  (c),  although  the  securities  re- 
ceived in  the  "reorganization"  have  a  readily  realizable  mar- 
ket value  at  the  time  of  their  receipt  by  the  taxpayer.  The 
amount  of  cash  ($10,000),  however,  reduces  the  basis  of  the 
original  securities,  so  that  upon  subsecjuent  sale  of  the  new 
securities  their  "cost"  is  deemed  to  be  $15,000. 

Official  illustrations. — The  official  illustrations,  to- 
gether v\'ith  a  tabular  statement  thereof  so  that  they  may  be 
readily  followed,  are  given  below : 

Regulation Examples. —  (i)   A       exchanged       certain 

property  which  he  had  purchased  subsequent  to  March  i,  1913,  for 
$5,000,  for  real  estate  having  no  readily  reahzable  market  value  and 
$2,000  in  cash.  No  gain  or  loss  is  realized  from  such  exchange. 
However,  if  A  subsequently  sells  the  real  estate,  the  difference  be- 
tween the  amount  realized  therefor  and  $3,000,  the  basis  of  the  prop- 
erty exchanged  reduced  by  the  amount  of  cash  received  in  the  ex- 
change, is  taxable  gain  or  deductible  loss,  as  the  case  may  be 

(Art.  1568.) 

(1)  Property,      cost  /   :^  ^^.^u^r^aoA   {   ^^^^     ^^^^^'^     having     no     readily 

(after  March  i.    -  ^^  excnangecl  .        realizable  market  value 
1913)  $5,000  )  °^  (   Cash  $2,000 

Basis — "cost"  of  real  estate  received  is  $3,000, 
viz.,  $5,000 — $2,000. 

Regulation (2)   A  exchanged  certain  property  which 

he  had  purchased  subsequent  to  March  i,  1913,  for  $14,000,  for  stock 
having  no  readily  realizable  market  value  and  bonds  having  a  readily 
realizable  market  value  of  $16,000.  A  realized  a  taxable  gain  of 
$2,000,  the  amount  by  which  the  fair  market  value  of  the  bonds  ex- 
ceeds the  cost  of  the  property  exchanged.  The  entire  amount  re- 
ceived from  the  subsequent  sale  of  the  stock  received  in  the  ex- 
change constitutes  taxable  income (Art.  1568.) 

(2)  Property,      cost  )   ■    „.._i-,„„„„,i   (  Stock  (having  no  readily  realizable 

(after  March  i,    -  "  exchanged  1       market  value) 

1913)  $14,000        )  °  (   Bonds   (market  value  $16,000) 

Taxable  gain  $2,000,  viz.,  $16,000 — $14,000. 

Basis — "cost"'   new   of   stock   received  is  o. 

Regulation (3)  A,  in  connection  with  a  reorganiza- 
tion of  a  corporation,  received  in  place  of  stock  purchased  by  him 
subsequent  to   March   i,   19 13,   for  $9,000,   stock   in   a   corporation   a 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         595 

party  to  the  reorganization  together  with  cash  in  the  amount  of 
$4,000.  No  gain  or  loss  is  reahzed  from  the  exchange.  However,  if 
A  subsequently  sells  the  stock,  the  difference  between  the  amount 
received  therefor  and  $5,000,  the  basis  of  the  old  stock  reduced  by 
the  amount  of  cash  received  in  the  exchange,  constitutes  taxable  gain 
or  deductible  loss,  as  the  case  may  be (Art.  1568.) 

(3)  Stock,    cost    (af-  I   is  exchanged  \   Stock  in  a  "reorganization" 

ter     March      i,    -  tnr  '1   r-    u  a- 

1913)  $9,000         )  ^""^  (  Cash  $4,000 

Basis — "cost"  of  stock  received   is  $5,000,  viz., 
$9,000 — $4,000. 

Regulation (4)   A   transferred   to    a   corporation,    all 

of  the  outstanding  stock  of  v^^-hich  was  owned  by  him,  property  pur- 
chased by  him  subsequent  to  March  i,  1913,  for  $40,000,  in  exchange 
for  stock  and  $50,000  in  cash.  A  realized  from  the  exchange  a  tax- 
able gain  of  $10,000,  the  amount  by  which  the  amount  of  the  cash 
exceeds  the  cost  of  the  property  transferred.  The  entire  amount  re- 
ceived from  the  subsequent  sale  of  the  stock  received  in  the  exchange 
constitutes  taxable  income (Art.   1568.) 

(4)  Property,      cost]   .  ,  A  Stock  (in  a  totally  owned  corpora- 

(after  March  i,    I  is  exchanged  ,         .on)    at   least   80   per   cent   con- 

1913)  $40,000  '  I      f^'-     1    '';^Y 

J  L  Cash  $50,000 

Gain  $10,000,  viz.,  $50,000 — $40,000. 

Basis — new   "cost"   of   stock   received   is  o. 

Regulation It  is  assumed  in  the  above  examples  that 

the  property  exchanged  was  not  of  a  kind  properly  to  be  included  in 
inventory.  If  the  property  exchanged  was  acquired  prior  to  March  i, 
19 13,  or  by  gift,  devise,  bequest,  or  inheritance,  see  articles  1561,  1562, 
and  1563 (Art.  1568.) 

The  basis  to  be  used  in  case  of  property  acquired  prior  to 
March  i,  19 13,  is  discussed  at  page  569. 

Property  acquired  by  gift  after  December  31,  1920,  is 
deemed  to  have,  in  the  hands  of  the  donee,  the  same  cost  or 
March  i,  19 13,  valtie  as  if  still  in  the  possession  of  the  donor.^" 
Gifts  acquired  prior  to  December  31,  1920,  and  property  ac- 
quired by  devise,  bequest  or  inheritance  are  treated  at  pages 
620. 

^"  See  page  619. 


59^ 


INCOME 


Determination  of  Fair  Market  Price  or  Value  at 
March  1,  1913 

It  should  be  noted  that  the  law  does  not  require  the  de- 
termination of  "fair  market  value"  on  March  i,  1913,  but 
'■fair  market  price  or  value."'  If  fair  market  price  can  be 
ascertained,  nothing  further  is  needed.  But  it  must  be  "fair," 
that  is,  representative  and  not  narrow. 

The  sale  of  a  few  shares  of  stock  out  of  thousands  is  not 
a  fair  criterion.  In  addition  the  price  must  meet  the  common 
definition  of  "market,"  which  presumes  a  willing  buyer  and 
a  willing  seller. 

If  any  one  of  these  elements  is  lacking  we  use  the  alterna- 
tive provided  in  the  law,  viz.,  "value."  Often  the  Treasury 
fails  to  consider  the  second  standard  and  insists  on  the  first. 

No  specified  method  of  determining  values. — 

Regulation What  the   fair   market  value  of   property 

was  on  March  i,  1913,  is  a  question  of  fact  to  be  established  by  any 
evidence  which  will  reasonably  and  adequately  make  it  appear 

(Art.  156 1.) 

Realizations  may  not  occur  for  many  years  and  it  is  some- 
times difficult  because  of  the  lapse  of  time  to  determine  a  fair 
value  as  of  Alarch  i,  1913.^^  It  is  advisable,  therefore,  if  sales 
are  at  all  probable,  to  give  consideration  to  the  factors  un- 
derlying valuations  and  to  accumulate  evidence  to  establish 
true  values  as  of  that  date. 

The  cost  of  reproduction  is  rarely  a  satisfactory  basis  for 
the  determination  of  fair  market  value  as  of  any  date.  When 
applied  to  the  present  time  we  find  that  many  properties  are 
sold  for  less  than  it  would  cost,  at  present  prices,  to  reproduce 
them.  In  many  cases  during  the  war.  prices  were  paid  far 
in  excess  of  reproduction  costs.  Recent  sales  by  willing  sellers 
to  willing  buyers  are  the  best  bases  of  all.  but  the  records  of 
such  sales  are  confined  almost  entirelv  to  stock  and  similar 


"For   definitions  of   "value,"   see  Income    Tax  I'rocedure,   1920,  pages 
343-344- 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS 


597 


exchanges.  Reproduction  cost  may,  however,  be  very  useful 
evidence  in  estabhshing  fair  market  value. 

What  is  "fair  market  value"? — The  following  extract 
from  a  charge  to  a  jury  which  was  approved'*^  on  appeal  by 
the  United  States  Supreme  C'ourt  may  be  used  as  an  authorita- 
tive guide  in  determining  what  is  ''fair  market  value." 

Decision.  The  market  value  of  goods  is  the  price  at  which  the 
owner  of  the  goods,  or  the  producer,  holds  them  for  sale;  the  price 
at  which  they  are  freely  offered  in  the  market  to  all  the  world ;  such 
prices  as  dealers  in  the  goods  are  willing  to  receive,  arid  purchasers 
are  made  to  pay,  when  the  goods  are  bought  and  sold  in  the  ordinary 

course  of   trade The   defendant   asserts  ....  that   the   only 

way  to  arrive  at  the  market  value  is  to  take  the  cost  of  production,  to 
compute  how  much  the  manufacturer  has  actually  disbursed  in  pro- 
ducing the  goods,  and  that  thus  you  have  the  actual  market  value. 
The  United  States,  however,  maintain  that  ....  they  are  freely  of- 
fered to  all  the  world,  and  held  at  known  and  estalilished  rates ;  .  .  .  . 
and  at  which  they  are  ready  to  furnish  them  to  all  the  world.  If 
this  latter  state  of  facts  be  true,  then  it  is  evident  that  the  prices  at 
which  the  producers  so  hold  them  are  the  market  prices 

The  Treasury's  definition  of  ''fair  market  value"  is  set 
forth  in  a  ruling  quoted  in  full  on  page  539. 

What  is  "value"  March  i,  191 3? — -In  the  absence  of 
trustworthy  data  regarding  "fair  market  price,"  the  law  gives 
taxpayers  the  alternative  of  determining  the  value  of  property 
on  March  i,  1913.  The  courts  and  text  writers  have  fre- 
quently differentiated  between  the  two  terms  and  little  diffi- 
culty is  encountered  in  ascertaining  the  general  principles  to 
be  observed. 

In  the  case  of  Virginia  v.  JVcst  Virginia,"^  decided  June  14, 
191 5)  by  the  United  States  Supreme  Court,  wherein  the  issue 
was  to  determine  what  proportion  of  Virginia's  indebtedness 
the  new  state  of  West  Virginia  should  pay,  it  became  neces- 
sary to  make  adjustments  of  certain  credits  and  debits  as  of 
January  i,  1861,  arising  out  of  the  valuation  of  certain  rail- 


^Cliquot,  Chanipagiw.  3  Wall.  114.  70  U.  S.  J 14,  18  L.  Ed.  116. 
'238  U.  S.  202,  59  L.  P2d.  1272,  35  S.  Ct.  795. 


5^8  INCOME 

way  stocks  and  other  securities  as  of  that  time.  Justice  Charles 
E.  Hughes,  in  speaking  of  stock  of  Richmond,  Fredericks- 
burg and  Potomac  Railroad  Company  (one  lot  amongst  the 
several  involved),  said: 

Decisions.  The  fact,  however,  that  there  was  no  sufficient  proof 
of  market  value  was  not  an  insuperable  obstacle  to  the  making  of  a 
fair  valuation.    It  was  clearly  proper  to  introduce  evidence  tending  to 

show   the   intrinsic   value   of  the   shares (Nelson   v.   First 

National  Bank,  69  Fed.  798-803 ;  Critch field  v.  Julia,  147  Fed.  65, 
73;  Henry  v.  A^.  A.  Construction  Co.,  158  Fed.  79,  81;  Murray  v. 
Stanton,  99  Mass.  345 ;  Industrial  and  General  Trust  Co.  v.  Tod,  180 
N.  Y.  215,  232;  State  v.  Carpenter,  51  Oh.  St.  83;  Redding  v.  Godkjuin, 
44.  Minn.  355;  Moffitt  v.  Hereford,  132  Mo.  513.) 

Property  concerning  which  no  proof  of  value  in  the  market  can 
be  given,  because  it  is  not  brought  into  the  course  of  trade  and  is 
incapable  of  any  estimate  in  that  mode  is  often  the  subject  of  legal 
valuation.  In  such  cases  the  value  is  to  be  ascertained  from  such 
elements  of  value  as  the  property  represents,  among  which  may  be 

the   cost  of  producing   an   article The   question   of   value   is 

not  to  be  determined  by  considering  the  separate  elements  of  which 
the  property  is  composed,  but  by  taking  it  as  a  whole,  where  it  is, 
regard  being  had  for  the  purpose  for  which  it  was  intended  and  for 
which  it  is  to  be  used.^° 

Where  property  is  destroyed  and  injured  which  has  a  market 
value,  this  must  be  shown  as  the  measure  of  damages;  where  it  has 
no  market  value  and  a  real  value  is  shown,  this  is  the  measure  of 
plaintiff's  recovery;  where  it  has  neither  a  market  value  nor  a  real 
value,  but  it  is  shown  what  it  would  cost  to  replace  or  reproduce  the 
article,  then  such  costs  is  the  measure  of  damages.  But  if  the  article 
has  no  market  value  nor  real  value,  and  it  cannot  be  reproduced  or 
replaced,  then  in  that  event  it  would  be  proper  to  show  what  it  was 
worth  to  the  plaintiff' '' 

....  Yet  a  thing  not  bought  and  sold  in  the  market  may  have 
a  value,  as  when  it  is  an  article  fitted  for  a  specific  use  of  the  owners, 
and  worthless  for  every  other  purpose.  To  attempt  to  test  it  by  the 
open  market,  where  it  is  never  offered  for  sale,  and  is  never  bought, 
would  be  absurd.  In  reason  the  cost  of  replacing  it  would  ordinarily 
be  the  standard  of  its  value. "■^ 

Ordinarily,  when  an  article  of  sale  is  in  the  market,  and  has  a 


^^  Sutherland  on  Damages,  Volume  2.  Article  448,  Fourth  Edition. 
^  iM.  K.  &  T.  Ry.  Co.  v.  Crczis.  120  S.  W.  mo,  54  Tex.  Civ.  App.  612. 
^^  Marlines  V,  State,   16  Tex.   App.   122,   quoting  3  Bish.   Crim.  Prac.^ 
sec,  751. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         599 

market  value,  there  is  no  difference  between  its  value  and  the  market 
price,  and  the  law  adopts  the  latter  as  the  proper  evidence  of  its 
value.  This  is  not,  however,  because  value  and  price  are  really  con- 
vertible terms,  but  only  because  they  are  ordinarily  so  in  a  fair 
market.  The  primary  meaning  of  value  is  worth,  and  this  worth  is 
made  up  of  the  useful  or  estimable  qualities  of  the  thing ""■' 

The  "value''  of  land  sought  to  be  condemned,  which  the  petitioner 
is  required  to  pay,  is  not  what  any  one  person  would  give  for  the 
land  for  his  own  particular  use,  but  what  could  probably  be  obtained 
for  it  if  a  sale  was  desirable  and  a  purchaser  sought,  applying  the 
ordinary  business  methods  to  find  him  and  to  dispose  of  the  prop- 
erty.'**> 

Valuation  of  patents. — The  valuation  of  patents  as  at 
March  i,   1913,  is  fully  discussed  in  Chapter  XVIII. 

Value  of  mines,  oil  wells,  etc.,  March  i,  1913." — The  gen- 
eral principles  underlying  valuations  as  of  a  past  date  have 
been  stated.  In  valuing  mines,  oil  wells  and  other  natural 
resources  the  Treasury  requires  many  details.  The  burden  of 
proof  is  properly  put  upon  taxpayers  to  support  their  claims 
and  any  reasonable  data  required  must  be  furnished  or  tax- 
payers may  expect  that  claims  will  be  disallowed.  As  the 
Treasury's  requirements*"  are  available  to  all  who  are  inter- 
ested it  is  not  necessary  to  quote  at  length  therefrom.     ■ 

Computation  of  value  of  mines,  etc.,  at  march  i, 
191 3,  OR  ANY  other  GIVEN  DATE. — ^The  following  table  is  used 


'' Kounts  V.  Kirkpatrick.  72  Pa.  St.  376,  13  Am.  Rep.  687. 
^"  Wciscr  Valley  Land  &  ll'atcr  Co.  z'.  Ryan,  190  Fed.  417,  in  C.  C.  A. 
221,  (the  quotation  is  from  the  syllabus  to  tlie  case). 

"  For  detailed  regulations  describing  the  present  value  method,  see 
Chapter  XXX III. 

''The  following  forms  may  be  obtained  upon  application  to  the  Super- 
intendent of  Documents,  Government  Printing  Office,  Washington,  D.  C, 
for  a  nominal  sum : 

Form  D  Schedules  for  valuation,  depletion  and  depreciation 
E  Schedule  for  valuation  of  coal  properties 
F  Schedule  for  valuation  of  deposits  of  non-metals 
O  For  oil  and  gas  producers 
T  General  forest  industries  questionnaire  for  the  years  prior 

to  1919 
T   (Timber)  Forest  industries  schedule 


6oo 


INCOME 


by  the  Trcasiirv's  engineers  in  the  vakiation  of  mines,  in  those 
cases  in  which  the  valuation  is  based  on  the  discounting  of 
prospective  earnings  to  present  vaUie.  Following  the  table 
is  an  illustration  showing  the  application  of  the  formula. 


Present  Worth  of  Each  Dollar  of  Operating  Profit 

Accumulated  during  life  of  n  years,  assuming  annual  rate  of  production  and  operating 
profits  per  unit  to  be  uniform  and  providing  for  interest  on  present  worth  at  r'  per 
cent  annually  and  a  payment  into  a  sinking  fund  which  at  4  per  cent,  interest  com- 
pounded annually,  will  amount  to  the  present  worth,  i.e.,  provide  for  return  of  capital, 
at  the  end  of  life. 


'rs. 

6% 

7% 

8% 

9% 

10% 

12% 

15% 

I 

•943396 

934579 

•925925 

917431 

90909-^ 

.892857 

•869565 

2 

.908766 

892946 

.876891 

861777 

847176 

.819408 

. 781010 

3 

.876389 

853937 

.832607 

812317 

792993 

.756976 

.708694 

4 

.846052 

818370 

.792418 

768072 

745178 

•703254 

.648525 

5 

.817570 

785469 

•755780 

728260 

702675 

.656540 

.597680 

6 

. 790781 

754961 

•722245 

692177 

664641 

■615547 

•554148 

7 

•765540 

72663S 

•69143s 

659519 

630410 

.579284 

•S16457 

8 

.741717 

700174 

.663032 

629635 

S99440 

•546979 

•483507 

9 

.719198 

675487 

.636765 

602251 

571286 

.518017 

•454455 

10 

.697880 

652354 

.612404 

577066 

545581 

.491906 

.428649 

1 1 

■677672 

630699 

.589748 

553820 

522019 

.468244 

.405574 

12 

.658489 

610277 

.568624 

532281 

500344 

.446702 

.384818 

13 

.640258 

591066 

.548887 

512330 

480337 

.427009 

.366049 

14 

.62291 1 

572950 

.530401 

493737 

461815 

.408936 

•348995 

15 

.606385 

555828 

•513053 

476390 

444619 

.392292 

•333431 

16 

.590625 

539630 

.496741 

460167 

428610 

•376914 

.319170 

17 

•575581 

524283 

•481376 

444963 

413671 

.362663 

.306056 

18 

.561205 

509716 

.466880 

430685 

399699 

.349420 

•293955 

19 

•547455 

496371 

•453178 

417253 

386603 

.337082 

.282754 

20 

•534292 

482719 

.44021 1 

404592 

374302 

•32SSS9 

•272358 

2r 

. 5216S0 

470171 

.427920 

392637 

362729 

•314774 

.262682 

22 

•S09587 

458216 

•416255 

381334 

351818 

■304658 

•253654 

23 

•497979 

446805 

.405166 

370630 

341517 

24 

.486835 

435903 

•394619 

360479 

331775 

25 

.476122 

425477 

■384571 

350840 

322549 

26 

.465820 

415496 

■374988 

341675 

313799 

27 

•455905 

405935 

•365S39 

332951 

305488 

28 

■446356 

396767 

•357096 

324637 

297587 

29 

•437155 

387970 

•348734 

316704 

290063 

30 

.428283 

379520 

•340726 

309127 

282893 

31 

.419724 

371399 

•333054 

32 

.411462 

363589 

■325695 

33 

•403483 

356072 

.318631 

34 

•395772 

348832 

•311846 

35 

.38S318 

341856 

■305324 

F.^c 

TORS  IN 

Above  Table 

36 

.381108 

33SI28 

.299049 

I 

37 
38 

•374130 
•367375 
.360832 

328637 
322371 

316318 

.293009    i 

.287190 

.281581 

n                 nr 

1 

nr' 

39 

R"  - 

-I   + 

40 

•354491 

310468 

.276171 

Dern'ec 

from  Hoskold's  Formula 

41 

.348345 

30481 1 

.270950 

42 

.342385 

299339 

.265909    1 

^resent  valu 

e  of  $1 

per  annum  in 

Lp., 

43 

.336602 

294043 

.261038    ) 

1  years,  inte 

rest  on 

cap 

tal  being  at 

44 

•330990 

288913 

.256328    c 

ne  rate,  r 

,  and 

for 

redemption 

\- 

45 

•325540 

283945 

.251774 

mother  rate 

r,   per 

:ent 

} 

46 

.320248 

279128 

■247367 

I 

47 

.315107 

274459 

.243100    / 

'ti  = 

where  K"   =  ( 

I  +r)-' 

48 

.310109 

269929 

.238967 

=~i"^  ' 

' 

49 

•305250 

265533 

.234962 

i?" 

50 

■300525 

261266 

.231079 

EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         6oi 

Example 

Copy  of  a  memorandum  prepared  by  the  Metals  Valuation  Section 
of  the  Income  Tax  Bureau  in  determining  the  valuation  of  mine  at 
March   i,  1913.     Italics  are  author's  notes. 

Ore  reserves  March  i,  1913 875,000  tons 

Gross  value  March   i,   1913    (875,000  X   $12.78) $11,182,500 

Selling  price  of  metal  in  ore  reserves — -actual  or  anticipated. 

Gross  cost  March  i,   1913   (875,000  X   $7.1537) 6,259,487 

Cost  of  mining  and  extracting  metal  in  ore  reserves — actual 
or  anticipated  and  excliisiz'c  of  depletion  and  of  depre- 
ciation of  plant. 
Art.  206  of  Reg.  O2,  defines  such  "cost"  as  comprising  all  cur- 
rent expenses  of  producing,  preparing  and  marketing  the 
mineral  product  sold,  exclusive  of  federal  income  and 
profits  taxes,  allowable  capital  additions  as  defined  in  Art. 
222  of  Reg.  62.  and  deductions  for  depreciation  and  deple- 
tion, but  including  cost  of  rapairs  and  rcplaceinoifs  neces- 
sary to  inaintai)i  the  plant  and  equipment  at  its  rated  ca- 
pacity and  efficiency. 

Net  returns    (actual  or  anticipated) $4,923,013 


Present  worth  (discounting  at  15%  and  4%,  using  8-vear 
life). 
Present  ivorth  is  inclusive  of  cost  of  plant  and  is  based  on 
earnings  on  capital  or  purchase  price  at  the  rate  of  15% 
per  annum  and  making  payments  into  a  sinking  fund  zvhich 
at  4%  compounded  annually  will  provide  for  the  return  of 
capital  at  end  of  %-year  life. 
The  above  table  is  calculated  for  the  investment  of  a  sinking 
fund  at  4%.  the  variables  being  the  rate  of  discount  on 
capital  and  the  years  of  life.  From  the  table  we  find  that 
the  present  value  of  each  dollar  of  operating  profit  accu- 
mulated during  the  life  is  .48350694. 

Present  zvorth   therefore   is  $4,923,013    X    .483507   =  $2,380,311 

Deduct  cost  of  plant   (actual  or  prospective) 1,000,000 


The  Treasury  deducts  the  full  cost  (actual  or  prospective) 
of  the  plant  from  the  March  i,  1913,  present  value  of  the 
mine  on  the  assumption  that  the  plant  must  be  constructed 
and  the  full  investment  therefor  made  at  the  beginning 
of  the  period  during  zvhich  the  ore  is  to  be  removed.  If 
the  plant  had  been  constructed  prior  to  March  i,  1913, 
its  value  at  that  date  zvould  be  deducted. 

Market  value  of  ore   en  bloc  March    i,   1913 $1,380,311 


Unit  of  depletion  per  ton    ($1,380,311    -^   875,000  tons) $1-5775 

"Discovery"  value  of  mines,  oil  and  gas  wells. — 

Ruling.     In  computing  the  gain  or  loss  from  the  sale  of  mines, 
oil   and   gas  wells,  discovered   on   or   after   March    i,    1913.   the  tax- 


6o2  INCOME 

payer  is  not  entitled  to  set  up  the  value  as  of  date  of  the  discovery 
or  within  thirty  days  thereafter,  as  the  basis  of  the  computation. 
.    .    .    .    (C.  B.  3,  page  44;  Sol.  Op.  26.) 

Such  value  is  permitted,  however,  for  depletion  purposes. 
(See  Chapter  XXXIII.) 

Value  of  claims  for  infringements,  judgments,  claims,  etc., 
March  i,  1913. — The  rules  for  determination  of  values  of  in- 
tangible assets  at  March  i,  191 3,  are  in  many  respects  similar 
to  those  heretofore  discussed.  The  position  of  the  Treasury 
is  set  forth  in  a  recent  ruling.  The  taxpayer  in  the  case 
secured  a  perpetual  injunction  in  191 1  restraining  an  infringer 
of  its  patents. 

Ruling.  Thus,  on  this  date  (July  31,  191 1)  a  definite,  assign- 
able property  right  vested  in  the  M   Company. 

The  case  was  referred  to  a  master  of  the  court  to  ascertain  and 
determine  subject  to  the  approval  of  the  court  the  amount  of  said 
gains,  profits  and  damages.  The  master  filed  a  final  report  with 
the  court  on  April  18,  1918,  measuring  the  damages  to  be  the  loss 
or  profit  on  the  sales  lost  by  the  complainant 

In  the  latter  part  of  1918  the  case  was  compromised,  and  the 
amount  finally  agreed  upon  and  received  was  X  Dollars 

In  view  of  the  foregoing  it  is  held  that  the  amount  received  in 
19 1 8  does  not  constitute  taxable  income  for  that  year,  for  the  reason 
that  the  right  to  receive  this  amount  existed  and  was  a  part  of  the 
assets  of  the  M  Company  on  March  i,  1913.     (Unreported  to  date.) 

Value  of  goodwill  at  March  i,  1913. — The  Treasury  has 
indicated  the  following  methods  : 

1.  The  difference  between  the  price  at  which  an  article  is 
sold  under  the  trade-name  and  under  no  trade-name  multi- 
plied by  the  number  of  units  sold  during  the  year  equals  profits 
attributable  to  goodwill.  Capitalize  this  at  20  per  cent. 

2.  Comparison  with  businesses  having  similar  sales  and 
profits  when  such  companies  have  goodwill  purchased  for 
cash. 

Ruling The   third   method   and   possibly   the   one   which 

will  most  frequently  have  to  be  applied  as  a  check  in  the  absence  of 
data  necessary  for  the  application  of  the  preceding  ones,  is  to  allow 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         603 

out  of  average  earnings  over  a  period  of  years  prior  to  March  i, 
1913,  preferably  not  less  than  five  years,  a  return  of  10  per  cent  upon 
the  average  tangible  assets  for  the  period.  The  surplus  earnings  will 
then  be  the  average  amount  available  for  return  upon  the  value  of 
the  intangible  assets,  and  it  is  the  opinion  of  the  committee  that  this 
return  should  be  capitalized  upon  the  basis  of  not  more  than  five 
years'  purchase — that  is  to  say,  five  times  the  amount  available  as 

return  from  intangibles  should  be  the  value  of  the  intangibles 

(C.  B.  2,  page  31;  A.  R.  M.  34.) 

Later*^  the  Treasury  held  that  the  10  per  cent  was  to  be 
appHed  to  the  net  tangible  assets.  Of  course,  the  smaller  the 
average  net  tangible  assets  to  be  capitalized,  the  greater  will  be 
the  earnings  to  be  capitalized  at  20  per  cent  to  establish  the 
goodwill  value. 

In  businesses  that  are  more  or  less  stable,  the  Treasury 
suggests  8  or  9  per  cent  return  on  tangibles  and  capitalizes 
the  earnings  applicable  to  goodwill  at  15  per  cent. 

Earnings  of  predecessor  organization  may  be  used. — 

Ruling.  In  determining  the  value  of  good  will  as  of  March  i, 
1913,  in  accordance  with  the  third  method  outlined  in  A.  R.  M.  34 
(C.  B.  2,  p.  31),  and  as  a  factor  in  the  ascertainment  of  the  value  of 
a  share  of  stock  as  of  that  date,  a  corporation  which  had  not  been 
in  existence  for  a  period  of  five  years  prior  to  that  date  was  per- 
mitted to  take  the  average  earnings  of  the  business  for  five  years,  thus 
including  a  part  of  the  period  of  the  partnership  organization  that  pre- 
ceded incorporation.      (B.  52-21-1990;  O.  D.  1146. ) 

It  would  also  be  proper  to  use  the  earnings  of  a  predecessor 
corporation.  In  reorganizations,  consideration  must  be  given 
to  any  abnormal  conditions  that  may  have  affected  adversely 
the  earnings  of  the  predecessor,  such  as  change  in  product, 
need  for  reducing  fixed  charges,  expansion  of  facilities,  all  of 
which  may  have  prevented  the  former  organization  from  show- 
ing large  earnings,  even  though  possessing  a  valuable  good- 
will on  which  the  successor  corporation  was  able  to  realize 
excellent  profits  in  subsequent  years. 


C.  B.  3,  page  43 ;  A.  R.  M.  68. 


Go4  INCOME 

Deduction  for  federal  taxes — ascertainment  of  net 
i:arnings. — The  ruling  (juolcd  l)el()\v  is  of  particular  inter- 
est not  only  in  holding  that  federal  taxes  need  not  be  de- 
ducted in  arriving  at  net  earnings  for  purposes  of  goodwill 
valuation,  but  because  it  clearly  permits  the  taxpayer  to  con- 
sider only  those  ordinary  expenses  and  costs  which  a  prospec- 
tive purchaser  would  take  into  account.  Any  extraordinary 
expenditures  should  be  restored  to  income  for  the  purpose  of 
the  computation. 

.  A  failure  to  cover  sales  commitments  in  a  rising  market 
resulted  in  a  loss  to  one  concern  which  had  a  very  valuable 
goodwill  and  sold  same  for  cash  the  following  year  at  a  high 
figure.  The  loss  in  question  materially  reduced  its  average 
earnings  for  the  preceding  five  years.  Such  abnormal  condi- 
tions rec[uire  that  the  earnings  record  be  studied  with  care. 
\\'hat  is  necessary  is  that  a  value  shall  be  reached,  after  full 
consideration  of  all  the  factors,  that  would  influence  an  intel- 
ligent i)urchaser,  who  would  make  due  allowance  for  fluctua- 
tions in  profits,  trend  of  sales,  excess  plant  capacity  (if  any), 
management,  character  of  product,  etc. 

Ruling Following  the  application  of  A.  R.  M.  34  em- 
ployed in  A.  R.  R.  252,  the  Unit,  in  the  instant  case,  has  determined 
the  value  of  the  intangible  assets  thus: 

On  Xovember  — ,  1919,  A  sold  the  business  of  which  he  was  sole 
owner.  It  was  necessary  to  report  as  income  the  difference  between 
the  value  of  the  business  on  2\Iarch  i,  1913,  and  the  price  at  which  it 
was  sold.  An  appraisal  of  the  tangible  assets  was  made  at  or  about 
the  time  of  the  sale.  Five  years'  earnings  prior  to  the  date  of  sale — 
that  is,  earnings  for  1915  to  1919,  inclusive — have  been  averaged  and 
a  rate  of  8  per  cent  on  the  value  of  the  tangible  assets  determined  by 
the  appraisal  has  been  considered  a  fair  return  on  such  tangible  assets 
and  the  balance  divided  by  the  difference  between  the  selling  price  of 
the  business  and  the  appraised  value  of  the  tangible  assets,  which 
gives  a  percentage  of  11.33  ^^  the  return  on  the  good  will.  This  ratio 
of  11.33  applied  to  the  average  earnings  for  five  years  prior  to  1913 
gave  the  value  of  the  good  will,  etc.,  as  of  March  i,  1913. 

In  computing  the  earnings  for  the  five  years  prior  to  the  sale, 
Federal  income  taxes  were  not  deducted 

In  this  discussion  is  to  be  kept  constantly  in  mind  that  the  objective 
to  be  attained  is  the  value  of  the  intangible  assets  as  of  March  i,  1913. 


EXCHANGES    UR    SALES    OE    CAPITAL   ASSETS         605 

By  value  is  here  meant  what  a  wilHng  purchaser  would  be  willing-  to 
give  and  a  willing  seller  would  be  willing  to  take  for  such  assets. 
In  the  absence  of  a  sale  as  of  the  approximate  date  of  March  i,  1913, 
it  is  recognized  that  any  amount  fixed  will  l)e  at  best  only  an  approxi- 
mation. The  best  method  of  determining  this  value  yet  suggested — 
and  the  employment  of  this  method  is  not  questioned  by  the  tax- 
payer— is  the  capitalization  of  the  net  earnings  of  the  intangibles. 
For  this  purpose  it  is  necessary  first  to  determine  the  net  earnings  of 
all  the  assets.  In  determining  net  earnings,  both  from  an  accounting 
standpoint  and  from  a  legal  standpoint,  it  is  necessary  to  deduct  from 
the  gross  receipts  cost  of  materials,  cost  of  labor,  cost  of  burden  or 
overhead,  and  the  amount  of  any  other  expenses  not  covered  by  these 
terms  but  which  are  not  properly  included  in  capital  expenditures. 

In  determining  the  percentage  to  be  used  in  the  capitalization  of 
the  net  earnings  of  the  intangible  assets  of  the  particular  business 
as  of  March  i,  1913,  the  Unit  has  tentatively  determined  the  average 
earnings  of  intangible  asets  for  the  period  of  five  years  immediately 
preceding  the  date  when  the  value  of  the  intangibles  was  definitely 
fixed  by  an  actual  sale,  but  in  computing  the  net  earnings  did  not 
deduct,  and  now  insists  that  it  should  not  deduct,  Federal  income 
taxes  for  those  years.  During  the  years  in  question^  I9i'5  to  1919, 
inclusive,  with  the  exception  of  the  year  1917,  no  tax  was  assessed 
upon  an  individual's  business  as  such.  The  only  tax  which  an  indi- 
vidual paid  was  upon  his  individual  income.  This  income,  during 
all  of  the  years  in  question,  was,  under  the  terms  of  the  several  Acts 
in  force,  made  up  of  his  receipts  from  all  sources  and  the  tax  was 
levied  upon  the  net  income  remaining  after  the  allowable  deductions 
had  been  made.  Under  no  construction  of  the  Revenue  Act  of  1913, 
or  the  Revenue  Act  of  1916  in  its  original  form  or  as  amended  by 
the  Revenue  Act  of  1917,  or  of  the  Revenue  Act  of  1918,  could  this 
tax  be  held  to  be  an  expense  of  any  business  in  which  the  taxpayer 
was  engaged  during  these  years.  The  tax  was  not  computed  until 
all  the  expenses  of  such  business  had  been  deducted  from  the  gross 
income,  and  no  room  appears  for  any  serious  contention  that  such 
tax  would  constitute  a  proper  deduction  in  determining  the  earning 

power  of  the  assets 

The  real  consideration  presented  by  the  inquiry  of  the  Income  Tax 
Unit,  therefore,  appears  to  be  whether  the  war  and  excess  profits 
taxes  imposed  upon  the  business  of  an  individual  by  section  201  of 
the  Revenue  Act  of  191 7  should  be  deducted  in  determining  the 
earnings  for  the  year  1917  of  the  intangible  assets  employed  in  such 
business. 

The  value  of  the  intangible  assets  to  be  determined,  as  above  pointed 
out,  is  the  value  as  of  March  i,  191 3.  At  that  time  no  tax  was  im- 
posed upon  the  business  of  an  individual  as  such,  nor  was  any  in  con- 
templation.    Any  tax  not  imposed  until  nearly   four  years  later  cer- 


6o6  INCOME 

tainly  was  too  reniole  to  have  been  anticipated.  Such  a  tax,  there- 
fore, could  not  have  entered  into  the  consideration  of  any  prospective 
purchaser  of  a  business  in  determining  upon  its  worth  to  him.  In  de- 
termining, therefore,  the  rate  per  cent  to  be  appHed  in  capitalizing 
the  net  earnings  as  of  March  i,  1913,  it  is  beUeved  that  no  other  or 
different  factors  should  enter  into  the  equation  than  those  which 
would  have  been  used  by  a  prospective  seller  and  a  prospective  pur- 
chaser as  of  that  date,  even  if  it  be  conceded,  for  the  sake  of  argument, 
that  such  taxes  constitute  expenses  which  would  properly  be  deducti- 
ble in  determining  the  net  earnings  of  intangible  assets  for  the  pur- 
pose of  computing  their  value  as  of  a  later  date.  But  the  tax  im- 
posed by  section  201  of  the  Revenue  Act  of  1917  is  "a  tax  *  *  * 
equal  to  the  following  percentages  of  the  net  income."  It  seems  rea- 
sonably clear,  therefore,  that  the  tax  does  not  apply  until  all  permis- 
sible deductions  from  earnings  have  been  made  and  that  the  tax  does 
not  itself  constitute  a  deduction  in  determining  such  earnings. 

It  is  therefore  held,  in  the  case  of  A',  that  in  determining  the  earn- 
ings chargeable  to  good  will  in  accordance  with  A.  R.  M.  34  Federal 
income  taxes  are  not  to  be  deducted.     (I-1-13;  A.  R.  M.  145.) 

The  use  of  the  average  rate  of  earnings  on  intangible  value 
during  1915-1919  as  the  basis  for  capitalizing  actual  earnings 
assignable  to  intangibles  prior  to  191 3,  is  open  to  question. 
Rates  of  earnings  and  interest  ^vere  both  abnormally  high 
during  a  considerable  portion  of  the  period  of  1915-1919,  and 
this  was  presumably  taken  into  account  by  the  purchaser  of 
the  property  in  19 19.  He  would  certainly  expect  to  capitalize 
abnormal  earnings  at  a  higher  rate  of  return  than  earnings 
during  a  period  of  relative  business  depression  such  as  some 
of  the  years  preceding  191 3. 

When  the  earnings  of  the  years  immediately  prior  to 
March  i,  19 13,  were  low,  due  to  any  abnormal  condition,  and 
the  earnings  of  the  years  immediately  following  March  i, 
1913,  reflect  a  more  normal  situation,  the  capitalization  of  the 
earnings  after  March  i,  191 3,  is  permissible. 

It  is  admitted  that  great  difficulty  arises  in  determining 
the  goodwill  of  a  business  which  did  not  change  hands  at  or 
about  March  i,  191 3.  Less  difficulty  arises  in  the  case  of  a 
corporation  if  a  considerable  number  of  the  shares  of  its  capi- 
tal stock  was  sold  at  or  about  March  i,  191 3.  The  following 
ruling  is  sound: 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         607 

Ruling.  In  determining  the  value  of  a  corporation's  assets,  in- 
cluding good  will,  as  at  March  I,  1913,  contemporary  sales  of  stock 
are  held  to  be  of  greater  weight  than  values  l)ased  on  appraisal.  (C. 
B.  I,  page  72>;  O.  791.) 

The  foregoing  ruling,  however,  cannot  be  apphed  if  only 
a  few  shares  were  sold. 

Ruling.  In  applying  the  third  method  outlined  in  A.  R.  M.  34 
(C.  B.  2,  p.  31),  of  determining  value  as  of  March  i,  1913,  of  in- 
tangible assets,  individuals  or  partnerships  in  determining  net  earnings 
should  deduct  a  reasonable  amount  on  account  of  the  salaries  of 
owners  actively  engaged  in  the  business.  (C.  B.  4,  page  43;  O. 
D.  937-) 

Goodwill  in  relation  to  federal  taxation. — The  following 
discussion**  calls  attention  to  some  of  the  most  important 
points  which  one  should  consider  when  placing  a  value  upon 
goodwill : 

Goodwill  is  an  intangible  and  fluctuating  asset  which  represents 
the  value  of  a  business  over  and  above  the  money,  other  tangibles  and 
accumulated  profits  invested  in  it 

In  actual  sales  and  purchases  the  value  has  been  computed  in 
a  variety  of  ways,  among  which  are:  (i)  the  aggregate  of  the 
entire  earnings  of  a  specified  period;  (2)  a  certain  number  (of  years' 
purchase)  times  the  average  earnings  in  excess  of  a  determined  rate 
on  the  average  tangible  investment  for  several  years;  and  (3)  the  cap- 
italization of  an  average  of  several  years'  earnings  at  a  specified  rate, 
deducting  therefrom  the  value  of  the  tangible  assets.  It  is  undoubt- 
edly true  that  in  a  number  of  cases  the  amount  paid  for  goodwill 
represents  only  the  difference  between  the  book  value  and  the  sales 
price,  which  price  is  the  result  of  a  compromise  between  bid  and 
asked  prices  with  little  or  no  regard  to  any  of  the  above-mentioned 
methods  of  computation. 

Goodwill  has  a  value  as  a  rule  only  when  a  business  has  earned 
and  it  is  expected  will  continue  to  earn  a  rate  on  the  invested  value 
of  the  tangible  assets  in  excess  of  a  certain  basic  rate  of  return. 
The  exception  to  the  rule  would  be,  for  example,  when  a  large 
amount  of  advertising  has  been  done  but  sufficient  time  has  not 
elapsed  to  show  the  value  of  this  advertising.  The  excess  of  earnings 
arises  from  a  number  of  factors,  such  as  patents,  reputation  for  in- 
tegrity, trade-names,  publicity  from  past  advertising,  location  and  a 
partial  or  complete  monopoly 


**  Goodiuill  in  licUiliun  lo  I'cdcnil  TdSdlioii,  Ity   N.  J.  Lenhart,  Chicago 
office,  Lybrand,  Ross  Bros,  and  iVlontgomcry. 


608  INCOME 

In  general,  investors  in  bonds,  preferred  stocks  or  common  stock 
place  considerable  importance  on  the  past  earnings,  reputation  and 
the  factors  of  goodwill  (although  perhaps  not  to  the  same  degree), 
because  no  investor  is  willing  to  invest  in  a  business  which  he  does 
not  believe  is  reasonably  assured  of  continued  success. 

The  rate  of  return  (earnings  to  investment)  that  will  attract 
investments  in  common  stock  in  any  particular  industry  cannot  be 
reduced  to  a  definite  figure.  The  factors  which  affect  the  yield 
expected  are : 

1.  A  seasoned  stock  with  a  long-continued  earning  and  dividend 

record  sells  at  a  lower  yield  than  an  unseasoned  stock. 

2.  A  business  with  stable  earnings  sells  at  a  lower  yield  than  a 

business  in  the  same  industry  with  unstable  earnings. 

3.  A  steady   growth   in   earnings   always   attracts   investors   at   a 

lower  yield  than  an  unsteady  growth  or  no  growth. 

4.  The  liberality  of  the  dividend  distribution,  marketability   and 

sectional  money  rates  have  considerable  effect  on  the  yield 
expected. 

It,  therefore,  seems  reasonable  to  assume  that  there  is  no  gen- 
eral rate  of  return  necessary  to  attract  investors  in  any  particular 
industry. 

If  any  particular  business  is  in  question  and  a  rate  of  return 
which  will  attract  an  investor  is  agreed  upon,  the  question  arises  as 
to  whether  the  investor  desires  the  agreed  return  upon  his  whole 
investment  or  if  he  desires  the  agreed  rate  on  his  investment  in 
tangible  assets  and  a  higher  rate  on  the  amount  invested  in  goodwill. 

One  method  of  computation  which  has  been  often  used  is  to 
decide  on  tlie  rate  of  earnings  necessary  to  attract  the  investor, 
which  may  be  9  per  cent,  for  example,  and  then  to  take,  say,  five 
times  the  excess  of  earnings  over  the  9  per  cent  on  the  investment 
during  a  specified  period.  Under  this  method  the  resulting  rate  of 
earnings  on  the  new  investment  figure  is  always  larger  than  the  rate 
represented  by  9  per  cent,  provided,  as  is  nearly  always  the  case, 
that  the  number  of  years  used  is  less  than  100  divided  by  the  rate  used, 
and  so  it  might  be  concluded  that  the  investor  requires  a  higher  rate 
of  return  on  the  amount  invested  in  goodwill  than  on  the  balance  of 
his  investment. 

That  this  is  not  generally  the  case  is  shown  by : 

1.  In  many  instances  a  business  is  purchased  in  which  goodwill 
is  the  bulk  of  the  asset  bought.  This  is  particularly  true  when  the 
goodwill  consists  largely  of  patents,  or  in  the  case  of  retail  stores 
where  the  location  is  particularly  favorable. 

2.  The  purchaser  expects  to  continue  the  business  and  further 
develop  the  goodwill.  The  various  elements  of  goodwill,  such  as 
location,  patents  and  trade-names,  are  no  more  likely  to  depreciate 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         609 

than  are  the  physical  assets  through  misuse,  obsolescence  and  poor 
management. 

3.  The  Treasury  Department  lias  consistently  refused  to  allow 
depreciation  on  goodwill  purchased,  which  attitude  assumes  goodwill 
to  be  of  a  more  permanent  nature  than  the  physical  assets. 

It  is  consequently  reasonable  to  assume  that  a  rate  of  return 
which  will  attract  the  investor  is  a  rate  on  his  entire  investment 
including  goodwill. 

In  view  of  the  foregoing  discussion  there  are  two  methods  of 
goodwill  computation  at  March  i,  1913,  which  seem  desirable  in  two 
situations,  namely:  (i)  when  the  business  is  sold  and  a  price  paid 
for  the  goodwill,  and  (2)  in  case  there  has  been  no  sale  and  when 
the  value  at  which  goodwill  is  paid  in  for  stock  is  to  be  determined 
or  in  the  case  of  liquor  interests  in  which  the  goodwill  has  been  lost 
through  enactments  by  Congress. 

The  procedure  to  be  used  in  the  first  instance  can  best  be  shown 
by  an  illustration  of  an  actual  case.     The  facts  are  as  follows: 

Income  in  1910 $150,000.00       Investment  for   1910 $750,000.00 

Income  in  191 1 160,000.00       Investment   for  igii 800,000.00 

Income  in  1912 170,000.00       Investment  for   1912 850,000.00 


Total $480,000.00  $2,400,000.00 


Average... $160,000.00  $   800,000.00 


Per  cent  of  return  20% 

$425,000.00  Investment 

375,000.00  Investment 

Income  in  1919 322,000.00  Investment  for  1019....   2,800,000.00 


Income  in  19x7 $425,000.00       Investment  for  1917. .  .  .$2,000,000.00 

Income  in  1918 375,000.00       Investment  for  1918....   2,400,000.00 


Total  $1,122,000.00  $7,200,000  00 


Average  $   374,000.00  $2,400,000.00 


*  Per  cent  of  return  15.5% 

In  this  case  the  amount  actually  paid  for  the  goodwill  early  in 
1920  was  $1,000,000,  which,  added  to  the  average  investment  of 
$2,400,000  gives  a  new  average  of  $3,400,000.  The  earnings  for  19 17, 
1918  and  1919  were  11  per  cent  on  the  $3,400,000,  and  it  is  quite 
evident  that  the  investor  expects  to  get  not  more  than  11  per  cent 
without  further  development  of  the  business. 

Now  the  earnings  decreased  during  the  period  of  191 7,  1918  and 
1919,  but  increased  in  the  pre-war  years.  Conditions  were  stable  in 
1910,  191 1,  1912,  whereas  the  years  1917,  1918  and  1919  were  war- 
time years  and  a  period  of  depression  could  be  expected.  Since 
when  conditions  are  stable  and  the  earnings  show  a  steady  increase, 
the  risk  is  considered  less  and  the  expected  yield  is  lower  than  when 


6io  INCOME 

the  reverse  is  true,  it  follows  that  in  1913  an  investor  or  the  same 
investor  would  undoubtedly  have  been  satisfied  with  considerably  less 
than  II  per  cent  and  certainly  not  more  than  10  per  cent.  On  the 
basis  of  $160,000  average  earnings  in  the  pre-war  years  and  an 
expected  return  of  10  per  cent,  the  business  was  worth  at  least 
$1,600,000  at  March  i,  1913,  and  the  goodwill  then  was  worth 
$800,000.  Due  to  the  nature  of  the  business,  patents,  location,  repu- 
tation, etc.,  the  earnings  could  be  expected  to  continue  for  a  minimum 
of  seven  years  and  probably  longer  without  additional  development. 
Seven  times  the  average  earnings  over  10  per  cent  in  the  pre-war 
years  shows  a  goodwill  of  $560,000,  which  is  obviously  low  (this 
is  demonstrated  in  the  actual  case  just  cited),  and  this  method  admits 
of  more  argument  than  the  one  used  in  the  illustration.  In  case 
there  are  factors  which  make  the  pre-war  period  entirely  different 
from  the  years  preceding  the  date  of  sale,  this  method  based  on  the 
actual  sales  price  as  illustrated  above  may  be  open  to  criticism,  but 
as  a  rule  it  seems  to  be  the  fairest  and  least  open  to  attack  in  case 
there  has  been  an  actual  sale  of  goodwill. 

In  case  there  has  been  no  sale  of  the  goodwill  a  more  or  less 
arbitrary  method  must  be  adopted.  Any  method  used  will  be  open 
to  discussion  and  it  is  of  the  highest  importance  to  get  as  many  com- 
paratively definite  factors  as  possible. 

It  has  been  demonstrated  in  the  published  Treasury  Department's 
reports  that  in  the  pre-war  years  the  great  majority  of  industries 
earned  less  than  10  per  cent  upon  the  invested  capital.  It  follows, 
therefore,  that  in  most  industries  the  rate  which  could  be  expected 
by  the  investor  willing  to  pay  an  amount  equal  to  or  greater  than 
the  invested  value  of  the  tangible  assets  was  less  than  10  per  cent. 
The  variations  in  the  rates  expected  by  an  investor  between  industries 
as  a  whole  depend  upon  the  risk  involved.  This  risk  varies  directly 
■with  the  number  of  years  the  profits  of  the  industry  can  be  expected 
to  continue  according  to  the  character  of  the  business. 

The  preferred  stock  rate  expected  in  an  industry  varies  much 
less  between  the  various  businesses  in  the  industry  than  does  the 
rate  on  common  stocks;  and  the  preferred  stock  rate  is,  therefore, 
much  easier  to  obtain  and  less  open  to  question. 

If  the  expected  rate  of  return  on  the  investment  in  a  business 
were  known  it  would  be  easy  to  capitalize  the  average  earnings  at 
that  rate  and  call  the  difference  between  the  book  value  of  the  net 
tangible  assets  and  the  figure  so  found  goodwill.  But  this  rate  is 
unknown  and  certainly  could  never  be  satisfactorily  agreed  upon. 
However,  since  the  expected  rate  varies  directly  with  the  risk,  the 
rate  would  seem  to  be  about  the  rate  of  the  average  earnings  to  an 
investment  figure  made  up  of  the  book  value  plus  a  number  of  years 
times  the  average  excess  of  earnings  over  the  preferred  stock  rate. 
The  number  of  years  will  be  determined  according  to  the  risk. 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         6ll 

The  manner  in  which  this  method  is  used  is  as  follows: 

Income  in  1910 $150,000.00       Investment  for  1910.   . .  .$75o,ooo.oo 

Income  in  191 1 160,000.00       Investment  for  191 1 800,000.00 

Income  in  1912 170,000.00       Investment  for  1912 850,000.00 


Total $480,000.00  $2,400,000.00 


Average $160,000.00  $800,000.00 


Preferred  stock  rate  was  about  6%  during  1912: 

6%  on  average  investment $  48,000.00 

Average  earnings 160,000.00 


Excess   over   6%    $112,000.00 


Seven  times  excess  over  6%  $784,000.00 


The  goodwill,  as  computed  above,  amounts  to  $784,000  as  com- 
pared with  $800,000  under  the  metliod  previously  discussed. 

The  preferred  stock  rate  should  be  the  rate  in  the  industry  in 
the  locality  of  the  particular  business.  This  rate  can  be  found  with 
some  degree  of  accuracy,  and  at  least  with  a  much  greater  degree 
of  accuracy  than  the  rate  necessary  to  attract  investors  to  the  pur- 
chase of  common  stock.  The  rate  should  be  the  average  over  a 
period  of  not  more  than  a  few  years  prior  to  the  date  at  which 
goodwill  is  to  be  computed. 

If  a  standard  line  of  industry  is  decided  upon  and  the  number 
of  years'  purchase  to  be  used  in  that  industry  is  agreed  upon,  the 
relative  degree  of  risk  and  the  number  of  years  to  be  used  in  some 
other  industry  should  result  in  no  wide  divergence  of  opinion.  The 
number  of  years  to  be  used  in  finding  the  average  return  on  the  in- 
vestment need  not  be  the  same  as  the  number  of  years'  purchase  used, 
since  cognizance  must  be  taken  of  any  special  features  present  and 
facts  which  make  certain  years  abnormal. 

The  conclusion  to  be  drawn  from  the  foregoing  discussion  is 
that  a  set  formula  cannot  be  developed  for  the  computation  of  good- 
will, but  each  case  should  be  considered  on  its  merits.  If  there  has 
been  a  sale  of  the  goodwill  the  first-mentioned  illustration  or  an  adap- 
tation of  it  would  give  the  most  accurate  result. 

If  there  has  been  no  sale  some  variation  of  the  second  illustration 
should  be  issued. 

In  valuing  shares  of  stock  as  at  March  i,  191 3,  when  there 
was  no  market  vakie  determinable,  the  Treasury  appHed  a 
formula  for  fixing  the  vahie  of  goodwill : 

Ruling The  Committee  is  of  the  opinion  that  the  market 

value  of  shares  of  stock  was  what  they  would  bring,  and  that  the 


6i2  INCOME 

best  evidence  of  what  they  would  bring  is  what  sucli  shares  did  in 
fact  bring  when  offered  for  sale  about  that  time  in  a  free  and  open 
market.  How^ever,  in  the  present  instance,  it  is  understood  that  there 
were  no  sales,  and  it  is  necessary  to  apply  other  tests,  the  market 
value  in  such  case  being  deemed  to  be  what  a  willing  buyer  might 
reasonably  have  been  expected  to  pay  or  a  willing  seller  to  accept 

for  the  stock A  prudent  investor  contemplating  an  investment, 

usually  takes  into  consideration  primarily  two  factors;  first,  the 
safety  of  his  capital,  and  second,  th'e  return  on  it  which  he  may 
reasonably  expect ( C.  P..  3.  page  47;  A.  R.  R.  252.) 

The   formula   set    forth   in   the   foregoing  ruling  is   sum- 
marized below,  using  the  figures  given  in  the  ruling: 

1916 

Tangible  assets 6io.t-      Average  tangible  assets    (3^ 

Selling   price   of   entire   com-  j-ears  prior  to  sale) 586.r 


mon  stock  i,200.r 


Average    net     income     (same 


Paid  tor  goodwill  590;tr  period)   i  I2.i- 

-      8%  of  586.1-  =  (approx.) 46.r 


Balance    applicable    to    good- 
will          66x 


Percentage   66.v  to  590.1-  =   i\%    (approx.)    ^  percentage  to  be  used  in 

capitalizing  average 
earnings  at  March  i, 
1913,  applicable  to  good- 
will. 

Average  tangibles    (5   years   prior  to   March    i, 

1913) 258.1- 


Average  earnings  30jr 

8%  of  258.1-  =   (approx.) 20.r 


Earnings  attributable  to   goodwill lox 


Capitalizing  lox  at  11.13%  =   (approx.) 92,1-  =^  value  of  goodwill 

March  i.  1913. 
Add,    Book    value    of   tangibles   at    March    i, 
1913    232.r 


Value  of  total  assets,  March  i.  1913 324.1- 

Deduct,  Par  value  of  preferred  stock 50.r 


Value  of  common  stock.  March  i.  1913 274.1- 


Adjustment    by    appraisals    of    various    dates. — ]\Iost    a])- 
praisals    made    either    by    taxpayers    or    disinterested    third 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         613 

parties  are  of  some  date  other  than  March  i,  191 3.  If  made 
within  a  short  time  before  or  after  that  date  the  books  of 
account  should  afford  sufficient  data  upon  which  adjustments 
could  be  based.  When  the  date  of  the  appraisals  is  more  than 
a  year  before  or  after  March  i,  1913,  the  application  of  book 
adjustments  is  not  of  itself  evidence  that  the  result  would 
represent  fair  market  value  as  of  that  date.  Actual  conditions 
at  the  date  of  the  appraisals  would  have  to  be  compared  with 
conditions  existing  March  i,  1913.  If  it  could  be  shown  that 
building  materials,  labor  and  other  elements  of  cost  were 
substantially  the  same,  and  if  normal  depreciation  were  ap- 
plied, there  is  no  good  reason  why  an  appraisal  of  a  date  more 
than  a  year  before  or  after  should  not  form  the  foundation 
for  an  adjustment  of  book  figures  to  conform  to  fair  mar- 
ket value  at  A'larch  i,  191 3.  The  Treasury  in  a  recent  ruling 
(1-5-60;  A.  R.  R.  747)  has  held  that  "retrospective"  apprais- 
als will  be  accepted  "when  the  facts  upon  which  the  appraisals 
are  based  have  been  established  l)y  proof."  The  proof  need  be 
only  such  "as  is  ordinarily  accepted  in  important  business 
transactions  of  like  character."  The  acceptance  of  such  ap- 
praisals is  an  important  departure  from  the  Treasury's  previous 
procedure.  (For  text  of  A.  R.  R.  747,  see  Appendix  A,  Chap- 
ter Vm.)  The  purpose  for  which  an  appraisal  was  made 
should  always  be  stated,  since  it  may  be  the  controlling  factor 
in  its  acceptance  or  rejection. 

When  the  actual  surplus  at  March  t.  1913,  does  not  ap- 
pear on  the  books  of  the  individual,  firm  or  corporation,  the 
difficulty  of  the  case  is  apparent,  but  the  mere  absence  of  defi- 
nite recorded  figures  compiled  and  stated  on  that  exact  date 
does  not  preclude  a  legitimate  inquiry  at  a  later  time  and  an 
endeavor  to  ascertain  accurate  data  as  of  that  date.'*^     Much 


"Doyle  V.  Mitchell  Brothers  Company,  247  U.  S.  179,  38  S.  Ct.  467, 
62  L.  Ed.  1054  (May  20,  1918).  Case  decided  under  tlie  1909  law:  "Nor  is 
the  result  altered  by  the  mere  fact  that  the  increment  of  value  had  not  been 
entered  upon  plaintiff's  books  of  account.  Such  books  are  no  more  than 
evidential,  being  neither  indispensable  nor  conclusive.  The  decision  must 
rest  upon  the  actual  facts." 


6i4  INCOME 

of  the  work  of  public  accountants  consists  in  stating  accounts 
as  of  a  past  date,  and  their  findings  are  almost  invariably  sus- 
tained by  the  courts.  Therefore,  if  a  corporation,  say,  in 
191 7,  sets  up  in  its  books  certain  assets  acquired  before  March 
I,  19 1 3  (but  not  carried  on  its  books  at  any  valuation,  or  at 
a  low  valuation),  credits  surplus  and  declares  a  large  special 
dividend,  it  cannot  be  contended  that  there  is  there  a  distri- 
bution of  taxable  income,  unless  the  undistributed  earnings  ac- 
cumulated since  March  i,  19 13,  are  sufficient  to  cover  the 
payment. 

Comparative  values  of  similar  property. — 

Ruling.  In  general,  value  as  at  March  i,  1913,  of  property, 
real,  personal,  or  mixed,  may  be  established  by  consideration  of  bona 
fide  transactions  in  like  property  occurring  on  or  about  March  i, 
1913)  together  with  all  other  facts  pertaining  to  such  value.  (C.  B. 
I,  page  37;  O.  D.  7.) 

Prorating  land  and  crop  values. — 

Ruling.  A  purchased  for  a  certain  price  land  together  with 
crops  growing  thereon.  The  basis  for  determining  gain  or  loss  upon 
subsequent  sale  of  the  crops  is  the  difference  between  the  cost,  or  if 
no  part  of  the  purchase  price  was  assigned  to  the  crops,  the  fair 
market  value  thereof  at  the  time  of  purchase,  and  the  selling  price 
less  cost  of  harvesting  and  marketing.     (C.  B.  3,  page  49;  O.  D.  714.) 

Average  of  stock  quotations  on  March  i,  1913. — The  ques- 
tion has  arisen  as  to  which  price  shall  be  accepted  in  case  of 
the  sale  of  stock  listed  on  an  exchange,  which  was  sold  at 
varying  prices  on  March  i,  1913.  A  ruling  has  been  issued 
covering  this  point  as  follows : 

Ruling.  'The  fair  market  price  or  value  of  March  i"'  is  held 
to  be  the  fair  market  price  or  value  as  of  the  entire  day  of  March  i, 
which,  in  the  case  of  variation  between  "opening  and  closing  price" 
for  the  day,  would  mean  the  average  price  for  the  day.  This,  how- 
ever, would  be  conditioned  upon  showing  that  the  exchange  quota- 
tion represented  the  fair  market  price  or  value  of  the  stock,  as  it  is 
this  "fair  market  price  or  value"  which  is  to  control,  however  that 
fact  may  be  ascertained.  (Letter  to  the  Corporation  Trust  Company, 
signed  by  Commissioner  W.  H.  Osborn,  and  dated  November  21, 
1916.) 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         615 

In  view  of  frequent  references  to  the  March  i,  19 13,  date 
it  is  worth  while  to  note  that  in  legal  and  commercial  usage 
this  refers  to  facts  as  they  existed  at  the  commencement  of 
business  on  March  i,  1913.  In  the  regulations  the  date  Jan- 
uary I,  1909,  is  often  used.  In  commenting  thereon  the 
Supreme  Court  of  the  United  States  has  said  "December  31. 
1908,  would  have  been  more  precise,"'"'  meaning  that  as  the 
date  from  which  to  measure  changes  in  values,  December  31, 
1908,  should  have  been  selected  instead  of  January  i,  1909. 
It  may  safely  be  assumed  that  if  called  upon  to  pass  upon  a 
case  where  there  was  a  difference  between  prices  at  the  close 
of  business  February  28,  191 3,  and  the  average  of  prices  dur- 
ing the  entire  day  of  March  i,  19 13,  the  Supreme  Court 
would  doubtless  uphold  the  closing  prices  of  February  28, 

1913- 

New  York  Stock  Exchange  prices  on  March  i,  19 13,  were 
substantially  the  same  as  on  February  28,  19 13,  so  the  point 
probably  is  of  little  importance. 

Ruling.  The  value  of  shares  of  stock  as  at  March  i,  1913, 
should  be  determined  on  the  basis  of  market  quotations  as  at  that 
date  instead  of  book  vakies.     (C.  B.  2,  page  30;  A.  R.  R.  33.) 

When  only  a  few  shares  were  sold  before  and  after  March 
I,  19 1 3,  taxpayers  may  claim  that  such  sales  were  not  repre- 
sentative nor  controlling.  The  Treasury  itself  supports  the 
statement.*^ 

Valuation  of  closely  held  stocks. — 

Decision.  In  appraising  shares  of  stock  held  in  a  corporation 
whose  sole  property  was  an  office  building,  the  shares  having  always 
been  held  in  one  family  and  never  sold,  the  contention  of  the  execu- 
tors was  that  the  value  of  the  shares  should  be  determined  by  the 
earnings  of  the  property,  which  were  shown  to  have  been  from  2.18^ 
to  4.i5>4  per  cent  over  a  period  of  six  years.  The  value  was  claimed 
not  to  exceed  $50  per  share  and  the  federal  authorities  had  valued 
it  at  $39  per  share.     [The  par  was  $100.] 


'"Hays  V.  Gaulcy  Mnuiitahi  Coal  Co..  247  U.  S.  189,  38  S.  Ct.  470,  62 
L.  Ed.  1 06 1,  May  20,  19 18. 

"  See  Excess  Profits  Tax  Procedure,  1921. 


6i6  INCOME 

The  court  held  that  capital  stock  representing  a  building  in  good 
condition  must  be  considered  as  worth  the  amount  originally  contrib- 
uted by  the  shareholders ;  that  the  stock  represented  the  assets,  sug- 
gesting this  to  be  the  foundation  of  the  stock  dividend  decision 
{Eisner  v.  Macombcr)  ;  that  while  earning  power  was  of  very  con- 
siderable influence  upon  market  value,  it  was  but  one  of  the  elements 
and  not  the  most  important  one ;  that  the  argument  advanced  would 
lead  to  the  conclusion  that  where  a  corporation  had  been  running 
at  a  loss,  the  stock  would  be  worthless. 

The  fact  that  the  stock  in  question  represented  a  minority  interest 
was  held  not  material  under  the  circumstances  where  the  corporation 
owed  no  debts  and  where  its  property  consisted  of  a  large  ofifice 
building,  well  located  in  the  heart  of  a  growing  city  and  where  there 
had  been  no  dissension  among  the  stockholders.  The  shares  were 
held  worth  par,  one  judge  dissenting.'*'^ 

Value  fixed  by  appraisers  of  state  court  may  be  rebutted. — 

Ruling.  The  appraised  value  of  stock  as  at  the  time  of  the 
creation  of  a  trust  estate,  by  appraisers  of  a  State  court,  creates  a 
presumption  only  that  the  stock  is  of  the  appraised  value;  this  pre- 
sumption may  be  rebutted  by  competent  evidence  to  the  effect  that 
the  stock  was  of  another  value  than  that  appraised.  ( C.  B.  i,  page  38; 
A.  R.  M.  7.) 

In  one  case  the  executrix  was  the  residuary  legatee.  There 
was  no  direct  inheritance  tax  in  the  state  at  that  time;  no 
question  of  commissions  was  involved;  the  real  value  of  the 
stock  did  not  seem  to  be  a  vital  one  to  the  appraisers,  who  in 
1 9 14  valued  stock  at  $100  a  share.  The  real  value  was  over 
$500  a  share.  The  Treasury  allowed  a  reappraisal  in  this 
case  because  the  value  of  $100  a  share  was  merely  nominal. 

Pro  rata  method — how  far  valid. — The  early  regulations 
under  both  the  1909  and  the  1913  laws*'  laid  down  the  rule 
that  in  the  case  of  certain  appreciations  in  values  extend- 
ing through  a  period  which  began  before  the  effective  date 
of  the  law,  the  appreciations  should  be  considered  to  have  ac- 
crued evenly  throughout  the  period.  The  taxable  portion,  con- 
sequently, should  be  determined  by  a  prorating  process  which 

■**  Note  on  Succession  of  Coleman,  85   Southern  43   (La.)   appearing  in 
the  Bulletin  of  the  National  Tax  .Issocialion.  November,  1020,  page  57. 
"1909  law,  Reg.  31,   1909;   1913  law,  T.  D.  2291,  February  8,   1916. 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         617 

would  make  the  amount  taxable  depend  upon  the  relative 
length  of  the  period  elapsed  before  and  after  the  act  took 
effect.  The  Supreme  Court  has  made  it  plain  that  this  method, 
while  in  itself  not  illegal  as  a  method,  must  be  considered 
merely  one  way  of  ascertaining  the  value  of  the  property  at 
March  i,  1913.  In  certain  cases  it  may  be  the  best  or  the 
only  way  of  estimating  that  value  and  in  such  cases  the  court 
has  indicated  its  acceptability.  In  the  presence  of  some  less 
arbitrary  and  more  accurate  method  of  valuing  property  at  the 
effective  date  of  the  law,  the  pro  rata  method  is  not  to  be  con- 
sidered valid. 

In  a  case  under  the  1909  law,  Hays  v.  Gaiiley  Moun- 
tain Coal  Company  (decided  by  the  Supreme  Court  of  the 
United  States,  May  20,  1918),'^°  the  court  pointed  out  the 
necessity  of  establishing  the  value  of  the  capital  assets  on 
December  31,  1908,  and  commented  as  follows  on  methods 
of  determining  that  valuation: 

Decision.  Whether  this  should  be  done  by  taking  an  inventory 
upon  the  basis  of  market  values  then  existing,  or  whether  the  entire 
increment  accruing  between  the  time  of  acquiring  and  the  time  of 
disposing  of  the  assets  should  be  prorated  as  if  it  had  arisen  through 
a  series  of  gradual  and  imperceptible  augmentations,  is  a  matter  of 
detail,  to  be  settled  according  to  the  best  evidence  obtainable,  and  in 
accordance  with  valid  departmental  regulations.  Treasury  Regula- 
tions 31,  December  3,  1909,  provided  for  inventories  at  the  beginning 
and  end  of  each  year  with  respect  to  manufacturing  and  mercantile 
companies ;  and  with  regard  to  a  sale  of  capital  assets  acquired 
prior  to  January  i,  1909,  and  sold  thereafter,  required  that  the 
amount  of  increment  or  depreciation  representing  the  difference 
between  the  selling  and  buying  prices  should  be  adjusted  so  as 
fairly  to  determine  the  proportion  of  the  loss  or  gain  arising  subse- 
quent to  the  date  mentioned ;  but  without  prescribing  any  particular 
method  of  doing  this.  Subsequent  rulings  required  that  sales  of  stocks 
and  bonds  should  be  regarded  as  sales  of  capital  assets  and  accounted 
for  accordingly  under  Regulations  31,  and  while  still  requiring  inven- 
tories, resorted  to  the  prorating  method  with  respect  to  real  estate, 
apparently  on  the  ground  that  increases  and  decreases  in  the  value 
of  this  class  of  property  during  particular  periods  could  not  be  accu- 
rately determined 

"'247  U.  S.  189,  38  S.  Ct.  470,  62  L.  Ed.  1061. 


5i8  INCOME 

The  present  case  was  heard  upon  an  agreed  statement  of  facts 
which  contains  nothing  from  whicli  the  value  of  the  stock  at  the 
time  the  act  took  effect  may  be  deduced,  otherwise  than  by  the  pro- 
rating method  that  was  adopted;  nor  is  any  objection  made  by  the 
respondent  to  the  application  of  that  method.  Hence  there  is  no 
lawful   ground   for   overthrowing   the   tax. 

Again,  in  the  case  of  U.  S.  v.  C.  C.  C.  &  St.  L.  Railway 
Co./^  decided  by  the  same  court  on  the  same  day,  the  court 
remarked : 

Decision.  Just  how  this  part  (the  portion  taxable  because  ac- 
crued after  the  effective  date  of  the  law)  is  to  be  separated  from 
that  which  previously  accrued  is  a  matter  of  some  nicety,  as  we  have 
shown  in  the  Hays  v.  Gauley  Mountain  Coal  Co.,  supra  case,  The 
circuit  court  of  appeals  adopted  the  theory  of  an  inventory  taken  as 
of  the  time  the  act  went  into  effect;  and  although  the  assets  here 
under  consideration  were  not  acquired  for  the  purpose  of  sale  in  the 
manner  of  merchandise,  but  were  bought  for  investment,  and  hence 
were  not  inventoried  on  December  31,  1908,  it  accepted  the  stipulated 
fact  that  the  stock  had  a  regular  market  value  of  $57  per  share  on 
that  date  as  supplying  the  lack  of  an  inventory.  This  result  accords 
with  the  vie\ys  we  have  expressed  in  the  cases  referred  to. 

The  Treasury  has  pointed  out  that  the  Gauley  Mountain 
Coal  Company  case  merely  approved  the  prorating  method 
when  there  is  no  better  way  of  determining  fair  "value." 

Ruling.  In  the  year  1900  a  taxpayer  purchased  two  shares  of 
corporate  stock  for  an  aggregate  amount  of  52  x  dollars,  and  in  1915 
sold  the  same  shares  for  36  x  dollars.  On  March  i,  1913,  this  stock  was 
quoted  at  24  x  dollars.  The  taxpayer  claims  that  he  is  entitled  to 
a  deduction  for  loss  upon  the  sale  of  stock  to  the  extent  of  the  pro 
rata  part  of  the  reduction  from  cost  to  sale  price  attributable  to  the 
period  after  March  i,  1913. 

The  excess  of  the  proceeds  of  a  sale  in  the  year  1915  of  stock 
acquired  by  the  taxpayer  prior  to  March  i,  1913,  over  the  market 
value  of  such  stock  on  March  i,  1913,  determined  according  to  "the 
best  evidence  obtainable,'"  is  income  for  such  taxpayer  for  the  year 
191 5,  regardless  of  the  fact  that  the  sale  price  of  such  stock  was 
less  than  the  cost  of  such  stock  to  the  taxpaver.  (C.  B.  i,  page  35; 
T.  B.  M.  72>-) 

In  this  case  the  Treasury  held  that  the  vahie  of  the  stock 
on  March  i,   1913,  was  "fairly  shown  by  the  market  quota- 


"247  U.  S.  195,  38  S.  Ct.  472,  62  L.  Ed.  1064. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         619 

tions  on  that  date,"  wliich  was  a  better  measure  than  pro- 
rating, and  therefore  must  he  used.  In  view,  however,  of  the 
Supreme  Court  decision  in  Goodrich  z-.  Edziurds  (advance 
opinions,  65  L.  Ed.  450),  there  is  no  taxable  gain  in  this  case 
as  original  cost  exceeded  the  selling-  price.  Under  the  1921 
law,  also,  there  would  l)e  neither  taxa])le  gain  nor  deductible 
loss  in  this  case. 

Income  Derived   from  Sale  or  Exchange  of  Property 
Acquired  by  Gift  and  Inheritance 

A  new  provision  has  been  inserted  into  the  1921  law  where- 
by appreciation  of  gifts  in  the  hands  of  the  donor  is  taxable 
to  the  donee  when  the  latter  subsequently  disposes  of  the  gifts. 

Law.  Section  202.  (a)  ....  (2)  In  the  case  of  such  property, 
acquired  by  gift  after  December  31,  1920,  the  basis  shall  be  the  same 
as  that  which  it  would  have  in  the  hands  of  the  donor  or  the  last  pre- 
ceding owner  by  whom  it  was  not  acquired  by  gift.  If  the  facts  neces- 
sary to  determine  such  basis  are  unknown  to  the  donee,  the  Com- 
missioner shall,  if  possible,  obtain  such  facts  from  such  donor  or  last 
preceding  owner,  or  any  other  person  cognizant  thereof.  If  the  Com- 
missioner finds  it  impossible  to  obtain  such  facts,  the  basis  shall  be 
the  value  of  such  property  as  found  by  the  Commissioner  as  of  the 
date  or  approximate  date  at  which,  according  to  the  best  information 
the  Commissioner  is  able  to  obtain,  such  property  was  acquired  by 
such  donor  or  last  preceding  owner.  In  the  case  of  such  property  ac- 
quired by  gift  on  or  before  December  31,  1920,  the  basis  for  ascertain- 
ing gain  or  loss  from  a  sale  or  other  disposition  thereof  shall  be  the  fair 
market  price  or  value  of  such  property  at  the  time  of  such  acquisi- 
tion;  .... 

Gifts  after  December  31,  1920. — 

Regulation.  In  computing  the  gain  or  loss  from  the  sale  or 
other  disposition  of  property  acquired  by  gift  subsequent  to  December 
31,  1920,  the  basis  shall  be  the  same  as  it  would  have  in  the  hands  of 
the  donor  or  the  last  i)rece(ling  owner  by  whom  it  was  not  acquired 
by  gift.  This  basis  in  the  hands  of  the  donor  or  last  preceding  owner 
by  whom  it  was  not  acquired  by  gift  shall  be  determined  under  the 
provisions  of  article  1561  and  the  taxable  gain  or  deductible  loss 
from  the  sale  or  exchange  shall  be  computed  in  accordance  therewith. 
If  the  donee  is  unable  to  ascertain  the  facts  necessary  to  determine 
such  basis,  he  shall  so  state  upon  his  return,  and  the  Commissioner 


620  INCOME 

shall  if  possil)le  obtain  such  facts  from  such  donor  or  last  pre- 
ceding owner  or  any  other  person  cognizant  thereof.  If  the  Com- 
missioner finds  it  impossible  to  obtain  such  facts,  the  basis  shall  be 
the  value  of  such  property  as  found  by  the  Commissioner  as  of  the 
date  or  approximate  date  such  property  was  acquired  by  said  donor 
or  last  preceding  owner.  In  order  to  insure  a  fair  and.  adequate 
appraisal  or  determination  of  the  proper  basis,  donors  making  gifts 
of  property  on  or  after  January  i,  1921,  should  leave  an  accessible 
record  of  the  facts  necessary  to  determine  the  cost  of  such  property 
(and  its  fair  market  value  as  of  March  i,  1913,  where  pertinent). 
(Art.   1562.) 

Gifts  before  January  i,  1921 — bequests,  devises  or  in- 
heritances.— 

Regulation.  In  computing  the  gain  or  loss  from  the  sale  or 
other  disposition  of  property  acquired  by  gift  on  or  before  December 
31,  1920,  or  by  bequest,  devise,  or  inheritance,  the  basis  shall  be  the 
fair  market  price  or  value  of  such  property  at  the  time  of  acquisition. 
The  term  "property  acquired  by  bequest,  devise,  or  inheritance"  as  used 
herein  included  (a)  such  property  interests  as  the  taxpayer  has  re- 
ceived as  the  result  of  a  transfer,  or  creation  of  a  trust,  in  contempla- 
tion of  or  intended  to  take  effect  in  possession  or  enjoyment  at  or 
after  death  and,  (b)  such  property  interests  as  the  taxpayer  has  re- 
ceived as  the  result  of  the  exercise  by  a  person  of  a  general  power 
of  appointment  (i)  by  will,  or  (2)  by  deed  executed  in  contemplation 
of  or  intended  to  take  effect  in  possession  or  enjoyment  at  or  after  his 

death In  the  case  of  property  acquired  by  gift,  bequest,  de 

vise,  or  inheritance,  prior  to  March  i,  1913,  the  taxable  gain  or  de- 
ductible loss  from  the  sale  or  other  disposition  thereof  shall  be  com- 
puted in  accordance  with  article  1561.  In  the  case  of  property  acquired 
by  bequest,  devise,  or  inheritance,  its  value  as  appraised  for  the  pur- 
pose of  the  Federal  estate  tax  or  in  the  case  of  estates  not  subject 
to  that  tax  its  value  as  appraised  in  the  State  court  for  the  purpose 
of  State  inheritance  taxes  shall  be  deemed  to  be  its  fair  market  value 
when  acquired.      (Art.  1563.) 

The  accepted  principle  of  law  is  that  property  acquired 
from  donors  or  decedents  is  capital  in  the  hands  of  the  recip- 
ients, and  that  under  the  sixteenth  amendment  to  the  Federal 
C\)nstitution  no  taxable  income  can  be  imposed  thereon.  This 
principle  was  adopted  in  the  1913,  191 6,  1917  and  191 8  fed- 
eral income  tax  laws.  As  to  property  acquired  from  dece- 
dents, the  rule  is  followed  in  the  192 1  law.     As  to  gifts  other 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         621 

than  from  decedents,  an  attempt  is  made  in  the  192 1  law  to 
tax  appreciation  in  the  value  of  gifts  made  after  December 
31,  1920,  when,  as  and  if  realized  by  donees. 

Income  from  sale  of  property  acquired  by  gift. '^ — Early  in 
1 92 1,  the  House  of  Representatives  passed  an  act"^  amending 
the  existing  law  and  ascribing  to  donees  upon  realization  the 
same  measure  of  gain  as  would  have  been  realized  by  donors 
if  the  gift  had  not  been  made.  The  Act  did  not  pass  the 
Senate. 

The  act  was  meritorious  so  far  as  it  reached  palpable  eva- 
sion of  taxes  upon  actual  profits.  Taxpayers  owned  property 
which  had  increased  tremendously  in  value  since  191 3.  The 
taxpayers  having  received  very  favorable  cash  offers  for  their 
properties  and  being  unwilling  to  pay  any  tax  on  the  prospec- 
tive profit,  conveyed  the  property  to  their  wives.  Immediately 
after  the  conveyance  the  wives  would  sell  the  properties  and 
under  the  1918  and  prior  laws  no  tax  could  be  assessed  thereon. 
It  was  agreed  that  something  should  be  done  to  reach  this 
species  of  evasion. 

Prior  to  January  i,  192 1,  if  the  recipient  of  a  gift  disposed 
of  it  during  his  lifetime,  he  reported  as  taxable  income  (if  a 
profit  was  realized)  the  difference  between  the  value  of  the 
gift  the  day  it  was  received,  or  if  it  was  received  before  March 
I,  19 1 3,  its  value  on  that  date,  and  the  amount  realized.  If 
the  proceeds  of  the  sale  were  less  than  the  value  on  the  date 
of  receipt  of  the  gift  or  on  March  i,  1913,  the  resulting  loss 
was  an  allowable  deduction. 

The  state  of  New  York  attempted  to  tax  donors  at  the 
time  of  making  gifts,^*  on  the  gain  measured  by  the  difference 
between  the  cost  to  the  donor  and  the  value  of  the  gift  when 
made.     The  Appellate  Division  of  the  Supreme  Court  of  the 

°^'  Section  202  (a-2). 

"H.  R.  14198,  passed  House  of  Representatives  May  27,  1921. 
"  New  York   State  Comptroller's  Regulations,  Art.  91 ;  amended  No- 
vember, 1921. 


622  INCOME 

state  of  New  York  held  the  act  to  be  unconstitutional  on  the 
ground  that  no  taxable  income  was  realized.'"' 
The  1921   federal  law  is  as  follows: 

Law.  Section  202.  (a)  .  .  .  .  (2)  In  the  case  of  such  property, 
acquired  by  gift  after  December  i,  1920,  the  basis  shall  be  the  same  as 
that  which  it  would  have  in  the  hands  of  the  donor  or  the  last  preceding 
owner  by  whom  it  was  not  acquired  by  gift.  If  the  facts  necessary  to 
determine  such  basis  are  unknown  to  the  donee,  the  Commissioner 
shall,  if  possible,  obtain  such  facts  from  such  donor  or  last  preceding 
owner,  or  any  other  person  cognizant  thereof.  If  the  Commissioner 
finds  it  impossible  to  obtain  such  facts,  the  basis  shall  be  the  value  of 
such  property  as  found  by  the  Commissioner  as  of  the  date  or  approxi- 
mate date  at  which,  according  to  the  best  information  the  Commis- 
sioner is  able  to  obtain,  such  property  was  acquired  by  such  donor 
or  last  preceding  owner.  In  the  case  of  such  property  acquired  by  gift 
on  or  before  December  31,  1920,  the  basis  for  ascertaining  gain  or  loss 
from  a  sale  or  other  disposition  thereof  shall  be  the  fair  market  price  or 
value  of  such  property  at  the  time  of  such  acquisition;   .... 

The  192 1  law'''  does  not  fall  into  the  error  of  taxing  the 
gift  itself.  The  tax  is  only  imposed  upon  actual  realization  by 
the  donee  of  a  gain  measured  by  cost  to  the  donor.  As  a 
means  of  reaching  gains  which  should  properly  be  taxed,  the 
new  provision  is  meritorious.  A  limit  of  time,  however, 
should  have  been  fixed.  Palpable  evasions  of  tax  usually 
arose  when  sales  were  made  immediately  after  transfers  of 
property.  In  other  words,  the  sales,  in  effect,  were  transac- 
tions by  and  for  the  ostensible  donors.  The  gifts  were  not 
bona  fide.  When  sufficient  time  elapses  between  the  date  of 
a  gift  and  realization  by  donees,  it  may  be  assumed  that  the 
gift  is  bona  fide. 

Undoubtedly  the  legality  of  the  new  provision  will  be  at- 
tacked. Donees  in  receipt  of  bona  fide  gifts  cannot  be  held  to 
realize  "income"  except  to  the  extent  of  appreciation  after  the 
date  of  the  gift.  It  is  recognized  in  the  192 1  and  prior  laws 
that  property  acquired  from  a  decedent  is  capital  in  the  hands 

"'People  ex  rcl.  JVilsou  v.  Wendell,  188  N.  Y.  Supp.  273;  People  ex  rel. 
Brewster  v.  Wendell,  188  X.  Y.  Supp.  510. 

°*  [Former  Procedure]  Under  1918  and  prior  laws,  the  basis  of  gain 
or  loss  regarding  property  acquired  by  gift  was  value  at  the  date  of  the  gift. 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         623 

of  recipients.  It  is  difficult  to  discern  any  difference  between 
bona  fide  gifts  and  bequests.  The  obligations  imposed  upon 
donees  may  be  found  to  be  unreasonable.  In  the  case  of  hus- 
bands and  wives  or  children  it  may  be  reasonable  to  require 
a  statement  of  cost  or  value  March  i,  19 13,  to  accompany  a 
gift.  In  many  other  cases  the  obligations  are  too  onerous. 
Gifts  to  employees  and  servants  frequently  consist  of  shares 
of  stock  of  closely  held  corporations  or  real  estate  or  other 
property  the  cost  of  which  to  donors  is  uncertain  and  difficult 
to  determine.  Often  there  will  be  hesitancy  to  divulge  the 
actual  cost.     In  such  cases  the  donee  is  unduly  penalized. 

The  new  provision  works  two  ways.  If  constitutional 
it  imposes  on  donees  liability  for  tax  when  the  donor  would 
have  realized  a  profit,  but  it  opens  up  two  opportunities  to 
donors  of  which  they  will  not  be  slow  to  take  advantage.  Here- 
tofore, in  order  to  transfer  possible  tax  liability  it  was  nec- 
essary to  make  irrevocable  gifts.  In  many  cases  securities  or 
other  property  declined  in  value  after  the  date  of  the  gift. 
The  donor  was  unable  to  take  advantage  of  the  loss  in  case 
of  sale.  Under  the  present  law  donors  will  be  able  to  wait 
almost  indefinitely  in  the  case  of  non-income  bearing  property 
before  deciding  whether  or  not  to  make  the  gift.  If  the  prop- 
erty declines  in  value  and  the  donor  decides  to  sell  it,  he  may 
deduct  the  loss.  If  it  increases  in  value  and  the  gift  is  made, 
the  donee  will  pay  the  same  tax  as  if  the  gift  had  been  made 
earlier.  Furthermore,  donees  may  now  make  new  gifts  to 
former  donors  in  which  case  the  latter  may  deduct  losses 
which  under  the  1918  and  prior  laws  would  only  have  been 
deductible  by  donees,  i.e.,  the  loss  accrued  after  the  first  gift. 

No  income  tax  is  imposed  upon  an  estate  for  any  appre- 
ciation in  values  which  may  exist  at  the  date  of  death,  but 
inheritance  taxes  are  based  on  actual  values. 

Appreciation  in  value  of  gift  is  not  income  to  donor. — The 

following  ruling  applies  to  the  determination  of  taxable  profit 
upon  sale  of  any  gift  received  prior  to  January  i,  1921.     It 


624  INCOME 

is  immaterial  wliether  the  sale  took  place  before,  or  takes 
place  after,  January  i,  192 1,  as  the  provision  of  the  192 1 
law  taxing  profits  from  property  sold  or  otherwise  disposed 
of  on  the  same  basis  as  though  the  property  were  in  the  hands 
of  the  donor  or  last  preceding  owner  who  did  not  acquire  it 
by  gift,  applied  only  to  gifts  made  after  December  31,  1920. 

Ruling In  the  case  of  a  real  and  actual  gift  of  property 

which  has  appreciated  in  value  between  the  time  of  acquisition  and  the 
time  the  gift  is  made,  the  appreciation  will  not  be  the  subject  of 
income  taxation,  and  the  donee  who  sells  it  will  return  as  income  only 
any  appreciation  realized  over  its  value  when  the  donee  actually 
became  the  owner  of  it. 

On  the  other  hand,  a  mere  colorable  gift  is  not  to  be  treated  as 
a  gift  at  all,  and  an  attempt  by  such  colorable  gift  to  evade  taxation 
is  fraud  for  which  either  party  who  participates  therein  may  be 
punished.      (C.  B.  i,  page  83;  S.  1022.) 

In  view  of  section  202  (a-2)  of  the  1921  law,  the  Treas- 
ury will  doubtless  hold  that  this  ruling  does  not  apply  to  gifts 
made  after  December  31,  1920. 

Homestead — value  at  date  of  acquisition. — 

Ruling.  The  basis  for  determining  gain  or  loss  from  the  sale 
of  a  homestead  acquired  from  the  Government  will  be  the  fair  mar- 
ket value  of  the  homestead  at  the  date  of  its  acquisition  or  the  value 
at  March  i,  1913,  if  acquired  prior  to  that  date. 

The  date  of  acquisition  of  a  homestead  acquired  by  public  grant 
is  the  date  of  entry  upon  the  land.  The  taxpayer  will  not  be  entitled 
to  add  to  the  value  of  the  homestead  the  amount  expended  for 
relinquishment  in  order  to  clear  the  Land  Office  records,  nor  any 
fees  paid  to  the  Government,  but  the  cost  of  improvements  may  be 
added  to  the  value  as  of  the  date  of  acquisition.  (C.  B.  2,  page  33: 
O.  D.  386.) 

The  foregoing  is  based  on  the  theory  that  a  "public 
grant"  is  in  the  nature  of  a  gift  from  the  government.''' 
Therefore  the  value  used  to  compute  profit  or  loss  on  sale  is 
the  same  as  that  used  in  the  case  of  any  gift,  viz.,  the  value 
at  date  of  acquisition  if  after  March  i,  1913.  and  before  Tanu- 

"  Letter  to  the  Corporation  Trust  Company,  signed  bj-  Acting  Commis- 
sioner Paul  F.  Myers,  dated  July  8,  1920. 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         625 

ary  i,   1921.     The  procedure  regarding  such  gifts  after  De- 
cember 31,  1920,  is  a  good  test  of  one's  imagination. 

Income  from  sale  of  property  acquired  by  inheritance. — 

Law.  Section  202.  (a)  .  .  .  .  (3)  In  the  case  of  such  property, 
acquired  by  bequest,  devise,  or  inheritance,  the  basis  shall  be  the  fair 
market  price  or  value  of  such  property  at  the  time  of  such  acquisition.'''^ 
The  provisions  of  this  paragraph  shall  apply  to  the  acquisition  of  such 
property  interests  as  are  specified  in  subdivision  (c)  or  (e)  of  section 
402. s^    .... 

Value  at  date  of  testator's  death  must  be  used. — 

Ruling.  In  computing  gain  or  loss  on  a  sale  of  stock  by  trustees 
under  a  will,  the  value  of  the  stock  at  the  date  of  the  testator's 
death  should  be  used  as  the  starting  point  rather  than  the  value  of 
such  stock  at  the  date  of  distribution  to  the  trustees. 

Any  gain  realized  on  such  a  sale  must  be  reported  as  taxable 
income  by  the  trustees,  who  will  also  be  required  to  pay  the  tax  due 
thereon.  The  fact  that  at  some  uncertain  date  in  the  future  the 
corpus  of  the  estate,  including  the  accumulation  of  income  of  a 
certain  character  will,  if  it  is  then  in  existence  be  paid  over  to 
exempt  corporations,  does  not  relieve  the  trustees  from  the  obliga- 
tion of  paying  the  tax (C.  B.  2,  page  34;  O.  1012.) 

The  last  paragraph  of  the  foregoing  ruHng  is  contrary  to 
a  recent  court  decision  based  on  the  19 16  and  191 7  laws. 
{Ledercr  v.  Stockton,  266  Fed.  173,  writ  of  certiorari  was 
granted  by  the  Supreme  Court  October  25.  1920,  254 
U.S.  625.) 

Ruling.  Under  the  terms  of  a  will  the  residue  of  the  estate  was 
bequeathed  to  the  testator's  three  sons,  to  be  divided  equally  among 
them.  This  residue  consisting  of  cash  and  a  number  of  securities 
was  in  accordance  with  mutual  agreement  divided  upon  the  basis  of 
the  market  price  of  the  securities  at  the  time  of  distribution,  which 
was  in  excess  of  their  value  at  the  date  of  decedent's  death,  as 
appraised  for  Federal  estate  tax  purposes.  Following  this  arrange- 
ment one  of  the  residuary  legatees  received  no  cash,  another  less 
cash  than  the  third,  but  all  received  an  equal  share  of  the  residue  in 

'^^  [Former  Procedure]  Reg.  45,  Art.  1562,  provided  that  the  value 
at  time  of  acquisition  should  be  the  basis  for  property  acquired  by  gift  as 
well  as  by  bequest,  devise  or  descent. 

''"Section  402  (c)  and  (e)  .deals  with  tlie  determination  of  the  gross 
estate  of  a  decedent  for  estate  tax  i)urposes.     For  details  see  Chapter  XL. 


626  INCOME 

accordance  with  the  terms  of  the  will.  The  question  presented  is 
whether  the  estate  derived  any  taxable  gain  from  the  transfer  of  the 
securities  to  the  residuary  legatees  and  whether  on  a  subsequent  sale 
by  the  legatees  the  basis  for  determining  gain  or  loss  is  the  fair  market 
value  of  such  securities  at  the  time  they  w^ere  received  by  the  legatees 
in  the  distribution  or  at  their  appraised  value  as  at  the  date  of  the 
death  of  the  testator. 

Held,  that  the  estate  of  the  decedent  derived  no  taxable  gain 
from  the  transfer  to  the  residuary  legatees  of  the  securities  forming 
a  part  of  the  residue  of  such  estate.  The  basis  for  determining  gain 
or  loss  upon  a  sale  of  securities  received  by  legatees  is  the  value  of 
such  securities  at  the  date  of  the  testator's  death,  as  appraised  for 
the  purpose  of  the  Federal  estate  tax,  whether  the  devise  or  bequest  be 
specific  or  residuary.      (C.  B.  3,  page  53;  O.  D.  667.) 

^^'here  securities  held  in  trust  for  the  beneficiaries  are  sub- 
secjuently  distributed  together  with  other  securities  represent- 
ing investments  by  the  executors,  it  is  necessary  to  segregate 
the  securities  for  purpose  of  determining  any  profit  on  sale 
l^y  the  beneficiaries. 

Ruling.  Held,  that  the  basis  to  be  used  in  determining  the  gain 
or  loss  resulting"  from  the  sale  of  those  securities  which  were  part 
of  the  estate  of  the  testator  at  the  time  of  his  death  is  the  value  of 
the  beneficiary's  vested  interest  in  such  securities  as  at  the  date  of  the 
decedent's  death ;  that  the  basis  to  be  used  in  determining  the  gain  or 
loss  resulting  from  the  sale  of  those  securities  representing  an  invest- 
ment made  by  the  trustees  after  the  death  of  the  decedent  is  the  cost 
of  such  securities  to  the  trustees.      (I-3-28;  1.  T.  1165.) 

Securities  are  to  be  valued  at  date  they  are  avail- 
able, IRRESPECTIVE  OF  DATE  RECEIVED. 

Ruling.  On  the  date  of  her  divorce  in  1919  a  beneficiary  under  a 
trust  instrument  executed  by  her  father  became  entitled  to  the  delivery 
by  the  trustee  of  securities.  Their  value  on  this  date  is  the  basis 
for  determining  gain  or  loss  from  a  sale,  notwithstanding  the  fact 
that  by  mistake  she  did  not  receive  them  till  two  years  subsequently. 
(B.  Digest  51-21-1976;  O.  D.  1136.) 

Value  as  between  life  tenant  and  remainderman. — 

Ruling.  Where  in  a  bequest  of  property  the  remaindermen  have 
only  a  contingent  interest  prior  to  the  death  of  the  life  tenant,  the 
basis  for  determining  gain  or  loss  from  a  sale  of  such  property  by 
the  remaindermen  is  its  value  as  of  the  date  of  death  of  the  life 
tenant.     ( C.  B.  3,  page  53;  O.  D.  '/2/.) 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         627 

When  interest  is  not  contingent. — 

Ruling.  Where  real  estate  is  devised  by  a  testator  to  his  widow 
for  Hfe  with  a  direction  that  upon  her  death  the  property  shall  be 
sold  and  the  proceeds  divided  among  the  testator's  children,  the  basis 
for  ascertaining  the  gain  or  loss  on  a  sale  of  such  real  estate  and 
distribution  of  the  proceeds  to  the  children  is  the  value  of  their  rights 
at  the  time  they  vested,  or  on  March  i,  1913,  if  they  vested  prior 
thereto 

The  possession  of  land  devised  to  the  children  of  a  testator  sub- 
ject to  a  life  estate  in  their  mother,  which  vested  in  fact  on  the  death 
of  the  life  tenant,  was  acquired  by  the  children  in  right  on  the  death 
of  the  testator.  The  provision  of  the  income  tax  law  exempting  from 
tax  the  value  of  property  acquired  by  a  devise  or  bequest  merely 
exempts  the  value  of  the  right  at  the  time  it  was  acquired  and  not 
any  value   which   subsequently   may   attach   to   it   pending   actual   or 

anticipated   arrival   of   the   period   of   enjoyment (C.    B.   3, 

page  50;  Sol.  Op.  35.) 

In  the  detailed  opinion  the  soHcitor  said : 

Section  2(c)  of  the  Revenue  Act  of  1916,  in  so  far  as  the  pres- 
ent question  is  concerned,  is  substantially  the  same  as  the  provisions 
of  section  202  of  the  Revenue  Act  of  1918,  here  involved.  Law 
Opinion  649,  upon  a  consideration  and  application  of  the  former 
section,  held  that  the  basis  for  determining  the  profit  from  a  sale  of 
real  estate  by  a  remainderman  after  the  termination  of  a  life  estate  is 
the  value  of  the  property  upon  the  date  when  the  remainder  vested 
in  possession.  That  opinion  is  inconsistent  with  the  view  here  enter- 
tained and  is  hereby  overruled. 

Capital  Gains 

Prior  to  January  i,  1922,  the  rates  of  tax  imposed  under 
all  federal  income  and  profits  tax  laws  were  the  same  upon 
capital  gains''"  as  upon  ordinary  net  income.  Under  the  192 1 
law  the  maximum  rate  of  tax  upon  net  capital  gains  realized 
after  January  i,  1922,  is  12^/2  per  cent.*^^    As  the  rate  includes 

°°  "There  are  capital  profits  and  revenue  profits.  Thus,  for  instance, 
part  of  a  tract  of  land  upon  which  a  factory  has  been  erected  is  sold  for  an 
amount  equal  to  the  original  cost  of  the  entire  undertaking.  This  is  realized 
income,  but  it  does  not  fall  within  the  ordinary  definition,  therefore  it  is  not 
wise  to  rely  upon  any  one  definition.  The  net  income  from  a  man's  voca- 
tion is  revenue  profit ;  the  net  profit  realized  from  an  outside  venture  is 
capital  profit."  [Auditing  Theory  and  Practice,  by  R.  H.  Montgomery 
(1921  edition),  page  309.] 

"'  For  computations,  etc.,  see  page  631. 


628  INCOME 

the  normal  tax  of  8  per  cent,  the  niaxinunn  surtax  is  4^2  per 
cent.  The  provision  does  not  ai)ply  to  corporations,  but  as  the 
tlat  tax  upon  corporations  is  12 J/2  per  cent  the  inhibition  is  of 
no  importance  for  the  year  1922. 

The  law  contains  the  following  definitions : 

Law.     Section  206.     (a)  That  for  the  purpose  of  this  title: 
(i)  The  term  "capital  gain"  means  taxable  gain  from  the  sale  or 
exchange  of  capital  assets  consummated  after  December  31,  1921; 

(2)  The  term  "capital  loss"  means  deductible  loss  resulting  from 
the  sale  or  exchange  of  capital  assets  consummated  after   December 

31.  1921; 

(3)  The  term  "capital  deductions"  means  such  deductions  as  are 
allowed  under  this  title  for  the  purpose  of  computing  net  income  and 
are  properly  allocable  to  or  chargeable  against  items  of  capital  gain  as 
defined  in  this  section; 

(4)  The  term  "capital  net  gain"  means  the  excess  of  the  total 
amount  of  capital  gain  over  the  sum  of  the  capital  deductions  and 
capital  losses; 

(5)  The  term  "ordinary  net  income"  means  the  net  income,  com- 
puted in  accordance  with  the  provisions  of  this  title,  after  excluding  all 
items  of  capital  gain,  capital  loss,  and  capital  deductions;  and 

(6)  The  term  "capital  assets"  as  used  in  this  section  means  prop- 
erty acquired  and  held  by  the  taxpayer  for  profit  or  investment  for 
more  than  two  years  (whether  or  not  connected  with  his  trade  or  busi- 
ness), but  does  not  include  property  held  for  the  personal  use  or  con- 
sumption of  the  taxpayer  or  his  family,  or  stock  in  trade  of  the  tax- 
payer or  other  property  of  a  kind  which  would  properly  be  included 
in  the  inventory  of  the  taxpayer  if  on  hand  at  the  close  of  the  taxable 
year 

The  provisions  of  the  192 1  law  with  respect  to  the  method 
and  rate  of  taxation  to  be  applied  to  capital  gains  realized 
after  December  31,  192 1,  are  as  follows: 

Law.     Section  206 (b)  In  the  case  of  any  taxpayer  (other 

than  a  corporation)  who  for  any  taxable  year  derives  a  capital  net  gain, 
there  shall  (at  the  election  of  the  taxpayer)  be  levied,  collected  and 
paid,  in  lieu  of  the  taxes  imposed  by  sections  210  and  211  of  this  title, 
a  tax  determined  as  follows: 

A  partial  tax  shall  first  be  computed  upon  the  basis  of  the  ordinary 
net  income  at  the  rates  and  in  the  manner  provided  in  sections  210 
and  211,  and  the  total  tax  shall  be  this  amount  plus  121^  per  centum 
of  the  capital  net  gain;  but  if  the  taxpayer  elects  to  be  taxed  under 
this  section  the  total  tax  shall  in  no  such  case  be  less  than  12^  per 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS        629 

centum  of  the  total  net  income.  The  total  tax  thus  determined  shall 
be  computed,  collected  and  paid  in  the  same  manner,  at  the  same 
time  and  subject  to  the  same  provisions  of  law,  including  penalties, 
as  other  taxes  under  this  title. 

Although  the  courts  and  economists  do  not  agree  on  the 
distinction  between  capital  and  income,  the  language  of  the 
law  is  not  ambiguous  and  there  should  be  little  difficulty  in 
computing  net  capital  gains. 

In  large  part  the  regulations  pertaining  to  the  capital  gain 
provisions  of  the  law  merely  repeat  in  slightly  different  phrase- 
ology the  language  of  the  law  itself  and  present  a  few  illus- 
trative figures  to  show  the  application  of  the  provisions  to  con- 
crete cases.  The  regulations  do,  however,  touch  specifically  on. 
two  points  which  are  not  mentioned  in  the  law  itself.  One  is 
with  reference  to  the  case  of  a  taxpayer  who  has  a  net  capital 
gain  and  a  net  loss  in  ordinary  income  account.  The  regula- 
tions hold  that  the  net  loss  in  ''ordinary  net  income"  cannot  be 
applied  against  net  capital  gain  if  the  benefit  of  the  I2)'2  per 
cent  rate  of  tax  on  the  capital  gain  is  to  be  availed  of.  The 
other  point  is  with  res])ect  to  the  question  of  whether  the 
two-year  period  runs  from  the  inception  of  an  investment, 
the  form  (but  not  the  substance)  of  which  has  changed  but 
from  which  change  under  section  202  (c)  no  taxable  profit 
or  deductible  loss  is  deemed  yet  to  have  arisen,  or  whether 
the  two-year  period  runs  from  the  time  the  investment  took 
the  form  it  had  at  the  time  of  sale.  Article  1561  (see  page 
570)  holds  that  in  such  case  the  time  during  which  the  invest- 
ment was  in  its  previous  form  is  included  in  the  two-year 
period. 

Regulation,  (a)  Section  206  applies  only  to  sales  or  exchanges 
of  capital  assets  consummated  after  December  31,  1921.  It  provides 
that  any  taxpayer  other  than  a  corporation  may,  if  he  so  desires,  state 
separately  in  his  return  his  net  gain  on  sales  or  exchanges  of  capital 
assets  and  pay  on  such  capital  net  gain  (as  defined  and  limited  in  the 
section)  a  fiat  tax  of  12^2  per  cent  in  lieu  of  the  tax  he  would  other- 
wise pay  on  such  income  under  sections  210  and  211.  On  his  net  income 
from  other  sources,  termed  "ordinary  net  income"  in  this  section, . 
he  would  be  taxed  under  those  sections.     If,  however,  he  elects  thus 


630 


INCOME 


to  segregate  his  capital  net  gain,  his  total  tax  on  the  aggregate  amount 
of  both  kinds  of  income  must  be  at  least  12^  per  cent  thereof. 

Definitions:    "capital  as.sets." — 

The  term  "capital  assets"  is  defined  to  mean  property  of  any  kind 
whatever  acquired  and  held  by  the  taxpayer  for  profit  or  investment 
for  more  than  two  years,  whether  or  not  connected  with  his  trade 
or  business,  not  including  property  ( for  example,  a  dwelling)  held  for 
the  personal  use  or  consumption  of  the  taxpayer  or  his  family,  or 
stock  in  trade  of  the  taxpayer  or  other  property  of  a  kind  properly  in- 
cluded in  an  inventory.  The  specific  property  sold  or  exchanged  must 
have  been  held  for  more  than  two  years,  but  in  the  case  of  a  stock 
dividend  the  prescribed  period  applies  to  the  original  stock  and  the 
stock  received  as  a  dividend  considered  as  a  unit  and  where  property 
is  exchanged  for  other  property  and  no  gain  or  loss  recognized  under 
the  provisions  of  section  202,  the  prescribed  period  applies  to  the 
property  exchanged  and  the  property  received  in  exchange  con- 
sidered as  a  unit. 

"Capital  gain"  and  "capital  loss." — - 

"Capital  gain"  is  taxable  gain  from  the  sale  or  exchange  of  capital  as- 
sets, while  "capital  loss"  is  deductilile  loss  resulting  from  the  sale  of 
capital  assets.  As  to  the  basis  for  determining  such  gain  or  loss  (in- 
cluding adjustment  for  depreciation)  see  article  1561 ;  as  to  better- 
ments and  repairs,  see  articles  24  (3)  and  103.  Ordinary  repairs  and 
taxes  are  annual  charges  against  income,  and  do  not  enter  into  the 
computation  of  such  gain  or  loss. 

"Capital  deductions"  and  "capital  net  gain." — 

"Capital  deductions"  are  deductions  properly  allocable  to  or  chargeable 
against  items  of  capital  gain,  including  items  of  expense  connected 
with  the  sale  or  exchange  of  a  capital  asset  ( for  example,  commissions 
paid  brokers  or  agents).  While  interest,  taxes,  and  other  carrying 
charges  are  usually  annual  charges  against  income,  they  may  be  al- 
located to  capital  gain  derived  from  the  sale  or  exchange  of  a  capital 
asset  for  the  taxable  year  in  which  such  asset  is  sold  or  exchanged 
to  the  extent  that  such  current  charges  exceed  the  income  directly 
derived  from  such  asset.  "Capital  net  gain"  is  the  excess  of  the  total 
amount  of  the  capital  gain  over  the  sum  of  the  capital  deductions  and 
capital  losses. 

Computation  of  capital  net  gain  and  tax. — 

For  illustration:  A  in  K)22  sold  li)  an  ofiice  building  for 
$1,000,000  which  he  had  bought  in   1915   for  $500,000  and  on  which 


EXCHANGES    OR    SALES    OF    CAPITAL   ASSETS         631 

there  was  depreciation  aggregating  $100,000;  and  (2)  stock  in  a 
mining  company  for  $10,000  which  he  had  purchased  in  1919  for 
$20,000.  Taking  no  account  of  capital  deductions  (for  example, 
commissions  paid  on  these  sales),  his  capital  gain  would  be  $600,000, 
his  capital  loss  $10,000,  and  his  capital  net  gain  $590,000.  Sup- 
pose that  his  other  net  income  ("ordinary  net  income")  in  1922  was 
$50,000.  Instead  of  paying  normal  tax  and  surtax  on  his  total  net 
income  of  $640,000,  he  may  segregate  these  capital  transactions  in 
his  return  and  pay  a  tax  of  12^2  per  cent  on  his  capital  net  gain  of 
$590,000,  plus  the  normal  tax  and  surtax  upon  his  ordinary  net  in- 
come of  $50,000.  Suppose,  on  the  other  hand,  that  A,  with  capital 
net  gain  of  $590,000,  not  only  had  no  "ordinary  net  income,"  but 
actually  sustained  a  net  loss  of  $50,000  in  his  business.  He  may  not 
deduct  such  net  loss  in  "ordinary  net  income"  from  his  capital  net 
gain  if  he  elects  to  be  taxed  under  section  206,  but  must  pay  12J/2 
per  cent  of  $590,000 (Art.  1651.) 

The  illustration  in  article  1651  quoted  above  may  be  stated 
in  tabular  form  as  follows : 

1922     Selling  price  of  office  building $1,000,000 

191 5     Cost  price  of  office  building $500,000 

Less:    Depreciation    100,000         400,000 

Capital  gain  $600,000 

1919     Cost  of  mining  stock   $     20,000 

1922     Selling  price  of  mining  stock 10,000 

Capital  loss   10,000 

Capital  net  gain   $590,000 

Other  income   ("ordinary  net  income") 50,000 

Total  net  income  ' $640,000 

Tax 
A  pays  125^%  on  $590,000 $  73,750 

Plus:  Normal  tax: 

Ordinary  net  income    $      50,000 

Less:    Exemption    (if    married   and   having 

no    dependents)     $       2,000 

$     48,000 
Taxable  at  4%   4,000  160 

Taxable  at  8%  $     44,000  3.520 

Surtax   (1922  rates)  on  $50,000 4,960 

Total  tax   $  82,390 


632  INCOME 

The  tax  computed  without  benefit  of  the  capital  gains  provision 
would  be  : 

Normal  tax : 

Normal   income    $    640,000 

Less :  Exemption  2,000 

$   638,000 
Taxable  at  4%    4.000    $        160 

Taxable  at  8%   : $    634,000  50.720 

Surtax  on  $640,000   290,960 

Total  tax   $341,840 

Difference    $259,450 

In  the  second  case  assumed  in  the  illustration 

Capital  net  gain  is  the  same  as  before $590,000 

But  instead  of  other  income  ("ordinary  net  in- 
come") of  $50,000,  A  sustained  a  net  loss  in 
business  of  $     50,000 

Such  net  loss  is  not  deductible  from  the  $590,000 
capital  net  gain  which  is  taxed  at  i2i/2%. 

The  net  loss  of  $50,000  from  business,  mentioned  in  the 
illustration,  should  not  be  confused  with  the  "net  loss"  de- 
scribed in  section  204  (see  Chapter  XXIX),  which  may  be 
carried  forward  to  the  succeeding  year.  The  $50,000  net  loss 
shown  in  the  illustration  is  merely  a  factor  in  the  alternative 
computation  under  the  capital  gains  provisions  Section  206. 
On  the  other  hand,  assume  that  A's  capital  gain  is $100,000 

and  that  A's  net  loss  from  business,  as  before,  is. .  . .     $50,000 

If  A  computed  the  tax  under  the  capital  gains  provision,  the  tax 

would  be  i2j/2%  of  $100,000,  or $  12,500 

If  A  does  not  elect  to  be  taxed  under  the  capital  gains  provision, 
the  tax  will  be  computed  as  follows : 

Normal  tax : 

Net  income    ($100,000  —  $50,000) $50,000 

Less:  Personal  exemption   2,000 

$48,000 
Taxable  at  4%    4,000     $        160 

Taxable  at  8%    $44,000  3,250 

Surtax  on  $50,000   4,960 

Total  tax   $    8,640 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS        633 

It  is  obvious  that  A  in  the  ilkistration  just  given  would 
not  invoke  the  capital  gains  section  of  the  law.  The  point  is 
that  losses  which  may  not  be  deductible  in  computing  capital 
gains  may  be  taken  in  computing  net  income  in  the  regular 
way.  Alternative  computations  will  have  to  be  made  so  the 
taxpayer  can  determine  which  yields  the  lower  tax. 

Application  of  credits  and  exemptions  in  alternative  com- 
putations.— 

Regulation (b)   The   credit   allowed  by  section   222^- 

....  is  a  credit  against  the  total  tax,  however  compnted,  but  the 
creeh'ts  allowed  l\v  section  216''''  are  allowed  "for  the  purpose  of  the  nor- 
mal tax  only"  and  may  not  l)e  taken  against  capital  net  gain,  although 
they  may  be  deducted  from  ordinary  "net  income."  For  example,  if 
B,  a  married  person,  had  capital  net  gain  of  $30,000  and  ordinary 
net  income  of  $2,000,  his  $2,500  personal  exemption  would  more  than 
offset  his  ordinary  net  income,  but  he  may  not  apply  any  part  of  it 
to  reduce  his  capital  net  gain (Art.  1651.) 

Tax  not  less  than  12^  per  cent  of  total  net  income. — 

Regulation Section  206  (b)  provides  that  if  the  tax- 
payer elects  to  be  taxed  under  that  section  his  total  tax  shall  in 
no  case  be  less  than  12^  per  cent  of  his  total  net  income.  In  the  ex- 
ample just  given,  the  tax  on  B's  capital  net  gain  of  $30,000  at  I2j^ 
per  cent  would  be  $3,750,  but  the  corrected  amount  of  his  total  tax 
under  this  limitation  is  12^  per  cent  of  his  total  net  income  of 
$32,000,  or  $4,000.  It  will  be  found,  hoA'ever,  that  B,  with  ordinary 
net  income  of  $2,000  and  capital  net  gain  of  $30,000,  would  not  elect 
to  be  taxed  under  section  206  because  under  the  surtax  rates  for  1922 
his  total  tax  computed  in  the  usual  way  would  be  only  $3,940  (normal 
tax  $2,240  plus  surtax  $1,700),  or  $60  less  than  if  computed  under 
section  206 (Art.  1651.) 

The  tax  in  the  foregoing  illustration  is  computed  thus : 
(i)   On  basis  of   capital  gains    $3,75o 

(2)  On  basis  of  applying  the  limitation  of  12^%  to  total  net  in- 

come         $4,000 

(3)  On  ordinary  basis,  disregarding  capital  gains  provision $3,940 

B  pays  the  last  of  the  three  taxes. 

•'""Section  222  refers  to  credit  for  foreign  income  and  profits  taxes. 
°'  Section  216  provides  for  credit  of  certain  dividends  and  interest,  and 
tor  the  personal  exemptions  and  credits  for  dependents. 


634  INCOME 

Effective  date. — The  law  refers  to  transactions  "consum- 
mated after  December  31,  192 1."  It  is  clear  that  sales  or 
exchanges  which  were  entirely  completed  before  January  i, 
1922,  cannot  be  reported  in  1922,  but  are  subject  to  the  rates 
in  force  prior  to  1922.  Irrespective  of  the  new  regulations, 
the  attitude  of  the  Treasury  must  be  that  the  word  "consum- 
mated" as  applied  to  the  taxation  of  income,  means  actual 
realization  and  not  a  "paper"  closing  of  a  transaction.  There 
will  be  cases  in  which  doubts  will  arise  as  to  the  actual  con- 
summation of  a  transaction,  and  in  some  cases  the  decision  will 
throw  the  gain  back  of  1922  and  in  almost  similar  cases  the 
gain  will  be  held  to  be  realized  in  1922.  Generally  speaking, 
transactions  prior  to  January  i,  1922,  which  did  not  result 
in  the  receipt  of  cash  or  property  of  a  readily  realizable  mar- 
ket value,  were  not  consummated  on  the  effective  date,  and 
the  gains  arising  from  such  transactions  should  not  be  reported 
until  they  are  actually  consummated. 

Meaning  of  term  "capital  assets." — Upon  the  interpreta- 
tion given  to  the  term  "capital  assets"  will  depend  the  classi- 
fication of  items  which  heretofore  have  not  been  carefully 
earmarked  as  capital  items  because  no  necessity  existed  for  a 
correct  classification.  It  is  immaterial  what  terminology  may 
have  been  used  by  taxpayers  in  the  past.  The  sole  test  here- 
after will  be  the  true  designation  of  items.  The  law  clearly 
sets  forth  three  negative  tests  which  permit  easy  classification : 

1.  Capital  assets  must  have  been  owned  for  at  least  two 

years. 

2.  Stock-in-trade  must  be  excluded. 

3.  Property  held  for  personal  use  or  consumption  must 

be  excluded. 

Meaning  of  two-year  requirement. — In  imposing  a  low 
rate  of  tax  it  was  the  intention  of  Congress  to  encourage  the 
transfer  of  investments.  It  had  been  claimed  that  property  held 
for  a  long  period  of  years  could  not  profitably  be  disposed  of 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS        635 

under  the  high  rates  of  tax.  The  argument  did  not  extend  to 
gains  arising  from  property  recently  acquired.  With  this  in 
mind  it  should  not  be  difficult  to  follow  the  two-year  limitation. 
Taxpayers  who  claim  the  benefits  of  the  special  rate  must  show 
that  the  assets  from  which  the  taxable  gains  arise  have  been 
"acquired  and  held  by  the  taxpayer"  for  more  than  two  years 
prior  to  date  of  sale.  The  property  disposed  of  must  be  the 
identical  property  acquired  more  than  two  years  previously, 
unless  the  existing  property  is  held  for  income  tax  purposes  to 
take  the  place  of  other  property. 

In  all  cases  which  are  held  not  to  be  closed  transactions 
the  two-year  period  runs  from  the  date  the  original  property 
was  acquired.  There  are  difficulties  in  applying  this  prin- 
ciple. \/Vhen  real  estate  which  is  real  property  has  been 
exchanged  for  shares  of  stock  which  are  personal  property,  it 
can  hardly  be  held  that  the  capital  asset  disposed  of  is  the  real 
estate  even  though  one  is  held  to  take  the  place  of  the  other 
and  no  tax  was  imposed  upon  the  exchange. 

It  may  be  held  that  capital  assets  disposed  of  must  have 
been  held  for  two  years  in  their  identical  form  although  the 
basis  of  tax  may  go  back  to  the  original  cost  of  property  for 
which  the  property  sold  was  exchanged.  The  section  must 
be  reasonably  construed.  A  building  is  a  capital  asset.  Sup- 
pose it  is  substantially  rebuilt  within  two  years  prior  to  sale. 
The  building  as  sold  has  not  been  held  for  two  years  but  the 
capital  asset  has  been  held  for  two  years.  In  other  words, 
a  mere  change  in  form  should  make  no  difference. 

Assets  (other  than  stock-in-trade)  owned  by  partnerships 
and  distributed  to  partners  at  book  values,  are  capital  assets 
in  the  hands  of  the  partners.  The  two-year  period  runs  from 
the  time  the  assets  were  acquired  by  the  partnership. 

Meaning  of  term  stock-in-trade. — Without  going  into 
refinements  of  terms  it  is  sufficient  to  state  for  income  tax  pur- 
poses that  stock-in-trade  is  that  which  the  Bureau  of  Internal 
Revenue  has  held  to  be  stock-in-trade.    There  have  been  many 


636  INCOME 

exclusions  of  what  might  have  l)eeii  called  stock-in-trade  under 
commercial  practice.  For  instance,  dealers  in  real  estate  do 
not  own  stock-in-trade.  All  of  their  assets  are  capital  assets. 
Taxpayers  engaged  in  business  should  be  careful  hereafter  to 
analyze  their  income  statements.  It  is  not  considered  good 
accounting  practice  to  credit  to  current  income  gains  arising 
from  sales  of  capital  assets ;  but  it  is  quite  easy  for  a  book- 
keeper to  make  such  entries.  In  the  past  it  has  made  little 
difference.     In  the  future  it  may  make  a  substantial  difference. 

The  Treasury  has  ruled  that  inventories  ma}-  be  taken  only 
of  merchandise  and  of  securities;  in  the  case  of  securities  per- 
mission to  inventory  is  strictly  limited  to  dealers  in  securities. 
Many  who  have  called  themselves  dealers  in  securities  have 
been  refused  the  classification  by  the  Treasury.''* 

Article  1585  of  Regulations  43  made  a  distinction  between 
corporations  and  partnerships  which  were  dealers  in  securities 
and  "officers  of  (such)  corporations  and  members  of  (such) 
I)artnerships,  who  in  their  individual  capacities  buy  and  sell 
securities,"  holding  that  the  officers  and  individual  partners 
were  not  dealers  in  securities.  They  were  not  permitted  to 
inventory  their  securities  and  obviously  therefore  their  secur- 
ities could  not  be  considered  "stock-in-trade." 

The  Treasury  recently  has  ruled'''  that  "a  taxpayer,  engaged 
in  the  real  estate  business,  is  not  permitted  to  inventory  real 
estate  which  is  held  for  sale  for  the  purpose  of  calculating  net 
income  subject  to  federal  income  tax."  Under  this  ruling 
the  gain  on  real  estate  owned  for  more  than  two  vears  will 
carry  the  12^  per  cent  rate.  In  the  case  of  bankers  and 
others  who  have  carried  securities  for  more  than  two  years  and 
which  have  not  been  inventoried,  for  federal  tax  purposes,  they 
may  sell  them  and  the  gain,  if  any,  will  be  taxed  at  12^/2 
per  cent.  In  any  event,  accounting  jjractice  determines  which 
assets  should  be  inventoried.  Those  which  should  not  be,  are 
capital  assets,  irrespective  of  erroneous  methods  of  accounting. 


Income  Tax  Procedure.  1921,  page   ^59. 

C.  B.  4,  page  47;  O.  D.  848  (March  2^.  1921). 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         637 

In  some  cases  inventories  of  stock-in-trade  improperly  in- 
clude capital  items  such  as  machinery  parts,  building  materials, 
etc.  In  case  of  resale  at  a  gain  the  items  should  be  segregated; 
otherwise  the  practice  has  no  effect  on  the  computation  of  capi- 
tal gains. 

Former  definitions  of  term  "capital  assets"  not 
BINDING. — The  Treasury  in  the  following  case  has  defined  the 
term  "capital  assets." 

Ruling.  In  the  case  of  a  bank  the  term  "Capital  Assets"  as  used 
in  article  545  of  Regulations  45  includes  bonds  and  other  securities 
in  which  it  has  invested  money  received  on  deposit.  Any  gain  de- 
rived by  the  bank  from  the  sale  of  such  securities  must  be  reported  in 
its  gross  income  and  the  amount  of  the  gain  is  to  be  ascertained  in 
accordance  with  the  rules  laid  down  in  that  article.  (C.  B.  4,  page 
276;  O.  D.  832.) 

Ordinarily  definitions  such  as  the  foregoing  will  not  affect 
the  specific  definitions  contained  in  the  law.  In  the  case  of 
banks  all  of  their  investments  are  capital  assets  unless  they 
were  permitted  by  the  Treasury  to  inventory  their  securities, 
having  first  qualified  as  dealers  in  securities. 

The  mere  act  of  calculating  depreciation  or  depletion  has 
much  to  do  with  the  determination  of  stock-in-trade.  The 
latter  is  periodically  revalued  for  income  tax  purposes.  Under 
the  regulations  assets  which  could  not  be  inventoried,  auto- 
matically become  capital  assets. 

Meaning  of  term  "personal  use  or  consumption." — 
Taxpayers  are  not  permitted  to  deduct  as  losses,  nor  permitted 
to  return  as  capital  gains,  the  losses  or  gains  arising  from  the 
sale  of  residences  occupied  by  the  taxpayers,  automobiles, 
jewels  and  similar  items  (article  1651,  see  page  570).  The  in- 
hibition is  fair  so  far  as  losses  are  concerned,  but  not  fair 
regarding  gains;  if  such  gains  are  taxable  at  all  they  certainly 
should  be  taxed  as  capital  gains. 

All  property,  including  residences  leased  to  others,  and  in- 


•  638  INCOME 

vestments  of  every  description,  excluding  only  assets  for  per- 
sonal use  or  consumption,  are  classed  as  capital  assets. 

Determination  of  "net"  capital  gains. — The  law  states  that 
"net"  capital  gains  consist  of  capital  gains  minus  capital  losses. 
Having  decided  which  assets  are  capital  assets,  the  calculation 
of  the  net  gain  or  net  loss  is  comparatively  simple,  and  being 
fully  discussed  elsewhere,  need  not  be  repeated.*"^  A  short 
formula  is  the  following : 

Debit  an  account  with  value  of  asset  at  March  i,  191 3, 
or  cost  if  acquired  since;  add  capital  expenditures  such  as 
carrying  charges  if  capitalized  (that  is,  if  not  deducted  in  tax 
returns  since  191 3)  ;  credit  depreciation  or  depletion  to  date 
of  sale;  credit  net  sales  price.  The  balance  of  the  account 
will  be  the  capital  gain  or  capital  loss. 

Net  capital  losses. — The  law  does  not  impose  the  limitation 
of  I'zYz  per  cent  upon  net  capital  losses.  Taxpayers  who  seek 
to  secure  the  maximum  benefit  under  the  new  law  will  endeavor 
to  bunch  their  capital  gains  in  one  taxable  year  and  their  capi- 
tal losses  in  another  taxable  year. 

For  discussion  see  page  627. 

Statement  of  capital  transactions  to  be  attached  to  return. — 

Regulation.  Segregation  of  capital  transactions  for  the  purposes 
of  section  206  is  required  only  where  the  taxpayer  elects  to  be  taxed 
under  that  section.  Where  his  total  income  tax  for  any  taxable  year 
does  not  exceed  12^  per  cent  of  his  net  income  he  will  not  elect  to 

be     so     taxed     for     that     year When     a     taxpayer     elects 

to  be  taxed  under  this  section  for  any  taxable  year,  he  shall  attach 
to  his  return  of  income  for  such  year  an  accurate  statement  under 
oath  showing  all  items  of  capital  gain,  capital  loss,  and  capital  de- 
ductions in  such  manner  as  will  clearly  show  the  exact  amount  of  his 
capital  net  gain  for  the  taxable  year.  Each  capital  transaction  must 
be  separately  shown  and  the  capital  items  with  respect  thereto  grouped 


°*  See  page  573,  where  effect  of  depreciation  on  sales  is  discussed,  and 
computations  on  page  577  showing  effect  of  depreciated  March  I,  1913, 
value,  and  depreciated  cost,  respectively 


EXCHANGES    OR    SALES    OF   CAPITAL   ASSETS         639 

together  in  order  that  the  capital  gain  derived  or  the  capital  loss 
sustained  from  each  capital  transaction  will  readily  appear.  In  the 
case  of  sales  or  exchanges  of  real  estate,  the  statement  must  show 
whether  or  not  it  was  held  as  a  residence  by  the  taxpayer  or  his  family. 
In  the  case  of  sales  or  exchanges  of  securities  or  any  other  property, 
the  statement  must  show  how  long  the  property  was  held  by  the  tax- 
payer immediately  preceding  the  sale  or  exchange.      (Art.   1652.) 


CHAPTER    XVIII 

INCOME  FROM  ROYALTIES  AND  PATENTS 

Income  from  royalties  and  similar  sources  is  not  specifically 
named  in  the  definition  of  income  in  the  law,  but  it  is  clearly 
included  within  its  terms. 

Law.      .Section   213 the  term    "gross  income" —  .... 

(a)  Includes     ....   gains,  profits  and  income  derived  from  any  source 
whatever. 

Regulation gross  income     ....   embraces     .... 

income   ....    such   as   ...    .   royalties   ....      (Art.   541.) 

The  law  provides  that  the  profit  which  arises  from  the  sale 
of  patents  and  copyrights  must  be  included  as  income  for  the 
year  in  which  it  is  received.  It  has  been  pointed  out  on  many 
occasions  that  this  procedure  works  an  unwarranted  hardship 
on  inventors  and  others  who  have  spent  considerable  time 
and  money  in  the  development  of  ideas  or  devices,  only  to  find 
that  on  selling  them  the  whole  of  the  increased  value  must 
be  returned  for  tax  purposes  in  a  given  year.  While  it  is 
admitted  that  proration  of  the  increment  over  the  develop- 
ment period  w  ould  l)e  extremely  difficult,  nevertheless  the  pres- 
ent procedure  burdens  the  unfortunate  inventor  or  author. 

Under  the  1918  and  prior  laws  no  relief  is  granted,  nor 
is  any  ettective  for  the  taxable  year  192 1  ;  but  for  1922  and 
subsequent  years  the  ''capital  net  gain''  provision  of  the  law 
(section  206)  will  limit  the  tax  payable  to  12^%  of  the 
profit,  if  the  patent  or  cop}right  has  been  held  for  at  least 
two  years. ^ 

Royalties  from  Mines,  Oil  Wells,  etc. 

Royalties  from  mines,  oil  wells,  etc.,  must  be  included  in 
iiross  income  for  the  vear  in  which  thev  are  received.     Tliis 


See  further  Chapter  XVII. 

640 


FROM   ROYALTIES   AND    PATENTS  641 

procedure  applies  even  if  the  title  to  the  producing  land  is  in 
question. 

Rulings.  Income  from  oil  royalties  must  be  returned  in  the  tax- 
able year  received,  even  though  the  title  to  the  producing  land  is  in 
litigation.  If  any  p^rt  of  the  royalty  income  is  ordered  by  the  court 
to  be  paid  over  to  another,  any  tax  previously  paid  thereon  will  be 
credited  against  any  income  tax  then  due  under  any  other  return 
of  the  taxpayer,  and  any  balance  of  the  excess  tax  paid  will  be  re- 
funded if  proper  claim  for  such  refund  is  made.  (C.  B.  4,  page  95; 
O.  D.  825.) 

This  ruling  was  later  explained  as  follows : 

In  the  case  of  a  dispute  as  to  the  title  of  oil-producing  land,  the 
royalties  belong  to  the  true  owner.  They  follow  the  land  and  come 
into  existence  regardless  of  the  person  or  activities  of  the  owner. 
If  one  collects  the  royalties  thinking  he  is  the  owner  and  then  by 
judgment  of  court  finds  that  another  is  the  owner,  he  must  surrender 
the  royalties  received  not  as  damages  but  simply  because  they  belong, 
and  belonged  from  the  beginning  to  the  true  owner.  The  one  who 
first  received  the  royalty  did  so  because  he  thought  the  land,  and 
therefore,  the  royalties  were  his. 

Where  a  patentee  obtains  a  judgment  against  the  infringer  of  a 
patent  by  virtue  of  which  the  infringer  must  account  for  all  profits 
made  through  the  infringement,  the  situation  is  materially  different. 
The  infringer  of  a  patent  directly  creates  by  his  activities  the  profits 
made;  but  for  him  they  might  not  have  come  into  existence.  These 
profits  as  earned  belong  to  him  and  are  properly  returned  as  in- 
come in  the  years  earned.  Hut  having  conmiitted  a  wrong  in  infring- 
ing the  patent  he  is  compelled  to  compensate  the  owner  for  the  dam- 
age done  him  and  the  measure  of  such  damage  in  equity  is  tlie 
profit  derived  by  such  infringement  and  such  further  amount  as  the 
Master  may  find.  A  judgment  requiring  an  accounting  of  profits, 
in  such  a  case,  is  the  equivalent  or  substitute  for  legal  damages.  It 
does  not  mean  that  the  profits  made  by  the  infringer  belong  to  the 
owner  of  the  patent  from  the  time  such  profits  are  made  and  that 
the  infringer  is  converted  into  a  trustee  for  the  owner  with  respect 
to  such  profit.  (Tilghinaii  v.  Proctor,  125  U.  S.  136;  Root  v.  R.  Ry. 
Co.,  105  U.  S.  214.)  With  this  understanding  of  the  nature  of  judg- 
ments requiring  an  accounting  of  profits  in  patent  infringement  cases 
it  is  clear  that  the  loss  sustained  by  the  infringer  must  be  taken  in 
the  year  judgment  is  rendered.     (B.  51-21-1981;  O.  D.  1141.) 

Royalties  subject  to  depletion  charges. — The  owner  of  a 
mine,  an  oil  well  or  other  similar  property  operated   on  a 


642  INCOME 

royalty  basis  must  return  as  income  his  royalties  received,  but 

he  is  permitted  to  deduct  expenses  and  to  charge  against  re- 
ceipts depletion  allowances  based  on  the  full  value  of  his 
property  as  at  March  i,  191 3,  if  purchased  before  that  date, 
or  on  the  basis  of  the  capital  originally  invested  if  purchased 
thereafter,^  except  in  the  case  of  mines  and  oil  wells  discovered 
by  the  taxpayer,  in  which  case  the  value  of  the  property  at  the 
date  of  discovery  or  within  thirty  days  thereafter  is  the  basis 
prescribed  by  law."  For  a  full  discussion  of  the  topic  of  deple- 
tion as  an  allowable  deduction,  consult  Chapter  XXXIII,  ''De- 
pletion." 

After  the  value  as  at  March  i,  1913,  is  determined,  a  proper 
calculation  must  be  made  as  to  how  much  of  the  royalties  re- 
ceived is  capital  and  how  much  is  income.  The  part  which  is 
capital  cannot  be  taxed,  but  all  royalties  which  accrue  must 


'  Foil  Banmbach  z:  Sargoit  Land  Co.,  242  U.  S.  503,  61  L.  Ed.  460, 
37  S.  Ct.  201. 

[Former  Procedure]  Full  depletion  allowances  have  been  per- 
missible deductions  only  since  1916.  The  1913  law  contained  a  provision 
restricting  such  charges  to  5  per  cent  of  the  gross  value  of  the  output 
of  the  mine,  and  in  spite  of  the  fact  that  this  worked  inequitaljly  in  some 
cases  the  courts  decided  that  it  was  constitutional.  The  1909  law  per- 
mitted no  deduction  at  all  for  depletion.  As  it  is  still  frequently  neces- 
sary to  pass  upon  returns  made  under  the  1913  law,  the  following  deci- 
sion issued  February  12,  1915,  is  of  interest: 

"In  the  case  of  mines  operated  by  a  lessee  on  a  royalty  basis,  it  is 
held  that  the  lessor  in  disposing  of  his  ores  or  natural  deposits  on  the 
basis  of  royalties  has  a  measure  of  profit  in  every  ton  of  ore  disposed 
of  in  this  way,  and  that  so  much  of  the  gross  receipts  on  account  of 
royalties  as  is  in  excess  of  depletion,  not  exceeding  5  per  cent  of  the  gross 
value  of  the  output  at  the  mine,  plus  any  incidental  expenses  to  which 
the  corporation  may  be  subject,  is  income  within  the  meaning  of  the 
federal  income  tax  law  and  should  be  so  returned  by  the  lessor."  (T.  D. 
2152.) 

The  above  ruling  was  obviously  defective  because  it  ignored  the  fact 
that  there  are  many  cases  where  royalties  received  have  no  "measure  of 
profit"  in  them.  Every  purchaser  or  owner  of  a  mine  or  oil  well  does 
not  have  a  bonanza.  He  may  have  paid  a  high  price  for  his  property, 
hoping  to  secure  royalty  returns  which  would  show  a  handsome  profit, 
but  his  hopes  may  fade  and  disappear  and  he  may  be  glad  to  get  his 
original  capital  back  without  interest. 

"  Section  214   (a-io). 


.   FROM  ROYALTIES  AND  PATENTS         643 

be  reported  as  gross  income  and  the  depletion  allowance  must 
be  deducted  in  order  to  ascertain  the  taxable  or  net  income. 

In  the  Manual  for  the  Oil  and  Gas  Industry  the  Treasury 
states  (page  29)  that  "if  a  certain  proportionate  part  of  the 
lessee's  capital  returnable  through  depletion  deductions  is  de- 
ducted in  a  given  year  the  same  proportion  of  the  lessor's 
capital  sum  returnable  through  depletion   will  be  deducted." 

This  rule  may  or  may  not  be  equitable.  No  general  rule 
can  deprive  the  lessor  or  lessee  of  the  right  to  a  depletion 
allowance  which  will  return  his  capital  free  of  tax. 

Ruling.  Land  was  purchased  in  19 14.  At  the  time  of  the  pur- 
chase the  mineral  rights  in  the  land  had  no  market  value,  that  is,  no 
part  of  the  purchase  price  of  the  land  was  paid  as  consideration  for 
the  mineral  rights  therein.  Subsequently  the  land  was  leased  on  a 
royalty  basis  for  oil  and  gas  development  and  in  1919,  amounts  were 
received  from  the  sale  of  interests  in  such  royalty. 

Held,  that  inasmuch  as  the  oil  and  gas  rights  had  no  market  value 
at  the  time  the  land  was  purchased  the  entire  amount  received  from 
the  sale  of  the  royalty  interests  is  income  for  the  year  of  its  receipt, 
subject,  however,  to  proper  adjustment  on  account  of  depletion  sus- 
tained.    (C.  B.  3,  page  89;  O.  D.  644.) 

The  ruling  is  inconsistent.  It  first  states  that  there  is  no 
capital  investment,  and  then  that  an  adjustment  is  to  be  made 
for  "depletion  sustained."  The  amount  of  depletion,  when 
there  is  no  capital  sum  to  be  depleted,  must  be  rather  difficult 
to  determine. 

The  following  ruling  deals  with  a  participating  lease  of 
oil  lands. 

Ruling.  B  acquired  a  lease  of  oil  land,  agreeing  that  the  lessors 
should  receive  a  one-sixth  royalty  interest  in  the  lease.  Tn  considera- 
tion of  the  lease  he  also  agreed  to  pay  x  dollars  to  the  lessors  from 
one-half  the  proceeds  of  all  sales  of  oil  and  gas  produced  by  the  five- 
sixths  working  interest  belonging  to  him  in  the  lease  and  one-fourth 
and  one-twelfth  of  the  proceeds  of  the  sales  of  oil  and  gas  produced 
by  him  upon  two  other  leases  he  owned.  Under  the  agreement  he  was 
obligated  to  pay  Federal  income  tax  upon  the  sums  payable,  together 
with  interest,  the  taxes  and  interest  being  payable  in  the  same  manner 
as  the  X  dollars. 

The  oil  is  piped  direct  to  the  purchasing  company,  which  remits  to 
C,  who  places  to  the  credit  of  the  less^  rs  amounts  properly  payable 


644  INCOME 

to  them.  Upon  forfeiture  of  the  lease  B  is  bound  to  pay  the  x  dollars 
taxes  and  interest,  and  he  may  not  sell  the  lease  without  paying  these 
amounts. 

Held,  that  all  income  received  from  the  five-sixths  interest  belong- 
ing to  B  and  the  one-fourth  and  one-twelfth  interest  in  the  two  other 
leases  represent  income  to  B  for  the  year  in  which  received  or  accrued, 
proper  deductions  being  taken  for  depletion  each  year. 

The  .r  dollars  may  not  be  amortized  over  the  period  required  for 
its  payment,  but  so  much  of  each  payment  as  represents  a  payment  on 
such  principal  amount,  income  tax  payable,  and  interest  upon  the 
payments,  should  be  claimed  as  a  deduction  for  the  year  in  which 
paid.      (B.  28-21-1723:   O.   D.  971.) 

Royalties  from  coal  lands. — In  the  anthracite  fields 
man}'-  owners  of  coal  lands  have  granted  perpetual  "mining 
leases"  to  operators.  The  Supreme  Court  of  Pennsylvania 
has  held  these  transfers  to  be  "sales. "^  In  all  cases  the  rev- 
enue therefrom  (usually  a  fixed  rate  per  ton  mined)  is  known 
as  "royalties."  Under  the  19 16  and  subsequent  laws,  the 
owners  of  coal  lands,  or  those  to  whom  a  "royalty"  is  being 
paid,  are  entitled  to  receive  in  cash,  free  from  income  tax,  an 
amount  equal  to  the  fair  value  of  the  property  on  March  i, 
191 3,  if  the  property  had  been  acquired  prior  to  that  date. 
This  valuation  is  assumed  to  be  capital.  After  such  principal 
sum  is  provided  for,  the  balance  of  the  collections  is  income 
and  is  subject  to  the  income  tax.  If  the  rate  of  royalties  is  a 
substantial  one.  it  is  probable  that,  of  the  royalties  received 
each  year,  part  is  capital  and  part  is  taxable  income. 

A  lease  to  mine  coal  in  Pennsylvania  provided  that  the 
lessor  should  retain  the  privilege  of  selling  the  property  at  the 
expiration  of  ten  years.  The  Treasury  held^  that  such  a  lease 
was  not  a  sale  of  the  coal  in  place,  but  the  deduction  for  de- 
pletion was  held  to  be  the  same  as  if  the  lease  were  a  per- 
petual one. 

Mining  royalties  (minimum)  received  in  advance. — In 
most  mining  districts  it  is  customary  for  owners  of  the  lands 


*  Hosack  V.  Crill,  204  Pa.  St.  97,  53  Atl.  640. 
°C.  B.  2,  page  143;  S.  1365. 


FROM   ROYALTIES   AND    PATENTS  645 

to  execute  contracts  or  leases  under  which  the  lessees  are  re- 
quired to  make  annual  payments  representing  a  fixed  per-ton 
compensation  or  royalty  for  a  definite  number  of  tons  of  ore 
or  coal.  These  payments  are  made  to  the  owners  and  are 
clearly  understood  by  both  parties  concerned  to  be  in  full  pay- 
ment of  royalties  for  an  equivalent  amount  of  ore  or  coal 
whenever  it  may  be  removed  thereafter.  These  payments  are 
usually  designated  as  advance  minimum  royalties,  and  may  be 
paid  for  several  successive  years  in  which  no  ore  or  coal  is 
mined.''  In  many  cases  the  property  is  surrendered  to  the 
lessors  before  the  quantities  paid  for  have  been  removed. 

Depletion  applicable  to  royalties. — 

Regulation.  ...  (b)  Where  the  owner  has  leased  a  mineral 
property  for  a  term  of  years  with  a  requirement  in  the  lease  that  the 
lessee  shall  extract  and  pay  for,  annually,  a  specified  number  of  tons, 
or  other  agreed  units  of  measurement,  of  such  mineral,  or  shall  pay, 
annually,  a  specified  sum  of  money  which  shall  be  applied  in  payment 
of  the  purchase  price  or  royalty  per  unit  of  such  mineral  whenever 
the  same  shall  thereafter  be  extracted  and  removed  from  the  leased 
premises,  the  value  in  the  ground  to  the  lessor,  for  purposes  of  deple- 
tion, of  the  number  of  units  so  paid  for  in  advance  of  extraction 
will  constitute  an  allowable  deduction  from  the  gross  income  of  the 
year  in  which  such  payment  or  payments  shall  be  made;  but  no 
deduction  for  depletion  by  the  lessor  shall  be  claimed  or  allowed  in 
any  subsequent  year  on  account  of  the  extraction  or  removal  in  sucli 
year  of  any  mineral  so  paid  for  in  advance  and  for  which  deduction 
has  once  been  made. 

Both  capital  and  income  accounts  must  be  ad- 
justed.— 

(c)  If,  for  any  reason,  any  such  mineral  lease  shall  be  termi- 
nated or  abandoned  before  the  mineral  which  has  been  paid  for  in 
advance  has  been  extracted  and  removed,  and  the  lessor  repossesses 
the  leased  property,  the  lessor  shall  adjust  his  capital  accounts  by 
restoring  to  the  capital  sum  of  the  property  the  depletion  deductions 
made  in  prior  years  on  account  of  royalties  on  mineral  paid  for  but 
not  removed,  and  his  income  account  shall  be  adjusted  so  as  to  include 
the  amount  so  restored  to  capital  sum  as  income  of  the  year  such 
lease  is  terminated  or  the  property  repossessed,  and  the  tax  thereon 
paid.     (Art.  215.) 


'[Former  Procedure]      See  Income  Tax  Procedure,  1919,  page  288. 


646  INCOME 

The  foregoing  regulation  properly  holds  that  when  a  lessor 
has  claimed  annual  depletion  equal  to  the  quantity  covered  by 
the  advance  royalties,  no  further  deduction  shall  be  made  when 
the  ore  is  subsequently  removed. 

The  regulation  further  provides  that  when  a  lessor  re- 
possesses the  property,  and  part  of  the  ore  or  mineral,  in  re- 
spect of  which  depletion  was  deducted,  has  not  been  removed 
by  the  lessee,  the  aggregate  of  the  excessive  deductions  will 
be  deemed  income  to  the  lessor  "and  his  income  account  shall 
be  adjusted  so  as  to  include  the  amount  ....  as  income  of 
the  year  such  lease  is  terminated  or  the  property  repossessed, 
and  the  tax  thereon  paid." 

This  latter  provision  may  work  great  hardship.  A  lessor 
may  lease  coal  lands  for  a  period  of  thirty  years  at  a  stated 
royalty  per  ton  for  coal  removed,  the  minimum  royalty  being 
fixed  at  $25,000  per  annum.  If  the  proper  depletion  based 
on  the  minimum  royalty  is  $10,000  per  annum,  there  is  re- 
turned as  net  income  $15,000  annually.  If  the  lessee  should 
mine  only  one-half  of  the  coal  paid  for  (and  in  many  cases  the 
proportion  is  less),  in  the  thirty-first  year  the  lessor  would  be 
presumed  to  have  realized  a  net  income  of  $150,000  and  the  tax 
thereon  might  be  $50,000.  Tlieoretically,  excessive  depletion, 
to  the  extent  of  $5,000  per  annum  for  thirty  years,  has  been 
claimed;  but  the  tax  saved  by  the  excessive  deduction  may  not 
have  amounted  to  more  than  one-half  of  the  tax  which  would 
be  payable  if  the  adjustment  were  made  in  the  year  of  repos- 
session. 

Furthermore,  the  taxpayer  probably  would  have  no  means 
of  pa)'ing  the  tax,  because  a  repossessed  coal  mine  has  little, 
if  any,  sale  value. 

In  most  cases  the  apparently  excessive  deductions  would 
not  be  excessive  at  all.  Depletion  could  only  be  charged  from 
year  to  year  on  the  basis  of  the  original  value  of  the  lease. 
The  lessee  would  nut  relinquish  possession  and  lose  his  ad- 
vanced royalties  if  the  mine  retained  its  value.  Therefore, 
at  the  end  of  the  period  the  lessor  would  have  merely  charged 


FROM  ROYALTIES  AND  PATENTS         647 

off  an  aggregate  sum  equal  to  the  depletion  of  the  coal  re- 
moved plus  the  depreciation  in  the  value  of  his  property. 

In  any  event  the  actual  value  of  the  property  repossessed 
is  the  maximum  amount  which  can  be  deemed  to  be  income. 
If  amended  returns  for  prior  years  are  not  accepted,  the  au- 
thor ventures  the  prediction  that  no  court  would  deem  the 
value  of  the  property  repossessed  to  be  income  taxable  solely 
in  the  year  of  repossession. 

When  the  failure  to  recoup  the  advanced  royalties  or  the 
lapse  of  the  lease  is  due  to  inefficient  operation,  inadequate 
capital  owned  by  the  lessee,  or  for  similar  reasons  other  than 
the  content,  availability,  etc.,  of  the  mine,  and  when  the  allow- 
ance in  previ(jus  years  for  depletion,  which  never  actually 
accrued,  has  resulted  in  real  income  not  yet  rc])orted,  amended 
returns  should  be  made  by  the  lessor.  Also,  if  advanced  roy- 
alties become  unrecoverable  because  minerals  have  not  been 
removed  during  a  definite  period  stipulated  in  the  lease,  within 
which  advanced  or  minimum  royalties  may  be  recovered,  there 
may  be  some  additional  income  of  the  lessor  for  previous 
years  for  which  amended  returns  should  be  made. 

Royalties  waived  for  several  years — received  in  one  year. — 

Ruling.  A  lessor  of  mining  property  who  waived  his  right  to 
royalties  for  several  years  on  account  of  the  fact  that  the  mine  was 
operated  at  a  loss,  and  received  all  of  the  royalties  in  the  year  1917, 
may,  if  he  has  submitted  returns  for  those  years  on  a  cash  receipts 
and  payments  basis,  deduct  from  the  income  received  in  1917  such 
depletion  allowance  as  appertains  to  that  income.  (C.  B.  2,  page  144; 
A.  R.  M.  17.) 

Royalties  from  Copyrights 

An  author  should  report  as  gross  income  all  sums  received 
from  copyright  privileges.  He  is  entitled  to  claim  as  deduc- 
tions all  expenses,  except  ordinary  living  expenses,  incurred  in 
producing  such  income. 

The  argument  which  appears  on  page  640  for  a  more 
equitable   tax   upon   the   earnings   of    inventors   applies    with 


648 


INCOME 


equal  force  to  the  earnings  of  authors.  It  must  be  admitted, 
however,  that  there  will  be  great  difficulty  in  framing  and 
administering  a  remedial  provision.  A  lawyer  who  works 
for  ten  years  and  finally  wins  an  important  case  has  an  equal 
claim  to  consideration. 

Regulation xA.mounts  expended  for  securing  a  copyright 

and  plates,  which  remain  the  property  of  the  person  making  the  pay- 
ments, are  investments  of  capital (Art.  293.) 

However,  deductions  can  be  made  for  depreciation^  and 
conservative  accounting  calls  for  rates  of  depreciation  on 
assets  of  this  kind  up  to  100  per  cent  per  annum. 

The  method  prescribed  for  computing  the  profit,  if  any, 
from  the  sale  of  copyrights,  is  the  same  as  that  for  patents.* 

The  British  [)ractice  as  to  copyrights  is  as  follows: 

British  practice.  (1)  Annual  payments  of  fixed  amount,  or 
being  a  fixed  share  of  profits,  are  assessed  on  the  person  making  the 
payment  in  the  same  way  as  interest. 

(2)  An  author,  playwriter,  or  artist  selling  copyrights,  etc.,  to 
publishers  is  chargeable  on  the  amount  received  less  his  expenses;  if 
sold  on  royalty,  the  whole  amount  of  the  royalty  is  chargeable. 

(3)  No  charge  is  made  upon  a  person  who  has  an  isolated  trans- 
action of  such  a  nature ;  the  profit  is  looked  upon  as  capital.  [Murray 
and  Carter,  Income  Tax  Practice  (1919  edition),  page  219.] 

Royalties  and  Profits  from  Patents 

Income  from  the  sale  of  patents  above  cost,  or  from 
royalties  when  such  royalties  include  profit  over  and  above 
the  return  of  capital,  is  taxable.^  The  general  principle  of  a 
return  of  capital  must  be  followed,  however.  No  tax  can  be 
imposed  on  receipts  from  the  sale  of  patents  or  patent  rights 
unless  the  owner  has  made  full  provision  to  reimburse  himself 
for  the  cost  or  value  of  them.  If  the  patents  were  applied  for 
or  owned  on  or  before  March  i,   19 13,  their  actual  value  at 


'  See  Chapter  XXXI,  "Depreciation." 

*  Art.  40,  page  652. 

'  [Former  Procedure]  For  a  short  time  the  Treasury  in  taxing 
royalties  ignored  Alarch  i,  1913,  values.  For  rulings  in  1916,  see  Income 
Tax  Procedure,  1920,  page  395. 


FROM   ROYALTIES   AND    PATENTS  649 

that  date  is  their  capital  value.     If  they  were  acquired  after 
that  date,  the  cost  is  considered  the  capital  value/" 

A  payment  to  bind  an  option  to  purchase  an  interest  in 
the  royalties  to  be  received  from  certain  patents  has  been  held 
to  be  income  to  the  recipient/^ 

Damages  received  from  infringements  of  patents. — Collec- 
tions of  damages  arising  from  infringements  may  be  income 
or  capital  or  both,  depending  on  the  fair  value  as  at  March 
I,  1913,  and  the  nature  of  the  damages  collected.  If  no  injury 
to  the  capital  value  has  resulted,  the  entire  collection,  less  ex- 
penses, is  income. 

If  the  capital  value  has  been  diminished  by  the  infringe- 
ment, the  amount  collected,  or  an  appropriate  part  thereof, 
should  be  applied  in  reduction  of  the  book  value  of  the  patents. 

Regulation A  person  may  sue  in  one  year  on  a  pecu- 
niary claim  or  for  property,  but  money  or  property  recovered  on  a 
judgment  therefor  rendered  in  a  later  year  would  be  income  in  that 
year,  assuming  that  it  would  have  been  income  in  the  earlier  year  if 
then  received.  This  is  true  of  a  recovery  for  patent  infringement. 
....      (Art.  51;  Reg.  45,  Art.  52.) 

The  foregoing  regulation  may  be  applicable  to  most  cases 
of  recoveries  arising  from  judgments,  but  there  are  many  ex- 
ceptional cases  which  must  be  decided  according  to  other  sec- 
tions of  the  law  and  according  to  the  decisions  of  the  courts 
which  define  taxable  income. 

As  stated  above,  the  fair  value  of  a  claim  as  of  March  i, 
191 3,'"  is  an  important  consideration.  If  a  taxpayer  was  en- 
titled to  property  in  1912,  but  did  not  recover  it  until  1921, 
it  cannot  be  held,  and  the  Treasury  does  not  hold,  that  he  re- 
ceived any  taxable  income  in  1921. 

If  he  became  entitled  to  property  in  1914,  but  did  not  re- 
turn it  in  that  year  because  he  did  not  know  its  actual  value, 
it  is  not  reasonable  to  claim  that  if  he  collected  the  claim  or 


'"Reg.  45,  Art.   1561,  page  570. 

"Bulletin  37-21-1813;  O.  D.  1028. 

''For  method  of  establishing  value  at  March  t,  1913,  see  page  596. 


650  INCOME 

received  the  property  in  1921,  the  entire  amount  would  be 
income  in  192 1.  The  courts  might  hold  that  the  income  arose 
in  1914  and  give  the  taxpayer  the  privilege  of  filing  an 
amended  return  for  that  year,  l3ut  there  is  little  in  the  trend  of 
recent  decisions  to  support  such  a  belief.  The  courts  are  more 
likely  to  hold  that  when  a  taxpayer  could  have  adopted  the 
accrual  basis  of  reporting,  but  did  not  do  so,  the  election  must 
stand. 

As  late  as  191 7  (see  Chapter  XXVI)  the  Treasury  held 
that  when  a  corporation  was  compelled,  in  1916,  to  pay  dam- 
ages arising  out  of  an  infringement  case  and  the  period  of  in- 
fringement ended  in  19 12,  no  part  of  the  sum  paid  was  de- 
ductible as  an  expense  in  19 16,  but  that  it  should  all  be  de- 
ducted (by  amended  returns)  in  the  period  prior  to  1912. 

Patent  development  costs. — The  cost  of  developing  a  pat- 
ent is  of  the  same  nature  as  carrying  charges  on  real  estate. 
One  has  the  option  of  capitalizing  the  items  or  of  charging 
them  off  as  current  expenses.  Frequently  it  is  difficult  to 
determine  which  course  should  be  pursued,  even  at  the  time. 
It  may  be  obvious,  after  a  period,  that  the  experiments  under 
way  are  not  yielding  satisfactory  results.  In  such  an  event 
the  cost  is  a  clear  expense.  More  often  the  result  is  doubtful, 
in  which  case  it  is  permissible  to  elect  whether  to  capitalize  or 
to  charge  off  the  amount. 

Conservative  accounting  methods  call  for  charging  off, 
but  the  owner  may  be  penalized  for  so  doing  if  current  profits 
are  not  large.  The  subsequent  sale  of  the  patent  for  a  con- 
siderable profit  would  result  in  a  tax  on  the  entire  sale  price, 
if  the  development  costs  had  all  been  claimed  as  deductions 
and  written  off. 

Regulation The  cost  of   defending  or  perfecting  title 

to  property  constitutes  a  part  of  the  cost  of  the  property  and  is  not 
a  deductible  expense (Art.  293.) 

The  foregoing  regulation  cannot  always  be  applied  to  pat- 
ent litigation.     If  the  litigation  does  not  clearly  add  to  the 


FROM    ROYALTIES    AND    PATENTS  65 1 

value  of  the  patent,  the  expenses  should  be  charged  off  as 
they  are  incurred.  This  view  is  adopted  by  the  Treasury  in  the 
following : 

Expense  of  patent  litigation  not  added  to  cost.— 

Ruling.  The  M  Company  expended  a  certain  amount  in  litigation 
defending  its  right,  title,  and  interest  in  a  patent  after  the  patent  had 
been  issued  by  the  Government. 

Held,  that  this  amount  may  be  deducted  as  an  ordinary  and  neces- 
sary operating  expense.  The  actual  cost  of  the  patent  represented 
by  various  Government  fees,  cost  of  drawings,  experimental  models, 
attorney's  fees,  etc.,  paid  before  the  patent  was  issued,  will  be  re- 
turned to  the  company  through  annual  depreciation  deductions. 
.    .    .    .    (C.  B.  2,  page  105;  A.  R.  R.  98.) 

Method  of  valuing  patents. — Owing  to  the  great  uncer- 
tainty which  often  exists  regarding  the  commercial  (that  is,  the 
market  or  income-producing)  value  of  a  patent,  it  is  difihcult 
to  arrive  at  a  fair  taxable  value  when  a  sale  or  transfer  is 
made  for  a  consideration  other  than  cash  before  the  patent 
is  fully  developed. 

In  ascertaining  the  net  taxable  income  of  an  inventor  or 
owner  to  be  assessed  as  of  the  year  in  which  a  transfer  takes 
place,  there  should  be  taken  into  consideration  the  stage  of 
the  patent's  commercial  development,  the  degree  of  prosperity 
attained  by  the  concern  manufacturing  it,  and  any  other  facts 
which  serve  to  fix  a  fair  value.  Some  of  the  information  may 
appear  to  be  of  a  later  date,  but  it  is  valuable  nevertheless. 

Value  of  patents  March  i,  1913. — In  the  191 7  law^^  patents 
were  included  among  tangible  assets.  In  the  19 18  law^^  pat- 
ents are  included  among  intangible  assets.  Generally  speaking 
the  rules  for  valuing  tangible  and  intangible  property,  hereto- 
fore discussed,  govern  the  valuation  of  patents.  The  distinc- 
tive features  which  exist  in  regard  to  patents  will  now  be  dis- 
cussed. 


Section  207   (a-3-a). 
Section  325   (a). 


652  INCOME 

X'alucs  of  patents  must  be  established  (a)  to  arrive  at  the 
basis  for  the  eomputation  of  depreciation  allowable  as  a  deduc- 
tion from  gross  income,  and  (b)  for  the  purpose  of  report- 
ing gains  or  losses  resulting  from  their  sale  or  disposition. 

Regulation.  A  taxpayer  disposing  of  patents  or  copyrights  by 
sale  should  determine  the  profit  or  loss  arising  therefrom  by  comput- 
ing the  difference  between  the  selling  price  and  the  cost.  The  taxable 
income  in  the  case  of  patents  or  copyrights  ac(|uircd  prior  to  March  i, 
1913,  should  be  ascertained  in  accordance  with  the  provisions  of  article 
1561.  The  profit  or  loss  thus  ascertained  should  be  increased  or  de- 
creased, as  the  case  may  be,  by  the  amounts  deducted  on  account  of 
depreciation  of  such  patents  or  copyrights  since  February  28,  1913, 
or  since  the  date  of  acquisition  if  subsequent  thereto.     (Art.  40.) 

A  patent  is  valuable  for  a  limited  period.  It  can  never 
be  treated  as  of  permanent  value  per  sc.  Rights  and  privi- 
leges permanent  in  their  nature  may  develop  from  patents, 
but  such  rights  should  not  be  classified  as  patents.  The  mo- 
nopoly granted  by  the  government  is  for  a  specific  period. 
Patents,  therefore,  come  within  the  category  of  depreciable 
assets.  At  times  it  is  difficult  to  distinguish  between  patents 
and  goodwill. ^^  Except  for  the  year  191 7  (when  patents 
were  tangibles),  the  only  difference  of  importance  between 
patents  and  goodwill  is  the  element  of  depreciation. 

Under  the  Treasury  regulations  a  deduction  for  deprecia- 
tion of  patents  is  made  at  the  election  of  the  taxpayer.  It  is 
not  obligatory.  However,  if  depreciation  has  been  taken  the 
amounts  so  deducted  must  be  considered  when  patents  are  sold 
or  disposed  of  in  the  same  manner  as  in  the  sale  of  tangible 
assets.'" 

Depreciation  is  such  an  important  element  that  the  correct 
valuation  of  patents  as  at  March  i,  1913,  may  make  a  tre- 
mendous difference  in  the  amount  of  taxes  payable  after  Jan- 
uary I,  191 7.  Prior  to  that  date  the  rate  of  tax  was  so  low 
that  it  made  little  difference  how  much  was  claimed  for  de- 


'  See  article  843. 
'  Art.  843. 


FROM   ROYALTIES   AND    PATENTS  653 

preciation  of  patents.  Taxpayers  who  practically  disregarded 
patent  values  and  depreciation  of  patents  prior  to  19 17,  are 
not  barred  from  reopening  their  accounts  and  tax  returns  and 
making  proper  adjustments/' 

Tlie  mere  failure  to  assert  one's  rights  does  not  operate  as 
a  waiver. ^"^  The  Commissioner  is  powerless  to  enforce  any 
regulation  or  rule  which  limits  the  right  of  a  taxpayer  to 
correct  his  tax  returns  for  previous  years,  except  only  in 
case  of  fraud. 

It  has  not  been,  and  cannot  be,  urged  that  the  opening  of 
tax  returns  arising  from  properly  supported  revaluations  can 
be  considered  fraudulent. 

There  is,  of  course,  one  very  practical  objection  to  the 
reopening  of  tax  returns  for  the  years  1916  and  prior.  Sec- 
tion 252  of  the  192 1  law  provides  that  no  claims  for  refund 
will  be  allowed  (including  those  under  the  1909  and  subse- 
quent laws)  unless  the  claim  is  filed  within  five  years  from 
the  day  when  the  return  was  due.  If,  however,  invested  capi- 
tal under  the  1917  or  1918  laws  is  decreased  by  the  Commis- 
sioner as  the  result  of  insufficient  deductions  in  prior  years, 
which  afifect  the  returns  of  earlier  years  and  so  result  in  a 
credit  for  taxes  in  the  earlier  years,  such  amount  may  be  cred- 
ited or  refunded  regardless  of  the  expiration,  of  the  five-year 
period. ^^ 

Returns  for  the  calendar  year  1916  were  due  March  i, 
191 7.  If  claims  in  respect  thereof  are  not  filed  before  March 
I,  1922,  the  Commissioner  will  have  no  power  to  grant  them. 

To  determine  the  actual  value  of  patents  at  March  i,  19 13, 
is  in  many  cases  a  difficult  task.  Each  case  must  be  decided  on 
its  own  merits.  There  existed  at  that  date  instances  in  which 
taxpayers  had  in  the  dim  past  merged  patents  and  other  in- 


"  For  table  of  terms  of  patents  and  copyrights  in  various  countries,  see 
C.  B.  3,  page  169. 

"  ....  Mere  delay  in  asserting  a  right  does  not  ipso  facto  bar  its 
enforcement  in  equity,  by  the  great  weight  of  authority,  unless  the  case  is 
barred  by  the  statute  of  limitations."     (21   C.  J.  221.) 

'"Law,  section  252.     See  page  255. 


654 


INCOME 


tangible  such  as  goodwill,  in  their  accounts.  In  other  in- 
stances a  number  of  patents  were  acquired  without  a  value 
being  placed  on  each  distinct  patent.  Intercompany  book 
transactions  also  frequently  tended  to  render  the  value  of 
patents  obscure.  Numerous  other  complications  exist.  Nev- 
ertheless, in  order  that  the  taxpayers'  interests  may  be  pro- 
tected and  in  order  that  the  government  may  receive  the  proper 
amount  of  tax,  patent  values  must  be  established.  Where  the 
amounts  involved  are  large,  it  is  a  problem  upon  which  sound 
judgment  and  experience  should  be  employed. 

Patents  accjuired  subsequent  to  March  i,  1913,  and  later 
disposed  of,  do  not  differ  from  other  assets  in  so  far  as  the 
method  of  treatment  for  the  purpose  of  determining  gain  or 
loss  on  the  transaction  is  concerned.^" 

If  patents  were  acquired  solely  for  cash  prior  to  March 
I,  191 3,  and  if  the  payments  can  be  readily  traced  through  the 
accounts,  the  tax  laws  presume  that  the  cash  payments  rep- 
resent the  actual  value  of  the  patents  at  the  time  acquired. 
Unless  the  purchase  was  made  immediately  before  March  i, 
19 1 3,  the  cash  payment  would  not  be  an  important  factor  in 
fixing  the  value  as  of  that  date. 

If  the  consideration  for  the  patents  was  stocks,  bonds  or 
notes  which  had,  a  marketable  value  at  the  time  of  acquisition, 
it  is  presumed  by  the  Treasury  that  the  value  of  the  patents 
was  equal  to  the  market  value  of  the  securities  received  there- 
for. If  the  securities  were  not  marketable  but  were  in  the 
nature  of  investm^t  securities  having  a  fixed  rate  of  return, 
their  appraisal  is  usually  a  comparatively  simple  matter. 

Cases  have  arisen  in  which  the  nominal  value  of  stock 
issued  for  patents  was  considerably  less  than  the  known  cash 
value.  Such  cases  occur  when,  for  some  particular  reason, 
it  is  desired  to  keep  the  capitalization  of  the  purchasing  cor- 
poration at  a  low  figure.  If  the  profit  on  sale  be  based  on  the 
nominal  value  of  the  stock,  substantial  injustice  will  be  done 
to  the  taxpayer.     The  profit  must  be  based  on  the  real  cash 


See  Chapter  XVII. 


FROM  ROYALTIES  AND  PATENTS         655 

value  as  of  the  time  of  acquisition,  little  or  no  attention  being 
paid  to  the  nominal  value  of  stock  issued  for  the  patents.  The 
foregoing  applies  particularly  to  common  stock  which  usually 
receives  the  greatest  benefit  from  a  successful  patent. 

Actual  value  may  be  determined  by  earnings,  past  or  pros- 
pective, which  are  attributable  to  the  ownership  of  patents. 
If  it  can  be  shown  that,  after  providing  for  a  return  on  the 
net  tangible  assets,  the  excess  is  due  to  the  ownership  of  pat- 
ents, such  excess  earnings  may  be  used  in  fixing  the  value  of 
the  patents. 

Royalties  paid  by  licensees  is  another  factor  to  be  consid- 
ered in  establishing  patent  valuations.  Royalty  agreements  and 
schedules  of  receipts  (herefrom  arc  valuable  supporting  evi- 
dence. 

Furthermore,  the  value  in  many  cases  may  be  demonstrated 
by  the  opinions  of  those  who,  by  reason  of  their  technical 
knowledge  and  experience,  are  familiar  with  the  value  of  the 
patents  in  question.  This  method  of  valuation  meets  with 
the  approval  of  the  Treasury. 

Ruling.,  ....  Where  there  is  no  established  market  to  serve 
as  a  guide  the  question  of  value,  even  of  tangible  assets,  is  one  largely 
of  judgment  and  opinion,  and  the  same  thing  is  even  more  true  of 
intangible  assets:     (C.  B.  2,  page  31  ;  A.  R.  M.  34.) 

In  rare  cases  the  value  of  patents  can  be  established  by 
sales  of  the  particular  patents  at  or  about  March  i,  1913.  It 
is  obvious  that  the  value  cannot  be  established  by  sales  of 
similar  property,  because  we  are  dealing  with  a  monopoly. 
The  law  does  not  attempt  to  limit  the  191 3  value  to  its  "mar- 
ket" price  at  that  time.  Section  202  (a)  reads  "the  fair 
market  price  or  value  of  such  property."  There  is  no  pos- 
sibility, in  99  out  of  100  cases,  of  ascertaining  a  "market 
price"  as  at  March  i,  19 13,  and  it  is  useless  to  attempt  it, 
because  the  law  intends  and  authorizes  taxpayers  to  deter- 
mine the  "value"  of  the  patents  as  at  that  date.^^ 


-'Reg.  45,  Art.  1561.     Sec  page  570. 


656 


INCOME 


Regulation.  No  method  of  determining  this  value  (March  i, 
1913)  can  be  stated  by  the  Department  which  will  adequately  meet 
all  circumstances.  What  that  value  was  is  a  question  of  fact  to  be 
established  by  any  evidence  which  will  reasonably  and  adequately 
make  it  appear.     (Reg.  33,  paragraph  6^.) 

In  general,  the  Commissioner  is  required  to  adopt  the 
standards  and  definitions  of  value  which  have  been  approved 
by  the  United  States  Supreme  Court.  The  Treasury,  while 
not  perhaps  applying  strict  technical  rules  of  evidence  in  mat- 
ters of  this  kind,  necessarily  receives  and  gives  the  same  weight 
to  evidence  admissible  in  court  as  would  be  accorded  to  such 
evidence  by  a  court.  It  therefore  becomes  important  to  con- 
sider what  attitude  the  courts  may  take  with  respect  to  the 
establishment  of  value  of  property  having  no  technical  mar- 
ket value.  The  courts  not  only  permit,  but  require,  that  per- 
sons should  be  brought  before  the  court  who,  from  their  tech- 
nical experience  and  knowledge,  are  better  qualified  to  form 
a  judgment  concerning  the  real  value  of  such  property  than  is 
the  ordinary  citizen ;  they  require  such  person  to  detail  his  expe- 
rience and  means  of  knowledge  to  the  jury,  and  then  they 
permit  him  to  express  his  opinion  as  to  the  actual  value  of  the 
property  in  question,  based  upon  his  knowledge  of  that  property 
in  particular  and  upon  his  experience  in  general.  The  follow- 
ing decisions  bear  upon  this  subject : 

Decisions.  This  question  of  damages,  under  the  rule  given  in 
the  statute,  is  always  attended  with  difficulty  and  embarrassment  both 
to  the  court  and  jury.  There  being  no  established  patent  or  license 
fee  in  the  case,  in  order  to  get  a  fair  measure  of  damages,  or  even 
an  approximation  to  it,  general  evidence  must  necessarily  be  re- 
sorted to.  And  what  evidence  could  be  more  appropriate  and  perti- 
nent than  that  of  the  utility  and  advantage  of  the  invention  over 
the  old  modes  or  devices  that  had  been  used  for  working  out  similar 
results?  With  a  knowledge  of  these  benefits  to  the  persons  who 
have  used  the  invention,  and  the  extent  of  the  use  by  the  infringer, 
a  jury  will  be  in  possession  of  material  and  controlling  facts  that 
may  enable  them,  in  the  exercise  of  a  sound  judgment,  to  ascertain 
the  damages,  or,  in  other  words,  the  loss  to  the  patentee  or  owner, 
by  the  piracy,  instead  of  the  purchase  of  the  use  of  the  invention. 
(Suffolk  Co.  V.  Hayden,  3  Wall.  315-320.) 


FROM    ROYALTIES   AND    PATENTS  657 

There  remains  for  consideration  but  a  single  point-that  there 
was  admitted  in  evidence  on  the  trial  the  opinions  of  witnesses  as 
to  the  value  of  the  land,  which  were  not  based  upon  the  sale  of  the 
same  or  similar  property,  and  were  not,  therefore,  the  opinions  of 
persons  competent  to  so  testify.  It  appears  that  the  land  taken  was  a 
strip  running  through  a  mining  claim,  which  had  been  patented  and 

belonged  to  the  defendants  in  error And  yet,   uncertain  and 

speculative  as  it  is,  such  "prospect"  has  a  market  value;  and  the 
absence  of  certainty  is  not  a  matter  of  which  the  railroad  company 
can  take  advantage,  when  it  seeks  to  enforce  a  sale.  Contiguous  to 
a  valuable  mine,  with  indications  that  the  vein  within  such  mine  ex- 
tends into  this  claim,  the  railroad  company  may  not  plead  the  un- 
certainty in  respect  to  such  extension  as  a  ground  for  refusing  to 
pay  the  full  value  which  it  has  acquired  in  the  market  by  reason 
of  its  surroundings  and  possibilities.  In  respect  to  such  value,  the 
opinions  of  witnesses  familiar  with  the  territory  and  its  surroundings 
are  competent.  At  best,  evidence  of  value  is  largely  a  matter  of 
opinion,  especially  as  to  real  estate.  True,  in  large  cities,  where 
articles  of  personal  property  are  subject  to  frequent  sales,  and 
where  market  quotations  are  daily  published,  the  value  of  such 
personal  property  can  ordinarily  be  determined  with  accuracy;  but 
even  there,  where  real  estate  in  lots  is  frequently  sold,  where  prices 
are  generally  known,  where  the  possibility  of  rental  and  other  cir- 
cumstances affecting  values  are  readily  ascertainable,  common  ex- 
perience discloses  that  witnesses  the  most  competent  often  widely 
differ  as  to  the  value  of  any  particular  lot;  and  there  is  no  fixed  or 
certain  standard  by  which  the  real  value  can  be  ascertained.  The 
jury  is  compelled  to  reach  its  conclusion  by  comparison  of  various 
estimates.  Much  more  so  is  this  true  when  the  effort  is  to  ascertain 
the  value  of  real  estate  in  the  country,  where  sales  are  few,  and 
where  the  elements  which  enter  into  and  determine  the  value  are  so 
varied  in  character.  And  this  uncertainty  increases  as  we  go  out  into 
the  newer  portions  of  our  land,  where  settlements  are  recent  and 
values  formative  and  speculative.  Here,  as  elsewhere,  we  are 
driven  to  ask  the  opinions  of  those  having  superior  knowledge  in 
respect  thereto.  It  is  not  questioned  by  the  counsel  for  plaintiff  in 
error  that  the  general  rule  is  that  value  may  be  proved  by  the  opinion 
of  any  witness  who  possesses  sufficient  knowledge  on  the  subject; 
but  their  contention  is,  that  the  witnesses  permitted  to  testify  had 
no  such  sufficient  knowledge.  It  is  difficult  to  lay  down  any  exact 
rule  in  respect  to  the  amount  of  knowledge  a  witness  must  possess; 
and  the  determination  of  this  matter  rests  largely  in  the  discretion 
of  the  trial  judge.  Stillwell  Manufacturing  Co.  v.  Phelps,  130  U.  S., 
520;  Lawrence  v.  Boston,  119  Mass.,  126;  Chandler  v.  Jamaica  Pond 
Aqueduct  Corporation,  125  Mass.,  544.  The  witnesses  whose  testi- 
mony is  complained  of,  all  testified  that  they  knew  the  land  and  its 


658 


INCOME 


surroundings;  and  many  of  them  that  they  had  dealt  in  mining 
claims  situated  in  the  district,  and  had  opinions  as  to  the  value  of  the 
property.  It  is  true,  some  of  them  did  not  claim  to  be  familiar  with 
sales  of  other  property  in  the  immediate  vicinity;  and  the  want  of 
that  means  of  knowledge  is  the  specific  objection  made  in  the  Su- 
preme Court  of  the  Territory  to  the  competency  of  those  witnesses. 
But  the  possession  of  that  means  of  knowledge  is  not  essential.  It 
has  often  been  held  that  farmers  living  in  the  vicinity  of  a  farm  whose 
value  is  in  question,  may  testify  as  to  its  value  although  no  sales  have 
been  made  to  their  knowledge  of  that  or  similar  property.  Indeed, 
if  the  rule  were  as  stringent  as  contended,  no  value  could  be  estab- 
lished in  a  community  until  there  had  been  sales  of  the  property  in 
question,  or  similar  property.  After  a  witness  has  testified  that  he 
knows  the  property  and  its  value,  he  may  be  called  upon  to  state 
such  value.  The  means  and  extent  of  his  information,  and  therefore 
the  worth  of  his  opinion,  may  be  developed  at  length  on  cross-exam- 
ination. And  it  is  fully  open  to  the  adverse  party,  if  not  satisfied 
with  the  values  thus  given,  to  call  witnesses  in  the  extent  of  whose 
knowledge  and  the  weight  of  whose  opinions  it  has  confidence.  (Mon- 
tana Railway  Co.  v.  Warren,  137  U.  S.  348,  352,  353,  354.) 

Inventions  are  of  all  sorts,  and  it  is  very  difficult  for  a  jury  to 
estimate  the  value  of  the  use  of  any  invention  either  before  or  after 
the  issue  of  letters  patent.  We  are  of  opinion  that,  in  the  discretion 
of  the  court,  a  witness  with  the  qualifications  shown  in  this  case 
might  be  permitted  to  give  an  opinion  of  the  value  of  the  use  of 
inventions  relating  to  stock  and  cattle  cars.  Sturgis  v.  Knapp,  33 
Vt,  486,  531;  Butler  V.  Mehrling,  15  111.,  488;  Brady  v.  Brady,  8 
Allen,  loi ;  Vandine  v.  Burpee,  13  Mete.  (Mass.),  288;  Beale  v.  City 
of  Boston,  166  Mass.,  53,  56,  43  N.  E.,  1029.  {Burton  v.  Burton 
Stock  Car  Co.,  50  N.  E.  Rep.  1029,  103 1.) 

Where  there  is  no  evidence  to  show  that  any  license  fee  has 
ever  been  paid  or  demanded,  the  jury,  in  estimating  the  damages, 
should  consider  the  utility  and  advantage  to  the  defendant  of  the 
use  of  the  patented  device,  as  compared  with  any  other  means  of 
obtaining  similar  results  whose  use  was  open  to  it,  and  may  compare 
the  cost  of  using  the  one  to  the  cost  and  saving  in  the  use  of  the 
other.  (Syllabus,  Brickill  ct  al.  v.  Mayor,  etc.,  of  Baltimore,  60  Fed. 
98,  8  C.  C.'a.  500.) 

In  the  last  case  cited,  the  Circuit  Court  of  Appeals  for  the 
Fourth  Circuit  approved  the   following  charge  to  the  jury: 

This  is  an  action  at  law  for  the  damages  sustained  by  the  plain- 
tiffs for  the  alleged  infringement,  and  in  such  actions,  when  there 
has  been  proved  an   established   royalty  or  license   fee,   which   has 


FROM    ROYALTIES   AND    PATENTS  659 

been  customarily  paid  to  the  owner  of  the  patent  by  those  who 
desired  to  use  it,  such  regular  price  for  a  license  is  the  primary  and 
true  criterion  of  the  plaintiff's  damage;  but  in  this  case  there  is 
no  evidence  of  any  license  fee  ever  having  been  demanded  or  paid 
by  any  one;  and  so,  if  you  find  in  favor  of  the  plaintiff's,  you 
should  consider  the  utility  and  advantage  to  the  defendant  of  the 
use  of  the  patented  device,  as  compared  to  any  other  means  of 
obtaining  similar  results  which  were  open  to  the  defendant  to  use, 
and  you  may  consider  the  cost  of  using  one  as  compared  with  the 
cost  and  savings  to  the  defendant  of  using  the  other;  and  from  these 
data,  if  proven  to  you,  you  should  ascertain,  in  the  exercise  of  a 
sound  judgment,  what  would  be  a  fair  compensation  to  the  plain- 
tiffs for  the  damage  which  they  have  sustained  by  reason  of  the 
defendant  having  infringed,  instead  of  having  purchased  the  right 
to  use,  the  invention. 

Ruling.  The  Committee  has  considered  the  question  of  provid- 
ing some  practical  formula  for  determining  value  as  of  March  i, 
1913,  or  of  any  other  date,  which  might  be  considered  as  applying  to 
intangible  assets,  but  finds  itself  unable  to  lay  down  any  specific  rule 
of  guidance  for  determining  the  value  of  intangibles  which  would 
be  applicable  in  all  cases  and  under  all  circumstances.  Where  there 
is  no  established  market  to  serve  as  a  guide  the  question  of  value, 
even  of  tangible  assets,  is  one  largely  of  judgment  and  opinion,  and 
the  same  thing  is  even  more  true  of  intangible  assets  such  as  good 

will,  trade-mark,  trade  brands,  etc (C.  B.  2,  page  31;  A.  R. 

M.  34.) 

Also  see  cases  cited  in  discussion  regarding  fair  value  of 
services,  page  871. 

Patents  not  issued  March  i,  1913,  may  be  valued. — The 
Treasury  very  properly  permits  applications  for  patents  to 
rank  with  those  issued  in  ascertaining  values  as  of  March  i, 
1913.^^  This  is  on  the  theory  that  there  is  an  assignable  prop- 
erty right  in  an  application  for  a  patent.  Obviously,  if  no 
patent  is  subsequently  issued  there  can  be  no  value  at  March 

I,  1913- 

The  method  of  depreciation,  when  a  patent  was  not  issued 
until  after  March  i,  1913,  necessarily  differs  from  that  appli- 
cable to  patents  issued  prior  to  March  i,  1913.  For  a  discus- 
sion of  this  point,  see  Chapter  XXXI. 


'X.  B.  3,  page  342;  A.  R.  R.  328. 


66o  INCOME 

Royalties  subject  to  depreciation  charges. — The  following 
ruling  explains  the  extent  to  which  royalties  subject  to  depre- 
ciation charges  are  taxable. ^^ 

Ruling.  A  invented  certain  apparatus  and  secured  United  States 
patents  thereon.  The  patents  were  assigned  to  a  foreign  corporation 
under  an  agreement  by  which  he  retained  40  per  cent  interest  in 
profits  therefrom.  Legal  title  to  the  patents  passed  to  the  company 
subject  to  the  agreement  mentioned.  A's  interest  was  recognized  by 
the  company  and  by  the  United  States  licensees  under  the  patents. 
The  committee  is  of  the  opinion  that  the  agreement  should  be  recog- 
nized as  giving  A  a  depreciable  interest  in  the  patents. 

The  value  of  each  patent  as  at  March  i,  1913,  should  be  segre- 
gated and  the  depreciation  allowable  thereon  determined  on  the  bdsis 
of  its  own  life  instead  of  using  as  a  basis  the  average  life  of  all  the 
patents  and  the  value  of  all  the  patents  in  bulk.  Of  the  total  depre- 
ciation allowable  for  any  year,  60  per  cent  is  deductible  in  the  return 
of  the  company  and  40  per  cent  in  A's  return.  (C.  B.  2,  page  142; 
A.  R.  M.  35.) 


°'  See    Chapter    XXXI    for   a    full    discussion    of   the   depreciation    of 
patents. 


CHAPTER    XIX 

INCOME  FROM  INTEREST— GENERAL 

All  interest,  except  on  slate,  municipal  and  certain  United 
States  securities,  is  to  be  included  in  gross  income,  whether 
on  notes,  bank  deposits,  securities,  bonds,  mortgages  or  deeds 
of  trust  or  other  similar  obligations  of  domestic  corporations 
and  insurance  companies,  bonds  issued  in  foreign  countries 
or  upon  foreign  mortgages  or  like  obligations  (not  payable 
in  the  United  States). 

Interest  on  tax-exempt  securities  is  not  to  be  reported  as  a 
part  of  gross  income.  The  statement  showing  the  number 
and  amount  of  such  securities  and  the  income  therefrom  which 
was  required  to  be  submitted  with  the  annual  income  tax  re- 
turn'- under  the  1918  law,  is  not  required- under  the  1921  law. 

Subject  to  the  exceptions  stated,  not  only  is  all  interest  re- 
ceived by  residents  and  domestic  corporations  taxable,  but  in- 
terest received  by  non-resident  aliens  and  foreign  corporations 
from  sources  w^ithin  this  country^  is  also  taxable — a  fact  which 
raises  an  interesting  cjuestion  of  international  double  taxation.' 

The  law  and  procedure  regarding  interest  derived  from 
United  States  obligations,  including  farm  loans,  will  be  found 
in  the  following  chapter.  Interest  from  all  other  sources  will 
be  discussed  in  this  chapter. 

Interest  subject  to  tax. — 

Law.  Section  213.  That  for  the  purposes  of  this  title  .... 
the  term  "gross  income" — 

(a)  Includes  gains,  profits,  and  income  derived  from  ....  in- 
terest  .... 


'  Prior  to  1918,  interest  which  was  entirely  exempt  from  taxation  did 
not  have  to  be  reported  at  all. 

""As  defined  in  section  217  (a-i)  of  the  1921  law.    See  Chapter  XXXVI. 

'For  discussion  of  the  principles  involved  in  the  taxation  of  non- 
resident aliens,  see  Chapter  XXXVI. 

661 


662  INCOME 

In  order  to  exclude  all  exempt  interest  from  taxation, 
taxpayers,  particularly  banks  and  other  financial  institutions, 
should  keep  separate  ledger  accounts  for  interest  from  various 
sources. 

Interest  accrued  but  not  collected. — So  far  as  possible  tax- 
payers are  expected  to  keep  their  accounts  on  an  accrual  basis 
and  return  as  income  all  interest  which  accrues  to  them. 

Regulation.  When  interest  coupons  have  matured,  and  are  pay- 
ahle,  but  have  not  been  cashed,  such  interest  payment,  though  not  col- 
lected when  due  and  payable,  is  nevertheless  available  to  the  taxpayer 
and  should  therefore  be  included  in  his  gross  income  for  the  year  dur- 
ing which  the  coupons  matured.  This  is  true  if  the  coupons  are  ex- 
changed for  other  property  instead  of  eventualyl  being  cashed.  De- 
faulted coupons  are  income  for  the  year  in  which  paid (Art. 

53;  Reg.  45,  Art.  54.) 

Unless  the  foregoing  regulation  is  intended  to  refer  only 
to  cases  where  payment  can  be  secured  upon  presentation  of 
the  coupons,  it  is  too  optimistic.  It  states  without  reserva- 
tion that  when  interest  is  due  it  "is  nevertheless  available  to 
the  taxpayer." 

Owners  of  public  utility  bonds  which  have  been  made 
worthless,  or  nearly  so,  by  the  hostile  action  of  municipal 
authorities,  as  in  New  York  City,  or  by  confiscatory  legis- 
lation in  other  places,  should  not  accrue  the  interest  until 
there  is  a  reasonable  chance  of  collecting  it.  Of  course,  if 
the  taxpayer  could  collect,  but  does  not,  there  is  no  excuse 
for  not  reporting  the  amount  accrued. 

Accrued  interest  returned  as  income  which  is  not  subse- 
quently collected. — Taxpayers  reporting  upon  the  accrual 
basis  should  report  as  taxable  income  accruals  from  real  estate 
mortgages,  loans  and  other  obligations  when  there  is  a  reason- 
able expectation  that  such  interest  will  be  received  in  due 
course.  In  cases  where  it  develops  that  the  debtor  is  unable 
to  pay  the  interest  previously  entered  as  income,  this  interest 
should  be  charged  off  on  the  taxpayer's  books  as  soon  as  it 


FROM    INTEREST— GENERAL  663 

is  known  to  be  worthless,  and  proper  credit  should  be  taken 
therefor  in  making  the  next  succeeding  income  tax  return.* 

Interest  accrued  prior  to  March  i,  1913,  not  taxable.^ — The 
regulations  provide  that  interest  which  fell  due  on  or  before 
March  i,  191 3,  and  was  subsequently  collected,  is  not  taxable. " 

Regulation.  Any  claim  existing  unconditionally  on  March  i, 
1913,  whether  presently  payable  or  not  and  held  by  a  taxpayer  prior 
to  March  i,  1913,  whether  evidenced  by  writing  or  not,  and  all  in- 
terest which  had  accrued  thereon  before  that  date,  do  not  con- 
stitute taxable  income,  although  actually  recovered  or  received 
subsequent  to  such  date.  Interest  accruing  on  or  after  that 
date  is  taxable  income.  Where  an  interest-bearing  claim  held 
on  February  28,  1913,  is  paid  in  whole  or  in  part  after  that  date,  any 
gain  derived  from  the  payment  of  the  claim  is  taxable.  The  amount 
of  such  gain  is  the  excess  of  the  proceeds  of  the  claim  (both  princi- 
pal and  interest)  exclusive  of  any  interest  accrued  since  February 
28,  1913,  already  returned  as  income,  over  the  cost  thereof  (both 
principal  and  interest  then  accrued).  However,  the  gain  to  be  in- 
cluded in  gross  income  where  the  fair  market  value  of  the  claim  as  of 
March  i,  1913,  is  greater  than  the  cost  thereof,  is  the  excess  of  the 
amount  received  over  such  value.  No  gain  results  where  the  amount 
received  from  the  claim  is  more  than  the  cost  thereof  but  less  than  its 

fair  market  value  as  of  A'larch  i,  1913 (y\rt.  90,  Reg.  45, 

Art.  87.) 

Interest  accrued  prior  to  January  i,  igog,  not  taxable. — 

Ruling.  Interest  which  accrued  prior  to  1909,  and  was  paid  in 
191 1,  was  not  income  within  the  provisions  of  the  excise  tax  law  of 
1909."     (C.  B.  3,  page  243;  T.  D.  3048.) 


*  [Former  Procedure]  Where  interest  on  loans  made  by  a  parent 
corporation  to  its  subsidiary  accrued  from  year  to  year,  but  was  not  paid, 
the  amount  thus  accrued  during  a  taxable  year  cannot  be  considered  income 
to  the  parent  company  within  the  meaning  of  the  Act  of  August  5,  1909. 
(T.  D.  3133,  dated  February  25,  1921.) 

°  [Former  Procedure]  It  was  held  that  interest  which  became  due 
and  payable  after  March  i,  191 3,  was  all  taxable  even  though  part  accrued 
prior  to  March  i,  1913.  The  instance  mentioned  concerned  an  interest 
coupon  due  April  i,  1913,  covering  six  months'  interest  to  that  date.  There 
was  an  attempt  to  tax  five  months'  interest  which  accrued  prior  to  March  i, 
1913.  The  proposed  assessment  could  not  be  supported  by  the  law  and  was 
not  insisted  upon. 

•  See  Chapter  XXII. 

'Northern  Pacific  Ry.  v.  Lynch,  Collector  (U.  S.  D.  C.  Minn.,  March 
22,  1920,  not  reported;  see  T.  D.  3048)  ;  also  see  Walker  v.  Gulf  &  Inter- 
state Ry.  Co.  of  Texas,  269  Fed.  885  (quoted  in  T.  D.  3133). 


664  INCOME 

The  Treasury  had  imposed  a  tax  on  interest  accrued  prior 
to  January  i,  1909,  collected  in  191 1,  although  the  decisions  of 
the  courts  should  have  been  sufficient  notice  to  the  Treasury 
that  its  position  was  untenable.  The  case  was  defended  by 
the  government  when  it  was  heard,  March  22,  1920,  but  the 
court  directed  that  the  tax  be  refunded,  with  interest  from 
the  date  of  its  collection. 

Interest  on  Obligations  of  States  and  Political 
Subdivisions 

It  will  be  recalled  that  the  law  exempts  interest  upon  "the 
obligations  of  a  State,  Territory,  or  any  political  subdivision 
thereof,  or  the  District  of  Columbia."     [Section  213    (b-4)]^ 

Definition  of  a  political  subdivision, — The  interpretation  of 
the  phrase  "interest  upon  the  obligations  of  a  state  ....  or 
any  political  subdivision  thereof"  has  raised  the  question  as  to 
whether  certain  special  assessment  districts  are  political  sub- 
divisions. The  present  regulations,  in  addition  to  defining 
obligations  of  a  state,  give  a  broad,  inclusive  definition  of  a 
political  subdivision  which  results  in  the  exemption  of  interest 
on  the  securities  of  special  assessment  districts  (drainage, 
irrigation,  school,  etc).^ 

Irrigation  districts. — 

Ruling.  In  some  of  the  Western  States  irrigation  districts  are 
created  by  an  election  duly  called  for  the  purpose.  The  county 
assessor  of  the  county  in  which  the  land  benefited  is  located  assesses 
all  such  property  on  the  assessment  rolls  of  the  county  and  a  tax  is 
levied  and  collected  in  the  same  manner  as  other  taxes  are  levied  and 
collected. 

Held,  the  district  is  a  political  subdivision  of  the  State  and  inter- 
est on  its  bonds  is  exempt  from  income  tax.  (C.  B.  2,  page  93;  O.  D. 
544-) 


^  For  text  of  section  213  (b-4)  and  Art.  74.  sre  page  359. 
"Infra   (Art.  74). 
[Former  Procedure]     For  conflicting  regulations   prior  to   1919,   see 
Income  Tax  Procedure,  1920,  page  403. 


FROM  INTEREST— GENERAL      ^     665 

Mortgage  indebtedness  assumed  by  municipality. — 

Regulation The^  purchase  by  a  State  of  property  sub- 
ject to  a  mortgage  executed  to  secure  an  issue  of  bonds  does  not 
render  the  bonds  obligations  of  the  State,  and  the  interest  upon  them 
does  not  become  exempt  from  taxation,  whether  or  not  the  State 
assumes  the  payment  of  the  bonds.     (Art.  74.) 

Land  sold  for  non-payment  of  taxes. — 

Ruling.,  Certificates  of  sale  issued  by  the  county  treasurers  of 
counties  of  Wisconsin  to  purchasers  of  land  sold  for  the  nonpayment 
of  taxes  are  not  obligations  of  political  subdivisions  of  the  State  of 
Wisconsin.  Such  certificates  do  not  place  any  obligation  upon  the 
county  to  pay  any  sum  of  money  to  such  purchasers.  The  statute 
provides  that  the  owner  or  occupant  of  such  land  may  at  any  time 
within  three  years  from  the  date  of  the  certificate  redeem  the  same 
or  any  part  thereof  by  paying  to  the  county  treasurer  for  the  use  of 
the  purchaser  the  amount  for  which  such  land  was  sold,  together 
with  subsequent  charges  thereon  authorized  by  law,  but  does  not  pro- 
vide that  the  county  is  either  directly  or  indirectly  liable  for  .the  re- 
deniption  thereof. 

It  is  held,  therefore,  that  tiie  interest  on  the  tax  certificates  issued 
by  county  treasurers  of  counties  of  Wisconsin  is  not  exempt  from  tax. 
(B.  48-21-1944;  O.  D.  1 1 14.) 

Interest  on  awards  by  state  or  municipality. — When  a  state 
or  city  takes  property  under  the  power  of  eminent  domain, 
or  when  other  awards  of  a  state  or  city  are  paid  with  in- 
terest, the  question  arises  as  to  whether  or  not  interest  on  an 
award  is  equivalent  to  interest  on  an  obligation  and  therefore 
is  exempt  from  federal  taxes. 

The  liability  of  a  city  to  pay  for  property  taken  under 
the  power  of  eminent  domain  is  certainly  an  obligation.  State 
constitutions  provide  that  private  property  shall  not  be  taken 
for  public  use  except  upon  just  compensation  paid  or  secured. 
A  city  is  allowed  to  give  its  own  bond  and  under  the  obliga- 
tion of  this  bond  it  is  compelled  to  pay  just  compensation. 
Such  just  compensation  is  due  as  of  the  date  of  the  taking, 
and  when  not  paid  immediately  the  citizen  is  placed  in  the 
same  position  by  the  payment  of  interest  as  such,  or  by  the 
payment  of  an  additional   amount,   which   in   some  cases   is 


666  ^  INCOME 

spoken  of  as  "damages  for  detention"  not  exceeding  legal 
interest,  but  it  is  in  substance  interest.  It  is,  of  course,  of  im- 
portance to  the  recipient  that  any  part  of  the  award  which 
actually  is  tax-exempt  interest  should  be  properly  designated. 

Rulings.  Bonds  were  issued  by  a  municipality  of  Wisconsin,  in 
accordance  with  the  general  city  charter  law  of  that  State,  to  cover 
deferred  installments  of  assessments  against  real  estate  for  the  cost 
of  certain  public  improvements.  Each  bond  was  a  lien  upon  all  the 
property  benefited  to  the  extent  of  unpaid  assessments  and  interest 
thereon.  The  bonds  contained  recitals  that  they  were  chargeable  only 
to  the  particular  prupcrty  described  therein,  and  that  they  should  in 
no  event  constitute  a  general  city  liability. 

Notwithstanding  the  bonds  were  not  a  general  liability  of  the 
city,  they  were  issued  l>y  the  city  for  public  purposes  and  are  obliga- 
tions of  a  political  subdivision  of  a  State  within  the  meaning  of 
section  213(b)  4  of  the  Revenue  Act  of  1918,  and  the  interest  upon 
such  bonds  is  accordingly  exempt  from  tax.  (C.  B.  2,  page  93;  O.  D, 
447-) 

Interest  received  by  a  contractor  on  paving  assessments  issued 
to  him  by  a  municipality  in  payment  for  work  under  the  provisions 
of  the  statutes  of  a  certain  State  is  exempt  income  under  section  213 

(b)   4  of  the  Revenue  Act  of  1918 (B.  34-21-1778;  O.  D. 

999-)  ] 

Interest  on  l)onds  issued  by  agricultural  and  horticultural  societies 
under  authority  of  section  7852,  compiled  laws  of  Michigan,  is  not 
exempt  from  tax  under  section  213  (b)  4  of  the  Revenue  Act  of 
1918.     (B.  31-21-1751:  O.  D.  983.) 

Sale  of  municipal  bonds  issued  at  a  discount. — 

Ruling.  The  M  bank  purchased  certain  10  year  4I/2  per  cent 
municipal  bonds  at  96.10  which  had  been  originally  issued  and  sold 
by  the  municipality  at  94.50.  The  question  is  presented  as  to  whether 
in  case  the  bank  sells  the  bonds  before  maturity  at  98,  the  profit 
realized  will  be  exempt  in  its  hands. 

Held,  that  inasmuch  as  no  person  other  than  the  municipality  can 
pay  the  interest  borne  by  the  obligations  of  the  municipality  (whether 
such  interest  is  paid  at  the  specified  rate  or  in  the  form  of  realized 
discount)  any  person  selling  municipal  bonds  for  an  amount  in  ex- 
cess of  the  cost  of  the  bonds  to  him  realizes  a  taxable  profit  to  the 
extent  of  such  excess  amount  even  though  the  bonds  were  issued  at 
a  discount. 

If,  therefore,  the  bank  sells  at  $98  the  municipal  bonds  issued  at 


FROM    INTEREST— GENERAL  667 

$94.50  and  purchased  by  it  at  $96.10,  it  will  derive  a  taxable  profit 
of  $1.90  on  each  bond  sold.  If,  however,  it  holds  the  bonds  to  maturity 
and  receives  $100  the  difference  between  the  purchase  price  of  the 
bonds  and  the  amount  received,  or  $3.90,  will  represent  exempt  in- 
come to  it.     (C.  B.  4,  page  31;  O.  D.  762.) 

Interest  from  Miscellaneous  Sources 

The  law  and  the  regulations  do  not  enumerate  all  the 
sources  from  which  taxable  interest  may  be  derived,  but 
as  with  other  items  of  income,  the  question  of  taxability  de- 
pends on  whether  or  not  the  amount  received  or  accrued  is 
in  fact  income. 

Interest   on  bank  deposits.'" — 

Regulation Interest  credited  on  savings  bank  deposits, 

even  though  the  bank  nominally  have  a  rule,  seldom  or  never  en- 
forced, that  it  may  require  so  many  days'  notice  in  advance  of  cash- 
ing depositors'  checks,  is  income  to  the  depositor  when  credited. 
....      (Reg.  45,  Art.  54.) 

As  to  non-resident  aliens  see  Chapter  XXXVI. 

Interest  on  loans  to  Liberty  bond  subscribers. — 

Ruling.  Interest  received  by  a  bank  on  loans  to  subscribers  for 
Liberty  bonds  is  not  interest  received  on  obligations  of  the  United 
States,  and  is  therefore  subject  to  tax.     (C.  B.  i,  page  67;  O.  D.  16.) 

Interest  on  Food  Administration  Grain  Corporation 
notes. — 

Ruling.  Interest  on  Food  Administration  Grain  Corporation 
notes  is  not  exempt  from  income  and  excess  profits  taxes.     (Telegram 

'"  [Former  Procedure] 

Regulation.  "Interest  on  bank  deposits  or  on  certificates  of  de- 
posit, whether  paid  or  accrued  and  unpaid,  must  be  included  in  the  annual 
income  return  of  the  person  entitled  to  receive  such  interest,  whether  on 
open  account  or  on  the  certificate  of  deposit."     (Reg.  22,  1914,  Art.  67.) 

This  regulation  ignored  the  "cash"  basis,  and  required  a  return  on 
the  accrual  basis.  If  the  taxpayer  did  not  receive  notice  of  the  interest 
until  after  his  cash  account  for  the  year  was  closed,  and  if  he  were  report- 
ing upon  a  cash  as  distinguished  from  an  accrual  basis,  he  would,  how- 
ever, not  have  been  required  to  include  the  interest  until  the  following 
year. 


668  INCOME 

to  The  Corporation  Trust  Compari}',  signed  by  Commissioner  Roper, 
April  13,  1919.) 

Interest  charged  to  construction. — 

Ruling.  No  taxable  income  accrues  to  a  public  utility  corpora- 
tion from  a  mere  book  entry  charging  construction  account  and 
crediting  income  account  due  to  charging  interest  on  the  company's 
own  funds  used  temporarily  for  construction  purposes,  as  permitted 
under  the  Interstate  Commerce  Commission's  classification ;  neither 
will  the  company  be  allowed  to  include  in  its  assets  such  amount  of 
interest  charged  to  capital  account  for  the  purpose  of  determining 
invested  capital.     (C.  B.  i,  page  212;  O.  D.  246.) 

By  O.  D.  1061  (B.  41-21-1862)  this  ruhng  was  extended 
to  apply  to  the  Revenue  Acts  of  1916  and  191 7. 

Income  from  bonds  paid  at  maturity  or  before. — When 
bonds  are  purchased  at  a  discount  from  their  face  vahie  or 
when  they  are  purchased  at  par  and  paid  ofT  at  a  premium,  the 
excess  received  above  cost  or  value  March  i,  191 3,  (and 
interest  periodically  collected)  is  taxable  income. 

If  a  taxpayer  keeps  his  accounts  on  an  accrual  basis  it 
would  be  good  accounting  practice  to  enter  annually  as  in- 
come a  proportional  part  of  the  difference  between  cost  and 
par,  and  return  such  accruals  for  income  tax  purposes.  When 
the  bonds  are  paid  at  maturity  or  called,  the  amount  to  be 
returned  will  be  only  the  difference  between  cost,  or  value 
March  i,  1913,  plus  the  amounts  previously  returned  (ex- 
cept interest  actually  collected)  and  the  amount  received. 

When  the  amount  received  is  less  than  cost  or  value  March 
I,  1913,  plus  the  amounts  returned  as  income,  the  difference 
is  an  allowable  deduction  as  a  loss.     (See  ('hapter  XXIX.) 

The  rule,  in  effect,  is  disapproved  by  the  Treasury  in  the 
following  ruling. 

Ruling.  Interest  received  or  accrued  on  bonds  purchased  at  a 
premium,  according  to  the  method  employed  in  keeping  books,  rep- 
resents  income   for   the  year   in    which   received   or   accrued   at   the 


FROM    INTEREST— GENERAL  669 

rate  carried  by  the  bonds  and  not  at  the  rate  which  would  be  reahzed 
after  amortizing  the  premium.'^     (C.  B.  3,  page  89;  O.  D.  622.) 

It  is  not  believed,  however,  that  a  taxpayer  who  keeps  his 
accounts  according  to  well-recognized  accounting  principles 
would  be  required  to  make  any  change  therein  in  order  to 
conform  to  the  foregoing  ruling,  which  conflicts  with  good 
practice. 

The  author  consistently  has  held  that  disanint  on  bonds 
or  like  securities  is,  in  effect,  an  increased  rate  of  interest. 
The  Treasury,  with  equal  consistency,  holds  that  the  discount 
is  a  profit  to  the  recipient  and  a  loss  to  the  payer. '- 

It  may  be  expected  that  non-interest  bearing  notes  and 
bonds  will  become  popular.  Taxpayers  in  receipt  of  large  in- 
comes loaning  money  for  more  than  two  years,  will  be  able  to 
btiy  the  obligations  at  a  discount  and  report  their  gross  returns 
thereon  as  capital  gains. 

Income  from  redemption  of  bonds — amortization  of  pre- 
mium.— The  following  regulation  summarizes  the  cases  in 
which  income  is  deemed  to  arise  upon  the  redemption  by  a 
corporation  of  its  own  bonds  or  from  the  amortization  of  the 
premium  on  its  bonds  sold  above  par. 

Regulation,      (i)    (a)   If  bonds  are   issued  by  a  corporation  at 

their  face  value,  the  corporation  realizes  no  gain  or  loss (c) 

If,  however,  the  corporation  purchases  and  retires  any  of  such  bonds 
at  a  price  less  than  the  issuing  price  or  face  value,  the  excess  of  the 
issuing  price  or  face  value  over  the  purchase  price  is  gain  or  income 
for  the  taxable  year. 

(2)  (o)  If  bonds  are  issued  by  a  cnrpuration  at  a  premium,  the 
net  amount  of  such  premium  is  gain  or  income  which  should  be  pro- 
rated or  amortized  over  the  life  of  the  bonds (c)  If,  how- 
ever, the  corporation  purchases  and  retires  any  of  such  bonds  at  a 
price  less  than  the  issuing  price  minus  any  amount  of  premium  al- 
ready returned  as  income,  the  excess  of  the  issuing  price  minus  any 
amount  of  premium  already  returned  as  income  (or  of  the  face  value 


';See  Chapter  XXVII. 

"Income  Tax  Procedure,  1921,  pages  510,  734;  Andifing,  Theory  and 
Practice,  by  R.  H.  Montgomery   (1921  edition),  page  531. 


670  INCOME 

plus  any  amount  of  premium  not  yet  returned  as  income)    over  the 
purchase  price  is  gain  or  income  for  the  taxable  year. 

(3)  (a)  If  bonds  are  issued  by  a  corporation  at  a  discount,  [and] 
....  (c)  If,  however,  the  corporation  purchases  and  retires 
any  of  such  bonds  at  a  price  less  than  the  issuing  price  plus  any 
amount  of  discount  already  deducted,  the  excess  of  the  issuing  price 
plus  any  amount  of  discount  already  deducted  (or  of  the  face  value 
minus  any  amount  of  discount  not  yet  deducted)  over  the  purchase 
price  is  gain  or  income  for  the  taxable  year.  (Art.  545.  Reg.  45, 
Art.  544.) 

The  subject  of  deductible  loss  because  of  the  purchase  and 
retirement  by  a  corporation  of  its  bonds  is  discussed  in  Chap- 
ter XXIX. 


Interest  received  by  stock-brokers  and  others. — Interest 
charged  by  stock-brokers  and  others,  who  in  the  ordinary 
course  of  business  make  regular  interest  entries  against  cus- 
tomers' accounts,  should  be  reported  in  income  tax  returns  at 
the  gross  amount  so  accrued  or  collected,  and  not  at  the  net 
amount  ascertained  by  deducting  interest  paid.  Under  the 
1 91 7  and  prior  laws,  reporting  the  net  amount  was  held  to  be 
illegal.^^ 

Sinking  fund  increment. — Under  the  earlier  laws  the  ques- 
tion arose  as  to  whether  or  not  interest  on  a  corporation's  own 
bonds  held  in  its  own  sinking  fund  should  be  reported  as  in- 
come. Under  the  1918  and  192 1  laws,  it  is  immaterial  how 
the  interest  is  reported.  The  limitation  on  the  interest  deduc- 
tion no  longer  exists. '■* 

Regulation.  If  a  corporation,  in  order  solely  to  secure  the  pay- 
ment of  its  bonds  or  other  indebtedness,  places  property  in  trust,  or  sets 
aside  certain  amounts  in  a  sinking  fund  under  the  control  of  a 
trustee,  vv'ho  may  be  authorized  to  invest  and  reinvest  such  sums  from 
time  to  time,  the  property  or  fund  thus  set  aside  by  the  corporation 


"This  point  was  decided  in  the  case  of  Altheimer  &  Rowlings  Imrst- 
vient  Co.  V.  Alien,  Collector  (248  Fed.  688,  160  C.  C.  A.  588,  248  U.  S.  578; 
certiorari  denied,  63  L.  E.  430,  39  S._  Ct.  20. 

'*  [Former  Procedure]  For  criticisms  of  regulations  under  former 
laws,  see  Income  Tax  Procedure,  1920,  page  407. 


FROM  INTEREST— GENERAL  671 

and  held  by  the  trustee  is  an  asset  of  the  corporation,  and  any  gain 
arising  therefrom  is  income  of  the  corporation  and  shall  be  included 
as  such  in  its  annual  return.  The  trustee,  however,  is  not  taxable  as 
such  on  account  of  the  property  or  fund  so  held.  (Art.  542,  Reg.  45, 
Art.  541.) 


Income  from  building  and  loan  associations.^^ — A  new  pro- 
vision has  been  written  into  the  law  exempting  dividends  or 
interest  from  building  and  loan  associations  up  to  an  amount 
of  $300  per  annum,  effective  for  the  years  1922- 1926,  inclu- 
sive. 

Law.     Section    213 (b)    .    .    .    .    (10)  So    much    of    the 

amount  received  by  an  individual  after  December  31,  1921,  and  before 
January  i,  1927,  as  dividends  or  interest  from  domestic  building  and 
loan  associations,  operated  exclusively  for  the  purpose  of  making  loans 
to  members,  as  does  not  exceed  $300;   .... 

Although  a  literal  interpretation  of  this  provision^*^  would 
indicate  an  exemption  aggregating  $300  over  the  period,  Jan- 
uary I,  1922,  to  December  31,  1926,  the  author  is  of  the 
opinion  that  the  intention  of  Congress  was  to  exempt  from 
taxation  interest  from  building  and  loan  associations  up  to 
a  maximum  of  $300  each  year.  The  author's  interpretation 
is  confirmed  by  a  study  of  the  original  House  provision  and  of 
the  conferees'  report.  The  House  bill  contained  the  fol- 
lowing : 

So  much  of  the  amount  received  by  an  individual  as  dividends  or 
interest  from  Domestic  Building  &  Loan  Associations,  operated  ex- 
clusively for  the  purpose  of  making  loans  to  members,  as  does  not 
exceed  $500. 

The  conference  report  makes  the  following  explanation 
of  the  change  made  in  the  final  act : 

Amendment  No.  152:  The  House  bill  provides  that  individuals 
should  not  be  required  to  include  in  their  gross  income  so  much  of  the 


'°  [Former  Procedure]  l^ir  prior  regulations  see  Incouic  l\tx  Pro- 
cedure, ig2i,  pages  511-512. 

'"Such  an  interpretation  lias  not  been  made  by  the  Treasury  in  Art. 
89  (2).  This  regulation  accords  with  the  intent  of  Congress,  even  if  the 
draftsmen  of  the  law   failed  tu  express  the  thought  accurately. 


672  INCOME 

amount  received  by  them  as  dividends  or  interest  from  Domestic 
Building  &  Loan  Associations  operated  exclusively  for  the  purpose 
of  making  loans  to  members,  as  does  not  exceed  $500.  The  Senate 
amendment  strikes  out  the  provision  of  the  House  bill.  The  House 
recedes  with  an  amendment  permitting  the  exclusion  from  gross  in- 
come of  an  amount  of  such  dividends  or  interest  not  in  excess  of 
5j^300  and  providing-  that  this  exclusion  from  gross  income  shall  only 
be  in  effect  from  January  i,  1922,  until  January  i,  1927. 

The  author's  contention  is  confirmed  by  the  following  ex- 
tracts from  the  Congressional  Record,  192 1. 
Congressman  Treadway : 

Perhaps  Mr.  Average  Man  may  become  fairly  well  to  do  and 
wishes  to  save  in  expectation  of  owning  his  own  home.  He  has  the 
opportunity  under  the  new  bill  of  investing  his  savings  in  a  mutual 
building  and  loan  association  and  up  to  $500  his  income  from  this 
source  will  be  exempted — another  evidence  of  the  interest  this  bill 
is  showing  in  the  home  life  of  the  man  of  moderate  means.  (Page 
5624.) 

Congressman  Longworth : 

This  bill  carries  this  provision :  We  make  the  first  $500  of  in- 
come received  from  capital  invested  in  the  stock  of  building  associa- 
tions exempt  from  any  tax  at  all.  We  put  it  on  tlie  same  basis  to  the 
extent  of  $500  as  all  otlier  nontaxable  investments.  There  is  no  ques- 
tion now  but  that  the  stock  in  a  building  association  amounting  to 
$10,000  will  be  a  reasonably  attractive  investment  and  will  result  in 
a  great  increase  of  capital  available  for  the  building  of  small  homes 
throughout  the  country.  This  is  a  small  thing  on  paper,  perhaps,  but 
I  believe  it  is  a  big  thing  in  the  interest  of  the  plain  people  of  this 
country,  and  Democrats  propose  to  vote  against  it.     (  Page  5704.) 

The  conferees  intended  merely  to  reduce  the  exemption  of 
$500  per  annum  to  $300  per  annum,  not  to  $300  spread  over 
five  years,  otherwise  the  reference  to  $10,000  of  principal 
would  have  been  absurd. 

The  foregoing  interpretation  has  been  accepted  by  the 
Treasury,  as  indicated  in  in  the  following: 

Regulation The  following  additional  exclusions   from 

gross  income   ....   are  allowed   .... 

(2)  So  much  of  the  amount  received  by  an  individual  after  De- 
cember 31,  1921,  and  before  January  i,  1927,  as  dividends  or  interest 
from  domestic  building  and  loan  associations  operated  exclusively  for 
the  purpose  of  making  loans  to  members  as  does  not  exceed  $300 
per  year;   ....      (Art.  89.) 


FROM    INTEREST— GENERAL  673 

Amount  to  be  reported. — 

Ruling An    amount    credited    to    shareholders    of    a 

building  and  loan  association,  when  such  credit  passes  without  re- 
striction to  the  shareholder,  has  a  taxable  status  as  income  for  the 
year  of  the  credit.  Where  the  amount  of  such  accumulations  does 
not  become  available  to  the  shareholder  until  the  maturity  of  a  share, 
the  amount  of  any  share  in  excess  of  the  aggregate  amount  paid  in  by 
the  shareholder  is  income  for  the  year  of  the  maturity  of  the  share. 
(Art.  53.     Reg.  45,  Art.  54.) 

Ruling.  A  taxpayer  is  deemed  to  have  received  items  of  gross 
income  which  have  been  credited  to  or  set  apart  for  him  without  re- 
striction. Therefore  an  amount  credited  to  shareholders  of  a  building 
and  loan  association,  when  such  credit  passes  without  restriction  to 
the  shareholder,  has  a  taxable  status  as  income  for  the  year  of  the 
credit  and  should  be  so  reported  by  the  shareholder. 

In  cases,  however,  where  the  amount  paid  in  by  the  shareholder 
and  the  accumulative  profits  do  not  become  available  to  the  shareholder 
until  the  maturity  of  a  share,  the  proceeds  of  any  share  subscribed  for 
subsequent  to  March  i,  1913,  in  excess  of  the  aggregate  amount  paid 
in  by  the  shareholder  is  income  for  the  year  of  the  maturity  of  the 
share. 

If  the  subscription  was  made  prior  to  March  i,  1913,  and  under 
the  rules  of  the  association  the  share  subscribed  for  had  a  cash  sur- 
render value  on  March  i,  1913,  and  any  year  thereafter  in  excess 
of  the  amount  paid  in  by  the  shareholder,  the  determination  of  any 
profit  realized  at  the  time  of  cash  surrender  or  for  the  year  of  the 
maturity  of  the  share  will  be  based  on  the  proceeds  in  excess  of  the 
cash  surrender  value  as  of  March  i,  1913,  plus  the  aggregate  amount 
paid  in  subsequent  thereto.     (C  B.  2,  page  87;  O.  D.  446.) 

Stockholders  in  btiilding  and  loan  associations  may  desire 
to  set  up  on  their  books  annually  the  interest  or  earnings 
allotted  to  their  particular  shares.  In  such  cases  the  only 
income  to  report  in  the  year  of  maturity  would  be  the  differ- 
ence between  income  already  taxed  and  final  profit  received. 

Shares  in  many  building  and  loan  associations  are  not  of 
the  same  nature  as  shares  in  corporations.  No  dividends 
are  declared,  but  earnings  are  ascertained  and  are  fully  ap- 
portioned pro  rata  to  the  outstanding  stock.  So  far  as  the 
books  of  the  associations  are  concerned,  an  actual  distribution 
is  made  and  no  surplus  account  is  carried. 

The  accruing  annual  income  from  building  and  loan  asso- 
ciation shares  and  from  life  insurance  policies  is  in  the  nature 


674 


INCOME 


of  interest  earnings,  as  the  funds  are  invested  almost  entirely 
in  bonds  and  mortgages.  They  are  formed  on  the  mutual 
plan  so  that  each  stockholder  or  policyholder  is  in  effect  real- 
izing annually  his  pro  rata  share  of  the  entire  net  income. 

If  under  any  tax  law  the  net  income  of  the  association  or 
company  should  be  taxed,  the  proportion  accruing  to  its  mem- 
bers would  be  free  from  the  normal  tax. 

Interest  on  securities  acquired  between  interest  dates. — 
When  securities  are  purchased  between  interest  dates  and 
the  buyer  pays  to  the  seller  an  amount  equal  to  the  accrued 
interest  between  the  last  interest  date  and  the  date  of  sale,  each 
should  enter  as  income  the  portion  of  the  interest  assignable 
to  the  period  during  which  he  owned  the  security. 

Ruling.  Interest  accrued  on  bonds  and  other  interest-bearing 
obligations  sold  between  interest  dates  is  income  as  such  to  the  vendor 
when  the  agreement  of  sale  specifies  a  division  between  the  price  of 
the  obHgation  and  the  accrued  interest. 

The  vendee  of  such  securities  may  exclude  from  interest  income 
a  sum  equal  to  the  amounts  advanced  by  him  to  the  vendor  on  ac- 
count of  accrued  interest. 

Capital  gain  or  loss  resulting  from  a  sale  of  interest-bearing  obli- 
gations sold  between  dates  at  a  stipulated  price  plus  accrued  interest 
is  computed  upon  a  basis  of  capital  investment,  and  without  regard 
to  amounts  paid  or  received  on  account  of  accrued  interest. 

The  burden  is  on  the  taxpayer  to  show  what  part  of  moneys  paid 
or  received  by  him  on  accoi^mt  of  a  transaction  involving  the  sale  or 
purchase  between  interest  dates  of  interest-bearing  obligations  should 
be  allocated  to  capital  investment  and  what  part  to  accrued  interest. 
In  the  absence  of  such  showing  the  construction  most  favorable  to 
the  Government  should  be  adopted.     (C.  B.  3,  page  90;  Sol.  Op.  46.) 

Interest  received  by  legatee. — T,  D.  2570  (November  6, 

191 7)  holds  that: 

Ruling.  A  legatee  is  required  to  return  as  income  the  full 
amount  of  interest  received  by  him  on  a  bond,  notwithstanding  the 
fact  that  a  part  of  the  first  coupon,  payable  after  he  had  received  it, 
had  been  added  to  the  bond  and  included  in  the  gross  estate  of  the 
decedent,  thereby  becoming  subject  to  the  estate  tax  law. 

If  the  estate  was  assessed  for  the  income  tax  on  the  accrued 


FROM    INTEREST— GENERAL  675 

interest  to  the  date  of  the  death  of  the  decedent  the  legatee 
should  not  pay  again  on  the  same  amount,  since  property  re- 
ceived by  legatees  is  capital  and  includes  accrued  interest.  The 
191 7  regulation  is  unsound  and  probably  will  not  now  be  en- 
forced. 

Coupons  used  as  purchase  price  for  other  securities. — 

Regulation.  Coui)ons  from  bonds  for  interest  thereon,  ex- 
changed for  other  bonds,  are  held  to  lie  the  equivalent  of  payment 
of  the  interest  coupons  and  purchase  of  the  new  bonds  with  the  cash. 
The  amount  of  the  coupons  is  to  be  accounted  for  as  income  for  the 
calendar  year  in  which  the  exchange  is  made.  (Reg.  33,  1918, 
Art.  4.) 

If  coupons  and  new  securities  were  exchanged  "par  for 
par,"  the  interest  represented  by  the  coupons  would  be  reduced 
by  an  amount  equal  to  the  difference  between  the  par  value 
of  the  new  securities  and  their  fair  market  value. 

Income  from  hfe  insurance  policies. — The  law  exempts 
from  income  taxation^'  the  entire  proceeds  of  life  insurance 
policies  (see  page  352)  upon  the  death  of  the  assured  when 
paid  to  individual  beneficiaries,  to  the  estate  of  the  assured  or  to 
a  corporation  beneficiary.^*     The  total  amount  paid  in  premi- 


"  The  taxability  of  the  proceeds  of  life  insurance  under  the  estate  tax 
law  is  discussed  in  Chapter  XL. 

''  [Former  Procedure] 

1913  Law.  Section  IIA.  Subdivision  2  B.  ".  .  .  .  the  proceeds  of  life 
insurance  policies  paid  upon  the  death  of  the  person  insured  or  payments 
made  by  or  credited  to  the  insured,  on  life  insurance,  endowment  or  an- 
nuity contracts,  upon  the  return  thereof  to  the  insured  at  the  maturity  of 
the  term  mentioned  in  the  contract,  or  upon  surrender  of  contract,  shall 
not  be  included  as  income." 

Under  the  1916  and  1917  laws  (section  4)  insurance  payable  to  the 
estate  of  the  insured  was  taxable. 

Regulation.  "Proceeds  of  life  insurance  policies  payable  to  the 
estate  of  a  decedent,  when  received  by  an  executor  or  administrator,  are, 
in  the  amount  of  which  such  proceeds  exceed  the  premium  or  premiums 
paid  by  the  decedent,  income  of  the  estate  to  be  accounted  for  by  the  exec- 
utor or  administrator  under  the  provisions  of  section  2  (b),  act  of  Sep- 
tember 8,  1916."     (Reg.  33,  1918,  Art.  29.) 

This  regulation  was  based  on  section  2  (b)  of  the  law.  Until  the 
question  is  judicially  settled  an  estate  is  entitled  to  claim  that  a  policy 
should  be  valued  as  of  March  i,  1913,  as  a  basis  for  taxation  under  the 
1916  or  1917  law.  Under  the  1918  law  insurance  paid  to  a  corporation 
beneficiary  was  taxable. 


676  INCOME 

unis  may  be  less  than  the  amount  eventually  received  from  the 
proceeds  of  a  policy,  but  the  difference  is  not  treated  as  taxable 
income.  The  law'''  expressly  limits  the  exemption.  When 
there  is  a  return  of  principal  to  the  assured  during  his  life, 
that  \ydrt,  if  any,  of  such  return  which  is  in  excess  of  the 
premiums  paid  is  taxable.  The  basis  of  this  provision  is 
that  the  amount  received  in  excess  of  the  premiums  paid 
represents   interest  on  the  premiums. 

The  purpose  of  the  law  in  mentioning  the  exemption  from 
taxation  of  premiums  returned  or  the  equivalent  of  premiums 
returned  evidently  was  to  leave  no  doubt  about  the  matter. 
When  premiums  are  paid  they  do  not  in  this  country^"  con- 
stitute an  allowable  deduction,  but  are  treated  as  capital  pay- 
ments. Therefore  the  return  of  all  or  any  part  of  such  capital 
could  not  be  taxed  under  an  income  tax  law.  However,  the 
law  covers  the  point,  even  if  unnecessarily,  and  there  can  be  no 
controversy  about  it.  If  the  assured  receives  at  the  maturity 
of  a  policy  on  the  endowment  plan,  or  from  its  cancellation, 
any  amount  in  excess  of  premiums  paid,  such  receipts  are 
taxable  income  and  must  be  returned."^  As  provided,  in 
article  47,  any  dividends  received  would  be  subject  only  to 
the  surtaxes. 

In  view  of  the  uncertainty  of  such  income  it  would  hardly 
be  practicable  to  accrue  it  annually  on  the  books  of  the  assured. 
This  means  that  the  entire  excess  above  premiums  paid  must 
be  included  in  the  returns  for  the  year  of  its  receipt. 

Regulations In  the  case  of  an  insurance  policy  its  sur- 
render value  as  of  March  i,  1913,  may  be  used  as  a  basis  for  the 
purpose  of  ascertaining  the  gain  derived  from  the  sale  or  other  dis- 
position of  such  property (Art.  90.) 

....  Where  an  insured  receives  under  life  insurance,  endow- 
ment,  or   annuity    contracts   sums   in   excess   of   the   premiums   paid 

therefor,  such  excess  is  income  for  the  year  of  its  receipt 

Distributions  on  paid-up  policies  which  are  made  out  of  earnings  of 


"Section  213   (b-2). 

"  For  British  practice,  see  Chapter  XXVI. 

"  See  "Paid-iip  Policies,"  Chapter  XXVI. 


FROM    INTEREST— GENERAL  677 

the  insurance  company  subject  to  tax  are  in  the  nature  of  corporate 
dividends  and  are  income  of  an  individual  only  for  the  purpose  of  the 
surtax.     (Art.  47.) 

Cash  surrender  value  of  policy  at  March  i,  19 13. — 

Ruling.  The  basis  for  ascertaining  the  taxable  income  resulting 
from  the  disposition  of  a  life  insurance  policy  acquired  prior  to 
March  i,  1913,  where  the  insured  transfers  the  policy  to  some  one 
other  than  the  insurance  company,  which  wrote  the  policy,  is  the  cash 
surrender  value  of  the  policy  as  at  March  i,  1913.  However,  if  the 
insured  surrenders  his  policy  and  all  his  rights  thereunder  to  the 
insurance  company,  which  wrote  the  policy,  the  aggregate  amount  of 
the  premiums  paid  during  the  period  the  policy  was  held,  or  the  cash 
surrender  value  of  the  policy  as  at  March  i,  1913,  whichever  is  greater 
in  amount,  is  to  be  taken  as  the  basis  in  computing  the  taxable  income 
derived  by  the  insured.     (C.  B.  2,  page  y'] ;  O.  D.  379.) 

Annuities. — 

Regulation.  Annuities  paid  by  religious,  charitable,  and  educa- 
tional corporations  under  an  annuity  contract  are  subject  to  tax 
to  the  extent  that  the  aggregate  amount  of  the  payments  to  the  annui- 
tant exceeds  any  amounts  paid  by  him  as  consideration  for  the  con- 
tract. An  annuity  charged  upon  devised  land  is  income  taxable  to 
the  annuitant,  whether  paid  by  the  devisee  out  of  the  rents  of  the  land 
or  from  other  sources.  The  devisee  is  not  required  to  return  as  tax- 
able income  the  amount  of  rent  paid  to  the  annuitant,  and  he  is  not 
entitled  to  deduct  from  his  taxable  income  any  sums  paid  to  the  annui- 
tant       (Art.  47.) 

Many  annuities  are  gifts.  In  such  cases  this  ruHng  strictly 
interpreted  would  not  apply.  The  amounts  received  by  the 
beneficiary  would  be  taxable  income  only  to  the  extent  of  the 
excess  of  the  aggregate  receipts  above  the  capital  value  of  the 
annuity  at  the  date  of  the  gift. 

Ruling.  An  individual  who  receives  income  from  an  annuity 
which  has  been  purchased  for  his  benefit  by  another  person  is  not 
liable  for  tax  thereon  until  the  payments  received  under  the  terms 
of  the  annuity  have  equaled  the  amount  paid  or  set  aside  to  purchase 
or  establish  same.     (C.  B.  2,  page  y(y\  O.  D.  170.) 

Deduction  in  case  of  tax-free  covenant  bonds. — It  has  been 
the  custom  for  certain  corporations  to  issue  bonds  containing 


678  INCOME 

a  covenant  binding  the  corporation  to  pay  the  interest  free  of 
all  taxes  which  it  may  be  required  to  withhold  at  the  source.^' 

Tax  paid  by  obligor  not  income  to  obligee. — The  192 1 
law  provides  that  the  rcipient  of  income  from  securities  con- 
taining a  tax-free  covenant  does  not  include  in  gross  income 
the  tax  of  2  per  cent  paid  by  the  obligor  (payer  of  the  income). 


~  [Former  Procedure]  The  1913  law,  by  establishing  the  system  of 
collection  at  the  source,  threw  upon  such  corporations  the  burden  of  pay- 
ing the  normal  tax  applicable  to  the  interest  payable  to  their  bondholders. 
The  rate  under  this  law  was  i  per  cent.  The  requirement  was  continued 
under  the  1916  law,  which  raised  the  rate  to  2  per  cent. 

1916  Law.  Section  5.  "  .  .  .  .  (c)  For  the  purpose  of  the  normal  tax 
only,  the  income  embraced  in  a  personal  return  shall  be  credited  with 
....  the  amount  of  income,  the  normal  tax  upon  which  has  been  paid  or 
withheld  for  payment  at  the  source  of  the  income  under  the  provisions  of 
this  title." 

In  1917,  when  the  system  of  collection  at  source  was  almost  completely 
abandoned  and  the  rates  of  the  normal  tax  were  increased  to  4  per  cent 
on  individuals  and  6  per  cent  on  corporations,  collection  at  the  source  was 
retained  to  the  extent  of  2  per  cent  only  in  the  case  of  these  tax-free 
covenant  bonds.     In  the  1918  law  the  same  provision  is  made. 

1918  Law.  Section  221.  "  .  .  .  .  (d)  Income  upon  which  any  tax  is 
required  to  be  withheld  at  the  source  under  this  section  shall  be  included 
in  the  return  of  the  recipient  of  such  income,  but  any  amount  of  tax  so 
withheld  shall  be  credited  against  the  amount  of  income  tax  as  computed 
in  such  return." 

Under  the  1918  law,  the  recipient  of  income  from  securities  having  a 
tax-free  covenant  was  required  to  include  in  gross  income  not  only  the 
income  actually  received,  but  also  the  tax  paid  by  the  obligor,  which  the 
Treasury  held  was  constructively  received.  Ever  since  the  issue  of  the 
second  edition  (jf  Reg.  45  (April,  1919),  the  author  has  contended  that  the 
tax  of  2  per  cent  paid  by  the  obligor  was  not  income  of  the  obligee.  That 
the  author  was  justified  in  his  criticism  oi  the  rulings  and  regulations  is 
proven  b_s'  the  new  provision  in  thf  KjJi  law.  For  a  full  dlNCussion  see 
Incciiiir  Tax  I'ruccditre,  1921,  pages  516-52J. 

The  Treasury's  position  has  been  upheld  in  a  recent  decision  by  the 
United  States  District  Court  for  the  Eastern  District  of  Pennsylvania 
{Massey  v.  Lederer,  Collector) .  In  that  case,  however,  the  court  did  not 
have  presented  to  it  and  did  not  consider  what  the  author  considers  to  be 
the  chief  factor,  viz.,  the  attempt  of  Congress  to  make  the  deduction  effec- 
tive by  permitting  it  to  be  deducted  from  the  amount  of  tax  payable.  Such 
action  precludes  the  inference  that  it  should  be  dealt  with  as  constructive 
income. 


FROM    INTEREST— GENERAL  679 

Law.  Section  234.  (a)  ....  (3)  ....  In  the  case  of  ob- 
ligors specified  in  sub-division  (b)  of  section  221- ■  no  deduction  for  the 
payment  of  the  tax  imposed  by  this  title,  or  any  other  tax  paid  pur- 
suant to  the  contract  or  provision  referred  to  in  that  subdivision,  shall 
be  allowed,  nor  shall  such  tax  be  included  in  the  gross  income  of  the 
obligee 

This  provision  is  effective  January  i,  1921;  therefore,  no 
tax  should  be  induded  by  the  recipient  in  192 1  income.  Sec- 
tion 221  (d)  still  permits  the  tax  paid  by  the  obligor  to  be 
deducted  from  the  tax  due  by  the  recipient  as  shown  by  his 
return."* 

Interest  from  foreign  subsidiaries. — 

Ruling.  A  domestic  corporation  owning  a  majority  of  the  stock 
of  foreign  corporations  should  include  in  its  income  tax  return  any 
amounts  of  interest  debited  to  its  foreign  subsidiaries,  but  it  may 
claim  as  a  deduction  any  amount  of  interest  credited  to  such  sub- 
sidiaries  (C.  B.  I,  page  239;  O.  D.  330.) 


See  page  323. 
See  page  333- 


CHAPTER     XX 

INCOME  FROM  INTEREST  ON   OBLIGATIONS  OF 
THE  UNITED  STATES 

(Including  Interest  on  Bonds  Issued  Under  the  Fed- 
eral  Farm    Loan   Act   and   on    Bonds   of   the   War 
Finance  Corporation) 

The  obligations  of  the  United  States,  interest  upon  which 
is  subject  to  special  treatment  in  tax  returns,  are  so  many 
and  so  large  in  amount  that  it  is  deemed  advisable  to  devote 
an  entire  chapter  to  the  income  from  such  obligations. 

At  the  outset  it  should  be  noted  that  there  are  two  broad 
statements  which  can  be  made  in  reference  to  interest  re- 
ceived by  all  taxpayers  (except  non-resident  aliens  and  for- 
eign corporations,  partnerships  and  associations  not  engaged 
in  business  in  the  United  States)^  upon  obligations  of  the 
United  States  and  obligations  issued  under  the  Federal  Farm 
Loan  Act  of  July  17,  19 16,  and  the  War  Finance  Corporation 
Act,  approved  April  5,  1918. 

1.  No  part  of  such  interest  is  subject  to  normal  income 
tax  upon  individuals  or  income  tax  upon  corporations. 

2.  Such  interest  is  subject  to  surtaxes  and  excess  profits 
and  war  profits  taxes"  only  in  the  case  of  obligations  issued 
after  September  i,  1917,  and  as  to  these,  only  so  far  as  such  in- 
terest is  not  exempt  under  provisions  of  the  several  Liberty 
bond  acts  and  other  acts  under  which  these  obligations  are 
issued. 

By  authority  of  one  of  these  acts  the  3^  per  cent  Victory 
notes,  although  issued  after  September  i,  191 7,  are  not  subject 
to  any  surtax,  excess  profits  or  war  profits  taxes.  All  the 
Farm  Loan  bonds  are  wholly  tax-exempt. 


'  See  page  692. 

'All  Lilierty  bonds  are  subject  to  the  estate  tax.     See  Cliapter  XL, 

680 


FROM    INTEREST   ON    U.    S.    OBLIGATIONS  68l 

Interest  which  is  wholly  exempt  from  tax  is  excluded  from 
"gross  income"  as  defined  in  the  192 1  law.  If  the  income  of  a 
taxpayer  is  wholly  from  exempt  sources,  or  if  his  income 
from  other  sources  is  less  than  $1,000  (single)  or  $2,000 
(married  or  head  of  a  family),  he  need  not  make  an  income 
tax  return  unless  his  gross  income  exceeds  $5,000.^ 

Law.  Section  213.  That  for  the  purposes  of  this  title  .... 
the  term  "gross  income" —  .... 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt 
from  taxation  under  this  title: 

(4)  Interest  upon  (a)  the  obligations  of  a  State,  Territory,  or  any 
political  subdivision  thereof,  or  the  District  of  Columbia;  or  (b)  se- 
curities issued  under  the  provisions  of  the  Federal  Farm  Loan  Act  of 
July  17,  1916;  or  (c)  the  obligations  of  the  United  States  or  its  pos- 
sessions; or  (d)  bonds  issued  by  the  War  Finance  Corporation.  In 
the  case  of  obligations  of  the  United  States  issued  after  September  i, 
1917  (other  than  postal  savings  certificates  of  deposit),  and  in  the  case 
of  bonds  issued  by  the  War  Finance  Corporation,  the  interest  shall  be 
exempt  only  if  and  to  the  extent  provided  in  the  respective  Acts  author- 
izing the  issue  thereof  as  amended  and  supplemented,  and  shall  be  ex- 
cluded from  gross  income  only  if  and  to  the  extent  it  is  wholly  exempt 
to  the  taxpayer  from  income,  war-profits  and  excess-profits  taxes; 

The  return  of  tax-exempt  securities  required  under  the  old 
law  is  no  longer  necessary.^ 

Interest  wholly  exempt. — The  obligations,  interest  upon 
which  is  wholly  exempt,  for  all  taxpayers,  from  surtaxes  and 
excess  profits  and  war  profits  taxes  are : 

I.  The    following   bonds,    certificates    and    notes    issued 
under  the  Liberty  Bond  Acts  and  all  United  States 
obligations  issued  before  September  i,   1917:^ 
(a)   The  3^  per  cent  First  Liberty  bonds,  original 
issue,  unconverted. 


*  See  page  52. 

*  The  1918  law  required  wholly  tax-exempt  interest  to  be  shown  in  the 
tax  return  only  for  information  of  the  Treasury  and  not  as  a  part  of  taxable 
income. 

°  Issued  under  the  First  Liberty  Bond  Act,  approved  April  24,  1917. 
Certificates-  of  indebtedness  issued  under  this  act  were  also  exempt. 


682  INCOME 

(b)  The  3^   per  cent  Victory  Loan  notes  issued 

under  the  Victory  Liberty  Loan  Act,  ap- 
proved March  3,  19 19.  These  bonds  have 
been  called  for  redemption  June  15,  1922. 

(c)  Postal  Savings  deposits.^ 

2,  Obligations  issued  under  the  Federal  Farm  Loan  Act 
of  July  17,  1916/ 

Interest  in  no  part  exempt  from  surtax  and  excess  profits 

tax. — The  interest  on  4^   Victory  Loan  notes  is  subject  to 
surtax  and  excess  profits  tax.* 

Treasury  notes  issued  under  Victory  Liberty  Act  are  essen- 
tially different  from  Treasury  certificates  and  are  placed  in 
the  same  class  with  \'ictory  4}i's  in  so  far  as  relates  to  ex- 
emption ;  in  other  words,  there  is  no  exemption  on  Treasury 
notes. 

Interest  subject  to  special  exemption.^ — The  special  exemp- 
tions in  force  under  the  19 18  law  have  been  materially  changed 
by  the  192 1  law.  No  longer  does  the  original  subscription  to 
certain  issues  play  a  part  in  determining  exempt  interest;  nor 
are  there  now  any  interrelated  exemptions. 


°  [Former  Procedure]  Only  the  interest  credited  on  postal  savings 
deposits  prior  to  September  i,  1917,  was  exempt  (Reg.  45,  Art.  77).  The 
1918  law  did  not  specifically  exempt  the  interest  from  postal  savings  certifi- 
cates of  deposits  as  does  the  1921  law  [section  213   (b-4-c)]. 

'  The  constitntionality  of  these  obligations  was  affirmed  by  the  U.  S. 
Supreme  Court  in  Smith  v.  Kansas  Cily  Titfe  &  Trust  Co.  et  al.,  February 
28,  1921  ;  advance  opinions,  65  L.  Ed.  360. 

*  Under  the  provisions  of  the  Victory  Liberty  Loan  Act  the  Treasury 
made  the  following  conditions  applicable  to  issue  of  the  Fifth  Loan,  in 
announcement  made  April   14,   1919. 

"The  Victory  Liberty  Loan,  which  will  be  offered  for  popular  sub- 
scription on  April  21,  1919,  will  take  the  form  of  4J4  Per  cent  three/four 
year  convertible  gold  notes  of  the.  United  States,  exempt  from  state  and 
local  taxes,  except  estate  and  inheritance  taxes,  and  from  normal  federal 
income  taxes.  The  notes  will  be  convertible,  at  the  option  of  the  holder, 
throughout  their  life  into  3^  per  cent  three/four  year  convertible  gold 
notes  of  the  United  States,  exempt  from  all  federal,  state  and  local  taxes, 
except  estate  and  inheritance  taxes.  In  like  manner  the  3J4  Per  cent 
notes  will  be  convertible  into  the  4^  per  cent  notes." 

"  [Former  Procedure]  For  details  as  to  procedure  under  the  1918  law, 
see  Income  Tax  Procedure,  1921,  page  524  et  seq. 


FROM    INTEREST   ON    U.    S.   OBLIGATIONS  683 

The  exemptions  now  applical)le  are  indicated  in  the 
following : 

Law.     Section   1328 (a)   On  and  after  January   i,  1921, 

4  per  centum  and  4]/^  per  centum  Liberty  bonds  shall  be  exempt  from 
graduated  additional  income  taxes,  commonly  known  as  surtaxes,  and 
excess-profits  and  war-profits  taxes,  now  or  hereafter  imposed  by  the 
United  States  upon  the  income  or  profits  of  individuals,  partnerships, 
corporations  or  associations,  in  respect  to  the  interest  on  aggregate 
principal  amounts  thereof  as  follows: 

Until  the  expiration  of  two  years  after  the  date  of  the  termination 
of  the  war  between  the  United  States  and  the  German  Government,  as 
fixed  by  proclamation  of  the  President,  on  $125,000  aggregate  principal 
amount;  and  for  three  years  more  on  $50,000  aggregate  principal 
amount. 

(b)  The  exemptions  provided  in  subdivision  (a)  shall  be  in  addi- 
tion to  the  exemptions  provided  in  section  7  of  the  Second  Liberty 
Bond  Act,  and  in  addition  to  the  exemption  provided  in  subdivision  (3) 
of  section  i  of  the  Supplement  to  the  Second  Liberty  Bond  Act  in  re- 
spect to  bonds  issued  upon  conversion  of  35^  per  centum  bonds,  but 
shall  be  in  lieu  of  the  exemptions  provided  and  free  from  the  condi- 
tions and  limitations  imposed  in  subdivisions  (i)  and  (2)  of  section  i 
of  the  Supplement  to  Second  Liberty  Bond  Act  and  in  section  2  of  the 
Victory  Liberty  Loan  Act. 

Regulation (3)   4  per  cent  and  4I4  per  cent  Liberty 

bonds  (but  not  4^  per  cent  Victory  notes),  Treasury  certificates  of 
indebtedness,  and  Treasury  (war)  savings  certificates  are  entitled  to 
certain  limited  exemptions  from  surtaxes  and  excess-profits  taxes  now 

or  hereafter  imposed  by  the  United  States For  the  period  from 

January  i,  1921,  to  July  2,  1923,  the  total  possible  exemption  from 
surtaxes  and  profits  taxes  amounts  to  $160,000,  while  for  the  period 
from  July  3,  1923,  to  July  2,  1926,  the  total  possible  exemption 
amounts  to  $55,000,  as  follcTws: 

Period  Jan.  i,  1921,  to  July  2,  1923: 

$5,000  in  the  aggrcgateof  first  4s,  first  4y4S,  first  second  434s,  second 
48  and  434^,   third  434s,    fourth  434s,   Treasury   certificates  of 
indebtedness,   and   Treasury    (war)    savings   certificates. 
30,000  of  first  second  434s. 

125,000  in  the  aggregate  of  first  4s,  first  4%s,  first  second  434s,  second 
4s  and  4%^,  third  434s,  and  fourth  4^/48. 

$160,000  total  possible  exemptions  for  this  period. 
Period  July  3,  1923,  to  July  2,  1926: 

$5,000  in  the  aggregate  of  first  4s,  first  434s,  first  second  434s,  second 
4s  and  434s,  third  434s,  fourth  4%^,  Treasury  certificates  of 
indebtedness  and  Treasury    (war)    savings  certificates. 


684  INCOME 

50.000  in  the  aggregate  of  first  4s,  first  4^As,  first  second  4/4s,  second 
4s  and  4J4s,  third  4/4 s,  and  fourth  4^4 s. 

$50,000  total  possible  exemptions  for  this  period.     (Art.  84.) 

The  changes  are  effective  as  of  January  i,  1921. 

The  Treasury,  in  administering  the  1918  law,  permitted 
tlie  capitalization  of  the  interest  received  on  each  issue  at  the 
appropriate  rate  and  applied  the  exemption  to  the  principal 
sum  so  obtained. 

As  indicated  by  the  new  forms  (schedule  E,  form  1040, 
for  individuals;  schedule  A-4,  form  1120,  for  corporations), 
the  Treasury  has  abandoned  this  practice.  For  example,  as- 
sume the  following : 

4%%   Liberty  bonds   held  for  6  months,  January   i   to  June  30, 

1921,    (par)    $200,000 

6  months'  interest  on  $200,000  at  4%%  is $4,250 

Total  maximum  exemption  160,000 

Principal  amount  in  excess  of  exemption   $  40,000 

6  months'  interest  on  $40,000  at  4%%  is  the  amount  of 

taxable   interest,  viz $   850 

Under  the  previous  procedure  the  total  interest  received 
($4,250)  would  be  capitalized  at  434  per  cent,  resulting  in 
an  "average  principal"  of  $100,000,  which  is  less  than  the 
$160,000  of  exempt  principal,  so  that  none  of  the  interest 
received  ($4,250)  would  be  taxable. 

Exemptions  not  limited  as  to  time. — It  will  be  noted  that 
tlie  partial  exemptions  which  are  unlimited  as  to  the  time  they 
remain  in  force  are  only  of  interest  on  $5,000  of  the  Second, 
Third  and  Fourth^"  Liberty  Loans  and  on  $5,000  of  bonds 
of  the  War  Finance  Corporation.  These  two  exemptions  are 
entirely  separate  and  a  single  taxpayer  may  have  the  benefit  of 
both. 


^"This  $5,000  exemption  applies  also  to  certificates  of  indebtedness  and 
War  Savings  and  Treasury  Savings  certificates,  and  War  Savings  Stamps. 


i 


FROM    INTEREST    ON    U.    S.   OBLIGATIONS  685 

$125,000  unconditionally  exempt  until  1923. — The  1921 
law'^  consolidated  the  various  exemptions  granted  under  the 
several  Liberty  Bond  Acts  and  supplements  thereto,  some  of 
which  were  conditional,  in  order  to  simplify  the  computation 
of  tax-exempt  interest.  By  eliminating  the  conditions  orig- 
inally attached  to  some  of  the  exemptions,  the  192 1  law  has 
liberalized  them.  July  2,  192 1,  has  been  officially  proclaimed 
as  the  date  of  the  termination  of  the  war  with  Germany,  and 
thus  the  exemption  periods  referred  to  in  section  1328  (a) 
expire  on  July  2,  1923,  and  on  July  2,  1926,  respectively. 
Therefore,  in  addition  to  the  $5,000  exemptions  referred  to  in 
the  preceding  paragraph,  the  interest  on  4  or  4)4  per  cent 
Liberty  bonds  is  exempt  up  to  a  principal  sum  of  $125,000 
until  July  2,  1923. 

$50,000  unconditionally  exempt  1923-1926. — x\fter  July  2, 
1923,  Liberty  bonds  of  any  issue  bearing  interest  at  4  or  4^ 
per  cent  are  for  a  further  period  of  three  years,  i.e.,  until  July 
2,  1926,  exempt  up  to  a  principal  sum  of  $50,000.  This  exemp- 
tion is  also  in  addition  to  the  $5,000  exemptions  already 
referred  to. 

Interest  accrued  upon  conversion  of  Victory  notes. ^" — 

Regulation.  All  interest  accrued  on  4%,  per  cent  Victory  notes 
at  the  date  of  any  conversion  by  the  taxpayer  into  3%  per  cent  Vic- 
tory notes  shall,  for  the  purpose  of  computing  net  income,  be  deemed 
to  be  interest  upon  4%  per  cent  Victory  notes,  and  subject  to  sur- 
taxes and  excess-profits  and  war-profits  taxes,  now  or  hereafter  im- 
posed by  the  United  States  upon  the  income  or  profits  of  individuals, 
partnerships,  associations,  or  corporations.  Any  and  all  amounts  re- 
ceived by  any  taxpayer  from  the  United  States  by  way  of  adjustment 
of  accrued  interest  upon  the  conversion  of  4%  per  cent  Victory  notes 
into  3%  per  cent  Victory  notes  shall  be  deemed  to  be  interest  upon 
4%  per  cent  Victory  notes. 

All  interest  accrued  on  3%  per  cent  Victory  notes  at  date  of  any 
conversion  by  the  taxpayer  into  4%  per  cent  Victory  notes  shall,  for 


"  Section  1328.     See  page  683. 

"For   procedure  on  conversion  of  other   issues   of   Liberty  bonds,   see 
Income  Tax  Procedure,  \g-ii,  page  S40. 


686  INCOME 

the  purpose  of  computing  net  income,  be  deemed  to  be  interest  upon 
3^  per  cent  Victory  notes  and  shall  be  entitled  to  the  exemptions  from 
taxation  to  which  interest  on  3%  per  cent  Victory  notes  is  entitled. 
(Art.  82.) 

Exemption  in  case  of  fiscal  years  ending  in  192 1, — Due  to 
the  change  in  the  exemption  requirements,  the  interest  accrued 
up  to  December  31,  1920,  is  exempted  under  the  conditions 
imposed  by  the  191 8  law,  while  that  accruing  after  January 
I,  1 92 1,  is  stibject  to  the  1921  law. 

Regulation.  In  the  case  of  a  return  rendered  for  a  fiscal  year 
beginning  in  1920  and  ending  in  1921,  the  interest  received  from  ob- 
Hgations  of  the  United  States  issued  after  September  i,  1917,  is,  in 
respect  to  the  amount  received  prior  to  January  i,  1921,  exempt  only 
if  and  to  the  extent  provided  in  the  acts  authorizing  the  issue  there- 
of. See  article  80,  Regulations  45.  The  interest  received  on  and  after 
January  i,  1921,  is  exempt  in  accordance  with  the  acts  authorizing  the 
issue  thereof  as  amended  and  supplemented  by  section  1328  of  the 
Revenue  Act  of  192 1.  See  article  83.  Since  the  basis  of  the  exemp- 
tions is  the  principal  amount  of  bonds  held  rather  than  the  amount  of 
interest  received,  where  the  holdings  are  not  constant  during  the  tax- 
able period,  if  at  any  time  the  holdings  of  any  issue  or  issues  are  less 
than  the  maximum  exempted  principal,  then  the  exempted  interest  for 
such  time  shall  be  only  the  amount  of  interest  received  or  accrued  upon 
the  principal  actually  held.    (Art.  85.) 

Exemptions  when  return  is  for  period  less  than  full  year. — 
When  return  is  made  for  a  period  less  than  one  year,  the  1921 
law  [section  226  (c)]  provides  that  the  net  income  "shall  be 
placed  on  an  annual  basis. "^"  The  amount  of  taxable  interest 
should  be  first  computed  before  the  net  income  is  placed  on 
an  annual  basis  because  such  taxable  interest  is  part  of  "net 
income." 

Interest  is  income  of  year  when  due. — Under  the  present 
ruling  of  the  Treasury  all  interest  on  bonds  is  income  of  the 
year  when  it  becomes  due,  whether  then  collected  or  not. 

Even    when    matured    coupons   have    not   been    collected, 

'^  See  page  167. 


FROM    INTEREST   ON   U.    S.    OBLIGATIONS  687 

they  should,  nevertheless,  be  included  in  the  return.      (Reg. 

62,  Art.  53.) 

Ruling.  An  owner  of  nontax-free  Liberty  bonds  who  has  made 
an  absolute  gift  of  the  coupons  attached  to  the  bonds  covering  inter- 
est due  for  a  number  of  years  will  be  required  to  include  in  his  income 
tax  return  the  interest  which  accrues  each  year  on  the  bonds,  and  to 
pay  any  tax  that  may  be  due  thereon.  If  the  gift  of  the  coupons  is  to 
an  institution  under  section  214(a)  11,  a  deduction  of  such  gift  would 
be  allowed  in  the  annual  income  tax  return.  (C.  B.  i,  page  84;  O.  D. 
120.) 

Separate  ledger  accounts  for  interest. — The  taxpayer 
should  keep  a  separate  ledger  account  for  "interest  received 
from  Liberty  bonds"  to  facilitate  segregation  of  such  parts 
thereof  as  are  taxable  and  non-taxable.  He  should  also  keep 
a  separate  ledger  account  for  "interest  paid  to  carry  non- 
taxable bonds"  because  such  interest  is  not  deductible  from 
gross  income.  This  account  will  not  include  any  interest  paid 
to  carry  obligations  of  the  United  States  issued  after  Septem- 
ber 24,  19 1 7,  including  the  3%  per  cent  Victory  notes  (if 
original  subscriptions  are  by  the  taxpayer),  because  such  inter- 
est is  deductible.^* 

Accrual  of  interest  on  Liberty  bonds. — The  practice  is 
common  among  business  concerns  to  accrue  other  items  of 
income  and  at  the  same  time  not  to  accrue  Liberty  bond  in- 
terest. There  is,  however,  no  logical  reason  for  not  accruing 
such  interest  when  other  items  of  income  and  expense  are  ac- 
crued. The  law  requires  that  accounts  be  kept  so  as  to  reflect 
the  actual  net  income  of  the  taxpayer.  The  accrual  method 
has  been  prescribed  to  accomplish  this  for  business  concerns. 

For  manner  of  treating  interest  on  bonds  purchased  and 
sold  between  interest  dates,  see  page  674. 

Of  the  aggregate  of  possibly  exempt  principal  of  $160,000, 
all  but  $5,000  represents  temporary  exemptions;  and  if  the 
taxpayer  is  to  secure  over  a  period  of  years  the  maximum 


"Sections  214  (a-2)  and  234  (a-2). 


688  INCOME 

amoniit  of  cxciniitiun,  he  must  make  his  return  of  income  on 
the  accrual  basis.  Returns  on  the  cash  basis  would  not  entitle 
the  taxpayer  to  the  exemption  of  interest  received  on  these 
issues  after  the  temporary  exemptions  expire. 

Discount  on  certificates  of  indebtedness. — 

Ruling.  In  the  case  of  Treasury  certificates  of  indebtedness 
which  are  offered  by  the  Government  at  par  and  accrued  interest 
and  not  at  a  discount,  only  the  coupon  interest  can  be  considered 
exempt  from  normal  tax,  and  from  surtax  to  the  extent  provided  by 
the  Act  approved  September  24,  191 7.  Where  such  certificates  are 
subsequently  purchased  at  a  discount,  the  difference  between  the  pur- 
chase price  and  the  par  value  of  the  certificates  received  at  maturity 
is  profit  subject  to  both  normal  tax  and  surtax.  The  subscriber  for 
Treasury  certificates  who  sells  them  at  a  discount  sustains  a  deductible 
loss,  which  is  the  difference  between  the  par  value  of  the  certificates 
and  the  selling  price.  Any  gain  or  loss  on  the  sale  of  Treasury 
certificates  of  indebtedness  prior  to  maturity  should  be  determined 
in  accordance  with  section  202  of  the  Revenue  Act  of  191 8.  (C.  B. 
3,  page  123  ;0.  D.  729.) 

Individuals 

The  foregoing  portion  of  this  chapter  applies  to  indi- 
viduals as  well  as  to  other  taxpayers,  but  the  following  points 
are  applicable  particularly  to  individuals. 

Under  the  law  individuals  are  taxed  as  such  upon  their 
income  from  partnerships  in  which  they  are  members,  from 
personal  service  corporations  in  which  they  are  stockholders^' 
and  from  estates  and  trusts  of  which  they  are  beneficiaries. 
It  is  necessary,  therefore,  for  the  individual  receiving 
Liberty  bond  interest  from  a  partnership,  a  personal  ser- 
vice corporation  or  a  fiduciary  to  group  all  such  interest 
received  by  issues  and  to  calculate  his  exempt  interest  on 
the  basis  of  his  combined  holdings  of  principal  as  an  indi- 
vidual, as  a  partner,  as  a  stockholder  in  a  personal  service 
corporation  and  as  a  beneficiary  of  an  estate  or  trust.  The 
various  regulations  of  the  Treasury  do  not  specifically  de- 
scribe the  manner  in  which  the  principal  of  Liberty  bonds 


Up  to  December  31,  192:. 


FROM   INTEREST   ON    U.    S.   OBLIGATIONS  68g 

held  by  partnerships,  personal  service  corporations,  estates 
and  trusts  shall  be  apportioned  among  the  individuals  receiv- 
ing the  income  therefrom  other  than  to  say  that  each  partner, 
etc.,  is  to  be  regarded  as  owning  a  "proportionate  part"  of 
the  bonds.  The  assignment  of  holdings,  hov^ever,  should 
ordinarily  be  made  on  the  basis  of  the  share  in  profits  or 
income  received  from  the  partnership,  corporation  or  fiduciary. 
The  instructions  on  form  1040  for  1921  read: 

Enter  in  column  5  on  the  proper  lines  the  principal  amounts  of 
the  various  obligations  owned  in  excess  of  the  exemptions  specified, 
during  the  taxable  period,  including  your  share  of  these  obligations 
held  by  partnerships,  personal  service  corporations  and  fiduciaries. 

In  case  of  a  net  loss  for  the  year  by  the  partnership,  per- 
sonal service  corporation  or  estate,  although  the  individual  will 
show  his  share  of  Liberty  bond  interest  received  from  the  part- 
nership, personal  service  corporation  or  estate,  any  undue  in- 
crease of  the  taxable  income  of  the  individual  thus  apparently 
created  will,  in  the  case  of  partners  and  stockholders  in  per- 
sonal service  corporations,  but  not  usually  in  the  case  of  bene- 
ficiaries of  trusts,^**  be  offset  by  the  share  of  the  loss  of  the 
partnership  or  personal  service  corporation  which  the  individ- 
ual will  also  show  in  his  return. 

The  regulations  covering  exemptions  of  Liberty  bond  in- 
terest received  from  partnerships,  personal  service  corpora- 
tions and  fiduciaries  are  as  follows : 

Regulation,  (o)  When  income  is  taxable  to  beneficiaries,  as 
in  the  case  of  a  trust  the  income  of  which  is  to  be  distributed  to  the 
beneficiaries  periodically,  each  beneficiary  is  regarded  as  the  owner 
of  a  proportionate  part  of  the  bonds  held  in  trust  and  is  entitled  to 
exemption  on  account  of  such  ownership  as  if  he  owned  such  propor- 
tionate part  of  the  bonds  directly.  When,  on  the  other  hand,  income 
is  taxable  to  the  trustee,  as  in  the  case  of  a  trust  the  income  of  which 
is  accumulated  for  the  benefit  of  unborn  or  unascertained  persons,  the 
trustee  is  regarded  as  the  owner  of  all  the  bonds  held  in  trust  and  the 
trust  is  entitled  to  exemption  on  account  of  such  ownership.  As  to 
exemptions  in  the  case  of  bonds  beneficially  owned  by  nonresident 
aliens,  see  article  94. 


"Sec  Chapter  XXXVII. 


690  INCOME 

(b)  As  the  income  of  a  partnership  is  taxable  to  the  individual 
partners,  each  partner  is  treated  as  the  owner  of  a  proportionate  part 
of  the  bonds  lield  by  the  partnership  and  is  entitled  to  exemption  on 
account  of  such  ownership  as  if  he  owned  such  proportionate  part  of 
the  bonds  directly.  This  principle  also  applies  to  stockholders  in  per- 
sonal service  corporations  during  the  calendar  year  192 1.    (Art.  84.) 

Partnerships 

Since  partnerships  are  not  taxed  as  such,  the  question  of 
Liberty  bond  interest  received  by  a  partnership  is  really  a 
qitestion  for  the  individual  partner  in  his  separate  return. 
The  partnersliip  return  merely  indicates  the  share  of  each 
partner  in  the  Liberty  b(jnd  interest  received  by  the  partner- 
ship.^' 

Stockholders  in   Personal   Service   Corporations 

The  question  of  taxable  interest  received  by  personal  ser- 
vice corporations  affects  the  income  of  the  stockholders,  as 
until  January  i,  1922,  they,  not  the  corporation,  are  taxable 
on  income  received  by  or  from  it.^^  The  exemptions  of  such 
stockholders  are  determined  in  the  same  inanner  as  members 
of  a  partnership.^^ 

Fiduciaries 

Liberty  bond  interest  received  by  executors,  administra- 
tors, guardians,  trustees  and  other  fiduciaries  is  taxable  to 
them  only  in  case  it  is  not  distributable  to  the  beneficiaries 
of  the  estate  or  trust.^" 

If  the  fiduciary  is  liable  to  tax,  he  is  entitled  to  the  same 
exemptif  ns  of  Liberty  bond  interest  as  an  individual. 


"  [Former  Procedure]  Under  the  1917  law  partnerships  as  such 
were  subject  to  the  excess  profits  tax.  T.  D.  2762,  dated  October  21, 
1918,  provides  that  in  calculating  Liberty  bond  interest  received  by 
a  partnership,  which  may  be  subject  to  excess  profits  tax,  the  part- 
nership shall  be  deemed  to  be  the  owner  of  the  bonds  upon  which 
the  interest  is  received. 

''  See  Chapter  XXIV. 

'"  See  Art.  84,  quoted  above. 

^  See  Chapter  XXXVII,  "Fiduciaries,"  for  discussion  of  the  cases 
in  which  fiduciaries  must  make  a  return  and  pay  a  tax.  See  also  Art.  84, 
quoted  above. 


FROM    INTEREST    ON    U.    S.    OBLIGATIONS  691 

Corporations 

The  general  statements  on  pages  680  and  684  in  this  chap- 
ter apply  to  interest  on  Liberty  bonds  received  by  corpora- 
tions other  than  personal  service  corporations. 

Exemptions  of  affiliated  corporations. — 

Ruling.  Each  of  several  affiliated  corporations  included  in  a 
consolidated  return  under  section  240  of  the  Revenue  Act  of  1918  is 
entitled  to  the  same  full  benefits  under  the  exemption  provisions  of 
the  several  Liberty  bond  acts  to  which  it  would  be  entitled  if  not 
affiliated.    (C.  B.  i,  page  87;  T.  B.  R.  7.) 

Parent  corporation  may  not  apportion  Liberty  bonds  held 
to  its  subsidiaries. — A  parent  corporation  may  not  apportion 
Liberty  bonds  held  by  it  among  the  affiliated  corporations. 
If  the  parent  corporation  should  make  a  bona  fide  sale  of 
bonds  to  the  subsidiary  corporations,  then  such  corporations 
would  be  entitled  to  the  exemptions  consequent  on  the  holding 
of  the  bonds  purchased,  except  that  the  status"^  of  "original 
subscriber,"  heretofore  discussed,  would  be  lost. 

Federal  Land  Bank  bonds  exempt. — The  income  from 
obligations  issued  under  the  l<>deral  Farm  Loan  Act  of  July 
17,  19 16,  is  exempt  from  normal  and  surtax  (includhig  excess 
profits  tax). 

Regulation.  As  section  26  of  the  Federal  Farm  Loan  Act  of  July 
17,  1916,  provides  that  every  Federal  land  bank  and  every  national 
farm  loan  association,  including  the  capital  and  reserve  or  surplus 
therein  and  the  income  derived  therefrom,  shall  be  exempt  from  taxa- 
tion, except  taxes  upon  real  estate,  and  that  farm  loan  bonds,  with 
the  income  therefrom,  shall  be  exempt  from  taxation,  the  income  de- 
rived from  dividends  on  stock  of  Federal  land  banks  and  national  farm 
loan  associations  and  from  interest  on  such  farm  loan  bontls  is  not 
subject  to  the  income  tax.     (Art.  75.) 


''  In  view  of  the  consolidation  of  the  Liberty  bond  tax  exemptions 
effected  by  section  1328  of  the  1921  law,  the  status  of  "original  subscriber" 
no  longer  has  any  importance,  excepting  with  respect  to  the  deductibility  of 
interest  paid  to  carry  3%  per  cent  Victory  notes. 


692  INCOME 

United  States  Obligations  Owned  by  Non-Resident  Aliens, 
Foreign  Corporations,  etc.^^ 

In  order  to  encourage  foreign  investors  to  buy  and  hold 
Liberty  bonds,  Congress  provided  in  the  Victory  Liberty  Loan 
Act  that  obhgations  of  the  United  States  shall  be  exempt  from 
federal,  state  and  local  taxes  while  beneficially  owned  by  non- 
resident aliens  and  foreign  corporations,  partnerships  and 
associations  not  engaged  in  business  in  the  United  States. 

Law.  Section  4.  That  section  3  of  the  Fourth  Liberty  Bond  Act 
is  hereby  amended  to  read  as  follows: 

"Section  3.  That,  notwithstanding  the  provisions  of  the  Second 
Liberty  Bond  Act  or  of  the  War  Finance  Corporation  Act  or  of  any 
other  Act,  bonds,  notes,  and  certificates  of  indebtedness  of  the  United 
States  and  bonds  of  the  War  Finance  Corporation  shall,  while  bene- 
ficially owned  by  a  nonresident  alien  individual,  or  a  foreign  corporation, 
partnership,  or  association,  not  engaged  in  business  in  the  United 
States,  be  exempt  both  as  to  principal  and  interest  from  any  and  all 
taxation  now  or  hereafter  imposed  by  the  United  States,  any  State,  or 
any  of  the  possessions  of  the  United  States,  or  by  any  local  taxing 
authority."-^ 


"See  Chapter  XXXVL 

"^Victory  Liberty  Loan  Act,  approved  March  3,  1919,  section  4. 


CHAPTER    XXI 

INCOME  FROM  RENTS 

Under  each  of  the  successive  income  tax  acts  rent  has, 
in  all  cases,  been  made  returnable  as  income  subject  to  taxation. 

Law.     Section  213 the  term  "gross  income" — 

(a)   Includes   ....   income  derived  from   ....   rent   .... 

Income  from  rents  may  be  reported  on  the  accrual  basis 
or  on  the  actual  receipt  basis.  If  books  of  account  are  kept, 
all  rents  accrued,  and  believed  to  be  collectible,  should  be 
reported.  Any  items  found  to  be  uncollectible  may  be  de- 
ducted as  losses  in  subsequent  returns.  If  reporting  on  the 
accrual  basis  is  not  practicable  or  convenient,  it  is  sufficient  to 
return  all  rents  received  in  cash  during  the  tax  year.^ 

No  taxable  income  accrues  where  corporations,  through 
book  entries,  have  charged  rental  to  construction  accounts 
and  credited  an  income  account." 

Permanent  improvements  by  lessees. — In  several  decisions 
the  courts  have  held  that  title  to  improvements  paid  for  by 
lessees  vests  in  lessors  as  soon  as  made.^  Prior  to  these  de- 
cisions the  Treasury  held  that  the  lessor  was  taxable  on  the 
value  of  improvements  at  the  end  of  the  lease.*  Since  these 
decisions  the  Treasury  holds  that  the  lessor  may  be  taxable  at 
the  time  when  the  improvements  are  made.  In  the  opinion  of 
the  author  the  decisions  merely  reiterate  many  other  court 
decisions  and  restrict  the  Treasury  in  its  attempt  to  tax  what 
is  not  income. 


'Rentals  from  "ground  rents"  as  existing  under  laws  of  the  state  of 
Maryland  should  be  returned  each  year  as  rent  and  are  subject  to  tax  as 
such.     (B.  45-21-1905;  O.  D.  1089.) 

-'C.  B.  4,  page  276;  O.  D.  811. 

^  See  page  697  et  seq. 

*  [Former  Procedure]  For  text  of  regulations  in  force  prior  to  1922 
and  criticism  thereof,  see  Income  Tax  Procedure,  1920,  pages  441-443,  and 
Income  Tax  Procedure,  1921,  pages  549-553. 

693 


694  INCOME 

The  new  regulations  give  the  lessor  the  option  of  reporting 
any  income  derived  from  the  making  of  improvements  by  the 
lessee  either  in  one  amount  upon  completion  of  the  improve- 
ments or  of  s])reading  such  income  over  the  period  of  the  lease. 

The  new  regulations  are  as  follows : 

Recti. ATioNs.  When  I)uil(liny,s  arc  erected  or  iiuprovenienls 
made  by  a  lessee  in  pursuance  of  an  agreement  with  the  lessor,  and 
such  buildings  or  improvements  are  not  subject  to  removal  by  the 
lessee,  the  lessor  may  at  his  option  report  the  income  therefrom  upon 
cither  of  the  following  bases: 

(a)  'J"he  lessor  may  report  as  income  at  the  time  when  such  build- 
ings or  improvements  are  completed  the  fair  market  value  of  such 
buildings  or  improvements  subject  to  the  lease.  This  amount  would 
ordinarily  be  the  difference  betw^een  the  value  of  the  land  free  from 
the  lease  without  such  improvements  and  the  value  of  the  land  sub- 
ject to  the  lease  with  such  improvements. 

(&)  The  lessor  may  spread  over  the  life  of  the  lease  the  estimated 
depreciated  value  of  such  buildings  or  improvements  at  the  termin- 
ation of  the  lease  and  report  as  income  for  each  year  of  the  lease 
an  aliquot  part  thereof. 

If  for  any  other  reason  than  a  bona  fide  purchase  from  the  lessee 
])y  the  lessor  the  lease  is  terminated,  so  that  the  lessor  comes  into  pos- 
session or  control  of  the  property  prior  to  the  time  originally  fixed 
for  the  termination  of  the  lease,  the  lessor  receives  additional  income 
for  the  year  in  which  the  lease  is  so  terminated  to  the  extent  that  the 
value  of  such  buildings  or  improvements  when  he  became  entitled 
to  such  possession  exceeds  the  amount  already  reported  as  income  on 
account  of  the  erection  of  such  buildings  or  improvements.  No 
appreciation  in  value  due  to  causes  other  than  the  premature  termin- 
ation of  the  lease  shall  be  included.  Conversely,  if  the  buildings  or 
improvements  are  destroyed  prior  to  the  expiration  of  the  lease,  the 
lessor  is  entitled  to  deduct  as  a  loss  for  the  year  when  such  destruc- 
tion takes  place  the  amount  previously  reported  as  income  because  of 
the  erection  of  such  buildings  or  improvements,  less  any  salvage  value 
subject  to  the  lease  to  the  extent  that  such  loss  was  not  compensated 
for  by  insurance.  If  the  buildings  or  improvements  destroyed  were  ac- 
quired prior  to  March  i,  1913,  the  deduction  shall  be  based  on  the 
cost  or  the  value  subject  to  the  lease  as  of  that  date,  whichever  is 
lower,  less  any  salvage  value  subject  to  the  lease  to  the  extent  that 
such  loss  was  not  compensated  for  by  insurance.     (Art.  48.) 

The  Treasury's  interpretation  of  the  earlier  regulation  illus- 
trates the  application  of  option  (a)  of  the  new  regulation 
above  quoted,  as  follows : 


FROM    RENTS  695 

Ruling.  A,  in  1915,  leases  certain  land  to  B  for  20  years.  B 
agrees,  in  part  consideration  for  the  lease,  to  erect  on  the  leased  ground 
a  building,  specifications  agreed  upon,  of  an  estimated  life  of  25  years 
and  to  cost  $50,000,  which  building  is  not  to  be  subject  to  removal  by 
B.   The  building  is  completed  in  1920. 

A  realizes  income  in  1920,  the  year  in  which  title  to  the  building 
passes.  The  measure  of  the  income  is  the  present  value  to  A  of  the 
building,  of  an  estimated  life  of  25  years  and  cost  of  $50,000,  the 
use  and  enjoyment  of  which  is  postponed  for  15  years.  The  depre- 
ciated value  of  the  building  at  the  termination  of  the  period  of  the 
lease  will  be  approximately  $20,000 — that  is,  cost  less  depreciation 
sustained.  The  income  of  A,  then,  is  the  discounted  value  of  $20,000 
receivable  at  the  end  of  15  years.  If  market  value  reflects  intrinsic 
value,  this  amount  should  equal  the  difference  between  the  value  of 
the  land  free  from  the  lease  without  the  buildings  and  the  value  of 
the  land  subject  to  the  lease  with  the  building.  However,  any  other 
evidence  available  should  be  considered  in  determining  this  present 
worth  to  the  taxpayer  of  the  legal  title  to  the  encumbered  building. 
Since  A  has  included  in  income  only  the  depreciated  value  of  the 
building,  he  is  entitled  to  a  depreciation  deduction  with  respect  to 
such  building  only  for  the  years  after  the  termination  of  the  period 
of  the  lease  when  A  has  come  into  possession.  This  depreciation  de- 
duction to  which  A  is  entitled  for  1935  and  subsequent  years  should 
be  computed  on  a  basis  of  the  estimated  remaining  life  of  the  build- 
ing and  a  "cost"  value  equal  to  the  market  value  placed  on  the  en- 
cumbered building  by  A  in  the  year  of  its  erection,  i.  e.,  the  annual 
depreciation  deduction  for  1935  and  subsequent  years  will  be  the 
quotient  obtained  by  dividing  (a)  the  value  of  the  improvements  to  A 
as  determined  by  him  when  the  same  completed  became  part  of  the 
realty,  by  (b)  the  number  of  years  in  the  estimated  remaining  life 
of  the  improvements  from  the  termination  of  the  lease. 

In  any  case  in  which  the  term  of  the  lease  is  greater  than  the 
estimated  life  of  the  improvement  no  income  should  be  accounted 
for  by  the  lessor  at  the  time  of  the  passage  of  title.  Also  if  the 
improvements  will  have  no  value  at  the  termination  of  the  lease,  as 
is  often  the  case  in  mining  leases,  no  income  is  realized  by  the  lessor. 
(C.  B.  4,  page  90;  Mim.  2714.) 

Option  (b)  in  Regulations  62  is  a  reasonable  basis  if  it 
can  fairly  be  assumed  that  income  arises  annually  out  to  the 
improvements  paid  for  by  the  lessee. 

Regtilations  45,  article  48,  and  the  interpretation  assumed 
several  factors  which  reduced  their  value  to  nil. 

Unimproved  land  upon  which  lessees  erect  buildings  rarely 
increases  in  fair  market  value  because  of  the  improvements. 


696  INCOME 

The  maximum  benefit  which  the  lessor  can  reahze  during  the 
lease  is  the  rental  reserved  in  the  lease.  The  lessor  will  of 
course  return  the  rent  as  gross  income,  but  it  cannot  be  claimed 
in  most  cases  that  additional  income  has  been  realized. 

In  the  illustration  it  is  assumed  that  a  building  erected  by  a 
lessee  has  a  life  of  twenty-five  years.  Experience  proves  that 
buildings  usually  become  obsolete  within  twenty-five  years, 
particularly  those  erected  by  lessees  for  a  special  purpose.  If 
lessors  are  required  to  report  upon  completion  income  equal 
to  the  estimated  present  value  of  the  building,  which  in  the 
illustration  would  be  a  substantial  sum,  where  would  the  cash 
be  found  to  pay  the  tax?  A  building  might  easily  be  com- 
pleted near  the  close  of  a  taxable  year.  There  would  be  no 
income  in  that  year  from  the  lessee  and  the  taxpayer  might 
have  no  other  source  of  income.  How  could  it  be  held  that  he 
had  taxable  income  to  the  extent  of  the  present  worth  of  a 
building  in  which  he  has  no  beneficial  interest  for  fifteen  years? 

The  author  does  not  know  of  any  such  transaction  which 
would  result  in  taxable  income.  Article  48  as  amended  does 
not  attempt  to  impute  income  where  there  is  none.  It  merely 
states  that  the  lessor  may  report  as  income  (a)  "the  fair  mar- 
ket value  of  such  building  or  improvement  subject  to  the 
lease,"  or  (b)  report  as  income  the  estimated  depreciated 
value  of  the  building  or  improvement  over  the  life  of  the 
lease.  It  leaves  to  the  lessor  the  fixing  of  the  depreciated 
value.  There  may  be  some  appreciation  in  value  on  account 
of  the  improvements,  but  any  apparent  appreciation  is  decidedly 
limited  by  the  terms  of  the  lease  which,  it  may  be  assumed, 
expressly  reserves  to  the  lessee  the  full  benefit  and  enjoyment 
of  the  improvements.  The  lessor  does  not  pay  for  the  im- 
provements and  it  is  not  intended  that  he  should  receive  much, 
if  anything,  more  than  the  stipulated  annual  rental.  As  was 
said  by  Mr.  Justice  Pitney  in  the  stock  dividend  case  :^ 

Enrichment  through  increase  in  value  of  capital  investment  is 
not  income  in  any  proper  meaning  of  the  term. 

'Eisner  7'.  Macomhcr,  252  U.  S.  189,  40  S.  Ct.  189,  64  L.  Ed.  521. 


FROM    RENTS  697 

In  Other  words,  there  must  be  reahzation  before  there  can 
be  taxable  income.'' 

In  the  old  regulations  the  Treasury  ignored  the  March  i, 
1913,  factor  and  attempted  to  impose  income  taxes  upon  prop- 
erty, which  is  unconstitutional.  The  new  regulations  are 
equally  faulty  in  ignoring  the  trend  of  the  decisions  of  the 
United  States  Supreme  Court.  It  will  probably  be  impossible 
to  impose  any  income  tax  whatever  on  a  lessor  at  the  time  when 
improvements  are  made,  even  though  title  vests  simultaneously ; 
but  it  may  easily  develop  that  at  the  end  of  a  lease,  when  title, 
possession  and  enjoyment  merge,  there  may  be  realized  and 
taxable  income  equal  to  the  fair  market  price  (equivalent  to 
cash)  of  the  improvements. 

Decisions.  (S}'!.)  Where,  in  1907,  the  owner  of  land  leased  the 
same  for  23  years,  under  an  agreement  requiringthe  tenant  to  construct 
an  expensive  brick  building,  and  on  the  tenant's  default  the  owner 
retook  possession  in  1916,  the  value  of  the  building  cannot  be  deemed 
income  accruing  in  the  year  1917,  within  income  tax  law  September 
8,  1916,  section  2  (a),  for  under  the  lease  the  title  to  the  building 
vested  in  the  owner  immediately  upon  construction,  and  the  lessee's 
default  caused  the  owner  a  loss.  {Miller  v.  Gcarin,  258  Fed.  22^^, 
169  C.  C.  A.  293;  certiorari  denied,  250  U.  S.  66y,  63  L.  Ed.  1197, 
40  S.  Ct.  13.) 

"The  net  income  of  a  taxable  person  shall  include  gains,  profits, 
and  income  derived  from  ....  sales,  or  dealings  in  property, 
whether  real  or  personal,  growing  out  of  the  ownership  or  use  of  or 
interest  in  real  or  personal  property,  also  from  interest,  rent,  divi- 
dends ....  or  gains  ....  from  any  source  whatever." 

Plaintiff  is  the  owner  of  a  lot  of  land  in  the  city  of  San  Fran- 
cisco, upon  which,  under  the  terms  of  a  lease  made  by  plaintiff  in 
1908  for  a  term  of  26  years,  there  was  erected  by  her  tenant  a  class  A 
steel  and  concrete  building,  the  lease  providing  that  "in  no  event 
shall  the  lessee  hereunder  have  any  right  to  remove  any  building 
from  said  premises."  The  building  was  completed  in  1910.  In  1916, 
the  tenant  defaulting  in  accrued  rent,  the  lease  was  by  mutual  ar- 
rangement canceled  and  terminated,  and  possession  of  the  leased 
premises  surrendered  to  plaintiff. 

The  tax  in  question  was  assessed  for  the  year  19 16  upon  the 
then  value  of  the  building  erected  under  the  lease,  upon  the  theory 


'See  Income  Tax  Procedure,  1920,  pages  441-443,  and  Income  Tax  Pro- 
cedure, 1921,  pages  549-553- 


698  INCOME 

that  the  structure  represented  "gains,  profits,  and  income"  accruing  to 
plaintiff  for  that  year,  under  an  interpretative  rule  of  the  Treasury 
Department,  made  for  the  guidance  of  taxing  officers,  that: 

"Permanent  improvements  under  lease  or  rental  contracts,  when 
improvements  become  a  part  of  real  estate,  the  difference  between 
cost  of  the  improvements  and  allowable  depreciation  during  the  lease 
term,  is  gain  or  profit  to  the  lessor  at  the  end  of  the  lease  term,  and 
is  to  be  accounted  for  as  income  at  that  time."  Paragraph  50,  Regula- 
tions 33,  Treasury  Department. 

The  government  claims  that  under  the  provisions  of  the  act,  and 
this  regulation  made  thereunder,  the  tax  was  properly  assessed  and 
collected ;  but  I  am  unable  to  sustain  this  view.  The  right  to  levy  the 
tax  turns  upon  the  question:  When  did  the  title  to  this  building 
vest  in  plaintiff  and  become  a  part  of  her  property  for  the  purpose 
of  taxation?  I  am  of  opinion  that  under  well-settled  principles,  aptly 
expressed  in  section  1013,  Civil  Code  of  California,  the  moment  the 
building  was  erected,  which  the  terms  of  the  lease  show  was  to  be- 
come and  remain  an  integral  part  of  the  land  upon  which  it  was  con- 
structed, the  title  thereto  vested  as  completely  in  the  plaintiff  as 
though  constructed  by  the  plaintiff  herself.  The  terms  of  the  lease 
clearly  disclose  that  the  erection  of  the  building  was  a  part  of  the  con- 
sideration for  the  lease,  and  that  it  was  provided  for  and  taken  into 
consideration  in  the  rent  reserved.  It  therefore  became,  upon  its 
completion,  a  part  and  parcel  of  plaintiff's  income-bearing  property, 
and  was  subject  to  taxation  in  her  as  of  that  date.  City  of  Oakland 
V.  Albers  Bros.  Milling  Co.  (Cal.  App.),  184  Pac.  868. 

The  regulation  of  the  Treasury  Department  cannot  be  applied  to 
such  a  state  of  facts;  if  so  intended,  it  must  give  way,  as  the  depart- 
ment has  no  power  to  abrogate  a  substantive  rule  of  law.  This  con- 
clusion is  not  affected  by  the  principles  stated  in  Board  of  Education 
V.  Grant,  118  Cal.  39,  50  Pac.  5;  or  San  Francisco  v.  McGinn,  67 
Cal.  no,  7  Pac.  187,  relied  on  by  defendant.  Nor  do  the  considera- 
tions urged  by  defendant  as  arising  from  the  relation  of  landlord 
and  tenant,  between  plaintiff  and  her  lessee,  apply  to  the  terms  of  the 
lease  here  involved. 

It  results  that  whatever  accession  of  value  resulted  to  plaintiff's 
property  from  the  erection  of  the  building  in  question  accrued  and 
became  vested  in  her  in  1910,  and  not  upon  the  termination  of  the 
lease.  As  this  was  prior  to  the  enactment  under  which  the  tax  was 
levied,  the  case  falls  by  analogy  within  the  principles  of  Doyle  v. 
Mitchell  Brother's  Co.,  247  U.  S.  179,  38  Sup.  Ct.  467,  62  L.  Ed. 
1054;  and  Hays  v.  Gauley  Motmtain  Coal  Co.,  247  U.  S.  189,  38  Sup. 
Ct,  470,  62  L.  Ed.  1061.  Those  cases  dealt  with  the  act  imposing  a 
corporation  excise  tax,  but,  like  the  present  act,  the  tax  was  imposed 
on  income,  and  not  upon  capital  invested,  or  property  as  such,  and 
it  was  held  that  increase  in  the  value  of  property  invested,  accruing 


I<'R0M    RENTS  699 

before  the  act  took  effect,  could  not  be  taken  into  account  or  treated 
as  income  not  realized  upon  until  after  that  fact.  (Cryan  v.  Wardell, 
263  Fed.  248.) 

Guaranteed  dividends  or  interest  as  rental  equivalent. — 

It  frequently  happens  that  where  one  corporation  leases  the 
property  of  another  corporation  the  lessee  pays  as  rental  a 
sum  equal  to  the  interest  on  certain  securities  or  equal  to  a 
fixed  dividend  upon  the  capital  stock  of  the  lessor.  The  rent- 
al paid  is  a  business  expense  of  the  lessee  corporation  and 
a  rental  income  of  the  lessor  corporation.  The  latter  must  so 
report  the  income  even  though  the  guaranteed  dividends  or  the 
interest  are  paid  directly  to  its  stockholders. 

The  following  ruling  and  regulation  summarize  previous 
rulings : 

Ruling.  A  lessee  corporation  which  owns  a  large  part  of  the 
stock  of  the  lessor  corporation  paid  the  annual  rental  of  504:  dollars 
not  directly  to  the  lessor  but  as  dividends  to  the  stockholders  of  the 
lessor,  retaining  that  part  of  the  rental  to  which  as  a  stockholder  it 
was  itself  entitled.  It  is  held  that  the  lessor  is  required  to  include  in 
its  gross  income  for  each  of  the  years  1916,  1917,  and  1918  the  full 
annual  rental  of  so.t"  dollars.     (B.  Digest  30-21-1747;  A.  R.  R.  589.) 

Regulation.  Where  a  corporation  has  leased  its  property  in 
consideration  that  the  lessee-  shall  pay  in  lieu  of  other  rental  an 
amount  equivalent  to  a  certain  rate  of  dividend  on  the  lessor's  cap- 
ital stock  or  the  interest  on  the  lessor's  outstanding  indebtedness, 
together  with  taxes,  insurance,  or  other  fixed  charges,  such  pay- 
ments shall  be  considered  rental  payments  and  shall  be  returned 
by  the  lessor  corporation  as  income,  notwithstanding  the  fact  that 
the  dividends  and  interest  are  paid  by  the  lessee  directly  to  the 
stockholders  and  bondholders  of  the  lessor.  The  fact  that  a  cor- 
poration has  conveyed  or  let  its  property  and  has  parted  with  its 
management  and  control,  or  has  ceased  to  engage  in  the  business  for 
which  it  was  originally  organized,  will  not  relieve  it  from  liability  to 
the  tax.  While  the  payments  made  by  the  lessee  directly  to  the 
bondholders  or  stockholders  of  the  lessor  are  rentals  as  to 
both  the  lessee  and  lessor  (rentals  paid  in  one  case  and  rentals 
received  in  the  other),  to  the  bondholders  and  the  stockholders 
such  amounts  are  interest  and  dividend  payments  received  as 
from  the  lessor  and  as  such  shall  be  accounted  for  in  their 
returns.     (Art.  547;  Reg.  45,  Art.  546.) 


700  INCOME 

The  procedure  as  outlined  above  is  prescribed  even  in  cases 
where  special  types  of  securities  are  issued  in  lieu  of  the  cap- 
ital stock  of  the  lessor  corporation.     The  ruling  follows : 

Regulation.  Stock  trust  certificates  or  leased  line  certificates, 
•as  the  case  may  be,  issued  by  the  lessee  for  the  purpose  of  securing 
or  holding  control  of  the  stock  of  the  lessor  are  held  to  be  issued  in 
lieu  of  the  certificates  of  capital  stock,  and  for  the  purpose  of  this 
tax  will  be  treated  as  capital  stock  and  the  amounts  received  by  the 
holders  of  these  certificates  are  dividends  to  the  holders,  to  be  treated 
as  rentals  by  both  lessee  and  lessor  and  constitute  an  allowable  de- 
duction in  the  one  case  and  an  item  of  income  in  the  other,  accord- 
ingly as  they  are  paid  and  received.     (Reg.  33,  1918,  Art.  104.) 

These  regulations  have  a  perceptible  effect  upon  the  amount 
of  the  tax  collected  by  the  Treasury  when,  as  under  the  191 7 
law,  there  is  a  difference  between  the  rate  applied  to  corpora- 
tions and  the  normal  tax  applied  to  individuals.' 

Expenditures  by  lessees  for  taxes. — Many  leases  between 
landlords  and  tenants  stipulate  that  the  latter  shall  pay  taxes 
or  make  necessary  repairs.  Expenditures  of  this  character 
are  considered  a  part  of  the  rent  and  must  be  reported  by  the 
landlord.* 


'  The  decision  upon  which  these  regulations  are  based  is  in  the  case 
of  Rensselaer  &  Saratoga  Railroad  Company  v.  Irwin,  Collector  (District 
Court,  N.  D.,  New  York),  March  5,  1917,  239  Fed.  739,  decided  under  the 
Act  of  October  3,  1913;  affirmed  249  Fed.  726,  161  C.  C.  A.  636;  writ  of 
certiorari  denied  by  Supreme  Court,  246  U.  S.  671,  38  S.  Ct.  424,  62  L.  Ed. 
931. 

The  1918  law  also  had  different  1919  normal  rates  for  corporations 
and  individuals  but  in  case  of  dividends  this  makes  no  real  difference  as 
the  receiving  corporation  (lessor)  now  pays  no  tax  on  dividends  received. 

*  [Former  Procedure]  Under  the  law  as  it  stood  prior  to  October 
3,  1917,  it  was  incumbent  upon  tenants  in  certain  circumstances  to  with- 
hold the  normal  tax  upon  rentals  paid.  In  such  cases  questions  some- 
times arose  concerning  the  interpretation  of  agreements  binding  teiiapls 
to  pay  taxes  in  addition  to  a  stipulated  cash  rental,  the  landlords  insisting 
that  income  taxes  so  withheld  should  be  assumed  by  the  tenant,  and  the 
tenants  contending  that  they  should  be  deducted  from  the  stipulated  cash 
rental  agreed  upon. 

On  September  21,  1916,  in  the  case  of  Suter  et  al.  v.  Jordan  Marsh  Co. 
(Supreme  Judicial  Court  of  Massachusetts.  225  Mass.  34.  113  N.  E.  580), 
the  court  decided  that  the  tenant  could  not  deduct  from  its  rental  the  nor- 
mal federal  income  tax,  having  agreed  to  pay  'all  taxes  and  assessments 
....  upon  or  in  respect  of  the  rent  payable  hereunder  by  the  lessee,  how- 
soever and  to  whomsoever  assessed."    The  court  stated  that  a  change  in  the 


FROM    RENTS 


701 


Regulation Taxes  paid  by  a  tenant  to  or  for  a  land- 
lord for  business  property  are  additional  rent  and  constitute  a  de- 
ductible item  to  the  tenant  and  taxable  income  to  the  landlord,  the 
amount  of  the  tax  being  deductible  by  the  latter (Art.  109.) 

Since  the  net  income  of  the  owner  is  the  same  whether  or 
not  the  taxes  paid  arc  inckided  as  income,  many  owners  do  not 
report  as  called  for  by  the  regulation  because  they  have  no 
personal  knowledge  of  the  amount  of  taxes  paid. 

Decision.  A  rental  contract  entered  into  in  1896  contained  the 
provision  that  the  lessee  should  pay,  among  other  things : 

"One-third  of  all  taxes  or  assessments,  special  or  otherwise,  and 
public  charges  of  every  kind  and  nature  that  shall  or  may  be  taxed 
or  assessed  against  the  (lessor)  or  its  property  during  the  aforesaid 
term  of  years." 

The  question  at  issue  was  whether  the  federal  income  tax  and 
the  federal  capital  stock  tax  were  to  be  deemed  embraced  in  the  con- 
tract and  to  be  an  obligation  of  the  lessee.  The  court,  approaching 
the  question  from  the  standpoint  of  the  circumstances  surrounding 
the  parties,  in  an  endeavor  to  interpret  the  intent,  considered  that 
the  fact  that  the  taxes  in  question  were  not  in  force  when  the  con- 
tract was  made  was  a  pertinent  circumstance  and  one  which  had  led 
the  courts  in  other  jurisdictions  to  limit  the  meaning  to  be  given  to 
the  taxes  mentioned  in  the  contract. 

It  passed  to  the  consideration  of  cases  where  an  income  tax  was 
itself  involved,  concluding  that  none  of  them  could  be  held  to  require 
the  payment  of  such  a  tax,  and  hence  it  held  here  that  no  such  obliga- 
tion was  found  to  be  in  the  contract  nor  was  it  necessarily  or  even 
reasonably  to  be  implied  from  the  language  used. 

The  same  reasoning  was  applied  to  the  consideration  of  the  fed- 
eral capital  stock  tax  or  excise  tax,  which  was  also  held  to  be  beyond 
the  contemplation  of  the  parties. 


law  as  to  taxation  during  the  term  of  the  lease  is  of  no  consequence.  "The 
covenant  is  to  pay  all  taxes  except  betterments."  The  court  held:  "The  de- 
fendant seeks  to  deduct  from  the  rent  reserved  that  which  it  contends  it 
already  has  paid  as  a  tax,  being  obligated  to  pay  all  taxes  assessed  on 
account  of  that  rent.    That  it  cannot  do." 

In  another  case,  Little  Schuylkill  Navigation  R.  R.  and  Coal  Co.  v. 
I'hila.  &  Reading  Ry.  Co.  (44  Penn.  County  Court  Reports  197),  a  lessor 
attempted  to  hold  the  lessee  liable  for  the  normal  tax  under  a  clause  in  a 
lease  obligating  the  lessee  to  pay  taxes,  but  here  the  provisions  as  to  the  kind 
of  taxes  the  lessee  should  pay  were  held  by  the  court  to  be  not  inclusive 
enough  to  subject  it  to  the  federal  income  tax.  The  lessee  agreed  to  pay 
"all  taxes,  charges,  and  assessments  ....  assessed  or  imposed  under  any 
existing  or  future  law  on  the  demised  premises  ....  or  on  the  business 
there  carried  on  or  on  the  receipts  ....  derived  therefrom,  or  upon  the 
capital  stock  ....  dividends  ....  or  ...  .  franchises  of  the   (lessor)." 


702  INCOME 

The  court  therefore  held  that  tlie  lessor  was  not  entitled  to 
recover  upon  either  item  of  its  claim  for  reimbursement  for  the 
taxes  paid  by  it.  {Des  Moine's  Union  Ry.  Co.  v.  Chicago  Great 
Western  Ry.  Co.,  177  N.  W.  90.)^ 

Rent  received  other  than  in  cash. — An  owner  of  property 
must  return  for  taxation  all  income  therefrom  whether  re- 
ceived in  cash  or  in  the  equivalent  of  cash.  Many  farms  are 
leased  under  agreements  which  provide  that  the  lessor  shall 
receive  as  rental  a  certain  portion  of  the  crops.  The  lessor 
must  return  for  taxation  the  fair  value,  less  all  expenses  in- 
curred, of  the  commodities  received  if  consumed  or  disposed 
of  by  gift  and  must  return  the  net  proceeds  if  sold  for  cash. 

Houses,  etc.,  occupied  by  rent-free  tenants. — It  may  be 
that  neither  cash  nor  produce  is  collected  from  the  occupants 
of  houses,  farms,  etc.,  but  the  equivalent  thereof  is  realized 
by  the  owner  in  a  different  form.^*'  A  taxpayer  may  own  a 
garage  large  enough  to  accommodate  the  family  of  a  chauf- 
feur. The  wages  paid  to  the  chauffeur  in  such  cases  will 
usually  be  less  than  if  he  were  obliged  to  live  elsewhere  and 
pay  rent.  Since  the  saving  in  wages  is  a  direct  reduction  of 
personal  or  living  expenses,  there  should  be  returned  for  tax- 
ation by  the  chauffeur  an  amount  equal  to  the  saving.  The 
same  rule  apphes  to  tenants'  houses  on  farms  and  country 
places. 

As  heretofore  stated,  the  rental  value  of  a  taxpayer's  resi- 
dence, when  occupied  by  himself,  is  not  taxable,  but  it  can- 
not be  assumed  that  such  exemption  extends  to  other  resi- 
dences which  are  occupied  by  employees  whose  services  are 
not  of  a  gainful  nature.  Should  not  the  decrease  in  the  ex- 
penses of  the  employer  be  deemed  to  be  constructive  income? 

Under  the  192 1  Revenue  Act,  the  rental  value  of  a  dwelling 
house  furnished  to  a  minister  of  the  gospel  as  part  of  his  com- 
pensation is  not  to  be  included  in  taxable  income." 


•  Bulletin  of  The  National  Tax  Association,  November,  1920,  page  51. 

'"  See  page  438. 

"  Section  213  (b-ii). 


CHAPTER    XXII 
INCOME  FROM  DIVIDENDS 

The  taxation  of  dividends  presents  certain  difficulties 
which  do  not  exist  in  the  taxation  of  other  income.  Divi- 
dends are  paid  from  the  surplus  earnings  of  corporations  and 
as  corporations  have  been  continuously  taxed  on  net  earnings 
since  the  incidence  of  the  federal  income  tax  on  March  i,  1913, 
taxation  of  the  same  earnings  when  distributed  to  stockhold- 
ers would  result  in  double  taxation  if  provision  were  not  made 
for  a  proper  adjustment.  Again,  earnings  distributed  since 
March  i,  1913,  out  of  the  surplus  accumulated  prior  to  that 
date  are  sometimes  held  to  be  capital  and  sometimes  taxable 
income.^  As  surtaxes  are  not  imposed  upon  corporations  Con- 
gress has  attempted  to  devise  various  methods  of  compelling 
corporations  to  declare  dividends,  or  to  penalize  the  corpora- 
tions which  do  not  make  adequate  distributions  of  profits.* 
Other  complications  exist  which  will  be  discussed  hereinafter. 
The  successive  federal  income  tax  laws  and  the  decisions  of 
the  Supreme  Court  of  the  United  States  are  gradually  clearing 
up  disputed  points.'* 

Dividends  are  taxable. — 

Law.     Section   213.     That  for  the  purposes  of   this   title   .... 
the  term  "gross  income" — 

(a)  Includes    gains,    profits,    and    income    derivedi    from   .... 
dividends 

Dividends  are  relieved  from,  normal  tax. — Previous  federal 
income  tax  laws  have  provided  that  dividends  received  by  in- 


'  See  page  715. 

"  See  Chapter  XXXV,  "Tax  011  Undistributed  Profits." 
'  In   view  of   many   unsettled   cases   relating  to   returns   going  back  to 
1913,  it  is  deemed  necessary  to  include  in  this  chapter  copious   references 
to  past  regulations  and  decisions.     For  full  details,  however,  the  reader  is 
referred  to  Income  Tax  Procedure,  1918,  1919.  1920  and  1921  editions. 


704 


INCOME 


divitluals  are  not  subject  to  the  normal  tax.*  The  1921  law 
denies  the  credit  of  dividends  for  normal  tax  purposes  in  two 
cases,  i.e.,  when  received  from  : 

1.  Corporations  entitled  to  benefits  of  section  262  (those 

derivino-  most  of  their  income  from  sources  within 

o 

United  States  possessions). 

2.  Foreign  corporations  50  per  cent  of  whose  gross  income 

for  the  preceding  three-year  period  is  froi-i  sources 
zvithont  the  United  States. ° 

Law.  Section  216.  [Individuals].  That  for  the  purpose  of  the 
normal  tax  only  there  shall  be  allowed  the  foUov/ing  credits: 

(a)  The  amount  received  as  dividends  (i)  from  a  domestic  cor- 
poration other  than  a  corporation  entitled  to  the  benefits  of  section 
262,  or  (2)  from  a  foreign  corporation  when  it  is  shown  to  the  satis- 
faction of  the  Commissioner  that  more  than  50  per  centum  of  the  gross 
income  of  such  foreign  corporation  for  the  three-year  period  ending 
with  the  close  of  its  taxable  year  preceding  the  declaration  of  such 
dividends  (or  for  such  psrt  of  such  period  as  the  corporation  has  been 
in  existence)  was  derived  from  sources  within  the  United  States  as  de- 
termined  under   the   provisions   of   section   217;   .... 

Section  234  (a-6)  provides,  in  practically  identical  lan- 
guage, for  the  deduction  of  dividends  in  computing  the  net 
income  of  corporations.'' 


*  In  the  case  of  state  income  taxes  the  foregoing  provision  does  not 
necessarily  apply  because  corporations  may  not  pay  a  state  income  tax  as 
such.  In  New  ^'ork  State,  corporations  pay  a  4^/2  per  cent  tax  on  net  in- 
comes, hut  it  is  imposed  as  a  franchise  tax.  Consequently  an  individual 
taxpayer  must  pay  state  income  tax  on  the  full  amount  of  dividends  re- 
ceived, with  no  allowance  or  credit  for  the  4j/<  per  cent  already  collected  on 
the  same  net  income. 

■^  See  page  711  for  discussion  of  reason  for  limitation  of  credit. 

"  [Former  Procedure]  Under  the  1909  excise  tax  law  corporations 
were  not  subject  to  tax  upon  dividends.  Under  the  1913  and  1916  laws 
they  were  taxed.  Under  the  191 7  law  they  were  taxed  2  per  cent  when 
out  of  1916  or  1917  earnings  and  i  per  cent  when  out  of  1913,  1914  or 
1915  earnings,  and  exempt  as  to  the  4  per  cent  war  income  tax.  The  1918 
law  relieved  corporations  from  any  tax  on  dividends  received  from  other 
corporations  which  were  themselves  taxable  under  the  federal  income  tax 
law. 

Corporation  tax  rates  were  as  follows:  1913,  1914,  1915.  i  per  cent; 
igi6,  2  per  cent ;  1917,  2  per  cent  and  4  per  cent  war  income  tax. 

Dividends  from  corporations  taxed  upon  their  net  income  in  Porto 
Rico  and  the  Philippine  Islands  were  not  allowed  as  credits,  free  of  tax, 
in  an  individual  return  and  were  not  allowed  as  a  deduction  in  arriving 
at  net  income  in  a  corporation  return.     (1918  law,  section  261.) 


FROM    DIVIDENDS 


705 


Dividends  on  stock  of  federal  reserve  banks  exempt  from 

both  normal  and  surtaxes. — 

Regulation.  As  section  7  of  the  Federal  Reserve  Act  of  De- 
cember 23,  1913,  provides  that  Federal  reserve  banks,  including  the 
capital  stock  and  surplus  therein  and  the  income  derived  therefrom, 
shall  be  exempt  from  taxation,  except  taxes  upon  real  estate,  such 
exemption  attaches  to  and  follows  the  income  derived  from  dividends 
on  stock  of  Federal  reserve  banks  in  the  hands  of  the  stockholders, 
so  that  the  dividends  received  on  the  stock  of  Federal  reserve  banks 
are  not  subject  to  the  income  tax.  Dividends  paid  by  member  banks, 
however,  are  treated  like  dividends  of  ordinary  corporations.  (Art. 
76.) 

The  above  regulation  calls  attention  to  the  fact  that  this 
exemption  of  dividends  received  by  member  banks  does  not 
extend  to  dividends  paid  on  the  stock  of  member  banks. 

Owners  of  record  liable  for  tax — Exception. — Many  stocks 
are  owned  by  others  than  shareholders  of  record.  In  such 
cases  the  following  regulation  is  of  importance  -J 

Regulation.  Dividends  on  stock  of  domestic  corporations  or 
resident  foreign  corporations  are  prima  facie  income  of  the  record 
owner  of  the  stock,  and  such  record  owner  will  be  liable  for  any  addi- 
tional tax  based  thereon,  unless  a  disclosure  of  the  actual  ownership 
is  made  to  the  Commissioner  on  Form  1087  which  shall  show 
that  the  record  owner  is  not  the  actual  owner  and  who  the 
owner  is  and  his  address.  In  all  cases  where  the  actual  owner  is  a 
nonresident  alien  individual  and  the  record  owner  is  a  person  in  the 
United  States,  the  record  owner  will  be  considered  for  tax  purposes 
to  have  the  receipt,  custody,  control,  and  disposal  of  the  dividend 
income  and  will  be  required  to  make  return  for  the  actual  owner, 
regardless  of  the  amount  of  the  income,  and  to  pay  any  surtax  found 
by  such  return  to  be  due.     (Art.  405.) 

"Dividend"  Defined 

The  statutory  definition  of  the  term  "dividend"  follows: 

Law.  Section  201.  (a)  That  the  term  "dividend"  when  used  in 
this  title  (except  in  paragraph  (10)  of  subdivision  (a)  of  section  234s  and 
paragraph  (4)  of  subdivision  (a)  of  section  245"'  means  any  distribution 


'  See  also  page  320. 

'Refers  to  distributions  by  insurance  companies   (other  than  life). 

'  Refers  to  distributions  by  life  insurance  companies. 


7o6  INCOME 

made  by  a  corporation  to  its  shareholders  or  members,  whether  in 
cash  or  in  other  property,  out  of  its  earnings  or  profits  accumulated 
since  February  28,  1913,  except  a  distribution  made  by  a  personal  ser- 
vice corporation  out  of  earnings  or  profits  accumulated  since  Decem- 
ber 31,  1917,  and  prior  to  January  i,  1922 

The  1 92 1  law  eliminates  from  the  definition  a  distribution 
"in  stock  of  the  corporation"  (stock  dividends),  as  well  as 
distributions  from  personal  service  corporation  earnings  which 
were  accumulated  during  the  period  that  such  earnings  were 
taxed  to  the  individual  stockholders.  The  words  ''earnings 
or  profits,"  which  are  the  same  as  in  the  1918  law,  were  held 
to  include  realizations  of  appreciation  accrued  prior  to  March 
I,  1913.     The  ruling  is  beheved  to  be  illegal.^" 

The  definition  given  in  the  regulations  limits  the  meaning 
of  the  term  still  further: 

Regulation.  Dividends  for  the  purpose  of  the  statute  comprise 
any  distribution  in  the  ordinary  course  of  business,  even  though  ex- 
traordinary in  amount,  made  by  a  domestic  or  foreign  corporation  to 
its  shareholders  out  of  its  earnings  or  profits  accumulated  since  Feb- 
ruary 28,    1913 The  term   "dividends"   does  not,   however, 

include  a  distribution  made  by  a  personal  service  corporation  out  of 
earnings  or  profits  accumulated  since  December  31,  1917,  and  prior 
to  January  i,  1922 (Art.  1541.) 

Distribution  must  be  "in  the  ordinary  course  of  business." 
— It  should  be  noted  particularly  '  that  the  regulation  just 
quoted  insists  that  the  distribution  shall  have  been  made  "in 
the  ordinary  course  of  business."  The  phrase  evidently  is 
meant  to  distinguish  such  dividends  from  liquidation  or  divi- 
dends extraordinary.^^ 


"'"  See  page  718. 

[Former  Procedure]     The  definition  in  the  1918  law  is : 

Law.  Section  201.  "(a)  That  the  term  "dividend"  when  used  in  this 
title  (except  in  paragraph  (10)  of  subdivision  (a)  of  section  234)  means 
(i)  any  distribution  made  by  a  corporation,  other  than  a  personal  service 
corporation,  to  its  shareholders  or  members,  whether  in  cash  or  in  other 
property  or  in  stock  of  the  corporation,  out  of  its  earnings  or  profits  accu- 
mulated since  February  28,  1913,  or  (2)  any  such  distribution  made  by  a 
personal  service  corporation  out  of  its  earnings  or  profits  accumulated  since 
February  28,  1913,  and  prior  to  January  i,  1918." 

"See  page  748. 


FROM   DIVIDENDS  707 

What  constitutes  a  distribution? — The  1921  law  now  pro- 
vides, in  effect,  for  the  constructive  receipt^^  of  dividends. 

Law.     Section  201 (e)  For  the  purposes  of  this   Act,  a 

taxable  distribution  made  by  a  corporation  to  its  shareholders  or  mem- 
bers shall  be  included  in  the  gross  income  of  the  distributees  as  of  the 
date  when  the  cash  or  other  property  is  unqualifiedly  made  subject  to 
their  demands 

Regulation A  taxable  distribution  made  by  a  corpoi'a- 

tion  to  its  stockholders  or  members  shall  be  included  in  the  gross 
income  of  the  distributees  when  the  cash  or  other  property  is  un- 
qualifiedly made  subject  to  their  demands.     (Art.  1541.) 

Very  few  stockholders  have  available  or  trustworthy  in- 
formation as  to  when  dividends  are  declared.  Their  records 
show  only  the  receipts  of  dividends,  even  when  accounts  are 
kept  on  an  accrual  basis.  It  would  be  rather  difficult  for  a 
taxpayer  keeping  accounts  on  a  cash  basis  to  make  the  neces- 
sary adjustments  at  the  beginning  and  end  of  each  year;  there- 
fore stockholders  who  report  dividends  as  of  date  of  receipt, 
which  is  the  first  time  they  are  under  the  control  of  the  stock- 
holders, will  be  complying  with  the  law. 

In  the  case  of  close  corporations  the  individual  accounts 
of  stockholders  may  be  treated  as  bank  accounts  and  it  is  rea- 
sonable to  charge  such  stockholders  with  notice  as  to  the  dates 
when  dividends  are  credited. 

Decision It  appears  that  in  the  year  1916  the  earn- 
ings of  the  company  were  distributed  to  the  stockholders  by  crediting 
them  with  their  pro  rata  shares  thereof  upon  the  books  of  the 
corporation.  This  dividend  was  not,  however,  actually  segregated 
from  the  general  assets  of  the  company.  Godfrey  F.  Park  thus  re- 
ceived credit  for  $21,120.94  and  Susan  R.  Park  for  $17,836.33. 

It  is  well  settled  that  the  declaration  of  a  dividend  creates  a 
debt  from  the  corporation  to  the  stockholders.  If  the  amount  of 
the  dividend  be  segregated  and  set  apart  from  the  other  corporate 
assets  in  money  or  securities  or  other  property,  then  the  same  be- 
comes a  trust  fund,  for  the  benefit  of  the  stockholders,  respectively. 
But  that  does  not  seem  to  have  been  done  in  this  case.  Therefore, 
the  crediting  of  the  pro  rata  shares  of  the  plaintiffs,  Godfrey  F. 
Park  and  Susan  R.  Park,  of  this  amount  to  their  respective  accounts 

"  See  page  387. 


7o8 


INCOME 


upon  the  books  of  the  company  merely  evidenced  the  indebtedness  of 
the  company  to  them,  and  did  not  constitute  the  receipt  of  income 
by  them.  Income  means  actual  cash  or  its  equivalent  received,  as 
opposed  to  contemplated  revenue  due  or  unpaid.  Maryland  Casualty 
Co.  V.  U.  S.,  52  Ct.  Cls.  201  209  (Affirmed  251  U.  S.  342,  345.) 

Although,  the  dividends  were  not  income  simply  because  credits 
to  the  extent  thereof  had  been  created,  yet  when  the  plaintifiTs  subse- 
quently drew,  as  they  did,  against  those  credits  and  obtained  the 
money  thereon,  then  they  did  become  income ^" 

In  the  foregoing  case  the  court  was  satisfied  that  certain 
stockholders  could  not  be  charged  with  the  constructive  re- 
ceipt of  their  dividends,  even  though  credited  to  their  indi- 
vidual accounts  in  the  books.  Under  the  192 1  law  such  divi- 
dends would  be  taxable  unless  the  company  could  not  pay  the 
amounts  credited.^* 

May  a  dividend  be  rescinded  by  directors  or  returned  by 
stockholders? — It  sometimes  happens  that  a  dividend  is  de- 
clared on  the  strength  of  book  or  paper  profits  and  subse- 
quently it  becomes  necessary  or  desirable  to  reverse  the  action 
and  arrange  to  secure  a  return  of  the  funds  paid  out  or  credited 
to  the  accounts  of  stockholders. 

If  a  single  stockholder  objects  to  the  rescinding  proposition 
after  the  formal  declaration  of  a  dividend  is  communicated  to 
him  or  after  the  dividend  has  been  credited,  no  legal  remedy 


^"Park  V.  Gilligan,  Collector,  U.  S.  Dist.  Ct.,  So.  Dist.  of  Ohio,  West. 
Div.,  June  11,  1921  (not  reported)  ;  sec  Corp.  Tr.  Co.  1921  Income  Tax- 
Service,  3067  et  seq. 

'*  [Former  Procedure]  Under  the  1918  law  the  Treasury  imposed  an 
impossible  condition  upon  stockholders  who  keep  their  accounts  on  a  cash 
basis. 

Rulings.  "The  date  of  payment  rather  than  date  of  receipt  is  the 
governing  factor  in  determining  when  a  dividend  should  be  treated  as  tax- 
able income  to  the  recipient.  Consequently,  a  dividend  paid  in  Kansas  and 
received  there  by  stockholders  December  30,  191 7,  but  not  received  by  stock- 
holders in  California  until  January,  1918,  will  be  taxable  at  1917  rates  to 
the  California  stockholders."     (C.  B.  i,  page  562;  O.  D.  97.) 

"A  distribution  by  a  corporation  in  1919  under  court  order  of  an  ac- 
cumulated cash  surplus,  as  a  result  of  suit  brought  by  certain  stockholders, 
which  was  decided  in  their  favor  by  the  lower  court  in  1917  and  affirmed 
by  the  appellate  court  in  1919,  must  be  returned  as  income  of  the  stock- 
holders for  the  year  1919  and  not  in  amended  returns  for  1917."  (C  .B.  2, 
page  87;  A.  R.  R.  124.) 


1 


FROM   DIVIDENDS 


709 


is  available  to  compel  action  on  his  part.  If,  however,  in  fact 
the  dividend  has  been  paid  out  of  capital,  the  so-called  divi- 
dend is  not  taxable  at  all  to  the  stockholders  and  the  directors 
may  be  required  to  reimburse  the  corporation  to  the  extent 
to  which  the  dividend  was  illegal.^' 

Ruling.  A  dividend  declared  and  paid  by  a  corporation  wa^  in 
part  illegal,  inasmuch  as  it  exceeded  the  true  earnings,  and  the  cor- 
poration later  rescinded  it.  To  the  extent  that  the  corporation  had 
a  legal  right  to  force  rescission  and  repayment  of  such  dividend, 
and  such  rescission  and  repayment  vi^ere  actually  made,  the  rescinded 
dividend  should  not  be  considered  income  to  the  stockholders  for 
the  purpose  of  taxation.     (C.  B.  i,  page  25;  T.  B.  M.  yy.') 

But  if  every  stockholder  consents  to  a  rescission  the  case 
is  entirely  different.  If  directors  pay  a  dividend  which  proves 
to  be  unwise,  or  excessive  or  illegal,  and  every  stockholder 
agrees  to  return  the  amounts  paid  or  credited,  it  may  be  ex- 
pected that  no  court  will  hold  that  the  payments  represent 
income  when  received  and  capital  payments  when  refunded, 
even  though  the  dividends  were  paid  or  credited  during  one 
taxable  year  and  the  refunds  occurred  during  the  next  year. 

If  the  entire  transaction  occurred  during  the  same  taxable 
year  it  would  not  even  appear  in  the  returns  or  accounts  of 
the  taxpayer.  In  effect  it  would  be  a  transaction  marked 
"void."  Therefore,  when  one  part  of  the  transaction  occurs 
very  late  in  one  taxable  year  and  the  other  part  in  the  next 
taxable  year  a  taxpayer  should  not  be  penalized  thereby. 

This,  however,  is  not  the  view  of  the  Treasury. 

Ruling.  A  corporation  in  due  course  of  business  during  the 
calendar  year  1918  declared  and  paid  a  dividend  the  major  portion 
of  which  was  paid  out  of  earnings  of  the  calendar  years  1914, 
191 5,  and  1916.  Both  at  the  time  of  declaration  and  at  the  time  of 
payment  of  such  dividend  the  Revenue  Act  of  1916  as  amended  by 
the  Revenue  Act  of  1917  (see  sec.  31  (b))  was  in  force,  which  pro- 
vided for  the  taxation  of  dividends  "at  the  rates  prescribed  by  law 
for  the  years  in  which  such  profits  or  surplus  were  accumulated 
by  the  corporation."  In  the  calendar  year  1919,  after  the  passage 
of  the  Revenue  Act  of   1918  which  changed  the  method  of  taxing 


'^'^ Auditing ,  Theory  and  Practice  (1921  edition),  by  R.  H.  Montgomery, 
pages  670-677. 


710  INCOME 

cash  dividends  so  that  they  became  taxable  at  current  rates,  the 
corporation  took  action  purporting  to  rescind  the  declaration  of  the 
dividend,  and  the  stockholders  repaid  the  amounts  receired  by  them 
from  the  corporation.  It  is  inferred  from  the  statement  of  facts 
that  the  declaration  and  payment  of  the  dividend  were  legal  and  that 
the  corporation  could  not  have  required  the  stockholders  to  pay  back 
the  amounts  received  in  distribution  but  that  such  repayments  were 

made  voluntarily 

The  rights  of  the  stockholders  with  respect  to  the  dividend 
became  fixed  at  some  time  not  later  than  the  date  of  payment  thereof. 
Such  rights  were  not  subject  to  any  liability  to  repay  amounts  re- 
ceived. The  dividend,  therefore,  became  during  the  calendar  year 
19 18  a  part  of  the  gross  income  of  the  stockholders.  After  it  had 
acquired  the  character  of  gross  income  the  stockholders  could  not 
by  voluntary  action  on  their  part  take  away  such  character.  The 
repayment  of  the  dividend  was  a  new  and  independent  transaction. 
.    .    .    .    (C.  B.  I,  page  65;  T.  B.  R.  42.) 

The  author  wholly  disagrees  with  the  foregoing  ruling. 
When  the  dividend  was  declared  and  paid  the  stockholders 
were  justified  in  assuming  that  Congress  would  keep  faith 
with  the  corporations  which  were  induced  to  pay  special 
dividends  in  19 18  under  a  guarantee  of  special  treatment.^* 
Congress  did  not  keep  faith  and  later  imposed  a  different  rate 
of  tax  by  retroactive  legislation.  The  corporations  having 
acted  under  a  law  which  was  subsequently  repealed  were 
legally  entitled  to  rescind  what  was  done  under  a  mistaken 
idea  of  the  good  faith  of  the  government.  The  government 
having  secured  action  through  deceit  is  estopped  from  bene- 
fitting by  such  action. 

In  a  subsequent  case,  the  Treasury  held  the  repayment  of  a 
dividend  did  not  relieve  the  stockholders  of  surtax  thereon, 
even  though  the  original  payment  of  the  dividend  was  made 
before  proper  provision  had  been  made  for  federal  taxes,  re- 
sulting in  an  impairment  of  capital. 

Ruling.  At  the  time  of  the  declaration  of  the  dividend  the  cor- 
poration had  earnings  and  profits  accumulated  since  February  28, 
1913,  out  of  which  the  dividends  could  be  paid.  In  December,  1919, 
additional  income  and  excess  profits  taxes  were  found  to  be  due  from 
this   corporation    for  the  year    1917,   the   collection   of   which   would 

"  See  page  732. 


FROM    DIVIDENDS  711 

seriously  have  impaired  the  capital  of  the  corporation.  It  was 
therefore  agreed  at  a  meeting  of  the  stockholders,  held  in  December, 
1919,  that  the  dividends   previously   paid  should  be   returned  to  the 

corporation 

It  might  be  inferred  that  no  dividends  may  be  declared  from 
surplus  and  undivided  profits  unless  a  reserve  fund  is  established 
for  the  payment  of  any  Federal  taxes  which  might  accrue  for  the 
year  prior  to  that  in  which  the  dividend  is  declared.  However,  such 
a  principle  could  not  be  applicable  to  all  prior  years  in  which  ad- 
ditional assessments  might  be  made.  The  Commissioner  is  em- 
powered, under  the  Revenue  Act  of  1918,  to  make  an  additional  as- 
sessment of  income  and  excess  profits  taxes  for  any  given  year  at 
any  time  within  five  years  after  the  return  was  due  or  was  made, 
and  in  the  case  of  a  false  or  fraudulent  return  with  intent  to  evade 
the  tax  the  amount  of  tax  due  may  be  determined  and  collected  at  any 
time  after  the  return  is  filed  (section  250  (d)  ).  It  is  apparent, 
therefore,  that  if  we  are  to  take  into  consideration  a  contingent 
liability  that  arises  by  reason  of  additional  assessment,  no  point  of 
time  will  arrive  at  which  directors  may  safely  say  that  earned  sur- 
plus and  undivided  profits  are  available  for  distribution  to  stock- 
holders in  the  form  of  dividends.      (C.  B.  4,  page  y^;  Sol.  Op.  no.) 

The  foregoing  ruling  is  not  sound.  The  repayment  of  the 
dividend  was  an  honest  and  legal  method  of  rectifying  a  mis- 
take. The  attempt  of  the  Treasury  to  force  the  payment  of 
income  taxes  on  an  improper  diversion  of  funds,  ignoring  the 
return  of  the  funds,  is  inexcusable. 

In  a  recent  case"  the  Treasury-  held  that  under  almost 
similar  circumstances  the  taxpayer  could  make  an  amended 
return  for  the  year  when  the  dividend  out  of  capital  was  re- 
ceived, on  the  ground  that  it  was  not  income. 

Distributions  by  foreign  corporations  considered  "divi- 
dends."— In  the  definition  quoted  on  page  705  the  term  "divi- 
dend" is  held  to  include  a  distribution  by  a  foreign  as  well  as 
by  a  domestic  corporation,  but  the  192 1  law^^  imposes  a  definite 
limitation  on  such  dividends  before  they  can  be  free  of  the 
normal  tax  in  the  hands  of  individual  stockholders,  or  from 
income  tax  imposed  on  a  corporation  recipient,  i.e.,  more  than 


See  I-3-27;  I.  T.  1 164. 
Sections  216  (a),  234  (a-6). 


712  INCOME 

50  per  cent  of  the  gross  income  of  the  foreign  corporation 
paying  the  dividend,  for  the  three-year  period  prior  to  declara- 
tion of  the  dividend,  must  have  been  from  sources  within  the 
United  States. 

The  insertion  of  this  Hmitation  in  the  192 1  law  was  to  pre- 
vent the  recipient  of  dividends  from  a  foreign  corporation 
securing  credit  for  normal  tax  on  income  even  though  normal 
tax  has  never  been  paid  by  the  foreign  corporation.  In  other 
words,  if  the  business  of  a  foreign  corporation  in  the  United 
States  is  so  small  or  so  unprofitable  as  to  jdeld  little  or  no  tax, 
the  recipient  of  dividends  will  not  now  secure  credit  for  a  tax 
which  has  not  been  collected  from  the  corporation.^" 

Method  of  return  of  dividends  from  foreign  corporations. 

— Receipt  by  an  individual  of  a  $250  dividend  on  the  ordinary 
shares  of  a  British  company  indicates  that  the  dividend  cred- 
ited was  $357.14  and  that  the  com.pany  paid  to  the  British 
government  an  income  tax  of  30  per  cent,  or  $107.14.  The 
gross  amount  ($357.14)  should  be  entered  in  the  return  as  a 
Mividend  subject  to  surtax  only,  and  credit  is  taken  for  the 
full  amount  of  the  tax  ($107.14).  This  applies  when  the 
British  company  received  more  than  50  per  cent  of  its  gross 
income  for  the  three-year  period  preceding  the  declaration  of 
the  dividend,  from  sources  within  the  United  States.  When 
the  British  company  received  less  tb.an  50  per  cent  of  its  gross 
income  from  the  United  States  as  above  noted,  the  full  divi- 
dend ($357.14)  must  be  entered  as  sul^ject  to  both  normal  tax 


"  [Former  Procedure] 

Ruling.  "Individuals  are  entitled  to  a  credit  for  the  purposes  of  the 
normal  tax,  of  dividends,  regardless  of  the  amount  of  such  dividends,  re- 
ceived from  a  foreign  corporation  taxable  upon  income  from,  sources  within 
the  United  States,  irrespective  of  the  amount  of  such  income.  This  applies 
equally  to  the  Revenue  Acts  of  1916,  1917  and  1918.  The  same  credit  is 
allowed  to  corporations  under  the  Revenue  Act  _of.i9i7,  for  the  purpose 
of  the  4  per  cent  war  income  tax  imposed  by  section  4  of  that  Act.  but  not 
for  the  purpose  cf  the  2  per  cent  tax  imposed  by  section  10  (a),  Revenue 
Act  of  1916  as  amended  bv  the  Revenue  Act  of  1917."  (C.  B.  2,  page  159; 
O.  D.  383.) 


FROM    DIVIDENDS 


713 


and    surtax,    bnt    credit    is    taken    for   the    30    per    cent    tax 

($107.14).^" 

Distributions  received  from  personal  service  corporations 
after  January  i,  1918,  may  or  may  not  be  "dividends." — Dis- 
tributions by  personal  service  corporations  lose  their  char- 
acter as  "dividends"  when  made  out  of  earnings  or  profits 
accumulated  after  December  31,  19 17,  and  prior  to  January  i, 
1922. 

Law.  Section  201.  (a)  That  the  term  "dividend"  ....  means 
any  distribution  made  by  a  corporation  to  its  shareholders  or  mem- 
bers, ....  except  a  distribution  made  by  a  personal  service  corpora- 
tion out  of  earnings  or  profits  accumulated  since  December  31,  1917, 
and  prior  to  January  i,  1922 

Any  distribution  received  from  a  personal  service  corpora- 
tion must  be  analyzed.  If  declared  out  of  earnings  accumu- 
lated after  December  31,  19 17,  and  prior  to  January  i,  1922, 
it  must  not  be  treated  as  a  dividend.  If  the  personal  service 
corporation  has  not  paid  the  tax  on  it,  it  is  subject  both  to 
the  normal  tax  and  to  the  surtax  in  the  hands  of  the  recipient. 
If  declared  from  earnings  accumulated  prior  to  January  i, 
1918,  or  after  December  31,  192 1,  it  is  subject  to  the  surtax 
or  exempt  from  all  tax,  the  same  as  an  ordinary  cash  dividend 
would  be. 

The  reason  for  this  is  that  prior  to  January  i,  1918,  for 
income  tax  purposes,  personal  service  corporations  were  taxed 
like  regular  corporations  and  paid  the  normal  income  tax  on 
their  earnings  up  to  the  end  of  191 7.  Beginning  with  Janu- 
ary I,  1918,  personal  service  corporations  were  not  subject  to 
income  tax,  but  their  earnings  were  taxed  to  the  individual 
stockholders.-^  Under  the  1921  law  [section  218  (d)],  per- 
sonal service  corporations,  after  December  31,  192 1,  will 
again  be  taxed  like  regular  corporations.     Thus,  to  detennine 


""Sec  Chapter  XXXVI   for  limitation  on  credit   for  foreign  taxes. 
■'  1918  law,  section  218   (e). 


714 


INCOME 


whether  or  not  a  "dividend"  from  a  personal  service  corpora- 
tion is  taxable,  it  is  necessary  to  consider  three  periods: 

1.  March  i,  1913,  to  December  31,  191 7,  inclusive. 

2.  January  i,  19 18,  to  December  31,  1921,  inclusive. 

3.  After  December  31,  192 1. 

If  the  "dividend"  is  from  earnings  accumulated  during 
(i)  and  (3),  it  is  only  subject  to  surtax,  like  a  regular  divi- 
dend. If  from  (2),  it  is  not  a  "dividend"  at  all  and  is  not 
subject  to  tax  in  the  hands  of  the  recipient  since  the  tax  on 
such  earnings  has  already  been  imposed  on  the  individual 
stockholders.^"  Earnings  prior  to  March  i,  1913,  are  tax- 
exempt  when  distributed  by  personal  service  corporations,  just 
as  are  the  earnings  of  ordinary  corporations. 

Dividends  from  personal  service  corporations  derived  from 
earnings  accumulated  after  December  31,  1917,  and  prior  to 
January  i,  1922,  are  to  be  treated  as  income  from  a  partner- 
ship. Therefore  income  received  by  the  personal  service  cor- 
poration, such  as  tax-exempt  interest  or  dividends  from  fed- 
eral land  banks  or  national  farm  loan  associations,  should  have 
been  reported  to  the  stockholders  separately,  in  order  that  the 
exemption  to  which  the  stockholders  are  entitled  would  be 
secured.  In  making  return  on  form  1040  the  stockholders 
should  segregate  the  receipts  from  personal  service  corpora- 
tions after  December  31,  191 7,  and  not  include  any  dividends 
which  constitute  a  distribution  of  profits  accumulated  after 
December  31,  191 7,  and  prior  to  January  i,  1922.  The  part 
of  the  undistributed  income  of  the  personal  service  corpora- 
tion which  accrued  to  the  stockholders  after  December  31, 
191 7,  should  be  reported  in  the  year  of  accrual  as  Item  9, 
schedule  E  of  form  1040.  Dividends  received  by  stockholders 
of  personal  service  corporations  after  January  i,  1918,  which 
constitute  a  distribution  of  earnings  prior  to  that  date,  should 
be  reported  the  same  as  dividends  from  ordinary  corporations. 


^For  discussion  of  personal  service  corporations  having  fiscal  years, 
see  page  820. 


FROM    DIVIDENDS 


7^5 


For  1922  and  subsequent  years,  dividends  received  out  of 
earnings  accumulated  after  December  31,  1921,  will  also  be 
entered  the  same  as  dividends  from  ordinary  corporations. 
After  December  31,  1921,  dividends  paid  by  personal  service 
corporations  are  subject  to  the  provisions  of  section  201  (b)." 
Dividends  paid  during  1922  will  be  applied  first  to  earnings 
accumulated  ratably  during  1922.  If  a  personal  service  cor- 
poration declares  a  dividend  in  March,  1922,  payable  April  i, 
1922,  it  will  be  held  that  it  must  first  be  applied  against  earn- 
ings accrued  from  January  i  to  March  31,  1922,  even  though 
tax-exempt  earnings  accumulated  prior  thereto  have  not  been 
distributed.  It  would  appear  to  be  advisable  for  all  personal 
service  corporations  which  have  available  funds,  to  pay  divi- 
dends immediately  in  order  that  the  greater  part  thereof  may 
be  apportioned  as  tax-exempt  to  the  period  prior  to  January  i , 
1922.  The  payment  ma}"  he  made  b}'-  declaration  that  all  such 
accumulations  be  credited  as  dividends  to  the  ])ersonal  accounts 
of  the  stockholders. 

Assume  a  personal  service  corporation  had  a  surplus  at 
December  31,  192 1,  of  $200,000,  all  accumulated  since  Janu- 
ary I,  1918.  The  normal  tax  and  surtax  thereon  will  have 
been  paid  by  the  individual  stockholders.  Assume  further  that 
the  earnings  from  January  i  to  February  28,  1922,  are  $20,- 
000.  On  February. 28,  1922,  a  dividend  of  $15,000  is  paid. 
The  sixty-day  rule  is  not  applicable.  The  entire  dividend  of 
$15,000  would  be  deemed  to  be  out  of  1922  earnings  and  tax- 
able to  the  stockholders  at  the  1922  surtax  rates,  but  exempt 
from  normal  tax.  No  part  of  the  $200,000  surplus  may  be 
distributed  free  from  tax  until  all  earnings  since  December 
31,  1 92 1,  are  first  distributed.^* 

Distributions  Which  Are  Not  "Dividends" 

Three  types  of  so-called  "dividends"  may  be  excluded  from 
gross  income : 


See  page  728. 

Section  201    (a).     For  further  discussion  see  pages  721-725. 


7i6  INCOME 

1.  From  earnings  accumulated  prior  to  March  i,  191 3. 

2.  From  appreciation  at  March  i,  1913. 

3.  Liquidating  dividends,  to  the  extent  that  they  are  a 

return  of  capital.  Included  hereunder  would  be 
dividends  stated  to  be  paid  from  depletion  and  de- 
preciation reserves. 

Law.     Section  201 (b)    .    .    .    .   any  earnings   or  profits 

accumulated  or  increase  in  value  of  property  accrued  prior  to  March 
I,  1913,  may  be  distributed  exempt  from  the  tax,  after  the  earnings  and 
profits  accumulated  since  February  28,  1913,  have  been  distri- 
buted  

The  words  "or  increase  in  value  of  property"  in  the  192 1 
law  are  new,  and  were  inserted  so  as  to  remove  all  doubt^^ 
that  dividends  paid  out  of  appreciation  at  March  i,  1913,  are 
not  taxable,  provided  the  earnings  accumulated  since  that  date 
are  first  distributed. 

Regulation.  Any  distribution  by  a  corporation  out  of  earnings 
or  profits  accumulated  prior  to  March  i,  1913,  or  out  of  increase  of 
value  of  property  accrued  prior  to  March  i,  1913  (whether  or  not 
realized  by  sale  or  other  disposition),  is  not  a  dividend  within  the 
meaning  of  the  Act.  Lhe  provisions  of  the  preceding  sentence  shall 
be  applied  uniformly  to  cases  arising  under  the  Revenue  Act  of  1916, 
the  Revenue  Act  of  1917,  the  Revenue  Act  of  1918,  as  well  as  the 
Revenue  Act  of  1921.  A  corporation  can  not  distribute  earn- 
ings or  profits  acciunulated  or  increase  in  value  of  property  accrued 
prior  to  March  i,  19 13,  unless  and  until  all  earnings  or  profits  ac- 
cumulated since  February  28,  1913,  have  been  distributed.  Li  de- 
termining whether  a  dividend  is  out  of  earnings  or  profits  accumulated 
prior  or  subsequent  to  March  i,  1913,  due  consideration  must  be 
given  to  the  facts  and  mere  bookkeeping  entries  increasing  or  de- 
creasing surplus  will  not  be  conclusive (Art.  1543.) 

Li  the  opinion  of  the  author  the  foregoing  regulation  cor- 
rectly interprets  the  provision  regarding  dividends  paid  from 
realization  of  appreciation  at  March  i,  191 3,  which  while  new 
in  the  1921  law,  in  no  way  change  the  clear  language  and  intent 
of  the  1916,  1917  and  1918  laws.     As  the  new  provision  di- 


"^  For  ruling  of  the  Treasury  that  under  ■'h^  1918  law  dividends  paid 
out  of  realized  appreciation  at  March  i,  1913,  are  taxable,  and  discussion 
thereon,  sec  pages  718  to  721. 


FROM    DIVIDENDS  717 

rectlv  concerns  dividends  paid  in  recent  years,  the  history  of 
the  dividend  sections  of  the  various  laws  will  be  discussed 
in  full. 

Under  the  191 3  law  the  Supreme  Court  has  held  that  cash 
dividends  declared  between  March  i,  19 13,  and  December  31. 
1915,  even  though  admittedly  out  of  surplus  accrued  prior  to 
March  i,  1913,  are  taxable. -'* 

The  decisions  would  seem  to  be  controlling  so  far  as  ordi- 
nary cash  dividends  paid  prior  to  December  31,  1915,  are  con- 
cerned, but  in  other  decisions"'  the  Supreme  Court  has  held 
that  special  circumstances  would  justify  a  departure  from  the 
former  decision,  so  that  cash  dividends  paid  after  March  i, 
19 1 3,  have  in  some  cases  been  held  free  from  taxation  and  in 
other  cases  subject  to  the  tax. 

1916  Law.  Section  31.  (a)  That  the  term  "dividends"  as  used 
in  this  title  shall  be  held  to  mean  any  distribution  made  or  ordered  to 
be  made  by  a  corporation,  joint-vStock  company,  association,  or  insur- 
ance company,  out  of  its  earnings  or  profits  accrued  since  March  first, 
nineteen  hundred  and  thirteen,  and  payable  to  its  shareholders,  whether 
in  cash  or  in  stock  of  the  corporation,  joint-stock  company,  association, 
or  insurance  company 

The  19 1 6  law  definitely  declared  that  earnings  accumu- 
lated prior  to  March  i,  1913,  had  been  capitaHzed  and  that 
dividends  therefrom  were  free  from  all  income  taxes.  No 
provision  was  made  that  the  earnings  subsequent  to  March  i, 
1913,  should  be  exhausted  before  declaring  dividends  out  of 
the  prior  period. 

Under  the  19 16  law  the  Treasury  made  no  effort  to  restrict 
the  payment  of  dividends  out  of  surplus  accrued  prior  to 
March  i,  1913,  but  very  properly  required  evidence  that  the 
corporations  were  keeping  strict  account  of  the  disposition  of 
the  surplus  at  that  date. 

The  Treasury  Department  consistently  interpreted  the  1916 


"^  Lynch  v.  Hornby,  247  U.  S.  339  (June,  1918)  ;  Pcabody  v.  Eisner, 
247  U.  S.  247  (June,  1918). 

'-''Southern  Pacific  Co.  v.  Lozvc,  247  U.  S.  330  (June  3,  1918)  ;  Gulf  Oil 
Corpn.  V.  Lcwellyn,  248  U.  S.  71   (December  9,  1918)  ;  see  page  739. 


7i8 


INCOME 


law  to  mean  that  a  board  of  directors  might  specify  the  period 
to  which  dividends  appHed,  and,  if  a  surplus  existed  at  March 
I,  1913,  and  a  board  of  directors  informed  stockholders  that 
a  certain  dividend  applied  thereto,  such  dividend  was  not  re- 
turnable and  of  course  not  taxable  to  the  stockholder. 

In  the  first  drafts  of  the  revenue  bill  of  19 17  it  was  pro- 
vided that  all  dividends  declared  during  19 17  were  applicable 
first  to  the  latest  earnings  of  corporations.  As  many  special 
cash  and  stock  dividends  (declared  after  January  i,  191 7) 
had  been  designated  as  payable  out  of  surplus  at  March  i, 
191 3,  and  as  most  such  dividends  would  not  have  been  paid  at 
all  if  subject  to  the  191 7  income  tax  rates,  great  injustice  would 
have  been  done  if  no  change  had  been  made  in  the  draft. 

It  was  finally  decided  that  the  application  of  dividends  to 
the  latest  earnings  should  be  obligatory  only  from  August  6, 
191 7.  This  was  the  date  on  which  the  Senate  Finance  Com- 
mittee reported  the  revenue  bill  as  amended  to  the  Senate.  As 
reported,  the  bill  indicated  the  intention  to  compel  the  distri- 
bution of  all  earnings  subsequent  to  March  i,  191 3,  before  the 
surplus  at  that  date  could  be  distributed.  This  was  sufficient 
notice  of  a  radical  change  in  the  19 16  law,  and  directors  who 
declared  dividends  during  191 7  but  after  August  6,  were 
chargeable  with  a  knowledge  that  the  19 16  law  was  to  be 
amended."^ 

Dividends  out  of  surplus  prior  to  March  i,  191 3. — The 
following  opinion  of  the  Solicitor  of  Internal  Revenue  which 
has  been  overruled  by  article  1543  of  Regulations  62  is  of 
more  than  ordinary  interest  because  it  held  that  certain  divi- 
dends, theretofore  believed  to  be  exempt  from  tax,  are  tax- 
able. 

Ruling.  The  following  question  is  raised:  Is  the  profit  made  by  a 
corporation  in  1918  or  subsequent  years,  from  the  realization  of  the 
appreciation  of  the  March  ist  value  of  property  (that  is,  the  profit 
realized  between  cost  and  March  ist  value  of  property  sold  in  1918 


"  See  Reg.  33,  1918,  Art.  107 ;  and  C.  B.  3,  page  36 ;  O.  D.  655. 


FROM   DIVIDENDS 


719 


or  subsequent  years),  taxable  as  income,  when  distributed  as  a 
dividend  to  a  stockholder  in  1918  or  subsequent  years? 

To  illustrate  the  point,  the  M  Corporation  purchased  capital  assets 
in  1910  for  $10,000.  On  March  i,  1913,  these  assets  had  a  value  of 
$20,000.  In  the  year  1918  or  a  subsequent  year  the  M  corporation 
sells  these  assets  for  $20,000  and  distributes  the  $10,000  realized  gain 
to  its  stockholders  as  dividends.  The  question  asked  is  v^^hether  the 
$10,000  thus  distributed  is  taxable  as  income  to  the  stockholders. 

It  was  held  in  Lynch  v.  Hornby,  247  U.  S.  339  (T.  D.  2731),  that 
such  increase  in  the  value  of  corporate  assets  accrued  prior  to  March 
I,  1913,  was  taxable  income  under  the  Income  Tax  Act  of  1913  when 
distributed  as  a  dividend  in  the  ordinary  course  of  business.  The 
court  stated: 

Hence  we  construe  the  provisions  of  the  Act  that  "the  net  in- 
come of  a  taxable  person  shall  include  gains,  profits,  and  income  de- 
rived from  ....  interest,  rent,  dividends,  ....  or  gains  or 
profits  and  income  derived  from  any  source  whatever"  as  including 
(for  the  purposes  of  the  additional  taxes)  all  dividends  declared  and 
paid  in  the  ordinary  course  of  business  by  a  corporation  to  its  stock- 
holders after  the  taking  effect  of  the  Act  (March  i,  1913),  whether 
from  current  earnings  or  from  the  accumulated  surplus  made  up  of 
past  earnings  or  increase  in  value  of  corporate  assets,  notwithstand- 
ing it  accrued  to  the  corporation  in  whole  or  in  part  prior  to  March 
I,  1913.     (Italics  mine.) 

The  definition  of  income  contained  in  section  213,  Revenue  Act 
of  1918  is,  in  its  essentials,  the  same  as  the  definition  in  the  Act  of 
1913,  and  it  follows,  tljerefore,  that  unless  Congress  has  by  other  statu- 
tory provisions  exempted  such  income  it  is  taxable. 

Pertinent  provisions  in  the  Revenue  Act  of  1918  bearing  on  this 
point  are  section  201   (a)  and  (b)  which  provide  as  follows: 

(a)  That  the  term  "dividend"  when  used  in  this  title  (except  in 
paragraph  (10)  of  subdivision  (a)  of  section  234)  means  (i)  any 
distribution  made  by  a  corporation,  ....  to  its  shareholders  or 
members,  ....  out  of  its  earnings  or  profits  accumulated  since 
February  28,  1913 

(b)  ....  any  distribution  made  in  the  year  1918  or  any  year 
thereafter  shall  be  deemed  to  have  been  made  from  earnings  or  profits 
accumulated  since  February  28,  1913,  or,  in  the  case  of  a  personal 
service  corporation,  from  the  most  recently  accumulated  earnings  or 
profits;  but  any  earnings  or  profits  accumulated  prior  to  March  i, 
1913,  may  be  distributed  in  stock  dividends  or  otherwise,  exempt  from 
the  tax,  after  the  earnings  and  profits  accumulated  since  February 
28,  1913,  have  been  distributed. 

It  seems  clear  that  the  distribution  here  in  question  is  a  "divi- 
dend" within  the  meaning  of  section  201  (a),  which  defines  a  divi- 
dend as  "any  distribution  made  by  a  corporation,  ....  out  of 
its  earnings  or  profits  accumulated  since  February  28,   1913."  Mere 


720 


INCOME 


increase  of  capital  assets  unrealized  is  not,  in  our  judgment,  "earnings 
or  profits."  Obviously  it  is  not  an  earning.  Is  it  a  "profit,"  as  that 
term  has  come  to  be  understood  in  income  tax  parlance?  In  Lynch 
V.  Tiirrish,  247  U.  S.  221,  the  Supreme  Court  quoted  with  approval 
the  following  from  Gray  v.  Darlington,  15  Wall.  63: 

Mere  advances  in  value  in  no  sense  constitutes  the  gains,  profits, 
or  income  specified  by  the  statute. 

In  Eisner  v.  Macomber,  252  U.  S.  189,  the  court  in  commenting  on 
the  meaning  of  income  states : 

Here  we  have  the  essential  matter :  Not  a  gain  accruing  to  capital, 
not  a  grozvth  or  increment  of  value  in  the  investment,  but  a  gain,  a 
profit,  something  of  exchangeable  value  proceeding  from  the  property, 
severed  from  the  capital  however  invested  or  employed,   .... 

Here  profit  is  made  synon3^mous  with  income,  and  income  is  held 
not  to  include  mere  appreciation  of  capital.  Hence  the  word 
"profit"  can  not  include  mere  appreciation  of  capital.  The  statute, 
section  213,  defines  income  as  including  "profits."  Surely  a  part  can 
not  be  said  to  be  greater  than  the  whole  as  that  whole  has  been  de- 
fined by  the  Supreme  Court.  See  also  article  23,  Regulations  45, 
holding  appreciation  of  capital  is  not  income. 

Such  appreciation  becomes  income,  or  profit,  however,  when  real- 
ized through  the  sale  of  such  assets  (Merchants  Loan  &  Trust  Co.  v. 
Smietanka,  decided  by  the  Supreme  Court,  Mar.  28,  1921 ;  T.  D. 
3173,  C.  B.  4,  p.  34).  It  is  clear,  therefore,  that  this  increase  did  not 
become  "earnings  and  profits"  to  the"  corporation  until  after  Febru- 
ary 28,  1913.  Therefore  any  distribution  out  of  it  must  have  been 
a  distribution  out  of  the  earnings  and  profits  accumulated  after  Feb- 
ruary 28,  1913.  That  such  increase  when  realized  is  not  taxable  to 
the  corporation  because  accrued  prior  to  March  i,  1913,  is  immaterial. 
The  definition  of  a  dividend  does  not  confine  itself  to  taxable  or  non- 
taxable earnings  or  profits.  It  is  concluded,  therefore,  that  the  dis- 
tribution is  a  dividend  within  the  meaning  of  section  201  (a). 

It  remains  to  be  determined  whether  this  distribution  falls  within 
the  express  exemption  of  section  201  (b),  which  provides  in  part: 

Any  distribution  made  in  the  year  1918  or  any  year  thereafter 
shall  be  deemed  to  have  been  made  from  earnings  or  profits  accumu- 
lated since  February  28,  1913 hnt  any  earnings  or  profits  ac- 
cumulated prior  to  March  i,  iQij,  niay  be  distributed  in  stock  divi- 
dends or  otherwise,  exempt  from  the  tax,  after  earnings  and  profits 
accumulated  since  February  28,  19 13,  haA^e  been  distributed. 

This  section,  read  in  connection  with  the  definition  of  a  dividend 
makes  manifest  the  intention  of  Congress  to  exempt  "earnings  and 
profits"  which  would  otherwise  be  taxable  under  the  doctrine  of  the 
Hornby  case.  It  will  be  noted,  however,  that  the  statute  is  pecul- 
iarly silent  as  to  the  increase  of  capital  assets  accrued  prior  to  March 
I,  19 13.    At  the  time  the  Revenue  Act  of  1918  was  passed  by  Congress 


FROM    DIVIDENDS  721 

the  case  of  Lynch  v.  Hornby  had  been  decided  and  it  must  be  assumed 
that  Congress  knew  that  under  that  decision  increase  of  corporate 
assets  as  well  as  earnings  and  profits  accumulated  prior  to  March  I, 
1913,  but  distributed  later  in  the  ordinary  course,  were  taxable  as 
income.  Whatever  may  be  conjectured  as  to  the  intention  of  Con- 
gress to  reverse  by  statute  the  entire  ruling  laid  down  in  the  Hornby 
case,  the  fact  remains  that  it  did  not  use  language  which  in  our 
judgment  is  sufficient  to  accomplish  that  result,  and  it  can  not  be 
assumed  by  an  executive  department  that  Congress  intended  to  ex- 
tend the  exemption  beyond  the  clear  import  of  the  words  used.  The 
express  exemption  applies  to  "earnings  and  profits"  accumulated 
prior  to  March  i,  1913,  and  as  has  already  been  demonstrated,  these 
terms  do  not  include  unearned  increment.  A  distribution  like  that 
under  consideration  in  this  case  is  not,  therefore,  within  the  ex- 
emption. 

For  the  reasons  above  stated  it  is  concluded  that  profits  made  by 
a  corporation  in  1918  or  subsequent  years  from  the  realization  of  ap- 
preciation of  corporate  assets  accrued  before  March  i,  1913,  is  tax- 
able income  to  the  stockholder  when  distributed  as  a  dividend  in 
1918  or  subsequent  years.  ( B.  43-21-1878,  Oct.  26,  1921;  L.  O. 
1 0/3-) 

The  foregoing"  ruling,  in  the  author's  opinion,  is  erroneous. 
It  is  based  upon  the  propositions  ( i )  that  the  words  "earnings 
and  profits"  do  not  embrace  an  increase  in  value  of  corporate 
assets  while  unconverted;  (2)  that  immediately  upon  realiza- 
tion by  sale  or  conversion  after  March  i,  19 13,  such  increase 
becomes  "earnings  and  profits  accumulated  after  February  28, 
1913"  ;  and  (3)  that  although  it  has  accrued  prior  to  March  i, 
191 3,  it  does  not  come  within  the  saving  provisions  of  section 
201  (b).  It  is  manifest  that  the  Solicitor  has  indulged  in 
some  very  fine-spun  reasoning,  and  has  given  to  the  statute  a 
very  narrow  interpretation,  contrary  to  the  well-settled  rule 
that  tax  statutes  must  be  construed  strongly  against  the  gov- 
ernment and  in  favor  of  the  citizen.'" 

If  for  argument  it  be  conceded  that  the  words  "earnings 
and  profits"  do  not  embrace  -a  mere  "increase  in  value"  until 
the  latter  is  realized  through  sale  or  conversion,  still  there  is 
no  justification,  especially  under  a  statute  which  in  case  of 
doubt  must  be  construed  in  favor  of  the  taxpayer,  for  holding 


Gould  V.  Gould,  245  U.  S.  151. 


722 


INCOME 


that  the  profit  which  has  resulted  from  a  sale  or  conversion 
was  "accumulated  since  February  28,  1913." 

The  "profit"  as  such,  it  is  true,  has  been  realized  since  that 
date,  but  it  has  not  "accumulated"  since  then.  The  word  "ac- 
cumulated" means  "to  bring  together  by  degrees  or  successive 
additions."^"  There  can  be  no  accumulation,  in  the  ordinary 
and  proper  sense  of  that  word,  when  an  increase  in  value  is 
turned  into  a  profit  by  the  single  act  of  sale  or  conversion. 
If  the  words  "earnings  and  profits,"  as  used  in  section  201,  are 
to  be  given  the  meaning  ascribed  to  them  in  the  above  ruling 
and  the  word  "accumulated"  its  ordinary  one,  then  the  increase 
in  value  of  corporate  assets,  when  distributed  among  stock- 
holders, may  not  be  considered  "a  dividend"  within  the  mean- 
ing of  that  section  and  hence  is  probably  not  taxable.  This 
would  apply  to  increases  which  have  accrued  subsequent  to 
March  i,  191 3,  as  w^ell  as  prior  thereto. 

Such  a  construction  would  not,  however,  in  the  author's 
opinion,  be  proper  because  the  various  income  tax  acts  have 
sought  to  tax  both  individuals  and  corporations  on  the  in- 
creases in  value  arising  after  March  i,  191 3,  when  reahzed 
through  sale  or  conversion;  and  there  is  nothing  to  show  that 
there  was  any  intention  on  the  part  of  Congress  to  exempt 
stockholders  from  the  tax,  except  as  set  forth  in  section  201 
(b).  Nor  is  there  anything  to  indicate  that  Congress  pro- 
posed to  exempt  any  dividends  in  the  hands  of  individuals  from 
the  normal  tax  when  the  corporation  was  not  subject  to  a 
tax  on  the  moneys  represented  thereby.  Yet  that  would  be 
the  result  of  the  above  ruling,  because  any  increase  in  value, 
in  so  far  as  it  is  represented  in  the  value  as  of  March  i,  19 13, 
is  not,  even  after  sale,  an  earning  or  profit  which  can  be  taxed 
against  the  corporation. 

But  it  is  thought  that  the  act  as  a  whole  when  considered 
in  connection  with  the  prior  acts  and  the  Act  of  192 1,  repels 
the  idea  that  any  such  narrow  interpretation  of  the  words 


'Standard  Dictionary. 


FROM   DIVIDENDS  723 

"earnings  and  profits"  may  be  adopted  as  the  Solicitor  has 
indulged  in.  The  Act  of  IQT3  contained  no  exemption  what- 
ever. The  1916  and  19 17  acts  exempted  dividends  out  of 
"earnings  or  profits  accrued"  prior  to  March  i,  1913.  They 
were  passed  after  decisions  adverse  to  taxing  dividends  paid 
in  the  ordinary  course  of  business  after  March  i,  1913,  out 
of  a  surplus  accumulated  before  that  date,  had  been  rendered 
by  the  District  Court  and  the  Circuit  Court  of  Appeals  in  the 
Hornby  case,  but  before  the  Supreme  Court  had  rendered  its 
decision  to  the  contrary.  The  19 18  act  was  in  all  respects 
material  to  this  question  the  same  as  the  191 7  act. 

The  foregoing  ruling  was  made  after  the  first  House  draft 
of  the  1 92 1  act  appeared.  In  the  latter,  the  words  of  the  ex- 
emption clause  of  section  201  (b)  were,  as  in  the  1918  act, 
"but  any  earnings  or  profits  accumulated  prior  to  March  i, 
191 3,  may  be  distributed  exempt  from  the  tax."  After  the 
ruling  was  promulgated,  the  House  draft  was  amended  in  the 
Senate  by  inserting  after  the  word  "accumulated"  in  the  clause 
in  question,  "or  increase  in  value  of  property  accrued."  Thus 
there  is  evidenced  a  clear  and  well-defined  purpose  or  policy 
commencing  in  1916  on  the  part  of  Congress  to  exempt  from 
tax,  dividends  paid  out  of  corporate  assets  accumulated  before 
March  i,  191 3.  The  fact  that  this  change  in  the  last  law  was 
made  after  a  department  ruling  diametrically  contrary  thereto, 
is  most  convincing  evidence  that  Congress  intended  in  the  19 18 
act,  that  increases  in  value' should  be  included  in  the  words 
"earnings  or  profits  accumulated,"  as  used  in  section  201  (a) 
and  (b).  The  reason  for  such  a  policy  is  to  make  the  tax  on 
dividends  the  same  in  principle  as  that  assessed  against  other 
kinds  of  income,  and  to  carry  out  the  purpose,  as  announced 
in  Congress,  of  the  framers  of  the  191 7  act  to  encourage  the 
payment  of  dividends  out  of  surplus  (without  distinction  as  to 
its  source)  accumulated  after  March  i,  1913.  All  of  the  acts 
since  191 3  have  exempted  individuals  and  corporations  from 
tax  on  appreciation  in  values  of  property  up  to  March  i,  19 13. 

The  reasonable  conclusion,  therefore,  is  that  Congress  in- 


724 


INCOME 


tended,  by  section  201,  subdivisions  (a)  and  (b),  of  the  1918 
act,  to  exempt  from  tax  such  of  the  profits  distributed  by  a 
corporation  as  represent  increases  in  value  which  have  accu- 
mulated before  March  i,  1913,  and  which  later  have  been 
realized  by  sale  or  conversion,  as  well  as  those  which  represent 
earnings  and  other  profits. 

The  Solicitor  states  that  section  213  defines  "income"  as 
including  "profits,"  and  goes  on  to  say,  "surely  a  part  cannot 
be  said  to  be  greater  than  the  whole  as  that  whole  has  been 
defined  by  the  Supreme  Court."  He  fails  to  state  that  section 
213  is  a  definition  of  gross — not  net — income  and  that  all  of 
the  items  in  section  213  are  to  be  included  in  the  taxable  year. 
If  section  213  is  controlling  and  realization  of  appreciation 
prior  to  March  i,  1913,  is  a  profit,  it  must  be  a  taxable  profit. 
But  of  course  it  is  not.  So  with  the  Solicitor's  other  extracts 
from  decisions  and  sections  of  the  law.  He  makes  the  part 
greater  than  the  whole.  The  law  as  a  whole  defines  taxable 
income,  taxable  gains,  taxable  dividends.  The  designation  of 
appreciation  and  surplus  at  March  i,  191 3,  has  been  capital 
uniformly  since  tJie  enactment  of  the  ipi6  law  (with  which 
the  Hornby  case  had  nothing  to  do),  and  no  part  of  that  capital 
is  to  be  taxed.  The  attempt  to  tax  it  in  the  hands  of  its  bene- 
ficial owners  is  a  clear  disregard  of  the  letter  as  well  as  the 
intention  of  the  law. 

Dealing  specifically  with  the  19 18  law,  which  forms  the 
special  burden  of  the  Solicitor's  opinion,  it  must  surely  be 
assumed  that  the  different  sections  of  the  law  which  deal  with 
the  same  sul:)ject  or  related  parts  of  it  were  intended  to  be 
consistent  and  to  give  the  same  meaning  to  the  same  thing. 
Section  201  (a),  in  defining  the  term  "dividends,"  deals  with  • 
the  "earnings  or  profits  accumulated  since  February  28,  1913," 
by  a  corporation.  Section  202  and  sections  232-234  define 
the  earnings  or  profits  of  a  corporation.  Section  202  states 
how  "gain  derived  ....  from  the  sale  or  other  disposition 
of  property"  is  to  be  computed;  the  section  simply  says  "gain," 
not  "taxable  gain,"  though,  of  course,  only  gain  computed  in 


FROM    DIVIDENDS  725 

accordance  with  this  section  is  taxable.  In  the  case  of  prop- 
erty acquired  prior  to  March  i,  19 13,  the  "gain  derived"  is 
only  the  realization  in  excess  of  the  value  at  that  date.  Section 
232  states  how  the  "net  income"  of  a  corporation  is  to  be 
computed,  namely,  by  deducting  from  "gross  income"  as  de- 
fined in  section  233  the  deductions  permitted  by  section  234, 
section  234  provides  that  the  deduction  for  depletion  shall  be 
on  the  basis  of  the  value  of  the  property  at  March  i,  191 3. 

Is  it  not  obvious  that  in  speaking  of  the  earnings  or  profits 
of  a  corporation  accumulated  since  February  28,  191 3,  they 
must  be  viewed  in  the  light  of  the  sections  which  define  how 
gains  and  income  of  a  corporation  are  to  be  computed,  and 
that  the  exclusion  of  appreciation  of  property  values  accrued 
prior  to  March  i,  19 13,  in  sections  202  and  234,  requires  a 
similar  exclusion  in  section  201  (a)  ?  The  treatment  of  appre- 
ciation prior  to  J\Iarch  i,  191 3,  in  sections  202  and  234  auto- 
matically includes  such  appreciation  in  the  "earnings  or  profits 
accumulated  prior  to  March  i,  191 3,"  which  are  referred  to 
in  section  201   (b). 

Application  of  tax-free  distributions  in  computing  gains 
and  losses. — The  second  sentence  of  section  201  (b)  provides 
that  in  computing  losses  in  final  realization,  prior  tax-free  dis- 
tributions must  be  credited  as  partial  returns  of  capital.  Sec- 
tion 201  (c),  on  the  contrary,  provides  that  in  computing 
gains  in  final  realization,  prior  tax-free  distributions  may  be 
ignored. 

For  illustrations  see  Chapter  XXIX. 

Distribution  from  proceeds  of  a  claim  at  March  1,  1913. — 

The  fact  that  what  a  corporation  had  at  March  i,  191 3,  was 
capital  and  that  payments  out  of  capital  are  not  taxable  in- 
come, is  clearly  stated  in  a  recent  case,"^  decided  under  the 
1916  law. 


'^Park  V.  Gilligan,  Collector,  U.  S.  Dist.  Ct.,  So.  Dist.  of  Ohio,  West 
Div.,  June  11.  1921  (not  reported)  ;  sec  Corp,  Tr.  Co.  1921  Income  Tax 
Service,  3067  et  scq. 


726  INCOME 

Decision.  The  item  represented,  therefore,  the  distribution  of 
the  proceeds  of  a  chose  in  action  arising  ex  delicto  long  prior  to 
March  I,  1913.  It  was  compensation  for  an  injury  which  John  D. 
Park  &  Sons  Co.  had  suffered  by  reason  of  a  violation  of  the  anti- 
trust law.  It  was  not  in  itself  a  profit,  but  was  indemnification  for 
a  wrong  which  had  caused  a  loss  of  profits.  On  March  i,  1913,  it 
was  represented  by  an  accrued  chose  in  action.  On  November  i,  1916, 
it  was  reduced  to  cash. 

By  the  Act  of  1913  dividends  were  taxable  if  paid  after  March  i, 
1913,  whether  from  profits  theretofore  accrued  or  thereafter.     Lynch 

V.  Hornby,  247  U.  S.  339 But  by  the  Act  of  1916  taxable 

dividends  were  limited  to  those  made  out  of  earnings  or  profits  ac- 
crued since  March  i,  1913.  And,  I  take  it,  whatever  claims  the  cor- 
poration had  upon  that  date,  whether  arising  from  profit  or  otherwise, 
are  to  be  considered  as  capital  then  accrued,  for  the  purposes  of  this 
act,  and  that  profit  since  accrued  means  after-acquired  gain,  which  did 
not  then  exist,  and  that  the  mere  fact  that  a  then  existing  claim,  even 
though  representing  a  profit,  was  afterwards  collected,  would  not 
make  it  a  profit  accrued  after  the  prescribed  date.  The  same  limitation 
was  carried  in  the  amendment  of  October  3,  1917,  and  substantially 
the  same  in  Section  201  of  the  Act  of  1918,  the  date  being  there 
changed  to  February  28,  1913.  Any  distribution  of  property  or 
money  accumulated  by  a  corporation  prior  to  March  i,  1913,  has  not 
been  taxable  as  income  at  any  time  since  the  enactment  of  the  Act 
of  September  8,  1916.  And  it  was  under  that  act  that  the  taxes  in 
question  were  imposed.  Therefore,  the  distribution  of  the  sum  realized 
from  the  compromise  of  the  chose  in  action  under  discussion  was  not 
a  dividend  taxable  as  income  unless  that  sum  can  be  regarded  as 
representing  profit  accrued  after  March  i,  1913. 

The  brief  filed  by  the  Government  rests  its  contention  upon  the 
proposition  that  when  a  dividend  is  declared  and  paid  by  a  corpora- 
tion such  dividend  is  presumed  to  have  been  paid  from  profits,  and  not 
from  capital,  and  that  if  the  value  of  the  capital  of  this  corporation, 
after  the  distribution  of  said  sum  of  $85,000,  was  equal  to  its  value 
of  March  i,  1913,  the  distribution  of  the  $85,000  was  a  distribution  of 
the  profits,  and  the  shares  received  by  the  plaintiffs  were  taxable  in- 
come. But  the  evidence  is  that  all,  or  practically  all,  of  the  profits 
that  accrued  to  this  corporation  between  March  i,  1913,  and  January 
1,  1917,  were  paid  out  in  other  dividends,  and  it  was  impossible  that 
this  $85,000  could  have  been  paid  out  of  earnings  on  hand.  The  cor- 
porate surplus  was  practically  exhausted  by  the  payment  of  such 
other  dividends  from  year  to  year.  Therefore,  the  presumption  upon 
which  the  argument  of  the  Government,  as  set  forth  in  the  brief,  rests, 
to-wit,  that  this  distribution  was  made  from  profits  accumulated 
within  the  taxable  period,  is  overcome  by  the  evidence.  The  fact  is 
that  this  asset,  which  had  accrued  and  existed  in  the  form  of  a  chose 


FROM    DIVIDENDS 


727 


in  action  at  and  long  prior  to  March  i,  1913,  was  on  November  i, 
1916,  realized  upon  and  distributed,  and  tlie  corporate  property  as  it 
stood  at  the  former  date  was  thereby  diniinisbed  accordingly.  There 
is  no  evidence  that  this  chose  in  action  was  of  any  greater  value  on 
the  latter  date  than  it  was  on  the  former.  Therefore,  as  this  distribu- 
tion was  not  out  of  profits  accrued  since  the  statutory  date,  it  was 
not  taxable  to  the  distributees  as  income. 

In  the  foregoing"  decision  the  court  upholds  the  conten- 
tions of  the  author  that  under  the  1916  and  subsec[uent  laws 
dividends  paid  out  of  capital  at  March  i,  19 13,  whether  on  the 
books  or  not,  were  not  taxable,  even  though  paid  prior  to 
January  i,  1921. 

Rentals  paid  to  stockholders. — In  a  recent  case'^  the  trustee 
in  bankruptcy  sought  to  deduct  from  the  bankrtipt's  gross  in- 
come as  an  expense  of  operation  certain  rentals  for  films  which 
the  Treasury  claimed  were  a  distribution  of  net  profits.  The 
bankrtipt  had  contracted  with  ten  manufacturers  of  moving 
picture  films,  each  originally  owning  one-tenth  of  the  bank- 
rupt's common  stock,  whereby  they  were  to  lease  to  it  their 
films  at  a  certain  sum  per  foot  plus  a  payment  at  the  end  of 
the  year,  which  payment  was  to  be  made  from  the  bankrupt's 
net  profits  during  the  year  in  excess  of  a  specified  dividend  on 
its  stock.  Since  this  additional  payment  was  based  entirely 
upon  the  amount  of  film  footage  each  lessor  had  furnished 
the  bankrupt  during  the  year  and  had  no  reference  to  the  stock- 
holdings, it  was  held  that  these  additional  payments  were  prop- 
erly deductible  as  additional  rent  and  did  not  constitute  an 
attempt  to  distribute  surplus  to  stockholders. 

Allocation  of  Dividends  to   Periods  When  Accumulated 

No  phase  of  the  subject  of  income  tax  has  demanded  so 
much  attention  as  the  determination  of  the  period  to  which 
dividend  payments  should  be  allocated.     Dividends,  for  pur- 


''  In  re  Ciencrul  Film  Corporation,  C.  C.  A.,  Second  Circuit,  274  Fed. 
903. 


;28  INCOME 

poses  of  allocation,  under  the  192 1  law  may  be  separated  into 
four  classes,  i.  c,  as  paid  from : 

1.  Earnings  accumulated  since  February  28,  191 3. 

2.  Earnings  accumulated  prior  to  March  i,  1913. 

3.  Appreciation  in  value  at  March  i,  191 3. 

4.  Capital. 

Law.     Section    201 (b)  For    the    purposes   of    this    Act 

every  distribution  is  made  out  of  earnings  or  profits,  and  from  the  most 
recently  accumulated  earnings  or  profits,  to  the  extent  of  such  earnings 
or  profits  accumulated  since  February  28,  1913;   .... 

The  following  section  of  the  192 1  law  is  a  re-enactment 
of  201  (e)  of  the  1918  law,  and  is  for  the  purpose  of  deter- 
mining invested  capital  only,  not  for  computing  income  taxes. 
It  loses  significance  with  the  repeal  of  the  excess  profits  tax. 

Law.  Section  201.  .  .  .  .  (f)  Any  distribution  made  during  the 
first  sixty  days  of  any  taxable  year  shall  be  deemed  to  have  been 
made  from  earnings  or  profits  accumulated  during  preceding  taxable 
years;  but  any  distribution  made  during  the  remainder  of  the  taxable 
year  shall  be  deemed  to  have  been  made  from  earnings  or  profits 
accumulated  betvireen  the  close  of  the  preceding  taxable  year  and  the 
date  of  distribution,  to  the  extent  of  such  earnings  or  profits,  and  if 
the  books  of  the  corporation  do  not  show  the  amount  of  such  earnings 
or  profits,  the  earnings  or  profits  for  the  accounting  period  within 
which  the  distribution  was  made  shall  be  deemed  to  have  been  ac- 
cumulated ratably  during  such  period.  This  subdivision  shall  not  be 
in  effect  after  December  31,  1921. 

The  general  regulation  covering  allocations  reads  in  tliis 
manner : 

Regulation,  (a)  For  the  purpose  of  income  taxation  every 
distribution  made  by  a  corporation  is  made  out  of  earnings  or  profits 
and  from  tlie  most  recently  accumulated  earnings  or  profits,  to  the 
extent  of   such   earnings   or   profits   accumulated   since   February   28, 

1913; 

{b)  Every  distribution  made  by  a  corporation  during  the  first 
60  days  of  a  taxable  year  shall  be  deemed  to  have  been  made  from 
earnings  or  profits  accumulated  during  tlie  preceding  taxable  years. 
Every  distribution  made  during  the  remainder  of  the  taxable  year 
after  the  first  60  days  shall  be  deemed  to  have  been  made  from  earn- 
ings or  profits  accumulated  during  the  taxable  year  up  to  the  date 
of  the  distribution  to  the  extent  of  such  earnings  or  profits.     The  pre- 


FROM   DIVIDENDS  729 

sumptions  contained  in  this  paragraph  affect  the  determination  of  in- 
vested capital  for  the  purpose  of  the  excess  profits  tax  and  are  not 
in  effect  after  December  31,  1921.  They  have  no  effect  upon  the 
rates  at  which  dividends  paid  in  1921  and  subsequent  years  are  taxed. 
In  ascertaining  v^aiether  or  not  a  distribution  was  made  out  of  earn- 
ings or  profits  of  the  taxable  year  there  should  first  be  set  aside  a 
proper  reserve  for  the  payment  of  accrued  income  and  excess  profits 
taxes.^'   .... 

In  the  case  of  a  personal  service  corporation  every  distribution  is 
made  out  of  earnings  or  profits  and  from  the  most  recently  accumu- 
lated earnings  or  profits,  to  the  extent  of  such  earnings  or  profits 
accumulated  since  February  28,  1913.  Such  a  distribution,  if  made 
during  the  first  60  days  of  a  taxable  year,  shall  be  deemed  to  have 
been  made  from  the  most  recently  accumulated  earnings  or  profits 
of  preceding  taxable  years,^*  and  if  made  during  the  remainder  of  the 
taxable  year  after  the  first  60  days,  from  earnings  or  profits  accumu- 
lated during  the  taxable  year  up  to  the  date  of  distribution  to  the  ex- 
tent of  such  earnings  or  profits.  The  presumption  contained  in  the 
preceding  sentence  is  not  in  effect  after  December  31,  1921.  As  stated 
in  article  1541  the  term  "dividend"  does  not  include  a  distribution 
made  by  a  personal  service  corporation  out  of  earnings  or  profits  ac- 
cumulated since  December  31,  1917,  and  prior  to  January  i,  1922. 
(Art.  1542.) 

The  Treasury  has  gone  to  considerable  length  in  explain- 
ing its  position  in  regard  to  the  manner  of  applying  the  rule 
laid  down  above.  Apparently  one  of  the  first  rulings  on  this 
subject  was  questioned  and  a  subsequent  ruling,  quoted  in  part 
below,  was  issued. 

Ruling.  The  word  "accumulated,"  as  used  in  the  phrase  "accu- 
mulated since  February  28,  1913,"  in  ruling  31-20-1098,  O.  D.  610, 
means,  in  the  judgment  of  the  Committee,  profits  which  have  been 
earned  and  not  dissipated  by  subsequent  losses.  While  it  is  recog- 
nized that  assets  can  not  be  earmarked  as  representing  earnings  of 
any  particular  year,  it  is  a  fair  assumption  that  the  earliest  surplus 
of  a  corporation  is  likely  to  be  represented  in  its  balance  sheet  by 
fixed  assets,  while  the  later  earnings  are  more  apt  to  be  represented 
by  liquid  assets.  Consequently  any  losses  sustained  in  a  given  year 
will  be  met  out  of  the  most  recent  earnings  embraced  in  its  surplus. 
It  follows  that  profits  of  any  year  can  not  be  diminished  by  prior 
losses,  but  it  is  fair  to  assume  that  such  earnings,  to  the  extent 
necessary,  will  go  to  satisfy  subsequent  losses.     There  is  no  obliga- 


'  See  Appendix  A,  Chapter  XI. 
See  page  733- 


7ZO 


INCOME 


tion  to  recognize  for  tax  purposes  the  surplus  of  March  i,  1913,  as 
capital  which  must  be  made  good  before  there  can  be  any  distribu- 
tion of  profits.     (C.  B.  3,  page  36;  A.  R.  M.  82.) 

In  the  detailed  ruling  the  following  illustration  is  given: 

Earnings  Losses  Surplus 

Mar.  I  to  Dec.  Jan.  1/14  to  Dec.               Mar.  1/13  .$100,000 

31/13    $10,000       31^16   $25,000  Dec.  31/13.   110,000 

Jan.    I    to    Dec.  Dec.  31/16.     85,000 

31/17   15,000  Jan.    I    to    Dec.                Dec.  31/17.    100,000 

Jan.    I   to   Dec.                   31/18  10,000  Dec.  31/18.     90,C|po 

31/19    5,000  Dec.  31/19.     95,000 

Jan.  1/20  to  date 

of  dividend..    15,000  Dividend,  1920. $25,000 

The  most  recent  loss  shown  is  that  of  1918.  This,  of  course, 
was  met  out  of  earlier  earnings  and  the  corporation  must  have  on 
hand  at  the  present  time  the  $5,000  earned  in  1919  as  well  as  the 
$15,000  earned  in  the  current  year.  Of  the  $15,000  earned  in  1917, 
$10,000  was  lost  in  1918,  leaving  it  with  $5,000  earnings  of  1917 
still  on  hand.  The  $15,000  of  1920  earnings,  together  with  the 
$5,000  of  1919  earnings  and  the  $5,000,  remaining  of  1917  earnings 
covers  the  dividend  of  $25,000,  showing  that  all  of  the  dividend 
was  paid  out  of  earnings  accumulated  since  March  i,  1913,  not- 
withstanding the  fact  that  the  company's  surplus  on  December  31, 
1919,  was  $5,000  less  than  it  was  on  March  i,  1913.  From  this  it 
might  be  argued  that  necessarily,  since  its  surplus  on  December 
31,  1919,  was  less  than  that  of  March  i,  1913,  any  distribution  in 
excess  of  the  earnings  of  1920  must  have  come  out  of  the  March  i 
surplus.  This,  however,  is  a  fallacy  since  there  is  no  obligation  to 
recognize  for  tax  purposes  the  surplus  of  March  i,  1913,  as  capital 
which  must  be  made  good  before  there  can  be  any  distribution  of 
profits 

A  corporation  with  a  surplus  of  $100,000  on  March  i, 
1913,  might  have  losses  in  alternate  years  up  to  1923  aggre- 
gating $100,000  and  profits  in  other  years  (all  paid  out  in 
dividends)  aggregating  the  same  amount.  The  effect  of  the 
ruling  would  be  that  on  January  i,  1923,  it  would  have  no 
surplus.  The  surplus  at  March  i,  1913,  which  was  supposed 
to  be  free  from  tax,  would  in  effect  all  have  been  taxed, 
although  the  dividends  paid  exactly  exhausted  that  surplus. 

If  no  dividends  were  paid,  the  corporation  on  January  i, 


I 


FROM    DIVIDENDS  73 1 

1923,  would  have  a  surplus  of  $100,000,  all  of  which  would 
be  deemed  to  have  been  earned  after  March  i,  19 13. 

The  foregoing  ruling  is  seriously  questioned  in  the  follow- 
ing :'' 

In  the  supposititious  case  a  corporation  was  in  possession  of  a 
surplus  of  say  $100,000,  March  i,  1913.  During  the  period  ended 
December  31,  1919,  it  sustained  a  net  loss  of  $5,000,  thereby  reducing 
its  surplus  to  $95,000.  It  declared  a  dividend  of  $25,000  some  time 
in  1920,  during  which  year  and  up  to  date  of  which  declaration 
its  earnings  are  supposed  to  have  been  $15,000.  Hence,  under  the 
most  limited  interpretation  the  corporation  must  have  paid  its  divi- 
dend out  of  the  $15,000  earned  in  1920,  and  $10,000  out  of  its  sur- 
plus earnings  of  March  i,  1913. 

The  department  has  ruled  that  because  the  corporation  earned, 
say,  $5,000  in  1919  and  $15,000  in  1920,  only  $5,000  of  the  $25,000 
dividend  could  be  considered  to  have  been  paid  out  of  the  surplus  of 
March  i,  1913.  Truly  a  remarkable  decision  reached  by  a  unique 
method  of  reasoning. 

In  the  foregoing  ruling  the  Treasury  declines  to  recognize 
surplus  at  March  i,  1913,  as  capital,  but  in  the  following  ruling 
dividends  paid  during  the  first  60  days  of  19 18,  which  under 
the  law  should  have  been  applied  first  to  earnings  accumulated 
during  preceding  taxable  years  (note  the  plural),  were  taxed 
at  the  1918  rates,  on  the  ground  that  the  years  prior  to  1913 
were  not  taxable  years. 

In  the  latter  case  surplus  at  March  i,  1913,  is  treated  as 
capital.  In  the  former  case  the  surplus  at  March  i,  191 3,  is 
treated  as  if  it  were  taxable  earnings.  The  rulings  are  not 
consistent  and  one  of  them  must  be  erroneous.  The  author  is 
of  the  opinion  that  the  following  ruling  is  sound  and  the  one 
on  page  729  is  unsoimd. 

Ruling.  Where  a  corporation  has  profits  accumulated  prior  to 
March  i,  1913,  but  none  accumulated  between  that  date  and  January 
I,  1918,  and  pays  dividends  during  the  first  60  days  of  1918,  such 
dividends  will  be  deemed  to  have  been  paid  from  earnings  or  profits 
accumulated   after   December   31,    1917.      (C.    B.    i,    page    26;    T.    B. 

R.  43.) 


"Journal  of  Accountancy,  Income  Tax  Department,  November,  1920. 


7-:;2  INCOME 

The  definition  of  the  word  "accumulated"  in  A.  R.  M.  82 
merely  states  that  it  means  "profits  which  have  been  earned 
and  not  dissipated."  The  definition  is  not  in  accord  with  the 
ordinary  meaning  of  the  two  words. 

Effect  of  stock  dividend  on  surplus  at  March  i,  19 13. — 

Ruling.  A  corporation  having  a  surplus  accumulated  in  part 
prior  and  the  remainder  subsequent  to  March  i,  1913,  transfers  to  its 
capital  account  a  portion  of  its  surplus  and  issues  new  stock  repre- 
senting the  amount  transferred,  then  declares  a  dividend  payable 
partly  in  cash  and  partly  in  shares  of  the  new  issue,  allocating  the  cash 
dividend  to  the  period  prior  to  March  i,  1913,  and  the  stock  issue 
to  the  period  subsequent  thereto. 

Held,  in  view  of  section  201  of  the  Revenue  Act  of  1918,  which 
provides  that  a  distribution  whether  paid  in  cash  or  in  other  prop- 
erty is  not  a  dividend  for  income  tax  purposes  unless  representing 
earnings  accumulated  since  February  28,  1913,  and  the  decision  of 
the  Supreme  Court  in  Eisner  v.  Macomber,  that  a  stock  dividend 
issued  as  a  result  of  the  transfer  of  earnings  accumulated  subsequent 
to  February  28,  1913,  to  capital  account  or  other  bookkeeping  pro- 
cedure equivalent  thereto,  is  not  a  distribution  which  is  taxable  under 
the  Revenue  Act  of  1918,  or  previous  income  tax  statutes,  that  the 
portion  of  the  dividend  which  is  paid  in  cash  will  be  deemed  to  have 
been  paid  out  of  surplus  accumulated  since  February  28,  1913,  to 
the  extent  of  the  earnings  and  profits  accumulated  since  that  date 
and  subject  to  tax,  while  that  portion  of  the  dividend  which  is  paid 
in  stock  will  not  be  taxable  as  income.  (Also  arts.  1542  and  1545.) 
(C.B.  3,  page  2350.0.587.) 

The  foregoing  ruling  is  believed  to  accord  with  good  ac- 
counting practice. 

All  cash  dividends  received  after  January  1,  1918,  taxable 
at  rates  in  force  in  period  when  received."® — Under  both  the 
1918  and  1921  laws,  all  dividends  (except  stock  dividends) 
are  taxable  to  the  recipients  as  income  at  the  rates  in  force  for 
the  period  during  which  the  dividends  are  received,  e.g.,  all 
cash  dividends  received  in  1921  are  taxable  at  1921  surtax 
rates,  and  those  received  during  1922  at  1922  rates. ^^ 


■°  For  former  procedure  as  to  all  dividends  taxable  at  rates  of  former 
years,  see  Income  Tax  Procedure,  1920,  pages  485-487. 

"Section  211  (a-2).  For  discussion  regarding  taxability  of  dividends 
on  the  basis  of  the  year  in  which  earned,  see  Income  Tax  Procedure,  1920, 
page  485,  and  Income  Tax  Procedure,  1921,  page  575. 


FROM   DIVIDENDS 


733 


Status  of  dividends  received  during  first  sixty  days  of  tax- 
able year. — To  clear  up  the  difficulty  of  determining  the  period 
to  which  dividends  should  be  charged  for  the  purposes  of  the 
excess  profits  tax  law,  it  has  been  arbitrarily  decided  that  all 
dividends  paid  within  sixty  days  after  the  close  of  a  taxable 
year  shall  be  assumed  to  have  been  declared  out  of  earnings 
which  accumulated  during  preceding  taxable  years.  If  a  tax- 
able year  ended  December  31,  1920,  any  dividend  paid  (no  mat- 
ter when  declared)  between  January  i,  and  March  i,  1921 
(both  inclusive)  would  be  deemed  to  have  been  out  of  the  earn- 
ings which  accumulated  prior  to  January  i,  1921.^*  The 
amount  of  such  dividend  thereupon  decreases  the  invested 
capital  of  the  corporation  from  and  after  the  date  of  payment. 

If  paid  after  March  i  the  dividend  will  be  deemed  to  have 
been  paid  out  of  192 1  earnings  (to  the  extent  of  the  earnings 
from  January  i  to  date  of  dividend  payment),  and  the  invested 
capital  as  of  January  i,  192 1,  will  not  be  decreased  thereby. 
Like  many  other  provisions  which  affect  the  excess  profits  tax, 
the  rule  in  most  cases  works  out  fairly.  The  next  dividend 
date  after  March  i  is  usually  April  i. 

By  April  i  there  is  usually  opportunity  to  accumulate  suf- 
ficient funds  to  pay  the  dividend  of  that  date  out  of  current 
earnings.  But  in  very  many  cases  dividends  paid  long  after 
April  I  are  deemed  by  the  directors  to  be  out  of  earnings  of 
the  previous  calendar  year. 

As  construed  by  the  regulations  in  the  case  of  ordinary 
corporations,  the  provision  has  no  bearing  on  anything  other 
than  tlie  excess  profits  tax,  and  consequently  its  consideration 
will  be  of  no  importance  in  making  returns  for  calendar  years 
ending  after  December  31,  1921. 

Sixty-day  clause  has  no  reference  to  rates. ^'-^ — - 

Ruling.  Cash  dividends  received  during  the  first  60  days  of 
1918  are  taxable  at  191S  rates.     (C.  B.  2,  page  25;  A.  R.  R.  127.) 


""See  ruling  and  conunent,  .appendix  A,  Chapter  XI. 
"For   discussion   of   this   question,  see  Income   Tax  Procedure,   1920, 
pages  461-2. 


734 


INCOMK 


Cash  dividends  received  during  the  first  sixty  days  of  1921 
and  subsequent  years  are  taxable  at  the  rates  of  the  years  in 
which  received   (article  1542). 

Local  Taxes  Paid  on  Bank  Stocks  No  Longer  Equivalent 

of  Dividends 

In  addition  to  the  cash  dividends  received  from  banks,  the 
owners  of  some  bank  stocks  have  local  taxes  paid  for  their 
account  by  the  banks.  The  amount  of  such  payments  is  deduc- 
tible by  the  bank*°  and  does  not  form  constructive  income  to 
the  stockholder,*^ 

Salaries  in  Excess  of  Reasonable  or  Necessary 
Allowances  to  be  Treated  as  Dividends 

As  to  the  treatment  of  amounts  ostensibly  paid  as  com- 
pensation, the  Treasury  has  issued  the  following  regulation. 

Regulation (i)   In  the  case  of  excessive  payments  by 

corporations,  if  such  payments  correspond  or  bear  a  close  relationship 
to  stock  holdings,  the  amount  of  the  excess  should  be  treated  as  divi- 
dends and  would  thus  be  exempt  from  the  normal  tax  in  the  hands 
of  the  recipients (Art.  106.) 

Before  the  foregoing  regulation  can  be  applied,  salaries 
must  be  found  to  be  excessive.  For  a  full  discussion  of  salary 
allowances,  see  Chapter  XXVI. 

Dividends  Paid  Otherwise  Than  in  Cash 

Regulation.  Dividends  paid  in  securities  or  other  property 
(other  than  its  own  stock),  in  which  the  earnings  of  a  corporation 
have  been  invested,  are  income  to  the  recipients  to  the  amount  of  the 
market  value  of  such  property  when  receivable  by  the  stock- 
holders       (Art.  1547.  Reg.  45,  Art.  1544.) 

Most  dividends  are  paid  in  cash  or  in  stock,  but  occasion- 
ally distributions  are  made  in  some  other  form.    When  a  divi- 


*"  Section  234  Ca-3). 

"Section  214  (a-3-d). 

[Former  Procedure]  Under  the  1918  and  prior  laws,  taxes  assessed 
on  stockholdings  and  paid  by  banks  on  behalf  of  their  stockholders,  were 
considered  as  additional  dividend  to  such  stockholders,  the  latter  in  turn 
entering  the  taxes  as  a  deduction  in  their  personal  returns. 


FROM    DIVIDENDS 


735 


dend  other  than  cash  or  stock  is  received,  it  should  be  returned 
for  taxation  at  its  cash  value.  If  its  equivalent  cash  value 
cannot  be  ascertained  at  time  of  receipt  it  should  be  returned 
when  and  if  cash  value  can  be  determined. 

In  the  foregoing  regulation  no  mention  is  made  of  any 
restriction  upon  the  credit  which  may  be  taken  for  the  normal 
tax.  The  law  defines  a  dividend  to  be  "any  distribution  made 
by  a  corporation  ....  out  of  its  earnings  or  profits."*^  In 
one  section  of  the  1918  law  there  is  an  indication  that  the 
credit  for  the  normal  tax  is  based  upon  and  limited  to  the 
earnings  or  profits  upon  which  income  tax  has  been  imposed.''' 
It  is  logical  and  proper  that  a  taxpayer  should  only  receive 
credit  for  the  normal  tax  upon  an  amount  equal  to  the  earnings 
which  have  paid  the  tax. 

In  the  1 92 1  law,  dividends  from  foreign  corporations  de- 
riving 50  per  cent  or  more  of  their  gross  income  from  outside 
the  United  States  may  not  be  credited  for  normal  tax. 

The  courts  have  drawn  a  very  fine  distinction  between  divi- 
dends which  are  in  final  liquidation  and  those  which  are  "recur- 
ring" or  which  leave  the  capital  intact.  In  1921  the  Supreme 
Court  of  the  United  States  decided  several  cases  which  must  be 
deemed  to  be  conclusive  of  these  factors.^* 

When  a  dividend  is  paid  in  the  stock  of  other  companies, 
or  in  property,  which  has  a  fair  market  value,  or  a  read- 
ily realizable  value,  and  when  the  capital  stock  of  the  paying 
corporation  remains  unimpaired,  the  dividends  are  taxable  as 
ordinary  cash  dividends. 

The  foregoing  principles  were  affirmed  in  the  cases  of 
United  States  v.  Rockefeller,^^  New  York  Trust  Company, 
et  al.  V.  Edwards, ^'^  and  United  States  v.  Phellis.*''     In  these 


"Section  201   (a). 

"Section  216  (a),  1918  law. 

**  Lynch  v.  Turrish,  247  U.  S.  221 ;  38  S.  Ct.  537;  62  L.  Ed.  1087;  Lynch 
V.  Hornby,  247  U.  S.  339;  38  S.  Ct.  543;  62  L.  Ed.  1149;  Brushaber  v.  Union 
Pac.  Ry.  Co.,  240  U.  S.  i ;  36  S.  Ct.  236;  60  L.  Ed.  493. 

"274  Fed.  952;  affirmed  November  21,  IQ21  ;  advance  opinions,  66 
r..  Ed.  74- 

"274  Fed.  952;  affirmed;  advance  opinions,  66  L.  Ed.  74. 

'■  U.  S.  V.  Fhellis.  advance  ()i)inions,  06  L.  Ed.  69  (N<)vem1)or  21.  1921). 


736 


INCOME 


cases  dividends  were  paid  in  the  stock  of  a  pipe  line  company 
and  in  the  stocks  and  securities  of  a  powder  company.  In  each 
case  the  securities  had  a  known  and  reahzable  market  value, 
and  in  each  case  the  capital  of  the  paying  companies  was  unim- 
paired by  the  distributions.  In  other  words,  the  court  held 
that  the  dividends  were  paid  from  surplus.  In  each  case  values 
at  March  i,  191 3,  were  taken  into  consideration. 
The  court  said  in  the  Rockefeller  case : 

Decision The  facts  are  in  all  essentials  indistinguish- 
able from  those  presented  in  United  States  v.  PhelUs,  decided  this  day. 
In  these  cases  as  in  that,  regarding  the  general  effect  of  the  entire 
transactions  resulting  from  the  combined  action  of  the  mass  of  stock- 
holders, there  was  apparently  little  but  a  reorganization  and  financial 
readjustment  of  the  affairs  of  the  companies  concerned,  here  a  sub- 
division of  companies,  without  immediate  effect  upon  the  personnel 
of  the  stockholders,  or  much  difference  in  the  aggregate  corporate 
activities  or  properties.  As  in  the  Phellis  case,  the  adoption  of  the 
new  arrangement  did  not  of  itself  produce  any  increase  of  wealth 
to  the  stockholders,  since  whatever  was  gained  by  each  in  the  value 
of  his  new  pipe  line  stock  was  at  the  same  moment  withdrawn  through 
a  corresponding  diminution  of  the  value  of  his  oil  stock.  Nevertheless 
the  new  stock  represented  assets  of  the  oil  companies  standing  in 
the  place  of  the  pipe  line  properties  that  before  had  constituted  por- 
tions of  their  surplus  assets,  and  it  was  capable  of  division  among 
stockholders  as  the  pipe  line  properties  were  not.  The  distribution, 
whatever  its  effect  upon  the  aggregate  interests  of  the  mass  of  stock- 
holders, constituted  in  the  case  of  each  individual  a  gain  in  the  form 
of  actual  exchangeable  assets  transferred  to  him  from  the  oil  com- 
pany for  his  separate  use  in  partial  realization  of  his  former  indi- 
visible and  contingent  interest  in  the  corporate  surplus.  It  was  in 
substance  and  effect,  not  merely  in  form,  a  dividend  of  profits  by 
the  corporation,  and  individual  income  to  the  stockholder 

In  the  Phellis  case  the  court  said  : 

Decision After  the  reorganization  and  the  distribution 

of  the  stock  of  the  Delaware  corporation,  the  New  Jersey  corporation 
continued  as  a  going  concern,  and  still  exists,  but  except  for  the  re- 
demption of  its  outstanding  bonds,  the  exchange  of  debenture  stock 
for  its  preferred  stock,  and  the  holding  of  debenture  stock  to  an 
amount  equivalent  to  its  own  outstanding  common  and  the  'collection 
and  disposition  of  dividends  thereon,  it  has  done  no  business.  It  is 
not,  however,  in  process  of  liquidation 

Upon  the  face  of  things,  however,  the  transfer  of  the  old  com- 


I 


FROM    DIVIDENDS 


737 


pany's  assets  to  the  new  company  in  exchange  for  the  securities  issued 
by  the  latter,  and  the  distribution  of  those  securities  by  the  old  com- 
pany among  its  stockholders,  changed  the  former  situation  materially. 
The  common  stock  of  the  new  company,  after  its  transfer  to  the  old 
company  and  prior  to  its  distribution,  constituted  assets  of  the  old 
company  which  it  now  held  to  represent  its  surplus  of  accumulated 
profits — still,  however,  a  common  fund  in  which  the  individual  stock- 
holders of  the  old  company  had  no  separate  interest.  But  when  this 
common  stock  was  distributed  among  the  common  stockholders  of  the 
old  company  as  a  dividend,  then  at  once — unless  the  two  companies 
must  be  regarded  as  substantially  identical — the  individual  stock- 
holders of  the  old  company,  including  claimant,  received  assets  of 
exchangeable  and  actual  value  severed  from  their  capital  interest  in 
the  old  company,  proceeding  from  it  as  the  result  of  a  division  of 
former  corporate  profits,  and  drawn  by  them  severally  for  their  in- 
dividual and  separate  use  and  benefit.  Such  a  gain  resulting  from 
their  ownership  of  stock  in  the  old  company  and  proceeding  from  it 
constituted  individual  income  in  the  proper  sense 

There  is  more  force  in  the  suggestion  that,  looking  through  and 
through  the  entire  transaction  out  of  which  the  distribution  came, 
it  was  but  a  financial  reorganization  of  the  business  as  it  stood  be- 
fore, without  diminution  of  the  aggregate  assets  or  change  in  the 
general  corporate  objects  and  purposes,  without  change  of  personnel 
either  in  officers  or  stockholders,  or  change  in  the  proportionate  in- 
terest of  any  individual  stockholder.  The  argument,  in  effect,  is  that 
there  was  no  loss  of  essential  identity  on  the  part  of  the  company, 
only  a  change  of  the  legal  habiliments  in  which  the  aggregate  corpor- 
ate interests  were  clothed,  no  substantial  realization  by  individual 
stockholders  out  of  the  previous  accumulation  of  corporate  profits, 
merely  a  distribution  of  additional  certificates  indicating  an  increase 
in  the  value  of  their  capital  holdings.  This  brings  into  view  the  gen- 
eral effect  of  the  combined  action  of  the  entire  body  of  stockholders 
as  a  mass. 

In  such  matters,  what  was  done,  rather  than  the  design  and  pur- 
pose of  the  participants,  should  be  the  test.  However,  in  this  case 
there  is  no  difference.  The  proposed  plan  was  set  out  in  a  written 
communication  from  the  president  of  the  New  Jersey  corporation  to 
the  stockholders,  a  written  assent  signed  by  about  90  per  cent  of  the 
stockholders,  a  written  agreement  made  between  the  old  company 
and  the  new,  and  a  bill  of  sale  made  by  the  former  to  the  latter,  all 
of  which  are  in  the  findings.  The  plan  as  thus  proposed  and  adopted, 
and  as  carried  out,  involved  the  formation  of  a  nezv  corporation*^ 
to  take  over  the  business  and  the  business  assets  of  the  old;  it  was 
to  be  and  was  formed  under  the  laws  of  a  different  State,  which  nec- 


'  The  italics  here  and  those  later  on  are  the  court's. 


738 


INCOME 


essarily  imports  a  dittereiit  measure  of  responsibility  tu  the  public, 
and  presumably  different  rights  between  stockholders  and  company 
and  between  stockholders  inter  sese,  than  before.  The  articles  of  as- 
sociation of  neither  company  is  made  to  appear,  but  in  favor  of  the 
asserted  identity  between  the  companies  we  will  assume  (contrary  to 
the  probabilities)  that  there  was  no  significant  difference  here.  But 
the  new  company  was  to  have  authorized  capital  stock  aggregating 
$240,000,000 — nearly  four  times  the  aggregate  stock  issues  and  funded 
debt  of  the  old  company — of  which  less  than  one-half  ($118,515,900) 
was  to  be  issued  presently  to  the  old  company  or  its  stockholders, 
leaving  the  future  disposition  of  a  majority  of  the  authorized  new 
issues  still  to  be  determined.  There  was  no  present  change  of  officers 
or  stockholders,  but  manifestly  a  continuation  of  identity  in  this 
respect  depended  upon  continued  unanimous  consent  or  concurrent 
action  of  a  multitude  of  individual  stockholders  actuated  by  motives 
and  influences  necessarily  to  some  extent  divergent.  In  the  light  of 
all  this  we  can  not  regard  the  new  company  as  virtually  identical  with 
the  old,  but  must  treat  it  as  a  substantial  corporate  body  with  its  own 
separate  identity,  and  its  stockholders  as  having  property  rights  and 
interests  materially  different  from  those  incident  to  ownership  of 
stock  in  the  old  company. 

The  findings  show  that  it  was  intended  to  be  established  as  such, 
and  that  it  was  so  created  in  fact  and  in  law.  There  is  nothing  to 
warrant  us  in  treating  this  separateness  as  imaginary,  unless  the 
identity  of  the  body  of  stockholders  and  the  transfer  in  solido  of  the 
manufacturing  business  and  assets  from  the  old  company  to  the  new 
necessarily  have  that  effect.  But  the  identity  of  stockholders  was 
but  a  temporary  condition,  subject  to  change  at  any  moment  at  the 
option  of  any  individual.  As  to  the  assets,  the  very  fact  of  their 
transfer  from  one  company  to  the  other  evidenced  the  actual  separate- 
ness of  the  two  companies 

....  There  was  neither  express  nor  implied  condition,  arising 
out  of  the  plan  of  reorganization  or  otherwise,  to  prevent  any  stock- 
holder from  selling  it;  and  he  could  sell  his  entire  portion  or  any  of  it 
without  parting  with  his  capital  interest  in  the  parent  company,  or 
affecting  his  proportionate  relation  to  the  interests  of  other 
stockholders.  Whether  he  sold  the  new  stock  for  money  or  retained 
it  in  preference,  in  either  case  when  he  received  it  he  received  as  his 
separate  property  a  part  of  the  accumulated  profits  of  the  old  com- 
pany in  which  previously  he  had  only  a  potential  and  contingent  in- 
terest. 

It  thus  appears  that  in  substance  and  fact,  as  well  as  in  appearance, 
the  dividend  received  by  claimant  was  a  gain,  a  profit  derived  from 
his  capital  interest  in  the  old  company,  not  in  liquidation  of  the 
capital  but  in  distribution  of  accumulated  profits  of  the  company; 
something  of  exchangeable  value  produced  by  and  proceeding  from 


FROM    DIVIDENDS  739 

his  investment  therein,  severed  from  it  and  drawn  by  him  for  his  sep- 
arate use.  Hence  it  constituted  individual  income  within  the  meaning  of 
the  income  tax  law,  as  clearly  as  was  the  case  in  Peabody  v.  Eisner, 
247  U.  S.  347 

The  court  failed  to  state  in  the  foregoing  cases  what  its 
decision  would  have  been  if  any  one  of  the  old  companies  had 
distributed  all  or  part  of  their  capital.  Inferentially  the  use  of 
italics  would  justify  an  inference  that,  if  the  capital  of  the 
old  companies  had  been  distributed,  the  substance  of  the  trans- 
actions would  have  been  that  the  stockholders  received  noth- 
ing in  the  way  of  taxable  income,  provided  that  the  new 
securities  were  ratably  issued  to  the  old  stockholders  who  there- 
after merely  owned  what  they  had  owned  before  the  distribu- 
tion and  that  there  was  a  change  in  form  only.  In  the  Phellis 
case  the  court  said  : 

Decision We    recognize    the    importance    of    regarding 

matters  of  substance  and  disregarding  forms  in  applying  the  provisions 
of  the  Sixteenth  Amendment  and  income  tax  laws  enacted  thereunder. 
In  a  number  of  cases  besides  those  just  cited  we  have  under  varying 
conditions  followed  the  rule.  Lynch  v.  Ttirrhh,  247  U.  S.  221 ;  South- 
ern Pacific  Co.  v.  Loive,  247  U.  S.  330 ;  Gulf  Oil  Corporation  v. 
Lezvellyn,  248  U.  S.  71. 

It  would  appear,  therefore,  that  the  court  regarded  the 
unimpairment  of  the  capital  of  the  old  companies  as  a  factor 
of  substance.  • 

Dividends  paid  in  stock  of  another  corporation.— 

Regulation A  dividend  paid  in  stock  of  another  corpo- 
ration is  not  a  stock  dividend,  even  though  the  stock  distributed  was 
acquired  through  the  transfer  by  the  corporation  declaring  the  divi- 
dend, of  property  to  the  corporation  the  stock  of  which  is  distributed 
as  a  dividend.  Where  a  corporation  declares  a  dividend  pay- 
able in  stock  of  another  corporation,  setting  aside  the  stock  to  be  so 
distributed  and  notifying  the  stockholders  of  its  action,  the  income 
arising  to  the  recipients  of  such  stock  is  its  market  value  at  the  time 

the  dividend  becomes  payable '*''     (Art.   1547.   Reg.  45,  Art. 

1 544-) 

*•  See  Art.  53.  .  , 


740  INCOME 

It  will  be  noted  that  the  rule  of  a  "market  value"  is  reiter- 
ated ill  this  regulation. 

A  dividend  paid  in  the  stock  of  another  corporation  is 
treated  as  a  cash  dividend  if  the  readily  realizable  market 
value  can  be  determined.  In  such  case  the  credit  for  the  nor- 
mal tax  may  be  taken. 

Dividends  paid  in  Liberty  bonds  and  other  government 
securities. — Many  corporations  have  paid  dividends  in  the  form 
of  United  States  bonds. ^°  Some  stockholders  formed  the 
opinion  that,  because  the  income  from  the  3^  per  cent  Liberty 
bonds  was  entirely  tax-free,  no  tax  would  accrue  to  income 
received  in  the  form  of  the  bonds  themselves.  This  view,  of 
course,  was  erroneous  because  the  tax  is  assessed  against  the 
receipt  of  the  dividend  and,  so  long  as  the  dividend  is  received 
in  cash  or  its  equivalent,  the  tax  should  be  levied.  The  case 
is  precisely  the  same  as  if  the  corporation  declared  the  dividend 
in  cash  and  the  stockholder  purchased  tax-free  securities  with 
the  proceeds. ^^  When  Liberty  bonds  are  selling  at  a  discount, 
the  tax  can  be  assessed  only  on  the  cash  value  of  the  dividend." 

Regulation Although  interest  on  State  bonds  and  cer- 
tain other  obligations  is  not  taxable  when  received  by  a  corporation, 
upon  amalgamation  with  the  other  funds  of  the  corporation  such  in- 
come loses  its  identity  and  when  distributed  to  stockholders  in  divi- 
dends is  taxable  to  the  same  extent  as  other  dividencis (Art. 

1541-) 

On  its  face  it  would  appear  that  it  is  inequitable  to  assess 
stockholders  for  surtaxes  on  dividends  which  can  be  identified 
as  having  been  paid  out  of  funds  derived  from  tax-free  se- 
curities. As  owners  of  the  corporation  the  stockholders  in 
effect  own  the  tax-free  securities  and  in  theory  should  pay  no 
tax  whatever  on  the  income  therefrom.     But  the  fact  that  the 


'"  For  opinion  of  the  Attorney  General  of  the  United  States  on  the 
taxability  of  dividends  paid  in  tax-exempt  bonds,  see  Income  Tax  Pro- 
cedure, 1918,  pages  154-156. 

"  Conversely,  the  corporation  is  permitted  to  take  the  loss.  (C.  B.  4. 
page  27;  A.  R.'R.  435.) 

""  Letter  from  Deputy  Commissioner  L.  F.  Speer,  November  12,  1918, 
and  Art.  1547. 


FROM    DIVIDENDS  74 1 

corporation  and  its  stockholders  are  separate  entities  prevents 
the  practical  application  of  the  theory.  If  the  directors  of  a 
corporation  desire  its  stockholders  to  receive  the  benefit  of 
the  exemption  it  will  be  necessary  first  to  distribute  the  se- 
ctffities  to  the  stockholders.  After  the  distribution  to  indi- 
vidual stockholders  the  income  will  be  entirely  free  from, 
taxation. 

Dividends  paid  in  bonds  which  sell  at  a  considerable  dis- 
count should  be  entered  by  the  recipients  at  the  market  value 
of  the  securities  received.  If  the  securities  are  subsequently 
sold  at  a  lower  price,  credit  may  be  claimed  for  the  loss  sus- 
tained. If  sold  at  a  higher  price,  the  profit  realized  should  be 
reported. 

Dividends  other  than  in  cash  are  not  closed  and  completed 
transactions  when  the  property  received  has  no  '"readily  realiz- 
able market  value."  But  the  rule  is  of  slight  significance  in 
the  case  of  government  bonds  which  are  so  nearly  the  equiva- 
lent of  cash  that  fluctuations  which  may  be  only  temporary  can 
be  disregarded. 

Dividends  paid  in  debenture  bonds. — In  ruling  that  divi- 
dends paid  in  debenture  bonds  were  taxable,  the  court  said : 

Decision.  The  plaintiffs  received  an  actual  payment  (in  the 
form  of  securities  available  for  disposition  in  the  market  and  en- 
tirely severed  or  distinguished  from  their  control  of  the  property  as 
stockholders)  of  profits  which  the  company  wished  to  distribute  as 
earnings  to  its  stockholders "'■■ 

Scrip  dividends. — 

Regulation Scrip  dividends  are  subject  to  tax  in  the  year 

in  which  the  warrants  are  issued.      (Art.  1547.     Reg.  45,  Art.  1544.) 

The  rule  of  readily  realizable  market  value  is  to  be  applied 
in  this  case  also. 

As  scrip  dividends  are  issued  only  by  corporations  unable 


'^^  Docrschuck  v.  [J.  S..  and  'riioinus  v.  U.  S.,  274  Fed.  739,  U.  S.  Dist. 
Ct.,  East.  Dist.  of  N.  Y.,  March  17,  1921. 


742  INCOME 

to  pay  cash,  the  vahiation  of  such  scrip  for  tax  purposes  should 
be  carefully  considered. 

Of  course,  if  the  scrip-  runs  for  a  comparatively  short 
period,  as  one  or  two  years,  if  the  rate  of  interest  it  bears  is 
high  enough  and  if  the  credit  of  the  issuing  corporation  is 
good  enough,  then  the  recipient  of  the  dividend  might  prop- 
erly treat  the  scrip  as  a  receipt  of  cash  and  return  it  accord- 
ingly. This,  however,  assumes  that  his  books  are  kept  on  an 
accrual  basis ;  otherwise  when  the  scrip  is  redeemed  in  cash  he 
may  include  it  again. 

For  a  person  reporting  on  the  basis  of  cash  receipts,  the 
safer  method  in  the  case  of  receipt  of  scrip  of  doubtful  char- 
acter or  which  has  no  active  market  would  seem  to  be  to  wait 
until  something  more  substantial  is  received  than  a  "scrap  of 
paper." 

In  the  following  ruling  the  principle  of  readily  realizable 
market  value  and  the  equivalent  of  cash  seems  to  be  ignored : 

Ruling.  The  M  Insurance  Company  issues  certificates  of  profit 
based  upon  premiums  received  on  marked-off  risks  of  the  previous 
year.  These  certificates  mature  in  six  years  and  are  subject  to  the 
future  losses  and  expenses  of  the  company  until  redeemed  and  may 
be  reduced  by  the  board  of  trustees  in  the  case  of  losses  and  ex- 
penses in  any  subsequent  year  exceeding  the  estimated  profits  of  that 
year.  Interest  is  payable  annually  upon  the  face  value  of  the  cer- 
tificates. 

Held,  that  the  certificates  are  in  the  nature  of  scrip  dividends 
in  accordance  with  article  1544  of  Regulations  45,  and  are  taxable 
at  the  rate  for  the  year  in  which  declared  or  issued  to  the  extent 
that  they  represent  undistributed  earnings  or  accumulated  profits. 
Inasmuch  as  they  are  affected  by  the  gains  or  losses  of  the  company 
during  their  maturing  period,  the  amount  of  such  gain  or  loss  should 
be  accounted  for  in  the  taxable  year  in  which  the  certificates  mature 
or  are  redeemed. 

The  amount  of  interest  annually  payable  on  these  certificates  is 
taxable  income  for  the  vear  in  which  it  is  received.  (C.  B.  3,  page  37; 
O.  D.  589.) 

If  the  certificates  mentioned  above  are  readily  convertible 
into  cash  the  market  or  discounted  value  thereof  would  seem 
to  be  the  proper  basis  of  the  return. 


FROM    DIVIDENDS 


Part  of  stock  dividend  paid  in  scrip. — 


743 


Ruling.  A  corporation  declared  a  dividend  payable  in  stock  of 
the  company  at  par  and  in  making  the  distribution  of  fractions  of 
shares  issued  scrip  certificates.  These  scrip  certificates  at  the  option  of 
the  stockholders  were  sold  by  the  corporation  as  agent  for  the  stock- 
holders. 

Held,  that  the  scrip  certificates  do  not  represent  a  cash  dividend 
but  a  stock  dividend  and  are  therefore  not  subject  to  tax.  (C.  B.  4, 
page  24;  O.  D.  859.) 

The  profit  on  the  scrip  certificates  sold  would  have  to  be 
computed  as  in  the  case  of  any  other  stock  dividends.^* 

Scrip  dividends  redeemable  in  cash  or  stock. — When 
scrip  dividends  give  an  option  to  the  recipient  to  redeem  the 
scrip  in  cash  or  stock,  the  question  arises  as  to  whether  or 
not  they  are  stock  dividends,  and  therefore  not  taxable,  par- 
ticularly when  the  stock  has  a  market  value  considerably  above 
the  amount  payable  in  cash.  When  they  are  issued  no  liability 
is  created,  the  only  entries  in  the  books  being  a  debit  to  surplus 
and  a  credit  to  "scrip  dividend  payable."  Therefore  no  tax 
can  be  imposed  at  that  point,  because  no  asset  of  any  kind  has 
been  segregated  or  distributed.  It  is,  in  effect,  merely  a  sus- 
pense account.  If  any  stockholder  takes  cash,  there  is  to  that 
extent  only  a  diminution  of  assets  and  a  distribution.  When 
all  stockholders  take  stock  there  is  no  distribution,  but  there 
is  a  transfer  from  surplus  to  capital,  and  all  the  elements  of  a 
stock  dividend  are  present. 

Cash  Dividends,  the  Taxability  of  which  Has  Been 
Questioned 

Dividends  declared  from  depreciation  and  depletion  re- 
serves.— During  19 17  certain  corporations,  particularly  copper 
mining  corporations,  adopted  a  policy  of  declaring  special 
dividends  which  were  described  as  return  of  capital  and  not 
a  distribution  of  profits.     As  such  distributions  were  charged 

"  See  page  770. 


744  INCOME 

to  depletion  reserves  on  the  corporation's  books,  it  was  claimed 
that  the  surplus  and  undivided  profits  were  not  affected 
thereby  and  for  this  reason  no  tax  could  be  assessed  on  the 
so-called  dividends. 

Regulation.  A  reserve  set  up  out  of  gross  income  by  a  corpora- 
tion and  maintained  for  the  purpose  of  making  good  any  loss  of 
capital  assets  on  account  of  depletion  or  depreciation  is  not  a  part  of 
surplus  out  of  which  ordinary  dividends  may  be  paid.  A  distribution 
made  from  a  depletion  or  depreciation  reserve  based  upon  the  cost 
of  the  property  will  not  be  considered  as  having  been  paid  out  of 
earnings  or  profits,  but  the  amount  thereof  shall  be  applied  against 
and  reduce  the  cost,  or  other  basis,  of  the  stock  upon  which  declared 
for  the  purpose  of  determining  the  gain  or  loss  from  the  subsequent 
sale  of  the  stock.  A  distribution  made  from  that  portion  of  a  deple- 
tion reserve  based  upon  a  valuation  as  of  !March  i,  1913,  which  is  in 
excess  of  the  depletion  reserve  based  upon  cost,  will  not  be  con- 
sidered as  having  been  paid  out  of  earnings  or  profits,  but  the  dis- 
tributee shall  not  be  allowed  as  a  deduction  from  gross  income  any 
loss  sustained  from  the  sale  or  other  disposition  of  his  stock  or 
shares  unless,  and  then  only  to  the  extent  that,  the  basis  provided  in 
section  202  exceeds  the  sum  of  (i)  the  amount  realized  from  the 
sale  or  other  disposition  of  such  stock  or  shares,  and  (2)  the  ag- 
gregate amount  of  such  distributions  received  by  him  thereon.  No 
distribution,  however,  can  be  made  from  such  a  reserve  until  all  the 
earnings  or  profits  of  the  corporation  have  first  been  distributed. 
(Art.  1546.) 

The  foregoing  regulation  differs  from  the  corresponding 
one  under  the  19 18  law   (Regulations  45,  article  1549)'^  in 


^^  [Former  Procedure]  The  first  ruling  of  the  Treasury  held  that 
dividends  out  of  depletion  reserves  were  not  taxable,  as  indicated  by  the 
following  : 

Ruling.  "Receipt  is  acknowledged  of  your  letter  of  July  3,  1917, 
and  in  reply  you  are  advised  that,  as  may  be  seen  upon  reference  to  Treas- 
ury Decision  2481,  the  federal  income  tax  law  of  September  8,  1916,  author- 
izes corporations,  joint-stock  companies,  etc.,  when  making  annual  income 
tax  returns,  to  deduct  from  gross  income  a  reasonable  allowance  for  the 
exhaustion,  wear  and  tear  of  property  arising  out  of  its  use  or  employment 
in  the  business  or  trade,  and  in  the  case  of  oil  and  gas  wells  and  mines,  a 
reasonable  allowance   for  depletion  of  natural  products. 

"You  are  further  advised  that  when  such  deductions  are  made  and  their 
amounts  are  carried  to  a  reserve  account,  and  later  a  dividend  is  declared 
and  paid  from  that  account,  the  amount  of  the  dividend  is  held  to  rep- 
resent a  return  of  capital  invested,  and  it  is  not  subject  to  income  tax  in 
the  hands  of  the  shareholders."  (Letter  to  Henry  W.  Beal,  Boston,  signed 
by  Deputy  Commissioner  L  F.  Speer  and  dated  July  14,  1917.) 


FROM    DIVIDENDS  745 

which  a  distribution  from  a  depletion  reserve  is  called  a  "liqui- 
dating dividend."  It  is  clear,  however,  that  after  all  profits 
accumulated  since  March  i,  1913,  arc  distributed,  a  dividend 
from  depletion  reserve  is : 

1.  A  return  of  capital. 

2.  A  reduction  of  the  cost  or  March  i,   19 13,  value  of 

the  shares  of  stock. 

A  corporation  should  not  be  permitted  to  declare  dividends 
out  of  capital  so  long  as  a  surplus  exists  on  the  books.  If  no 
surplus  exists,  a  distribution  of  capital  should  be  coincident 
with  a  reduction  in  the  capital  stock  of  the  corporation.  Re- 
serves are  created  for  the  purpose  of  keeping  the  capital 
intact,  and  any  diminution  of  such  reserves  automatically  re- 
duces the  capital.  This  should  not  be  done  unless  stock- 
holders can  be  depended  upon  to  grasp  the  significance  of 
the  transaction.  It  is  not  likely  that  an  ordinary  stockholder 
who  received  a  dividend  described  as  having  been  charged 
to  a  depletion  reserve  would  comprehend  that  it  represented 
a  distribution  of  capital.  He  would  retain  his  stock  certificate 
and  would  not  be  notified  that  the  par  value  had  been  re- 
duced. It  is  most  likely  that  he  would  report  the  dividend 
for  taxation  with  other  dividends. 

Certain  corporations  have  notified  their  stockholders  that 
parts  of  the  dividends  were  from  depletion  reserves.  Stock- 
holders of  such  corporations  may  naturally  assume  that  the 
earned  surplus  of  the  corporations  has  been  exhausted  and 
that  the  dividends  are  in  fact  out  of  depletion  reserves.  When 
such  dividends  are  received  they  should  be  entered  by  the  re- 
cipients as  receipts  of  capital  and  should  not  be  reported  as 
taxable  dividends. 


The  ruling  quoted  in  footnote  on  previous  page  was  revoked  by  T.  D. 
2540   (October  10,  1917). 

Regulation.  "A  distribution  from  such  a  reserve  will  be  considered 
a  liquidating  dividend  and  will  constitute  taxable  income  to  a  stockholder 
only  to  the  extent  that  the  amount  so  received  is  in  excess  of  the  cost  or 

fair  market  value  as  of  March  i,  1913,  of  his  shares  of  stock " 

(Reg.  45,  Art.  154Q.) 


746 


INCOME 


Even  llioiigii  a])prcciali()ii  at  March  i,  1913,  lias  not  been 
realized  through  sale,  or  through  depletion  charges,^"  tax-free 
distributions  may  be  made  therefrom,  provided,  of  course, 
earnings  since  March  i,  19 13,  have  all  been  distributed. 

Dividends  paid  out  of  appreciation  of  goodwill. — The 
author  does  not  care  to  assume  that  cash  dividends  would 
ever  be  paid  out  of  surplus  arising  from  appreciation  in  the 
value  of  goodwill  or  other  capital  assets.  But  since  stock 
dividends  are  sometimes  paid  out  of  marked-up  assets,  no 
doubt  some  corporations  will  attempt  to  pay  cash  dividends 
from  the  same  source."  If  the  stockholder  were  to  receive  a 
dividend  accompanied  by  a  notice  from  the  corporation  that 
it  was  in  fact  from  surplus  so  created  the  stockholder  should 
enter  the  dividend  as  free  from  tax.  Appreciation  accrued 
after  March  i,  191 3,  is  taxable  when  realized,  but  in  the  case 
cited  it  should  be  specifically  stated  that  realization  had  not 
taken  place.  The  dividend,  in  fact,  would  be  out  of  capital 
and  would  not  be  taxable.  The  stockholder  would  be  entitled 
to  assume  that  the  earned  surplus  of  the  corporation  had  been 
exhausted. 

Dividends  from  capital  surplus. — The  regulations  are  clear 
that  no  tax  will  be  imposed  upon  a  dividend  paid  from  capital 
surplus.^*  Capital  surplus  may  arise  through  the  payment 
by  stockholders  of  an  amount  in  excess  of  the  par  value  of 
capital  stock,  through  appreciation  set  up  on  the  books  as  an 
asset,  through  the  creation  of  shares  of  "no  par"  value  and 
in  other  ways. 

It  is  sometimes  claimed  that  distributions  similar  to  the 
foregoing  may  be  made  at  any  time  irrespective  of  whether 
or  not  the  surplus  earned  since  March  i,  191 3,  has  been  dis- 
tributed. 


See  pages  718-725. 

See  Chapter  XXIII,  "Stock  Dividends." 

Art.  1543,  page  716. 


FROM    DIVIDENDS  747 

Obviously  the  distribution  of  capital  dividends  diminishes 
the  assets  of  a  corporation  to  exactly  the  same  extent  as 
when  a  distribution  of  earnings  is  made.  This  question 
then  arises :  Is  a  provision  of  law  enforceable  which  forbids 
any  distribution  until  distribution  is  made  of  surplus  earned 
since  March  i,  1913?     Section  201    (b)   reads: 

Law.     Section     201 (b)   ....   every     distribution     is 

made  out  of  earnings  or  profits,  and  from  the  most  recently  accumu- 
lated earnings  or  profits,  to  the  extent  of  such  earnings  or  profits 
accumulated  since  February  28,  1913;  but  any  earnings  or  profits  ac- 
cumulated or  increase  in  value  of  property  accrued  prior  to  March  i, 
1913,  may  be  distributed  exempt  from  the  tax,  after  the  earnings  and 
profits  accumulated  since  February  28,  1913,  have  been  distri- 
buted  

The  author  is  of  the  opinion  that  this  provision  of  the  law 
is  enforceable  except  when  the  distributions  consist  of  pay- 
ments required  by  the  reduction  or  cancellation  of  capital 
stock. 

When  a  corporation  reduces  its  capital  stock  state  cor- 
poration laws  require  that  the  stock  certificates  shall  be  can- 
celed or  stamped,  and  it  would  be  illegal  for  a  corporation  to 
advise  its  stockholders  that  payments  in  reduction  or  retire- 
ment of  capital  stock  should  be  deemed  to  be  dividends  out 
of  recent  earnings,  merely  because  of  a  federal  law  which 
attempts  to  require  a  distribution  of  current  earnings  before 
previous  earnings  are  distributed. 

As  a  matter  of  fact  payments  in  reduction  of  capital  stock 
may  be  made  to  only  one  of  several  classes  of  stockholders. 

In  many  cases  the  obligations  to  retire  preferred  stock^* 
are  contractual  and  the  payments  must  be  made  if  the  corpora- 
tions are  in  funds. 

This  view  has  been  accepted  by  the  Treasury. 

Ruling.  The  term  "distribution"  as  used  in  Section  201  (6) 
of  the  Act  means  the  dehvery  or  transfer  of  property  by  a  corpora- 
tion to  its  stockholders.     Whether  any  distribution  by  a  corporation 


"  For  discussion  of  redemption  of  stock  held  to  be  equivalent  of  a  cash 
dividend  [section  20J   (d)],  ?ee  page  764. 


748  INCOME 

is  to  be  deemed  to  have  been  made  from  earnings  or  profits  depends 
upon  the  facts  in  each  case.  However,  the  term  '"distribution"  as 
used  in  Section  201  (b)  of  the  statute  does  not  contemplate  the  pay- 
ments made  by  a  corporation  to  its  stockholders  in  retiring  its  own 
stock  if  the  liquidation  of  the  stock  was  in  pursuance  of  an  obligation 
arising  out  of  the  stock  contract,  unless  it  appears  that  the  corpora- 
tion had  the  option  of  distributing  its  assets  with  a  credit  to  capital 
stock  account  or  to  surplus  account.  However,  inasmuch  as  a  retire- 
ment of  capital  stock  would  indicate  that  additional  capital  was  not 
required,  any  retirement  of  common  stock,  leaving  the  surplus  stand, 
would  be  regarded  by  this  office  as  making  the  corporation  one 
coming  within  the  provisions  of  Section  220  of  the  Revenue  Act  of 
I9t8.«o^    (C.  B.  2,  page  25;  O.  D.  360.) 

The  foregoing  rule  may  not  be  applicable  when  the  dis- 
tribution to  stockholders  consists  of  the  return  by  a  corpora- 
tion of  a  special  or  temporary  assessment  on  its  stockholders 
which  is  specifically  returned  when  the  emergency  is  over. 

Liquidating  Dividends 

The  192 1  law  makes  no  specific  reference  to  distributions 
in  liquidation.  Section  201  (c)  of  the  1918  law  which  pro- 
vided that  "amounts  distributed  in  the  liquidation  of  a  cor- 
poration shall  be  treated  as  payments  in  exchange  for  stock," 
appeared  in  the  House  draft  of  the  192 1  law  but  was  stricken 
out  in  the  Senate.  The  new  subsection  (c)  which  was  in- 
serted in  conference  reads : 

Law.  Section  201.  .  .  .  .  (c)  Any  distribution  (whether  in 
cash  or  other  property)  made  by  a  corporation  to  its  shareholders  or 
members  otherwise  than  out  of  (i)  earnings  or  profits  accumulated 
since  February  28,  1913,  or  (2)  earnings  or  profits  accumulated  or  in- 
crease in  value  of  property  accrued  prior  to  March  i,  1913,  shall  be 
applied  against  and  reduce  the  basis  provided  in  section  202  for  the 
purpose  of  ascertaining  the  gain  derived  or  the  loss  sustained  from  the 
sale  or  other  disposition  of  the  stock  or  shares  by  the  distri- 
butee  

Whatever  the  reason  for  eliminating  specific  reference 
to  the  liquidation  of  a  corporation,  it  is  clear  from  the  fore- 
going section  of  the   1921   law  that  any  distribution  out  of 


**  See  Chapter  XXXV,  "Tax  on  Undistributed  Profits  of  Corporations-" 


FROM    DIVIDENDS  749 

earnings  accumulated  since  March  i,  1913,  is  a  dividend. 
If  not  clear  in  subsection  (c),  there  is  nothing  ambiguous  in 
subsection  (a)  which  provides  that  the  term  dividend  "means 
any  distribution  made  in  cash  or  in  other  property,  out  of  its* 
earnings  or  profits  accumulated  since  February  28,  1913."  It 
is  probable  that  the  narrow  construction  placed  by  the  Treas- 
ury upon  section  201  (c)  of  the  1918  law  is  responsible  for 
the  change.  That  section  was  construed  to  mean  that  the  credit 
for  normal  tax  could  not  be  taken  in  distributions  in  liquida- 
tion.''^ In  the  author's  opinion  the  1918  law  did  not  so  state 
and  there  certainly  was  no  intention  to  deprive  stockholders  of 
the  credit. 

Distributions  which  are  dividends. — As  heretofore  stated, 
dividends  include  any  distribution  out  of  earnings  accumu- 
lated since  March  i,  19 13.  There  is  not  a  word  in  any  section 
of  the  law^  w^hich  contradicts  this  statement  in  section  201  (a). 
A  distribution  may  be  final  or  partial.  The  section  contem- 
plates final  distributions  in  its  reference  to  distributions  in 
property  other  than  cash. 

Regulation.  Where  a  corporation  distributes  all  of  its  property 
in  complete  liquidation  or  dissolution,  the  gain  realized  by  the  stock- 
holder from  the  transaction,  computed  under  section  202,  is  taxable 
as  a  dividend  to  the  extent  that  it  is  paid  out  of  earnings  or  profits 
of  the  corporation  accumulated  since  February-  28,  1913.  If  the 
amount  received  by  the  stockholder  in  liquidation  is  less  than  the 
cost  or  other  basis  of  the  stock,  a  deductible  loss  is  sustained. 
(Art.  1545.) 

Therefore,  the  right  to  credit  the  normal  tax  is  perfectly 
clear. 

In  computing  excess  profits  tax  in  191 7  the  Treasury  held 
that  liquidation  dividends  were  dividends,  and  could  be  "credi- 
ted" as  ordinary  dividends. 

Taxable  status  of  liquidation  dividends. — The  term 
"dividend"  as  used  in  section  201    (a)   may  be  limited  to  dis- 

"'  See  page  75 1- 


y^(y  INCOME 

trilnitious  made  from  earnings  accumnlated  since  February 
->>,  ^913-  Corporations  have  [)ai(l  the  normal  tax  on  these 
earnings.     Stockholders  are  liable  for  the  surtax. 

• 

Distributions  which  are  not  dividends. — In  view  of  the 
hmitation  on  the  term  "dividend"  in  section  201  (a),  it  is 
obvious  that  all  distributions,  otherwise. than  out  of  earnings 
accumulated  since  March  i,  191 3,  are  returns  of  capital,  either 
taxable  or  not  taxable  according  to  their  nature. 

Regulation.  Any  distribution  made  by  a  corporation  to  its  stock- 
holders otherwise  than  out  of  (i)  earnings  or  profits  accumulated 
since  February  28,  1913,  or  (2)  earnings  or  profits  accumulated  or 
increase  in  value  of  property  accrued  prior  to  March  i,  1913,  is  not 
a  dividend  and  is  not  taxable  to  the  recipient.  Any  such  distribution, 
however,  shall  be  applied  against  and  reduce  the  cost,  or  other  basis, 
of  the  stock  upon  which  declared,  for  the  purpose  of  determining 
the  gain  or  loss  from  the  subsequent  sale  of  the  stock. 

Example. — A  purchased  certain  stock  in  1915  for  $10,000  and  re- 
ceived in  1921  a  distribution  thereon  of  $2,000  paid  by  the  corporation 
otherwise  than  out  of  its  earnings  or  profits  or  the  increase  in  value  of 
property  accrued  prior  to  March  i,  1913.  This  distribution  does  not 
constitute  taxable  income  to  A.  If  A  subsequently  sells  the  stock 
the  difference  between  the  amount  realized  therefor  and  $8,000  is 
taxable  gain  or  deductible  loss,  as  the  case  may  be.     (Art.  1544.) 

The  foregoing  regulation  properly  intimates  that  distribu- 
tions out  of  earnings  accumulated  since  March  i,  191 3,  are 
dividends.  It  also  intimates  that  distributions  out  of  earnings 
or  increase  in  value  of  property  accrued  prior  to  March  i,  1913, 
may  be  dividends.  As  the  latter  distributions  are  not  taxable 
in  any  event,  it  should  be  immaterial  how  they  are  designated. *^- 
The  stipulation  that  distributions  which  are  not  dividends  shall 
be  applied  to  reduce  the  cost,  or  March  i,  1913,  value,  of  the 
stock  upon  which  declared  is  proper.  It  is  equivalent  to  stat- 
ing that  such  cost  or  value  shall  be  reduced  by  the  receipt  of 
any  distribution  of  capital  which  the  corporation  may  make. 

Taxable  status  of  distributions  which  are  not  divi- 
dends.— Naturally  any  distributions  of  capitak  are  free  from 


It  does  make  a  difference,  however.     See  page  748. 


FROM    DIVIDENDS  751 

normal  or  surtaxes,  unless  and  until  there  is  a  taxable  net  gain, 
in  which  case  the  gain  is  taxable  as  any  other  net  gain,  viz.,  if 
the  stock  is  held  for  more  than  two  years  the  maximum  tax  is 
I2J/2  per  cent;"^  if  held  for  less  than  two  years  the  gain  is  sub- 
ject to  the  full  surtax  rates. 

Under  the  19 18  law  it  was  the  duty  of  the  directors  to  dis- 
tribute the  assets  in  such  a  way  that  all  earnings  subsequent  to 
March  i,  1913,  should  first  be  distributed  formally  as  divi- 
dends. Distributions  of  surplus  and  appreciation  at  March 
I,  19 1 3.  should  first  have  been  made  and  finally  the  capital 
returned.  The  last  noted  distribution  was  taxable  or  not  tax- 
able under  section  201  (c)  and  article  1544. 

Liquidating  dividends  under  the  1918  law. — The  19 18  law 

contained  this  specific  provision : 

Law.  Section  201.  .  .  .  .  (c)  Amounts  distributed  in  the  liqui- 
dation of  a  corporation  shall  be  treated  as  payments  in  exchange  for 
stock  or  shares  and  any  gain  or  profit  realized  thereby  shall  be  taxed 
to  the  distributee  as  other  gains  or  losses 

It  was  a  new  provision  and  was  intended  to  set  up  an 
equitable  basis  for  the  taxation  of  distributions  in  liquidation. 
It  was  not  intended  as  a  substitute  for  the  sections  which 
governed  the  distributions  of  earnings  accumulated  since  March 
I,  19 1 3.  It  was  not  intended  as  a  penalty  clause  nor  as  im- 
posing double  taxation.  The  Treasury,  however,  construed  it 
as  an  inclusive  pronouncement  that  in  connection  with  the 
liquidation  of  a  corporation  there  could  be  no  such  thing  as  a 
dividend.  The  position  was  not  justified  by  the  language  of 
the  law;  on  the  contrary  it  was  inconsistent  with  the  clear 
meaning  of  several  other  sections.  In  its  administration  there 
were  difficulties  which  were  caused  by  the  unwarranted  con- 
struction placed  upon  section  201    (c)   rather  than  by  the  facts. 

Regulation.  So-called  liquidation  or  dissolution  dividends  are 
not  dividends  within  the  meaning  of  the  statute,  and  amounts  so  dis- 
tributed, whether  or  not  including  any  surplus  earned  since  February 

"'  See  page  627. 


;7-2  INCOME 

28,  1913,  are  to  be  regarded  as  payments  for  the  stock  of  the  dis- 
solved corporation.  Any  excess  so  received  over  the  cost  of  his  stock 
to  the  stockholder,  or  over  its  fair  market  value  as  of  March  i, 
1913,  if  acquired  prior  thereto,  is  a  taxable  profit.  A  distribution  in 
liquidation  of  the  assets  and  business  of  a  corporation,  which  is  a 
return  to  the  stockholder  of  the  value  of  his  stock  upon  a  surrender 
of  his  interest  in  the  corporation,  is  distinguishable  from  a  dividend 
paid  by  a  going  corporation  out  of  current  earnings  or  accumulated 
surplus  when  declared  by  the  directors  in  their  discretion,  which  is 
in  the  nature  of  a  recurrent  return  upon  the  stock.  (Reg.  45,  Art. 
1548.) 

The  following"  case  is  typical  of  an  average  dissolution. 
Usual!}'  there  are  several  distributions. 

Ruling.  In  May, -1917,  a  corporation  declared  a  dividend  out 
of  surplus  profits  earned  during  the  three  years  immediately  pre- 
ceding, a  distribution  being  made  accordingly  in  1917.  In  July  of 
the  same  year,  at  a  meeting  of  the  board  of  directors,  a  sale  of  the 
real  estate  owned  by  the  company  was  authorized  and  in  February, 
1918,  the  stockholders  agreed  that  the  capital  stock  should  be  re- 
turned to  them  according  to  the  number  of  shares  they  held  on  that 
date  and  that  all  other  assets  of  the  corporation  be  distributed  and 
paid  as  dividends. 

Held,  that  the  dividends  received  in  1917  should  be  treated  as 
a  distribution  of  earnings  or  profits  accumulated  subsequent  to  March 
I,  1913,  and  subject  to  tax  in  the  hands  of  the  stockholders  as  pro- 
vided in  section  31  of  the  Revenue  Act  of  1917,  but  that  the  entire 
amounts  distributed  as  a  single  and  final  dividend  in  1918,  including 
both  capital  and  surplus,  should  be  treated  as  the  proceeds  of  a  liqui- 
dation.    (B.  Digest  47-20-1309;'  A.  R.  M.  93.) 

As  a  matter  of  fact,  the  distribution  in  May,  19 17,  was 
just  as  much  part  of  a  final  distribution  as  that  made  in  Feb- 
ruarv.  1918.  The  law  reads  "amounts  distributed  in  the  liquid- 
ation." Surely  the  distribution  in  May,  1917,  was  "in"  (not 
out)   of  the  distribution. 

In  the  following  ruling  the  Treasury  apparently  reversed 

its  position  that  a  liquidating  dividend  was  to  be  applied  against 

the  cost  of  the  stock  and  any  excess  would  be  subject  to  both 

normal  and  surtax.     Only  the  "return  of  capital"  is  applied 

against  the  cost. 

Ruling.  Each  and  every  distribution  made  by  the  corporation 
to  its  stockholders  during  the  taxable  vear  will  be  deemed  to  have 


FROM   DIVIDENDS  753 

been  made  from  earnings  or  profits  of  tlie  corporation  to  the  extent 
that  the  corporation  had  such  earnings  and  profits  on  hand  at  the  time 
the  distribution  was  made.  Any  distribution  in  excess  of  the  earnings 
and  profits  of  the  corporation  on  hand  at  the  date  of  distribution 
represents  a  return  of  capital  to  the  stockholders,  and  if  such  return 
of  capital  added  to  any  amounts  of  capital  previously  returned  to 
the  stockholders  does  not  equal  the  cost  to  them  of  their  stock  it  will 
not  be  subject  to  either  the  normal  tax  or  surtax  in  their  hands.  If 
at  the  time  of  any  distribution  the  stockholders  had  received  a  return 
of  capital  in  an  amount  equal  to  the  cost  of  their  stock,  the  entire 
amount  distributed  to  them  in  excess  of  the  earnings  and  profits  of  the 
corporation  on  hand  at  the  date  of  distribution  represents  taxable  in- 
come to  them  subject  to  both  normal  tax  and  surtax  at  the  rates 
for  the  taxable  year.  In  case  of  the  subsequent  liquidation  of  the 
corporation  or  the  sale  by  the  stockholders  of  their  stock  upon  which 
they  have  had  any  return  of  capital,  the  amount  so  returned  to  them 
must  be  added  to  the  amount  received  in  liquidation  or  to  the  selling 
price,  as  the  case  may  be,  for  the  purpose  of  determining  the  gain  or 
loss  arising  to  them  from  the  transaction.  (C.  B.  4,  page  44;  O.  D. 
9550 

In  a  subsequent  ruling  (Bulletin  36-21-1797;  Sol.  Op.  115) 
the  Treasur}'  returned  to  its  former  position  of  subjecting 
liquidating  dividends  to  both  normal  and  surtax. 

Liquidating  dividends  under  1917  and  prior  laws. — As  the 
1918  law  is  the  only  one  which  contains  any  reference  to  dis- 
tributions in  liquidation,  as  distinguished  from  any  other 
kind  of  distribution,  we  are  compelled  tmder  the  191 3, 
1916,  1917  laws,  as  well  as  under  the  1921  law,  to  depend  on 
the  laws  themselves  for  guidance.  In  the  191 7  law  there 
was  a  clearly  defined  method  prescribed  for  all  ordinary  and 
extraordinary  dividends. °*  When  a  corporation  was  dissolved 
and  its  assets  were  distributed,  they  were  taxable  as  dividends 
or  as  gains,  depending  on  circumstances.  In  the  absence  of 
special  statutes,  words  must  be  given  their  usual  significance. 
Therefore  the  use  of  the  word  "dividends"  in  191 7  and  prior 
laws  included  dividends  in  dissolution  or  liquidation  as  well 
as  ordinary  dividends. 


°*  For  dividends  allocated  to  and  taxed  at  the  rates  in    force  in  prior 
years,  see  Income  Tax  Procedure,  1918,  pages  136,  145. 


754 


INCOME 


The  Supreme  Court  of  the  United  States  passed  upon  this 
very  point  in  two  decisions  handed  down  the  same  day.  The 
cases  are  Lynch  v.  Turrish^^  and  Lynch  v.  Hornby, ^^  decided 
June  3,  1918.  In  the  Turrish  case  the  court  held  that  a  divi- 
dend in  dissolution  was  not  taxable;  and  in  the  Hornby  case 
the  court  decided  that  a  dividend  was  taxable.  In  both  cases 
the  dividends  were  from  earnings  or  gains  accumulated  prior 
to  March  i,  1913.  In  the  Turrish  case,  even  though  there 
was  a  final  and  complete  distribution,  the  court  always  referred 
to  the  distribution  as  a  dividend.  The  Commissioner  assessed 
the  tax  on  the  theory  that  it  was  "a  dividend  received  from  a 
domestic  corporation"  and  taxable  as  an  ordinary  dividend. 
The  court  held  that  no  taxable  income  arose  from  the  receipt 
of  the  dividend.  Reference  w^as  made  to  the  fact  that  a 
stockholder  has  no  title  to  the  property  of  a  corporation  "prior 
to  a  dividend  being  declared." 

It  is  obvious  that  prior  to  the  enactment  of  the  1918  law- 
no  one  questioned  the  fact  that  a  dividend  in  liquidation  was 
a  "dividend."  There  were  serious  questions  regarding  the 
taxable  status  of  values  at  March  i,  19 13,  and  the  position  of 
stockholders  w^io  purchase  at  a  high  price  and  who  might  pay 
excessive  taxes  upon  a  dividend  in  partial  liquidation.  But 
these  questions  never  arose  regarding  the  distribution  of  earn- 
ings accumulated  since  March  i,  19 13.  In  the  case  of  new 
stockholders  who  pay  excessive  taxes  on  partial  liquidations, 
because  they  are  deemed  to  be  ordinary  dividends,  the  United 
States  Supreme  Court  in  the  case  of  United  States  v.  Phellis'^^ 
said : 

Decision.  The  possibility  of  occasional  instances  of  apparent 
hardship  in  the  incidence  of  the  tax  may  be  conceded.  Where,  as  in 
this  case,  the  dividend  constitutes  a  distribution  of  profits  accumulated 
during  an  extended  period  and  bears  a  large  proportion  to  the  par 
value  of  the  stock,  if  an  investor  happened  to  buy  stock  shortly  before 
the  dividend,  paying  a  price  enhanced  by  an  estimate  of  the  capital 

"247  U.  S.  219. 
"247  U.  S.  338. 
"^  Advance  opinions,  66  L.  Ed.  69. 


FROM   DIVIDENDS  755 

plus  the  surplus  of  llic  company,  and  after  distribution  of  llic  surplus, 
with  corresponding  reduction  in  the  intrinsic  and  market  value  of  the 
shares,  he  were  called  upon  to  pay  a  tax  upon  the  dividend  received, 
it  might  look  in  his  case  like  a  tax  upon  his  capital.  But  it  is  only 
apparently  so.  In  buying  at  a  price  that  reflected  the  accumulated 
profits,  he  of  course  acquired  as  a  part  of  the  valuable  rights  pur- 
chased the  prospect  of  a  dividend  from  the  accumulations — bought 
"dividend  on,"  as  the  phrase  goes — and  necessarily  took  subject  to  the 
burden  of  the  income  tax  proper  to  be  assessed  against  him  by  reason 
of  the  dividend  if  and  when  made.  He  simply  stepped  into  the  shoes 
in  this  as  in  other  respects  of  the  stockholder  whose  shares  he  ac- 
quired, and  presumably  the  prospect  of  a  dividend  influenced  the 
price  paid,  and  was  discounted  by  the  prospect  of  an  income  tax  to  be 
paid  thereon.  In  short,  the  question  whether  a  dividend  made  out  of 
company  profits  constitutes  income  of  the  stockholder  is  not  affected  by 
antecedent  transfers  of  the  stock  from  hand  to  hand. 

Under  section  202  (c)  and  (e)"^  of  the  1921  law,  there 
is  no  doubt  that  upon  a  reduction  in  capital  stock,  or  an  ex- 
change of  shares  for  shares  and  cash  in  a  "reorganization," 
the  cash  is  to  be  applied  in  reduction  of  the  cost  of  the  original 
shares. 

Deferred  dividends  and  redemption  of  preferred  stock. — 

Ruling.  In  1919  a  corporation  paid  three  deferred  dividends 
on  its  outstanding  issue  of  first  preferred  stock  and  at  the  same  time 
redeemed  the  entire  issue  of  such  stock  at  a  premium  of  12V2  per 
cent.  It  is  stated  that  the  dividends  so  paid  were  those  due  February 
I  and  August  i,  1910,  and  February  i,  1911;  that  the  actual  surplus 
necessary  to  pay  them  was  accumulated  prior  to  December  31,  1911; 
that  there  had  not  been  any  actual  declaration  of  these  dividends 
prior  to  1919  for  the,  reason  that  the  terms  of  issue  of  the  stock 
prescribed  when  the  dividends  became  due,  the  company  merely 
having  the  privilege  of  deferring  payment  and  that  it  was  the 
understanding  of  the  officers  of  the  company  that  its  surplus  was 
held  to  pay  past  due  dividends.  The  stock  certificates  contained  a 
provision  in  accordance  with  which  the  deferred  dividends  were  paid 
and  the  stock  redeemed. 

The  three  deferred  dividends  will  be  considered  to  have  been 
paid  out  of  earnings  and  profits  accumulated  since  February  28,  1913, 
as  provided  for  in  section  201  (a)  and  (b).  Revenue  Act  of  1918, 
unless  it  can  be  shown  that  all  earnings  and  profits  accumulated 
since  that  date  were  first  distributed.     If  it  can  not  be  shown  that 


See  pages  535  and  592. 


756 


INCOME 


the  earnings  and  profits  accumulated  since  February  28,  1913,  were 
first  distributed,  the  distribution  constitutes  income  to  the  recipient 
stockholders  subject  to  additional  tax  at  the  graduated  rates,  but  not 
to  the  normal  tax. 

The  payment  in  redemption  of  the  stock  was  a  distribution  in 
part  liquidation  of  the  corporation  within  the  meaning  of  section 
201  (c),  and  not  a  dividend  as  defined  in  section  201  (a)  of  the 
act.  The  amount  received  by  each  stockholder  in  excess  of  the  cost 
of  his  shares  of  stock  to  him  or  their  fair  market  value  as  of  March  i, 
1913,  if  acquired  prior  to  that  date,  represented  taxable  income  to 
him,  subject  to  both  normal  and  additional  tax.  (C.  R.  2,  page  29; 
O.  D.  488.) 

The  last  paragraph  of  the  foregoing  ruling  is  probably  ttn- 
sound  under  the  1918  law  and  would  not  be  applicable  under 
the  1 92 1  law.     Assume  a  corporation  has: 

Common  stock   $150,000 

Preferred  stock   100,000 

Surplus   (accumulated  since  March   i, 

1913)    80,000 


In  192 1  the  entire  preferred  stock  was  redeemed  at  a 
premium  of  123/4  per  cent.  The  charge  to  surplus  would  be 
$12,500,  as  distribution  from  "earnings  or  profits  accumulated 
since  February  28,  1913";  thus  coming  within  the  definition 
of  a  "dividend"''''  which  is  exempt  from  normal  tax. 

Dividends  of  uncertain  character. — Corporate  officers 
should  ascertain  the  exact  status  of  funds  from  which  divi- 
dends are  paid  before  sending  out  dividend  cheques.  Vague 
statements  as  to  the  source  of  funds  are  confusing  to  the 
recipients  and  lay  the  corporation  open  to  just  criticism  for 
not  finding  out  in  advance  whether  or  not  the  dividend  is 
taxable.     One  dividend  notice  read  : 

•  Of  the  $1,600,000  which  we  declared  January  10,  1919,  as  accu- 
mulated dividends  on  the  second  preferred  stock,  $427,347.18,  or 
26.7  per  cent  of  the  total,  was  out  of  1918  earnings,  and  the  balance, 
$1,172,652.82,  or  73.3  per  cent,  out  of  the  earnings  of  1917. 


Section  201    (b).     See  page  716. 


FROM    DIVIDENDS  .  757 

Such  a  wording  puts  a  stockholder  on  notice  that  there  may 
be  a  measure  of  non-taxability  in  the  dividend.  In  the  case 
cited  the  dividend  would  be  fully  taxable  because  it  made  no 
difference  when  the  earnings  were  accumulated.  There  was 
no  excuse  for  sending  out  such  a  misleading  notice. 

Another  notice  sent  out  early  in  1919  was  as  follows: 

Notice  to  stockholders: 

The  federal  income  tax  law  provides  that  the  term  "dividends"  as 
used  in  the  law,  means  any  distribution  made  by  a  corporation  "out 
of  its  earnings  or  profits." 

All  the  distributions  made  by  this  company  during  the  year  1918 
are  considered  by  the  company  to  have  been  made  not  out  of  "earn- 
ings or  profits,"  but  out  of  capital,  as  the  charges  for  depletion  and 
depreciation  for  the  year  1918,  were  in  excess  of  the  operating  profits 
for  the  year.  The  company  assumes  no  responsibility  for  the  cor- 
rectness of  this  opinion. 

As  the  company  which  sent  out  the  foregoing  notice  was 
a  large  one,  it  would  have  better  served  the  interests  of  its 
stockholders  if  it  had  secured  and  included  a  good  legal 
opinion,  thus  giving  the  stockholders  something  affirmative 
to  work  on,  instead  of  scaring  them  by  disclaiming  all  re- 
sponsibility. 

The  notice  should  state  whether  the  dividend  is  paid  from: 

1.  Earnings  accumulated  since  February  28,   19 13. 

2.  Earnings  accumulated  before  March  i,  19 13. 

3.  Appreciation  at  March  i,  1913. 

4.  Capital    (in  reduction  of  capital  stock). 

If  from  (i),  the  dividend  is  subject  to  surtax  only;  if  from 
(2)  or  (3),  or  both,  the  dividend  is  "tax-free,"  but  wull  re- 
duce the  cost  or  March  i,  191 3,  value  in  case  of  sale  pf  the 
shares  at  a  loss.  If  from  (4),  the  "dividend"  is  not  subject 
to  tax,  but  reduces  the  cost  or  March  i,  1913,  value  of  the 
shares  in  case  of  sale,  whether  a  gain  or  a  loss  is  made. 

Dividends  on  life  insurance  policies. — So-called  dividends 
declared  by  life  insurance  companies  on  certain  classes  of  un- 


758  INCOME 

matured  policies  are  in  fact  reductions  of  premiums  and  are 
not  taxable.  As  a  rule  policyholders  deduct  the  amounts  of 
such  so-called  dividends  from  the  premiums  payable,  but  even 
if  dividends  are  drawn  in  cash  by  the  insured,  such  items, 
unless  received  on  paid-up  policies,  do  not  constitute  taxable 
income  and  should  be  excluded  from  returns. 

Regulation Distributions  on  paid-up  policies   which  are 

made  out  of  earnings  of  the  insurance  company  subject  to  tax  are  in 
the  nature  of  corporate  dividends  and  are  income  of  an  individual  only 
for  the  purpose  of  the  surtax.     (Art.  47.) 

Dividends  on  tontine  policies. — 

Ruling.  A  taxpayer  took  out  an  insurance  policy  on  the  tontine 
plan  in  1902  and  in  1917  received  the  total  accumulated  dividends.  The 
face  value  of  the  policy  will  be  paid  to  him  in  1922,  if  living. 

Held,  that  the  amount  received  in  191 7  was  not  required  to  be 
reported  as  income  for  that  year.  The  excess  of  the  amount  received 
at  maturity  of  the  policy  plus  all  dividends  received  thereon,  over 
the  total  premiums  paid  prior  to  March  i,  1913,  or  the  cash  surrender 
value  of  the  policy  as  of  that  date,  whichever  is  greater,  plus  the 
premiums  paid  subsequent  to  March  i,  1913,  will  represent  taxable 
income  to  be  reported  for  the  year  in  which  received  for  both  normal 
and  additional  tax  purposes.     (C.  B.  2,  page  85;  O.  D.  490.) 

So-called  dividends  which  are  in  fact  refunds  are  not  tax- 
able.— The  word  "dividend"  is  often  carelessly  used.  There- 
fore, the  recipient  of  a  dividend  (or  what  purports  to  be  a 
dividend)  from  an  unusual  source  should  ascertain  the  source 
from  which  it  is  derived  before  returning  it  for  taxation. 
The  income  tax  is  not  imposed  on  refunds  which  are  merely 
repayments  of  excessive  prices  paid  for  goods  purchased,  etc. 

Regulation rebates  made  to  purchasers,  whether  or  not 

members  of  the  association,  in  proportion  to  their  purchases  may  be 
excluded  from  gross  income  in  computing  the  net  income  subject  to 
tax.  Any  profits  made  from  non-members  and  distributed  to  mem- 
bers in  the  guise  of  rebates  are,  of  course,  subject  to  tax.  (Reg.  45, 
Art.  522.) 

Premiums  received  from  a  corporation  on  its  capital  stock 
are  equivalent  of  dividends. — Many  issues  of  preferred  stocks 


FROM    DIVIDENDS 


759 


contain  provisions  compelling  the  retirement  or  purchase  there- 
of by  the  issuing  corporations  at  substantial  premiums  above 
par  value.  When  corporations  acquire  shares  of  their  capital 
stock  in  this  manner  the  payments  must  be  charged  to  surplus 
and  cannot  be  treated  as  allowable  deductions.  The  payments 
are  clearly  distributions  of  surplus  or  profits''"  and  the  normal 
income  tax  having  been  paid  thereon  by  the  corporations,  the 
stockholders  are  not  required  again  to  pay  the  normal  tax. 

In  reporting  premiums  for  income  tax  purposes  stock- 
holders should  enter  the  amounts  precisely  as  if  a  dividend 
had  been  received. 

If  the  earned  surplus  were  not  sufficient  to  pay  the 
premiums,  and  the  funds  were  derived  from  capital  surplus 
or  from  gifts  to  the  corporation  by  holders  of  common  stock, 
the  recipients  could  not  claim  credit  for  the  normal  tax.  In 
the  absence  of  advices  to  the  contrary  it  may  be  assumed  that 
the  premiums  represent  a  distribution  of  earnings.  Corpora- 
tions which  have  no  surplus  are  rarely  able  to  carry  out  the 
redemption  provisions  of  a  preferred  stock  issue. 

Under  the  192 1  law  such  distributions  are  clearly  divi- 
dends.^^ 

Dividends  in  kind. — Article  1570  states  that  when  a  part- 
nership distributes  its  assets  in  kind  and  not  in  cash,  the  part- 
ner realizes  no  gain  or  loss  until  he  disposes  of  the  property. 
No  mention  is  made  of  "dividends  in  kind"  by  corporations.'' 

A  dividend  in  kind,  generally  speaking,  means  a  distribu- 
tion of  taxable  assets  which  cannot  readily  be  turned  into 
money,  or  which  the  stockholders  or  directors  do  not  desire 
to  turn  into  money. 

A  stock  dividend  is  not  a  dividend  in  kind.  When  a  cor- 
poration distributes  to  its  stockholders  the  stock  of  another 


"  The  term  "dividend"  means  any  distribution  made  bj-  a  corpora- 
tion out  of  its  earnings  or  profits.     [1921  law,  section  201   (a).] 

'' C.  B.  2,  page  29;  O.  D.  488.     See  page  755. 

"[Former  Procedure]  Art.  1566,  Reg.  45  (April  17,  1919  edition), 
provided  for  distributions  in  kind  by  corporations  but  the  provision  was 
eliminated  by  T.  D.  2924   (September  26,  1919). 


-r,0  INCOME 

company  it  is  a  dividend  in  kind.  If  the  stock  so  distributed 
has  a  fair  market  value  the  dividend  is  taxable.  If  it  does 
not  have  a  fair  market  value  it  is  not  taxable  until  realized. 

There  ha\c  been  some  so-called  distributions  in  kind  which 
should  be  held  to  be  taxable. 

A  corporation  sells  its  capital  assets  for  cash,  invests  the 
proceeds  in  marketable  securities  and  divides  the  securities 
among  its  stockholders.  This  is  simply  a  dividend  payable  in 
securities  and  is  taxable,''  even  though,  technically,  it  is  a 
dividend  in  kind. 

A  corporation  buys  a  plot  of  land  and  holds  it  for  some 
years.  No  sales  are  made  and  no  fair  market  price  is  ascer- 
tainable. The  corporation  dissolves  and  conveys  the  land 
pro  rata  to  its  stockholders.  This  is  a  distribution  in  kind  and 
no  tax  can  be  imposed  until  the  stockholders  dispose  of  their 
holdings,  in  whole  or  in  part. 

The  foregoing  illustrations  are  of  clear  cases — one  im- 
mediately taxable  and  the  other  not.  Between  the  two  there 
are  cases  not  so  easy  to  decide.  Whether  or  not  the  dividend 
is  presently  taxable  depends  largely  on  two  factors :  ( i )  When 
were  the  assets  divided  in  kind  acquired?  (2)  Is  there  any 
fair  market  value  for  the  assets  distributed? 


Dividends  Received  by  Corporations 

The  192 1  law  has  two  new  features  in  respect  of  dividends 
received  by  corporation. 

Law.  Section  234.  (a)  That  in  computing  the  net  income  .... 
there  shall  be  allowed  as  deductions 

(6)  The  amount  received  as  dividends  (a)  from  a  domestic  cor- 
poration other  than  a  corporation  entitled  to  the  benefits  of  section 
262,  or  (b)  from  any  foreign  corporation  when  it  is  shown  to  the  sat- 
isfaction of  the  Commissioner  that  more  than  50  per  centum  of  the 
gross  income  of  such  foreign  corporation  for  the  three-year  period 
ending  with  the  close  of  its  taxable  year  preceding  the  declaration  of 
such  dividends  (or  for  such  part  of  such  period  as  the  foreign  corpora- 

"  See  page  734- 


FROM   DIVIDENDS  761 

tion  has  been  in  existence)  was  derived  from  sources  within  the  United 
States  as  determined  under  section  217;   .    .    .    . 

It  imposes  no  tax  on  dividends  received  by  one  corporation 
from  another  corporation  unless  r<^ceived  from 

(a)  A   domestic   corporation    receiving   most   of   its    in- 

come from  within  a  possession  of  the  United 
States. 

(b)  A  foreign  corporation  deriving  50  per  cent  or  more 

of  its  income  from  without  the  United  States  under 
certain  conditions/'* 

Dividends  other  than  (a)  and  (b)  arc  to  be  inchided  in 
gross  income,  but  the  full  amount  may  be  deducted  in  ascer- 
taining net  income. 

It  is  now  recognized  that  it  is  not  equitable  to  impose  tax 
on  dividends  received  by  a  corporation,  because  the  normal 
tax  has  already  been  paid  on  the  earnings  so  distributed.  Fur- 
thermore, when  a  corporation,  which  has  received  dividends, 
in  turn  pays  out  its  own  net  income  in  dividends,  the  recipients 
(if  individuals)  are  subject  to  the  surtax.  Therefore,  any 
income  tax  assessed  against  dividends  received  by  corpora- 
tions is  double  taxation.  The  1913,  1916  and  19 17  laws  all 
imposed  expressly  or  by  implication  full  or  partial  income 
taxes  upon  dividends  received  by  corporations,  but  the  19 18 
law'  granted  full  credit  for  dividends  received  in  determining 
the  taxes  payable  by  the  receiving  corporation.^'^ 

The  1 92 1  law  has  placed  a  limitation  on  the  full  credit 
[section  234  (a-6)]. 

Dividends  (received  by  corporations)  which  are  not  tax- 
able.— Under  the  191 6,  191 7,  1918  and  1921  laws,  dividends 
payable  out  of  surplus  accrued  prior  to  March  i,  191 3,  are 
not  taxable.  This  provision  applies  to  corporations  as  well 
as  to  individuals.^*^ 


"Section  234  (a-6).     See  page  760. 

"  [Former  Procedure]     For  regulations  and  procedure  under  former 
laws  see  Income  lax  Procedure,  1919,  pages  344-347. 
"  Section  201    (a). 


762  INCOME 

Under  the  191 3  law,  the  Supreme  Court  has  held  that 
dividends  received  prior  to  December  31,  191 5,  are  taxable 
even  though  paid  out  of  surplus  accrued  prior  to  March  i. 
1913,"  but  in  a  ruling  case  an  exception  was  made  to  the 
rule/*  The  departure  from  the  rule  was  justified  by  the 
court  on  the  ground  that  the  holding  company  was  in  actual 
possession  and  control  of  the  funds  represented  by  dividends 
prior  to  March  i,  191 3,  and  that  the  declaration  of  the  divi- 
dends after  March  i,  1913,  merely  resulted  in  bookkeeping 
entries,  there  being  no  transfer  of  cash  or  property  nor  in 
fact  any  change  in  actual  status.  As  stated  by  the  court, 
"the  payment  was  only  constructive." 

In  a  later  case'^  the  Supreme  Court  again  decided  that 
a  dividend  paid  out  of  surplus  accrued  prior  to  March  i, 
1913,  was  not  taxable,  on  the  ground  "that  the  transaction 
should  be  regarded  as  bookkeeping  rather  than  as  dividends 
declared  and  paid  in  the  ordinary  course  by  a  corporation." 

A  holding  company  acquired  all  of  the  stock  of  a  sub- 
sidiary. The  subsidiary  then  paid  its  entire  surplus  to  the 
holding  company  as  a  dividend.     The  Treasury  held : 

Ruling.  A  cash  dividend  paid  in  1916  by  a  subsidiary  to  parent 
corporation,  its  sole  stockholder,  is  taxable  under  the  Revenue  Act 
of  1916  to  the  extent  that  such  dividend  was  paid  from  surplus  earned 
after  March  i,  1913  (1916  law  only).     (C.  B.  i,  page  19;  T.  B.  R.  45.) 


"Lynch  v.  Hornby,  247  U.  S.  338  (June,  191H,). 

'"Southern  Pacific  Company  v.  Lowe,  247  U.  S.  330  (June,  1918). 

''Gulf  Oil  Corporation  v.  LeivcUxn,  248  U.  S.  71  (December  9,  1918). 
See  also  Park  v.  Gilligan,  U.  S.  Dist.  Ct.,  So.  Dist.  of  Ohio,  West.  Div., 
Juno  II,  1921   (1916  Act). 


CHAPTER    XXIII 

INCOME  FROM  STOCK  DIVIDENDS 

The  Supreme  Court  of  the  United  States  has  decided  that 
stock  dividends  are  not  taxable  as  income/  There  are  those 
who  still  believe  that  a  benefit  accrues  to  the  recipient  of  a  stock 
dividend.  Such  people  show  an  utter  disregard  of  the  market 
quotations  for  stocks  before  and  after  stock  dividends  are 
declared.  In  most  cases  the  old  shares  freely  sell  higher  than 
the  new  shares,  including  the  dividend.  However,  the  feeling 
exists  that  some  sort  of  a  legal  tax  should  be  imposed  and 
corporations  are  on  notice  that  what  could  not  be  done  directly 
may  be  done  indirectly.  In  at  least  two  states  stock  dividends 
have  been  held  to  be  taxable  income." 

Since  imposition  of  the  federal  income  tax  in  19 13,  the 
author  has  consistently  taken  the  position  that  the  Supreme 
Court  would  decide  that  the  declaration  of  a  stock  dividend 
could  not  be  treated  as  a  distribution  of  income.  Those  who 
are  interested  in  the  various  laws,  regulations,  rulings  and 
court  decisions  which  preceded  the  handing  down  of  the  de- 
cision in  the  Alacoiuber  case  in  1920  will  find  them  discussed 
in  detail  in  Income  Tax  Procedure,  \c)iy  to  1920,  both  in- 
clusive. 

Procedure  of  current  interest  includes  the  definition  of  a 
stock  dividend,  the  computation  of  gain  or  loss  upon  the  sale 
of  the  old  or  new  stock  and  the  method  employed  in  obtaining 
credit  for  or  refund  of  the  tax  collected  before  the  final 
decision. 


'  Eisner  v.  Macomber,  252  U.  S.  189,  40  S.  Ct.  189,  64  L.  Ed.  521,  March 
8,  1920.  For  full  text  of  decision  of  court  and  minority  opinion,  see  Cor- 
jjoration  Trust  Company   1920  Income  Tax   Service,  pages  468-487. 

'State  ex  rel.  Dulaney  v.  Nygaard,  183  N.  W.  884  (Wise.)  ;  Tax  Com- 
missioner V.  Putnam,  2.2r/  jVlass.  522;  116  N.  E.  904;  L.  R.  A.  1917  F.  806. 

763  J 


764  INCOME 

What  Is  a  Stock  Dividend? 

A  stock  dividend  is  a  dividend  declared  by  a  corporation 
payable  in  stock  of  the  same  corporation.  Uncertainty  regard- 
ing stock  dividends  still  exists.^  Some  confuse  a  stock  divi- 
dend with  a  dividend  payable  in  the  stock  of  another  cor- 
poration. Some  hold  that  a  dividend  on  common  stock  pay- 
able in  preferred  stock  is  not  a  true  stock  dividend. 

The  former  view  is  clearly  erroneous.  The  latter  view  has 
some  merit;  but  the  author  is  of  the  opinion  that  a  dividend 
payable  in  any  class  of  stock  of  the  same  corporation  is  not 
taxable. 

The  principal  change  in  the  1921  law  regarding  stock  divi- 
dends is  the  addition  of  the  following: 

Law.     Section  201 (d)  A   stock  dividend  shall  not  be 

subject  to  tax  but  if  after  the  distribution  of  any  such  dividend  the 
corporation  proceeds  to  cancel  or  redeem  its  stock  at  such  time  and 
in  such  manner  as  to  make  the  distribution  and  cancellation  or  re- 
demption essentially  equivalent  to  the  distribution  of  a  taxable  dividend, 
the  amount  received  in  redem.ption  or  cancellation  of  the  stock  shall  be 
treated  as  a  taxable  dividend  to  the  extent  of  the  earnings  or  profits 
accumulated  by  such  corporation  after  February  28,  1913 

The  foregoing  new  section  is  reasonable.  It  would  be 
unfortunate  if  a  tax-exempt  distribution,  the  equivalent  of 
cash,  could  be  made  indirectly,  whereas  a  direct  distribution 
would  be  taxable.  In  providing  that  the  proceeds  of  redemp- 
tion of  stock  dividends  shall  be  treated  as  dividends  instead  of 
as  the  proceeds  of  sales  of  stock,  the  law  now  recognizes  the 
principle  that  the  proceeds  of  the  sale  or  redemption  of  stock 
dividends  are  free  from  the  normal  tax,*  to  the  extent  that  the 
dividend  represents  a  charge  against  surplus  accrued  since 
February  28,  19 13. 

The  methods  of  issuing  stock  dividends  have  been  de- 
scribed by  the  Treasury  as  follows : 


*  See  hearings  before  the  Committee  on  Ways  and  Means,  House  of 
Representatives,  March  18  and  19,  1920,  page  38  et  seq.  The  question  as  to 
whether  a  stock  dividend  can  legally  be  declared  in  the  state  of  Missouri  has 
been  decided  in  the  affirmative.     (C.  B.  4,  page  24;  O.  D.  887.) 

"  See  page  770. 


FROM    STOCK   DIVIDENDS  765 

Definition  o£  stock  dividend. — 

RuL'iNG I.  Where  a  corporation,  being  authorized  so  to 

do  by  the  laws  of  the  State  in  which  it  is  incorporated,  transfers 
a  portion  of  its  surpkis  to  capital  account,  issues  new  stock  repre- 
senting the  amount  of  the  surplus  so  transferred,  and  distributes  the 
stock  so  issued  to  its  stockholders,  such  stock  is  not  income  to  the 
stockholders  and  the  stockholders  incur  no  liability  for  income  tax 
by  reason  of  its  receipt. 

Cash  dividend  with  option  or  agreement  to  buy  stock. — 

2.  Where  a  corporation,  being  thereunto  lawfully  authorized, 
increases  its  capital  stock,  and  simultaneously  declares  a  cash  divi- 
dend equal  in  amount  to  the  increase  in  its  capital  stock,  and  gives 
to  its  stockholders  a  real  option  either  to  keep  the  money  for  their 
own  or  to  reinvest  it  in  the  new  shares,  such  dividend  is  a  cash  divi- 
dend and  is  income  to  the  stockholders  whether  they  reinvest  it  in 
the  new  shares  or  not. 

3.  Where  a  corporation,  which  is  not  permitted  under  the  laws 
of  the  State  in  which  it  is  incorporated  to  issue  a  stock  dividend, 
increases  its  capital  stock  and  at  the  same  time  declares  a  cash  divi- 
dend under  an  agreement  with  the  stockholders  to  reinvest  the 
money  so  received  in  the  new  issue  of  capital  stock,  such  dividend 
is  subject  to  tax  as  income  to  the  stockholder.  (C.  B.  3,  page  38; 
T.  D.  3052.) 

The  foregoing  ruling  is  not  sustained  by  the  following" : 

Decision.^  The  sole  question  in  this  case  is  whether  the  dividend 
received  by  the  defendant  from  the  Gulf  Oil  Corporation  in  1913, 
constituted  taxable  income  within  the  meaning  of  the  Act  of  Congress. 
If  it  be  a  stock  dividend,  then  the  plaintiff  cannot  recover,  for  the 
Supreme  Court  in  Towne  vs.  Eisner,  245  U.  S.  424,  has  held  that  a 
dividend  received  by  the  stockholder  in  shares  of  stock  of  the  cor- 
poration, was  not  income  within  the  meaning  of  the  Act  of  1913.  It 
is  clear  that  if  the  resolution  declaring  the  dividend  in  question,  had 
provided  for  the  payment  of  the  dividend  in  stock,  the  dividend  would 
not  have  been  taxable.  It  is  also  clear  that  the  defendant  received  pay- 
ment of  the  dividend  in  shares  of  stock,  and  that  he  did  this  pursuant  to 
an  agreement  made  prior  to  the  declaration  of  the  dividend,  which 
agreement  was  communicated  to  the  corporation  before  that 
declaration  was  made.  It  is  clear  that  out  of  112,080  shares,  the  hold- 
ers of  all  but  1740  shares  actually  accepted  payment  of  the  dividend 
in  stock,  and  that  the  money  to  pay  cash  to  the  holders  of  said  1,740 


°  Lezvellyn,  Collector  v.  Mellon,  U.  S.  District  Court,  Western  District 
of  Pa.  (July  13,  1921)    (1913  Act). 


766 


INCOME 


shares  was  provided  by  T.  Mellon  &  Sons  pursuant  to  an  agreement 
made  before  the  declaration  of  the  dividend,  that  they  would  take  and 
pay  for  any  such  shares  as  the  holders  might  refuse  to  accept  as  pay- 
ment therefor.  After  the  transaction,  the  defendant  had  two  shares  to 
represent  the  interest  in  the  same  property,  which  prior  thereto  was 
represented  by  one.  After  the  transaction,  there  were  twice  as  many 
shares  of  the  corporation  in  the  hands  of  stockholders  as  there  were 
before.  The  corporate  assets  had  not  been  diminished  by  the  transac- 
tion. Therefore,  for  two  shares  which  defendant  possessed  at  the 
close,  there  was  for  him  the  same  value  as  for  one  share  represented  at 

the  beginning In   every  view  of  the  transaction,  we   find 

that  its  substance  is  clear.  In  cases  like  the  present,  substance  is  con- 
trolling, and  not  form.  The  courts  look  through  all  forms  of  corporate 
transactions,  and  have  regard  to  the  substance.  Southern  Pacific  Co. 
vs.  Lowe,  247  U.  S.  330;  Gulf  Oil  Corporation  vs.  Lewelly-n,  248  U.  S. 
71  ...  .  the  Government  urged  upon  the  Court  the  necessity  of 
observing  the  form,  not  in  so  many  words  but  by  their  brief  filed. 
They  insist  that  the  dividend  was  a  cash  dividend,  because  the  resolu- 
tion of  the  Board  so  stated.  By  implication,  therefore,  they  would 
place  the  defendant  in  the  position  of  having  the  right  to  use  the  check 
of  thq  corporation,  which  as  a  matter  of  fact,  never  came  into  his 
hands,  and  w'hich  as  a  matter  of  fact,  must  have  been  drawn  against 
"no  funds,"  notwithstanding  his  agreement  wnth  his  associates  and 
with  T.  Mellon  &  Sons,  and  notwithstanding  the  important  fact  that 
without  such  agreements  the  resolution  of  the  Board  would  never  have 
been  passed.  That  the  Board  would  never  have  passed  such  resolution 
if  there  had  been  no  such  agreement,  seems  clear,  not  only  from  the 
testimony  of  the  witnesses  to  that  effect,  but  from  other  facts  which 
appear  in  evidence,  as,  for  instance,  the  absence  of  sufficient  money 
and  the  limited  credit  possessed  by  the  corporation,  whose  obligations 
to  banks  were  given  high  standing  by  the  endorsement  of  some  of  the 
very  men  who  entered  into  the  said  agreement.  In  every  aspect  of 
this  case,  the  defendant  was  not  in  the  position  where  he  was  merely 
entitled  to  carry  out  his  agreement,  but  he  was  bound  to  do  so.  The 
dividend  in  question  seems  to  be  a  final  step  in  a  series  of  transac- 
tions having  for  their  object  the  refinancing  of  the  corporation,  and 
was  based  upon  earnings  and  accumulations  by  subsidiary  companies 
through  a  period  of  years. 

The  foregoing  decision,  if  maintained  by  the  higher  courts, 
would  seem  to  make  the  following  ruling  illegal : 

Stock  dividends  declared  by  national  banks, — 

Ruling.     In  view  of  the  fact  that  national  banks  are  authorized 
by  law  to  issue  only  cash  dividends  (see  "Instructions  of  the  Comp- 


FROM    STOCK   DIVIDENDS  767 

troller  of  the  Currency  Relative  to  the  Organization  and  Powers  of 
National  Banks"  for  1919,  p.  56)  such  dividends,  coupled  with  the 
right  to  apply  same  to  the  purchase  of  an  increase  in  capital  stock, 
are  not  within  the  decision  of  the  Supreme  Court  in  the  Eisner  v. 
Macomber  case  and  are  taxable  income  to  the  stockholder  for  surtax 
purposes.     (C.  B.  3,  page  24;  O.  D.  588.) 

When  a  national  bank  issues  to  its  stockholders  cheques 
which  are  supposed  to  be  used  in  payment  for  new  stock  but 
are  negotiable,  so  that  a  stockholder  not  wishing  to  purchase 
the  new  stock  can  freely  divert  the  dividend  to  any  other  pur- 
pose, the  dividend  cannot  be  called  a  stock  dividend.  But  if  on 
each  cheque  were  the  words  "stock  dividend,"  and  if  most  of 
the  stockholders,  pursuant  to  a  general  agreement,  turned  back 
the  cheques  in  payment  for  new  stock,  it  is  probable  that  the 
courts  will  look  through  the  form  and  find  the  substance  to  be  a 
stock  dividend.  If  the  bank  were  to  issue  non-negotiable 
cheques,  with  conditions  stated  to  the  effect  that  the  only  pos- 
sible use  to  be  made  of  them  would  be  to  return  them  in  ex- 
change for  shares  of  new  stock  without  power  of  assignment 
or  hypothecation,  it  may  be  assumed  that  the  courts  will  hold 
this  to  be  a  stock  dividend,  on  the  ground  that  the  national 
bank  act  did  not  intend  that  a  bank  should  be  deprived  of 
privileges  possessed  by  other  corporations.  On  the  other 
hand,  a  national  bank  receives  from  the  government  broad 
privileges,  and  an  unusual  supervision  is  maintained  over  its 
affairs,  and  it  may  not  be  feasible  for  a  national  bank  to  pay 
a  dividend  which  would  be  held  to  be  the  equivalent  of  a  stock 
dividend. 

Stock  dividend  from  surplus  accumulated  prior  to  March 
I,  1913.— 

Ruling 4.  Where  a  corporation,  having  a  surplus  accu- 
mulated in  part  prior  to  March  i,  1913,  and  being  thereunto  lawfully 
authorized,  transfers  to  its  capital  account  a  portion  of  its  surplus, 
issues  new  stock  representing  the  amount  so  transferred  to  the  capital 
account  and  then  declares  a  dividend  payable  in  part  in  cash  and  in 
part  in  shares  of  the  new  issue  of  stock,  that  portion  of  the  dividend 


768  INCOME 

paid  in  cash  will,  to  the  amount  of  the  surplus  accumulated  since 
March  i,  1913,  be  deemed  to  have  been  paid  out  of  such  surplus, 
and  be  subject  to  tax,  but  the  portion  of  the  dividend  paid  in  stock 

will  not  be  subject  to  tax  as  income (C.  B.  3,  page  38; 

T.  D.  3052.) 

The  Supreme  Court  has  held  that  a  stock  dividend  is  not  a 
distribution.  Therefore,  the  cash  dividend  would  be  applied 
to  the  earnings  accumulated  after  March  i,  19 13.  In  other 
words,  capitalizing  surplus  by  means  of  a  stock  dividend  will 
not  serve  to  render  cash  dividends  tax-free  unless  and  until 
the  surplus  accumulated  since  March  i,  191 3,  has  been  dis- 
tributed in  cash. 

Stock  dividend  in  preferred  stock. — A  dividend  in  pre- 
ferred stock  is  held  not  to  be  taxable,"  because  the  amount 
thereof  is  transferred  from  surplus  to  capital,  and  as  each 
existing  stockholder  receives  a  pro  rata  share  of  the  new  pre- 
ferred stock  there  is  no  change  whatever  in  the  evidences  of 
interest  in  the  corporation's  net  worth.  Each  stockholder  has 
the  same  proportionate  share  after  the  dividend  as  before.  If 
the  charter  or  by-laws  of  a  corporation  permitted  it  to  dis- 
tribute new  stock  to  certain  of  its  stockholders  to  the  exclusion 
of  others  it  could  hardly  be  deemed  to  be  a  stock  dividend. 

If  there  is  an  existing  issue  of  preferred  stock  and  addi- 
tional shares  of  preferred  are  issued  to  common  stockholders 
as  a  dividend,  the  position  of  the  common  stockholders  will 
be  changed  if  the  earnings  are  insufficient  to  pay  the  preferred 
stock  dividend  or  in  case  of  dissolution. 

Ruling.  A  stock  dividend  paid  in  true  preferred  stock  is  ex- 
empt from  tax  the  same  as  though  the  dividend  were  paid  in  common 
stock;  however,  if  the  stock  issued  and  distributed  as  a  dividend  ranks 
with  or  prior  to  the  interest  of  general  creditors  with  respect  to  the 
payment  of  either  interest  or  principal),  it  can  not  be  considered  true 
preferred  stock,  and  must  be  treated  as  income  to  the  recipient. 
(C.  B.  4,  page  24;  O.  D.  801.) 


Art.  1548.    See  page  774. 


FROM    STOCK    DIVIDENDS  769 

Stock  dividends  received  from  subsidiary  companies. — 
When  a  subsidiary  corporation  declares  a  stock  dividend,  the 
holding  corporation  owning  the  majority  of  the  stock  of  such 
subsidiary,  if  it  has  not  theretofore  taken  up  the  surplus  of  the 
subsidiary,  may  set  up  on  its  books  as  an  asset  its  interest  (the 
percentage  of  its  ownership  of  stock)  in  the  surplus  capitalized 
on  the  books  of  the  subsidiary  corporation  for  the  purpose  of 
the  stock  dividend.  This  should  be  done,  however,  only  in 
case  the  subsidiary  has  earned,  since  the  acquisition  of  owner- 
ship by  the  holding  corporation,  profits  of  an  arnount  which 
at  least  equals  the  amount  of  surplus  so  capitalized.  In  other 
words,  if  the  holding  company  owned  93  per  cent  of  the  sub- 
sidiary, it  would  be  justified  in  entering  on  its  books  the  stock 
dividend  at  a  value  equal  to  93  per  cent  of  the  amount  of  sur- 
plus transferred  to  the  capital  accouiit  on  the  books  of 'the 
subsidiary.  The  amount  so  transferred  or  capitalized  is 
ordinarily,  if  not  invariably,  the  par  value  of  the  stock  issued 
as  a  dividend. 

It  has  been  urged  that  the  dividend  may  be  set  up  ''at  the 
same  value  as  the  cost  per  share  of  its  original  holdings  in  said 
subsidiary,"  but  this  is  not  correct.  ■  Assuming  that  $100  per 
share,  i.e.,  the  par  value,  is  regarded  as  the  cost  to  the  holding 
corporation,  the  statement  quoted  would  produce  the  same  re- 
sult as  the  above  rule.  This,  however,  would  really  be  a  mere 
coincidence.  If  the  holding  corporation  has  purchased  con- 
trol for  more  or  less  than  par,  and  if  this  value  is  so  recorded 
on  its  books,  such  procedure  would  not  produce  the  desired 
results. 

The  holding  corporation  could  of  course  declare  a  stock 
dividend  on  the  amount  that  it  credits  to  surplus  on  account  of 
the  value  placed  on  the  stock  dividend  received  from  the  sub- 
sidiary. 

Dividend  paid  in  stock  of  another  corporation  is  not  a 
stock  dividend. — When  a  new  corporation  has  been  organized 
to  take  over  certain  properties  of  an  old  corporation  and  the 


770 


INCOME 


stock  that  the  new  corporation  paid  to  the  old  for  such  proper- 
ties is  distributed  as  a  dividend  to  the  stockholders  of  the  old 
corporation,  the  dividend  is  held  to  be  taxable  and  not  a  stock 
dividend/ 

Ruling 5-  A  dividend,  paid  in  stock  of  another  cor- 
poration held  as  a  part  of  the  assets  of  the  corporation  paying  the 
dividend,  is  income  to  the  stockholder  at  the  time  the  same  is  made 
available  for  distribution  to  the  full  amount  of  the  then  market  value 
of  such  stock  (Peabody  v.  Eisner,  247  U.  S.  347)  ;  and  if  such  stock 
be  subsequently  sold  by  the  stockholder,  the  difference  between  its 
market  value  at  date  of  receipt  and  the  price  for  which  it  is  sold 

is  additional  income  or  loss  to  him,  as  the  case   may  be 

(C.  B.  3,  page  38;  T.  D.  3052.) 

This  ruling  is  sound.  If  the  stock  received  does  not  have 
a  fair  market  value,  the  equivalent  of  cash,  no  tax  can  be  im- 
posed until  sale  is  made. 

The  proceeds  of  sale,  when  realized,  are  free  from  the 
normal  tax.  Section  216  of  the  law  would  appear  to  free 
dividends  from  the  normal  tax  in  any  event,  but  the  in- 
tention of  the  section  is  to  apply  the  credit  for  the  normal 
tax  only  up  to  the  earnings  or  profits  upon  which  income  tax 
has  been  imposed.^ 


Computation  of  Profit  or  Loss  on  Sales  of  Stock  Dividends 
or  of  Stock  upon  Which  Such  Dividends  Were  Declared 

Under  the  1918  and  prior  laws,  the  Treasury  treated  the 
proceeds  of  sales  of  stocks  and  liquidation  dividends  as  sales 
of  property  (stock)  and  failed  to  allow  credit  to  stockholders 
for  the  normal  tax  which  had  been  paid  by  corporations.  If 
the  Treasury's  theory  is  correct,  the  carrying  of  a  stock  divi- 
dend for  tw^o  years  now  enables  the  holder  to  take  advantage 
of  the  123^  per  cent  tax  on  capital  gains.     The  loss  of  the 


'  U.  S.  f.  Phcllis,  Supreme  Court  No.  260,  October  Term  1921,  advance 
opinions,  66  L.  Ed.  69.    Also  see  cases  cited  on  page  739. 
*  Section  216  (a).     See  pages  347-350. 


I 


FROM    STOCK   DIVIDENDS  771 

credit  for  normal  tax  is  in  every  case  of  a  substantial  income 
far  more  than  offset  by  freedom  from  surtax  rates. 

The  author,  however,  does  not  believe  that  the  past  prac- 
tice of  the  Treasury  regarding  dividends  has  been  in  accord 
with  the  laws.^ 

General  rules  for  ascertaining  cost. — 

Regulation.  Stock  issued  by  a  corporation  as  a  dividend  does 
not  constitute  taxable  income  to  a  stockholder  in  such  corporation, 
but  gain  may  be  derived  or  loss  sustained  by  the  stockholder  from  the 
sale  of  such  stock.  The  amount  of  taxable  gain  derived  or  deductible 
loss  sustained  from  the  sale  of  such  stock,  or  from  the  sale  of  the 
stock  with  respect  to  which  it  is  issued,  shall  be  determined  as  pro- 
vided in  article  1561,  after  the  cost,  or  both  the  cost  and  fair  market 
value  as  of  March  i,  1913,  if  acquired  prior  thereto,  of  both  the  old 
and  the  new  shares  is  determined  in  accordance  with  the  following 
rules : 

When  shares  are  of  same  character. — 

(i)  Where  the  stock  issued  as  a  dividend  is  all  of  substantially 
the  same  character  or  preference  as  the  stock  upon  which  the  stock 
dividend  is  paid,  the  cost  of  each  share  (or  when  acquired  prior  to 
March  i,  1913,  the  fair  market  value  as  of  such  date)  will  be  the 
quotient  of  the  cost  (or  such  fair  market  value)  of  the  old  shares  of 

stock,  divided  by  the  total  number  of  the  old  and  new  shares 

(Art.  1548.  Reg.  45,  Art.  1547.) 

Comments  on  regulations. — Proceeds  of  the  sale  of 
stock  dividends  declared  out  of  the  earnings  accumulated  since 
March  i,  191 3,  should  be  entered  as  dividends  received  up  to 
the  par  value  of  the  stock,  in  order  to  receive  the  benefit  of  the 
credit  for  the  normal  tax.  The  excess,  if  any,  above  par  value, 
less  the  cost  as  ascertained  by  using  the  formula  in  the  regu- 
lation, constitutes  a  profit  and  is  taxable  as  such. 

If  the  profit  is  not  sufficient  to  permit  this  method,  one 
should  enter  the  proceeds,  up  to  the  par  value  of  the  shares, 
as  a  dividend  and  claim  credit  as  a  realized  loss  for  the  dif- 
ference between  cost  and  the  total  price  realized,  less  the 
amount  entered  as  a  dividend.    This  works  out  as  follows : 

'  See  page  748. 


772 


INCOME 


Cost  on  July   i,   1913   (new  corporation)   of 

100   shares    .  .  .- $10,000.00 

Stock  dividend,  in  1921,  100  shares 

Total  shares 200  


Total  cost  (average  cost  per  share  $50) $10,000.00 


In  1921  sell   100  shares  for $10,000.00 

Cost   of    100   shares 5,000.00 


Taxable   profit    $  5,000.00 


-As  the  corporation  char^^ed  the  1921  dividend  to  its  sur- 
phis  account  and  paid  the  normal  income  tax  thereon  as  the 
earnings  were  reahzed  during"  19 13  to  1921  and  credited  to 
surplus,  the  stockholder's  holdings  as  to  $50  per  share  on  200 
shares  or  $100  per  share  on  100  shares  are  free  from  normal 
tax.  Therefore  the  taxpayer  would  in  this  case  enter  the 
entire  profit  of  $5,000  as  a  dividend  received. 

Again : 

Cost  on  July   i,   1913,  of  100  shares    $10,000.00 

Stock  dividend  in  1921,     100  shares 

Total  shares 200 


Total  cost   (average  cost  per  share  $50) $10,000.00 


In  1921   sold  200  shares  for $12,000.00 

Cost  of  200   shares 10.000.00 


Taxable    profit    $  2,000.00 


The  corporation  has  paid  the  normal  tax  on  $10,000. 
In  order  to  secure  the  benefit  thereof  the  taxpayer  must  enter 
in  his  1 92 1  return  a  dividend^"  of  $10,000  and  take  credit  for 
a  loss  of  $8,000,  thus  accounting  for  realized  net  income  of 


^^  It  is,  of  course,  not  a  dividend  in  a  technical  sense,  but  the  re- 
turns are  not  flexible  enough  to  permit  its  entry  in  any  other  way.  The 
transaction  should  be  explained  on  the  return. 


i 


FROM    STOCK    niVIDENDS  773 

$2,000,  which  will  be  subject  to  the  surtax.  If  the  taxpayer 
were  merely  to  return  the  $2,000  as  a  profit  the  entire  credit 
for  the  normal  tax  paid  on  $10,000  would  be  lost. 

It  is  clear  that  the  recipient  of  a  stock  dividend  when 
being  taxed  on  the  proceeds  thereof  is  entitled  to  the  benefit 
of  the  normal  tax  which  the  corporation  has  already  paid  on 
the  earnings  since  March  i,  191 3.  The  new  regulations  con- 
form to  this  principle. 

This  principle  has  been  followed  by  the  Treasury  in  deny- 
ing to  taxpayers  the  right  to  treat  dividends  on  preferred 
stocks  as  entitled  to  credit  for  the  normal  tax  when  the  paying 
corporations  have  not  been  taxed  on  the  net  income  from  which 
the  dividends  are  derived. ^'^ 

Ruling.  In  explanation  of  rule  2  contained  in  article  1547 
[Regulations  45]  1-   .    .    .    .,  the  following  example  is  given: 

The  X  Company,  which  has  outstanding  a  certain  number  of 
shares  of  common  stock  of  a  market  value  of  $90  per  share,  declares 
a  10  per  cent  stock  dividend  payable  in  preferred  stock  having  a 
market  value  of  $120  per  share.  A,  who  owns  100  shares  of  common 
stock  having  a  market  value  of  $9,000,  receives  10  shares  of  pre- 
ferred stock  which  have  a  market  value  of  $1,200,  making  the  market 
value  of  his  holdings  on  the  date  of  the  receipt  of  the  dividend 
$10,200,  of  which  15/17  represents  the  value  of  the  common  stock 
and  2/17  the  value  of  the  preferred  stock.  If  the  common  stock 
cost  the  shareholder  $8,500  (or  if  it  was  acquired  prior  to  March  i, 
1913,  and  had  on  that  date  a  value  of  $8,500)  such  cost  or  value 
shall  be  apportioned  to  the  common  and  the  preferred  stock  in  the  ra- 
tio of  15  to  2.  In  other  words  15/17  of  $8,500,  or  $7,500,  represents  for 
the  purpose  of  determining  gain  or  loss  the  "cost"  or  the  fair  market 
value,  as  the  case  may  be,  of  the  100  shares  of  common  stock  in 
respect  to  which  the  preferred  stock  was  issued.  The  basis  for 
determining  the  gain  or  loss  arising  from  the  sale  of  any  share  of 
such  common  stock  will,  therefore,  be  $75. 

Of  the  $8,500  representing  the  original  cost  of  the  100  shares  of 
common  stock,  or  their  market  value  as  of  March  i,  1913,  if  they 
were  acquired  prior  to  that  date,  2/17,  or  $1,000,  will  represent  the 
"cost"  of  the  10  shares  of  preferred  stock  received  as  a  dividend, 
the  basis  for  deterrnining  the  gain  or  loss  upon  the  sale  of  each  share 
of  such  stock  being  $100.     (C.  B.  3,  page  39;  O.  D.  y^2.) 


"C.  B.  I,  page  93;  O.  D.  3^«- 
'-'Art.  1548. 


774 


INCOME 


In  tabulated  form,  this  appears  as  follows : 

Market  value  Total  market 
per  share  value 

loo  common   $  Qo "'  $9,000     (a) 

10  preferred    120  1,200     (b) 


$10,200     (c) 


Ratio  of  (a)  to  (c)  =  15/17  X  $8,500  =  $7,500  =  new  cost  of  100  common 
Ratio  of  (b)  to  (c)  =  2/17  X  $8,500  =  $1,000  =  new  cost  of  10  preferred 

When  shares  are  of  different  character. — 

Regulation (2)  Where  the  stock  issued  as  a  dividend  is 

in  whole  or  in  part  of  a  character  or  preference  materially  different 
from  the  stock  upon  which  the  stock  dividend  is  paid,  the  cost  (and 
when  acquired  prior  to  March  i,  1913,  the  fair  market  value  as  of 
such  date)  of  the  old  shares  of  stock  shall  be  divided  between  such 
old  stock  and  the  new  stock,  in  proportion,  as  nearly  as  may  be,  to 
the  respective  values  of  each  class  of  stock,  old  and  new,  at  the 
time  the  new  shares  of  stock  are  issued,  and  the  cost  (or  when 
acquired  prior  to  March  i,  1913,  the  fair  market  value  as  of  such 
date)  of  each  share  of  stock  will  be  the  quotient  of  the  cost  (or  such 
fair  market  value  as  of  March   i,  1913)   of  the  class  to  which  such 

share  belongs  divided  by  the  number  ot  snares  m  that  class 

(Art.  1548.  Reg.  45,  Art.  1547.) 

Purchases  at  different  times  and  different  prices. — 

Regulation (3)  Where  the  stock  with  respect  to  which  a 

stock  dividend  is  issued  was  purchased  at  different  times  and  at  dift'erent 
prices  and  the  identity  of  the  lots  can  not  be  determined,  any  sale  of 
the  original  stock  will  be  charged  to  the  earliest  purchases  of  such 

stock and   aiiy   sale   of   dividend   stock   issued   with   respect 

to  such  stock  will  be  presumed  to  have  been  made  from  the  stock 
issued  with  respect  to  the  earliest  purchased  stock,  to  the  amount 
of  the  dividend  chargeable  to  such  stock. 

(4)  Where  the  stock  with  respect  to  which  a  stock  dividend  is 
declared  was  purchased  at  different  times  and  at  dift'erent  prices, 
and  the  dividend  stock  issued  with  respect  to  such  stock  can  not  be 
identified  as  having  been  issued  with  respect  to  any  particular  lot  of 
such  stock,  then  any  sale  of  such  dividend  stock  will  be  presumed  to 
have  been  made  from  the  stock  issued  with  respect  to  the  earliest  pur- 
chased stock,  to  the  amount  of  the  stock  dividend  chargeable  to  such 
stock.     (Art.  1548.) 


"The  market  value  of  $90  is  considered  to  be  after  the  dividend  is  dis- 
tributed. 


FROM    STOCK   DIVIDENDS  775 

The  last  paragraph  (4),  of  the  foregoing  regulation  was 
not  in  the  old  regulations/*  When  the  dividend  stock  cannot 
be  identified  as  issued  to  any  particular  purchase,  it  must  now 
be  allocated  to  the  earliest  purchased  stock.  Formerly,  a  tax- 
payer was  permitted  to  "allocate,  according  to  his  wishes. "^^ 

The  author  has  suggested  in  previous  editions  of  this  work 
that  purchases  should  be  averaged  as  such  method  accords 
with  good  accounting  practice.  It  is  easily  computed  and 
readily  understood  and  in  the  long  run  produces  the  same 
amount  of  tax. 

If  the  average  method  is  not  used,  the  principle  of  alloca- 
tion to  the  earliest  purchases  has  been  stated  in  a  recent  case^^ 
as  follows : 

Decision The  law  may,  and  in  fact  does,  recognize  an 

identity  in  every  share,  which  can  indeed  be-  traced  upon  the  books 
of  the  company,  at  least  until  certificates  are  consolidated  and  later 
subdivided.  The  purchase  of  a  number  of  shares  can  be  earmarked 
by  the  certificate,  and  it  is  an  enormous  convenience  to  keep  the  pur- 
chase separate.  Yet  it  is  possible  and  consistent  when  new  shares 
are  declared  to  attribute  them  ratably  in  subdivision  of  those  already 
issued.  They  are  not  so  entered  on  the  books,  it  is  true,  but  the  books 
are  not  kept  in  accordance  with  the  underlying  doctrine  of  Eisner  v. 
Macomber,  252  U.  S.  189,  40  S.  Ct.  189,  64  L.  Ed.  521,  in  any  event. 
At  least  the  earlier  certificates  need  not  lose  their  separate  identity 
because  new  shares  are  filiated  to  them  in  proper  proportion. 

An  illustration  will  make  clear  what  I  mean.  Suppose  a  man 
has  certificate  A,  for  100  shares,  bought  at  $100,  certificate  B,  for  100, 
bought  at  $150,  and  certificate  C,  for  100,  bought  at  $200.  Suppose, 
further,  that  a  stock  dividend  of  50  per  cent  is  declared,  and  he  gets 
one  certificate  D,  for  150  shares,  without  paying  anything.  If  he  sells 
certificate  A,  he  would  be  deemed  to  sell  not  the  whole  of  his  first 
purchase,  but  only  two-thirds  of  it,  and  he  could  credit  himself  with 
only  $6,666.  If  he  sold  certificate  B,  he  would  credit  him- 
self with  $10,000,  and  if  certificate  C  with  $13,333.  If  '''^  sold  cer- 
tificate D,  he  could  credit  himself  with  $15,000,  made  up  of  $3,333 
from  his  first  purchase,  $5,000  from  his  second,  and  $6,666  from  his 
third.  If,  on  the  other  hand,  he  sold  only  a  part  of  certificate  D, 
some  arbitrary  rule  of  apportionment  must  be  adopted,  allocating  the 


"T.  D.  3238  (October  22,  1921)  added  paragraph  4  to  Art.  1547,  Reg.  45. 
"C.  B.  3,  page  40;  O.  D.  735. 

^' Toiviw  V.  McEUtfjott.  U.  S.  District  Court,  Southern  District  of  New 
York,  274  Fed.  960  (August  5,   1921). 


776  INCOME 

shares  sold  among  his  purchasers.  The  most  natural  analogy  is  with 
payment  upon  an  open  account,  where  the  law  has  always  allocated  the 
earlier  payments  to  the  earlier  debte,  in  the  absence  of  a  contrary  in- 
tention. Accordingly,  if  all  the  new  shares  were  not  sold  at  once,  I 
think  the  first  sales  would  be  attributed  to  the  first  purchases  still  re- 
maining unsold  when  the  stock  dividend  was  declared.  I  do  not  see 
that  this  method  will  result  in  confusion  in  its  application,  and  it 
carries  into  effect  the  underlying  theory  of  Eisner  v.  Maconibcr.  supra. 

The  two  illustrations  given  below  show  the  procedure  to  be 

followed. 

Market 
Cost  Value 

Purchased  lo  shares  common  @  $ioo $i,ooo  $   900(a) 

"  40       "  "         @      80 3,200  3,6oo(b) 

"  30       "  "         @      40 1,200  2,700(0) 

Total       80 $5,400  $7,200 

10%   Stock  Dividend:      " 

I  share  preferred $  80(d) 

4      "  "         320(e) 

3      "  "        240(f) 

Total         8 $640 

Ratio  of  (a)  to  (a)  +   (d)  =:  900/980=91.8 

Ratio  of  (b)  to   (b)   -f   (e)  =  360/392=91.8 

Ratio  of   (c)  to   (c)  -f-   (f)  =  270/294=91.8 

Per  cent  Total 

91.8  X  $1,000=  cost  apportioned  to  first  10  shares  of  common  = 

91.80  per  share $  918.00 

91.8  X  $3,200  =  cost  apportioned  to  second  40  shares  of  common 

^=  73-44  per  share 2,937.60 

91.8  X  $1,200  ^  cost  apportioned  t  j  third  30  shares  of  common  = 

36.72  per  share 1,101.60 

Total  original  cost $4,957.20 


The  above  reveals  that  when  sales  are  made  from  any 
one  of  the  three  lots  shown  a  different  cost  is  used  for  each  lot. 

In  contrast  with  this  method  is  the  use  of  an  average,  to 
which  the  Treasury  objects,  viz., 

91.8  per  cent  of   $5,400   (total  cost  as  above)   =  $4,957.20  total  new  cost 
Total  cost  apportioned  to  old  shares  divided  by  number  of  old  shares  = 
$4,957.20  -^  80  =  61.97  average  cost  of  old  share. 

The  following  computation  illustrates  the  allocation  of  the 
cost  between  stock  originally  purchased  and  dividend  stock  of 


FROM    STOCK   DIVIDENDS  yyy 

a  different  class  when  several  different  lots  were  purchased  at 
different  prices : 

When  more  than  one  stock  dividend  is  received,  and  vari- 
ous purchases  have  been  made,  the  effect  of  the  receipt  of  each 
stock  dividend  is  to  reduce  the  proportion  of  the  cost  to  be 
assigned  to  each  share  of  the  increased  number  of  shares. 
Each  lot  of  purchased  stock  will  usually  carry  a  different  orig- 
inal cost,  and  sales  are  made  gradually  eliminating  the  earliest 
purchases.  There  is  thus  a  continually  changing  l)asis  on 
which  to  compute  profit  from  sale. 

Statement  of  Acquisition  of  Stock  and  Cost 

No.  of  Shares  Cost 

1909  Purchased    i.ooo  $  84,800.00 

1910  Stock  dividend  3354% ZZiVi  

Purchased    zVz  495-75 


Total    (average  $63.81   per  share)  ..  .      1,336^  $85,295.75 

1911     Deduct:      Shares    given    to    son,    taken    at 

$63.81   per  share    iG^i  1,063.50 


Mar.   I,   1913 

Held  at  this  date 1,320                $  84,232.25 

1914     Received  as  legacy,  taken  at   market  value 

at  date  of  decedent's  death 200  40,000.00 

1917  ( I )   Stock  dividend  5o7c 760                     

1918  Purchased     120  24,000.00 

1919  (2)    Stock  dividend  25% 600                     

1920  (3)   Stock  dividend  40% 1.200                     


Totals    4.200  $148,232.25 


Allocation  of  Stock  Dividends  to  Earliest  Purchases  or  Acqui- 
sitions TO  Determine  Profit  on  Subsequent  Sale 

No.  of  Shares  Cost 

Stock  held  at  March  i,   191 3,  at  market  value 

at  that  date   1,320  $264,000.00 

(1)  50%  stock  dividend   received   in    1917 
(50%  of   1,320) 660 

(2)  25%  stock   dividend   received   in   1919 
(25%  of  1,980) 495 

(3)  40%  stock   dividend   received   in    1920 
(40%  of  2,475) 990 

3,465  at  $76. 19  =  $264,000.00 


778  INCOME 

Stock  received  as  a  legacy  in  1914 200  $  50,000.00 

(i)   50%   stock   dividend  received  in   191 7 
(50%  of  200)   100 

(2)  25%   stock  dividend  received  in   1919 
(257f   of   300)... ;...._. 75 

(3)  40%   stock  dividend  received  in   1920 
(40%  of  375) 150 

525  at  $95.24  =  $  50,000.00 

Stock  purchased  in  1918 120  $  24,000.00 

(2)  25%   stock  dividend   received  in   1919 
(25%   of    120). 30 

(3)  40%   stock  dividend   received  in   1920 
(40%   of   225) 60 

210  at  $1 14.29  =  $  24,000.00 

Total  shares  owned  at  June  30,  1921 — as  above    4,200  at  $80.48  =^  $338,000.00 
1921     Stock  sold  at 1,000  at  $70.00=     70.000.00 


Cost  per  share  of  shares  owned  at  March  i, 
1913,  after  allocating  stock  dividends  = 
$84,232.25    -^    3.465    shares $       24.31 

Cost  of  1,000  shares  sold  in  1921 $24,310.00 

Value  as   at   March   i,   1913,''  of    1,000  shares 

sold    in    1921 $76,190.00 

Proceeds  of  1,000  shares  sold  in  1921 $70,000.00 


Since  the  sales  price  is  less  than  value  at  March  i,  1913. 
but  more  than  cost,  the  taxpayer  reports  neither  gain  nor  loss. 

In  the  ca.se  of  a  sale  of  1,000  shares  received  as  stock  divi- 
dend (par  $100,000),  the  amount  to  be  reported  as  dividend 
and  also  deducted  on  return  so  as  to  secure  the  benefit  of  the 
normal  tax  which  has  been  paid  by  the  corporation  on  the 
earnings  transferred  to  capital  account  through  issuance  of 
stock  dividends,  is  computed  as  follows : 

March  i,   1913,  shares  owned 1,320 

Dividend  stock  allocated  to  holdings  at  March  i,  1913 2,145 

Total  shares  in  lot  to  which  sale  in  1921  is  allocated 3465 

Shares  sold  in  1921   (having  par  value  of  $100,000) 1,000 

Portion  of  $100,000  representing  proceeds  of  sale  of  stock   divi- 
dends exempt  from  normal  tax  : 

2,145 

X  $100,000  = $61,904.76 

3,465  '== 

"  See  ruling  (C.  B.  i,  page  31;  A.  R.  6). 


J 


FROM    STOCK    DIVIDENDS 


■/79 


In  order  to  secure  the  benefit  of  the  credit  for  normal  tax, 
the  entire  $61,904.76,  when  part  of  sale  is  original  holdings 
and  part  is  stock  dividend,  and,  when  wholly  the  proceeds  of 
sale  of  stock  dividend,  should  be  entered  as  a  dividend  on  one 
side  and  as  a  loss  on  the  other  side  of  the  return. 

Dividends   paid  in  scrip   are   stock   dividends. — 

Ruling.  A  corporation  declared  a  dividend  payable  in  stock  of 
the  company  at  par.  In  making  the  distribution  of  fractions  of  shares 
scrip  certificates  were  issued.  In  order  to  facilitate  the  disposal  for 
the  stockholders  of  their  scrip,  where  they  did  not  desire  to  purchase 
additional  scrip  to  entitle  them  to  a  full  share  of  new  stock,  the  cor- 
poration sold  in  the  open  market  as  an  agent  of  the  stockholders  the 
scrip  certificates  received  for  fractional  shares  of  dividend  stock. 
The  sale  was  entirely  optional  with  the  stockholders. 

Held,  that  the  scrip  certificates  received  as  a  dividend  do  not  repre- 
sent a  cash  dividend  but  a  stock  dividend  and  are  not  subject  to  tax. 
(C.  B..4,  page  24;  O.  D.  859.) 

Fractional  shares  must  be  used  in  ascertaining  new  cost. — 
When  fractional  sliares  of  stock  are  received  as  a  dividend, 
they  serve  to  reduce  the  average  cost.  Sometimes  adjustments 
are  made  in  cash  on  account  of  such  fractional  shares,  the 
cash  payment  representing  the  market  price  of  the  stock, 
which  may  be  more  than  par.  In  such  cases  the  amount  of  the 
payment  should  be  returned  as  the  proceeds  of  a  dividend  up 
to  par  and  adjustment  should  be  made  for  the  excess,  depend- 
ing on  cost  of  old  stock  or  value  at  March  i,  1913. 

Ruling.  The  resolution  of  the  board  of  directors  of  a  corporation, 
declaring  a  stock  dividend,  provided  that  no  fractional  shares  of 
stock  should  be  issued,  but  that  all  fractions  of  shares  should  be 
united  into  whole  shares  and  sold  by  the  treasurer  and  the  proceeds 
thereof  paid  to  the  stockholders  entitled  thereto,  such  resolution  hav- 
ing been  approved  by  the  stockholders.  Held,  that  the  stockholders 
by  approving  the  action  of  the  board  of  directors  approved  and,  in 
fact,  authorized  the  action  of  the  treasurer^  in  uniting  and  sell- 
ing the  fractional  shares  and  paying  over  the  proceeds  therefrom 
to  those  stockholders  entitled  to  the  fractional  shares,  and  that 
those  stockholders  entitled  to  receive  fractional  shares,  but  who  actually 
received  cash  representing  their  portion  of  the  proceeds  of  the  sale 


78o 


INCOME 


of  the  fractional  shares  should  compute  the  gain  or  loss  thereon 
under  the  provisions  of  Treasury  Decision  3059.^^  (C.  B.  4,  page 
28;  O.  D.  781.) 

Stock  dividends  declared  out  of  surplus  created  by  a  re- 
appraisal of  or  appreciation  in  assets. — There  may  be  some 
justification  for  reappraising  physical  assets,  but  there  can  be 
no  good  excuse  for  issuing  stock  for  goodwill  unless  it  has 
been  made  the  subject  of  sale. 

It  is  to  be  hoped  that  only  few  such  instances  occur.  Any 
corporation  which  writes  up  the  value  of  goodwill,  credits  the 
amount  to  surplus  account,  and  out  of  such  alleged  .surplus 
declares  a  dividend,  may  expect  to  be  charged  with  practicing 
a  fraud  on  its  stockholders  and  on  anyone  who  afterwards 
acquires  the  stock.  Goodwill  when  it  appears  on  the  balance 
sheet  of  a  corporation  or  partnership  is  supposed  to  be  carried 
at  cost  price  or  less,  and  any  action  which  tends  to  obscure 
this  inference  may  result  in  deception,  even  if  there  is  no 
intention  to  deceive. 

Refund  of  Taxes  Paid  on  Stock  Dividends 

Ruling.  A  claim  for  credit  on  Form  47A  for  payment  of  tax 
on  stock  dividends  is  to  be  accepted  as  a  suspension  of  immediate 
collection  of  tax  due  only — 

(i)  Against  income  or  income  and  excess-profits  taxes  due  and 
unpaid. 

(2)  If  amount  claimed  as  a  credit  does  not  exceed  the  amount 
of  tax  collected  on  the  stock  dividend  less  any  additional  tax  due 
and  unpaid  upon  the  sale  of  stock  received  as  a  dividend  or  stock 
upon  which  the  dividend  was  declared.  (The  basis  of  determining 
the  gain  or  loss  upon  sale  of  stock  is  stated  in  Regulations  45, 
article  1547,  paragraphs  i  and  2.  That  article  provides  that  the 
cost  of  each  share  of  stock  is  the  quotient  of  the  cost  of  the  old 
stock  divided  by  the  number  of  old  and  new  shares  added  together.) 

(3)  When  accompanied  by  an  affidavit  of  the  taxpayer  (sup- 
ported by  statements  from  the  corporation  which  distributed  the 
dividends   as   to   the   amount   distributed   to  the   taxpayer   and  years 


"  C.  B.  3,  page  38.  ".  .  .  .  that  portion  of  the  dividend  paid  in  cash 
will,  to  the  amount  of  the  surplus  accumulated  since  March  i,  1913,  be 
deemed  to  have  been  paid  out  of  such  surplus,  and  be  subject  to  tax " 


FROM    STOCK    DIVIDENDS  781 

in  whicli  the  profits  distributed  were  eanietl)   covering  the  following 
information : 

(a)  Whether  the  dividend  consists  of  stock  of  the  corporation 
distributing  the  dividend  to  the  taxpayer,  or  of  stock  of  another  cor- 
poration acquired  by  the  distributor. 

(b)  The  name  of  each  corporation  declaring,  the  declaration  of, 
and  the  date  of  receipt  by  the  taxpayer  of,  the  stock  dividends,  the 
tax  on  which   was  paid   and  is  covered  by  the  claim. 

(c)  The  year  in  which  the  stock  dividend  was  included  in  the 
taxpayer's  return  of  income. 

(d)  The  number  of  shares  the  taxpayer  received  and  the  value 
placed  upon  the  dividend  in  the  return.  (If  no  sale  of  stock  was 
made,  the  taxpayer  need  not  furnish  the  following  information.) 

(e)  If  any  sale  has  been  made  of  stock  of  the  corporation  de- 
claring the  dividends,  whether  the  stock  be  that  acquired  by  a  divi- 
dend, or  upon  which  the  dividend  was  declared,  state — 

(i)   The  number  of  shares  sold. 

(2)  The  selling  price. 

(3)  The  date  or  dates  of  sale. 

(4)  The  portion,  if  any,  of  the  selling  price  included  as  taxable 
profit  in  the  return  of  net  income  for  the  year  the  sale  was  made 
and  the  item  in  the  return  under  which  the  amount  was  reported. 

(/)  State  how  many  shares  of  stock  the  taxpayer  owned  at  the 
time  he  received  the  first  stock  dividend;  how  much  that  stock  cost 
the  taxpayer  and  the  date  the  stock  was  acquired.  (If  acquired 
prior  to  March  i,  1913,  state  its  value  on  that  date  and  manner  of 
determining  the  value.) 

(g)  State  separately  the  dates  from  March  i,  1913,  upon  which 
you  received  stock  dividends,  the  number  of  shares  received  on  each 
date,  and  the  names  of  the  corporations  distributing  the  dividends. 

The  receipt  or  canceled  check  covering  the  pa3'ment  of  tax 
involved  in  the  claim  should  be  attached  to  the  claim.  (C.  B.  2, 
page  246;  M.  2436.) 

Stock  dividends  on  shares  carried  on  margin  with 
broker. — 

Ruling.  A  taxpayer  in  19 18  carried  on  margin  with  a  stock 
brokerage  firm  shares  of  stock  in  a  certain  corporation.  As  the 
stock  was  not  owned  outright  by  the  taxpayer  it  was  not  registered 
in  his  name  but  in  the  name  of  the  broker,  together  with  other 
shares  carried  under  similar  conditions.  Subsequently  the  corpora- 
tion paid  a  stock  dividend  to  its  recorded  stockholders,  of  which 
the  brokerage  firm  was  one,  and  it  in  turn  distributed  the  same  pro- 
portionately to  the  marginal  owners. 

For  the  purpose  of   making  claim   for   credit   or   refund   of   the 


-82  INCOME 

taxes  paid  on  these  stock  dividends,  the  taxpayer  should  accom- 
pany his  claim  with  a  statement  from  the  paying  corporation  showing 
the  number  of  shares  of  stock  standing  in  the  name  of  the  brokerage 
firm,  and  the  amount  of  stock  dividends  paid  to  such  firm  during 
the  year  1918;  also  a  statement,  signed  by  the  brokerage  firm,  indi- 
cating the  number  of  shares  of  the  corporation's  stock  which  the 
firm  carried  for  his  account,  and  the  amount  of  stock  dividends 
turned  over  to  him  by  the  brokerage  firm.  (C.  B.  3,  page  308;  O.  D. 
625.) 

Can  recipient  of  stock  dividend  on  which  tax  was  paid  re- 
fuse to  accept  refund  of  tax? — Taxpayers,  who  received  stock 
dividends  on  which  income  tax  has  been  assessed  and  collected 
and  have  since  sold  their  stock,  may  have  suffered  a  loss  which 
they  would  not  have  incurred  if  Congress  had  not  made  such 
a  mess  of  the  whole  subject  of  the  taxation  of  stock  dividends. 

It  might  be  possible  for  anyone  who  has  sold  his  stock 
to  maintain  this  position :  that  having  followed  the  law  and 
the  regulations,  and  having  paid  the  tax  assessed  against  him, 
he  was  justified  in  assuming  that  the  matter  was  entirely  closed. 
In  other  words,  the  government  would  be  estopped  from  col- 
lecting a  greater  tax  in  such  cases. 

If  thereafter  he  sold  the  stock  received  as  a  dividend  and 
reported  the  proceeds  of  sale  in  accordance  with  the  law  and 
the  regulations,  having  paid  the  tax  assessed  upon  him,  he 
was  again  justified  in  assuming  the  matter  was  closed. 

If  he  is  compelled  to  accept  a  refund  of  the  tax  paid  on 
account  of  the  dividend  and  amend  his  return  on  account  of  the 
sale,  he  may  be  assessed  for  a  very  large  additional  tax  for 
which  he  would  not  have  been  liable  except  for  the  action  of 
Congress.^" 

Does  Stock  Dividend  Belong  to  Life  Tenant  or  to 
Remainderman  ? 

On  the  question  whether  a  stock  dividend  goes  to  the  life 
tenant  as  income  or  to  the  remainderman  as  capital,  there  are 
at  least  three  rules. ■"   The  United  States  Supreme  Court"^  and 


'*  For   further   comment   and   illustration,   see  Income    Tax  Frocednre, 
1920,  pages  498-9. 


FROM    STOCK    DIVIDENDS  783 

a  minority  of  state  courts  give  it  to  the  remainderman.  Among 
the  states  is  Massachusetts,-^  although  it  holds  the  dividend 
taxable  as  intome.  England  gives  the  stock  dividend  to  the 
life  tenant  if  it  is  an  ordinary  dividend  and  to  the  remainder- 
man if  it  is  an  extraordinary  one.-^  New  York,"*  Pennsyl- 
vania"'^' and  several  other  states^**  split  it.  What  comes  from 
corporate  profits  acquired  subsequent  to  the  creation  of  the 
trust  goes  to  the  life  tenant.  What  comes  from  earlier  ac- 
cumulations is  kept  for  the  remainderman. 

Retroactive  Tax  on  Stock  Dividends 

Mr.  Wayne  Johnson,  Solicitor  of  Internal  Revenue,  testi- 
fying before  the  Committee  on  Ways  and  Means  of  the  House 
of  Representatives  said : 

It  has  been  decided  by  the  Supreme  Court  in  the  Brushaber'-^  case 
that  we  could  have  an  act  retroactive  in  its  features,  and  that  has 

been  done An  excise  tax.  or  any  other  tax,  on  tlie  issue  of 

stock  based  on  capitalization  of  surplus,  which  would  be  equivalent  in 
amount  to  the  revenues  which  we  have  lost  on  account  of  the  adverse 
stock  dividend  decision,  would  be  perfectly  valid 

Since  the  foregoing  statement  was  made  the  192 1  law  has 
been  enacted.  It  contains  no  provision  for  the  imposition  of  an 
excise  tax  011  stock  dividends.  It  is  therefore  most  unlikely 
that  any  further  attempt  wnll  be  made  to  impose  a  retroactive 
tax  on  stock  dividends,  to  recoup  the  revenue  lost  by  the  gov- 
ernment by  reason  of  the  Supreme  Court  decision. 


*"  "The  Judicial  Debate  on  the  Taxability  of  Stock  Dividends  as  In- 
come," by  Thomas  Reed  Powell,  Bulletin  of  the  National  Tax  Association, 
May,  1920,  page  247. 

'^Gibbons  v.  Mahon.  136  U.  S.  549,  34  L.  Ed.  525,  10  S.  Ct.  1057. 

"  Minot  V.  Paine,  99  Mass.  loi. 

^  See  note  on  pages  801-802  to  Brander  v.  Brandcr,  4  Ves.  Jr.  800 
(Am.  Ed.)  ;  31  Eng.  Rep.  414. 

-*  Matter  of  Osborne,  209  N.  Y.  450,  50  L.  R.  A.  (N.  S.)  510,  Am. 
Ann.  Cas.  1915  A.  298,  52  N.  Y.  Supp.  48;  affirmed,  166  App.  Div.  547. 

''Earp's  Appeal,  28  Pa.  St.  368. 

^°  See  cases  cited  in  Tax  Commissioner  v.  Putnam,  227  Mass.  522,  532. 

^  Brushabcr  v.  Union  Pac.  Ry.  Co.,  240  U.  S.  i,  36  S.  Ct.  236,  60  L.  Ed. 
493. 


CHAPTER    XXIV 

INCOME  FROM  PARTNERSHIPS,  LIMITED 

PARTNERSHIPS  AND  PERSONAL  SERVICE 

CORPORATIONS 

The  T921  law  made  no  change  in  the  status  of  the  part- 
nership under  the  income  tax  law/  Like  the  previous  laws, 
the  present  one  in  effect  ignores  the  partnership's  existence  as 
an  independent  entity  and  taxes  the  partners  on  the  income 
from  the  business  in  substantially  the  same  manner  as  though 
the  income  were  received  from  an  individual  business  enter- 
prise. 

What  is  a  partnership  under  income  tax  law? — There  are 
three  classes  of  taxpayers  upon  which  in  all  cases,  or  in 
specific  cases,  taxes  are  imposed  upon  what  is  known  as  a 
partnership  basis.  This  simply  means  that  the  tax  is  not  levied 
upon  a  group  or  an  entity,  but  upon  the  individuals  who  com- 
pose the  group.     These  groups  are : 

1.  Common  law  partnerships 

2.  Limited  partnerships  of  a  certain  type 

3.  Personal   service    corporations. - 

Under  the  federal  income  tax  laws  the  treatment  of  the 
foregoing  classes  is  not  entirely  uniform.  Individual  mem- 
bers of  common  law  partnerships  are  uniformly  taxed  as  in- 
dividuals. Members  of  limited  partnerships  may  or  may  not 
be  taxed  as  individuals.  Stockholders  of  personal  service  cor- 
porations are  supposed  to  be  taxed  as  individuals,  but  the  fed- 
eral income  tax  law  lacks  the  power  to  change  a  corporation 
into  a  partnership  and  the  attempt  to  do  so  has  resulted  in 
certain  complications  which  are  discussed  hereafter. 


'As  in  the  case  of  the  1918  law,  it  relieves  partnerships  of  the  excess 
profits  tax. 

-Only  to  December  31.  1921  ;  after  that  date  personal  service  corpora- 
tions are  taxed  as  ordinary  corporations. 

784 


I 


FROM    PARTNERSHIPS  785 

General  ownership. — Ordinarily  when  two  or  more  per- 
sons are  associated  together  for  the  purpose  of  conducting 
a  business  for  profit,  they  are  deemed  to  constitute  a  partner- 
ship. The  following  article  points  out  when  certain  rela- 
tionships do  not  constitute  a  partnership. 

Regulation.  Joint  investment  in  and  ownersliip  of  real  and 
personal  property  not  used  in  the  operation  of  any  trade  or  business 
and  not  covered  by  any  partnership  agreement  does  not  constitute  a 
partnership.  Co-owners  of  oil  lands  engaged  in  the  joint  enterprise 
of  developing  the  property  through  a  common  agent  are  not  neces- 
sarily partners.  In  the  absence  of  special  facts  affirmatively  showing 
an  association  or  partnership,  where  a  vessel  is  owned  by  several  in- 
dividuals and  operated  by  a  managing  owner  or  agent  for  the  account 
of  all,  the  relation  does  not  constitute  either  a  joint-stock  association 
or  a  partnership.  The  participation  of  two  United  States  corpora- 
tions in  a  joint  enterprise  or  adventure  does  not  constitute  them 
partners.     (Art.  1507.)^ 

A  joint  venture  entered  into  by  agreement  between  a 
United  States  corporation  and  an  individual  was  held  not  to  be 
a  partnership.* 

When  the  net  losses,  if  any,  were  to  be  borne  by  one  of  the 
parties,  it  was  held  that  this  one  fact  was  insufficient  to  show 
that  the  agreement  was  not  a  partnership.^ 

Ruling.  A  taxpayer  and  several  others  were  the  subscribers  to 
a  syndicate  agreement  of  which  B  was  the  manager,  the  purpose  of 
which  was  the  purchase  of  stock  in  a  certain  corporation.  The 
articles  state  -that  "nothing  herein  contained  or  otherwise  shall  con- 
stitute the  parties  hereto  partners,"  and  there  is  no  evidence  that  a 
partnership  was  in  fact  established.  The  agreement  further  pro- 
vides that  no  subscriber  shall  be  liable  except  to  the  extent  of  his  in- 
dividual obligation.  The  legal  and  equitable  title  to  the  stock  was  in 
the  subscribers,  a  fact  inconsistent  with  the  view  that  the  syndicate 
was  either  a  corporation  or  association.  Nothing  in  the  agreement 
indicates  a  trust  relationship. 

....  The  relation  is  called  subscriber  and  manager  and  is  anal- 
ogous to  client  and  broker.   The  broker  buys  and  sells  the  stock,  realiz- 


^  [Former  Procedure] 

RuLiNf;.  Article  150/",  Regulations  45  (revised)  applies  to  situations 
arising  under  both  the  Revenue  Act  of  1917  and  the  Revenue  Act  of  1918. 
(C.  B.  2,  page  II  ;  O.  D.  411.) 

'  C.  B.  I,  ])agc  9;  O.  D.  96. 

°C.  B.  2,  page  II  ;  S.  1361. 


786  INCOME 

ing  a  profit  or  loss  reflected  in  the  client's  account.  The  entrance  of 
others  into  this  relation  as  joint  principals  does  not  affect  it.  The  re- 
lationship remains  that  of  principal  and  agent. 

Held,  that  these  agreements  constituted  the  principals  joint  owners 
in  a  ioint  venture.  As  such  each  is  taxable  in  his  individual  capacity 
on  income  from  that  source.  Each  subscriber  has  an  interest  in  the 
joint  account  of  such  a  nature  that  a  pro  rata  profit  or  loss  inures  to 
him  on  each  completed  transaction  evidenced  by  a  purchase  and  sale 
of  stock  at  a  higher  or  lower  price  as  the  case  may  be. 

Dividends  upon  the  stock  held  by  the  syndicate  should  be  reported 
in  the  taxpayer's  return  for  the  year  in  which  the  dividends  were 
declared  and  collectible  in  the  proportion  which  his  interest  bears 
to  the  total  amount  of  stock  held  by  the  syndicate. 

The  average  cost  to  the  syndicate  can  not  be  set  up  as  a  basis  for 
establishing  a  loss  to  the  taxpayer  upon  the  termination  of  the  agree- 
ment when  he  paid  to  the  syndicate  the  excess  of  the  purchase  price 
over  the  market  price  on  that  day. 

The  sale  of  his  stock  at  the  lower  market  price  to  a  new  syndicate 
at  the  termination  of  the  first  agreement  would  constitute  a  closed 
transaction  reflecting  a  loss  to  the  extent  that  such  stock  is  not  trans- 
ferred to  him  as  his  pro  rata  share  of  the  new  syndicate.  (I-2-15; 
I.  T.  1156.) 

The  foregoing  ruling"  states  that  the  net  income  of  subscrib- 
ers is  based  upon  closed  transactions.  These  no  doubt  are  sub- 
ject to  deductions  for  expenses.  It  would  seem  necessary  for 
the  managers  to  render  periodical  reports  to  subscribers  in 
order  that  the  latter  may  return  the  aggregate  net  income  for 
the  taxable  periods. 

Return  of  estimated  profits  on  joint  accounts. — 

Ruling.  In  case  two  distinct  partnerships  enter  into  a  single 
venture  under  agreement  to  terminate  in  two  years  no  part  of  profit 
to  be  distributable  or  drawings  allowed  during  that  period  and  any 
profit  to  be  held  intact  until  the  latter  part  of  1919,  the  amount  of 
profit  realized  and  determinable  each  taxable  year  should  be  reported 
proportionately  in  the  respective  returns  of  the  partnerships  regard- 
less of  the  agreement.  Individual  members  of  each  partnership  are 
subject  to  tax  upon  their  pro  rata  share  of  profit  even  though  actual 
distribution  is  postponed  until  termination  of  the  agreement.  (C.  B. 
I,  page  174;  O.  D.  187.) 

The  foregoing  is  sound  only  so  far  as  there  is  an  amount 
of  "realized  and  determinable"  profit  before  the  end  of  the 


FROM   PARTNERSHIPS  787 

period.  If  it  is  a  single  venture  there  can  hardly  be  a  realized 
profit  unless  and  until  the  venture  as  a  whole  is  closed.  The 
case  is  not  analogous  to  the  closing  of  books  upon  an  inventory 
or  accrual  basis. 

Domestic  partnerships. — The  following  regulation  defines 
a  domestic  partnership : 

Regulation.  A  domestic  ....  partnership  is  one  organized  or 
created  in  the  United  States,  including  only  the  States,  the  Territo- 
ries of  Alaska  and  Hawaii,  and  the  District  of  Columbia,  and  a 
foreign  ....  partnership   is   one  organized   or   created  outside   the 

United  States  as  so  defined The  nationality  or  residence  of 

members  of  a  partnership  does  not  affect  its  status.  A  partnership  cre- 
ated by  articles  entered  into  in  San  Francisco  between  residents  of 
the  United  States  and  residents  of  China  is  a  domestic  partnership. 
....  (Art.  1509.) 

The  Treasury  has  also  issued  several  rulings  defining 
partnerships.® 

Ruling.  A,  and  B,  his  wife,  founded  a  hospital  under  an  oral 
agreement  that  it  was  to  be  their  joint  business.  The  original  invest- 
ment of  approximately  x  dollars  was  contributed  by  B.  The  building 
for  the  enterprise  is  owned  jointly  by  A  and  B  and  the  balance  of  the 
property  used  in  the  business  is  owned  by  them  equally.  The  profits 
arising  from  the  enterprise  over  and  above  living  expenses  have  been 
placed  back  in  the  business  and  the  losses,  if  any,  are  charged  to  the 
enterprise.  The  powers  and  responsibilities  are  equally  divided,  each 
party  having  authority  to  draw  checks,  receive  payments,  and  per- 
form similar  acts.  Neither  party  may  dispose  of  his  or  her  interest 
without  the  consent  of  the  other. 

Since  there  is  an  equal  sharing  of  the  profits  and  losses,  a  com- 
munity of  interest,  a  mutual  agency  between  the  parties  to  the  agree- 
ment, and  an  intention  to  form  a  partnership,  and  since  a  wife  may 
enter  into  a  partnership  with  her  husband  in  the  particular  State, 
the  business  conducted  by  A  and  B  is  held  to  be  a  partnership  for  the 
purpose  of  Federal  taxation.     (I-1-2;  I.  T.  1151.) 

Annual  Returns  by  Partnerships 

Partnerships  pay  no  income  taxes  as  entities,  but  the  part- 
ners   are    individually    taxable    on    their    distributive    shares. 


See  B.  40-21-1850;  A.  R.  R.  629;  and  B.  33-21-1772;  Sol.  Op.  117. 


788  INCOME 

Nevertheless,  every  partnership  must,  under  the  1921  law" 
file  an  annual  return  giving  the  data  necessary  for  the  deter- 
mination of  the  distributive  shares. 

Law.  Section  224.  That  every  partnership  shall  make  a  return 
for  each  taxable  year,  stating  specifically  the  items  of  its  gross  in- 
come and  the  deductions  allowed  by  this  title,  and  shall  include  in 
the  return  the  names  and  addresses  of  the  individuals  who  would  be 
entitled  to  share  in  the  net  income  if  distributed  and  the  amount  of 
the  distributive  share  of  each  individual.  The  return  shall  be  sworn 
to  by  any  one  of  the  partners. 

The  return  should  be  made  on  form  1065.  (See  Appendix.) 
The  Commissioner  has  extended  the  time  for  filing  partner- 
ship returns  for  1921  until  May  15,  1922.^  This  extension 
does  not  apply  to  members  of  partnerships.  It  will  be  neces- 
sary for  them  to  apply  for  an  extension,  unless  a  general  exten- 
sion is  authorized. 

Regulation.  The  return  of  a  partnership  shall  state  speci- 
fically (a)  the  items  of  its  gross  income  enumerated  in  section 
213  of  the  statute;  (b)  the  deductions  enumerated  in  section  214, 
other  than  the  deduction  provided  in  paragraph  (11)  of  subdivision 
(a)  of  that  section;  (c)  the  amounts  specified  in  subdivisions  (a) 
and  (b)  of  section  216  received  by  the  partnership;  (d)  the  amount 
of  any  income,  war  profits  and  excess  profits  taxes  of  the  partnership 
paid  during  the  taxable  year  to  a  foreign  country  or  to  any  posses- 
sion of  the  United  States,  and  the  amount  of  any  such  taxes  accrued 
but  not  paid  during  the  taxable  year;  (e)  the  names  and  addresses 
of  the  individuals  who  would  be  entitled  to  share  in  the  net  income  of 
tlie  partnership  if  distributed;  (/)  the  amount  of  the  distributive 
share  of  such  net  income  of  each  such  individual;  and  (g)  such  other 
facts  as  are  required  by  form  1065.      (Art.  412.) 

Consolidated  returns.'' — The  1918  law  did  not  either  per- 
mit or  require  partnerships  to  make  consolidated  returns  with 


'  [Former  Procedure]  Before  1918  partnerships  were  required  to 
file  returns  only  upon  special  request  of  the  Commissioner  or  collector. 
(Reg.  33,  1918,  Art.  30.)  Such  requests  were  made  in  1914,  but  none  sub- 
sequently except  that  under  the  1917  law  returns  were  required  from 
all  partnerships  as  a  basis  for  the  assessment  of  excess  profits  tax.  (Sec- 
tion 211.)     The  1918  law  required  returns. 

*  T.  D.  3272,  dated  January  19,  1922. 

°  This  subject  is  also  discussed  further  in  Appendi.x  A,  Chapter  XIV, 
"Consolidated  Returns  of  Affiliated  Corporations." 


FROM    PARTNERSHIPS  789 

corporations  the  stock  of  which  was  owned  by  them.  The 
192 1  law,  while  not  specifically  permitting  taxpayers  to  include 
partnerships  in  consolidated  returns,  authorizes  the  Commis- 
sioner to  consolidate  the  accounts  of  two  or  more  related  busi- 
nesses of  corporations  or  partnerships  or  individuals  owned 
or  controlled  by  the  same  interests. 

Law.     Section    240 (d)    ....  in   any   case    of   two   or 

more  related  trades  or  businesses  (whether  unincorporated  or  incorpo- 
rated and  whether  organized  in  the  United  States  or  not)  owned  or 
controlled  directly  or  indirectly  by  the  same  interests,  the  Commissioner 
may  consolidate  the  accounts  of  such  related  trades  and  businesses, 
in  any  proper  case,  for  the  purpose  of  making  an  accurate  distribution 
or  apportionment  of  gains,  profits,  income,  deductions,  or  capital  be- 
tween or  among  such  related  trades  or  businesses. 

Regulation This  provision  relates  not  to  the  payment 

of  taxes,  but  to  the  determination  of  the  true  income  of  related  trades 
or  businesses  and  thus  indirectly  to  the  amount  of  taxes  which  may 
be  due  under  Title  II  (income  taxes)  and  Title  III  (excess  profits 
taxes)  of  the  statute.     (Art.  637.) 

It  would  appear  only  equitable  that  the  Commissioner 
should  exercise  the  power  conferred  on  him  by  section  240  (d) 
in  every  case  where  a  consolidation  of  partnership  accounts 
with  other  partnership  or  corporate  accounts  is  necessary  to 
obviate  hardship  which  would  otherwise  be  imposed  on  a 
partnership.  Therefore,  taxpayers  should  request  the  Com- 
missioner to  exercise  his  power  in  those  cases  where  it  seems 
necessary  to  the  imposition  of  only  a  fair  tax  on  profits  of 
partnerships  having  affiliations  with  corporations  or  other 
partnerships.  ^° 


^^  [Former  Procedure]  No  provision  whatever  for  consolidated  re- 
turns, either  of  corporations  or  partnerships,  appeared  in  either  the  1913  or 
1916  laws.  In  the  administration  of  the  1917  law,  the  Treasury  permitted 
consolidated  returns  by  corporations  for  excess  profits  purposes  but  not  for 
income  tax  purposes.  The  1921  law  confirms  this  administrative  procedure 
as  follows : 

Law.  Section  1331.  "(a)  That  Title  II  of  the  Revenue  Act  of  1917 
shall  be  construed  to  impose  the  taxes  therein  mentioned  upon  the  basis 
of  consolidated  returns  of  net  income  and  invested  capital  in  the  case 
of  domestic  corporations  and  domestic  partnerships  that  were  affiliate(/ 
during  the  calendar  year  J 917. 


790  INCOME 

Distributive    shares   of   partners — taxability. — 

Regulations.  Partnerships  as  such  are  not  subject  to  taxa- 
tion under  the  statute,  but  are  required  to  make  returns  of  income. 
....  Individuals  carrying  on  business  in  partnership  are,  however, 
taxable  upon  their  distributive  shares  of  the  net  income  of  such 
partnership,  whether  distributed  or  not,  and  are  required  to  include 
such  distributive  shares  in  their  returns.  The  net  income  of  the 
partnership  shall  be  computed  in  the  same  manner  and  on  the  same 
basis  as  the  net  income  of  an  individual,  except  that  the  deduction  of 
contributions  or  gifts  is  not  permitted,  as  these  are  allowable  deduc- 
tions to  the  respective  partners  in  their  individual  returns.     (Art.  331.) 

The  distributive  share  of  the  net  income  of  the  partnership  which 
a  partner  is  required  to  include  in  his  return  is  his  proportionate 
share  of  the  net  income  of  the  partnership,  either  (a)  for  the  taxable 
year  upon  the  basis  of  which  the  partner's  net  income  is  computed, 
or  (b),  if  the  partner's  net  income  is  computed  upon  the  basis  of  a 
taxable  year  different  from  that  upon  the  basis  of  which  the  net  in- 
come of  the  partnership  is  computed,  for  the  taxable  year  of 
the  partnership  ending  within  the  taxable  year  upon  the 
basis  of  which  the  partner's  net  income  is  computed.  Amounts  earned 
and  distributed  to  a  partner  by  a  partnership  after  the  end  of  its 
taxable  year  and  before  the  end  of  his  corresponding  taxable  year 
should  be  accounted  for  both  by  the  partnership  and  by  the  partners 
in  their  returns  for  their  next  succeeding  taxable  years.  Where  the 
result  of  partnership  operation  is  a  net  loss,  the  loss  will  be  divisible 
by  the  partners  in  the  same  proportion  as  net  income  would  have  been 


"(b)  For  the  purpose  of  this  section  a  corporation  or  partnership  was 
afiiliated  with  one  or  more  corporations  or  partnerships  (i)  when  such 
corporation  or  partnership  owned  directly  or  controlled  through  closely 
afifiliated  interests  or  by  a  nominee  or  nominees  all  or  substantially  all  the 
stock  of  the  other  or  others,  or  (2)  when  substantially  all  the  stock  of  two 
or  more  corporations  or  the  business  of  two  or  more  partnerships  was  owned 
by  the  same  interests :  Provided,  That  such  corporations  or  partnerships 
were  engaged  in  the  same  or  a  closely  related  business,  or  one  corporation 
or  partnership  bought  from  or  sold  to  another  corporation  or  partnership 
products  or  services  at  prices  above  or  below  the  current  market,  thus 
effecting  an  artificial  distribution  of  profits,  or  one  corporation  or  partner- 
ship in  any  way  so  arranged  its  financial  relationships  with  another  cor- 
poration or  partnership  as  to  assign  to  it  a  disproportionate  share  of  net 
income  or  invested  capital.  For  the  purposes  of  this  section,  public  service 
corporations  which  ( i)  were  operated  independently,  (2)  were  not  physically 
connected  or  merged  and  (3)  did  not  receive  special  permission  to  make  a 
consolidated  return,  shall  not  be  construed  to  have  been  affiliated;  but  a 
railroad  or  other  public  utility  which  was  owned  by  an  industrial  corpora- 
tion and  was  operated  as  a  plant  facility  or  as  an  integral  part  of  a  group 
organization  of  affiliated  corporations  which  were  required  to  file  a  consoli- 
dated return,  shall  be  construed  to  have  been  affiliated. 

"(c)  The  provisions  of  this  section  are  declaratory  of  the  praxi^§iojQis 
of  Title  II  of  the  Revenue  Act  of  1917." 


FROM    PARTNERSHIPS  791 

divisible,  unless  the  partnership  agreement  provides  for  the  division  of 
a  loss  in  a  manner  different  from  the  division  of  a  gain,  and  may  be 
used  by  the  individual  partners  in  their  returns  of  income.  (Art. 
332.) 

Establishment  of  fiscal  years. — Section  226  of  the 
1 92 1  law  makes  it  possible  for  a  partnership  to  change  from  a 
calendar  year  to  a  fiscal  year,  a  fiscal  year  to  a  calendar  year 
or  one  fiscal  year  to  another.^^  The  procedure  is  fully  out- 
lined in  the  chapters  on  returns.^" 

Partnership  fiscal   years. — 

Law.  Section  205 (c)  If  a  fiscal  year  of  a  partnership  be- 
gins in  1920  and  ends  in  1921,  or  begins  in  1921  and  ends  in  1922,  then 
(i)  the  rates  for  the  calendar  year  during  which  such  fiscal  year  be- 
gins shall  apply  to  an  amount  of  each  partner's  share  of  such  partner- 
ship net  income  (determined  under  the  law  applicable  to  such  year) 
equal  to  the  proportion  which  the  part  of  such  fiscal  year  falling  within 
such  calendar  year  bears  to  the  full  fiscal  year,  and  (2)  the  rates  for 
the  calendar  year  during  which  such  fiscal  year  ends  shall  apply  to 
an  amount  of  such  partner's  share  of  such  partnership  net  income  (de- 
termined under  the  law  applicable  to  such  calendar  year)  equal  to  the 
proportion  which  the  part  of  such  fiscal  year  falling  within  such  calen- 
dar year  bears  to  the  full  fiscal  year. 

The  192 1  law  with  net  income  differently  computed  and 
different  rates  of  tax  in  1922  than  under  the  1918  law,  in- 
volves adjustments  in  case  of  fiscal  year  partnerships  so  as 
to  tax  the  income  in  accordance  with  the  law  in  effect  when 
the  income  was  earned. 

Fiscal  years  i  920-1 921. — The  following  regulation  pre- 
scribes the  method  for  ascertaining  the  amount  of  partnership 
income  attributable  to  the  portions  of  the  calendar  years 
1920  and  192 1  included  within  the  partnership  fiscal  year. 

Regulation.  If  the  fiscal  year  of  a  partnership  began  in  the 
calendar  year  1920  and  ended  in  the  calendar  year  1921,  the  method 
of  computing  the  taxes  of  the  partners  is  as  follows:  (a)   The  amount 


"  [Former  Procedure]  In  the  past  it  was  customary  to  require  a 
partnership  to  give  notice  of  the  establishment  of  a  fiscal  year  thirty  days 
prior  to  March  i.     (Reg.  33,  1918,  Art.  31.) 

"  See  page  69  et  seq. 


792  INCOME 

of  each  partner's  distributive  share  of  the  net  income  of  the  partner- 
ship for  such  fiscal  year  attributable  to  the  calendar  year  1920  is  found 
by  determining  the  net  income  of  the  partnership  for  its  entire  fiscal 
year  in  accordance  with  the  law  applicable  to  the  calendar  year  1920 
(Title  II  of  the  Revenue  Act  of  1918)  and  the  distributive  share 
thereof  of  each  partner,  and  then  taking  such  proportion  of  that  dis- 
tributive share  as  the  part  of  the  taxable  period  falling  within  the 
calendar  year  1920  bears  to  the  entire  taxable  period;  (b)  the  amount 
of  each  partner's  distributive  share  of  the  net  income  of  the  partner- 
ship for  such  fiscal  year  attributable  to  the  calendar  year  192 1  is 
found  by  determining  the  net  income  of  the  partnership  for  its  en- 
tire fiscal  year  in  accordance  with  the  law  applicable  to  the  calendar 
year  1921  and  the  distributive  share  thereof  of  each  partner,  and 
then  taking  such  proportion  of  that  distributive  share  as  the  part  of  the 
taxable  period  falling  within  the  calendar  year  1921  bears  to  the  full 
taxable  period.     (Art.  334.) 

Although  the  rates  of  tax  for  the  years  1920  and  192 1 
imposed  itpon  the  income  of  the  individual  members  of  part- 
nerships are  the  same,  there  are  certain  differences  in  the  com- 
putation of  net  income  under  the  1918  and  192 1  laws,  which 
will  affect  the  tax  applicable  to  the  portions  of  the  years  1920 
and  192 1,  included  in  the  partnership  fiscal  year.  The  chief 
differences  are : 

1.  Allowance  for  net  losses. 

2.  Additions  to  reserve  for  bad  debts. 

3.  Interest  paid  to  carry  certain  Liberty  bonds. 

4.  Dividends  from  certain  foreign  corporations  and  from 

appreciation  at  March  i,  1913. 

5.  Exempt  Liberty  bond  interest. 

6.  Loss  on  "wash  sales." 

7.  Credits  for  foreign  taxes. 

8.  Income   from  business  carried  on  in  a  possession  of 

the  United  States. 

The  foregoing  regulation  prescribes  three  steps : 

( 1 )  Determine  the  net  income  for  the  full  fiscal  year : 

(a)  Under  the  19 18  law  (for  1920). 

(b)  Under  the    1921    law. 

(2)  Compute  each  partner's  share  as  if  for  a  full  year. 

viz., 


FROM    PARTNERSHIPS 


793 


(a)  His  share  of   (i-a). 

(b)  His  share  of   (i-b). 

(3)    Each  partner's  share  is  deemed  to  be  the  sum  of: 

(a)  That  portion  of   (2-a)   which  the  part  of  the 
fiscal  year  falHng  in  1920  is  of  a  full  year. 

(b)  That  portion  of   (2-b)   which  the  part  of  the 
fiscal  year  falling  in  192 1  is  of  a  full  year. 

The  amount  of  net  income  in  (3-a)  is  taxable  at  rates 
in  efifect  for  year  1920  (under  the  19 18  law)  ;  the  net  income 
in   (3-b)   is  taxable  at  the  1921  rates  (under  the  1921  law). 

Fiscal  years  1921-1922. — 

Regulation.  If  the  fiscal  year  of  the  partnership  began  in  the 
calendar  year  1921  and  ends  in  the  calendar  year  1922  the  rates  of 
tax  for  the  calendar  year  1921  apply  to  the  amount  of  each  partner's 
distributive  share  of  the  net  income  of  the  partnership  for  such  fiscal 
year  attributable  to  the  calendar  year  1921,  and  the  rates  for  the  calen- 
dar year  1922  to  the  amount  of  each  partner's  distributive  share  of 
such  income  of  the  partnership  attributable  to  the  calendar  year  1922. 
(a)  The  amount  of  each  partner's  distributive  share  of  the  net  in- 
come of  the  partnership  for  such  fiscal  year  attributable  to  the  cal- 
endar year  I9jfi  is  found  by  determining  the  net  income  of  the  part- 
nership for  its  entire  fiscal  year  in  accordance  with  the  law  applicable 
to  the  calendar  year  1921  and  the  distributive  share  thereof  of  each 
partner,  and  then  taking  such  proportion  of  the  distributive  share  as 
the  part  of  the  taxable  period  falling  within  the  calendar  year  1921 
bears  to  the  entire  taxable  period;  (b)  the  amount  of  each  partner's 
distributive  share  of  the  net  income  of  the  partnership  for  such  fiscal 
year  attributable  to  the  calendar  year  1922  is  found  by  determining 
the  net  income  of  the  partnership  for  its  entire  fiscal  year  in  accord- 
ance with  the  law  applicable  to  the  calendar  year  1922  and  the  dis- 
tributive share  thereof  of  each  partner,  and  then  taking  such  propor- 
tion of  that  distributive  share  as  the  part  of  the  taxable  period  falling 
within  the  calendar  year  1922  bears  to  the  entire  taxable  period. 
....      (Art.  335.) 

The  principles  governing  the  computation  of  net  income 
attributable  to  the  calendar  years  1921  and  1922  are  the  same 
as  illustrated  herein  above  for  fiscal  years  1 920-1 921.  While 
a  fiscal  year  ending  in  1922,  however,  is  affected  by  only  one 
law,  viz.,  the  192 1  law,  the  capital  gains  provisions  thereof  are 


794  INCOME 

not  effective  until  January  i,  1922.'"  The  restriction  on  losses 
from  "wash  sales"  is  not  effective  until  November  23,  1921. 
The  dift'erent  treatment  of  such  items  under  the  same  law, 
but  as  applied  differently  in  the  years  1921  and  1922,  requires 
that  two  computations  of  net  income  be  made,  each  for  the 
full  fiscal  year: 

1.  As  if  the  fiscal  year  was  the  calendar  year  1921. 

2.  As  if  the  fiscal  year  was  the  calendar  year  1922. 
From  this  point  the  procedure  for  determining  the  pro  rata 

part  attributable  to  192 1  and  1922  is  the  same  as  illustrated 
above  for  1 920-1 921  fiscal  years. 

Example 

Assume  the  following:  A  partnership  with  fiscal  year  ended  Sep- 
tember 30,  1921,  has  net  income  for  the  full  year  of  $40,000  (when 
computed  under  the  1918  law).  When  computed  under  the  1921  law, 
the  net  income  for  the  full  fiscal  year  is  $36,000.  Partner  A  has  a 
one-half  interest  in  the  profits. 

A's  income  from  the  partnership  would  he  computed  as  follows : 

I 

Net  income  for  full  year  under  1918  law  as  above $40,000 


A's   share    ('4   of  $40,000) $20,000 


Taxable   at    igi8   rates    (3   months    falling   in   1920,   or    34   year), 

14   of   $20,000    $  5.000 

II 
Net  income  for  full  j'ear,  under  1921  law  as  above $36,000 


A"s  share    (54  of  $36,000) $18,000 


Taxable  at   1921    rates    (9  months    falling   in    1921,   or   ^   year), 

^  of  $18,000 13.500 


Total  to  be  reported  $18,500 


Application  of  different  rates  for  fiscal  years  1921-1922.^* — 

Regulation In  determining  the  rates  of  tax  applicable 

to  the  amounts  of  the  distributive  shares  of  the  partners  attributable 


"  See  page  627. 

'*  [Former  Procedure] 

Application  of  rates  of  previous  years. — 

1918  Law.     Section  206.     "That  whenever  parts  of  a  taxpayer's  income 


FROM    PARTNERSHIPS 


795 


to  the  calendar  years  1921  and  1922,  respectively,  the  amounts  subject 
to  the  rates  for  the  calendar  year  1922  shall  be  placed  in  the  lower 
brackets  of  the  rates  schedule  provided  in  the  present  statute,  and 
the  amounts  attributable  to  the  calendar  year  1921  in  the  next  higher 
brackets  of  the  rates  schedule  applicable  to  that  year.     (Art.  335.) 

Congress  did  not  re-enact  in  the  1921  law  the  provisions  of 
section  206  of  the  19 18  law  which  provided  for  the  superim- 
position  of  income  of  the  earlier  year  on  that  of  the  later 
year.  The  Treasury  in  the  foregoing  regulation  follows  the 
method  previously  prescribed  by  the  19 18  law\  The  1921  law 
is  not  specific  as  to  how  the  computation  should  be  made. 

An    illustration    will    make   clear    the    application    of    the 

method. 

Example 

Assume  that  A  has  income  from  a  partnership  (a  one-fourth  in- 
terest therein)  with  fiscal  year  ended  June  30,  1922,  and  that  there 
are  no  items  requiring  different  treatment  in  1921  and  1922. 

Partnership  profits,  12  months  ended  June  30,  1922 $100,000 

A's  share  (^  of  $100,000)    $  25,000 

Other  income  in  calendar  year  1922 1,000 

Total  income  to  be  reported $  26,000 

Taxable  at  1922  rates : 

Yz  of  A's  share  of  partnership  income $  12,500 

Other  income    1,000 

Total    $  13,500 

Taxable  at  1921  rates :         •  • 

1/2  of  A's  share  of  partnership  income $  12,500 


are  subject  to  rates  for  different  calendar  years,  the  part  subject  to  the  rates 
for  the  most  recent  calendar  j'ear  shall  be  placed  in  the  lower  brackets  of 
the  rate  schedule  provided  in  this  title,  the  part  subject  to  the  rates  for  the 
next  preceding  calendar  year  shall  be  placed  in  the  next  higher  brackets  of 
the  rate  schedule  applicable  to  that  year,  and  so  on  until  the  entire  net 
income  has  been  accounted  for.  In  determining  the  income,  any  deduc- 
tions, exemptions  or  credits  of  a  kind  not  plainly  and  properly  chargeable 
against  the  income  taxable  at  rates  for  a  preceding  year  shall  first  be 
applied  against  the  income  subject  to  rates  for  the  most  recent  calendar 
year;  but  any  balance  thereof  shall  be  applied  against  the  income  subject 
to  the  rates  of  the  next  preceding  year  or  years  until  fully  allowed." 

Regulation.  Section  206  of  the  statute  applied  to  a  partner's  share 
of  partnership  net  income,  to  a  stockholder's  share  of  the  net  income  of  a 
personal  service  corporation (Reg.  45,  1641.) 


7C)6  INCOME 

The  tax  is  coiuputed  as  toUows: 

Net  income  $i3,5u<J 

Less:    Exemption   2,000 

$11,500 
Taxable  at  4%    4.000  $160 

Taxable  at  8%    $  7.5oo  600 

Surtax  at  1922  rates  on  $13,500 125 

Total  tax  at  1922  rates $       885 

Normal  tax,  $12,500  at  8% $1 ,000 

The  surtax  commences  with  the  next  highest  bracket,  viz. : 

$13,500  to  $14,000 :  $    500  at     5/'f 25 

14,000  to     16,000 :     2,000  at     b'^/c 120 

16,000  to     18,000 :     2,000  at     77c 140 

18,000  to     20,000 :     2,000  at     S'/f 160 

20,000  to     22,000 :     2,000  at     9% 180 

22,000  to     24,000 :     2,000  at  10% 200 

24,000  to     26,000  :     2,000  at  1 1  % 220 

Tax  on  1921  income   $     2,045 

Total  tax  for  calendar  year  1922  (payable  by  individual) $     2,930 


The  tax  on  the  remaining'  $12,500  of  income  taxable  at  1921 
rates  is  assessed  normal  tax  at  the  full  8  per  cent  rate,  the  specific 
exemption  of  $2,000  having  already  been  used,  and  the  first  $4,000 
taxable  at  4  per  cent  having  also  been  used  already  in  the  computa- 
tion above,   at    1922   rates. 

Partnerships  for  192 1  may  be  taxed  as  corporations. — In 
order  to  avoid  the  high  surtaxes  imposed  upon  individuals, 
the  1 92 1  law  extends  to  partnerships  the  right  retroactively 
to  incorporate  their  birsiness  for  the  yeaT  192 1.  It  is  provided 
that  capital  must  be  an  income-producing  factor,  in  which 
case  incorporation  may  take  place  at  any  time  up  to  March 
23,   1922. 

Law.  Section  229.  That  in  the  case  of  the  organization  as  a 
corporation  within  four  months  after  the  passage  of  this  Act  of  any 
trade  or  business  in  which  capital  is  a  material  income-producing  factor, 
and  which  was  previously  owned  by  a  partnership  or  individual,  the  net 
income  of  such  trade  or  business  from  January  i,  1921,  to  the  date  of 
such  organization  may  at  the  option  of  the  individual  or  partnership 
be  taxed  as  the  net  income  of  a  corporation  is  taxed  under  Titles  II 
and  III;  in  which  event  the  net  income  and  invested  capital  of  such 
trade  or  business  shall  be  computed  as  if  such  corporation  had  been 
in  existence  on  and  after  January  i,  1921,  and  the  undistributed  profits 


FROM    PARTNERSIIII'S  797 

or  earnings  of  such  trade  or  business  shall  not  be  subject  to  the  sur- 
taxes imposed  in  section  211,  but  amounts  distributed  on  and  after 
January  i,  1921,  from  the  earnings  or  profits  of  such  trade  or  business 
accumulated  after  December  31,  1920,  shall  be  taxed  to  the  recipients 
as  dividends;  and  all  the  provisions  of  Titles  II  and  III  relating  to 
corporations  shall  so  far  as  practicable  apply  to  such  trade  or  business: 
I'rovidcd,  That  this  section  shall  not  apply  to  any  trade  or  business,  the 
net  income  of  which  for  the  taxable  year  192 1  was  less  than  20  per 
centum  of  its  invested  capital  for  such  year:  Provided  further,  That 
any  taxpayer  who  takes  advantage  of  this  section  shall  pay  the  tax 
imposed  by  section  1000  of  the  Revenue  Act  of  1918  as  if  such  taxpayer 
had  been  a  corporation  on  and  after  January  i,  1921. 

In  no  case  would  it  be  beneficial  for  a  partnersliip  to 
incorporate  retroactivel}^  for  192 1  unless  the  earnings  were 
large  and  had  not  been  withdrawn  from  the  business. 

Changes  in  partnership  during  taxable  j^ear. — There  are 
many  changes  in  partnership  relations  which  do  not  involve 
dissolution  of  an  existing  partnership.  When  changes  occur 
during  a  fiscal  year,  because  of  the  death  or  withdrawal  of  a 
partner  or  the  admission  of  a  new  partner,  and  when  the  part- 
nership continues  except  as  to  the  changes  mentioned,  no  good 
purpose  would  seem  to  be  served  Ijv  making  returns  until  the 
end  of  the  taxable  year. 

Regulation Whenever  a  new  partner  is  admitted  to  a 

partnership,  or  any  existing  partnership  is  reorganized,  the  facts  as 
to  such  change  or  reorganization  should  be  fully  set  forth  in  the  next 
return   of    income,    in    order    that   the    Commissioner    may    determine 

whether  any  gain  or  loss  has  been  realized  by  any  partner 

(Art.  1570.) 

The  reference  to  the  "next  return"  would  not  indicate  that 
an  immediate  or  special  return  was  required.  In  any  event 
every  partnership  return  is  merely  an  "information"  return 
and  is  useful  only  after  the  returns  on  which  it  is  a  check 
are  filed. 

Return  by  receiver  of  partnership, — Article  424  of  Regula- 
tions 62  provides  that  "a  receiver  in  charge  of  the  business  of 


798  INCOME 

a  partnership  shali  make  a  return  for  it  on  form  1065."  This 
also  would  be  in  the  form  of  a  return  of  information  and 
would  not  be  a  return  on  which  the  tax  would  be  directly 
assessed.  It  would,  however,  indicate  the  distributive  profits 
or  losses  of  the  partners  during  the  period  covered  by  the  re- 
ceivership. When  a  receiver  is  appointed  for  a  partnership 
the  same  person  is  usually  made  receiver  for  each  of  the 
partners. 

Net  Income  of  Partners — How  Determined 

The  general  provision  of  the  law  governing  the  taxation 
of  partnerships,  which  includes  all  partnerships,  except  limited 
partnerships  of  the  "corporation"  type,  reads  as  follows: 

Law.  Section  21S.  (a)  That  individuals  carrying  on  business 
in  partnership  shall  be  liable  for  income  tax  only  in  their  individual 
capacity.  There  shall  be  included  in  computing  the  net  income  of 
each  partner  his  distributive  share,  whether  distributed  or  not,  of  the 
net  income  of  the  partnership  for  the  taxable  year,  or,  if  his  net  in- 
come for  such  taxable  year  is  computed  upon  the  basis  of  a  period 
different  from  that  upon  the  basis  of  which  the  net  income  of  the 
partnership  is  computed,  then  his  distributive  share  of  the  net  income 
of  the  partnership  for  any  accounting  period  of  the  partnership  end- 
ing within  the  fiscal  or  calendar  year  upon  the  basis  of  which  the  part- 
ner's net  income  is  computed 

The  regulations,  except  for  article  t,;^2,^^  do  not  attempt 
to  elaborate  this  section  of  the  law. 

The  return  of  the  partnership  (form  1065)  serves  two 
useful  purposes :  ( i )  It  is  such  a  compilation  as  would  have 
to  be  prepared  by  the  partnership  in  any  event,  in  order  to 
assemble  and  segregate  the  taxable,  partly  taxable  and  non- 
taxable income  and  the  allowable  and  non-allowable  deduc- 
tions. (2)  After  the  compilation  is  made  the  distributive  share 
of  each  partner  is  so  stated  as  to  set  forth  clearly  the  man- 
ner in  which  it  should  be  taken  up  in  the  partner's  individual 
return. 

'^  See  page  790.  ,  •        ' 


FROM    PARTNERSHIPS 


799 


Net  income  of  a  partnership  defined. — The  tax  is  to  be 
levied  on  the  distributive  shares  '*of  the  net  income  of  the 
partnership,"  and  this  phrase  is  defined  in  the  law  as  follows : 

Law.     Section  218 (c)  The  net  income  of  the  partnership 

shall  be  computed  in  the  same  manner  and  on  the  same  basis  as  pro- 
vided in  section  212  except  that  the  deduction  provided  in  paragraph 
(11)  of  subdivision  (a)  of  section  214  shall  not  be  allowed 

Section  212  describes  the  method  of  determining  the  net 
income  of  individuals  and  section  214  (a-ii)  permits  the 
deduction  of  certain  gifts^*'  up  to  15  per  cent  of  the  taxpayer's 
net  income.  The  effect  of  the  section  of  the  law  quoted  above, 
therefore,  is  to  put  a  partnership  on  exactly  the  same  basis  as 
an  individual,  so  far  as  determining  net  incpme  is  concerned, 
with  the  single  exception  that  gifts  of  the  type  described  may 
not  be  deducted.  The  distributive  shares  of  the  partnership 
profits,  however,  form  a  part  of  the  individual  partner's  "net 
income,"  from  which  such  gifts  may  be  deducted  up  to  the  limit 
of  15  per  cent.  Consequently  no  disadvantage  accrues  to  the 
partnership  because  of  the  provision  forbidding  the  deduction." 

Whether  or  not  the  contributions  made  directly  by  the 
partnership  exceed  the  15  per  cent  limit,  the  individual  part- 
ners must  return  as  their  share  of  the  net  income  of  the  part- . 
nership  the  full  distributive  share  without  any  deductions  for 
contributions.  The  credit  to  which  each  partner  is  entitled 
depends  upon  the  entire  taxable  income  of  the  partner  and  is 


"See  Chapter  XXXIV. 

"  [Former  Procedure] 

Ruling.  Recommended,  upon  reconsideration  of  the  appeal  of  the  M 
Company,  a  partnership,  that  the  action  of  the  Income  Tax  Unit  in  dis- 
allowing a  deduction  on  account  of  contributions  made  to  the  American 
Red  Cross  in  1917  by  the  partnership  be  reversed,  and  that  the  firm  be 
allowed,  under  the  provisions  of  section  206  of  the  Revenue  Act  of  1917, 
to  deduct  charitable  contributions  or  gifts,  as  described  and  limited  in  sec- 
tion 5  (a)  of  the  Revenue  Act  of  1916,  as  amended,  even  though  such  con- 
tributions were  not  so  closely  connected  with  the  trade  or  business  as  to 
secure  to  it  some  definite  benefit  or  consideration. 

Committee  Recommendation  245  (C.  B.  3,  page  323),  is  hereliy  re- 
voked.    [B.  Digest  45-21-1914;  A.  R.  651   (Sol.  Op.  116).] 

The  foregoing  ruling  is  in  accord  with  the  author's  position  as  stated  in 
Income  Tax  Procedure,  1919,  page  830. 


8oo  INCOME 

not  affected  by  the  relation  of  the  contributions  of  the  firm  to 
the  total  income  of  the  firm. 

Donations  should  be  charged  to  a  special  ledger  account. 
The  donation  account  should  be  closed  by  transfers  to  the 
partner's  accounts.  Each  partner  would  be  able  to  determine 
whether  or  not  the  15  per  cent  allowance  had  l^een  exceeded 
in  his  case.  This  special  account  should  include  only  those 
donations  subject  to  the  15  per  cent  limitation.  All  other  dona- 
tions, properly  classified  as  expenses,  should  be  charged  to 
appropriate  expense  accounts. 

Credits  for  certain  dividends  and  interest^  normal 
TAX  ONLY. — The  "distributive  share"  upon  which  the  part- 
ner is  taxable  includes  certain  items  which  when  received 
directly  as  a  part  of  an  individual's  income  are  subject  only 
to  the  surtax  rates.  Such  items  are  dividends  from  certain 
classes  of  corporations,  and  interest  on  certain  government 
securities  whose  terms  of  issue  provide  for  exemption  from  the 
normal  tax.  The  law  definitely  provides  that  the  identity  of 
these  items  shall  be  preserved  so  that  each  partner  may  claim 
as  a  credit  his  proportionate  share  of  the  income  represented 
by  them. 

Law.     Section  218 (b)  The  partner  shall,  for  the  purpose 

of  the  normal  tax,  be  allowed  as  credits,  in  addition  to  the  credits  al- 
lowed to  him  under  section  216,-  his  proportionate  share  of  such 
amounts  specified  in  subdivisions  (a)  and  (b)  of  section  216  as  are  re- 
ceived by  the  partnership 

Subdivisions  (a)  and  (b)  of  section  216  describe  the 
dividends  and   interest   referred  to.^^ 

Regulation.  In  addition  to  the  credits  ordinarily  allowed  to  an 
individual,  a  partner  is  entitled  to  the  following  credits:  (a)  A  credit 
against  net  income  for  the  purpose  of  the  normal  tax  only  of  pro- 
portionate shares  of  such  dividends  specified  in  section  216  (a)  and 
article  301,  and  of  such  interest  not  entirely  exempt  from  tax  upon 
obligations  of  the  United  States  and  bonds  of  the  War  Finance  Cor- 
poration as  are  received  by  the  partnership;  and  (b)  a  credit  against 
income  tax  of  the  partner's  proportionate  share  of  any  income,  war 


"*  See  pages  681  and  704. 


FROM    PARTNERSHIPS  8oi 

profits,  and  excess  profits  taxes  of  llie  partnership  paid  or  accrued  dur- 
ing the  taxable  year  to  a  foreign  country  or  to  any  possession  of  the 
United  States  subject  to  the  limitations  of  section  222  of  the  statute. 
(Art.  333.) 

The  procedure  regarding  exemption  for  dividends,  interest 
and  taxes^**  is  fully  outlined  in  the  respective  chapters  deal- 
ing with  those  subjects   and  in  the  chapters  on  returns. 

Interest    on    tax-exempt    bonds    to     be    entirely 

OMITTED  FROM  THE  CALCULATION  OF  NET  INCOME. The  basis 

prescribed  for  the  calculation  of  net  income  in  section  218  (c), 
quoted  on  page  799,  plainly  excludes  entirely  interest  upon 
tax-exempt  securities.^" 

Identity  of  income  of  partnership — how  far  trace- 
able.— In  the  gross  earnings  or  expenses  of  a  partnership 
there  may  be  items  other  than  the  specified  dividends  or  in- 
terest which  would  be  favorably  treated  in  the  returns  of 
individuals  if  segregated  from  the  partnership  profits.  If  there 
are  such  items  partners  may  confidently  report  them  separately 
unless  and  until  partnerships  are  taxed  as  entities."^ 


'"  [Former  Procedure]     Credit  for  1917  excess  profits  tax  restricted 

TO   I9I7   INCOME. 

Law.  Section  218.  "(c)  In  the  case  of  an  individual  member  of  a 
partnership  which  makes  return  for  a  fiscal  year  beginning  in  191 7  and 
ending  in  1918,  his  proportionate  share  of  any  excess-profits  tax  imposed 
upon  the  partnership  under  the  Revenue  Act  of  1917  with  respect  to  that 
part  of  such  fiscal  year  falling  in  1917,  shall,  for  the  purpose  of  determin- 
ing the  tax  imposed  by  this  title,  be  credited  against  that  portion  of  the 
net  income  embraced  in  his  personal  return  for  the  taxable  year  1918  to 
which  the  rates  for  1917  apply." 

This  provision  is  equitable.  The  partner's  tax  on  1917  profits,  not 
reported  until  1918,  should  be  based  on  1917  rates;  therefore  the  credit 
for  the  1917  excess  profits  tax  was  applicable  against  the  1917  income,  not 
against  1918  income. 


""  [Former  Procedure]  For  full  discussion  of  the  foregoing,  see  In- 
come Tax  Procedure,  1919,  pages  2>72-2>72)- 

'■"  [Former  Procedure]  Regulations  Zi  were  subject  to  criticism.  It 
happens  that  under  the  1916  law,  the  1918  law  and  the  new  1921  law  the 
kinds  of  partnership  income  which  it  is  an  advantage  to  "identify"  are 
"specially  provided  for."  Therefore  taxpayers  are  not  concerned  at  pre.sent 
about  the  restriction.  For  text  of  old  regulations,  court  decisions  and  com- 
ments, see  Income  Tax  I'rnccdnrc,  1920,  page  505. 


8o2  INCOME 

Ruling.  An  individual  member  of  a  partnership  received  a 
salary  for  services  performed  as  an  employee  of  a  city  and,  in  ac- 
cordance with  his  contract  with  the  firm,  turned  over  to  it,  as  the 
value  of  his  time,  the  entire  amount  so  received. 

Held,  that  the  individual  partner  might  deduct  the  amount  of 
the  salary  in  his  personal  return  as  a  business  expense,  but  that  no 
deduction  could  be  claimed  by  the  partnership,  since  to  allow  the 
amount  received  by  it  to  be  treated  as  exempt  income  would  in  effect 
be  to  regard  it  as  an  employee  of  the  city,  which  was  not  the  fact. 
(C.  B.  2,  page  104;  A.  R.  M.  25.) 

The  foregoing  ruling  does  not  so  state,  but  it  must  be 
assumed  that  the  partner  rendering  the  service  omits  the  salary 
from  his  return  even  though  he  deducts  the  entire  amount 
turned  over  to  the  firm. 

Information  needed  to  take  advantage  of  credits 
AND  DEDUCTIONS. — In  vicw  of  the  credits  and  deductions  set 
forth  in  the  preceding  paragraphs,  the  partner  should,  before 
preparing  his  personal  return,  secure  from  the  partnership 
specific  information  regarding  the  following  points  in  addi- 
tion to  the  mere  statement  of  net  profit  or  net  loss.^^ 

1.  Dividends  received: 

(a)  W'hen   from  domestic  corporation  not  entitled 

to  benefits  of  section  262.-' 

(b)  When  from  foreign  corporation  which  derives 

50  per  cent  of  its  gross  income  from  sources 
within  the  United  States."* 

2.  Interest    received    upon    "obligations  pf    the    United 

States  and  bonds  issued  by  the  War  Finance  Cor- 
poration which  is  included  in  gross  income  under 
section  213"  of  the  law.^° 


'"Which  it  is  assumed  would  be  drawn  up  in  accordance  with  the  law 
and  the  regulations.     See  page  788. 

-^  See  pages  347  to  350. 

^  See  page  711. 

"'  [Former  Procedure]  The  1918  law  required  that  interest  entirely 
exempt,  including  that  received  on  Farm  Loan  bonds,  be  reported  but  not 
included  in  net  income.  The  1921  law  did  not  re-enact  this  requirement. 
See  page  801. 


FROM    PARTNERSHIPS  803 

3.  Gifts.^« 

4.  Foreign  income  or  excess  profits  taxes. ^^ 

5.  Capital  gains  and  losses  (see  Chapter  XVII). 

Deduction  for  partnership  losses. — Partnership  losses 
are,  of  course,  deductible  in  the  returns  of  the  individual  part- 
ners. The  following  regulation  explains  the  basis  of  division 
among  partners : 

Regulation.     Losses   sustained   during   the   taxable   year  .... 

are  fully  deductible  ....  if  (a)  incurred  in  the  taxpayer's  trade  or 
business,  ....   (Art.  141.) 

Even  though  the  distributive  share  on  the  firm's  books 
is  a  net  profit,  if  the  aggregate  of  dividends  and  interest  de- 
scribed on  page  799  is  greater  than  the  net  profit  the  difference 
is  an  allowable  deduction  as  a  loss  to  the  partner. 

If  the  books  of  a  partnership  show  a  net  profit  of  $40,000 
with  two  equal  partners,  each  is  subject  to  surtax  on  his  dis- 
tributive share,  irrespective  of  the  character  of  the  income. 
If  the  firm  received  $50,000  in  dividends  each  partner  should 
return  $25,000'  from  that  source  and  claim  credit  for  a  loss 
of  $5,000.  The  amounts  entered  as  dividends  will  be  free 
of  normal  tax,  and  the  difference  between  $25,000  and  $5,000 
($20,000  each)  will  automatically  be  subject  to  the  surtax, 
which  commences  at  $5,000"^  for  192 1,  and  at  $6,000  for  1922. 


^"'See  Chapter  XXXIV. 

[Former  Procedure]  When  fiscal  years  ended  in  1918,  other  than  at 
December  31,  1918,  it  was  necessary  to  know  the  amount  of  partnership 
income  subject  to  the  191 7  income  and  excess  profits  tax  rates. 

"'  For  method  of  obtaining  credit,  see  Chapter  XXVIII. 

"*  [Former  Procedure] . 

Ruling In   the   case    of    a    partnership    sustaining   operating 

losses  the  question  arises  as  to  whether  or  not  the  full  distributive  share 
of  dividends  received  by  the  partnership  should  be  included  in  the  amount 
reported  on  line  25,  page  2,  of  the  form  for  1913,  eliminating  any  entry 
on  line  19.  The  effect  of  this,  if  nothing  further  is  done,  would  be  to 
return  the  entire  distributive  share  of  the  dividends  received  by  the  partner- 
ship as  liable  to  surtax,  no  notice  being  taken  of  the  operating  losses. 

The  Committee  is  of  the  opinion  that  the  correct  method  of  treat- 
ment is  to  include  on  line  25  the  total  distributive  share  of  dividends  and 
to  enter  on  line  32  a  proportionate  share  of  the  losses  sustained,  which 
would  have  the  effect  of  including,  for  surtax  purposes  only,  the  net 
distributive  share  of  the  partnership  income.  (C.  B.  _',  page  168;  A.  R.  M. 
13.) 


8o4  INCOME 

Net  loss  pronision  applies  to  partners liips. — 

Law.  Section  204.  ....  (b)  If  for  any  taxable  year  beginning 
after  December  31,  1920,  it  appears  upon  the  production  of  evidence 
satisfactory  to  the  Commissioner  that  any  taxpayer  has  sustained  a  net 
loss,  the  amount  thereof  shall  be  deducted  from  the  net  income  of  the 
taxpayer  for  the  succeeding  taxable  year;  and  if  such  net  loss  is  in  ex- 
cess of  the  net  income  for  such  succeeding  taxable  year,  the  amount 
of  such  excess  shall  be  allowed  as  a  deduction  in  computing  the  net 
income  for  the  next  succeeding  taxable  year;  the  deduction  in  all  cases 
to  be  made  under  regulations  prescribed  by  the  Commissioner  with 
the  approval  of  the  Secretary. 

(c)  The  benefit  of  this  section  shall  be  allowed  to  the  members  of 
a  partnership 

Regulation Where  the  result  of  partnership  opera- 
tion is  a  net  loss,  the  loss  will  be  divisible  by  the  partners  in  the  same 
proportion  as  net  income  would  have  been  divisible,  unless  the  partner- 
ship agreement  provides  for  the  division  of  a  loss  in  a  manner  dif- 
ferent from  the  division  of  a  gain,  and  may  be  used  by  the  individual 
partners  in  their  returns  of  income.     (Art.  332.) 

This  subject  is  discussed  in  detail  in  Chapter  XXIX. 

Profits  from  sale  or  exchange  of  capital  assets. — 
Since  the  1921  law  taxes  capital  gains  on  a  different  basis  from 
other  profits,"'^  it  is  necessary  for  partnerships  to  keep  a  sep- 
arate record  of  all  sales  or  exchanges  of  capital  assets. 

Law.     Section    206 (c)      In    the    case    of    a    partnership 

....  the  proper  part  of  each  share  of  the  net  income  which  consists, 
respectively,  of  ordinary  net  income  and  capital  net  gain,  shall  be  de- 
termined under  rules  and  regulations  to  be  prescribed  by  the  Com- 
missioner with  the  approval  of  the  Secretary,  and  shall  be  separately 

shown  in  the  return  of  the  partnership and  shall  be  taxed  to 

the  member  ....  as  provided  in  sections  218  .  .  .  .  ,  but  at  the  rates 
and  in  the  manner  provided  in  subdivision  (b)  of  this  section.^" 

Re(;ulatiox.  Under  subdivision  (c)  of  section  206  the  members 
of  a  partnership  shall  be  taxed  as  provided  in  section  218^  but  with 
respect  to  any  capital  net  gain,  may  elect  to  be  taxed  as  provided  in 
section  206.  Similarly  estates  or  trusts  or  the  beneficiaries  thereof 
shall  be  taxed  as  provided  in  section  219,  but  with  respect  to  any 
capital  net  gain  may  elect  to  be  taxed  as  provided  in  section  206.  In 
all  cases,  however,  of  election  to  be  taxed  under  section  206  the  mini- 
mum tax  on  the  total  net  income    (ordinary  net  income  plus  capital 


'This  subject  is  discussed  in  detail  in  Chapter  XVII.     See  page  627. 
'  See  page  628. 


FROM    PARTNERSHIPS  805 

net  gain)  is  123^  per  cent.  Where  the  net  income  of  a  partnership, 
estate,  or  trust  consists  in  whole  or  in  part  of  capital  net  gain,  there 
shall  he  attached  to  the  return,  upon  the  request  of  any  memher  or 
beneficiary  (or  without  such  request)  at  the  election  of  a  fiduciary  of 
an  estate,  a  statement  showing  (i)  all  items  of  capital  gain,  capital 
loss,  and  capital  deductions,  as  provided  in  article  1652,  and  (2)  the 
names  of  members  or  beneficiaries  and  the  amounts  of  their  re- 
spective shares  in  such  capital  net  gain.     (Art.  1653.) 

The  members  of  partnerships  may  elect  the  basis  upon 
which  they  will  be  taxed.  This  may  result  in  the  same  capital 
gain  being  taxed  on  two  different  bases  as  to  the  respective 
shares  of  partners  therein. 

The  accounting  period. — The  partner  is  taxable^^  on  his  dis- 
tributive share  of  the  net  income  ''for  any  accounting  period 
of  the  partnership  ending  within  the  fiscal  or  calendar  year 
upon  the  basis  of  which  the  partner's  net  income  is  computed." 
The  1918  law,  it  will  be  recalled,  permitted  an  individual,  for 
the  first  time,  to  report  on  the  basis  of  his  fiscal  year.  The 
phrase  just  quoted  makes  it  clear  that  a  partnership  having 
a  fiscal  or  closing  period  different  from  that  of  the  individual 
partner,  need  not  attempt  to  make  an  additional  closing  of 
the  books  or  ascertainment  of  profits  or  losses  in  order  that 
the  partner  may  return  his  share  of  the  net  profits  or  losses 
of  the.  partnership  for  his  full,  personal  fiscal  year.  Dift'erent 
partners  may,  indeed,  have  fiscal  years  ending  at  various  dates 
and  to  insist  upon  a  closing  of  the  books  in  each  instance 
would  be  out  of  the  question. 

What  the  government  wants  from  an  individual  who  is 
a  partner  in  one  or  more  firms  is  a  full  and  accurate  return 
of  his  share  of  the  partnership  profits  for  the  twelve  months 
ending  at  some  date  during  his  personal  fiscal  year.  The 
acceptance  of  this  as  sufficient  obviates  the  necessity  of  guess- 
ing or  roughly  calculating  the  partner's  income  when  the  fiscal 
year  of  the  partnership  does  not  agree  with  that  of  the  partner. 
It  is  convenient  and  accurate  to  report  the  amount  shown  by 


""  Section  218  (a). 


8o6  INCOME 

the  partnership  records,  and,  as  the  income  tax  has  come  to 
stay,  individuals  should  change  their  own  fiscal  periods  to  the 
regular  closing  date  of  their  partnerships. 

It  should  be  borne  in  mind  that  so-called  salaries  paid  to 
partners  are  in  effect  a  distribution  of  anticipated  profits 
(Chapter  XXVI).  They  may,  however,  have  been  deducted 
on  the  partnership  books  in  determining  the  net  annual  profits 
distributable  at  the  end  of  the  fiscal  year.  //  so  deducted  such 
salaries  should  be  included  as  taxable  income,  for  the  year  in 
which  received,  in  each  partner's  individual  return,  in  addition 
to  his  remaining  share  of  the  partnership  profits  for  the  fiscal 
year  mentioned  above. 

When  a  partnership  begins  business  at  some  date  other 
than  January  i  and  it  is  intended  to  establish  a  fiscal  year  end- 
ing twelve  months  thereafter  the  partnership  would  make  no 
return  as  of  December  31.  If  the  partners  keep  their  personal 
books  on  the  same  fiscal  year  basis  no  return  would  be  required 
for  December  31.  But  if  the  partners  do  not  establish  fiscal 
years  they  must  report  as  of  December  31.  In  their  returns 
for  the  first  calendar  year,  neither  profit  nor  loss  from  the  part- 
nership would  be  returned. 

Procedure  when  personal  and  partnership  accounts  are  on 
different  bases. — A  partner  may  have  been  accustomed  to  keep 
his  personal  accounts  on  a  cash  basis,  while  his  firm's  accounts 
are  on  an  accrual  basis.  In  such  a  case  he  may  continue  to 
keep  his  personal  accounts  as  before  if  it  is  not  practicable  for 
him  to  change  to  an  accrual  basis,  but  in  reporting  his  share 
of  firm  profits  or  losses  he  must  include  the  entire  amount  of 
profit  or  loss  accrued  to  or  incurred  by  him  on  the  firm's  books 
for  the  fiscal  or  calendar  year.  It  is  immaterial  how  or  when 
he  receives  his  share,  and  whether  or  not  the  firm's  books 
include  many  accrued  items. 

Dissolution  of  or  changes  in  partnership. — 

Regulation.  When  a  partner  retires  from  a  partnership,  or  it  is 
dissolved,  he  realizes  a  gain  or  loss  measured  by  the  difference  be- 


FROM    PARTNERSHIPS  807 

tween  the  price  received  for  his  interest  and  the  cost  to  him  of  his 
interest  in  the  partnership,  including  in  such  cost  the  amount  of  his 
share  in  any  undistributed  partnership  net  income  earned  since  he 
became  a  partner  on  which  the  income  tax  has  been  paid.  However, 
if  such  interest  in  the  partnership  was  acquired  prior  to  March  i, 
1913,  both  the  cost  as  hereinbefore  provided  and  the  vaUie  of  such 
interest  as  of  such  date,  plus  the  amount  of  the  share  in  any  un- 
distributed partnership  net  income  earned  since  February  28,  1913,  on 
which  the  income  tax  has  been  paid,  shall  be  ascertained  and  the  tax- 
able gain  derived  or  the  deductible  loss  sustained  shall  be  computed  as 
provided  in  article  1561.  If  the  partnership  distributes  its  assets 
in  kind  and  not  in  cash,  the  partner  realizes  no  gain  or  loss  until  he 
disposes  of  the  property  received  in  liquidation.  Whenever  a  new 
partner  is  admitted  to  a  partnership,  or  any  existing  partnership  is 
reorganized,  the  facts  as  to  such  change  or  reorganization  should  be 
fully  set  forth  in  the  next  return  of  income,  in  order  that  the  Com- 
missioner may  determine  whether  any  gain  or  loss  has  been  realized 
by  any  partner.     (Art.  1570.) 

Upon  the  dissolution  of  or  a  change  in  a  partnership  and 
a  distribution  of  assets  in  kind  it  is  not  probable  that  any 
taxable  gain  or  profit  would  immediately  arise.  In  a  dis- 
tribution upon  the  basis  of  book  values  there  is  no  gain  or 
loss,  because  it  will  be  assumed  that  ithe  partners  in  their 
individual  returns  will  have  accounted  for  all  gains,  profits 
or  income  which  were  shown  on  the  books  of  partnership. 
When  the  accounts  of  the  partnership  in  dissolution  are  con- 
tinued a  partner  may  await  the  result  of  the  transactions  for 
the  entire  taxable  year  before  taking  up  in  his  accounts  any 
gain  or  loss. 

The  foregoing  regulation  refers  to  the  cases  where  a 
partner  realizes  in  cash  or  its  equivalent  some  amount  greater 
or  less  than  is  shown  in  his  capital  account  in  the  firm's  books. 
The  books  may  show  that  the  book  value  of  a  partner's  one- 
half  interest  in  the  firm  is  $50,000.  Goodwill  is  not  carried 
as  an  asset. 

If  the  goodwill  is  valued  at  $40,000  and  sold  to  the  con- 
tinuing partner  or  someone  else  for  that  amount  the  retiring 
partner  will  receive  in  cash  $70,000.  If  the  goodwill  of  the 
business  on  March  i,   19 13,  was  worth  $40,000  the  retiring 


8o8  INCOME 

partner  will  not  realize  any  taxable  gain.  If  the  fair  market 
value  of  the  goodwill  on  March  i,  1913,  was  $25,000  the 
retiring  partner  must  report  a  realized  profit  of  $7,500.  If 
the  business  was  started  after  March  i,  1913,  his  taxable 
profit  is  $20,000. 

Readjustment  of  partnership  interests. — 

Ruling,  (i)  ....  If  a  retiring  partner  or  the  estate  of  a  de- 
ceased partner  takes  his  portion  of  the  partnership  property  in  kind 
there  is  no  realization  of  income,  such  realization  being  postponed 
until  the  property  so  received  is  in  turn  sold. 

(2)  If,  on  the  other  hand,  the  retiring  partner  or  the  estate  sells 
to  the  remaining  partners  his  interest  in  the  partnership  for  cash 
it  is  held  that  the  difference  between  the  cost,  or  value  as  of  March  i, 
1913,  of  such  interest  constitutes  gain  or  loss  for  the  purpose  of 
computing  the  income  of  such  partner  or  estate,  and  that  the  remain- 
ing partners,  as  a  result  of  this  transaction,  have  only  added  to  their 
holdings  in  the  partnership  property.  They  have  made  a  purchase 
and  not  a  sale,  and  can  have  realized  nothing  in  the  way  of  profit 
or  loss.'-   ....      ( C.  B.  3,  page  61  ;  Sol.  Op.  42.) 

Assume  that  a  retiring  partner's  capital  account  shows 
a  credit  balance  of  $25,000.  He  sells  to  a  continuing  partner 
for  $20,000.  If  the  latter  subsequently  converts  the  assets 
into  the  equivalent  of  cash  at  the  book  figures  he  will  realize 
a  profit  of  $5,000. 

If,  however,  he  purchases  fixed  assets  or  fails  to  convert 
other  assets,  the  $5,000  credit  to  the  retiring  partner's  account 
operates  as  a  reserve  and  is  not  true  surplus  nor  gain. 

Ruling (3)   The  effect  of  the  admission  of  a  new  partner 

depends  upon  the  terms  of  his  admission.  If,  under  the  terms  of 
the  partnership  agreement  he  contributes  property  or  cash  to  the 
capital  of  the  partnership  he  acquires  a  right,  upon  dissolution,  to 
a  return  of  his  contribution  together  with  his  proportionate  share 
of  the  net  profits  of  the  partnership  business,  and  in  the  meantime 
to  a  corresponding  share  in  the  net  earnings  of  the  partnership. 
There  is  no  realization  on  the  part  of  any  partner.  If,  on  the  other 
hand,  he  purchases,  for  cash,  an  interest  in  the  existing  partnership, 
it  is  clear  that  what  he  has  acquired  is  simply  a  right  to  share  in 
the  profits  of  the  partnership  during  its  continuance  and  in  any  sum 


See  Bulletin  37-21-1820;  O.  D.  10.33. 


'FROM    PARTNERSHIPS  809 

remaining,  upon  tlie  dissolution  of  the  partnership,  after  the  satis- 
faction of  creditors  and  of  the  equities  as  between  the  contributing 
partners.  Since  this  would  represent  a  ])urchase,  by  the  incoming 
partner,  there  could  be  no  realization  as  to  him,  and,  as  to  the  mem- 
bers of  the  former  partnership,  the  amount  paid  by  him  will  clearly 
be  income  to  them  in  direct  proportion  to  their  respective  interests 
in  the  former  partnership  and  should  be  returned  by  them  as  such. 
(C.  B.  3,  page  61  ;  Sol.  Op.  42.) 

Assets  of  old  partnership  taken  over  at  current 
VALUATION. — In  the  detailed  opinion  (see  digest  above),  the 
specific  question  was  stated  as  follows : 

An  opinion  is  requested  whether  upon  the  dissolution  of  a  part- 
nership by  the  withdrawal  or  death  of  a  partner  and  the  formation 
of  a  new  partnership  which  takes  over  the  assets  of  the  old  partner- 
ship belonging  to  the  remaining  partners,  at  current  valuation,  the 
transaction  is  to  be  considered  closed  so  that  the  increase  in  the 
value  of  the  assets  as  written  up  on  the  books  of  the  new  partner- 
ship over  the  cost  or  value  as  of  March  i,  1913,  of  such  assets  to 
the  former  partners  constitutes  taxable  income  to  them 

And  the  answer  given  by  the  Treasury  confirms  the  posi- 
tion taken  by  the  author  that  unrealized  appreciation  is  not 
income."" 

....  In  other  words,  to  hold  that  by  valuing  his  contrilnition 
to  the  partnership  at  a  greater  amount  than  its  cost  to  him,  or  value 
as  of  March  i,  1913,  he  could  realize  the  difference  as  income  would 
be  to  hold  that  the  partner  could  make  a  profit  by  selling  to  himself. 
Such  a  conclusion  is  wholly  at  variance  with  the  decisions  of  the 
courts  and  the  rulings  of  this  department 

Distributions  to  partners  other  than  in  cash. — A  partner 
should  return  for  taxation  the  exact  amount  credited  to  his 
capital  account  in  the  books  of  the  firm  at  the  end  of  its  fiscal 
year,  after  deducting  tax-exempt  interest,  etc.  Any  payments 
to  a  partner  charged  against  his  capital  account  are,  of  course, 
not  returnable  because  such  payments  merely  represent  dis- 
tributions of  capital  or  of  incoine  already  reported  and  taxed. 

The    same    principle    applies    to    partnership    distributions 


Income  Tax  Procedure,  1920,  page  510. 


8io  INCOME 

Other  than  in  cash.  For  instance,  a  firm  may  own  property 
or  securities  which  it  wishes  to  divide  among  the  partners. 
The  amount  at  which  such  items  appear  on  the  firm's  books 
as  assets  determines  the  book  value  of  the  partners'  interests 
therein,  and  when  distribution  is  made  the  items  should  be 
entered  by  the  partnership  and  the  partners  at  book  valuation. 
After  distribution  of  the  assets  such  book  valuation  is  the 
basis  of  gain  or  loss,  except  that  assets  acquired  before  March 
I,  19 1 3,  must  be  valued  as  of  that  date. 

Ruling.  Where  a  distribution  of  partnership  profits  is  made 
in  securities  carried  in  an  investment  account  by  the  partnership, 
first  each  partner  must  be  taxed  on  the  basis  of  his  distributable 
share  of  the  partnership  profits  for  the  year  1917,  which  partnership 
profits  will  be  ascertained  without  claiming  any  loss  with  regard 
to  the  unsold  securities  held  in  the  investment  account  of  the  partner- 
ship; second,  the  individual  partners  receiving  these  securities  as 
a  distribution  of  partnership  profits  shall  determine  their  future 
gain  or  loss  when  such  securities  are  sold  and  on  the  basis  of  the 
cost  of  the  securities  to  the  partnership  or  their  market  value  on 
March  i,  1913,  if  acquired  before  that  date.  (C.  B.  i,  page  46;  T. 
B.  R.  34.) 

Partnerships  Composed  of  Corporations 

As  a  general  rule,  a  corporation  cannot  enter  into  a  part- 
nership."* In  a  few  states,  as  in  Texas,  this  rule  has  been 
changed  by  statute.  The  reason  for  the  rule  is  that  to  allow 
a  corporation  to  enter  into  partnership  would  be  contrary  to 
the  general  theory  of  the  incorporation  acts.^^  For  income 
tax  purposes,  however,  it  has  been  held  that  a  partnership 
composed  of  corporations  should  be  classed  as  a  partnership 
rather  than  as  a  corporation.^'^  In  regard  to  the  case  under 
consideration,  it  should  be  noted  that  the  laws  of  Hawaii  per- 
mit corporations  to  become  members  of  a  partnership.  The 
subject  is  not  of  general  interest  enough  to  warrant  a  full 
discussion  in  these  pages,  but  it  may  be  said  that  unless  the 


'''*  Pearcc  v.  Madison,  etc.,  R.  R.  Co.,  62  U.  S.  441.     See  also  Bulletin 
42-21-1866;  A.  R.  M.  139. 

="C.  B.  3,  page  18;  Sol.  Op.  36. 

'"Haiku  Sugar  Co.  ef  al.  v.  Johnstone,  249  Fed.  103. 


FROM    LIMITED    PARTNERSHIPS  8ll 

charter  of  a  corporation  expressly  prohibits  its  entering  into 
partnership  relations  with  other  corporations  or  with  individ- 
uals, it  may  do  so,  .subject  to  the  further  possible  restriction 
that  the  corporation  laws  of  the  state  may  inhibit  such  rela- 
tionship. 

Limited  Partnerships 

The  Treasury  draws  a  distinction  between  different  types 
of  limited  partnerships,  regarding  one  type  as  corporations 
and  the  other  type  as  partnerships  for  income  tax  purposes. ^^ 

Limited  partnerships  may  or  may  not  be  partnerships. — 

Regulation.  So-called  limited  partnerships  of  the  type  author- 
ized by  the  statutes  of  New  York  and  most  of  the  States  are  part- 
nerships and  not  corporations  within  the  meaning  of  the  statute.  Such 
limited  partnerships,  which  can  not  limit  the  liability  of  the  general 
partners,  although  the  special  partners  enjoy  limited  liability  so  long 
as  they  observe  the  statutory  conditions,  which  are  dissolved  by  the 
death  or  attempted  transfer  of  the  interest  of  a  general  partner,  and 
which  can  not  take  real  estate  or  sue  in  the  partnership  name,  are 
so  like  common  law  partnerships  as  to  render  impracticable  any  dif- 
ferentiation in  their  treatment  for  tax  purposes.  Michigan  and  Illi- 
nois limited  partnerships  are  partnerships.  A  California  special  part- 
nership is  a  partnership.     (Art.   1505.) 

Limited  partnership  as  corporation. — 

Regulation.  On  the  other  hand,  limited  partnerships  of  the  type 
of  partnerships  with  limited  liability  or  partnership  associations  au- 
thorized by  the  statutes  of  Pennsylvania  and  of  a  few  other  States 
are  only  nominally  partnerships.  Such  so-called  limited  partnerships, 
offering  opportunity  for  limiting  the  liability  of  all  the  members, 
providing  for  the  transferability  of  partnership  shares,  and  capable 
of  holding  real  estate  and  bringing  suit  in  the  common  name,  are 
more  truly  corporations  than  partnerships  and  must  make  returns 
of  income  and  pay  the  tax  as  corporations.  The  income  received  by 
the  members  out  of  the  earnings  of  such  limited  partnerships  will  be 
treated  in  their  personal  returns  in  the  same  manner  as  distributions 
on  the  stock  of  corporations.  In  all  doubtful  cases  limited  partner- 
ships will  be  treated  as  corporations  unless  they  submit  satisfactory 
proof  that  they  are  not  in  effect  so  organized.     A  Michigan  partner- 


'"  [Former  Procedure]     All   limited  partnerships  were  formerly  con- 
sidered corporations.     (Reg.  33,  1918,  Art.  62.) 


8i2  INCOME 

ship  association  is  a  corporation.     Such  a  corporation  may  or  may 
not  be  a  personal  service  corporation.      (Art.  1506.) 

OhxO  partnerships. — 

Ruling.  A  partnership  association  or  limited  partnership  organ- 
ized under  sections  8059-8078  of  the  Ohio  Code  is  an  association  and 
not  a  partnership,  within  the  meaning  of  section  i  of  the  Revenue  Act 
of  1918,  and  is  taxable  as  a  corporation.  ( C.  B.  2,  page  11;  O.  D. 
444-) 

Virginia  partnerships. — 

Ruling.  Virginia  partnership  associations  or  limited  partner- 
ships formed  under  sections  2878  to  2886,  inclusive,  of  the  Virginia 
code  of  1904,  are  to  be  treated  as  corporations  or  joint-stock  com- 
panies for  income  tax  purposes. 

The  status  of  Virginia  limited  partnerships  formed  under  the 
act  of  March  14,  1918  (acts  of  Assembly  of  Virginia,  1918),  must 
be  determined  in  each  case  by  consideration  of  the  certificate  of 
partnership  and  all  pertinent  facts.     (C.  B.  i,  page  9 ;  O.  D.  334.) 

"Pennsylvania"  type  of  limited  partnerships. — Lim- 
ited partnerships  of  the  Pennsylvania  type  mentioned  above  are 
such  as  are  organized  under  the  act  of  Jtme  2,  1874."^  The  lim- 
ited or  special  partnerships,  created  by  the  acts  of  March  21. 
1836,^'''  April  6,  1870/'^  and  June  15,  1871,"*^  are  not  covered. 
The  matter  is  discussed  in  an  opinion  from  the  Attorney 
General's  department.^"  In  general,  so  far  as  article  1506 
applies  to  limited  partnerships  created  under  the  act  of  June 
2,  1874,  it  seems  to  be  sound.  Such  a  limited  partnership  is 
a  quasi-corporation,*"  having  many  of  the  characteristics  of  a 
corporation.  The  limited  partnerships  of  1836,  1870  and  1871 
are  quite  different  and  are  not  within  the  ruling  in  Coal  Com- 
pany V.  Rogers,  nor  should  they  be  within  article  1506. 

In  the  circumstances  it  would  be  better  to  designate  lim- 
ited partnerships,  which  must  be  treated  throughout  as  cor- 


=*P.  L.  271. 

'» P.  L.  143. 

'"  P.  L.  56. 

"  P.  L.  389.       . 

■*"'  5  Pennsylvania  District  Reports  288. 

"  Oak  Ridge  Coal  Co.  v.  Rogers,  108  Pa.  St.  147. 


FROM  PERSONAL  SERVICE  CORPORATIONS    813 

porations,  as  being  of  the  "corporation  t3q)e"  rather  than  the 
"Pennsylvania  type." 

Ruling.  The  M  Company,  a  partnership  organized  under  the 
laws  of  the  State  of  Pennsylvania,  desires  to  be  classed  for  Federal 
tax  purposes  as  a  limited  partnership  of  the  type  mentioned  in  article 
1506  of  Regulations  45. 

The  said  partnership  differs  from  the  type  of  partnerships  pro- 
vided for  in  the  Pennsylvania  statute  in  that  the  word  "limited"  does 
not  appear  in  the  firm  name,  yearly  meetings  of  the  partners  are 
not  provided  for  except  by  inference,  no  mention  is  made  of  a 
common  seal  and  no  provision  is  made  for  limiting  the  liability  of 
the  members.  It  dift'ers  from  an  ordinary  partnership  in  that  it  is 
not  dissolved  by  the  death  of  one  or  more  of  the  partners,  but  re- 
sembles a  partnership  and  differs  from  a  joint  stock  association  or 
corporation  in  that  it  does  not  provide  for  the  free  transferability  of 
the  interest  of  a  member. 

It  is  held,  therefore,  that  the  M  Company  is  a  partnership  and 
should  be  required  to  file  returns  as  such.  (  C.  B.  3,  page  15;  O.  D. 
599-) 

Distributions  by  limited  partnerships. — All  divisions  of 
profits  by  limited  partnerships  which  are  of  the  corporation 
type  should  be  treated  by  the  partners  as  dividends.  The  nor- 
mal tax  will  have  been  paid,  so  that  for  192 1  the  recipients 
will  receive  credit  of  8  per  cent  on  such  distributions  in  cal- 
culating their  normal  tax. 

Undivided  profits  will  not  be  included  in  the  returns  of 
partners  of  the  limited  partnership  as  in  the  case  with  ordinary 
partnerships,  but  limited  partnerships  of  the  corporation  type 
are  subject  to  the  excess  profits  tax.*^ 

Personal  Service  Corporations   Grouped   with 
Partnerships 

In  an  attempt  to  put  partnerships  and  corporations  on  a 
more  equal  footing  the  1918  law  established  a  class  of  "per- 
sonal service  corporations"  which  are  to  be  considered  part- 
nerships for  income  tax  purposes.     This  provision  was  re-en- 


"  Discontinued  after  December  31,  lOJi. 


8i4  INCOME 

acted  by  the  1921  law  only  for  the  year  1921.  Personal  ser- 
vice corporations  are  specifically  exempt  from  the  corporation 
income  and  excess  profits  tax/" 

Law.  Section  218.  ....  (d)  Personal  service  corporations  shall 
not  be  subject  to  taxation  under  this  title,  but  the  individual  stock- 
holders thereof  shall  be  taxed  in  the  same  manner  as  the  members  of 
partnerships.  All  the  provisions  of  this  title  relating  to  partnerships 
and  the  members  thereof  shall  so  far  as  practicable  apply  to  personal 
service  corporations  and  the  stockholders  thereof:  Provided,  That 
for  the  purpose  of  this  subdivision  amounts  distributed  by  a  personal 
service  corporation  during  its  taxable  year  shall  be  accounted  for  by 
the  distributees;  and  any  portion  of  the  net  income  remaining  un- 
distributed at  the  close  of  its  taxable  year  shall  be  accounted  for  by 
the  stockholders  of  such  corporation  at  the  close  of  its  taxable  year 
in  proportion   to   their   respective   shares 

Alternative    tax    on    personal    service    corporations. — The 

stock  dividend  decisicjn'"'  of  the  Supreme  Court,  in  which  it 
is  held  in  effect  that  stockholders  cannot  be  taxed  unless  they 
actually  receive  income  in  their  individual  capacity  as  dis- 
tinguished from  income  realized  by  the  corporation  as  a  sep- 
arate entity,  raised  a  grave  doubt  as  to  whether  Congress  had 
the  right  to  tax  stockholders  of  personal  service  corporations 
on  the  undistributed  income  of  such  corporations.  Beginning 
with  1922,  personal  service  corporations  make  returns  and  are 
taxed  as  other  corporations. 

To  make  certain,  however,  that  personal  service  corpora- 
tions or  the  stockholders  thereof  should  not  escape  taxation 
entirely  for  the  years  19 18,  19 19,  1920  and  1921  in  the  event 
that  the  personal  service  sections  of  the  19 18  and  1921  laws 
are  declared  invalid,  provision  is  made  in  the  192 1  law  for  an 
alternative  tax  for  the  years  mentioned,  as  regular  corporations. 
In  such  event  returns  would  have  to  be  made  for  the  years 
19 1 8,  19 1 9.  1920  and  1921  as  a  regular  corporation. 


"Law,  section  231   (14).    See  page  46. 

*^  Eisner  v.  Macombcr,  252  LT.  S.  189,  40  S.  Ct.  189,  64  L.  Ed.  521.  This 
was  fully  discussed  by  the  Solicitor  at  the  "Hearings  before  the  Committee 
on  Ways  and  Means,  House  of  Representatives,"  March  18  and  19,  1920. 
See  Incoiiic  Tax  Procedure.  1921,  pages  643-645 


FROM    PERSONAL    SERVICE   CORPORATIONS  815 

Law.  Section  1332.  (a)  That  if  either  subdivision  (e)  of  section 
218  of  the  Revenue  Act  of  1918  or  subdivision  (d)  of  section  218  of  this 
Act  is  by  final  adjudication  declared  invalid,  there  shall,  in  addition  to 
all  other  taxes,  be  levied,  collected,  and  paid  on  the  net  income  (as  de- 
fined in  section  232)  received  during  the  calendar  years  1918,  1919, 
1920,  and  192 1,  by  every  personal  service  corporation  (as  defined  in 
section  200)  included  within  the  provisions  of  such  subdivisions,  a 
tax  equal  to  the  taxes  imposed  by  Title  II  and  III  of  the  Revenue 
Act  of  1918  and,  in  the  case  of  income  received  during  the  calendar 
year  1921,  by  Titles  II  and  III  of  this  Act. 

(b)  In  such  event  every  such  personal  service  corporation  shall, 
on  or  before  the  fifteenth  day  of  the  sixth  month  following  the  date 
of  entry  of  decree  upon  such  final  adjudication,  make  a  return  of  any 
income  received  during  each  of  the  calendar  years  1918,  1919,  1920,  and 
1921  in  the  manner  prescribed  by  the  Revenue  Act  of  1918  (or  in  the 
manner  prescribed  by  this  Act,  in  the  case  of  income  received  during 
the  calendar  year  1921).  Such  return  shall  be  made  and  the  net  in- 
come shall  be  computed  on  the  basis  of  the  taxpayer's  annual  account- 
ing period  (fiscal  year  or  calendar  year,  as  the  case  may  be)  in  the 
manner  provided  for  other  corporations  under  the  Revenue  Act  of  1918 
and  this  Act. 

(c)  If  either  subdivision  (e)  of  section  218  of  the  Revenue  Act  of 
1918  or  subdivision  (d)  of  section  218  of  this  Act  is  so  declared  invalid, 
claims  for  credit  or  refund  of  taxes  paid  under  both  such  sections 
shall  be  allowed,  if  made  within  the  time  provided  in  subdivision  (f) 
of  this  section. 

(d)  In  case  the  claim.s  for  credit  or  refund,  filed  within  six  months 
from  such  date  of  entry  of  decree,  represent  less  than  30  per  centum 
of  the  outstanding  stock  or  shares  in  the  corporation,  the  amount  of 
taxes  imposed  by  this  section  upon  such  corporation  shall  be  reduced 
to  that  proportion  thereof  which  the  number  of  stock  or  shares  owned 
by  the  shareholders  or  members  making  such  claims  bears  to  the  total 
number  of  stock  or  shares  outstanding. 

(e)  The  tax  imposed  by  this  section  shall  be  assessed,  collected, 
and  paid  upon  the  same  basis,  in  the  same  manner,  and  subject  to  the 
same  provisions  of  law,  including  penalties,  as  the  taxes  imposed  by 
sections  230  and  301  of  the  Revenue  Act  of  1918  (or  by  sections  230 
and  301  of  this  Act,  in  the  case  of  income  received  during  the  calendar 
year  1921),  but  no  interest  or  penalties  shall  be  due  or  payable  thereon 
for  any  period  prior  to  the  date  upon  which  the  return  is  by  this  sec- 
tion required  to  be  made  and  the  first  installment  paid.  The  amount 
of  tax  paid  by  any  shareholder  or  member  of  a  personal  service  cor- 
poration pursuant  to  the  provisions  of  subdivision  (e)  of  section  218 
of  the  Revenue  Act  of  1918  or  subdivision  (d)  of  section  218  of  this 
Act  shall  be  credited  against  the  tax  due  from  such  corporation  under 
this  section  upon  the  joint  written  application  of  such  corporation  and 


8i6  INCOME 

such  shareholder  or  member  or  his  representatives,  heirs,  or  assigns,  if 
such  apphcation  is  filed  with  the  Commissioner  within  six  months  from 
such  date  of  entry  of  decree. 

(f)  Notwithstanding  any  other  provision  of  law,  no  claim  for  a 
credit  or  refund  of  taxes  paid  under  subdivision  (e)  of  section  218  of 
the  Revenue  Act  of  1918  or  subdivision  (d)  of  section  218  of  this  Act, 
may  be  filed  after  the  expiration  of  six  months  from  such  date  of  entry 
of  decree:  Provided,  hoivci'cr,  That  a  personal  service  corporation  of 
which  no  shareholder  or  member  has  filed  such  claim  within  such 
period  of  six  months,  shall  not  be  subject  to  the  tax  imposed  by  this 
section. 

Regulation.  Section  1332  of  the  statute  is  an  alternative  measure 
and  is  of  no  effect  unless  and  until  either  subdivision  (e)  of  section 
218  of  the  Revenue  Act  of  1918  or  subdivision  (d)  of  section  218  of 
the  statute  of   1921   is  declared  invalid  by  final  adjudication'.      (Art. 

There  is  a  very  serious  doubt  as  to  the  constitutionaHty  of 
the  foregoing  section  of  the  law.  While  the  Supreme  Court 
has  held  consistently  that  retroactive  tax  laws  are  not  uncon- 
stitutional, the  author  is  of  the  opinion  that  the  courts  will  find 
great  difficulty  in  upholding  this  extension  of  retroactive  legis- 
lation. 

Many  taxpayers  accepted  in  good  faith  the  provision  of 
the  1 918  law.  Business  has  been  conducted  on  this  basis 
for  over  four  years.  There  have  been  many  sales  of  stock. 
And  in  many  cases  the  profits  have  been  distributed  before  the 
sales  were  made.  In  several  outstanding  cases  taxpayers  who 
controlled  personal  service  corporations  have  died  and  control 
has  passed  to  new  owners. 

The  provision  is  probably  illegal  l^ecause  it  is  an  attempt 
to  lcv\-  a  tax  by  alternative  legislation. 

It  will  1)6  recalled  that  the  first  draft  of  the  1918  excess 
profits  tax  law  proposed  alternative  methods,  but  it  was  re- 
jected ])ecause  the  ''constitutional"  lawyers  in  Congress  said 
that  it  would  be  unconstitutional.  Section  1332  is  preceded  by 
a  heading  which  reads :  ''Alternative  tax  on  personal  service 
corporations."  This  heading  was  placed  there  by  Congress. 
Therefore,  there  is  no  doubt  about  this  being  alternative  legis- 
lation. 


FROM    PERSONAL    SERVICE    CORPORATIONS  817 

The  courts  have  held  with  reference  to  curative  statutes 
that  if  the  defect  is  in  the  nature  of  the  act  itself,  it  cannot 
be  obviated  by  a  subsequent  act/" 

The  following  case,  however,  illustrates  the  injustice  of 
this  section : 

During  1918,  1919,  1920,  A  owned  all  of  the  stock  of  a 
corporation  which  earned  the  following  profits : 

1918  $200,000 

1919  250,000 

1920  300,000 

A  dies  in  the  early  part  of  1921  and  his  estate  on  account 
of  the  personal  nature  of  the  business  decides  to  sell  the  stock 
of  the  corporation.  Prior  to  A's  death  he  had  withdrawn  and 
paid  taxes  on  all  of  the  profits  each  year  because  the  business 
did  not  need  capital. 

With  the  death  of  A,  the  corporation  lost  its  chief  income- 
producing  factor.  The  estate  of  A  sold  the  stock  for  $50,000 
to  B,  C  and  D,  who  had  been  faithful  employees  for  many 
years.  These  employees  had  been  in  frequent  contact  with  A's 
clients,  and  believed  that  they  could  continue  the  business. 

Assume  that  in  1922  the  courts  hold  that  it  was  an  error 
to  have  taxed  A  as  a  stockholder  and  instead  the  corporation 
should  have  been  taxed. 

The  shocking  result  is  that  the  faithful  employees,  B,  C 
and  D,  are  deprived  of  the  earnings  of  the  corporation.  The 
corporation  would  probably  be  liable  for  the  following  taxes : 
1918,  $100,000;  1919,  $80,000;  1920,  $100,000;  total, 
$280,000. 

A  legally  withdrew  all  of  the  profits  up  to  192 1.  The 
estate  therefore  might  collect  a  large  refund  on  account  of 
receiving  credit  for  the  normal  tax  now  to  be  paid  Ijy  the  cor- 
poration. 

B,  C  and  D  have  no  ground  for  an  action  against  the  estate. 

Exit  B,  C  and  D ! 

"  Cooley,   Constitutional    Piinitatioiis  J82    (ylh   edition),  page   544. 


8i8  INCOME 

Returns  of  Personal  Service  Corporations 

Generally  speaking,  all  of  the  provisions  of  the  192 1  law 
relating  to  returns  apply  alike  to  all  classes  of  taxpayers. 

Both  the  stockholders  and  the  corporations  have  to  make 
returns.  The  return  of  a  personal  service  corporation  is, 
however,  as  in  the  case  of  a  partnership,  merely  an  informa- 
tion return. 

The  Commissioner  has  extended  the  time  for  filing  personal 
service  corporation  returns  for  the  year  192 1  until  May  15, 
1922.^®  This  extension  does  not  apply  to  the  members  of 
personal  service  corporations.  It  will  be  necessary  for  them 
to  apply  for  individual  extensions  unless  a  general  extension  is 
made. 

Regulations.  Every  personal  service  corporation  must  make  a 
return  of  income  regardless  of  the  amount  of  its  net  income.  It  shall 
be  made  for  the  taxable  year  of  the  personal  service  corporation ;  that 
is,  for  its  annual  accounting  period  (fiscal  year  or  calendar  year,  as 
the  case  may  be),  regardless  of  the  taxable  year  of  its  stockhold- 
ers. For  the  calendar  year  1921  the  return  shall  be  made  on 
Form  1065.  If  the  personal  service  corporation  makes  any  change 
in  its  accounting  period,  it  will  render  the  return  in  accord- 
ance with  the  provisions  of  section  226  of  the  statute  and  article  431. 
The  return  of  a  personal  service  corporation  covering  any  period  be- 
ginning prior  to  January  i,  1922,  should  state  specifically  (a)  the  items 
of  its  gross  income  enumerated  in  section  213  of  the  statute;  (6)  the 
deductions  enumerated  in  section  214  of  the  statute,  other  than  the 
deduction  provided  in  paragraph  (11)  of  subdivision  (a)  of  that  sec- 
tion; (r)  the  amounts  specified  in  subdivisions  (a)  and  (b)  of  section 
216  of  the  statute  received  by  the  personal  service  corporation;  (d) 
the  amount  of  any  income,  war  profits,  and  excess  profits  taxes  of  the 
personal  service  corporation  paid  during  the  taxable  year  to  a  foreign 
country  or  to  any  possession  of  the  United  States,  and  the  amount  of 
any  such  taxes  accrued  but  not  paid  during  the  taxable  year;  (e)  the 
amounts  distributed  by  the  corporation  during  its  taxable  year,  vi^ith 
the  dates  of  distribution  and  the  names  of  the  distributees;  (/)  the 
names  and  addresses  of  the  stockholders  of  the  corporation  and  their 
respective  shares  in  such  corporation  at  the  close  of  its  taxable  year, 
and  on  December  31,  1921  ;  (g)  such  facts  as  tend  to  show  whether  or 
not  the  corporation  is  a  personal  service  corporation  with  reference 
to  any  period  beginning  prior  to  January  i,  1922;  and  (h)  such  other 


T.  D.  3272,  dated  January  19,  1922. 


FROM  PERSONAL  SERVICE  CORPORATIONS     819 

facts  as  are  required  by  the  form.  Earnings  attributable  to  the  calen- 
dar year  1922  and  subsequent  years  are  taxed  to  the  personal  service 
corporation  in  the  same  manner  as  the  earnings  of  ordinary  corpora- 
tions are  taxed (Art.  624.) 

....  An  individual  stockholder  of  a  personal  service  corpora- 
tion is  subject  to  tax  much  like  a  member  of  a  partnership  upon  his 
distributive  share  of  the  net  income  of  the  corporation  earned  on  or 
after  January  i,  1918,  and  prior  to  January  i,  1922.  The  net  income 
of  a  personal  service  corporation  attributable  to  the  period  prior  to 
January  i,  1922,  as  in  the  case  of  a  partnership,  shall  be  computed 
in  the  same  manner  and  on  the  same  basis  as  the  net  income  of  an  in- 
dividual, except  that  the  deduction  of  contributions  or  gifts  is  not 
permitted (Art.  336.) 

A  stockholder  of  a  personal  service  corporation  is  required  to 
include  in  his  gross  income  for  each  taxable  year  up  to  and  includ- 
ing that  taxable  year  within  which  falls  the  end  of  the  last  taxable 
period  of  the  personal  service  corporation  prior  to  January  i,  1922: 
(a)  Any  dividends  paid  by  the  corporation  in  such  year  out  of  earn- 
ings or  profits  accumulated  since  February  28,  1913,  and  before  Jan- 
uary I,  1918;  (b)  his  share  of  any  distribution  made  by  the  cor- 
poration in  such  year  out  of  earnings  or  profits  accumulated  since  the 
close  of  its  taxable  year  ending  with  or  during  his  next  preceding  tax- 
able year;  and  (c)  his  distributive  share  of  the  undistributed  net  in- 
come of  the  corporation  for  its  taxable  year  ending  with  or  during 
his  taxable  year  provided  he  was  at  the  close  of  its  taxable  year  a 
stockholder  in  the  corporation,  notwithstanding  he  might  since  have 
ceased  to  be  a  stockholder (Art.  338.) 

Former  stockholders  of  personal  service  corporations  to 
whom  distributive  shares  were  assigned  in  the  returns  of  the 
corporations,  who  reported  such  shares  in  their  individual 
returns,  should  be  careful  when  disposing  of  their  stock  to 
keep  this  fact  in  mind.  Ordinarily  Vi^hen  shares  of  stock  are 
acquired  the  purchaser  or  donee  is  on  notice  that  only  the 
normal  tax  has  been  paid  on  the  corporation's  earned  surplus 
account.  In  the  case  of  a  personal  service  corporation  the 
surtax  also  will  have  been  paid  by  or  imposed  on  someone  else 
from  January  i,  19 18,  to  the  end  of  the  taxable  year  next 
preceding  the  transfer  of  the  stock  (but  not  beyond  December 
31,  1921). 

Personal  service  corporations  with  fiscal  years  ending 
in   1922. — One  of  the  many  evils  of  constant  tinkering  with 


820  INCOME 

tax  laws  is  the  necessary  adjustments  which  follow  changes 
in  rates.  This  problem  confronts  taxpayers  in  dealing  with 
personal  service  corporations  which  have  fiscal  years  beginning 
in  1 92 1  and  ending  in  1922.  Prior  to  the  change  in  the  192 1 
law,  the  procedure  for  reporting  in  the  stockholders'  return 
income  from  a  personal  service  corporation  was  complicated. 
Not  only  the  gross  distributive  shares  of  accrued  income  had 
to  be  reported  but  dividends  declared,  and  the  period  in  which 
the  earnings  were  accumulated  were  factors  to  be  noted  and 
reported. 

Law.  Section  218.  ....  (d)  Personal  service  corporations 
shall  not  be  subject  to  taxation  under  this  title,  but  the  individual  stock- 
holders thereof  shall  be  taxed  in  the  same  manner  as  the  members  of 
partnerships.  All  the  provisions  of  this  title  relating  to  partnerships 
and  the  members  thereof  shall  so  far  as  practicable  apply  to  personal 
service  corporations  and  the  stockholders  thereof:  Provided,  That  for 
the  purpose  of  this  subdivision  amounts  distributed  by  a  personal  ser- 
vice corporation  during  its  taxable  year  shall  be  accounted  for  by  the 
distributees;  and  any  portion  of  the  net  income  remaining  undistributed 
at  the  close  of  its  taxable  year  shall  be  accounted  for  by  the  stock- 
holders of  such  corporation  at  the  close  of  its  taxable  year  in  propor- 
tion to  their  respective  shares 

Fiscal  years  of  personal  service  corporations. — Beginning 
January  i,  1922,  personal  service  corporations  are  taxed  as 
ordinary  corporations.  In  order  to  take  care  of  the  transition 
period — the  change  of  basis  from  personal  service  corporation 
to  regular  corporation — the  following  provision  was  inserted 
in  the  1921  law : 

Law.  Section  218 (d)  ....  In  the  case  of  a  personal  ser- 
vice corporation  having  a  fiscal  year  beginning  in  1921  and  ending  in 
1922,  amounts  distributed  prior  to  January  i,  1922,  to  its  stockholders 
out  of  earnings  or  profits  accumulated  after  December  31,  1920,  shall 
be  taxed  to  the  distributees;  and  the  stockholders  of  record  on  Decem- 
ber 31,  1921,  shall  be  taxed  upon  their  distributive  shares  of  the  differ- 
ence (if  any)  between  such  distributive  profits  and  the  portion  of  the 
corporation's  net  income  assignable  to  the  calendar  year  1921,  deter- 
mined in  the  manner  provided  in  clause  (i)  of  subdivision  (c)  of  section 
205  of  this  Act. 


FROM  PERSONAL  SERVICE  CORPORATIONS     821 

Fiscal  years  1920-192  i. — The  treatment  of  partnership 
income  ilhistrated  in  the  preceding  pages, ''°  in  the  case  of  hscal 
years  ended  in  1921,  is  appHcable  to  personal  service  corpora- 
tions with  fiscal  years   1920-192 1. 

Regulation.  In  the  case  of  a  personal  service  corporation  havin.s: 
a  fiscal  year  beginning  in  1920  and  ending  in  1921,  the  corporation  must 
make  a  return  of  income  on  Form  1065.  The  income  for  such 
year  is  not  taxable  to  the  corporation,  but  is  taxable  to  the  sharehold- 
ers in  a  manner  similar  to  that  in  which  the  earnings  of  partnerships 
are  taxed (Art.  337.) 

Fiscal  years  1921-1922.- — Two  returns  must  be  filed  for 
fiscal  years  ending  in  1922. 

Regulation In  the  case  of  a  personal  service  corpo- 
ration having  a  fiscal  year  beginning  in  192 1  and  ending  in  1922,  the 
return  must  be  filed  both  on  Form  1065  and  on  Form  1120.  The  net 
income  attributable  to  the  calendar  year  1921  is  that  portion  of  the 
net  income  reflected  upon  Form  1065  (computed  as  if  the  fiscal 
year  were  the  calendar  year  1921),  which  the  part  of  the  taxable 
period  falling  within  the  calendar  year  1921  bears  to  the  entire  period; 
and  this  amount  is  taxable  to  the  shareholders  of  the  corporation 
at  the  rates  in  effect  as  of  December  31,  1921.  The  income  attributable 
to  the  calendar  year  1922  is  that  portion  of  the  net  income  re- 
flectd  upon  Form  1120  (computed  as  if  the  fiscal  year  were  the 
calendar  year  1922),  which  the  part  of  the  taxable  period  falling 
within  the  calendar  year  1922  is  of  the  entire  period:  and  this 
amount  is  taxable  to  the  corporation  as  the  income  of  ordinary 
corporations  is  taxed.     (Art.  337.) 

The  statement  in  the   foregoing  regulation  "at  the  rates 

in  effect  as  of  December  31,  1921,"  is  apt  to  be  confusing.     It 

does  not  mean  that  the  personal  service  stockholder  must  take 

up  in  his  192 1  return  his  share  of  earnings  of  the  corporation 

undistributed  at  December  31,    192 1.     He  takes  this   up   in 

his  1922  return. 

Example 

Assume  a  personal  service  corporation  with  fiscal  year  ending 
March  31,  1922: 

(i)   Net   income   for   full   fiscal  year  computed  under  the  law  as 
"  See  page  791.  ^ 


822  INCOME 

applicable   to   the   calendar   year   1921    (to   be   reported   on 

form   1065 )    $40,000 

(2)  Net  income   for  full  fiscal  year  computed  under  the  law  as 

applicable   to  the  calendar  year   1922    (to   be   reported  on 

form  1 120)   $36,000* 

(3)  Net  income  attributable  to  1921   (3^  of  $40,000) $30,000 

(4)  Net  income  attributable  to  1922  (^  of  $36,000) $  9,000 

*  Difference  in  net  income  under  the  1921  law  (as  between  1921  and  1922)  may 
arise   from   "wash   sales"    (see  page  591)    capital   gains   (see  page   627),   etc. 

Assume  further  that  the  net  income  of  the  personal  service  cor- 
poration for  the  fiscal  year  ended  March  31,  192 1,  was  $50,000.  If 
the  entire  stock  was  owned  by  A,  a  single  individual  (reporting  on  the 
calendar  year  basis),  and  no  dividends  had  been  paid,  in  his  1921 
return  he  would  report  $50,000,  representing  his  "share  of  the  un- 
distributed net  income  of  the  corporation  for  its  taxable  year  ending 
with  or  during  his  taxable  year.''"" 

If  the  corporation  on  December  15,  1921,  had  paid  a  dividend  of 
$20,000.  A  would  have  to  report  same  in  his  192 1  return  in  addition 
to  the  $50,000  referred  to  above. 

Income  to  be  reported  by  stockholder  of  personal 
service  corporation. — • 

Regulation In  the  case  of  a  personal  service  corpora- 
tion having  a  fiscal  year  beginning  in  1921  and  ending  in  1922,  amounts 
distributed  prior  to  January  i,  1922,  to  its  stockholders  out  of  earnings 
or  profits  accumulated  during  its  current  taxable  year  are  taxable 
to  the  distributees  and  should  be  reported  in  the  personal  returns  of 
such  distributees,  and  the  stockholders  of  record  on  December  31, 
1921,  of  such  personal  service  corporation  must  report  as  income 
their  distributive  shares  of  the  difference  (if  any)  between  such  dis- 
tributive profits  and  the  portion  of  the  corporation's  net  income  as- 
signable to  the  calendar  year  1921,  determined  in  the  manner  provided 
in  section  205   (c)    (i)  of  the  statute  and  articles  334,  335,  and  ^T^y. 

The  earnings  of  the  personal  service  corporation  attributable  to 
the  period  subsequent  to  December  31,  1921,  are  taxable  to  the  stock- 
holder only  when  distributed,  as  in  the  case  of  dividends  of  ordinary 
corporations.      (Art.  338.) 

The  words  "distributive  profits"  in  the  last  clause,  second 
paragraph,  of  subdivision  (d),  section  218,  quoted  on  page 
820,  read,  in  the  House  bill,  "distributed  profits."  When  the 
House  bill  was  amended  l)y  the  Senate,  the  above  quoted  clause 

°"  Art.  338. 


FROM    PERSONAL   SERVICE   CORPORATIONS  823 

was  carried  over  verbatim,  except  that  the  words  "distributed 
profits"  were  changed  to  "distributive  profits."  (This  appar- 
ently is  a  misprint  and  was  not  intended  to  be  changed.)  If  we 
read  the  words  as  "distributed  profits"  the  meaning  will  be 
made  clear. 

Example 
In  the  illustration  given  above  assume  that  A  is  the  sole  stock- 
holder at  December  31,  1921.     Then  he  must  report  in  his  1922  calen- 
dar year  return  his  "distributive  share"  of: 

The  portion  of  the  corporation's  net  income  as- 
signable to  the  calendar  year  1921 $30,000 

Less:  Profits  distributed  (dividend  paid  Decem- 
ber  15,   1921 )    20,000 

Taxable  at  1921   rates   $10,000 


The  $10,000  taxable  at  1921  rates  represents  A's  "distributive 
share  of  the  difference  ....  between  such  distributed  profits  and 
the  portion  of  the  corporation's  net  income  assignable  to  the  calendar 
year  1921,"  referred  to  in  article  338  quoted  above. 

Prerequisites  of  a  Personal  Service  Corporation 

The  language  defining  a  personal  service  corporation  is 
very  clear.  The  1921  law  re-enacted  the  definition  of  the 
1918  law  without  any  change. 

Law.  Section  200 (5)  The  term  "personal  service  cor- 
poration" means  a  corporation  whose  income  is  to  be  ascribed  primarily 
to  the  activities  of  the  principal  owners  or  stockholders  who  are  them- 
selves regularly  engaged  in  the  active  conduct  of  the  affairs  of  the 
corporation  and  in  which  capital  (whether  invested  or  borrowed)  is 
not  a  material  income-producing  factor;  but  does  not  include  any  for- 
eign corporation,  nor  any  corporation  50  per  centum  or  more  of  whose 
gross  income  consists  either  (i)  of  gains,  profits,  or  income  derived 
from  trading  as  a  principal,  or  (2)  of  gains,  profits,  commissions,  or 
other  income,  derived  from  a  Government  contract  or  contracts  made 
jctween  April  6,  1917,  and  November  11,  1918,  both  dates  inclusive. 

The  following  illustrations  used  by  Mr.  Kitchin  when  the 
1918  law  was  under  consideration,  may  be  regarded  as  an 
authoritative  expression  of  the   intention  of   Congress. ^^ 


'^^Congressional  Record,  September  18,  1918,  page  11329,  but  this  was 
said  before  the  provision  was  inserted  eliminating  "traders"  from  the  scope 
of  the  definition. 


824 


INCOME 


An  insurance  agency  that  writes  insurance  on  commissions  and 
re(|uires  no  capital;  a  corporation  of  architects,  which  requires  no 
capital ;  a  lawyers'  guaranty  title  company  that  looks  up  titles  and 
requires  no  capital ;  any  company  where  the  earnings  may  be 
ascribed  primarily  to  personal  services  and   in  which   capital   is  not 

a  material  income-producing  factor where  it  (capital)  is  not 

actually  required — where  the  business  does  not  require  them  to  have 
capital. 

The  intention  of  the  lawmakers  is  indicated  also  by  sub- 
sequent statements.  The  following  explanation  was  made  on 
March  i8,  1920,  by  Mr.  Kitchin  i"^- 

The  section  provides  that  a  personal  service  corporation  is  a 
corporation  whose  income  is  to  be  ascribed  primarily  to  the  activities 
of  the  principal  stockholders  or  owners  who  are  themselves  regu- 
larly engaged  in  the  active  conduct  of  the  affairs  of  the  corporation 
and  in  which  capital  invested  or  borrowed  is  not  a  material  income- 
producing  factor.  It  seems  that  there  is  nothing  in  the  statute  pre- 
venting an  accumulation  of  surplus  or  profits.  It  may  have  a  thou- 
sand stockholders,  but  4  men  may  own,  say,  75  or  60  per  cent  of 
the  stock,  and  if  those  4  men,  say,  the  president,  the  secretary,  the 
manager,  and  supervisor,  or  whatever  they  may  be,  give  their  active 
service  to  it,  and  you  can  attribute  the  profits  they  may  make,  or  sub- 
stantially all  of  their  profits,  to  their  services,  then  it  is  a  personal 
service  corporation  under  that  section.  If  from  the  accumulated 
profits  or  surplus  any  substantial  part  of  its  income  was  derived, 
perhaps  this  of  itself  would  take  it  out  of  the  personal  service  cor- 
poration class. 

The  regulations  and  rulings  of  the  Treasury  have  deviated 
more  and  more  from  legislative  intent.  It  was  to  be  expected 
from  these  expressions  that  the  controlling  test  would  be 
found  in  an  answer  to  the  question:  'Ts  capital  (invested  or 
borrowed)  a  material  income-producing  factor?"  No  rule 
can  be  laid  down  which  can  be  used  as  an  infallible  answer  to 
the  question.  Each  taxpayer  who  believes  that  he  may  claim 
the  benefit  of  the  section  is  entitled  to  have  his  claim  considered 
on  its  merits. 


i 


°*' Hearings  before  tlie  Committee  on  Ways  and  Means,  House  of  Rep- 
resentatives, March  18  and  19,  1920,  page  38. 


FROM  PERSONAL  SERVICE  CORPORATIONS    825 

Regulation.  The  term  "personal  service  corporation"  means  a 
corporation,  not  expressly  excluded,  the  income  of  which  is  derived 
from  a  profession  or  business  (a)  which  consists  principally  of  ren- 
dering personal  service,  (b)  the  earnings  of  which  are  to  be  ascribed 
primarily  to  the  activities  of  the  principal  owners  or  stockholders, 
and  (c)  in  which  the  employment  of  capital  is  not  necessary  or  is 
only  incidental.  No  definite  and  conclusive  tests  can  be  prescribed 
by  which  it  can  be  finally  determined  in  advance  of  an  examination 
of  the  corporation's  return  whether  or  not  it  is  a  personal  service 
corporation.  In  the  following  articles  are  laid  down  the  general 
principles  under  which  such  determination  will  he  made.      (Art.  1523.) 

Tliis  article  denotes  a  direct  departure  from  the  law.  The 
law  states  that  capital  must  not  be  a  "material  income-produc- 
ing factor."  In  (c)  we  find  that  capital  of  any  kind  must  be 
unnecessary  or  only  incidental.  Under  the  law  capital,  so  long 
as  it  is  not  inaterial,  may  be  employed.  In  each  example  cited 
by  Mr.  Kitchin  some  capital  would  be  necessary. 

It  seems  entirely  to  have  escaped  the  attention  of  the 
Treasury  that  the  intention  of  the  law  is  clear  enough. 
Many  protests  were  made  under  the  191 7  law  regarding  the 
hardships  suffered  by  owners  of  closely  held  corporations 
wherein  the  capital  was  out  of  proportion  to  the  business  done 
or  income  earned.  So-called  small  corporations  were  afforded 
relief  under  section  302.  But  this  was  not  considered  fair 
to  those  corporations  in  which  capital  is  not  material  and 
compensation  for  personal  services  is  a  substantial  factor. 
Section  218  fe)'^'  is  not  and  was  not  intended  to  be  used  as  an 
exclusive  remedy.  It  was  expressly  intended  to  be  an  in- 
clusive remedy.  It  should  be  administered  liberally.  If  the 
rulings  hereinafter  discussed  are  illustrative  of  all  others  which 
have  been  rendered  it  may  be  expected  that  the  courts  will  be 
asked  to  grant  relief  in  many  cases. 

Reduction  in  tax  when  part  personal  service  corporation. 
— When  any  substantial  part  of  the  income  of  a  corporation 
is  from  fees  or  personal  services  of  any  kind,  it  is  the  intention 
of  the  law  to  afford  relief. 


'^^'■1918  law.     The  Cdrre.sponding  .section  of  tlie    H)2i   law  is  218   (d). 


826  INCOME 

If  it  can  qualify  as  a  personal  service  corporation  no  ex- 
cess profits  tax  is  payable.  If  it  cannot  so  qualify  and  capital 
is  out  of  proportion  to  the  net  income  or  other  unusual  condi- 
tions exist,  relief  can  be  secured  under  sections  327  and  328.^* 

If  at  least  30  per  cent  of  the  total  net  income  is  from  per- 
sonal services  and  the  remainder  of  the  net  income  is  from 
non-personal  service  activities,  the  part  of  the  net  income 
which  is  from  personal  services  will  be  taxed  at  a  less  rate  than 
if  the  entire  income  were  taxed  at  the  graduated  excess  profits 
tax  rates." 

When  "trading"  corporations  cannot  qualify. — When  50 
per  cent  of  the  gross  income  of  a  corporation  consists  of 
"gains,  profits  or  income  derived  from  trading  as  a  principal" 
such  corporation  cannot  qualify  as  a  personal  service  corpora- 
tion.'' 

Many  close  corporations  carry  on  extensive  business  with 
little  invested  capital  of  their  own.  In  some  cases  the  funds 
necessary  to  carry  on  the  business  are  derived  from  borrowed 
money  and  in  other  cases  the  trading  is  done  as  broker  or 
agent.  The  reference  in  the  law  is  to  buying  and  selling  on 
one's  own  account,  which  usually  means  taking  title  to  goods 
and  reselling  them.  It  has  no  reference  to  certain  types  of 
brokerage  and  commission  houses  which  do  not  take  title  to 
the  property  they  sell  and  do  not  have  a  substantial  amount  of 
invested  capital.  In  general,  trading  is  any  kind  of  commercial 
activity  wherein  buying  and  selling  of  commodities  are  con- 
cerned. SelHng  the  product  of  one's  brains  or  skill,  or  selling 
one's  services  would  appear  not  to  be  "trading"  in  the  strict 
sense  of  the  section.  Selling  anything  else  would  seem  to  be 
trading. 

Ruling.  Section  200  of  the  Revenue  Act  of  1918  excludes  from 
personal  service  classification  a  corporation  50  per  cent  or  more  of 


"  See  Excess  Profits  Tax  Procedure,  1921. 

^'^  Section  303,  1918  law,  which  was  re-enacted  without  change  in  the 
1921  law.  For  illustration  and  comment,  see  Excess  Profits  Tax  Procedure, 
1921. 

"  Section  200. 


FROM  PERSONAL  SERVICE  CORPORATIONS     827 

whose  gross  income  consists  of  gains,  profits,  or  income  derived  from 
trading  as  a  principal.  It  does  not  necessarily  follow,  however,  that 
if  50  per  cent  or  more  of  the  gross  income  was  derived  from  the 
personal  service  phase  of  the  business,  that  the  corporation  may  claim 
personal  service  classification.     (C.  B.  i,  page  14;  O.  D.  i.) 

There  is  no  provision  of  the  law  which  prohihits  such  a 
claim  being  made.  If  the  company  can  meet  the  other  tests, 
it  is  entitled  to  be  classified  as  a  personal  service  corporation. 

"Trading"  corporations  may  qualify. — Great  care  was 
taken  in  writing  section  200.  If  there  had  been  the  slightest 
thought  in  the  minds  of  the  framers  of  the  law  that  in  no  case 
should  trading  corporations  be  permitted  to  qualify  as  per- 
sonal service  corporations  it  would  have  been  extremely  easy 
to  bar  them.  If  it  had  been  intended  to  exclude  all  corpora- 
tions in  which  some  trading  is  carried  on,  the  provision  cover- 
ing trading  would  have  read  something  like  this :  "but  does 
not  include  ....  any  corporation,  10  per  centum  or  more  of 
whose  gross  income  consists  either   ( i )   of  gains,  profits  or 

income  derived  from  tradings  as  a  principal "     But  we 

find  that  after  giving  long  consideration  to  the  subject  the 
restriction  as  to  trading  gains,  profits  or  income  is  50  per 
cent  or  more.  In  other  words,  practically  one-half  of  the 
income  may  be  from  trading  and  the  corporation  still  may 
quahfy.  The  w^ords  "trading  as  a  principal"  extend  and  do 
not  limit  the  privileges.  It  is  a  fair  inference  from  these 
words  that  all  trading  not  as  a  principal  is  prima  facie  evi- 
dence of  qualification  as  a  personal  service  corporation. 

Trading  as  a  principal  means  buying  and  selling  commodi- 
ties on  one's  own  account. 

Corporation  with  substantial  capital  may  qualify. — A  de- 
tailed description  of  the  kind  of  corporation  that  may  qualify 
in  the  personal  service  class  is  given  in  the  following: 

Ruling.  The  business  of  the  M  corporation  is  insurance  bro- 
kerage and  average  adjusting,  principally  in  connection  with  marine 
insurance.    It  was  formed  by  a  consolidation  of  several  firms  engaged 


828  INCOME 

in  the  same  line  of  business.  None  of  these  firms  contributed  any 
capital  or  any  tangible  assets  except  some  office  furniture.  Both 
preferred  and  common  stock  were  issued  in  comparatively  large 
amounts.  The  preferred  stock  was  issued  to  the  directors  at  par 
in  order  to  secure  funds  for  payment  of  expenses  and  advances  to 
directors  in  anticipation  of  earnings.  The  common  stock  was  issued 
to  the  members  of  the  constituent  firms  for  an  arbitrary  amount 
merely  as  a  basis  for  the  apportionment  of  future  earnings.  It  rep- 
resented no  tangible  property  and  bore  no  relation  to  any  estimated 
value  of  good  will.  No  common  stock  could  be  held  by  anyone  not 
an  officer,  director,  or  employee  of  the  company. 

All  the  directors  are  actively  engaged  in  the  business  of  the  cor- 
poration. No  substantial  amount  of  capital  is  employed  to  lend  to 
customers,  or  to  buy  or  carry  goods  for  the  corporation  or  to  buy 
insurance  for  its  clients;  nor  are  the  accounts  of  its  clients  or  cus- 
tomers financed  or  carried  to  any  substantial  extent.  Ninety-five 
per  cent  of  the  gross  income  is  derived  from  personal  services  ren- 
dered by  the  owners  or  principal  stockholders  of  the  corporation. 

Held,  that  this  corporation  is  a  personal-service  corporation 
within  the  meaning  of  section  200  of  the  Revenue  Act  of  1918, 
and  that  its  excess-profits  tax  for  1917  should  be  computed  at  the 
8  per  cent  rate  imposed  by  section  209  of  the  Revenue  Act  of  1917. 
.    .    .    .    (C.  B.  2,  page  17;  A.  R.  R.  46.) 

In  the  foregoing  case  the  corporation  showed  "accounts 
receivable  6X  dollars,  cash  24X  dollars,  while  its  accounts 
payable  are  40X  dollars."  There  can  be  no  doubt  that  the 
corporation  was  entitled  to  classification  as  a  personal  service 
corporation,  but  it  is  difficult  to  follow  the  reasoning  under 
which  it  was  held  to  be  qualified  and  the  reasoning  in  some  of 
the  cases  which  will  be  discussed  hereafter,  in  which  the  items 
of  accounts  receivable  and  accounts  payable  are  held  to  be 
evidences  of  dealing  in  something  other  than  the  services  of 
the  principal  stockholders. 

Holding   companies. — 

Regulation A    corporation    can    not   be   considered   a 

personal  service  corporation  when  another  corporation  (not  itself  a 
personal  service  corporation)  owns  or  controls  substantially  all  of 
its  stock  or  when  substantially  all  of  its  stock  and  of  the  stock  of 
another  corporation  (not  itself  a  personal  service  corporation)  form- 
ing part  of  the  same  business  enterprise  is  owned  or  controlled  by  the 
same  interests.     (Art.  1524.) 


FROM    PERSONAL    SERVICE   CORPORATIONS  829 

Loss  OF  SUBSIDIARY HOW  TAKEN  UP  BY  PARENT  COM- 
PANY.  

Ruling.  In  view  of  the  fact  that  personal  service  corporaticftis 
are  not  required  to  file  consolidated  returns,  a  profit  realized  or  loss 
sustained  by  a  personal  service  corporation,  attributable  to  its  owner- 
ship of  stock  in  another  personal  service  corporation,  should  be 
accounted  for  in  the  same  manner  as  in  the  case  of  an  individual 
stockholder. 

Where  the  business  of  a  personal  service  corporation  results  in  an 
operating  loss,  such  loss  will  be  divided  among  the  stockholders  at 
the  close  of  its  taxable  year  in  proportion  to  their  respective  shares, 
and  will  constitute  an  allowable  deduction  in  their  returns  of  annual 
net  income.     (C.  B.  3,  page  198;  O.  D.  581.) 

I.     What  constitutes  rendering  of  personal  service? — 

(a)     Services  must  be  rendered  principally  by  the 

STOCKHOLDERS. 

Regulation.  In  order  that  a  corporation  may  be  deemed  to  be 
a  personal  service  corporation  its  earnings  must  be  derived  princi- 
pally from  compensation  for  personal  services  rendered  by  the  cor- 
poration to  the  persons  with  whom  it  does  business.  Merchandising 
or  trading  either  directly  or  indirectly  in  commodities  or  the  services 
of  others  is  not  rendering  personal  service.  Conducting  an  auction, 
agency,  brokerage  or  commission  business  strictly  on  the  basis  of 
a  fee  or  commission  is  rendering  personal  service.  If,  however, 
the  corporation  assumes  any  such  risks  as  those  of  market  fluctua- 
tion, bad  debts,  failure  to  accept  shipments,  etc..  or  if  it  guarantees 
the  accounts  of  the  purchaser  or  is  in  any  way  responsible  to  the 
seller  for  the  payment  of  the  purchase  price,  the  transaction  is  one 
of  merchandising  or  trading,  and  this  is  true  even  though  the  goods 
are  shipped  directly  from  the  producer  to  the  consumer  and  are 
never  actually  in  the  possession  of  the  corporation.  The  fact  thai 
earnings  of  the  corporation  are  termed  commissions  or  fees  is  not 
controlling.  The  fact  that  a  commission  or  fee  is  based  on  a  differ- 
ence in  the  prices  at  which  the  seller  sells  and  the  buyer  buys  raises 
a  presumption  that  the  transaction  is  one  of  merchandising  or  trading, 
and  it  will  be  so  considered  in  the  absence  of  satisfactory  evidence 
to  the  contrary.     (Art.  1525.) 

The  foregoing  regulation  provides  that  if  a  corporation  is 
in  any  way  responsil)le  to  the  seller  for  the  payment  of  the 
purchase  price,  the  transaction  is  one  of  merchandising  or 
trading. 


830  INCOME 

The  Treasury  cannot,  by  regulation  or  otherwise,  change 
the  law  or,  in  the  absence  of  clear  statutory  authority,  lay 
clown  different  tests  for  the  determination  of  wdiether  one  is 
"trading  as  a  principal"  than  the  general  law  recognizes  and 
applies.  \\'hen  Congress  used  the  expression  "trading  as  a 
principal,"  it  will,  under  the  most  elementary  rules  of  statu- 
tory construction,  be  presumed  to  have  used  it  in  its  accepted 
legal  sense. 

The  mere  fact  that  one,  who  is  in  fact  an  agent,  agrees 
to  pay,  or  becomes  otherwise  responsible  for,  the  debts  of 
his  principal,  does  not  constitute  him  the  principal ;  nor  would 
it  make  him  a  "trader"  in  any  true  sense. 

The  Committee  on  Appeals  and  Review  has  held  that  a 
taxpayer  who  is  engaged  in  the  brokerage  business  is  entitled 
to  be  taxed  as  one  "not  having  more  than  a  nominal  capital" 
under  the  Act  of  191 7,  even  though  it  might  be  sued  on  the 
contracts  which  it  entered  into  on  behalf  of  its  principals.^^ 

The  true  test  is  whether  or  not  a  given  corporation  is  really 
trading  as  a  principal  or  simply  acting  as  an  agent.  A  number 
of  facts  and  circumstances  may  enter  into  the  determination 
of  that  question  in  any  given  case.  One  of  these  circumstances 
may  very  well  be  the  fact  that  the  corporation  is  responsible 
for  the  debts  which  it  contracts,  presumably  on  behalf  of  an- 
other, but  that  is  not  an  inclusive  or  conclusive  test.  Nor.  in 
view  of  the  well-recognized  rule  of  law,  that  under  certain 
circumstances  an  agent  may  make  himself  personally  respon- 
sible for  the  obligations  of  the  principal — upon  which  the 
principal  is  also  liable — without  changing  his  legal  status  as 
an  agent,  can  it  be  considered  a  very  material  one. 

It  will  be  noted  that  any  agency  or  brokerage  business 
conducted  strictly  on  the  basis  of  fees  or  commissions  is 
deemed  to  be  rendering  personal  service,  but  that  any  trading 
in  commodities  or  the  services  of  others  is  not  rendering  per- 
sonal service.    This  is  hardlv  consistent,  because  most  brokers 


C.  B.  4,  page  20;  A.  R.  R.  500.     See  page  836. 


FROM    PERSONAL   SERVICE    CORPORATIONS  831 

use  the  services  of  employees,  in  which  case  there  is  a  trading 
in  such  services.  The  Treasury  illustration  quoted  in  Excess 
Profits  Tax  Procedure,  192 1,  pages  87,  88,  deals  with  a  cor- 
poration which  renders  engineering  services  and  assumes  an  in- 
come of  $60,000  therefrom.  It  may  reasonably  be  assumed 
that  the  fees  paid  for  services  are  for  the  services  of  others  than 
the  principal  stockholders.  The  language  of  the  statute  would 
seem  to  be  broad  enough  to  include  as  personal  service  cor- 
porations those  which  trade  in  the  services  of  others. 

In  specific  cases  the  Treasury  has  held  that  corporations 
may  not  be  taxed  as  personal  service  corporations  in  the  fol- 
lowing circumstances :  if  a  corporation  deals  in  the  services 
of  others  who  are  connected  with  the  corporation  not  through 
stock  ownership  but  merely  as  employees  in  branch  offices, 
etc.r/"^  if  a  corporation  assumes  risks  of  market  fluctuations, 
bad  debts,  etc.,  or  if  it  guarantees  or  is  in  any  way  responsible 
to  the  seller  for  payment  of  the  purchase  price;"'*  if  the  busi- 
ness conducted  is  a  commercial  enterprise ;"°  if  a  freight- for- 
warding business  advances  the  necessary  costs  of  transporta- 
tion for  the  concerns  with  which  business  is  donef^  if  a  so- 
called  commission  business  takes  title  to  the  merchandise  sold, 
is  liable  to  the  consignor  and  rebills  the  merchandise. *'^ 

A  corporation  which  obtained  "selling  contracts  covering 
lots,  tracts  and  other  parcels  of  land"^^  disposed  of  on  a  com- 
mission basis,  claimed  assessment  under  section  209  of  the 
191 7  excess  profits  tax  law,  on  the  ground  that  it  had  only 
"nominal  capital."  It  made  no  purchases  on  its  own  account 
and  did  not  finance  real  estate  operations.  It  had  capital  stock 
paid  in  of  $2,000,  and  some  earned  surplus. 

Ruling The    taxpayer    contends   that    it    requires    and 

employs  no  more  than  a  nominal  capital  in  the  conduct  of  its  business, 
that  the  character  of  its  business  is  such  that  capital  is  not  required, 

°'C.  B.  2,  page  20;  A.  R.  M.  59. 

^"C.  B.  2,  page  19;  A.  R.  M.  50. 

""C.  B.  I,  page  14;  T.  B.  R.  58. 

"C.  B.  I,  page  13;  A.  R.  R.  7. 

°=C.  B.  2,  page  23;  A.  R.  R.  23;  and  C.  B.  2,  page  20;  A.  R.  M.  "^q. 

"  C.  B.  4,  page  17 ;  A.  R.  R.  464. 


832  INCOME 

and  that  its  success  is  due  to  and  its  net  income  is  derived  solely 
from  the  activities  of  its  ofificers,  all  of  whom  are  stockholders.  To 
this  contention  the  Committee  does  not  agree  for  the  reason  that  it 
is  shown  that  in  the  conduct  of  its  husiness  the  corporation  does  re- 
quire capital  and  that  its  income  is  derived  in  a  large  part  from  ser- 
vices rendered  by  others. 

....  In  view  of  the  fact  that  the  said  corporation  was  ultra- 
conservative  in  its  capitalization  and  the  further  fact  that  the  amount 
of  capital  it  had  invested  in  the  business  was  insufficient  at  times  to 
meet  the  needs  of  that  business  and  v^as  less  than  normal  as  com- 
pared with  the  amount  of  business  transacted  and  as  compared 
with  the  amount  of  capital  employed  by  other  concerns  doing  a 
similar  business,  the  Committee  recommends  that  the  case  be  returned 
to  the  Unit  for  adjustment  and  assessment  of  excess  profits  tax  under 
the  provisions  of  section  210  on  the  basis  of  the  average  percentages 
shown  on  the  data  sheet  submitted  to  the  Committee.  (  C.  B.  4,  page 
17;  A.  R.  R.  464.) 

The  following  have  been  held  by  the  Treasury  to  be  per- 
sonal service  corporations  and  are  taxed  as  .such:  a  corpora- 
tion which  conducts  a  commercial  school  but  does  not  take 
students  as  boarders,  the  principal  owners  of  which  devote  all 
their  time  to  preparation  of  courses,  inspection  of  lessons, 
etc.  ;"*  a  corporation  whose  business  is  the  sale  of  real  estate 
for  clients  and  the  collection  of  rents  from  property  listed  with 
it,  whose  entire  income  comes  from  commissions  on  business 
derived  from  the  activity  of  the  principal  owners  ;^'^'  an  agency 
which  acts  as  consignee  agent  in  the  United  States  for  a  for- 
eign corporation  acquiring  no  title  to  the  products  handled 
but  deriving  its  income  from  commissions  on  sales  made  by 
its  principal  st(jckholders."" 

(b)     The  business  must  be  conducted  principally 

BY  THE  STOCKHOLDERS. 

Regulation.  In  determining  whether  a  corporation  is  a  per- 
sonal service  corporation,  no  weight  can  be  given  to  the  fact  that  it 
renders  personal  services  unless   (a)   the  principal  owners  or  stock- 


"C.  B.  2,  page  16;  A.  R.  R.  24. 
""^  C.  B.  3,  page  21 ;  A.  R.  R.  210. 

""  C.  B.  2,  page  24;  A.  R.  AI.  420;  and  for  a  similar  case  see  C.  B.  4, 
page  20. 


FROM    PERSONAL   SERVICE   CORPORATIONS  833 

holders  are  regularly  engaged  in  the  active  conduct  of  its  affairs  and 
are  engaged  in  such  a  manner  that  the  earnings  are  to  be  ascribed 
primarily  to  their  activities,  and  (b)  its  affairs  are  conducted  prin- 
cipally by  such  owners  or  stockholders.     (Art.   1527.) 

The  statute  does  not  require  (and  the  Committee  on  Ap- 
peals and  Review  has  so  held)  that  the  income  shall  l)e  due 
entirely  but  only  primarily  to  the  activities  of  the  principal 
stockholders.  It  has  been  recently  decided  by  the  Committee 
that  a  corporation  doing  a  stevedoring  business  ma}-  be  entitled 
to   personal   service   classification." 

2.  To  what  extent  must  the  earnings  be  derived  from 
services  rendered  by  the  stockholders? — 

(a)      A  NON-PERSONAL  SERVICE  ELEMENT  MAY  BE  PRESENT 

IF  IT  IS  NEGLIGIBLE, 

Regulation.  It  frequently  happens  that  corporations  are  en- 
gaged in  twfo  or  more  professions  or  businesses  which  are  more  or 
less  related,  one  of  which  does  not  consist  of  rendering  personal 
service.  Thus  an  engineering  concern  may  also  engage  in  contract- 
ing, which  amounts  to  trading  in  materials  and  labor,  a  brokerage 
concern  may  guarantee  some  of  its  accounts,  a  photographer  may 
sell  pictures,  frames,  art  goods  and  supplies,  or  a  dealer  in  a  com- 
modity may  furnish  expert  advice  or  services  with  respect  to  its 
installation,  use,  etc.  In  such  case  the  corporation  is  not  a  personal 
service  corporation  unless  the  non-personal  service  element  is  neg- 
ligible or  merely  incidental  and  no  appreciable  part  of  its  earnings 
are  to  be  ascribed  to  such  sources.      (Art.  1526.) 

An  advertising  agency  which  is  incorporated,  the  principal 
owners  of  which  are  personally  engaged  in  the  business,  al- 
though capital  is  employed  to  carry  the  accounts  of  cus- 
tomers, should  be  classed  as  a  personal  service  corporation. 
In  such  a  case  capital  would  be  no  more  than  incidental  and 
would   ncjt  be  a   material   income-producing   factor. 

Income  from  mere  ownership  of  property  invalidates 

CLAIM. 

Rulings.  A  claim  for  assessment  as  a  personal  service  corpora- 
tion should  be  denied  where  the  income  of  the  corporation  is  derived 
entirely  as  a  result  of  the  ownership  of  certain  property   (such  as 


"'Bulletin  41-21-1858;  A.  R.  R.  463.     See  page  834. 


834  INCOME 

patents)  and  is  in  no  sense  derived  from  the  personal  activities  of 
any  of  tiie  stockholders.     ((".  B.  J,  page  13;  T.  B.  M.  9.) 

A  sanitarium  owned  and  operated  by  doctors,  who  in  addition  to 
selling  their  services  derive  income  from  the  buildings  and  grounds 
by  housing  patients,  can  not  be  termed  a  corporation  within  the  per- 
sonal service  class.     (C.  B.  i,  page  15;  O.  D.  2.) 

(b)  Earnings  are  not  derived  from  personal  ser- 
vices IF  the  principal  duties  of  the  stockholders  are 
TO  supervise  a  force  of  employees. 

Regulation.  Where  the  principal  owners  or  stockholders  do 
not  render  the  principal  part  of  the  services,  but  merely  supervise 
or  direct  a  force  of  employees,  the  corporation  is  not  a  personal 
service  corporation.  If  employees  contribute  substantially  to  the 
services  rendered  by  a  corporation,  it  is  not  a  personal  service  cor- 
poration unless  in  every  case  in  which  services  are  so  rendered  the 
value  of  and  the  compensation  charged  for  such  services  are  to  be 
attributed  primarily  to  the  experience  or  skill  of  the  principal  owners 
or  stockholders  and  such  fact  is  evidenced  in  some  definite  manner 
in  the  normal  course  of  the  profession  or  business.  The  fact  that 
the  principal  owners  or  stockholders  give  personal  attention  or  render 
valuable  services  to  the  corporation  as  a  result  of  which  its  earnings 
are  greater  than  those  of  a  corporation  engaged  in  a  like  or  similar 
business,  the  principal  owners  or  stockholders  of  which  do  not 
devote  personal  attention  to  the  management  or  supervision  of  its 
affairs,  does  not  of  itself  constitute  the  corporation  a  personal  service 
corporation.     (Art.  1528.) 

Ruling The   Bureau   has   uniformly   taken   the   position, 

and  the  Committee  thinks  correctly,  that  the  business  of  stevedoring 
is  primarily  trafficking  in  the  labor  of  others,  and  it  therefore  recom- 
mends that  the  action  of  the  Unit  in  assessing  tax  under  section  2io 
rather  than  under  section  209  be  approved.  (C.  B.  3^  page  22;  A.  R.  R. 
213O 

That  is  to  say,  a  corporation  engaged  primarily  in  the  trad- 
ing in  labor  of  others  should  not  be  classed  as  a  personal  serv- 
ice corporation. 

The  Committee  has  held,  however,  that  the  following  facts 
do  not  constitute  general  stevedoring  business : 

Ruling.  A  corporation,  the  stockholders  of  which  are  efficiency 
engineers  in  the  stevedoring  line,  acts  as  consultants  to  general  steve- 
dores, and  has  a  contract  with  a  foreign  government  under  which  the 
longshoremen  employed  by  the  company  receive  the  full  amount  for^ 


FROM    PERSONAL   SERVICE   CORPORATIONS  835 

their  labor  which  was  received  by  the  corporation  by  way  of  ad- 
vances from  the  foreign  government  to  meet  the  weekly  pay  roll.  The 
income  is  ascribed  primarily  to  the  activity  of  the  sole  stockholders. 
Capital  is  not  a  material  income-producing  factor.  The  corporation 
is  therefore  entitled  to  classification  as  a  personal  service  corporation. 
(B.  Digest  41-21-1858;  A.  R.  R.  463.) 

It  is  apparent  in  the  foregoing  case  that  the  company  had 
pay-rohs  which  imphes  "trafficking  in  the  services  of  others" 
and  that  it  depended  on  "advances"  to  meet  the  pay-rolls. 
Probably  it  was  legally  liable  to  the  employees  if  the  "ad- 
vances" were  not  received.  The  company  undoubtedly  is  a 
personal  service  corporation,  but  so  are  others  similarly  situ- 
ated which  have  been  denied  the  classification. 

3.  To  what  extent  may  capital  be  used  to  conduct  the 
business? — 

(a)  Capital  must  not  be  a  material  income-produc- 
ing  FACTOR. 

Regulation.  In  determining  whether  a  corporation  is  a  per- 
sonal service  corporation,  no  weight  can  be  given  to  the  fact  that  the 
invested  capital  of  the  corporation  for  the  purpose  of  the  war  profits 
and  excess  profits  tax  or  the  actual  investment  of  the  principal 
owners  or  stockholders  is  comparatively  small.  The  test  established 
by  the  statute  with  respect  to  capital  is  entirely  different.  That  test 
is  the  nature  of  the  profession  or  business  as  indicated  (o)  by  the 
kind  of  services  it  renders  and  (6)  the  extent  to  which  capital  is 
required  to  carry  on  such  profession  or  business.  If  the  use  of 
capital  is  necessary  or  more  than  incidental,  capital  is  a  material 
income-producing  factor  and  the  corporation  is  not  a  personal  service 
corporation.  No  corporation  is  a  personal  service  corporation  if  it 
carries  on  business  of  a  kind  which  ordinarily  requires  the  use  of 
capital,  irrespective  of  whether  the  owners  or  stockholders  have 
actually  invested  a  substantial  amount  of  capital.     (Art.   1531.) 

As  stated  on  page  824,  the  law  expressly  permits  the  use 
of  capital.  The  limitation  is  that  it  must  not  be  material. 
The  regulation  is  framed  to  exclude  as  many  as  possible  not- 
withstanding the  effort  of  the  lawmakers  to  include  all  that  can 
reasonably  qualify. 

Until    recently    the   Income   Tax  Unit   has   held   that   the 


836  INCOME 

mere  fact  that  a  company  might  be  hable  under  an  obHgation 
should  preckide  a  taxpayer  from  a  classification  of  a  personal 
service  corporation. 

The  Committee  has  disposed  of  this  point  in  a  sensible 
wa}'. 

Ruling^  The  M  corporation  was  a  broker  in  metals  and  employed 
onl)'  a  nominal  capital.  No  advances  were  made  to  the  manufacturer 
and  collections  from  the  purchaser  were  only  transmitted  through  the 
broker.  Although  the  corporation  was  liable  to  be  sued  under  its 
contracts  with  the  purchaser  the  Committee  considers  that  the  nominal 
capital  of  the  corporation  clearly  establishes  the  fact  that  it  was 
contemplated  it  should  not  be  held  responsible  except  by  way  of 
personal  service  to  both  buyer  and  seller.  Accordingly  the  Com- 
mittee recommends  that  assessment  of  the  excess  profits  tax  be  made 
in  accordance  with  the  provisions  of  section  209  of  the  Revenue  Act 
of  1917 (C.  B.  4,  page  20;  A.  R.  R.  500.) 

(b)     There  must  not  be  a  substantial  amount  of 

CAPITAL  ACTIVELY  EMPLOYED,  WHETHER  SECURED  DIRECTLY 
OR  INDIRECTLY, 

Regulation.  The  term  '"capital"  as  used  in  section  200  of  the 
statute  ....  means  not  only  capital  actually  invested  by  the  owners 
or  stockholders,  but  also  capital  secured  in  other  ways.  Thus  if 
capital  is  borrowed  either  directly  as  shown  by  bonds,  debentures, 
certificates  of  indebtedness,  notes,  bills  payable  or  other  paper,  or 
indirectly  as  shown  by  accounts  payable  or  other  forms  of  credit,  or 
if  the  business  of  the  corporation  is  in  any  way  financed  by  or 
through  any  of  the  owners  or  stockholders,  these  facts  will  be 
deemed  evidence  that  the  use  of  capital  is  necessary.  If  a  substan- 
tial amount  of  capital  is  used  to  finance  or  carry  the  accounts  of 
clients  or  customers,  it  will  be  inferred  that  because  of  competition 
or  other  reasons  such  practice  is  necessary  in  order  to  secure  or  hold 
business  which  otherwise  would  be  lost,  and  that  the  corporation  is 
not  a  personal  service  corporation.  If  a  corporation  engaged  in  an 
agency,  brokerage  or  commission  business  regularly  employs  a  sub- 
stantial amount  of  capital  to  lend  to  principals,  to  buy  and  carry 
goods  on  its  own  account,  or  to  buy  and  carry  odd  lots  in  order  that 
it  may  render  more  satisfactory  service  to  its  principals  or  customers, 
it  is  not  a  personal  service  corporation.  In  general  the  larger  the 
amount  of  the  capital  actually  used  the  stronger  is  the  evidence  that 
capital  is  necessary  and  is  a  material  income-producing  factor  and 
that  the  corporation  is  not  a  personal  service  corporation.  (Art. 
1532.) 


FROM    PERSONAL   SERVICE    CORPORATIONS  837 

Generally  speaking,  the  test  is  not  the  small  amount  of 
capital  employed,  but  the  nature  of  the  business  as  indicated 
by  the  kind  of  services  rendered,  rather  than  by  the  extent 
to  which  capital  is  required.  If  capital  is  employed,  but  is 
not  needed  for  the  conduct  of  the  business,  the  size  of  the 
capital  alone  would  not  prevent  a  corporation  from  being 
classed  as  a  personal  service  corporation. 

The  test  is,  would  the  capital  without  the  personal  service 
element  produce  the  income  which  has  been  earned? 

To  constitute  a  "personal  service  corporation"  no  definite 
percentage  of  stock  need  be  held  by  those  conducting  the  busi- 
ness.— 

Regulation.  No  definite  percentage  of  stock  or  interest  in  the 
corporation  which  must  be  held  by  those  engaged  in  the  active  con- 
duct of  its  affairs  in  order  that  they  may  be  deemed  to  be  the  prin- 
cipal owners  or  stockholders  can  be  prescribed  as  a  conclusive  test, 
as  other  facts  may  affect  any  presumption  so  established.  No  cor- 
poration or  its  owners  or  stockholders  shall,  however,  make  a  return 
in  the  first  instance  on  the  basis  of  its  being  a  personal  service  cor- 
poration unless  at  least  80  per  cent  of  its  stock  is  held  by  those  regu- 
larly engaged  in  the  active  conduct  of  its  affairs.     (Art.  1529.) 

The  regulations  do  not  require  that  at  least  80  per  cent 
of  the  stock  of  the  corporation  must  be  held  by  those  regu- 
larly engaged  in  the  active  conduct  of  its  affairs,  but  do 
stipulate  that  unless  80  per  cent  of  the  stock  is  so  held  the 
corporation  must  first  make  the  corporation  return  and  sub- 
sequently make  application  for  the  privilege  of  being  classed 
as  a  personal  service  corporation. 

Change  of  ownership  does  not  take  a  corporation  out  of 
the  personal  service  class. — 

Regulation.  The  fact  that  the  owners  or  stockholders  of  the 
corporation  may  change  during  the  course  of  the  taxable  year  does 
not  take  a  corporation  which  is  normally  in  the  personal  service 
class  out  of  that  class.  Frequent  changes  in  the  ownership  of  any 
substantial  interest  or  number  of  shares  are,  however,  evidence  bear- 
ing on  the  question  as  to  whether  the  principal  owners  or  stockholders 
are  actively  engaged  in  the  conduct  of  the  affairs  of  the  corporation. 


838  INCOME 

The  incapacity,  retirement,  or  death  of  a  principal  owner  or  stock- 
holder who  has  been  actively  engaged  in  the  conduct  of  its  affairs 
will  not  be  deemed  to  make  any  change  in  the  status  of  the  cor- 
poration during  a  reasonable  time  thereafter.     (Art.   1530.) 

Personal  service  corporation  entitled  to  net  loss  provision. 

— If  a  personal  service  corporation  shows  a  net  loss  for  the 
year  1921,  the  same  may  under  certain  conditions  be  applied 
against  the  succeeding  year.**^ 

Credits  allowed  stockholders  of  personal  service  corpora- 
tions.— 

Regulation.  A  stockholder  of  a  personal  service  corporation  is 
entitled  to  credit  for  the  purpose  of  the  normal  tax  only  for  amounts 
received  in  distribution  of  earnings  or  profits  of  the  corporation  ac- 
cumulated since  February  28,  1913,  except  such  amounts  as  represent 
earnings  of  the  personal  service  corporation  accumulated  after  De- 
cember 31,  1917,  and  prior  to  January  i,  1922,  which  would  have  been 

taxed  directly  to  the  stockholder In  addition  to  the  credits 

ordinarily  allowed  to  an  individual,*  a  stockholder  of  a  personal  ser- 
vice corporation  is  entitled  relative  to  income  properly  allocated  to  the 
period  beginning  with  January  i,  1918,  and  ending  with  December 
31,  1921,  to  the  following  credits:  (a)  A  credit  against  net  income 
for  the  purpose  of  the  normal  tax  only  of  his  proportionate  share  of 
such  dividends  and  interest  allowed  as  credits  by  section  216  as  are  re- 
ceived by  the  personal  service  corporation,  and  (b)  a  credit  against 
income  tax  of  the  stockholder's  proportionate  share  of  income,  war 
profits,  and  excess  profits  taxes  of  the  personal  service  corporation 
paid  or  accrued  during  the  taxable  year  to  a  foreign  country  or  to 
any  possession  of  the  United  States,  subject  to  the  limitations  of 
section  222  of  the  statute.      (Art.  339.) 

Foreign  corporations  cannot  be  classed  as  personal  service 
corporations. — Even  though  a  foreign  corporation  doing 
business  in  the  United  States  derives  all  its  income  from  tKe 
activities  of  its  principal  owners,  it  cannot  be  classed  as  a 
personal  service  corporation.  Under  1918  and  192 1  laws, 
all  foreign  corporations  (whether  personal  service  or  not) 
are  taxed  under  sections  327  and  328. 


Section  204.    See  page  804. 


J 


FROM    PERSONAL   SERVICE   CORPORATIONS  839 

Corporations  with  large  government  contracts  may  not 
qualify. — When  50  per  cent  or  more  of  the  gross  income  of 
a  corporation  is  derived  from  "gains,  profits,  commissions 
or  other  income  derived  from  a  government  contract  or 
contracts  made  between  April  6,  191 7,  and  November  11, 
1918,"  it  cannot  qualify  as  a  personal  service  corporation.®" 
This  would  include  engineering  and  other  corporations  whose 
activities  were  devoted  to  government  work  during  1918.'^'' 

Corporations  which  do  not  distribute  earnings  may  be 
classed  as  personal  service  corporations. — The  attempt  to  im- 
pose in  the  19 18"  law  a  penalty  tax  on  the  undistributed  profits 
of  all  corporations  was  very  properly  defeated. 

The  1 92 1  law  renews  previous  attempts  to  tax  undistrib- 
uted profits,""  though  by  a  somewhat  different  procedure.  The 
new  law  provides  that  if  the  stockholders  of  a  corporation, 
which  is  used  to  prevent  the  imposition  of  the  surtax,  "agree 
thereto,  the  Commissioner  may,  in  lieu  of  all  income,  war 
profits  and  excess  profits  taxes  imposed  upon  the  corporation 
for  the  taxable  year,  tax  the  stockholders  or  members  of  such 
corporation  upon  their  distributive  shares  in  the  net  income," 
in  the  same  manner  as  the  partners  of  a  partnership  are  taxed. ^^ 

Computation  of  tax  when  corporation  is  partly  a  personal 
service  corporation. — Section  303  provides  that  if  at  least  30 

l)er  cent  of  the  net  income  of  a  corporation  is  derived  from 
a  business,  which  if  constituting  its  sole  business  would  bring 
it  within  the  class  of  personal  service  corporations,  the  tax 
upon  that  part  of  the  income  shall  be  computed  separately. 
Such  a  corporation  is  subject  to  the  excess  profits  tax  (but  not 


"'  Section  200. 

'"For  definition  of  government  contract,   see   section   i,   1921   law. 

"  See  Chapter  XXXV  for  discussion  of  the  1917  law. 

'■'Section  220.     See  C'hapter  XXXV. 

"  [Former  Procedure]  Under  the  1918  law  (section  220)  if  a  corpora- 
tion was  used  to  evade  the  surtax,  the  stockholders  tliereof  were  taxed  in 
the  same  manner  as  stockholders  of  a  personal  service  corporation.  The 
stockholders  had  no  right  of  election. 


840  .  INCOME 

later  than  December  31,  1921,  as  of  which  date  it  is  repealed). 
Tt  should  be  noted  on  this  point,  however,  that  in  computing 
the  tax  there  must  be  ascribed  to  the  personal  service  part  of 
the  business  the  same  amount  of  capital  which  is  normally 
required  by  corporations  which  have  been  deemed  to  be  per- 
sonal service  corporations  not  subject  to  the  excess  profits 
tax/* 

Status  of  stockholders  in  personal  service  corporation. — 

The  surplus  accumulated  prior  to  January  i,  1918,  by  a  cor- 
poration designated  under  the  1918  and  1921  laws  as  a  per- 
sonal service  corporation,  w^ill  have  been  subjected  to  the  nor- 
mal income  taxes  imposed  between  March  i,  191 3,  and  De- 
cember 31,  1917.  The  status  of  the  surplus  follows  any  trans- 
fers of  shares  of  capital  stock — that  is,  dividends  declared  be- 
fore or  after  the  transfer  were  free  from  the  normal  tax 
whether  paid  to  a  new  or  to  an  old  stockholder.  In  1921  the 
purchaser  of  shares  of  stock  of  a  personal  service  corporation 
W'Ould  certainly  be  free  from  the  normal  tax  on  dividends  de- 
clared out  of  surplus  accumulated  prior  to  January  i,  1918,  and 
would  be  free  from  the  surtax  as  well  on  dividends  declared 
from  earnings  accumulated  after  January  i,  1918,  but  prior 
to  the  current  year. 

Because  of  the  fact  that  all  earnings  between  January  i, 
1 91 8,  and  December  31,  1921,  are  subjected  not  only  to  nor- 
mal tax  but  also  to  personal  surtax,  regardless  of  whether 
distributed  or  not,  whereas  only  normal  tax  has  been  paid 
on  the  undistributed  earnings  accumulated  prior  to  that  date, 
it  is  important  that  the  corporation's  books  show  a  clear 
line  of  demarcation  between  the  surplus  or  undistributed  profits 
accumulated  respectively  prior  to  and  subsequent  to  January 
I,  1918. 

Ruling.  A  stockholder  of  a  personal-service  corporation  having 
reported  in  his  individual  return  for  the  taxable  year  his  distributive 
share  of  the  undistributed  net  income  of  the  corporation   for  such 


See  Excess  Profits  Tax  Procedure,  1921. 


FROM  PERSONAL  SERVICE  CORPORATIONS    841 

taxable  year  should  not  again  report  such  income  when  it  is  actually 
received  in  a  subsequent  year,  neither  will  it  be  necessary  to  make 
any  notation  respecting  such  profits  in  the  return  for  the  subsequent 
year.     (C.  B.  i,  page  174;  O.  D.  141.) 

Personal  service  corporations  should  declare  at  once  in 
dividends  the  earnings  which  have  accumulated  during  the 
period  January  i,  19 18,  to  December  31,  1921.  These  profits 
have  already  been  subjected  to  both  the  normal  and  surtax 
for  these  various  years.  If  these  profits  are  not  declared  in 
dividends,  a  personal  service  corporation  will  soon  be  in  a 
position  where  the  more  recently  accumulated  profits  must  be 
declared  in  dividends  before  these  "tax-free"  profits  may  be 
withdrawn  by  the  stockholders.''^ 

Amended  returns  and  claims  when  establishing  personal 
service  status. — 

Ruling.  A  corporation  filing  returns  on  Form  1120  and  subse- 
quently desiring  to  establish  its  status  as  a  personal  service  corpora- 
tion should  adopt  the  following  method  of  procedure: 

It  should  file  amended  returns  on  Form  1065  accompanied  with 
claim  for  refund  on  Form  46  for  the  tax  or  installments  thereof  paid. 
The  individual  members  of  the  corporation  should  also  file  amended 
returns  accompanied  with  claims  in  abatement,  Form  47,  covering 
the  additional  assessment  shown  by  such   returns. 

In  the  event  that  the  corporation  is  found  to  be  taxable  under 
sections  230  and  301  of  the  Revenue  Act  of  1918,  the  claim  for 
refund  will  be  disallowed.  In  case  the  corporation  establishes  a  per- 
sonal service  status,  the  claim  for  refund  will  be  allowed  for  the  tax 
paid  by  the  corporation,  and  the  claims  in  abatement  will  be  dis- 
allowed and  assessment  made  to  the  extent  of  the  additional  tax 
shown  to  be  due  on  the  amended  individual  returns. 

Where  the  procedure  is  adopted,  'however,  the  installments  of 
tax  which  become  due  prior  to  determination  of  the  status  of  the 
corporation  as  shown  by  its  return,  as  originally  filed,  must  be  paid 
on  or  before  the  due  dates.  Such  installments  are  not  subject  to 
either  abatement  or  credit,  but  can  only  be  covered  by  supplemental 
claim  for  refund.     (C.  P».  3,  page  198;  O.  D.  614.) 


For  a  detailed  discussion,   see  page  713. 


PART  III 
DEDUCTIONS 


CHAPTER    XXV 

DEDUCTIONS  AND  CREDITS— GENERAL 

Method  of  treatment. — The  statute  specifies  the  particular 
deductions  and  credits  which  may  be  subtracted  from  gross 
income  to  determine  taxable  net  income  or  from  the  tax  as 
ascertained  under  certain  sections  to  determine  the  net  tax 
to  be  paid.  These  deductions  and  credits  are  listed  separately 
in  the  law  and  differ  somewhat  with  the  character  of  the  tax- 
payer— whether  a  corporation,  a  personal  service  corporation 
or  an  individual,  or  whether  a  resident  or  a  non-resident.  In 
this  book  all  the  peculiarities  relating  to  non-resident  aliens, 
including  deductions,  are  relegated  to  a  special  chapter 
(XXXVI).  The  deductions  and  credits  allowed  to  others  than 
non-resident  aliens,  whether  individuals  or  corporations,  are 
consolidated  and  are  treated  topically  in  the  series  of  chap- 
ters which  follows.  This  method  of  treatment  is  convenient 
because  most  of  the  deductions  apply  with  equal  force  to 
individuals  and  corporations.  Often  the  wording  is  exactly 
the  same  and  in  such  cases  repetition  is  avoided,  for  only  one 
construction  can  be  placed  upon  it.  Where  there  is  any  vari- 
ance in  the  deductions  the  fact  is  noted  and  the  comments 
separated  within  the  chapter,  care  being  taken  to  make  clear 
the  limited  application  of  the  statements  which  relate  only  to 
corporations  or  only  to  individuals. 

Since  the  law  is  printed  in  full  in  the  Appendix  and  since 
all  the  provisions  relating  to  deductions  are  quoted  verbatim 
under  the  various  individual  topics  in  the  succeeding  chapters, 
it  is  not  necessary  to  give  here  the  various  lists  of  allowable 
deductions.  For  these  the  reader  is  referred  to  sections  214 
(a)  and  234  (a)  of  the  statute. , 

Deductions  limited  to  those  specified  in  the  statute. — While 
the  tax  is  levied  on  "net  income  received,"  that  term  is  not 

845 


846  DEDUCTIONS 

the  usual  "net  income"' of  the  accountant's  vocabulary.  It  is 
a  resultant  obtained  Ijy  subtracting  from  gross  income,  as  de- 
termined in  the  particular  manner  described  in  the  preceding 
chapters,  certain  specified  deductions  which  are  discussed  in 
the  chapters  which  follow.  In  the  language  of  the  regula- 
tions : 

Regulation.  Net  income  is  that  portion  of  the  gross  income 
which  remains  after  all  proper  deductions  have  been  taken  into 
account.  The  net  income  of  corporations  is  determined  in  general 
in  the  same  manner  as  the  net  income  of  individuals,  but  the  deduc- 
tions allowed  corporations  are  not  precisely  the  same  as  those 
allowed  individuals (Art.  531.) 

The  law  expressly  excludes  certain  items  usually  regarded 
as  legitimate  deductions  from  income,  and  the  Treasury  has 
held  that  some  other  items  of  ordinary  expenses  are  not  al- 
lowable. Some  of  these  restrictions  apply  both  to  individuals 
and  to  corporations.  Others  apply  merely  to  one  or  the  other. 
Neither  individuals  nor  corporations,  for  example,  may  deduct 
special  assessments  of  certain  types  or  interest  on  money  bor- 
rowed to  purchase  certain  tax-exempt  securities.  On  the 
other  hand,  an  individual  may  deduct  charitable  contributions 
to  a  limited  extent,  while  a  corporation  may  not.  Again,  an 
individual  may  not  deduct  personal  expenses,  which  makes  it 
necessary  to  define  personal  expenses  very  carefully,  while  a 
corporation,  of  course,  is  presumed  to  have  no  "personal"  ex- 
penses. Taxes  imposed  on  an  individual's  residence  and  in- 
terest on  money  borrowed  for  personal  use  are  not  considered 
personal  expenses.  Moreover,  under  the  1918  and  1921  laws 
an  individual  can  deduct  the  net  loss  sustained  by  any  "cas- 
ualty" which  happens  to  his  automobile  or  other  property  (such 
as  a  stock  of  liquors),  a  loss  which  is  nothing  more  than  a  per- 
sonal or  living  expense.  Furthermore,  individuals  may  deduct 
the  interest  paid  on  loans  which  are  used  to  defray  personal 
expenses.  Inconsistencies  such  as  these  give  rise  to  most  of  the 
complications  encountered  in  drawing  up  returns.  Those 
charged  with  the  preparation  of  returns  should  carefully  study 


DEDUCTIONS    AND    CREDITS— GENERAL  847 

the  ])rovisions  of  the  law  bearing  on  deductions  and  be  pre- 
pared to  pass  on  the  propriety  of  including  or  excluding  the 
various  items  of  expenditures  which  have  been  made.^ 

Deductions  may  be  determined  by  accrual  method. — 

Law.  Section  212 (b)  The  net  income  shall  be  com- 
puted upon  the  basis  of  the  taxpayer's  annual  accounting  period  (fiscal 
year  or  calendar  year,  as  the  case  may  be)  in  accordance  with  the 
method  of  accounting  regularly  employed  in  keeping  the  books  of  such 
taxpayer;  but  if  no  such  method  of  accounting  has  been  so  employed, 
or  if  the  method  employed  does  not  clearly  reflect  the  income,  the  com- 
putation shall  be  made  upon  such  basis  and  in  such  manner  as  in  the 
opinion  of  the  Commissioner  does  clearly  reflect  the  income 

Section  200 The  term  "paid,"  for  the  purposes  of  the 

deductions  and  credits  under  this  title,  means  "paid  or  accrued"  or 
"paid  or  incurred,"  and  the  terms  "paid  or  incurred"  and  "paid  or 
accrued"  shall  be  construed  according  to  the  method  of  accounting 
upon  the  basis  of  which  the  net  income  is  computed  under  section 
212;     .... 

If  the  taxpayer  keeps  no  regular  books  of  account,  and 
if  he  does  keep  books,  but  on  the  basis  of  cash  receipts  and 
payments,  he  must  claim  his  deductions  on  the  basis  of  cash 
actually  paid  out.  In  all  cases  where  it  is  possible  to  do  so, 
the  taxpayer  should  keep  his  books  on  an  "accrual"  basis.  If 
this  method,  which  is  now  specifically  authorized  by  the  regu- 
lations, is  once  adopted  it  must  be  followed  in  subsequent 
years.  The  application  of  the  accrual  method  is  thus  described 
in  the  regulation: 

Regulation,  (i)  Approved  standard  methods  of  accounting  will 
ordinarily  be  regarded  as  clearly  reflecting  income.  A  method  of 
accounting  will  not,  however,  be  regarded  as  clearly  reflecting  income 
unless  all  items  of  gross  income  and  all  deductions  are  treated  with 
reasonable  consistency All  items  of  gross  income  shall  be  in- 
cluded in  the  gross  income  for  the  taxable  year  in  which  they  are 
received  by  the  taxpayer,  and  deductions  taken  accordingly,  unless  in 
order  clearly  to  reflect  income  such  amounts  are  to  be  properly  ac- 
counted for  as  of  a  different  period (Art.  23.) 


'  The  form  of  reconcilement  statement  which  will  be  found  in  Excess 
Profits  Tax  Procedure.  Uj2i.  ChaptiT  XV,  affords  a  mcTins  of  preventin.t,' 
the  omission  of  any  allowable  deduction  in  the  books,  and  as  to  classihca- 
tion  it  calls  attention  to  any  omission  of  allowable  items  not  in  the  books. 


848  DEDUCTIONS 

Each  year's  return  must  be  complete  within  itself. — 

Regulation.  Each  year's  return,  so  far  as  practicable,  both  as 
to  gross  income  and  deductions  therefrom,  should  be  complete  in 
itself,  and  taxpayers  are  expected  to  make  every  reasonable  effort 

to    ascertain    the    facts    necessary    to    make    a    correct    return 

(Art.  III.) 

The  foregoing  principle  is  discussed  in  the  chapters  which 
follow.  The  intention  is  to  impose  no  unreasonable  restric- 
tions on  taxpayers  whi)  follow  good  accounting  principles. 

The  new  article  omits  the  provision  that  losses  from  theft 

or  embezzlement  are  deductible  in  the  year  of  occurrence.   This 

is  in  accordance  with  article  126. 

Ruling.  Where  a  corporation  engaged  in  buying  and  selling 
real  estate  purchases  a  piece  of  property  and  holds  it  for  a  profi':,  the 
interest,  taxes,  and  ordinary  repairs  incident  to  the  property  lepre- 
sent  charges  for  the  year  in  which  paid  or  are  so  charged  upon  the 
books  as  to  represent  liabilities  of  the  corporation  and  are  allowable 
deductions  in  computing  net  income  even  though  in  excess  of  the 
gross  income  derived  from  the  property.  Such  charges  are  not 
capital  expenditures  if  the  corporation  lias  any  income  from  which 
to  deduct  them  and  they  should  not  be  added  to  the  cost  of  the 
property  in  determining  the  amount  of  gain  or  loss  arising  from  its 
sale  except  to  the  extent  that  the  corporation  has  no  gross  income 
from  any  source  against  which  to  deduct  such  expenditures  for  the 
taxable  year  in  which  they  were  made.     (C.  B.  2,  page  112;  O.  D.  398.) 

The  principle  of  each  return  being  complete  in  itself  is  sub- 
stantialh'  modified  by  section  204  of  the  192 1  law,  which 
allows  net  losses  to  be  used  to  reduce  the  taxable  income  of  the 
next  t\\o  succeeding  years.     See  Chapter  XXIX. 

Amended  returns  may  be  made  to  adjust  items  applicable 
to  prior  years. — 

Ruling.  A  corporation  during  its  fiscal  year  ended  May  31,  1919, 
sold  certain  goods,  the  weight  and  grade  of  which  were  guaranteed 
by  contract.  At  the  close  of  that  fiscal  year  a  number  of  claims 
involving  shipments  not  conforming  to  specifications  were  in  process 
of  adjustment,  settlement  of  which  was  made  during  the  ensuing 
fiscal  year. 

Inasmuch  as  the  corporation's  liability  is  not  in  dispute  and  the 
amount  thereof  is  merely  an  accounting  detail  to  be  determined 
under  an  existing  contract  or  agreement  and  in  accordance  with  a 


DEDUCTIONS    AND    CREDITS— GENERAL  849 

recognized  method  of  procedure  the  Committee  is  of  opinion  that 
such  adjustments  are  applicable  to  the  year  in  which  the  sales  were 
made  and  hence  properly  deductible  in  the  return  of  the  corporation 
for   its   fiscal   year   ended   May   31,    19 19.     (C.    B.   3,   page    147;   A. 

R.  R.  275.) 

These  regulations  must  be  reasonably  construed.  All  busi- 
ness concerns  and  all  individuals  have  items  of  receipts  and 
expenses  which  cannot  be  incorporated  in  books  of  account 
prior  to  closing  time.  In  the  well-managed  concern  the 
amounts  are  usually  insignificant  and  when  subsequently  ascer- 
tained they  are  entered  as  current  items  in  the  succeeding 
period.  If  the  amounts  are  large  the  treatment  is  different 
and  adjustment  of  the  accounts  of  the  prior  period  and  the 
filing  of  amended  returns  are  in  order,  but  after  the  accounts 
for  a  fiscal  year  are  once  closed  there  should  be  no  reopening 
unless  it  is  a  matter  of  substantial  importance. 

This  interpretation  is  apparently  in  accord  with  the  gen- 
eral rule  laid  down  in  another  regulation  for  the  inclusion  or 
exclusion  of  insignificant  amounts  in  one  year  or  another.  It 
does  not  disturb  the  clear  reflection  of  income. 

Regulation The   time   as   of   which   any   item   of   gross 

income  or  any  deduction  is  to  be  accounted  for  must  be  determined 
in  the  light  of  the  fundamental  rule  that  the  computation  shall  be 
made  in  such  a  manner  as  clearly  reflects  the  taxpayer's  income. 
If  the  method  of  accounting  regularly  employed  by  him  in  keeping 
his  books  clearly  reflects  his  income,  it  is  to  be  followed  with  respect 
to  the  time  as  of  which  items  of  gross  income  and  deductions  are  to 
be  accounted  for.  If  the  taxpayer  does  not  regularly  employ  a 
method  of  accounting  which  clearly  reflects  his  income,  the  com- 
putation shall  be  made  in  such  manner  as  in  the  opinion  of  the 
Commissioner  clearly  reflects  it.     (Art.  22.) 

The  regulation  quoted  on  page  109  (article  iii)  makes  it 
plain  that  the  taxpayer  may  file  amended  returns  on  his  own 
initiative.  Tlie  Commissioner,  in  turn,  may  on  his  part  re- 
(juire  such  returns. 

Regulation If  in  the  opinion  of  the  Commissioner  such 

information  indicates  that  the  returns  for  any  previous  years  did 
not  reflect  the  true  income,  amended  returns  for  such  years  will 
be  required (Reg.  45,  Art.  23.) 


850  DEDUCTIONS 

It  is  the  desire  of  the  Treasury  to  obtain  returns  which 
accurately  reflect  for  a  given  year  the  actual  income  and  the 
actual  expenses  applicable  to  that  year.  The  Treasury  ac- 
cepts or  requires  amended  returns,  if  based  on  meritorious 
grounds,  whether  or  not  the  outcome  is  favorable  to  the  gov- 
ernment. The  action  of  some  inspectors  would  lead  one  to 
believe  that  amended  returns  are  in  order  only  when  the  net 
result  is  against  the  taxpayer,  but  the  responsible  officers  of 
the  Treasury  maintain  no  such  attitude. 

Desirability  of  good  records. — Most  individuals  keep  poor 
accounts  or  none  at  all.  It  is  desirable  from  almost  ever}' 
point  of  view  to  keep  careful  financial  records,  and  the  income 
tax  levied  at  the  present  high  rates  makes  it  almost  imperative 
that  this  be  done.  It  is  important  from  the  point  of  view  of 
the  government  in  order  that  no  taxable  items  may  be  missed. 
It  is  important  from  the  point  of  view  of  the  individual  in 
order  that  his  burden  may  not  be  inequitably  large  as  com- 
pared with  his  neighbor's.  But  since  most  individuals  find  it 
easier  to  recall  all  the  items  of  their  income  than  of  their  ex- 
penditure, they  usually  do  not  avail  themselves  of  all  allowable 
deductions.  In  other  words,  the  keeping  of  careful  records  in 
this  case  will  work  out  more  to  the  advantage  of  the  taxpayer 
than  to  that  of  the  government ;  but  it  will  also  result  in  the  tax 
being  more  equitably  spread,  which  is  an  advantage  from  every 
point  of  view. 

Accounts  of  partnerships  and  corporations  are,  as  a  rule, 
better  kept  than  those  of  individuals.  They  are,  of  course, 
supposed  to  include  all  items  which  can  be  claimed  as  allowable 
deductions.  The  items  disallowed  by  the  law  and  regulations 
are  discussed  in  detail  in  the  chapters  which  follow.  If  the 
accrual  method  is  used  all  items  of  deductions,  minus  those 
specifically  forbidden,  as  taken  from  the  record  of  expenses  or 
liabilities,  should  yield  the  proper  result.  If  the  accrual  method 
is  not  followed,  the  taxpayer  must  depend  upon  his  cash 
account. 


CHAPTER    XXVI 

DEDUCTIONS  FOR  EXPENSES 

General 

The  1921  law  re-enacts  the  provision  of  the  19 18  law  re- 
garding deductions  for  expenses.  The  new  law  specifically 
permits  individuals  to  deduct  traveling  expenses.^ 

The  chief  problems  of  procedure  connected  with  deduc- 
tions for  expenses  are  occasioned  by  the  presence  of  certain 
restrictions  in  the  law  itself.  First  of  all,  the  statute  forbids 
the  deduction  of  personal  living  expenses.^  This  is  quite 
necessary  and  proper,  but  it  involves  the  difficult  task  of  estab- 
lishing a  sharp  line  of  demarcation  between  business  and  liv- 
ing expenses.  Gifts,'  in  the  next  place,  are  not  generally  de- 
ductible ;  but  in  many  cases  it  is  not  easy  to  determine  whether 
a  payment,  nominally  a  gift,  is  not  more  truly  an  expense.  The 
law  does  not  permit  the  deduction  of  capital  expenditures  ex- 
cept in  the  form  of  depreciation  allowances,  and  here  once 
more  it  is  necessary  to  set  up  a  series  of  distinctions  between 
this  type  of  expenditures  and  business  expenses  proper.  Again, 
care  must  be  taken  not  to  allow  any  distribution  of  profits 
under  the  guise  of  business  expense.  Other  difficulties  are 
caused  by  the  prohibition  of  certain  expenditures  as  contrary 
to  public  policy  and  by  the  necessity  of  taking  a  position  on 
the  question  of  insurance — as  to  how  far  expenses  are  deduc- 
tible which  seek  to  safeguard  the  income  from  risks  of  various 
sorts. 

In  this  chapter  the  first  general  section  is  devoted  to  the 


*  See  page  864. 

'This  rule  is  considerably  modified  if  section  214  (a-6)  (allowing 
for  losses  arising  out  of  casualties)  is  interpreted  to  cover  ordinary  accidents 
to  personal  property,  the  use  of  which  has  always  been  regarded  as  private 
or  family  expense. 

"  Sec  Chapter  XXXIV,  "Deductions  for  Gifts  and  Donations." 

851 


852  DEDUCTIONS 

establishment  of  the  distinction  between  business  and  personal 
expenses  and  is  consequently  applicable  to  individuals  only. 
The  remainder  of  the  chapter  deals  with  various  specific  types 
of  expenses  and,  unless  otherwise  specified,  applies  alike  to 
individuals,  partnerships  and  corporations.  In  the  case  of 
many  of  these  expenses  the  deductibility  of  a  particular  item 
becomes  a  complicated  question  involving  several  of  the  dis- 
tinctions referred  to  in  the  preceding  paragraph,  as,  for  ex- 
ample, when  a  salary  must  be  shown  to  be  not  a  gift,  a  per- 
sonal expense,  a  distribution  of  profit,  a  distribution  of  assets 
or  a  payment  for  property.* 

Expenses  which  are  deductible. — 

Law.  Section  214.  [Individuals]  (a)  That  in  computing  net 
income  there  shall  be  allowed  as  deductions:  / 

(i)  All  the  ordinary  and  necessary  expenses  paid  or  incurred  dur- 
ing the  taxable  year  in  carrying  on  any  trade  or  business,  including  a 
reasonable  allowance  for  salaries  or  other  compensation  for  personal 
services  actually  rendered;  traveling  expenses  (including  the  entire 
amount  expended  for  meals  and  lodging)  while  away  from  home  in 
the  pursuit  of  a  trade  or  business;  and  rentals  or  other  payments  re- 
quired to  be  made  as  a  condition  to  the  continued  use  or  possession, 
for  purposes  of  the  trade  or  business,  of  property  to  which  the  tax- 
payer has  not  taken  or  is  not  taking  title  or  in  which  he  has  no  equity;* 

Section  234.  [Corporations]  (a)  That  in  computing  the  net 
income  of  a  corporation  subject  to  the  tax  imposed  by  section  230 
there  shall  be  allowed  as  deductions: 

(i)  All  the  ordinary  and  necessary  expenses  paid  or  incurred 
during  the  taxable  year  in  carrying  on  any  trade  or  business,  including 
a    reasonable   allowance   for    salaries    or    other   compensation   for   per- 


'  See  page  870. 

[Former  Procedure]  Sections  214  (a-i)  and  234  (a-i)  of  the  1921 
law  are  identical  with  those  in  the  1918  law,  except  for  the  addition  of  the 
provision    in   the    former   relating  to   traveling   expenses. 

1916  Law.  Section  5.  [Individuals]  "(a)  ....  First.  The  neces- 
sary expenses  actually  paid  in  carrying  on  any  business  or  trade,  not  includ- 
ing personal,  living,  or  family  expenses ;" 

Section  12.  [Corporations]  "(a)  ....  First.  All  the  ordinary  and 
necessary  expenses  paid  within  the  year  in  the  maintenance  and  operation 
of  its  business  and  properties " 

'For  comment  on  last  two  lines  which  were  added  by  the  1916  law, 
see  Chapter  XXVII,  "Deductions  for  Interest." 


FOR   EXPENSES  853 

sonal  services  actually  rendered,  and  including  rentals  or  other  pay- 
ments required  to  be  made  as  a  condition  to  the  continued  use  or 
possession  of  property  to  which  the  corporation  has  not  taken  or  is 
not  taking  title,  or  in  which  it  has  no  equity ; 

The  principle  underlying  the  deductions  for  expenses  was 
well  expressed  in  a  ruling  under  the  1913  law,  as  follows: 

Ruling.  Only  those  expenses  which  are  incurred  in  earning 
income  which  is  subject  to  tax  under  the  income  tax  law  constitute 
allowable  deductions  in  computing'  net  income  taxable  under  the  law. 
(T.  D.  2137,  January  30,  1915.) 

In  general,  there  has  been  adherence  to  the  foregoing  prin- 
ciple. In  some  cases,  however,  expenses  which  have  been  in- 
curred in  earning  taxable  income  have  not  been  allowed. 

Restrictions  on  expense  deductions. — The  restrictions  on 
deductions  for  expenses  are  the  following  :*' 

Law.     Section    215.      [hidividualsl     That    in    computing    net    in- 
come no  deduction  shall  in  any  case  be  allowed  in  respect  of — 
(i)  Personal,  living,  or  family  expenses; 

(2)  Any  amount  paid  out  for  new  buildings  or  for  permanent 
improvements  or  betterments  made  to  increase  the  value  of  any  prop- 
erty or  estate; 

(3)  Any  amount  expended  in  restoring  property  or  in  making  good 
the  exhaustion  thereof  for  which  an  allowance  is  or  has  been  made;^ 
or 

(4)  Premiums  paid  on  any  life  insurance  policy  covering  the  life 
of  any  officer  or  employee,  or  of  any  person  financially  interested  in  any 
trade  or  business  carried  on  by  the  taxpayer,  when  the  taxpayer  is 
directly  or  indirectly  a  beneficiary  under  such  policy. ^   .... 

Section  235.  [Corporations!  That  in  computing  net  income  no 
deduction  shall  in  any  case  be  allowed  in  respect  of  any  of  the  items 
specified  in  section  215. 

Accrued  expenses  may  be  deducted, — When  the  accounts 
of  a  taxpayer  are  kept  on  the  accrual  basis  all  expenses  in- 
curred to  the  end  of  the  taxable  year,  whether  paid  or  not  are 


'[Former  Procedure]  These  provisions  are  identical  with  those  of  the 
1918  law. 

'  See  Chapter  XXXI,  "Depreciation." 
'  See  page  894. 


854  DEDUCTIONS  "      "     ' 

allowable  deductions  and  should  be  entered  in  the  books.  It 
is,  however,  most  reprehensible  to  enter  accrued  items  of 
expenses  unless  all  items  of  accrued  income  are  also  entered. 
The  term  "expenses  ....  incurred"  must  be  taken  in  its 
usual  commercial  sense.  It  would  be  improper  for  a  concern 
to  enter  as  an  accrued  expense  at  the  end  of  the  taxable  year 
any  items  of  which  the  business  had  not  received  the  benefit. 
An  office  telephone  company  sent  out  notices  on  December 
27,  1918,  to  the  effect  that  the  signing  of  a  contract  for  its 
service  was  sufficient  to  warrant  the  inclusion  of  the  liability 
thereby  incurred  as  an  allowable  expense  in  the  1918  accounts. 
The  statement  was  incorrect.  In  the  first  place,  if  the  equip- 
ment was  a  capital  expenditure  it  could  not  be  deducted  as  an 
expense,  and,  in  the  second  place,  if  it  was  an  allowable  expense 
item  it  should  not  be  allowed  until  the  business  received  the 
benefit,  which  could  not  occur  before  the  year  in  which  the 
service  was  actually  installed. 

Business  Expenses  Distinguished  from  Personal  Expenses 

Definition  of  "business  or  trade." — The  law  specifies  that 
an  individual  must  not  include  "personal,  living  or  family  ex- 
penses" in  his  computation  of  deductible  expenses.  He  may 
subtract  under  this  head  merely  "the  ordinary  and  necessary 
expenses  paid  or  incurred  ....  in  carrying  on  any  trade  or 
business."^  "Business"  and  "trade"  are  used  synonymously 
and  have  been  defined  as  follows  in  an  old  regulation  : 

Ruling.  That  which  occupies  and  engages  the  time,  atten- 
tion and  labor  of  anyone  for  the  purpose  of  liveHhood,  profit  or  im- 
provement; that  which  is  his  persona]  concern  or  interest;  employ- 
ment, regular  occupation,  but  it  is  not  necessary  that  it  should  be  his 
sole  occupation  or  employment.     (T.  D.  1989.  June  2,  1914.) 

It  is  apparent  that  this  definition  is  broad  enough  to  in- 
clude professions  of  all  types, ^^  as  well  as  various  avocations 


•  Section  214  (a-i). 

'"The  excess  profits  tax  law  of  October  3.  1917,  specitically  included 
professions  within  the  definition  of  "trade"  and  "business."  (See  sec- 
tion 200.) 


FOR    EXPENSES  855 

aiui  "side-lines."'^  Moreover,  it  is  not  neeessary  for  a  person 
to  own  a  business  in  order  to  be  in  business  or  to  have  business 
expenses.  Salaried  officers  and  employees  and  persons  re- 
ceiving their  remuneration  on  a  commission  basis  often  have 
business  expenses  which  are  necessary  and  are  allowable  as 
deductions.  Recognition  of  this  is  found  in  the  original  edi- 
tion of  Regulations  45.^" 

Regulation Amounts  paid  from  a  salary  received  for  all 

services  rendered  and  expenses  incurred  are  deductible  as  business 
expenses  wrhen  the  expenditures  are  occasioned  by  the  services  in 
respect  of  which  the  salary  is  paid (Reg"-  45,  Art.  292.) 

In  the  April  17,  1919,  edition  of  the  regulations  the  state- 
ment was  omitted.  The  omission,  however,  cannot  operate  to 
deprive  anyone  of  a  deduction  for  business  expenses  which  the 
law  permits. 

The  circumstances  of  each  case  are  considered  by  the 
Treasury  in  deciding  whether  expenditures  are  business  or  per- 
sonal. Office  rent  paid  by  a  taxpayer  whose  income  is  derived 
principally  from  investments,  is  deductible  if  it  can  be  shown 
that  such  rent  is  ordinary  and  necessary. ^^  Expenses  incurred 
in  making  a  trip  to  Washington  in  connection  with  the  assess- 
ment of  additional  tax  by  the  Treasury  have  been  held  to  be 
deductible.^*  Rental  of  a  safe  deposit  box  is  held  to  be  deducti- 
ble only  when  used  in  connection  with  trade  or  business.^^ 

"Personal  expenses"  defined. — In  a  case  involving  the  ques- 
tion, whether  or  not  transportation  paid  by  a  commuter  is  a 
deductible  expense,  the  solicitor  has  very  aptly  defined  personal 
expenses. 

.  Ruling "Business  expenses,"   as  defined  in  article   loi, 

Regulations  45,  includes  all  items  entering  into  what  is  ordinarily 


"  See  C.  B.  4,  page  119;  O.  D.  805. 

"The  preliminary  edition  of  these  regulations  was  issued  soon  after 
the  enactment  of  the  1918  law. 

"C.  B.  4,  page  123;  O.  D.  877. 

"  C.  B.  4,  page  123;  O.  D.  849. 

"  Telegram  to  Guaranty  Trust  Co.,  signed  by  Commissioner  Wm.  M. 
Williams,  dated  March  8,  1921. 


856  DEDUCTIONS 

known  as  the  cost  of  goods  sold,  together  with  selling  and  manage- 
ment expenses.  In  short,  every  necessary  item  of  expense  in  con- 
ducting business,  incurred  primarily  because  of  and  solely  in  the 
furtherance  of  the  business  engaged  in,  is  held  to  be  an  ordinary  and 
necessary  business  expense. 

To  what  extent  can  this  definition  of  business  expenses  be  applied? 
Does  it  include  any  and  all  expenses  which  in  any  way  bear  upon  or 
have  a  relation  to  or  a  connection  with  the  business  engaged  in  by 
the  individual?  Obviously,  amounts  paid  out  for  medical  attention 
necessary  for  the  upkeep  of  the  body  and  the  preservation  of  health 
are  personal  and  have  no  connection  with  business.  Likewise,  sums 
paid  to  the  grocer,  to  the  tailor,  amounts  paid  for  insurance  and 
house  rent.  These  expenses  arise  independently  of  business.  The 
test,  therefore,  is  whether  an  expense  is  incurred  primarily  because 
of  business  as  the  immediate  cause  inducing  the  expenditure. 

....  Obviously,  an  individual  is  free  to  fix  his  residence  wher- 
ever he  chooses.  He  fixes  it  according  to  his  personal  convenience 
and  inclinations,  as  a  matter  separate  and  apart  from  business.  Any 
expense,  therefore,  incident  to  such  residence  as  fixed  by  the  individ- 
ual is  a  matter  personal  to  him 

It  is  therefore  held  that  the  cost  of  transportation  paid  by  a  sal- 
aried employee  living  at  a  distance  from  his  employment,  in  order  to 
go  to  and  return  from  sucli  employment,  is  not  deductible  as  a  busi- 
ness expense  within  the  meaning  of  the  Revenue  Acts  of  October  3, 
1913,  September  8,  1916,  as  amended,  and  February  24,  1919.  (C.  B. 
I,  page  loi ;  S.  1048.) 

The  foregoing  ruling  liolds  that  traveHng  expenses,  when 
incurred  in  connection  witli  a  taxpayer's  duties,  are  allowable 
deductions.  The  ruling  is  sound.  It  is  difficult,  however,  to 
distinguish  between  occasional  and  frequent  business  expenses. 

If  trips  were  made  monthly,  apparently  the  expense  would 
be  allowed;  when  trips  are  made  daily  the  expense  is  not 
allowed.  The  principle  does  not  seem  to  be  logical.  It  would 
seem  to  be  more  logical  to  confine  "personal,  living  and  family 
expenses"  to  those  which  are  expended  whether  or  not  a  per- 
son is  in  business.  If  a  person  engages  in  business  and  is 
required  to  incur  business  expenses,  the  additional  cost  should 
be  treated  as  a  deduction  from  gross  income.  The  solicitor 
(in  Opinion  1048)  falls  into  an  error  when  he  states  that 
"obviously  an  individual  is  free  to  fix  his  residence  wherever 
he  chooses."     In  the  case  of  the  Congressman's  secretary  he 


FOR    EXPENSES  857 

was  required  to  fix  it  in  VVasliingtonJ'"'  Only  when  one  enjoys 
a  "lazy"  income  is  one  free  to  live  where  one  likes.  The  author 
would  like  to  see  a  court  decision  on  the  deductibility  of  the 
commuters'  railroad  fares. 

Theory  underlying  the  segregation  of  business  expenses. — 
In  the  opinion  of  the  author  the  exact  line  between  personal 
and  business  expenses  can  be  determined  with  theoretical  ac- 
curacy by  ascertaining  whether  or  not  the  various  items  would 
have  been  expended  had  the  taxpayer's  income  been  derived 
from  some  source,  other  than  business,  which  required  no  out- 
lay for  business  expenses.  For  example,  if  a  salesman  or 
other  employee  receives  a  salary  of  $3,000  per  annum,  the 
query  should  be  propounded:  "What  would  his  personal,  liv- 
ing or  family  expenses  be  if  his  income  of  $3,000  were  de- 
rived from  investments?"  Theoretically  he  should  be  per- 
mitted to  deduct  any  additional  expenses  incurred  over  and 
above  those  which  he  would  pay  if  he  were  free  to  live 
wherever  he  chose  and  in  any  manner  he  chose  within  the 
limitations  of  his  $3,000  investment  income.  If  in  order 
to  earn  his  salary  he  must  purchase  books,  attend  lectures 
and  incur  similar  expenses,  they  should  be  proper  deductions. 
If  he  must  belong  to  a  luncheon  club  and  entertain  at  his  own 
expense  prospective  or  actual  customers,  the  dues  and  other 
charges  of  the  club  should  be  considered  as  business  expenses 
and  therefore  as  allowable  deductions.  If,  to  be  within  reach 
of  his  place  of  business,  he  must  live  in  a  community  where 
rents  are  high,  this  additional  amount  should  be  considered  a 
business  expense,  as  should  also  the  cost  of  his  coninuitation 
ticket  on  the  railway. 

There  are,  however,  apparent  difficulties  in  applying  in 
practice  the  theoretical  distinction  worked  out  in  the  pre- 
ceding paragraph.  Moreover,  the  specific  provision  of  the 
law  forbidding  the  deduction  of  actual  "personal,  living  or 
family  expenses"  complicates  the  situation,  for,  as  a  matter  of 


See  ruling  (C.  B.  4;  O.  D.  8O5).  page  865. 


858  DEDUCTIONS 

fact,  items  which  would  ordinarily  be  classified  as  "family" 
and  "personal"  expenses  (such,  for  example,  as  house  rent) 
may  be  and  often  are  at  the  same  time  true  business  expenses 
as  ascertained  by  the  test  given  above.  The  law  forbids  the 
deduction  of  the  higher  rent  which  A  pays  to  be  near  his  work 
and  the  regulations  forbid  the  deduction  of  the  commutation 
fare  of  B  who  prefers  to  spend  time  and  railway  fare  rather 
than  rent  in  order  to  secure  accessibiHty  to  his  business. ^^ 
Theoretically  both  deductions  should  be  permitted.  To  work 
out  a  complete  solution  it  is  necessary  both  to  change  the  law, 
in  order  to  recognize  certain  "living"  expenses  as  business  ex- 
penses, and  to  liberalize  the  present  regulations." 

Importance  of  precise  distinction. — The  importance  of 
distinguishing  carefully  between  business  and  personal  ex- 
penses and  of  securing  a  full  deduction  of  the  former  is  greatly 
emphasized  by  two  elements  in  the  situation.  The  first  is 
that  "unearned"  income,  which  at  present  is  taxed  at  the  same 
rates  as  business  income,  often  has  no  business  expenses  at- 
tached to  it  and  consequently  runs  no  danger  of  excessive 
taxation  through  failure  to  deduct  such  expenses.    If  business 


"  See  ruling,  page  865. 

"  The  situation  has  been  partly  met  in  England  by  the  establish- 
ment of  allowances  roughly  equivalent  to  annual  business  expenses  of  this 
sort  which  are  difficult  to  determine  exactly,  a  practice  permitted  under  the 
following  section  of  the  British  Act  of  1918  (8  &  9  Geo.  5,  C.  40)  : 

"Where  the  Treasury  are  satisfied  with  respect  to  any  class  of  per- 
sons in  receipt  of  any  salary,  fees,  or  emoluments  payable  out  of  the 
public  revenue  that  such  persons  are  obliged  to  lay  out  and  expend 
money  wholly,  exclusively,  and  necessarily  in  the  performance  of  the 
duties  in  respect  of  which  such  salary,  fees,  or  emoluments  are  pay- 
able, the  Treasurx'  may  fix  such  sum,  as  in  their  opinion  represents  a 
fair  equivalent  of  the  average  annual  amount  laid  out  and  expended  as 
aforesaid  by  persons  of  that  class,  and  in  charging  of  the  tax  on  the  said 
salary,  fees,  or  emoluments,  there  shall  be  deducted  from  the  amount 
thereof  the  sums  so  fixed  by  the  Treasury;  provided  that  if  any  person 
would,  but  for  the  provisions  of  this  rule,  be  entitled  to  deduct  a  larger 
amount  than  the  sum  so  fixed,  that  sum  may  be  deducted  instead  of  the 
sum  so  fixed."     (Sch.  E,  Rule  10.) 

It  may  be  that  a  fairly  satisfactory  solution  of  the  problem  in 
this  country  can  be  found  by  following  the  lines  suggested  in  this 
law. 


FOR   EXPENSES  859 

Expenses  arc  not  completely  deductible,  business  income  stands 
at  a  still  greater  disadvantagCj  as  compared  with  funded 
income,  than  is  intended  when  the  rates  on  both  earned  and 
unearned  incomes  are  the  same.  In  the  opinion  of  the  author 
the  failure  to  tax  unearned  income  at  a  higher  rate  than 
earned  income  in  itself  constitutes  a  sufficiently  great  dis- 
crimination without  adding  to  it  in  this  manner.  The  other 
elerrient  which  emphasizes  the  desirability  of  carefully  segre- 
gating business  expenses  is  the  fact  that  the  average  citizen 
of  the  United  States  is  not  given  to  a  close  analysis  of  his 
personal  expenditures.  He  thus  is  apt  to  be  taxed  excessively, 
unless  his  attention  is  called  to  the  importance  of  accurate 
accounts.  Moreover,  knowledge  of  one's  personal  expendi- 
tures undoubtedly  leads  to  greater  economy  and  increased 
savings.  This,  in  tuni,  means  larger  amounts  available  for 
future  income  taxation,  a  fact  which  should  not  be  overlooked 
by  taxing  authorities  in  framing  regulations  governing  de- 
ductions for  expenses. 

Suggestion  for  segregating  business  expenses. — Where 
business  expenses  are  intermingled  with  personal  expenses,  it 
is  sometimes  helpful  to  approach  the  problem  in  a  negative 
fashion — that  is,  to  ascertain  first  the  amounts  paid  for  per- 
sonal, living  and  family  expenses  (items  which  are  not  de- 
ductible) and  to  assume  tentatively  that  the  remainder  repre- 
sents business  expenses.  With  such  an  assumption  in  mind 
the  examination  of  the  charges  composing  this  remainder 
often  reveals  deductible  items  not  otherwise  apparent." 

In  the  paragraphs  which  follow  various  items  officially 
classified  are  cited  as  illustrative  of  allowable  deductions. 
So  long  as  good  faith  is  observed  in  the  inclusion  of  an  ex- 
pense item,  it  is  not  likely  to  arouse  objection. 


'*  The  remainder,  determined  in  the  negative  manner  thus  described, 
would,  of  course,  not  be  an  item  acceptable  to  the  tax  authorities.  The 
suggestion  is  made  merely  as  a  method  of  discovering  deductible  items 
which  can  be  consolidated  into  a  positive  total  of  business  expenses, 
suitable  for  use  in  the  return. 


860  DEDUCTIONS 

May  personal  expenses  be  deducted  as  casualties? — Sec- 
tion 215  provides  that  "no  deduction  shall  in  any  case  be  al- 
lowed in  respect  of  (a)  personal,  living  or  family  expenses." 
But  under  deductions  this  statement  appears : 

Law.  Section  214.  (a)  That  in  computing  net  income  there  shall 
be  allowed  as  deductions:   .... 

(6)  Losses,  sustained  during  the  taxable  year  of  property  not 
connected  with  the  trade  or  business  (but  in  the  case  of  a  nonresident 
alien  individual  only  property  within  the  United  States)  if  arising  from 
fires,  storms,  shipwreck,  or  other  casualty,  or  from  theft,  and  if  not 
compensated  for  by  insurance  or  otherwise;   .... 

It  is  claimed  that  the  allowable  deduction  for  a  cas- 
ualty to  property  "not  connected  with  the  trade  or  business" 
would  extend  to  net  losses  sustained  on  private  automobiles. 
li  so,  the  deduction  would  also  extend  to  the  breakage  of 
statuary  and  ornaments  in  one's  home,  to  eyeglasses  and  per- 
haps to  children's  toys. 

The  author  is  of  the  opinion  that  section  215  is  control- 
ling as  to  all  items  which  the  taxpayer  ordinarilv  reeards  as 
"personal,  living  or  family  expenses,"  and  therefore  section 
214  (a-6)  includes  only  losses  arising  from  such  casualties 
as  could  not  be  regarded  as  personal,  living  or  family  expenses. 

If  a  residence  burns  down,  the  loss  not  covered  by  in- 
surance is  deductible.  The  test  should  be  whether  or  not  there 
has  been  a  property  loss,  and  no  deduction  should  be  per- 
mitted which  cannot  reasonably  be  so  construed.  In  most 
cases  ta.xpayers  have  three  classes  of  expenditures:  (i)  ex- 
penses connected  with  business  or  trade;  (2)  expenses  involved 
in  investments  and  transactions  entered  into  for  profit;  (3) 
personal,  living  or  family  expenses.  Losses  arising,  out  of 
class  (2)  are  fully  deductible  under  the  1921  law.  The  resi- 
dences of  taxpayers  may  be  said  to  l)e  in  a  class  by  themselves, 
but  items  which  the  taxpayer  himself  has  always  regarded  as 
in  class  (3)  should  not  be  taken  out  of  that  class  except  for  a 
sound  economic  reason.  The  author  does  not  believe  that  such 
a  reason  exists. 

While  it  can  hardly  be  said  that  the  wording  of  the  sec- 


FOR    EXPENSES  86l 

tions  is  ambiguous,  yet  the  intention  of  the  framers  of  the 
law  is  an  important  factor,  and  it  may  be  assumed  without 
investigation  that  there  was  no  intention  on  their  part  of  com- 
pletely reversing  all  former  procedure  and  permitting  the  de- 
duction of  such  an  item  as  a  loss  arising  from  the  puncture 
of  an  automobile  tire. 

Wages  for  personal  service. — The  law  does  not  permit  a 
deduction  for  wages  paid  to  those  in  domestic  service,  nor  to 
those,  such  as  dressmakers  and  others,  who  produce  articles 
consumed  in  the  taxpayer's  family,  but  wages  paid  to  those 
who  help  to  produce  the  income  may  be  deducted.  This  rule  is 
broad  enough  to  include  in  most  cases  the  salary  of  a  private 
secretar}'.  The  distinction  drawn  in  the  1918  edition  of  the 
Income  Tax  Primer  is  suggestive : 

Ruling.  I  employ  a  man  to  assist  me  in  operating  my  farm  and 
a  wom.an  to  assist  about  the  house.  Is  the  compensation  paid  to  each 
allowable  as  a  deduction? 

Unquestionably,  as  to  the  amount  paid  to  the  male  employee,  but 
a  line  must  be  drawn  as  to  the  amount  paid  to  the  female  employee. 
If  her  time  is  employed  entirely  in  taking  care  of  milk  and  cream 
produced  for  sale,  in  the  production  of  butter,  cheese,  etc.,  the  care  of 
milk  cans  and  churns,  or,  if  a  separate  table  is  maintained  for  laborers 
employed  on  the  farm  and  her  services  are  used  entirely  in  the  prepa- 
ration and  serving  of  the  meals  furnished  the  laborers  and  in  caring 
for  their  rooms,  the  compensation  paid  her  constitutes  an  allowable 
deduction.  If,  however,  she  is  employed  to  assist  in  caring  for  the 
farmer's  own  household,  no  deduction  can  be  claimed.  {Income  Tax 
Primer,  1918,  question  60.) 

Wages  paid  to  children. — 

Regulation The  father  is  legally  entitled  to  the  services 

of  his  minor  children,  any  allowances  which  he  gives  them,  whether 
said  to  be  in  consideration  of  services  or  otherwise,  are  not  allow- 
able deductions  in  his  return  of  income -"      (Art.  291.) 

The  1918  edition  of  the  Income  Tax  Primer,  in  addition  to 


°"  [Former  Procedure]  Article  8  of  Regulation  2i,  1918,  reads: 
"As  a  rule,  allowances  which  he  gives  them  ....  are  not  allowable  de- 
ductions .  .  .  ."  The  present  regulation  is  more  emphatic  in  the  denial 
of  this  item. 


S62  DEDUCTIONS 

affirming  the  above  rule,  makes  the  positive  statement  that 
compensation  paid  to  a  child  who  has  attained  his  majority 
may  be  deducted  if  of  the  nature  of  a  business  expense. ^^ 

Under  the  British  practice,  if  any  of  the  children  or  other 
relatives,  except  the  wife,  of  a  trader  earn  their  livelihood  in 
his  employ,  and  if  the  trader  provides  their  board  and  lodging 
as  part  of  their  remuneration,  the  expense  thereof  may  be 
charged  in  his  accounts  as  a  trade  expense  irrespective  of  the 
age  of  the  employee.  On  the  other  hand,  if  he  withdraws  some 
of  his  goods  for  domestic  use,  he  should  make  an  allowance 
therefor  in  his  return  of  income. 

Business  expenses  of  the  professional  man. — Many  law- 
yers, doctors  and  other  professional  men  keep  fairly  accurate 
records  of  income,  but  are  not  careful  to  separate  personal 
and  living  expenses  from  those  incurred  in  producing  their 
income.  If  care  is  taken  to  assemble  all  items  of  taxable  in- 
come, equal  care  should  be  taken  to  compile  a  schedule  of 
allowable  deductions  from  income. 

The  official  procedure  in  deducting  professional  expenses 
is  outlined  in  the  regulations  in  this  language: 

Regulation.  A  professional  man  may  claim  as  deductions  the 
cost  of  supplies  used  by  him  in  the  practice  of  his  profession,  ex- 
penses paid  in  the  operation  and  repair  of  an  automobile  used  in 
making  professional  calls,  dues  to  professional  societies  and  subscrip- 
tions to  professional  journals,  the  rent  paid  for  office  rooms,  the  ex- 
pense of  the  fuel,  light,  water,  telephone,  etc.,  used  in  such  offices, 
and  the  hire  of  office  assistants.  Amounts  currently  expended  for 
books,  furniture,  and  professional  instruments  and  equipment,  the  use- 
ful life  of  which  is  short,  may  be  deducted. 22   ....      (Art.  104.) 

Under  this  new  article  professional  men  may  deduct  cur- 
rent expenditures  for  books,  etc.,  if  the  life  of  such  articles  is 
short. 

Ruling.  Expenses  incurred  by  doctors  in  taking  post-graduate 
courses  are  deemed  to  be  in  tlie  nature  of  personal  expenses  and  not 
deductible.     (B.  31-21-1755:  O.  D.  984.) 

^Income  Tax  Primer,  1918,  question  61. 
■"  See  pages  868,  869. 


FOR   EXPENSES  863 

Expenses  incurred  hy  school  teachers  attending  summer 
school  have  been  held  to  be  personal. ^^  A  professional  singer 
may  not  deduct  amounts  paid  to  a  specialist  in  the  care  of  his 
throat." 

Depreciation  on  property  "of  a  permanent  char- 
acter.''— Property  "of  a  permanent  character,"  expenditures 
for  which  may  not  be  deducted  as  business  expenses,  is,  of 
course,  subject  to  depreciation.  Earlier  rulings  specifically 
stated  that  depreciation  allowances  might  be  claimed  for  it.*' 

In  order  to  secure  the  benefit  of  the  deduction  of  the 
entire  cost  in  the  case  of  such  items  as  professional  books  it 
is  necessary  merely  to  ascertain  the  aggregate  cost  of  such 
books  and  to  spread  the  cost  over  their  effective  or  serviceable 
life.  If  a  technical  book  is  obsolete  at  the  end  of  one  year 
the  depreciation  allowance  for  the  year  will  be  its  whole  cost. 
Roughly  speaking,  after  a  library  is  once  established  the  cost 
of  additions  is  probably  less  than  actual  depreciation; 
therefore  it  will  probably  work  to  the  advantage  of  the  tax- 
payer to  be  precise  in  dealing  with  this  item.  But  substantial 
justice  will  be  done  to  the  government  and  taxpayer  alike 
if  the  ordinary  purchases  of  professional  and  business  books 
are  treated  as  necessary  expenses  and  the  question  of  deprecia- 
tion is  ignored. 

When  office  is  in  rented  residence. — In  case  a  pro- 
fessional man  lives  in  a  rented  house  and  uses  a  portion  of  it 
for  professional  or  business  purposes  the  Treasury  holds  that 
the  proportion  of  the  rental  paid  which  is  chargeable  to  the 
rooms  so  used  may  be  deducted  as  a  business  expense. 

Regulation In  the  case  of  a  professional  man  who  rents 

a  property  for  residential  purposes,  but  incidentally  receives  there 
clients,  patients,  or  callers  in  connection  with  his  professional  work 
(his  place  of  business  being  elsewhere),  no  part  of  the  rent  is  de- 
ductible as  a  business  expense.    If,  however,  he  uses  part  of  the  house 

"C.  B.  4,  page  209. 

"*B.  37-21-1819;  O.  D.  1032. 

^'Income  Tax  Primer,  1918,  question  59. 


864  DEDUCTIONS 

for  his  office,  such  portion  of  the  rent  as  is  properly  attributable  to 
such  office  is  deductible (Art.  291.) 

The  above  ruling,  refusing  to  permit  the  deduction  of  a 
portion  of  the  rent  of  a  residence  used  partly  for  business 
purposes  in  case  "the  place  of  business"  is  elsewhere,  appears 
to  raise  the  question  as  to  whether  or  not  a  professional  man 
may  have  more  than  one  place  of  business.  The  regulation 
apparently  assumes  in  the  phrase,  "the  place  of  business  being 
elsewhere,"  that  he  can  have  only  one  place  of  business.  As 
a  matter  of  fact  he  may  have  several.  In  case  the  expenses 
of  the  additional  quarters  are  "necessary"  to  the  practice  of 
the  profession,  they  are  certainly  deductible  under  the  law. 

When  office  is  in  owned  residence. — No  definite  rul- 
ing appears  to  have  been  issued  covering  the  case  of  the  pro- 
fessional man  who  owns  his  residence  and  uses  part  of  it 
as  his  place  of  business,  but  there  is  no  doubt  about  the  pro- 
priety of  deducting  in  such  a  case  the  proper  proportion  of  the 
depreciation,  repairs,  fuel,  light,  water,  telephone,  etc. 

Traveling  expenses. — 

Law.  Section  214.  [Individuals]  (a)  That  in  coirtputing  net 
income  there  shall  be  allowed  as  deductions: 

(i)  ....  traveling  expenses  (including  the  entire  amount  ex- 
pended for  meals  and  lodging)  while  away  from  home  in  the  pursuit 
of  a  trade  or  business;   .... 

Regulation.  Traveling  expenses,  as  ordinarily  understood,  in- 
clude railroad  fares  and  meals  and  lodging.  If  the  trip  is  undertaken 
for  other  than  business  purposes,  such  railroad  fares  are  personal  ex- 
penses and  such  meals  and  lodging  are  living  expenses.  If  the  trip 
is  solely  on  business,  the  reasonable  and  necessary  traveling  expenses, 
including  railroad  fares,  meals,  and  lodging,  become  business  instead 
of  personal  expenses,  (a)  If,  then,  an  individual,  whose  business 
requires  him  to  travel,  receives  a  salary  as  full  compensation  for  his 
services,  without  reimbursement  for  traveling  expenses,  or  is  employed 
on  a  commission  basis  with  no  expense  allowance,  his  traveling  ex- 
penses, including  the  entire  amount  expended  for  meals  and  lodging, 
are  deductible  from  gross  income.  (&)  If  an  individual  receives  a 
salary  and  is  also  repaid  his  actual  traveling  expenses,  he  shall  include 
in  gross  income  the  amount  so  repaid  and  may  deduct  such  expenses. 


FOR   EXPENSES  865 

(f)  If  an  individual  receives  a  salary  and  also  an  allowance  for  meals 
and  lodging-,  as,  for  example,  a  per  diem  allowance  in  lieu  of  subsis- 
tence, the  amount  of  the  allowance  should  be  included  in  gross  income 
and  the  cost  of  such  meals  and  lodging  may  be  deducted  therefrom. 
A  payment  for  the  use  of  a  sample  room  at  a  hotel  for  the  display  of 
goods  is  a  business  expense.  Only  such  expenses  as  are  reasonable 
and  necessary  in  the  conduct  of  the  business  and  directly  attributable 
to  it  may  be  deducted.  A  taxpayer  claiming  the  benefit  of  the  deduc- 
tions referred  to  herein  must  attach  to  his  return  a  statement  show- 
ing (i)  the  nature  of  the  business  in  which  engaged;  (2)  number 
of  days  away  from  home  during  the  taxable  year  on  account  of 
business;  (3)  total  amount  of  expenses  incident  to  meals  and  lodg- 
ing while  absent  from  home  on  business  during  the  taxable  year; 
(4)  total  amount  of  other  expenses  incident  to  travel  and  claimed 
as  a  deduction. 

Claims  for  the  deductions  referred  to  herein  must  be  substantiated, 
when  required  by  the  commissioner,  by  records  showing  in  detail  the 
amount  and  nature  of  the  expenses  incurred. 

Commuters'  fares,  are  not  considered  as  traveling  expenses  and  are 
not  deductible.     [Art.  loi  (a).] 

The  1 92 1  law  merely  confirms  a  deduction  which  under 
any  reasonable  interpretation  was  fully  allowable  under  all 
previous  laws.  Under  the  1918'^*  and  prior  tax  laws,  the  regu- 
lations provided  thjit  the  amount  expended  as  business  travel- 
ing expenses  should  be  reduced  by  any  saving  of  personal  ex- 
penses, the  reduced  amount  being  a  proper  deduction  from 
gross  income.  To  properly  determine  anv  saving  was  a  diffi- 
cult task  and  a  great  inconvenience. 

Ruling.  Amounts  expended  during  the  taxable  year  by  a  secre- 
tary to  a  Member  of  Congress  and  by  his  assistants  for  railroad 
fares,  in  making  trips  from  their  homes  to  Washington  and  return 
in  connection  with  their  duties,  may  be  claimed  as  a  deduction  in  com- 
puting their  net  income.  Such  expenditures  incident  to  trips  made 
for  purely  personal  reasons  are  not  deductible.  (C.  B.  4,  page  212; 
O.  D.  865.) 

Any  expenditures  for  traveling  other  than  in  the  pursuit 
of  a  trade  or  business  are  not  deductible  under  any  of  the  tax 
laws. 

If  a  taxpayer  who  claims,  say,  $500,  for  five  trips  from 
New  York  to  Chicago  and  return  during  192 1  is  called  upon 

"'°  [Former  Procedure]  See  Art.  292,  Reg.  45,  as  amended  by  T.  D. 
3146.    See  Income  Tax  Procedure,  1021,  pages  672,  673. 


866  DEDUCTIONS 

for  proof,  it  would  probably  be  a  sufficient  compliance  with 
the  law  to  prepare  an  affidavit  setting  forth  that  the  trips 
were  exclusively  on  business,  that  the  railroad  fares  were 
so  much  and  that  meals  and  other  necessary  expenses  aver- 
aged so  much  a  day.  The  test  will  be,  what  a  jury  would 
allow,  and  it  would  not  be  necessary  to  produce  vouchers  be- 
cause good  business  practice  does  not  call  for  the  securing  of 
receipted  bills  for  meals  and  similar  expenses.  The  Treasury 
Department,  however,  is  strict  in  requiring  detailed  informa- 
tion and  w'ill  disallow  deductions  which  cannot  be  reasonably 
supported.     Compromises  will  apparently  not  be  made.^ 

Ruling.  A  taxpayer  engaged  in  a  business  in  19 17  and  1918 
which  required  him  to  spend  a  part  of  his  time  away  from  home  but 
who  failed  to  furnish  the  detailed  information  called  for  in  article 
292  of  Regulations  45,  1920  edition,  although  requested  to  do  so,  is 
not  entitled  to  claim  as  a  deduction  expenses  incurred  for  meals  and 
lodging  in  connection  with  carrying  on  such  business.  Treasury  De- 
cision 3101  amending  article  292,  Regulations  45,  has  been  superseded 
by  Treasury  Decision  3146  (Regulations  45,  1920  edition),  in  which  no 
mention  is  made  as  to  the  effective  date  of  the  provisions  of  article 
292.     (B.  Digest  29-21-1735;  A.  R.  R.  572.) 

Expenses  reimbursed  may  be  ignored  in  returns. — 
Traveling  or  other  expenses  incurred  in  rendering  services 
by  the  taxpayer,  which  are  afterward  refunded  to  him  should 
be  included  in  gross  income  and  deduction  claimed  for  actual 
expenses.     [See  article  loi  (a).] 

Traveling  expenses  which  are  not  deductible. — 

Rulings.  A  Member  of  Congress  may  not  deduct  expenses  in- 
curred in  making  trips  of  a  personal  nature  to  and  from  Washington, 
the  expense  of  taking  members  of  his  family  to  or  from  Washington, 
living  expenses  while  in  Washington,  or  campaign  expenses.  (C. 
B.  4,  page  211 ;  O.  D.  864.) 

Living  expenses  paid  by  a  single  taxpayer  who  has  no  home  and  is 
continuously  employed  on  the  road  may  not  be  deducted  in  comput- 
ing net  income.     (C.  B.  4,  page  212;  O.  D.  905.) 

....  Where  a  man  makes  a  contract  of  employment  with 
an    employer    in    this    country,    and    upon    completion    of    such    con- 

"I-2-19;  A.  R.  R.  719. 


FOR   EXPENSES  867 

tract  he  makes  a  second  contract  with  another  employer  in  a  foreign 
country,  without  allowance  for  travel  expenses,  the  expenditure 
incurred  in  reaching  such  place  of  employment  cannot  be  considered 
as  an  expense  incurred  in  furtherance  of  a  trade  or  business,  but 
rather  as  an  expenditure  to  fulfill  a  condition  precedent  to  such 
employment  in  a  trade  or  business  and  is  therefore  regarded  as  a 
personal  expense  and  not  deductible.  The  test  is  whether  an  expense 
is  incurred  primarily  because  of  business  as  the  immediate  cause 
inducing  the  expenditure.     (C.  B.  2,  page  157;  O.  D.  451.) 

The  foregoing  ruling  is  questionable.  The  expense  is  not 
the  same  as  that  of  a  commuter.  The  gross  amount  of  the  com- 
pensation to  be  collected  in  the  foreign  country  is  taxable.  The 
cost  of  getting  there  arises  from  the  income  and  would  seem  to 
be  directly  connected  with  that  income.  It  is  not  a  pleasure 
trip,  but  purely  a  business  trip.  If  a  business  trip,  the  cost 
must  be  a  necessary  business  expense  and  allowable  under  the 
law.  In  principle  this  expense  is  just  as  properly  deductible 
as  the  expenses  of  a  Congressman's  secretary.^* 

Personal  expenses  of  army  officers  and  government  offi- 
cials.— 

Regulation The  cost  of  the  equipment  of  an  army  officer 

to  the  extent  only  that  it  is  specially  required  by  his  profession  and 
does  not  merely  take  the  place  of  articles  required  in  civilian  life  is 
deductible.  Accordingly,  the  cost  of  a  sword  is  an  allowable  deduc- 
tion, but  the  cost  of  a  uniform  is  not."°      (Art.  291.) 

Ruling.  Any  amounts  expended  in  purchasing  furnishings  and 
maintaining  the  residential  portion  of  an  embassy  are  considered 
personal  expenses.  Amounts  expended  in  entertaining  are  likewise 
considered  personal  expense.  While  it  is  recognized  that  ambassadors 
do  a  certain  amount  of  entertaining,  Congress  does  not  require  it  as 
one  of  the  duties  of  the  position  or  make  specific  appropriations  for 


™  See  ruling   (C.  B.  4,  page  212;  O.  D.  865),  quoted  on  page  865. 

"  [Former  Procedure]  The  above  ruling  reverses  the  procedure 
formerly  in  force.  The  previous  practice,  which  operated  very  un- 
fairly was  prescribed  in  the  following  language: 

Regulation.  The  pay  and  allowance  of  army  officers  are  based 
on  the  obligation  of  an  officer  to  provide  equipment  and  mounts  as  a 
personal  expense.  The  cost  of  mounts  and  equipment  is  not  therefore 
a  deductible  expense.     (Reg.  33,  1918,  Art.  8.)    • 

For  detailed  criticism  of  this  regulation  see  Income  Tax  Procedure, 
1919,  page  411. 


868  DEDUCTIONS 

such  entertainment.  It  is  held  that  such  expenditures  are  personal 
expenses  and  not  business  expenses,  and  are  therefore  not  deductible. 
(B,  36-21-1802;  O.  D.  1020.) 

The  foregoing  ruling  is  not  sound.  The  author  hopes 
that  it  will  be  questioned  by  someone  who,  in  order  to  properly 
])erform  his  duties,  has  expended  part  of  his  salary  for  other 
than  personal  or  family  expenses.  A  business  man  deducts, 
and  properly  so,  all  similar  e.xpenses. 

Clothing  and  personal  equipment  as  a  business  expense. — 
Wherever  clothing  and  other  equipment,  such  as  the  uniforms 
and  instruments  of  musicians,  constitute  business  expenses 
because  not  adaptable  to  private  use,  the  cost  thereof  is  an 
allowable  deduction.  To  the  extent  that  uniforms  serve  to 
diminish  one's  living  expenses  no  deduction  is  proper,  but  if 
an  additional  expense  is  incurred  solely  to  enable  one  to  earn 
a  living,  this  cost  is  nothing  more  or  less  than  a  necessary 
business  expense. 

This  rule  is  in  harmony  with  the  regulation  regarding 
actors'  costumes. '^^ 

Automobiles  used  in  part  for  business  purposes. — 

Ruling.  The  Committee  is  unable  to  distinguish  any  essen- 
tial difference  between  expenses  incurred  in  travel  by  railroad  and 
those  incurred  in  travel  by  automobile,  where  such  travel  by  either 
conveyance  is  undertaken  solely  on  account  of  business  interests  and. 
not  for  the  personal  pleasure  of  the  taxpayer.  Since  railroad  fares 
paid  in  connection  with  business  trips  are  deductible  as  a  necessary 
expense  of  the  business,  the  Committee  sees  no  reason  why  the 
expense  of  such  trips,  when  made  by  automobile,  should  not  fall 
within  the  same  category. 

It  is  therefore  the  opinion  of  the  Committee  that  such  portion  of 
the  upkeep  and  operating  expenses  of  a  taxpayer's  automobile  as  was 
occasioned  by  its  use  in  the  taxpayer's  business  is  properly  deductible 

as  a  business  expense  in  the  return  of  such  taxpayer (C. 

B.  3,  page  131 ;  A.  R.  R.  266.) 

Perhaps  the  item  of  expense  most  difficult  to  apportion  be- 
tw'een   living   and   business   is   the   upkeep   of   an   automobile 


See  Chapter  XXXI. 


FOR   EXPENSES  •  869 

which  is  used  both  for  business  and  for  personal  purposes. 
The  test  is  apparently  simple  enough.  "Personal,  living  or 
family"  expenses  are  not  allowable  deductions.  Business  ex- 
penses are  allowable  deductions. 

In  the  application  of  the  test,  however,  interesting  prob- 
lems sometimes  arise.  Often  the  apportionment  is  easily  es- 
tablished, because  the  facts  as  to  the  relative  use  for  the  two 
purposes  are  clear;  but  in  other  cases  the  whole  theory  of  what 
is  business  expense  as  compared  with  living  expense  is  in- 
volved. For  instance,  a  clerk  lives  some  distance  away  from 
his  place  of  employment.  It  takes  him  an  hour  to  make  the 
trip  each  way.  He  purchases  an  automobile  and  cuts  down 
the  time  one-half.  Is  the  upkeep  of  the  automobile  a  neces- 
sary business  expense?  If  he  sleeps  a  half -hour  longer  each 
morning  and  reaches  home  a  half -hour  earlier  each  afternoon 
the  automobile  expense  would  appear  at  first  glance  to  be  100 
per  cent  personal.  But  suppose  the  added  leisure  increases  his 
efficiency  during  work  hours.  Or  suppose  he  spends  an  hour 
more  each  day  at  work  and  earns  more  money,  all  of  which 
is  taxable.  On  either  of  the  last  two  suppositions  that  part  of 
the  automobile  expense  which  is  fairly  chargeable  to  the  daily 
trip  would  seem  to  be  a  reasonable  and  proper  business  ex- 
pense. Of  course,  the  refinement  cannot  be  carried  beyond 
the  point  of  practicability,  and  it  must  be  admitted  that  ad- 
ministrative control  of  such  deductions  is  difficult.  If  the 
deduction  cannot  stand  the  test  of  reasonableness,  it  should 
not  be  claimed. 

Premiums  on  certain  insurance  a  personal  expense. — 

Regulation.  Insurance  paid  on  a  dwelling  owned  and  occupied 
by  a  taxpayer  is  a  personal  expense  and  not  deductible.     Premiums 

paid   for   life   insurance   by   the   insured   are   not   deductible 

(Art.  291.) 

Ruling.  Premiums  paid  by  a  taxpayer  on  insurance  taken  out 
under  the  War  Risk  Insurance  Act,  whether  or  not  the  insurance  is 
subsequently  converted,  are  not  deductible  in  computing  net  income 
under  the  Revenue  Act  of  1918.     (C.  B.  4,  page  208;  O.  D.  828.) 


870  ■  DEDUCTIONS 

Alimony  and  damages  for  breach  of  promise  are  personal 
expenses. — 

Regulation Alimony  and  an  allowance  paid  under  a  sep- 
aration agreement  are  not  deductible   from   gross  income ^^ 

(Art.  291.)^^ 

Expenses  incurred  on  account  of  a  partnership. — 

Ruling.  By  the  terms  of  a  partnership  agreement  one  of  the 
members  of  the  partnership  is  required  to  pay  out  of  his  own  funds 
the  compensation  of  one  of  the  employees  of  the  partnership  who 
performs  a  part  of  the  duties  delegated  to  said  member. 

Held,  that  the  amount  so  paid  constitutes  a  proper  deduction  in 
the  income  tax  return  of  the  member  under  section  214  (a)  i  of  the 
Revenue  Act  of  1918.     (C.  B.  4,  page  137;  O.  D.  947.) 

The  above  ruling  under  the  1918  law  reverses  a  decision 
made  by  the  Treasury  under  the  191 7  law,  wherein  business 
expenditures  by  an  individual  made  in  behalf  of  the  partner- 
ship were  not  allowed. ^^  All  expenses  incurred  by  a  partner 
in  the  furtherance  of  a  partnership  of  which  he  is  a  member 
(for  which  he  has  not  been  reimbursed)  are  deductible  as  being 
necessary  business  expenses.  Certainly  if  such  expenditures 
are  made  for  the  purpose  of  promoting  his  interest  in  the  firm, 
it  cannot  be  said  that  they  are  personal  expenses. 

Salaries,  Wages,  Commissions  and  Similar  Compensation 

The  authority  for  deducting  salaries  and  wages  is  found 
in  the  following  section  of  the  law : 

Law.  Section  214.  (a)  That  in  computing  net  income  there 
shall  be  allowed  as  deductions: 

(1)  All  the  ordinary  and  necessary  expenses  paid  or  incurred  dur- 
ing the  taxable  year  in  carrying  on  any  trade  or  business,  including 
a  reasonable  allowance  for  salaries  or  other  compensation  for  personal 
services  actually  rendered;   .... 


Gould  V.  Gould,  245  U.  S.  151,  38  S.  Ct.  53.  62  L.  Ed.  211. 
'  See  page  367. 
'C.  B.  3,  page  130;  O.  D.  593. 


I 


FOR    EXPENSES  871 

Meaning  of  phrase  "including  a  reasonable  allowance  for 
salaries." — The  author  has  always  contended^*  that  the  Treas- 
ury has  no  power  to  decide  whether  the  salaries  paid  in  good 
faith  by  corporations  to  their  officers  are  reasonable  or  other- 
wise. In  the  past  the  Treasury  has  attempted  to  determine 
on  an  arbitrary  basis  how  much  of  the  salary  paid  to  a  par- 
ticular officer  was  "reasonable"  and  has  tried  to  disallow  the 
deduction  of  anything  in  excess  of  the  amount. 

The  author's  position  on  this  matter,  namely,  that  a  salary 
payment  is  not  subject  to  review  by  the  Treasury,  unless  part 
of  the  payment  is  not  really  salary  but  a  distribution  of  profits 
or  assets,  has  been  completely  upheld  by  the  courts  in  1921.  An 
appeal  was  taken  by  the  Treasury  in  the  Philadelphia  Knitting 
Mills  case^"  (quoted  in  Income  Tax  Procedure,  1921)  and  a 
decision  was  handed  down  on  June  13,  1921,  by  the  United 
States  Circuit  Court  of  Appeals  for  the  Third  Circuit. ^^ 

The  court  said : 

Decision.  In  view  of  the  proceedings  below  tlie  question  in- 
volved in  the  case  is  somewhat  elusive.  In  our  examination  of  these 
proceedings  we  find  really  two  questions,  one  raised  by  the  Government 
and  seemingly  abandoned ;  the  other  raised  by  the  court  and  ruled  on. 

The  question  on  which  the  Government  seeks  the  opinion  of  this 
court  is :  Has  the  Government  the  right,  under  the  cited  provision  of 
the  Corporation  Excise  Tax  Act  of  August  5,  1909,  to  inquire  and 
determine  whether  a  salary,  paid  by  a  corporation  and  deducted  in 
its  return  as  an  "ordinary  and  necessary"'  expense,  is  reasonable  and 
fair  compensation  for  the  services  rendered,  and  thereupon  to  revise 
the  return  and  limit  the  deduction  to  what  it  considers  a  reasonable 
salary;  and,  in  the  event  of  dispute,  to  have  a  jury  pass  upon  and 
decide  the  same  ? 

Such  a  power  in  the  Government,  if  it  exists,  must  have  been 
conferred  by  the  statute.  The  statute  provided  for  a  tax  at  a 
named  rate  upon  the  net  income  of  a  corporation,  to  be  ascertained 
by  deducting  from  its  gross  income  "all  ordinary  and  necessary  ex- 
penses." (Sec.  38.)  The  statute  did  not  specifically  make  a  salary 
an  allowable  deduction,  though  it  was  so  construed  by  the  Bureau  of 
Internal   Revenue  when  the   salary   is  a   "reasonable   and   fair   com- 


'*  Income  Tax  i'rocedurc,  1921,  page  678  ct  seq. 

"  U.  S.  V.  Philadelphia  Knitting  Mills  Co.,  U.  S.  Dist.  Ct.,  Eastern  Dist. 
of  Penna.,  No.  4832,  November  5,  1920,  268  Fed.  270.  This  case  was  under 
the  1909  law. 

"273  Fed.  657. 


872  DEDUCTIONS 

pensation  for  services  rendered  regardless  of  the  amount  of  stock 
such  officer  maj'^  hold."  We  are  asked  to  approve  this  executive  con- 
struction of  the  statute  as  though  it  were  part  of  it.  In  order  not 
to  beg  the  question,  we  must  look  to  the  statute  alone  to  find  the  power 
which  the  Government  asserts. 

Confining  our  inquiry  to  the  statute,  it  appears  that  the"  basis 
on  which  a  salary  may  be  allowed  as  a  valid  deduction  is  that  it  was 
in  fact  an  "ordinary  and  necessary  expense  (of  the  corporation) 
actually  paid in  the  maintenance  and  operation  of  its  busi- 
ness." To  be  a  necessary  expense  it  must  have  been  paid  for  services 
actually  rendered.  (Jacobs  &  Davies,  Inc.  v.  Anderson,  228  Fed.  505, 
506.)  Whether  services  were  rendered  and  whether  also  they  were 
commensurate  with  the  salary  paid  are  matters  of  judgment  and 
discretion  reposed  by  general  law  in  the  board  of  directors  of  the 
corporation.  As  the  board  of  directors  is  charged  with  the  duty  and 
clothed  with  the  discretion  of  fixing  the  salaries  of  the  corporation's 
officers,  the  Government  had  no  right  (until  expressly  granted  by 
statute)  to  inquire  into  and  determine  wiiether  the  amounts  thereof 
are  proper,  that  is,  whether  they  are  too  nnich  or  too  little.  But,  while 
the  amount  of  salary  fixed  by  a  board  of  directors  is  presumptively 
valid,  it  is  not  conclusively  so,  because  the  Government  may  inquire 
whether  the  amount  paid  is  salary  or  something  else.  Admittedly 
the  Government  has  a  right  to  collect  taxes  on  net  income  of  a  cor- 
poration based  on  profits  after  all  ordinary  and  necessary  expenses, 
including  salaries,  are  paid.  It  has  a  right,  therefore,  to  attack  the 
action  of  a  board  of  directors  and  show  by  evidence,  not  that  a  given 
salary  is  too  much,  but  that,  in  the  circumstances,  the  whole  or  some 
part  of  it  is  not  salary  at  all  but  is  profits  diverted  to  a  stockholding 
officer  under  the  guise  of  salary  and  as  such  is  subject  to  taxation. 

Of  the  same  opinion  was  the  learned  trial  judge,  though  in  enter- 
ing judgment  of  nonsuit  he  raised  and  ruled  upon  a  second  question 
which  was  not  whether  the  salaries  paid  were  commensurate  with 
the  services  rendered  Init  whether  there  was  evidence  which  would 
sustain  a  finding  that  the  sums  paid  were  not  all  salaries  but  were 
part  profits. 

i\\\  inquiry  of  this  kind  is  directed  to  a  fact;  and,  as  in  all  cases 
turning  on  a  fact,  the  attention  of  the  trial  judge  is  directed  to  the 
sufficiency  of  the  evidence  to  establish  the  fact.  The  question  of  fact 
here  was  whether  the  money  paid  was  all  salary  or  part  profits.  The 
presumption  arising  from  the  action  of  the  board  of  directors  was  that 
it  was  all  salary.  In  order  to  overcome  this  presumption  the  burden 
was  on  the  Government  to  produce  evidence,  not  necessarily  conclusive, 
but  sufficient  to  raise  a  valid  inference  that  some  definite  part  of  the 
compensation  was  not  salary  but  was  profits. 


i 


FOR   EXPENSES  873 

Whatever  peculiar  features  there  may  have  been  in  the  case, 
the  court  found  no  difficulty  in  enunciating  the  essential  prin- 
ciple which  must  govern  the  Treasury's  procedure. 

"The  presumption  arising  from  the  action  of  the  board  of 
directors  was  that  it  was  all  salary.  In  order  to  overcome  this 
presumption  the  burden  was  on  the  Government  to  produce  evi- 
dence, not  necessarily  conclusive,  but  sufficient  to  raise  a  valid 
inference  that  some  definite  part  of  the  compensation  was  not 
salary  but  was  profits." 

A  clearer  statement  is  impossible.  Salaries  voted  by  the 
board  of  directors  stand  unless  the  Treasury  can  produce  em- 
dence  that  part  of  the  payment  was  not  salary  but  was  in 
reality  profits. 

The  arbitrary  disallowance  by  revenue  agents  is  not  evi- 
dence, nor  does  it  "raise  a  valid  inference"  that  part  of  the 
payment  is  not  salary.  The  burden  is  on  the  Treasury,  not 
on  the  taxpayer,  to  prove  its  contention. 

In  spite  of  the  clear  and  definite  language  used  by  the  court, 
the  following  ruling  a])])eared  in  Bulletin  39-21  : 

Ruling.  In  the  ordinary  case  where  an  assessment  is  involved, 
if  the  Commissioner  finds  that  a  portion  of  an  amount  paid  as  salary  or 
compensation  is  not  properly  compensation  for  services,  and  a  tax- 
payer attempts  to  upset  such  finding,  the  burden  of  proof  in  court  would 
be  upon  him  (the  taxpayer),  to  show  that  the  action  of  the  Commis- 
sioner was  wrong  and  that  such  salary  was  nothing  more  than  a 
reasonable  allow^ance  for  compensation. 

It  therefore  clearly  appears  that  the  Commissioner  is  fully  au- 
thorized to  disallow  a  deduction  as  ordinary  and  necessary  expenses 
of  the  full  amount  of  an  alleged  salary  paid  to  an  officer  by  a  cor- 
poration where  the  facts  of  the  particular  case  show  that  the  amount 
represents  something  other  than  compensation  for  services,  and  in 
order  to  determine  this  fact  he  (the  Commissioner)  may  take  into 
consideration  salaries  paid  to  similar  officers  of  other  corporations. 
....      (B.  39-21-1841;  A.  R.   M.   138.) 

The  burden  of  proof  is  not  on  the  taxpayer,  but  on  the 
Treasury.  If  it  can  be  shown  that  part  of  the  payment  repre- 
sents something  other  than  salary,  the  Treasury  can  disallow 
such  amount,  but  only  if  evidence  is  forthcoming  to  that  effect. 


874  DEDUCTIONS 

The  Treasury  is  not  authorized  to  use  a  stereotyped  table  of 
salaries  to  determine  "reasonableness."  \\'hat  similar  officers 
receive  from  other  corporations  is  not  relevant.  The  criterion 
is,  "Is  the  payment  a  true  salary?" 

The  Treasury  contends  that  the  decision  applies  only  to 
1917  and  prior  law^s,  and  that  the  phrase,  "including  a  reason- 
able allowance  for  salaries,"  which  first  appeared  in  the  1918 
law,  granted  new  powers  to  the  Commissioner.  This  is  not  the 
case.    The  Commissioner  claimed  full  powers  prior  to  19 18. 

In  view  of  the  statement  of  the  court  that  Congress  may 
limit  the  deduction  for  salaries,  the  question  to  be  answered 
under  the  19 18  act  is :  Did  Congress  intend  to  delegate  such  a 
power  to  the  Commissioner? 

Assuming  that  Congress  did  intend  to  delegate  such  a 
power  to  the  Commissioner  (which  is  seriously  doubted  in  the 
opinion  of  the  author — the  intention  was  to  extend  the  deduc- 
tion, not  to  extend  the  power  of  the  Commissioner),  it  is 
doubted  if  Congress  may  delegate  this  power  to  the  Commis- 
sioner. If  this  discretion  may  be  delegated  to  him,  why 
can  not  Congress  go  a  little  further  and  say  that  corpora- 
tions and  individuals  shall  pay  a  tax  on  a  net  income  which 
shall  be  determined  by  the  Commissioner  of  Internal  Rev- 
enue? 

It  would  be  extremely  difficult  for  Congress  to  place  a 
limit  upon  officers'  salaries  other  than  the  present  limitation 
on  deductions  of  "necessary  expenses."  In  other  words,  a 
law  would  have  to  be  framed  so  that  all  taxpayers  would  be 
treated  alike  and  the  fixing  of  a  specific  amount  would  be 
ridiculous.  It  would,  moreover,  be  economically  unsound  to 
enact  such  a  limitation. 

The  limitation  to  "necessary"  is  sufficient  to  prevent  fraud. 
Any  other  limitation  would  impair  the  efficiency  of  honest 
concerns,  and  it  would  work  many  inequities.  The  opera- 
tion of  a  corporation  should  be  left  in  the  hands  of  the  direc- 
tors. The  author  is  of  the  opinion  that  there  is  no  necessity 
for  such  a  provision,  because  if  salaries  are  arranged  so  as 


I 


FOR  EXPENSES  875 

to  distribute  profits,  the  Commissioner  has  ample  power  to 
require  an  adjustment.""'^ 

Amounts  ostensibly  paid  as  compensation — Test  of  deduc- 
tibility.— 

Regulation.  Among  the  ordinary  and  necessary  expenses  paid 
or  incurred  in  carrying  on  any  trade  or  business  may  be  included  a 
reasonable  allowance  for  salaries  or  other  compensation  for  personal 
services  actually  rendered.  The  test  of  deductibility  in  the  case  of 
compensation  payments  is  whether  they  are  reasonable  and  are  in  fact 
payments  purely  for  services.  This  test  and  its  practical  application 
may  be  further  stated  and  illustrated  as  follows : 

(i)  Any  amount  paid  in  the  form  of  compensation,  but  not  in  fact 
as  the  purchase  price  of  services,  is  not  deductible,  (a)  An  ostensible 
salary  paid  by  a  corporation  may  be  a  distribution  of  a  dividend  on 
stock.  This  is  likely  to  occur  in  the  case  of  a  corporation  having 
few  stockholders,  practically  all  of  whom  draw  salaries.  If  in  such 
a  case  the  salaries  are  based  upon  or  bear  a  close  relationship  to  the 
stockholdings  of  the  officers  or  employees,  it  would  seem  likely  that 
the  salaries,  if  in  excess  of  those  ordinarily  paid  for  similar  services, 
are  not  paid  wholly  for  services  rendered,  but  in  part  as  a  distribu- 
tion of  earnings  upon  the  stock,  (b)  An  ostensible  salary  may  be  in 
part  payment  for  property.  This  may  occur,  for  example,  where  a 
partnership  sells  out  to  a  corporation,  the  former  partners  agreeing 
to  continue  in  the  service  of  the  corporation.  In  such  a  case  it  may 
be  found  that  the  salaries  of  the  former  partners  are  not  merely  for 
services,  but  in  part  constitute  payment  for  the  transfer  of  their 
business. 

(2)  The  form  or  method  of  fixing  compensation  is  not  decisive  as 
to  deductibility.  While  any  form  of  contingent  compensation  invites 
scrutiny  as  a  possible  distribution  of  earnings  of  the  enterprise,  it 
does  not  follow  that  payments  on  a  contingent  basis  are  to  be  treated 
fundamentally  on  any  basis  different  from  that  applying  to  com- 
pensation at  a  flat  rate.  Generally  speaking,  if  contingent  com- 
pensation is  paid  pursuant  to  a  free  bargain  between  the  employer 
and  the  individual  made  before  the  services  are  rendered,  not  influ- 
enced by  any  consideration  on  the  part  of  the  employer  other  than 
that  of  securing  on  fair  and  advantageous  terms  the  services  of  the 
individual,  it  should  be  allowed  as  a  deduction  even  though  in  the 
actual  working  out  of  the  contract  it  may  prove  to  be  greater  than 
the  amount  which  would  ordinarily  be  paid. 

(3)  In  any  event  the  allowance  for  the  compensation  paid  may  not 
exceed  what  is  reasonable  in  all  the  circumstances.     It  is  in  general 

"  U.  S.  V.  Philadelphia  Knitting  Mills  Co.,  273  Fed.  657. 


876  DEDUCTIONS 

just  to  assume  tliat  reasonable  and  true  compensation  is  only  such 
amount  as  would  ordinarily  be  paid  for  like  services  by  like  enter- 
prises in  like  circumstances.  But  if  the  salaries  paid  bear  a 
close  relationship  to  stock  ownership,  see  paragraph  ( i )  of  this 
article.  The  circumstances  to  be  taken  into  consideration  are  those 
existing  at  the  date  when  the  contract  for  services  was  made,  not 
those  existing  at  the  date  when  the  contract  is  questioned.^®  .... 
(Art.  105.) 

In  dealing  with  necessary  expenses  no  possible  fault  can 
be  found  with  the  test  laid  down  in  the  foregoing  regulations 
regarding  such  payments,  viz.,  whether  they  are  reasonable  or 
not. 

The  test  of  deductibility  of  compensation  payments  is 
whether  or  not  they  are  legal  and  are  in  fact  payments 
purely  for  services.  When  a  salary  is  a  necessary  business  ex- 
pense it  may  be  ten  times  as  much  as  the  Commissioner  thinks 
a  "reasonable"  salary  would  be,  yet  the  entire  amount  is  an 
allowable  deduction. 

It  must  always  be  borne  in  mind  that  if  the  payments  are 
allowed  as  expenses  the  recipients  must  report  the  amounts 
received  as  income.  This  is  of  .special  importance  in  dealing 
with  employees  whose  compensation  depends  on  profits. ^^ 

The  Treasury  is  now  considering  the  propriety  of  salaries 
claimed  in  returns  for  prior  years,  and  many  adjustments 
are  being  made.  Too  much  weight  is  being  given  to  com- 
parisons with  prior  years.  The  1917  and  1918  laws  en- 
deavored to  reduce  the  inevitable  burdens  of  the  excess  profits 
tax  by  permitting  as  deductions  reasonable  salaries,  even  though 
no  salaries  or  very  small  salaries  had  been  claimed  in  prior 
tax  returns.  Based  on  the  higher  cost  of  living  and  the  higher 
salaries  paid  by  business  concerns  whose  officers  are  not 
large  stockholders,  it  would  seem  that  in  some  cases  the  al- 
lowances now  being  made  by  the  Treasury  are  too  low.  The 
matter  is  one  which  must  be  settled  on  the  merits  of  each  case. 


See  Art.  32. 
'  See  Chapter  XIV. 


FOR  EXPENSES  877 

Compensation  fixed  by  contracts. — 

Ruling.  The  committee  has  reached  the  conclusion  that  where 
salaries  have  been  fixed  long  before  any  Excess  Profits  Tax  Law 
was  contemplated  the  Income  Tax  Unit  is  not  authorized  by  the  law 
or  regulations  to  arbitrarily  fix  the  salaries  of  the  officers  of  any 
company  at  an  amount  less  than  that  authorized.  In  general,  the 
committee  does  not  think  that  the  Unit  is  authorized  by  law  or  regu- 
lation to  look  back  of  any  corporate  action  fixing  the  salaries  of 
officers  when  such  action  was  taken  by  the  directors  long  before 
any  Excess  Profits  Tax  Law  was  even  contemplated,  and  where  the 
salaries  were  not  fixed  on  the  basis  of  stock  ownership  or  do  not 
bear  a  close  relationship  thereto.  Neither,  in  the  judgment  of  the 
committee,  is  the  Unit  authorized  to  look  back  of  any  corporate 
resolution  fixing  salaries  after  the  passage  of  the  Excess  Profits  Tax 
Law,  provided  there  is  no  evidence  of  intent  to  reduce  the  tax  of  the 
corporation,  and  provided  that  after  deducting  the  amount  actually 
fixed  and  paid  the  corporation  has  a  normal  return  on  its  invested 
capital  left,  or  where  such  deduction  does  not  reduce  the  net  earn- 
ings subject  to  tax  below  that  of  competing  concerns  which  secure 
the  services  of  officers  and  employees  by  open  bargaining.  (C.  B. 
2,  page  no;  A.  R.  R.  53.) 

After  the  issuance  of  this  ruling,  the  Treasury  officials,  in 
certain  cases,  reduced  salaries,  and  in  consequence  a  protest 
was  filed  by  the  taxpayers  concerned,  claiming  that  A.  R.  R.  53 
(above)  prohibits  such  action.  The  matter  was  again  referred 
to  the  Committee  on  Appeals  and  Review,  with  the  result  that 
a  memorandum  of  a  more  definite  character  answering  specific 
questions  was  issued.  This  memorandum  is  digested  as  fol- 
lows : 

Ruling.  Held,  that  compensation  on  whatever  basis  fixed  repre- 
senting only  the  price  paid  for  services  pursuant  to  a  free  bargain  be- 
tween a  stockholder  and  the  business  enterprise  is  deductible  in  de- 
termining the  taxable  net  income  of  such  enterprise ;  that  the  Income 
Tax  Unit  has  authority  under  the  law  and  regulations  to  analyze  the 
payments  made  as  compensation  for  services  rendered  in  order  to  de- 
termine whether  there  are  included  therein  amounts  ostensibly  paid  as 
compensation  but  which  in  fact  represent  a  distribution  of  profits; 
and  that  A.  R.  R.  53  (C.  B.  2,  p.  no),  is  not  applicable  in  cases  where 
the  element  of  free  bargaining  does  not  enter  into  the  action  taken  by 
the  board  of  directors  of  the  corporation  in  fixing  the  amount  of 
salaries  to  be  paid  to  tlic  officers  who  are  controlling  stockholders  or 
sole  stockholders,  and  particularly  does  not  apply  where  the  corporation 


878  DEDUCTIONS 

is  uwned,  conti'olled,  officered,  and  directed  by  the  same  persons.  (B. 
Digest  39-21-1841 ;  A.  R.  M.  138.) 

The  following  quotation,  which  appears  as  an  opinion  of 
the  Solicitor,  is  of  interest  here : 

Ruling It  may  be  admitted  that  the  expenses  claimed  as 

a  deduction  in  any  case  were  necessary  in  the  sense  of  being  legally 
binding  and  were  incurred  under  a  contract  entered  into  in  the  best 
of  faith  and  with  no  possibile  reference  to  taxation,  and  yet  if  they 
were  not  "ordinary  and  necessary,"  if  they  were  unusual  and  not 
essential  to  the  maintenance  and  operation  of  the  business  and  the 
properties  of  the  corporation  they  would  still  be  not  deductible. 
Although  they  would  admittedly  be  expenses  they  would  not  be  the 

expenses    for    the    deduction    of    which    the    statute    provides 

(C.  B.  3,  page  133;  L.  O.  1045.) 

The  author  reiterates  his  opinion  that  the  Treasury  cannot 
substitute  its  judgment  for  that  of  directors  and  stockholders. 

Ruling.  The  salesmen  employed  by  a  corporation  have  contracts 
with  it  guaranteeing  them  weekly  or  monthly  drawing  accounts.  Under 
these  contracts  the  corporation  is  obligated  to  make  weekly  or  monthly 
allowances  so  long  as  the  salesmen  remain  in  the  employ  of  the  cor- 
poration, regardless  of  the  amount  of  business  secured  by  them.  It 
does  not  appear  that  any  of  the  advances  are  repaid  by  the  salesmen 
unless  they  earn  commissions  in  a  subsequent  year  in  excess  of  such 
advances. 

Held,  that  advances  so  made  by  the  corporation  in  1917,  constituted 
an  allowable  deduction  as  a  business  expense  in  computing  the  cor- 
poration's net  income  for  that  year.     (C.  B.  4,  page  117;  A.  R.  R.  374.) 

The  case  has  arisen  wherein  a  salary  contract  having  a  few 
years  to  run  is  terminated  by  the  payment  of  a  lump  sum  in 
lieu  of  stipulated  annual  amounts.  Does  such  lump  sum  con- 
stitute a  deduction  in  the  year  paid,  or  should  it  be  prorated 
over  the  remaining  years  of  the  contract? 

When  the  recipient  reports  the  entire  amount  in  the  year 
received,  it  appears  that  such  amount  should  be  taken  as  a 
deduction  in  one  year  by  the  payer.  While  the  inclusion  of 
the  total  amount  tends  to  make  the  salary  accounts  compara- 
tively large,  the  termination  of  the  contract  may  be  to  the  best 
interests  of  the  payer  and  therefore  be  considered  necessary 
and  reasonable  in  carrying  on  business  in  that  year. 


FOR   EXPENSES  879 

Factors  which  enter  into  the  determination  of  the  reason- 
ableness of  compensation. — 

Ruling.  The  problem  of  determining  reasonable  compensation 
for  personal  services  is  one  of  difficulty,  in  that  there  are  few  general 
rules  which  can  be  laid  down  as  guides  to  a  decision.  Many  factors 
are  involved,  among  them  being  the  character  and  amount  of  respon- 
sibility, ease  or  difficulty  of  the  work  itself,  time  required,  working 
conditions,  future  prospects,  living  conditions  of  the  locality,  indi- 
vidual ability,  technical  training,  profitableness  to  the  employer  of 
the  services  rendered,  and  the  number  of  available  persons  capable 
of  performing  the  duties  of  the  position.  These  and  other  factors 
have  a  bearing,  and  the  amount  of  weight  to  be  attached  to  each 
one  can  be  determined  only  in  the  light  of  the  circumstances  in  each 
particular  case.     (C.  B.  i,  page  220;  T.  B.  M.  44.) 

Method  of  determining  reasonableness  of  compensation. — 

Ruling The  department  is  not  warranted  in  fixing  any 

amount  as  a  maximum  limit  for  deductions  for  officers'  salaries  and 
compensation  for  personal  services,  but  that  each  case  must  be 
decided  in  the  light  of  all  its  circumstances.  (C.  B.  i,  page  105; 
T.  B.  R.  46.) 

The  Committee  on  Appeals  and  Review  has  evidently 
deviated  from  this  principle.  For  instance,  in  a  later  case  the 
following  appears: 

Ruling The  apphcation  of  the  formulae  provided  by  the 

compilation  of  salary  statistics  shows  that  the  allowance  for  com- 
pensation made  by  the  Unit  is  fully  equal  to  the  average  of  that  paid 
for  similar  services  by  similar  enterprises  under  similar  circum- 
stances, and  though  the  computation  of  the  amount  appears  to  have 
been  somewhat  meticulous,  the  Committee  finds  no  reason  for  any 
substantial  modification.       (C.  B.  3,  page  140;  A.  R.  R.  223.) 

Cases  wherein  compensation  paid  was  held  reasonable. — 

Rulings.  All  the  stock  of  a  corporation  was  owned  by  its  four 
officers,  who  devoted  all  their  time  and  attention  to  the  business  of 
the  corporation,  acting  not  only  as  officers  but  also  as  buyers,  book- 
keepers, etc.  These  officers  drew  only  nominal  salaries  of  1/36  x  dol- 
lars each  for  a  number  of  years  after  organization. 

The  gross  sales  increased  from  11  x  dollars  in  the  first  year  of 
business  to  64  x  dollars  in  1916  and  90  x  dollars  in  1917.  Early  in 
1917,  before  the  passage  of  any  excess-profits  tax  law,  the  board  of 
directors  fixed  salaries  of  2  :r  dollars  each  for  three  of  its  officers  and 


88o  DEDUCTIONS 

X  dollars  for  the  fourth.     These  salaries  were  paid  in  1917  and  de- 
ducted from  gross  income. 

Held  that  the  amounts  paid  and  deducted  were  reasonable  and 
properly  deductible  from  gross  income.  (C.  B.  2,  page  109;  A.  R. 
M.  30.) 

A  company's  gross  sales  in  1917  amounted  to  1000  x  dollars  and 
its  net  income  was  125  x  dollars.  Salaries  and  contingent  compen- 
sation were  paid  to  its  officers  and  certain  employees  as  follows: 

Basic  salary.  Total. 

President  and  treasurer g  x  dollars.  9  x  dollars. 

Secretary  and  general  manager 6  x  dollars.  18  x  dollars. 

Assistant   treasurer    3  x  dollars.  11  x  dollars. 

Office  manager   x  dollars.  9  x  dollars. 

Office  manager  (Y  office)    2  x  dollars  10  x  dollars. 

S7  X  dollars. 

Contracts  were  made  prior  to  igiy  with  these  officers  and  em- 
ployees for  services  to  be  performed.  The  value  of  the  services  to 
be  performed  and  the  possibility  of  securing  more  remunerative  em- 
ployment were  taken  into  consideration  in  making  the  contracts. 
No  payments  were  based  on  stock  holdings.  The  contingent  com- 
pensation or  commission  was  paid  for  the  purpose  of  retaining  the 
services  of  men  who  had  grown  up  with  the  business  and  were 
familiar  with  the  various  phases  of  the  business,  and  was  based  on 
net  profits  after  regular  dividends  had  been  paid. 

The  committee  recommends  that  the  full  amount  of  compensation 
paid  be  allowed  as  a  deduction,  since  it  represented  the  price  paid  for 
services  pursuant  to  a  free  bargain  made  in  advance  between  the 
individual  and  the  business  enterprise.  (C.  B.  2,  page  109;  A.  R. 
R.31.) 

A  started  a  business  a  number  of  years  ago  with  a  small  amount 
of  capital.  At  a  later  date,  the  business  was  incorporated,  90  per 
cent  of  the  stock  being  issued  to  A.  The  business  was  developed  by 
his  efforts  until  in  1917  the  gross  sales  amounted  to  555  x  dollars 
and  the  net  income  to  65  x  dollars,  whereas  in  191 1  the  gross  sales 
amounted  to  only  167  x  dollars  and  the  net  income  to  8  .ir  dollars. 
In  prior  years  A,  as  president  of  the  corporation,  drew  a  nominal 
salary  of  x  dollars,  taking  his  earnings  as  dividends,  but  in  1917  his 
salary  was  increased  to  10  x  dollars. 

In  view  of  the  extraordinary  circumstances  of  the  case,  including 
the  fact  that  A  is  and  has  been  the  sole  administrative  officer  of  the 
corporation  and  devotes  his  entire  time  to  its  direction  in  all  details, 
the  salary  of  10  x  dollars  does  not  appear  to  be  excessive  and  is, 
therefore,  an  allowable  deduction  as  a  business  expense.  (C.  B.  2, 
page  109;  A.  R.  R.  32.) 


FOR   EXPENSES  88 1 

A,  the  president  and  treasurer  of  a  close  corporation,  and  B,  its 
vice  president,  each  held  45  per  cent  of  the  outstanding  capital  stock. 
C,  its  secretary,  held  3  2/2^  per  cent  of  the  stock.  Nominal  salaries 
were  paid  to  A  and  C.  There  was  an  agreement  between  A  and  B 
that  A  was  to  receive  in  addition  to  his  share  on  his  capital  invested, 
direct  compensation  in  proportion  to  the  results  he  might  achieve 
for  the  company.  Accordingly  A,  and  C  also,  received  in  1915,  1916 
and  1917  as  additional  compensation  10  per  cent  and  i  per  cent,  re- 
spectively, of  the  profits.  These  amounts,  although  large,  were  not 
in  proportion  to  stock  holdings  and  having  been  paid  according  to 
agreement  made  in  advance  and  for  services  rendered  are  held  to 
be  deductible  as  ordinary  and  necessary  business  expenses  of  the 
company.     (C.  B.  2,  page  no;  A.  R.  M.  39.) 

Cases  wherein  compensation  was  held  unreasonable. — 

Rulings.  The  Committee  is  of  opinion  that  where  a  division  of 
the  profits  of  a  business,  as  a  bonus  to  its  officers  and  managers, 
absorbs  all  the  profits  derived,  except  an  amount  sufficient  to  pay 
dividends  at  a  moderate  rate  upon  its  preferred  and  common  capital 
stock,  such  a  distribution  can  not  be  regarded  as  an  "ordinary  and 
necessary"  expense  of  business,  and  that  the  excess  over  a  reasonable 
amount  for  compensation  should  be  disallowed. 

Such  a  distribution  to  managers  and  officers  of  a  company  which 
varied  from  year  to  year  as  to  the  percentage  paid  to  each  and 
where  the  same  persons  did  not  always  participate  in  the  distribution 
can  not  be  said  to  have  occurred  as  a  result  of  open  bargaining,  or 
as  the  result  of  bona  fide  contracts  and  arrangements  entered  into 
and  followed  prior  to  the  year  1917,  even  though  such  payments 
were,  in  fact,  purely  for  services  and  in  accordance  with  an  estab- 
lished custom  of  the  company.     (C.  B.  3,  page  140;  A.  R.  R.  223.) 

A  close  corporation  operated  for  a  number  of  years  prior  to 
1917,  sometimes  making  moderate  losses  and  sometimes  moderate 
profits,  paying  only  nominal  salaries  to  its  officers.  In  1917  it  was 
highly  successful  and  distributed  to  the  five  stockholders  who  are  also 
officers  approximately  12  per  cent  of  its  net  income,  in  exact  propor- 
tion to  their  stock  holdings.  Of  the  total  amount  distributed  18  per 
cent  was  paid  currently  during  the  year  and  82  per  cent  was  paid  on 
or  about  the  close  of  the  year  1917.  In  view  of  the  salaries  paid  by 
other  companies  in  the  same  line,  doing  a  corresponding  volume  of 
business,  the  aggregate  salaries  paid  appears  to  be  excessive;  and  as 
some  of  the  officers  receiving  the  largest  salaries  did  not  devote  all 
of  their  time  to  the  work,  a  substantial  part  of  the  so-called  salaries 
would  seem  to  be  nothing  more  than  a  distribution  of  profits.  Forty 
per  cent  of  the  deduction  taken  for  above  salaries  was  not  allowed. 
(C.  B.  1,  page  105;  T.  B.  M.  70.) 


882  DEDUCTIONS 

Treatment  of  excessive  compensation. — 

Regulation.  x\s  to  the  treatment  of  amounts  ostensibly  paid  as 
compensation,  but  not  allowed  to  be  deducted  as  such,  the  following 
rules  apply : 

(i)  In  the  case  of  excessive  payments  by  corporations,  if  such 
payments  correspond  or  bear  a  close  relationship  to  stock  holdings, 
the  amount  of  the  excess  should  be  treated  as  dividends  and  would 
thus  be  exempt  from  the  normal  tax  in  the  hands  of  the  recipients. 
If  such  payments  constitute  in  part  payment  for  property,  the  amount 
of  the  excess  should  be  treated  by  the  corporation  as  a  capital  ex- 
penditure and  by  the  recipient  as  part  of  the  purchase  price. 

(2)  In  the  case  of  excessive  payments  by  individuals  or  partner- 
ships, the  amounts  disallowed  should  ordinarily  be  treated  as  shares 
of  the  profits  of  a  partnership,  except  that  a  payment  for  property 
should  be  treated  by  the  individual  or  partnership  as  a  capital  ex- 
penditure and  by  the  recipient  as  part  of  the  purchase  price.*" 
(Art.  106.) 

The  foregoing  regulations  are  properly  applicable  when- 
ever distributions  of  profits  ostensibly  as  compensation  have 
been  made.  The  1922  regulations  omit  part  of  the  same  article 
in  Regulations  45,  which  attempted,  in  effect,  to  treat  excessive 
payments  as  salaries  in  order  to  deny  to  the  recipients  the  right 
to  credit  the  norinal  tax. 

Ruling.  The  Unit  reduced  the  amount  of  the  deduction  claimed 
by  the  M  Company  for  salaries  of  its  officers  which  had  been  voted 
by  its  board  of  directors.  It  is  stated  by  one  of  the  officers  that 
such  action  would  necessitate  the  return  to  the  corporation  of  the 
amount  disallowed  as  a  deduction  for  salaries,  and  a  request  is  made 
for  permission  to  file  an  amended  return  for  the  years  the  excess 
salaries  were  paid  to  him  and  that  the  overpayment  on  his  returns 
be  credited  to  the  payment  of  tax  for  1920. 

Held,  that  where  a  corporation  by  proper  action  of  its  board  of 
directors  votes  compensation  to  its  officers,  and  the  corporation  has 
paid  the  amount  to  them,  the  individuals  must  report  the  full  amount 
of  such  compensation  in  their  individual  returns.  The  amount  dis- 
allowed as  a  deduction  by  this  office  on  account  of  excessive  salaries 
paid  by  a  corporation  has  no  effect  on  the  legality  of  the  corporation 


*'^  [Former  Procedure]  T.  D.  2696,  April  10,  1918,  which  covered 
most  of  the  points  contained  in  articles  105  (see  page  876)  and  106,  above 
quoted,  also  provided : 

"If  a  compensation  contract  with  the  majority  stockholder  or  stock- 
holders is  approved  by  all  the  stockholders,  as  well  as  by  the  directors,  it 
might,  however,  be  dealt  with  like  any  other  contract." 


FOR   EXPENSES  883 

act  in  actually  paying  the  excessive  compensation  to  its  officers.  An 
individual  to  whom  an  amount  of  salary  has  been  paid  by  a  corpora- 
tion in  excess  of  the  amount  allowed  the  corporation  as  a  deduction 
for  compensation  paid  its  officers  is  under  no  obligation  to  refund 
the  excessive  amount  of  salary  to  the  corporation.  The  individual 
should  report  as  income  the  entire  amount  of  salary  paid  by  the  cor- 
poration for  the  year  in  which  received  or  accrued. 

It  is  held  further,  that  under  article  106,  Regulations  45,  the  excess 
of  the  amount  allowed  the  corporation  as  a  deduction  in  returns  of 
annual  net  income  and  which  bore  a  close  relationship  to  the  stock 
holdings  of  such  officers  are  not  subject  to  normal  tax  in  the  hands 
of  the  recipients.  No  claim  for  refund  will  lie  if  the  payments  made 
ostensibly  as  salaries  represented  an  appropriation  of  assets  of  the 
corporation.     (B.  35-21-1792;  O.  D.  1012.) 

The  foregoing  is  in  some  respects  contradictory  and  is 
based  on  article  106  before  it  was  modified  in  the  1922  regu- 
lations. If  the  salaries  were  in  fact  excessive,  they  were  illeg- 
ally voted  by  the  directors.  If,  upon  full  investigation,  it  was 
found  that  profits  were  being  distributed,  it  was  proper  to  dis- 
allow the  deductions  for  expenses;  but  if  the  payments  were 
not  in  exact  proportion  to  stockholdings,  the  directors  acted 
illegally  and  the  excess  payments  should  be  returned. 

Bonuses  and  other  special  compensation*^ — Although  the 
question  of  bonuses  is  covered  in  a  general  fashion  in  arti- 
cles 105  and  106  of  the  regulations,  quoted  above,  it  is  more 
specifically  treated  in  the  following  paragraph : 

Regulation.  Bonuses  to  employees  will  constitute  allowable 
deductions  from  gross  income  when  such  payments  are  made 
in  good  faith  and  as  additional  compensation  for  the  services  actually 
rendered  by  the  employees,  provided  such  payments,  when  added  to 
the  stipulated  salaries,  do  not  exceed  a  reasonable  compensation  for 
the  services  rendered (Art.  107.) 

This    regulation    accords    with    sound    business    practice. 


"  [British  Practice]  "The  principle  established  would  extend  to 
bonuses  as  follows:  where  the  payments  are  made  to  the  employees  be- 
cause they  are  employees  they  are  assessable.  They  are  in  every  way  re- 
garded as  part  of  the  salary  earned.  The  employer  may,  of  course,  in- 
clude them  among  his  expenses  for  purposes  of  his  own  assessment." 
Income  Tax  Practice,  by  W.  E.  Snelling  (London),  2nd  Ed.,  page  126. 


884  DEDUCTIONS 

However,  it  has  not  been  observed  by  all  revenue  agents.  If  a 
taxpayer  believes  that  deductible  items  have  been  disallowed 
an  appeal  should  be  made  to  the  Commissioner,  who  can  be 
depended  upon  to  confirm  the  regulation  just  quoted. 

The  question  of  reasonableness  is  one  which  must  be 
left,  in  most  cases,  to  the  directors  of  a  corporation.  A 
bonus  may  appear  to  be  unreasonable,  but  if  paid  in  good  faith 
it  becomes  a  necessary  business  expense. 

It  would  be  a  fine  thing  if  the  Treasury  could  disallow 
all  overpayments  to  employees,  and  distribute  the  aggregate 
to  underpaid  employees.  Unfortunately  there  are  obstacles 
to  such  procedure. 

In  the  opinion  of  the  author  the  courts  will  not  disallow 
any  compensation,  no  matter  how  unreasonable  it  appears 
to  be  on  the  surface,  and  no  matter  how  large  it  seems  to 
be  when  compared  with  the  amounts  paid  by  other  concerns, 
unless  the  payment  is  proved  to  be  merely  a  division  of  profits 
distributed  proportionately  to  stockholdings. 

Contingent  salaries  are  deductible  in  the  year  paid. — 

Ruling.  When  additional  compensation  is  agreed  to  be  paid 
by  a  corporation  to  its  officers  at  a  future  date,  upon  the  happening 
of  certain  contingencies  expected  to  result  from  the  rendition  of  ser- 
vices, the  amount  of  such  compensation  being  left  for  future  deter- 
mination, the  amount  eventually  so  paid  is  not  to  be  treated  as  back 
salary  and  allocated  to  the  years  during  which  the  services  v^^ere 
rendered,  but  constitutes  a  business  expense  to  the  corporation  for 
the  taxable  year  in  which  the  same  was  paid.  (C.  B.  3,  page  142; 
A.  R.  R.  232.) 

Salaries  may  be  determined  after  close  of  fiscal  year — 
when? — 

Ruling.  The  compensation  of  the  officers  of  a  corporation  had 
been  continued  without  change  for  several  years.  In  1919,  two  days 
before  the  close  of  its  fiscal  year,  the  salaries  of  the  principal  officers 
of  the  corporation  were  largely  increased  for  the  year  then  closing. 

Section  234  (a)  of  the  Act  of  1918  provides  that  in  computing 
the  net  income  of  a  corporation  subject  to  tax  there  shall  be  allowed 
as  deductions  all  ordinary  and  necessary  expenses  paid  or  incurred 


FOR   EXPENSES  885 

during  the  taxable  year,  including  a  reasonable  allowance  for  salaries. 
The  authorization  to  increase  the  salaries  in  question  occurred  before 
the  books  were  closed  for  the  fiscal  year,  and  as  such  became  a  lia- 
bility of  the  corporation  for  that  year.  If  the  compensation  thus 
authorized  was  reasonable  the  total  amount  is  an  allowable  deduction. 
(C.  B.  2,  page  in;  O.  D.  504.) 

The  foregoing  case  should  be  distinguished  from  cases  like 
the  following: 

Ruling.  The  M  Company,  years  ago,  established  an  annual 
bonus  system  for  paying  its  ofiicers  and  employees  additional  com- 
pensation for  services  rendered.  In  1914,  191 5  and  1916  no  bonuses 
were  paid,  and  on  January  i,  1917,  the  system  was  abolished.  The 
bonuses  as  to  amount  were  always  fixed  by  an  officer  who  resided  in 
Europe,  and  who  usually  visited  this  country  once  a  year.  War 
conditions  in  1917  and  1918  prevented  his  visiting  this  country,  and 
consequently  the  amount  of  the  bonuses  was  not  determined  until 
his  visit  in  1919,  at  which  time  bonuses  were  paid  for  1916. 

Held,  that  the  bonuses  in  question  were  not  paid  on  account  of 
services  rendered  during  the  year  1919,  and  therefore  can  not  be 
deducted  as  items  of  business  expense  for  that  year.  Bonuses  or 
additions  to  salaries  voted  subsequent  to  the  close  of  any  taxable 
year,  and  also  subsequent  to  the  closing  of  the  books  for  such  taxable 
year  can  not  be  considered  as  ordinary  and  necessary  expenses  of 
doing  business  during  such  year  as  are  deductible  under  the  Revenue 
Act  of  1918. 

The  aggregate  of  these  bonuses  constitutes  income  to  the  recipi- 
ents for  the  year  1919  because  they  were  first  credited  to  them  and 
made  available  during  that  year.     (C.  B.  2,  page  in  ;  O.  D.  497.) 

In  other  v^ords,  the  business  could  deduct  the  expense  in 
1916  (a  low  tax  year)  if  at  all,  but  the  recipients  were  tax- 
able in  1919  (a  high  tax  year)  !  In  view  of  the  specific  reason 
for  the  delay,  which  rendered  an  election  by  the  employees 
impossible,  the  latter  should  have  been  permitted  to  file 
amended  returns  for  19 16. 

Ruling.  The  Committee  reconnnends  the  disallowance  of  addi- 
tional compensation  claimed  by  a  corporation  as  a  deduction  for  1917 
where  such  additional  compensation  was  not  as  a  matter  of  fact 
authorized  or  paid  until  1919  and  that  such  additional  compensation 
be  allowed  as  a  deduction  under  the  heading  of  ordinary  and  neces- 
sary expenses  in  the  taxpayer's  return  for  the  year  1919  in  which  year 
the  payment  was  actually  made.     (C.  B.  4,  page  134;  A.  R.  R.  519.) 


886  DEDUCTIONS 

In  this  case,  the  secretary-treasurer  of  a  corporation  per- 
formed all  of  the  executive  duties  of  the  president  during  the 
latter's  illness  in  191 7,  but  due  to  a  combination  of  circum- 
stances it  was  not  possible  to  pass  the  appropriate  additional 
compensation  resolution  until  19 19. 

Under  proper  accounting  methods  the  profit  of  191 7  should 
bear  the  expenses  of  the  services  performed  in  that  year,  even 
if  payment  was  not  made  until  two  years  later.  For  this 
reason,  the  deduction  in  191 7  should  have  been  permitted. 

The  Committee  quoted  T.  B.  M.  86*"  in  its  opinion  as 
follows : 

Ruling Salaries  voted  subsequent  to  the  close  of  any 

taxable  year,  and  also  subsequent  to  the  close  of  the  books  for  such 
taxable  year,  can  not  be  considered  an  ordinary  and  necessary  expense 
of  doing  business 

The  ruling  is  sound  or  unsound  depending  on  circum- 
stances. The  date  of  voting  a  salary  is  not  of  major  impor- 
tance. An  officer  or  employee  who  renders  service  is  entitled 
to  reasonable  compensation  from  day  to  day  (even  though  none 
is  voted),  under  the  ordinary  rule  of  law  that  the  recipient  of 
a  benefit  is  bound  to  pay  for  it  unless  there  is  a  prompt  dis- 
avowal of  an  intention  to  pay. 

"Christmas  gifts." — Regulations  62*^  do  not  specifically 
discuss  the  deductibility  of  the  "Christmas  gifts"  which  so 
many  business  houses  are  accustomed  to  distribute  to  em- 
ployees each  year.  The  reasoning  of  article  105  would  indi- 
cate that  such  payments  to  employees  are  deductible  so  long 
as  the  total  compensation,  including  such  payments,  "is  only 
such  amount  as  would  ordinarily  be  paid  for  like  services  by 
like  enterprises  in  like  circumstances."  However,  it  may  be 
that  the  Treasury  expects  to  classify  these  payments  in  the 
category  of  "donations"  as  defined  in  the  following  para- 
graph. 


"C.  B.  I,  page  106. 
*^See  page  420. 


FOR   EXPENSES  887 

Regulation Donations  made   to   employees   and  others, 

which  do  not  have  in  them  the  element  of  compensation  or  are  in 
excess  of  reasonable  compensation  for  services,  are  considered  gratu- 
ities and  are  not  deductible  from  gross  income.     (Art.   107.) 

In  the  author's  opinion  the  Treasury,  in  the  matter  of 
Christmas  gifts  and  similar  items,  has  not  always  interpreted 
the  law  properly  in  the  past.  Most  Christmas  gifts  to 
employees  are  wages,  pure  and  simple.  Particularly  where 
the  gifts  are  large,  an  employee,  on  being  asked  the  amount 
of  his  compensation  for  the  year,  will  in  his  answer  name 
a  figure  which  includes  the  "gifts."  This  is  not  a  theory. 
It  is  standard  business  practice  to  include  items  of  this  kind 
as  one  of  the  necessary  business  expenses  intended  by  the 
framers  of  the  law  to  be  an  allowable  deduction. 

Educational  and  "welfare"  outlays  for  employees. — It  is 

now  considered  advantageous  for  an  employer  to  educate  and 
stimulate  his  employees  in  all  matters  relative  to  the  business 
and  to  promote  their  development  so  that  they  may  become 
more  useful  and  valuable.  Schools  are  founded,  classes  are 
formed,  lecture  courses  are  arranged,  gymnasiums  are  opened, 
athletic  games  are  encouraged,  entertainments  are  provided, 
and  many  other  ways  are  found  of  carrying  out  the  purpose 
in  view.  Some  of  these  plans  appear  to  be  altruistic  and  of  a 
semi-charitable  nature.  When  this  idea  is  uppermost,  the  cost 
of  the  ventures  should  be  entered  on  the  books  as  gifts  or 
donations. 

If,  as  is  often  the  case,  the  controlling  motive  is  the  better- 
ment of  the  business,  the  cost  is  a  business  expense,  pure  and 
simple,  even  though  the  results  are  disappointing.  In  these 
days  of  labor  and  other  administrative  troubles,  the  cost  of  any 
practical  and  effective  plan  of  improving  the  moral,  mental 
and  physical  condition  of  employees  is  a  practical  business 
expenditure.  It  is  not  a  charitable  scheme.  It  is  a  money- 
making,  not  a  money-spending,  proposition.      Tn  the  opinion 


888  DEDUCTIONS 

of  the  author  such  expenses  are  allowable  deductions  and  may 
be  so  claimed. 

Ruling.  Inquiry  is  made  whether  the  following  are  allowable 
deductions  in  the  income  tax  returns  of  a  taxpayer : 

(i)  Amounts  expended  in  outfitting  a  baseball  team  which  repre- 
sents the  taxpayer,  and  the  uniforms  of  which  bear  the  name  of  the 
taxpayer  the  players  represent. 

(2)  Expenses  incurred  in  furnishing  entertainment  to  the  tax- 
payer's employees  by  means  of  picnics  or  dances. 

Inasmuch  as  it  appears  that  the  name  of  the  taxpayer  is  given 
considerable  publicity  in  the  appearance  of  the  taxpayer's  baseball 
team  in  various  parts  of  the  district  in  which  the  taxpayer  does  busi- 
ness and  by  a  report  of  the  games  in  the  newspapers  of  the  vicinity, 
it  is  held  that  the  expenses  incurred  relative  to  the  outfitting  and 
support  of  the  ball  team  representing  the  taxpayer  are  similar  to 
those  expended  in  other  methods  of  advertising  and  are  deductible  as 
business  expenses  in  the  income  tax  returns  of  the  taxpayer. 

However,  expenses  incident  to  the  furnishing  of  entertainment  to 
the  employees  by  means  of  picnics  or  dances  are  not  such  "ordinary 
and  necessary"  business  expenses  as  are  comprehended  by  the  Revenue 
Act  of  1918,  and  therefore  are  not  allowable  deductions  from  gross 
income  for  purposes  of  computing  income  tax.  (B.  37-21-1815; 
O.  D.  1030.) 

The  author  is  of  the  opinion  that  the  latter  part  of  the  fore- 
going ruling  is  unsound. 

Such  entertainments  contribute  to  a  finer  esprit  de  corps, 
which  in  turn  is  reflected  in  the  productivity  of  the  business. 
If  the  directors  believe  that  the  expenses  are  necessary,  the  bur- 
den of  proof  is  on  the  Treasury  to  show  that  they  are  not. 

Ruling.  Where  a  corporation  encourages  or  requires  its  em- 
ployees to  attend  part-time  schools  it  may  deduct  as  a  business  ex- 
pense reasonable  amounts  paid  as  compensation  to  such  employees 
during  their  absence  from  employment  while  attending  such  schools. 
(C.  B.  4,  page  i3o;0.  D.  850.) 

Pensions  to  ex-employees  and  their  dependents. — 

Regulation.  Amounts  paid  for  pensions  to  retired  employees 
or  to  their  families  or  others  dependent  upon  them,  or  on  account  of 
injuries  received  by  employees,  and  lump-sum  amounts  paid  or  accrued 
as  compensation  for  injuries,  are  proper  deductions  as  ordinary  and 
necessary  expenses.  Such  deductions  are  limited  to  the  amount  not  com- 
pensated for  by  insurance  or  otherwise.    No  deduction  shall  be  made 


FOR   EXPENSES  889 

for  contributions  to  a  pension  fund  held  by  the  corporation,  the 
amount  deductible  in  such  case  being  the  amount  actually  paid  to  the 
employee.  When  the  amount  of  the  salary  of  an  officer  or  employee 
is  paid  for  a  limited  i)eriod  after  Iiis  death  to  his  widow  or  heirs,  in 
recognition  of  the  services  rendered  by  the  individual,  such  payments 
may  be  deducted (Art.  108.) 

This  regulation  recognizes  that  the  total  payments  to  em- 
ployees themselves  or  to  their  dependents  are  allowable  de- 
ductions.** It  is  open  to  criticism,  however,  because  of  its  re- 
fusal to  permit  the  deduction  of  amounts  set  aside  during 
accounting  periods  as  accruing  expenses.  The  regulation  is 
inconsistent  with  other  regulations  which  permit  deductions 
for  liabilities  incurred  but  not  paid.  Amounts  appropriated 
to  pension  funds  are  supposed  to  approximate  the  liabilities 
which  attach  to  all  pension  plans.  Obviously  in  many  cases 
actual  payments  are  deferred,  but  if  it  can  be  shown  that  the 
contributions  to  a  fund  are  not  in  excess  of  the  reasonable 
requirements  of  the  pension  plan,  applicable  to  the  employees 
on  the  payrolls  during  the  period  in  question,  the  entire  con- 
tribution is  clearly  a  necessary  expense  of  the  business. 

Contributions  to  pension  funds  which  are  deducti- 
ble.— 

Ruling.  Donations  by  a  corporation  to  a  pension  fund  for  the 
benefit  of  its  officers  and  employees,  the  fund  being  organized  entirely 


"  [Former  Procedure]  The  procedure  in  regard  to  the  deducti- 
bility of  pensions  paid  to  dependents  of  employees  has  had  a  checkered 
history.     T.  D.  2090  provided  that : 

Regulation.  Amounts  paid  for  pensions  to  retired  empolyees,  or 
to  their  families,  or  others  dependent  upon  them,  or  on  account  of  injuries 
received  by  employees,  are  proper  deductions  as  ordinary  and  necessary 
expenses.  i 

However,  the  1918  edition  of  Regulations  33,  articles  136  and  137, 
took  the  position  that : 

Regulatiox.  When  the  amount  of  the  salary  of  an  officer  or  em- 
ployee is  paid  for  a  limited  period  after  his  death  to  his  widow  or  heirs, 
in  recognition  of  the  services  rendered  by  the  individual,  no  services  being 
rendered  by  the  widow  or  heirs,  such  payment  is  not  "ordinary  and  neces- 
sary" expense  of  transacting  business  and  does  not  constitute  an  allowable 
deduction. 

This  was  once  more  reversed  by  Reg.  45,  Art.  iu8.  Art.  108  of  Reg.  62 
is  the  same  as  in  Reg.  45. 


890  DEDUCTIONS 

separcate  and  distinct  from  the  corporation,  having  its  own  set  of 
books,  making  its  own  investments,  and  paying  its  own  expenses, 
legal  title  of  which  does  not  remain  in  the  corporation,  are  deemed 
to  be  donations  to  a  charitable  institution  conducted  for  the  benefit 
of  the  corporation's  employees  or  their  dependents  representing  a  con- 
sideration for  a  benefit  flowing  directly  to  the  corporation  as  an 
incident  of  its  business  and  are  allowable  deductions  from  gross  in- 
come in  determining  net  income  subject  to  tax.  (C.  B.  i,  page  224- 
O.  D.  no.) 

Commissions  of  various  types. — 

Commissions  paid  to  salesmen  and  commissions  on 

INSURANCE   premiums  DEDUCTIBLE. 

Regulation Commissions  paid  salesmen,  ....  commis- 
sions on  insurance  premiums,  ....  are  income  to  the  recipients; 
....   (Art.  32.) 

Consequently  they  are  deductible  as  compensation  for  ser- 
vices.*^ 

Management  compensation  or  commissions  paid 
AGENTS  deductible. — An  old  Treasury  decision  specifically 
states  that: 

Ruling.  A  commission  paid  to'  a  real  estate  agent  for  col- 
lecting rents  and  for  management  of  property,  is  a  legitimafe  busi- 
ness expense  and  constitutes  an  allowable  deduction  in  computing  net 
income.     (T.  D.  2090.) 

The  same  rule  would  apply  to  the  charges  of  trust  com- 
panies or  other  agents  who  collect  income  and  manage  per- 
sonal as  well  as  real  property. 

Usually  the  recipient  of  the  income  receives  and  enters  a 
net  amount  and  fails  to  record  the  items  of  gross  income  and 
deductions  therefrom.  Where  part  of  the  income  is  from 
dividends  or  tax-free  covenant  bond  interest  this  method  results 
in  a  loss  of  the  credits  for  normal  tax.  When  all  the  items 
of  income  are  entered  gross  there  should  also  be  entered  as  de- 
ductions the  expenses  which  are  applicalile  to  the  income. 

"  See  page  420. 


FOR   EXPENSES  891 

Commissions  paid  to  stockbrokers  not  deductible  as 
expenses. 

Regulation Commissions  paid  in  purchasing  securities 

are  a  part  of  the  cost  price  of  such  securities.     Commissions  paid  in 

selling  securities  are  an  offset  against  the  selling  price (Art. 

293-) 

When  securities  are  sold  the  profit  is  decreased  or  the 
loss  is  increased  by  the  commissions  charged.  Therefore  the 
amounts  paid  in  such  commissions  are  fully  deductible  even- 
tually. 

Compensation  paid  in  stock  deductible.*^ — 

Regulation Compensation  paid  an  employee  of  a  cor- 
poration in  its  stock  is  to  be  treated  as  if  the  corporation  sold  the 

stock   for   its  market  value  and  paid  the   employee   in   cash 

(Art.  33.) 

Stock  issued  to  employees  for  services. — During  recent 
years  many  concerns  have  sold  stock  to  their  employees  so  that 
they  may  participate  in  the  profits  of  the  business.  Generally, 
these  sales  are  made  on  an  instalment  plan,  the  company  credit- 
ing a  small  amount  each  year  to  the  employee,  which  is  applied 
to  the  purchase  of  the  stock.  The  employee  also  pays  a  small 
amount  every  week  or  month,  which  is  likewise  applied  against 
the  purchase  price  of  the  stock. 

The  amounts  which  the  company  credits  to  the  employee 
are  for  services  rendered  and  are  deductible  as  a  necessary 
business  expense. 

Rulings.  A  proportionate  part  of  the  par  value  of  a  company's 
stock  delivered  to  a  trustee  to  be  held  in  escrow  for  the  benefit  of 
certain  employees  of  the  company  which  stock  is  to  be  delivered  to 
them  at  the  expiration  of  a  number  of  years  in  recognition  of  faithful 
service,  may  be  taken  as  a  deduction  in  the  income  tax  returns  of  the 
company  for  each  of  such  years  during  the  period  the  trustee  holds 
the  stock,  providing  the  corporation  keeps  its  books  on  an  accrual 
basis. 

If  the  employee  for  whom  the  stock  was  deposited  should  forfeit 

"  See  page  430. 


892  DEDUCTIONS 

his  right  to  receive  the  stock,  the  corporation  must  report  as  income 
in  the  year  in  which  the  right  to  receive  the  stock  is  forfeited,  the 
amounts  taken  as  a  deduction  in  previous  years  on  account  of  the 
forfeited  stock.     (C.  B.  i,  page  107;  O.  D.  124.) 

If  a  corporation  distributes  shares  of  its  treasury  stock  to  its  em- 
ployees as  additional  compensation,  the  market  value  of  the  stock  at 
the  time  of  distribution  is  deductible  by  the  corporation.  Any  differ- 
ence between  such  market  value  of  the  stock  and  its  cost  to  the  cor- 
poration is  neither  taxable  gain  nor  a  deductible  loss  to  the  corpora- 
tion.    (C.  B.  4,  page  137;  A.  R.  M.  114.) 

This  ruling  depends  on  the  fact  that  no  taxable  profit  or 
deductible  loss  can  arise  from  transactions  engaged  in  by  a 
corporation  in  its  own  treasury  stock.  Had  it  distributed  stock 
in  some  other  corporation  owned  by  it,  the  difference  between 
cost  and  market  price  would  be  a  taxable  profit  or  deductible 
loss,  as  the  case  may  be. 

Compensation  to  employee  of  a  partnership  under  a  par- 
ticipation of  profits  agreement  deductible. — 

Regulation compensation  for  services  on  the  basis  of  a 

percentage  of  profits  ....  [is]  income  to  the  recipients;  .... 
(Art.  32.) 

It  follows,  of  course,  that  the  payment  constitutes  an  item 
of  business  expense  to  the  partnership. 

Partners'  and  sole  proprietors'  so-called  salaries. — Except 
for  the  purposes  of  excess  profits  taxation  the  designation 
of  salaries  for  partners  or  proprietors  is  essentially  an  artificial 
and  pointless  practice.  Withdrawals  made  by  individuals  or 
partners  from  a  business  in  which  they  own  all  or  part  of  the 
capital  are  normally  in  anticipation  of  profits.  As  between 
partners,  salary  allowances  may  serve  to  adjust  or  define  dis- 
tributions of  profits  or  sharing  of  losses,  but  merely  calling 
such  drawings  expenses  does  not  make  them  so. 

In  the  language  of  the  Treasury  :^'  "Wages  or  salary  drawn 
by  a  taxpayer  from  his  own  business  are  more  in  the  nature 


*'  Income  Tax  Primer,  1918,  question  62. 


FOR  EXPENSES 


893 


of  a  charge  out  of  profits  than  a  charge  against  profits.  If 
such  could  be  deducted  they  would  merely  be  added  to  his 
income,  the  effect  of  which  would  be  to  take  money  out  of 
one  pocket  and  put  it  in  another."  For  the  proper  determina- 
tion of  super-normal  profits,  however,  it  was  necessary  to 
take  such  deductions  into  account. 

Insurance 

Life  insurance  premiums  paid  by  insured  not  deductible. — 

Regulation Premiums  paid  for  life  insurance  by  the  in- 
sured are  not  deductible (Art.  291.) 

Ruling.  Where  a  corporation  insures  the  life  of  its  president, 
the  stockholders  being  beneficiaries  in  proportion  to  their  stock  hold- 
ings and  the  wife  of  the  president  (not  herself  a  stockholder)  being 
a  beneficiary  in  proportion  to  her  husband's  stock  holdings,  no  deduc- 
tion for  the  payment  of  premiums  can  be  allowed  under  article  294 
of  Regulations  45,  as  amended  by  T.  D.  3019,  since  the  corporation 
itself   is   indirectly   a   beneficiary  under  the  policy. 

The  premiums  paid  on  such  a  policy  are  a  charge  against  surplus 
and  represent  dividends  to  the  stockholders  subject  to  surtax  to  the 
extent  that  such  premiums  are  paid  out  of  earnings  or  surplus  accu- 
mulated since  February  28,  1913.  This  applies  as  well  to  the  officer 
upon  whose  life  the  insurance  is  carried.  (C.  B.  3,  page  192;  O. 
D.  659.) 

As  no  part  of  the  proceeds  of  the  policy  would  be  paid 
to  the  taxpayer  the  Treasury  ignores  the  corporate  entity  in 
the  foregoing  decision.  The  decision  is  sound,  however,  from 
an  equitable  if  not  from  a  legal  point  of  view.  When  the 
equity  is  in  favor  of  the  taxpayer  the  Treasury  finds  it  im- 
possible to  look  through  the  corporate  entity. 

Whether  or  not  the  deduction  of  life  insurance  premiums 
of  this  type  should  be  permitted  resolves  itself  very  largely 
into  a  question  as  to  whether  or  not  the  degree  of  security  of  a 
source  of  income  shall  be  taken  into  account  in  levying  a  tax 
on  the  income  from  that  source.  For  example,  shall  income 
from  personal  effort,  which  may  suddenly  be  terminated  at 
the  death  of  the  producer,  be  given  some  concession  compared 
with  "funded"  income?     In  England,  where  this  qiiestion  is 


894  DEDUCTIONS 

of  long  standing/^  the  earned  incomes  arc  not  only  taxed  at 
lower  rates  but  premiums  on  insurance  on  one's  own  life  or 
that  of  his  wife  are  deductible  up  to  one-sixth  of  the  net  in- 
come.""^ 

At  the  time  the  191 3  law  was  passed  Judge  Hull  explained 
that  no  deduction  was  permitted  for  such  expenditures  because 
the  exemption  was  large  enough  to  cover  them.  The  exemp- 
tion was  materially  lowered  in  the  19 17  law,  but  no  deduction 
was  provided  for  life  insurance  premiums. 


"Business"    life    insurance   premiums    not    deductible/" — 

Law.  Section  215.  [Individuals  and  corporations — items  not 
deductible]  ....  (4)  Premiums  paid  on  any  life  insurance 
policy  covering  the  life  of  any  officer  or  employee,  or  of  any  person 
financially  interested  in  any  trade  or  business  carried  on  by  the  tax- 
payer, when  the  taxpayer  is  directly  or  indirectly  a  beneficiary  under 
such  policy. 


*' Seligman,  The  Income  Tax,  pages  79,  133,  154-155.  After  first  per- 
mitting the  deduction  and  then  forbidding  it,  the  permission  was  firmly 
established  in  the  law  in  1853. 

■"  Murray  and  Carter,  A  Guide  to  Income  Tax  Practice,  8th  Ed.,  page 
259.  The  allowance,  however,  is  "not  admissible  as  a  deduction  in  arriving 
at  the  total  income  for  the  purpose  of  a  claim  for  relief  in  respect  of 
'earned  income.'  " 

°"  [Former  Procedure]  Under  T.  D.  2090  (December  14,  1914)  pre- 
miums on  such  insurance  were  deductible,  but  when  the  policies  matured 
or  upon  the  death  of  the  insured  the  amount  received  was  reportable  as 
income.  This  procedure  was  changed  by  T.  D.  2519  (August  30,  1917) 
which  forbade  the  deduction  of  the  premiums  annually  but  provided  in- 
stead that  they  might  be  cumulated  and  deducted  from  the  gross  proceeds, 
when  received,  of  any  policies  of  which  the  business  concern  was  the 
beneficiary.  As  applied  to  term  policies  for  special  purposes  if  there 
was  no  surrender  value,  the  premiums  represented  a  business  expense 
and  credit  should  have  been  claimed  therefor.  The  test  of  deductibility 
prior  to  1917  should  rest  on  reasonable  protection  to  a  business  as  against 
investment  or  profit  possibilities.  If  the  premiums  paid  merely  provided 
for  reimbursement  of  possible  business  losses  by  fire  or  death  of  a 
valuable  executive,  or  against  any  true  business  risk,  the  cost  of  insur- 
ance was  correspondingly  a  true  business  expense. 

1917  Law.  Section  32.  "That  premiums  paid  on  hfe  insurance  policies 
covering  the  lives  of  officers,  employees  or  those  financially  interested  in 
any  trade  or  business  conducted  by  an  individual,  partnership,  corpora- 
tion, joint-stock  company  or  association,  or  insurance  company,  shall  not 


FOR  EXPENSES  895 

"Group"  insurance  premiums  are  deductible. — The  law 
disallows  deductions  for  premiums  only  when  the  taxpayer  is 
a  beneficiary.  So-called  "group"  insurance  premiums  are 
deductible  because  the  proceeds  of  the  policies  are  paid  to 
someone  other  than  the  taxpayer. 

Regulation If,  however,  the  taxpayer  is  in  no  sense  a 

beneficiary  under  such  a  policy,  except  as  he  may  derive  benefit  from 
the  increased  efficiency  of  the  officer  or  employee,  premiums  so  paid 
are  allowable  deductions ^^     (Art.  294.) 

Accident  insurance  premiums. — The  192 1  law,"^"  and 
regulations^^  hold  that  proceeds  of  accident  insurance  policies 
are  not  taxable  income.  Therefore  premiums  paid  for  acci- 
dent insurance  are  not  allowable  deductions.  The  controlling 
reason  for  taking  out  accident  insurance  is  to  secure  special 
income  in  case  one's  regular  income  is  shut  off.  It  would 
therefore  seem  logical  to  tax  the  income  and  allow  credit  for 
premiums  paid  and  for  any  unusual  expenses  arising  from 
the  contingency  giving  rise  to  the  payment  of  the  insurance. 

In  the  case  of  a  business,  however,  such  premiums  are 
deductible. 


be  deducted  in  computing  the  net  income  of  such  individual,  corporation, 
joint-stock  company  or  association,  or  insurance  company,  or  in  computing 
the  profits  of  such  partnership  for  the  purposes  of  subdivision  (e)  of  sec- 
tion eight  (3)." 

A  possible  explanation  of  the  insertion  of  Section  32  in  the  law  in 
1917  is  the  desire  to  prevent  evasion.  It  is  conceivable  that  in  a  year  of 
high  tax  rates  a  concern  might  reduce  its  taxes  by  insuring  heavily 
various  persons  associated  with  the  business.  Evasion  would  be  par- 
ticularly easy  if  the  various  types  of  "investment"  insurance  were  avail- 
able. 

The  provision  of  the  1918  law  was  inserted  in  the  1921  act  without 
change. 

"  In  an  early  edition  of  Regulations  45,  this  sentence  read  as  follows : 

"But  if  the  taxpayer  is  in  no  sense  a  beneficiary  imder  such  a  policy, 
except  as  he  may  derive  advantage  from  the  increased  efficiency  of  the 
employee,  and  pays  the  premiums  purely  as  reasonable  additional  compen- 
sation of  such  employee,  they  are  allowable  deductions." 

"Section  213  (b-6). 

"See  page  351. 


896  DEDUCTIONS 

Property  insurance  premiums — when  deductible. — 

Regulations Other  items  that  may  be  included  as  busi- 
ness   expenses    are  ....  insurance    premiums    against    fire,    storm, 

theft,  accident  or  other  similar  losses  in  the  case  of  a  business 

(Art.  loi.) 

Insurance  paid  on  a  dwelling  owned  and  occupied  by  a  taxpayer 
is  a  personal  expense (Art.  291.) 

In  conformity  with  these  rulings,  premiums  on  insurance 
covering  a  dwelling  house  occupied  by  the  owner  may  not  be 
deducted."  On  the  other  hand,  if  the  insurance  covers  a 
barn  on  a  farm  it  is  deductible. 

Premium  on  fidelity  bonds  deductible. — 

Regulation.  Where  an  employee  is  required  to  furnish  bond 
and  pay  the  premium  on  such  bond  as  a  necessary  incident  to  his 
employment,  the  premium  on  the  bond  will  constitute  an  allowable 
deduction  in  computing  net  income.     (T.  D.  2090.) 

Ruling.  Premiums  paid  on  indemnity  bonds  furnished  by  Gov- 
ernment employees  for  the  faithful  performance  of  their  duties  con- 
stitute allowable  deductions  in  computing  net  income  for  the  purpose 
of  the  income  tax.     (C.  B.  4,  page  124;  O.  D.  878.) 

If  the  premium  is  paid  by  the  employer  the  payment  is 
likewise  deductible  as  a  business  expense. 

Premiums  paid  on  insurance  policies   to   secure  loans. — 

Rulings.  A  taxpayer  who  borrowed  money  for  business  purposes 
and  was  required  to  take  out  life  insurance  in  favor  of  the  lender  as 
security  for  the  loan,  is  entitled  to  deduct  the  premiums  paid  for 
such  insurance  as  a  business  expense  under  Section  214  (a)  1  of 
the  Revenue  Act  of  1918;  however,  the  premiums  will  cease  to  con- 
stitute a  business  expense  upon  maturity  and  payment  of  the  loan. 
(C.  B.  2,  page  104;  O.  D.  396.) 

The  premiums  paid  on  a  life  insurance  policy  taken  out  by  a  tax- 
payer for  the  sole  purpose  of  protecting  a  bank  from  which  he  pro- 
cured a  loan,  constitute  an  allowable  deduction  in  determining  net 
income,  even  though  the  insurance  was  not  taken  out  until  some  time 
after  the  loan  had  been  made.     (B.  Digest  35-21-1791 ;  O.  D.  loii.) 

Likewise  it  would  appear  that  if  any  policy  were  assigned 


Income  Tax  Primer,  1918,  question  67. 


FOR   EXPENSES  897 

to  secure  a  loan,  the  premiums  would  immediately  become  de- 
ductible, but  the  Treasury  has  held  that : 

Ruling.  Office  Decision  396  (C.  B.  2,  page  104),  holding  that  pre- 
miums paid  on  a  life  insurance  policy  required  as  collateral  for  a 
loan  are  deductible  as  a  business  expense,  is  to  be  strictly  construed. 
The  policy  must  have  been  taken  out  for  the  sole  purpose  of  using 
it  as  security  for  the  loan.  A  taxpayer  is  not  permitted  to  deduct 
the  premiums  paid  on  a  policy  taken  out  prior  to  the  negotiations  for 
a  loan  and  later  assigned  to  the  lender  as  security  for  such  loan. 
The  subsequent  assignment  of  the  policy  to  the  lender  is  merely  inci- 
dental to  the  purpose  for  which  the  policy  was  secured,  and  no  addi- 
tional expense  is  incurred  or  loss  sustained  by  virtue  of  its  temporary 
use  as  collateral.  The  increase  in  the  cash  surrender  value  of  a  policy 
accruing  during  the  period  it  is  used  as  collateral  is  not  to  be  con- 
sidered in  computing  the  net  income  of  the  person  who  pays  the 
premium. 

A  corporation  which  takes  out  a  policy  on  the  life  of  one  of  its 
officers  for  the  purpose  of  using  the  policy  as  collateral  may  not 
deduct  the  premiums  paid  thereon.     (C.  B.  3,  page  139;  O.  D.  711.) 

It  is  difficult  to  reconcile  the  last  paragraph  of  the  fore- 
going ruling  with  O.  D.  396.  It  is  made  plain,  however,  that 
in  certain  cases  life  insurance  premiums  are  deductible  even 
though  the  taxpayer  is  "indirectly"  a  beneficiary. 

It  would  also  appear  that  if  a  creditor  takes  an  assignment 
of  life  insurance  as  security,  he  will  be  entitled  to  deduct  the 
premiums  paid  on  the  insurance,  if  the  debtor  fails  to  pay  the 
premiums. 

W^hen  changes  such  as  renewals  and  reduction  of  loans 
occur,  it  may  be  necessary  to  divide  the  amount  paid  as  premi- 
ums in  order  to  arrive  at  deductible  portion. 

Ruling.  In  case  a  loan  is  renewed  for  the  full  amount,  and  a 
policy  of  insurance  taken  out  in  favor  of  the  lender  for  the  express 
purpose  of  securing  the  loan  is  continued  as  security,  the  premium  paid 
thereon  by  an  individual  taxpayer  is  deductible  as  a  business  ex- 
pense under  the  same  conditions  applicable  in  the  case  of  the  original 
loan. 

If  partial  payment  is  made  upon  the  maturity  of  the  loan,  and  the 
loan  is  renewed  for  the  reduced  amount,  the  premium  paid  is  de- 
ductible only  to  the  extent  that  it  is  paid  on  insurance  required  as 
security  for  the  reduced  amount  of  the  loan.  (C.  B.  4,  page  123; 
O.  D.  843.) 


898 


DEDUCTIONS 


'Self-insurance"  reserves. 


Regulation.  Funds  set  aside  by  a  corporation  for  insuring  its 
own  property  are  not  a  proper  deduction,  but  if  such  funds  are  set 
aside,  or  a  reserve  therefor  is  set  up,  any  loss  actually  sustained  and 
charged  to  such  funds  or  reserves  may  be  deducted.  (Reg.  33,  1918, 
Art.  144.) 

If  the  amounts  set  aside  are  simply  equal  to  the  premiums 
charged  by  an  insurance  company  it  is  quite  possible  that  the 
courts  would  decide  that  such  reserves  or  provisions  against 
losses  would  be  allowable  deductions  as  business  expenses. 
Certainly  sound  accounting  practice  requires  that  such  items 
should  be  charged  to  an  expense  account. 

Insurance  under  v/orkmen's  compensation  laws.— Premi- 
ums- paid  to  insurance  companies  or  state  insurance  commis- 
sions by  employers  under  workmen's  compensation  laws  are 
deductible.  If  these  laws  permit  an  employer  to  establish  re- 
serves for  the  purpose  of  carrying  the  risk,  such  reserves  can- 
not be  deducted,  but  payments  to  employees  from  such  reserves 
are  deductible. 

Rulings.  Under  the  Workmen's  Compensation  Law  of  a  State, 
employers  are  required  either  to  make  periodical  payments  to  the 
State  Insurance  Fund  created  to  compensate  employees  for  injuries 
received  in  the  course  of  their  employment,  or  to  maintain  a  benefit 
fund  providing  for  the  payment  of  such  compensation,  giving  a  bond  as 
additional  security  for  the  payment  of  such  compensation. 

Where  the  employer  makes  the  periodical  payments  to  the  insur- 
ance fund  of  a  State  such  payments  are  allowable  deductions  for  the 
year  in  which  paid  or  accrued. 

If,  however,  the  employer  maintains  a  fund  actually  depositing 
periodically  in  a  trust  company  an  amount  to  be  held  in  reserve  as  a 
special  fund  for  the  payment  of  compensation  as  injuries  occur,  the 
amount  thus  deposited  is  not  an  allowable  deduction  from  gross 
income,  since  there  is  no  means  of  determining  how  much  of  this  fund 
will  be  used  for  the  purpose  for  which  it  is  held.  In  such  case  the 
actual  amount  paid  during  a  year  to  the  employees  as  compensation 
where  injuries  occur  is  a  proper  deduction  for  that  year  whether  the 
amount  so  paid  is  greater  or  less  than  the  deposits  made  during  the 
period  to  the  fund  which  is  maintained.     (B.  27-21-1712;  O  .D.  964.) 

A  corporation  carried  its  own  compensation  insurance  in  ac- 
cordance with  the   Workmen's   Compensation   Law   of   the   State   of 


l<OR   EXPENSES  899 

Pennsylvania.  Compensation  for  personal  injury  to,  or  for  the  death 
of,  an  employee  by  an  accident  in  the  course  of  his  employment  is 
based  upon  a  certain  percentage  of  the  employee's  wages,  with  cer- 
tain stated  maximum  and  minimum  limitations,  payable  in  periodical 
installments,  the  same  as  wages,  over  periods  extending  in  some  cases 
as  long  as  16  years.  The  compensation  thus  fixed  is  subject  to 
change  in  the  event  of  a  subsequent  change  in  the  disability  status 
of  the  employee,  or  his  status  as  to  dependents.  The  amount  of  com- 
pensation is  fixed  by  the  Compensation  Board  of  the  State.  In  some 
cases  the  board  may  order  the  compensation  paid  in  a  lump  sum. 

By  filing  a  certified  copy  of  the  agreement  or  award  with  the 
Court  of  Common  Pleas  of  any  county  in  the  State,  the  amount  of 
compensation  shown  in  such  agreement  or  award  will  be  entered  as  a 
judgment  against  the  employer,  which  judgment  is  a  lien  against 
the  property  of  the  employer  from  the  date  of  filing  the  agreement 
or  award.  Execution  in  all  such  cases  shall  be  for  the  amount  of 
compensation  and  interest  thereon  due  and  payable  up  to  the  date  of 
the  issuance  of  the  execution,  with  costs,  and  further  execution  may 
issue  from  time  to  time  as  further  compensation  shall  become  due 
and  payable  until  the  full  amount  of  the  judgment  with  costs  shall 
have  actually  been  paid.     (Sec.  428.) 

Only  so  much  of  the  award  as  under  its  terms  the  corporation  wa.s 
required  to  pay  during  the  taxable  year  may  be  accrued  as  a  liability 
for  that  year.     (B.  Digest  49-21-1959;  O.  D.  1123.) 

Under  the  Ohio  Workmen's  Compensation  Law  certain  em- 
ployers are  allowed  to  carry  their  own  risk  or  insurance.  Com- 
pensation payments  in  case  of  industrial  injury  are  usually  paid  in 
weekly  installments.  In  death  and  permanent  disability  cases  the  Ohio 
Industrial  Commission  makes  an  award  covering  the  total  liability 
in  each  case.  The  employer  then  sets  aside  a  reserve  covering  the 
amount  of  the  award  and  makes  weekly  payments  until  the  entire  award 
is  exhausted. 

The  question  submitted  is  whether  the  entire  amount  of  the  re- 
serve set  aside  may  be  deducted  in  the  year  in  which  the  award  is  deter- 
mined and  the  reserve  set  aside  or  whether  the  amount  of  the  reserve 
should  be  allocated  to  the  years  in  which  actually  paid. 

Held,  that  only  so  much  of  the  award  as  under  the  terms  of  agree- 
ment the  employer  is  required  to  pay  during  any  year,  represents  a 
liability  against  profits  for  that  year.  The  employer  may  therefore 
deduct  in  any  year  the  amount  of  the  award  paid  or  accrued  during 
that  year.     (B.  33-21-1768;  O.  D.  992.) 

The  foregoing  ruling  is  not  sound.  Correct  accounting 
procedure  requires  the  setting  up  of  a  liabiHty  when  it  is  ascer- 
tained.   The  entire  award  is  a  determined  liability  and  should 


900 


DEDUCTIONS 


therefore  be  allowed  in  full  in  year  of  award.  It  in  no  way- 
benefits  future  operations,  and  payment  in  instalments  is  simi- 
lar to  discharging  any  liability  in  instalments.  The  method 
of  payment  does  not  determine  the  period  in  which  the  liabil- 
ity is  deductil^le. 

Ruling.  Where  insurance  is  taken  out  by  a  corporation  on  the 
life  of  the  guarantor  of  a  debt  to  the  corporation,  the  surrender  value 
of  the  policy  can  not  be  included  in  invested  capital  but  the  premiums 
paid  may  be  deducted  as  a  business  expense. 

An  amount  received  by  the  corporation  in  1919  from  the  insur- 
ance company  in  distribution  of  a  20-year  surpkis  should  be  included 
in  gross  income  for  that  year. 

The  amount  received  upon  the  death  of  the  insured  in  excess  of 
the  cash  surrender  value  of  the  policy  on  T^Iarch  i,  1913,  must  be 
accounted  for  as  income  of  the  year  in  which  received.  (B.  Digest 
47-21-1938;  O.  D.  1 109.) 

Insurance  reserves   to   equalize   profits  not  deductible. — 

Ruling.  The  present  reconnnendation  is  made  in  response  to 
a  request  that  reserves  for  crop  insurance  be  allowed  as  deductions 
from  gross  income. 

The  argument  of  the  petitioners,  briefly  summarized,  is  as  fol- 
lows: 

The  canning  industry  is  peculiarly  subject  to  localized  climatic 
conditions  which  greatly  affect  the  output  from  year  to  year. 

The  expenses  of  a  cannery  being  to  a  large  extent  constant,  the 
result  is  that  the  cost  per  unit  of  output  is  much  less  in  the  year  of 
large  crops  than  in  the  years  of  crop  failure. 

The  climatic  conditions  being  local  rather  than  general,  the  high 
cost  per  unit  in  the  years  of  scant  crops  is  not  compensated  by  the 
higher  prices  of  output ;  and  there  results  an  alternation  of  abnor- 
mally hijh  profits  and  abnormally  low  profits,  depending  on  the 
alternation  of  favorable  and  unfavorable  climatic  conditions. 

On  the  theory  that  these  changes  follow  a  somewhat  definite  cycle, 
it  is  claimed  that  an  equitable  adjustment  would  be  secured  by  estab- 
lishing a  reserve  for  crop  insurance  as  suggested  above. 

The  Revenue  Act  recognizes  that  in  any  business  the  profits  may 
vary  from  year  to  year.  It  deliberately  adopts  the  policy  of  levying 
additional  taxes  on  annual  profits  above  the  average.  It  does  not 
make  any  corresponding  reduction  for  a  year  in  which  the  profits 
are  below  the  average.  An  actual  net  loss  in  one  year  may,  under 
section  204,  be  offset  against  net  profits  of  another  year,  but  this  is  a 
special  relief  provision  limited  in  its  application  to  the  narrow  class 
of  cases  covered  by  that  section.    The  equalization  of  profits  between 


FOR   EXPENSES  901 

years  which  show  no  loss  or  the  accumulation  of  reserves  against 
future  losses  are  not  sanctioned  by  the  law.  In  general,  the  statute 
evidences  a  clear  intent  to  restrict  within  the  narrowest  limits  deduc- 
tions for  addition  to  reserves  other  than  the  reserves  of  insurance 
companies  required  by  law.  It  is  doubtful  even  whether  a  reserve 
against  an  incurred  but  unpaid  liability  can  be  recognized,  when  the 
liability  is  at  all  indefinite.  But  there  can  be  little  doubt  that  a 
reserve  against  a  future  loss  is  unrecognized  by  the  statute,  and  no 
doubt  at  all  that  a  reserve  against  fluctuations  in  future  profits  has 
no  standing  of  a  kind  which  would  warrant  the  deduction  of  addi- 
tions thereto  in  computing  net  income  for  purposes  of  taxation. 

The  allowance  of  a  charge  for  crop  insurance  clearly  differs  from 
the  allowance  for  depreciation  in  the  element  of  definiteness  of  calcu- 
lation. The  certainty  of  depreciation  is  unquestioned,  and  the  life 
of  the  depreciating  asset  can  be  estimated  with  a  fair  approximation 
of  accuracy.  But  even  the  depreciation  allowance  is  given  by  virtue 
of  express  statutory  authority. 

The  theory  of  a  regularly  recurring  crop  cycle,  particularly  as 
limited  to  localized  industries,  is  still  a  theory.  The  particular  theory 
of  a  crop  cycle  cited  in  the  petitioners'  brief  refers  to  a  general  world- 
wide cycle.  Such  a  cycle  is  deliberately  ruled  out  of  consideration 
by  the  petitioners  who  claim  that  while  a  general  shortage  of  crops 
would  in  part  be  compensated  by  higher  prices,  the  shortages  for 
which  they  wish  to  provide  are  local  shortages  in  closely  contiguous 
territory  which  are  so  limited  as  to  have  no  noticeable  effect  on  gen- 
eral market  prices. 

The  petitioners  claim  that  if  a  crop  insurance  reserve  is  capable 
of  being  determined  with  reasonable  certainty,  it  is  an  allowance 
the  canner  has  a  legal  right  to  claim  but  admit  also  that  crop  insur- 
ance has  entering  in  it  so  many  variable  factors  that  no  insur- 
ance companies  will  write  the  risks.  The  petition  therefore  in  part 
rests  on  a  debated  economic  theory  which  relates  at  best  to  conditions 
not  applicable  to  the  case  at  issue,  and  in  part  on  an  admittedly  non- 
existing  accuracy  of  calculation. 

The  request  is  in  effect  a  proposal  to  equalize  profits  in  a  manner 
not  contemplated  by  the  Act,  and  it  is  accordingly  recommended  that 
the  petition  be  denied.     (C.  B.  i,  page  103;  T.  B.  R.  13.) 

The  author  is  of  the  opinion  that  the  foregoing  ruHng  is  in 
accordance  with  the  law.  He  is  also  of  the  opinion  that  the 
argument  of  the  canning  industry  is  economically  sound,  and 
that  a  change  should  be  made  in  the  law  to  meet  these  condi- 
tions. 

The   Treasury  has  held^^  that  if   insurance  has   actually 


C.  B.  I,  page  104;  O.  D.  215. 


902 


DEDUCTIONS 


been  taken  out,  the  premiums  are  deductible  as  necessary 
business  expenses.  This  perhaps  is  a  way  out  of  the  difficulty, 
as  it  should  be  possible  for  each  industry  to  organize  an  in- 
surance company. 

The  1 92 1  law^"  grants  the  relief  sought,  at  least  in  part. 
Losses  of  one  year  may  be  carried  forward  one  or  two  years. 

Procedure  when  premiums  are  paid  in  advance. — 

Regulation.  Premiums  paid  in  advance,  covering  a  period  of 
several  years,  are  to  be  taken  as  a  deduction  on  the  basis  of  one  of 
two  methods.  When  the  books  are  kept  on  a  cash  basis,  the  entire 
amount  is  deductible  in  the  year  in  which  the  premium  is  paid. 
When  the  books  are  kept  on  an  accrual  basis  the  premium  is  to  be 
prorated  over  the  period  covered  by  the  insurance.  (Reg.  33,  1918, 
Art.  8.) 

Assessments  for  insuring  bank  deposits. — 

Regulation.  Banking  corporations,  which  pursuant  to  the  laws 
of  the  States  in  which  they  are  doing  business,  are  required  to  set 
apart,  keep,  and  maintain  in  their  banks  the  amount  levied  and 
assessed  against  them  by  the  State  authorities  as  a  "Depositors'  guar- 
anty fund,"  inay  deduct  from  their  gross  income  the  amount  so  set 
apart  each  year  to  this  fund,  provided  that  such  fund,  when  set  aside 
and  carried  to  the  credit  of  the  State  banking  board  or  duly  author- 
ized State  officer,  ceases  to  be  an  asset  of  the  bank  and  may  be  with- 
drawn in  whole  or  in  part  upon  demand  by  such  board  or  State  officer 
to  meet  the  needs  of  these  officers  in  reimbursing  depositors  in  in- 
solvent banks,  and  provided  further  that  no  portion  of  the  amount 
thus  set  aside  and  credited  is  returnable  under  tlie  laws  of  the  State 
to  the  assets  of  the  banking  corporation.  If,  however,  such  amount 
is  simply  set  up  on  the  books  of  the  bank  as  a  reserve  to  meet  a  con- 
tingent liability  and  remains  an  asset  of  the  bank,  it  will  not  be  de- 
ductible except  as  it  is  actually  paid  out  as  required  by  law  and  upon 
demand  of  the  proper  State  officers.     (Art.  567.) 

Rentals 

No  difficulty  arises  concerning  ordinary  rentals  paid  in 
cash  in  business  operations.  Sometimes,  however,  the  rental 
charge  is  increased  by  expenditures  not  included  in  the  cash 

.  "  Section  204. 


FOR   EXPENSES  903 

payments  to  the  landlord.  These,  of  course,  are  deductible 
under  the  head  of  rentals. 

Rentals  paid  to  stockholders  of  a  corporation  based  upon 
net  profits  are  held  not  to  be  dividends  if  payments  were  made 
for  use  of  property  and  were  not  based  on  stockholdings."^^ 
Ostensible  rental  payments  which  are  in  reality  distributions  of 
profits  to  stockholders  will  not  be  allowed  by  the  Treasury 
as  business  deductions. 

Certain  interest  payments  are  held  to  be  the  equivalent  of 
rentals  and  are  deductible  as  such.     (See  page  931.) 

Taxes  paid  by  a  tenant. — 

Regulation Taxes  paid  by  a  tenant  to  or  for  a  landlord 

for  business  property  are  additional  rent  and  constitute  a  deductible 
item  to  the  tenant  and  taxable  income  to  the  landlord,  the  amount 
of  the  tax  being  deductible  by  the  latter (Art.  109.) 

A  statement  in  the  Primer  emphasizes  the  fact  that  in  this 
case  the  property  must  not  be  used  by  the  tenant  as  a  home." 

Permanent  improvements  on  leased  ground. — 

Regulation The  cost  borne  by  a  lessee  in  erecting  build- 
ings or  making  permanent  improvements  on  ground  of  which  he  is 
lessee  is  held  to  be  a  capital  investment  and  not  deductible  as  a  bus- 
iness expense.  In  order  to  return  to  such  taxpayer  his  investment  of 
capital,  an  annual  deduction  may  be  made  from  gross  income 
of  an  amount  equal  to  the  total  cost  of  such  improvements  di- 
vided by  the  number  of  years  remaining  of  the  term  of  lease,  and 
such  deduction  shall  be  in  lieu  of  a  deduction  for  depreciation.  If 
the  remainder  of  the  term  of  lease  is  greater  than  the  probable  life 
of  the  buildings  erected,  or  of  the  improvements  made,  this  deduction 
shall  take  the  form  of  an  allowance  for  depreciation.^^      (Art.  109.) 


'^'  In  re  General  Film  Corporation,  274  Fed.  903. 

^"Income  Tax  Primer,  1918,  question  69. 

■^^  [Former  Procedure]  In  an  early  edition  of  Regulations  45,  this 
part  of  this  article  read  as  follows : 

"The  lessee  will  not  be  permitted  to  deduct  from  the  gross  income  any 
depreciation  with  respect  to  such  buildings,  but  the  cost  of  incidental 
repairs  necessary  to  keep  them  in  an  efficient  condition  for  the  purposes 
of  their  use  may  be  deducted.  If,  however,  the  life  of  the  improvement 
is  less  than  the  life  of  the  lease,  depreciation  may  be  taken  by  the  lessee 
instead  of  treating  the  cost  as  rent." 


904 


DEDUCTIONS 


The  Treasury  has  held,  however,  that  a  reserve  to  cover 
a  possible  but  unknown  cost  of  restoring  the  premises  to  their 
original  condition  is  not  deductible.  The  cost  of  restoring 
the  property  at  the  expiration  of  the  lease,  if  the  lessee  is 
required  to  restore  it,  will  be  an  allowable  deduction  for  the 
year  in  which  it  is  actually  incurred.**" 

Rental  of  apartment  deductible  when  subleased. — 

RuLiXG The  taxpayer  lived  in  an  apartment  where  it 

was  the  custom  of  the  residents  to  sublease  their  apartments  or 
houses  for  the  summer  months.  In  his  1920  return  the  taxpayer  in- 
cluded in  his  gross  income  the  amount  received  as  rent  for  the  apart- 
ment which  he  sublet  and  deducted  as  a  business  expense  the  amount 
which  he  had  to  pay  as  rent  for  the  apartment,  claiming  that  he  had 
sublet  his  apartment  as  a  purely  business  proposition  and  that  the 
transaction  was  entered  into  for  profit.  He  occupied  no  part  of  the 
apartment  after  it  was  sublet. 

Held,  that  the  rent  which  the  taxpayer  was  required  to  pay  for  the 
apartment  during  the  time  that  it  was  sublet  at  a  profit  is  deductible 
in  computing  net  income.     (B.  50-21-1972;  O.  D.  1134.) 

Deduction  for  payment  for  cancellation  of  lease. — Although 
the  following  case  does  not  come  under  the  principle  upon 
which  article  109  is  based,  it  was  decided  in  accordance  there- 
with : 

Ruling.  A  business  property  was  leased  for  a  term  of  years, 
but  prior  to  the  termination  of  the  lease  the  lessor  paid  a  fixed  sum 
to  the  lessee  for  its  cancellation. 

Held,  that  the  amount  so  paid  by  the  lessor  constitutes  a  business 
expense  and  that  he  may  deduct  an  aliquot  part  thereof  in  his  return 
for  the  year  in  which  the  lease  was  canceled  and  for  each  succeeding 
year  the  lease  had  to  run.     (C.  B.  2,  page  112;  O.  D.  397.) 

The  theory  of  the  foregoing  ruling  would  seem  to  be  that 
the  lessor  made  a  capital  investment  in  something  he  had  dis- 
posed of,  viz.,  the  use  of  property  which  had  been  leased  to 
another. 

If  the  life  of  the  lease  does  not  extend  beyond  the  taxable 


C.  B.  2,  page  112;  O.  D.  516. 


FOR   EXPENSES  905 

period,  there  is  no  doubt  tiiat  the  entire  amount  is  deductible 
in  the  period. 

Rulings.  A  lump  sum  paid  as  damages  by  the  lessee  of  business 
premises,  by  reason  of  the  cancellation  of  a  lease  for  a  term  of  years, 
is  deductible  for  the  year  in  which  paid  or  accrued.  (B.  28-21-1726; 
0.  D.  974.) 

B  owned  a  lease  which  expired  in  1921.  A,  in  order  to  procure 
this  lease  at  the  expiration  of  B's  term,  agreed  to  pay  to  the  lessor, 
in  addition  to  a  lump  sum  of  3.r  dollars  for  the  lease  for  the  period 
from  1921  to  1941,  .V  dollars  for  each  of  the  years  1917,  1918,  1919, 
and  1920. 

Held,  that  the  advanced  payments  were  in  effect  a  bonus  and  con- 
stituted a  capital  outlay  representing  additional  cost  of  the  leasehold 
acquired,  and  may  not  be  construed  as  an  ordinary  or  necessary  ex- 
pense of  doing  business  for  any  year  prior  to  the  possession  of  the 
lease.     (B.  Digest  50-21-1973;  A.  R.  R.  676.) 

The  amount  of  a  bonus  paid  by  a  corporation  to  secure  immediate 
possession  of  a  theatre  under  a  lease  which  was  limited  to  the  tax- 
able period,  and  attorneys'  fees  in  connection  with  the  transaction, 
constitute  necessary  expenses  or  costs  of  operation  for  such  period  and 
are  not  required  to  be  capitalized.     (C.  B.  3,  page  109;  A.  R.  R.  178.) 

When  March  i,  1913,  value  affects  deduction  for  rent. — 

Ruling.  The  value  as  of  March  i,  1913,  of  a  leasehold  acquired 
prior  to  that  date,  cannot  be  used  in  determining  the  amount  deduct- 
ible each  year  by  the  lessee  when  the  leasehold  was  acquired  on  the 
basis  of  annual  rental  payments  equal  to  a  percentage  of  the  income 
derived  from  the  leased  property,  no  specified  sum  having  been  paid 
in  addition  to  the  annual  rentals.  The  amount  deductible  by  the  lessee 
each  year  is  the  rental  payment.     (C.  B.  3,  page  144;  O.  D.  675.) 

The  facts  in  the  foregoing  case  are  not  stated  and  no 
intelHgent  criticism  is  possible,  but  comment  is  made  because 
in  many  cases,  similar  on  their  face,  lessees  would  be  entitled 
to  deductions  in  excess  of  the  annual  rental  payment.  If  the 
rental  were  on  a  sliding  scale  it  is  probable  that  the  lease  would 
have  had  no  capital  value  at  March  i,  1913,  but  if  the  percent- 
age were  on  a  fixed  basis  it  is  quite  possible  that  the  lease 
would  have  had  a  substantial  value. 

Department  store  buildings  are  frequently  leased  on  the 


9o6  DEDUCTIONS 

basis  of  annual  rental  payments  equal  to  a  percentage  of  the 
gross  sales.  If  A  leased  a  building  to  B  for  20  years  in  1903 
on  a  basis  of  2  per  cent  of  sales  and  in  191 3  the  current  rate 
was  7  per  cent,  B  thereafter  could  deduct  annually  an  amount 
in  excess  of  the  rental  paid  equal  to  a  proportion  of  the  capital 
value  remaining  on  March  i,  19 13.  That  is,  if  the  value  of 
the  lease  on  March  i,  1913,  was  $100,000,  B  could  deduct 
$10,000  annually  for  10  years  in  addition  to  the  rental  pay- 
ment. 

Cost  of  lease  may  be  apportioned  over  term  as  rent. — 

Regulation.  Where  a  leasehold  is  acquired  for  business  pur- 
poses for  a  specified  sum,  the  purchaser  may  take  as  a  deduction  in 
his  return  an  aHquot  part  of  such  sum  each  year,  based  on  the  num- 
ber of  years  the  lease  has  to  run (Art.  109.) 

When  a  premium  is  paid  to  secure  a  lease,  the  amount 
represents  an  additional  expense  of  doing  business,  the  effect 
being  the  payment  of  a  higher  rent.  The  proper  method  of 
handling  it  is  to  set  up  the  amount  paid  as  a  deferred  asset, 
charging  off  each  year  the  proportion  of  the  premium  which 
has  expired.  Since  it  represents  increased  rent,  the  rent  paid 
and  the  proportion  of  the  premium  should  be  carried  into  the 
expense  account  as  one  item. 

A  corporation  issued  $100,000  of  its  capital  stock  to  pay 
for  a  leasehold  having  31  years  to  run.  The  question  arose 
as  to  how  it  should  be  treated  in  the  accounts.  If  the  value 
placed  upon  the  leasehold  was  not  excessive,  the  transaction 
was  the  same  as  if  the  corporation  had  sold  its  stock  for  cash 
and  had  then  purchased  the  lease  for  cash.  In  that  event  it 
would  have  been  proper  to  charge  off  each  year  as  an  expense 
one  thirty-first  of  the  amount  paid. 

Ruling,  In  March,  1920,  a  taxpayer  leased  certain  property,  the 
lease  to  be  effective  October,  1922.  To  obtain  the  lease  the  lessee 
paid  to  the  lessor  x  dollars  to  cover  the  period  intervening  between 
the  date  of  the  execution  of  the  lease  and  date  the  lease  becomes 
effective. 

Held,  that  the  sum  paid  in  1920  by  the  lessee  for  the  privilege  of 


FOR   EXPENSES  907 

securing  this  lease  is  a  business  expense  and  is  a  proper  charge  against 
the  taxpayer's  business  for  the  period  from  March  — ,  1920,  to  Oc- 
tober — ,  1922,  and  is  to  be  apportioned  over  that  period.  (B.  35-21- 
1793;  O.  D.  1013.) 

The  payment  for  the  period  intervening  is  treated  as  an 
ordinary  rental  disbursement.  Onl>  i:he  amount  which  appHes 
to  the  taxable  period  may  be  taken  as  a  deduction. 

Ruling.  The  commission  paid  by  the  lessor  to  a  broker  for  ne- 
gotiating a  long-term  lease  should  not  be  prorated  over  the  term  of 
the  lease  but  constitutes  a  proper  deduction  in  computing  net  in- 
come for  the  year  in  which  paid  or  accrued.     (I-4-40;  I.  T.  1171.) 

It  is  difficult  to  distinguish  the  foregoing  ruling  from  office 
decision  1013,  qtioted  above. 

Deferred  payments  to  lessor  deductible  when  accrued. — 

Ruling.  Under  the  terms  of  a  lease  of  real  estate  it  is  provided 
that  the  lessee  may  withhold  for  the  first  three  years  of  the  life  of 
the  lease  a  certain  part  of  the  annual  rental  in  order  that  it  may 
conserve  its  liquid  assets.  The  amounts  so  withheld  are  to  be  paid 
to  the  lessor  in  monthly  installments  during  the  remaining  life  of  the 
lease.  In  the  event  of  the  cancellation  of  the  lease  the  amounts  so 
withheld  are  agreed  to  be  an  absolute  liability  of  the  lessee.  The 
books  of  the  lessee  are  kept  on  the  accrual  basis. 

Held,  that  the  amount  of  the  rental  withheld  by  the  lessee  during 
each  of  the  first  three  years  of  the  lease  may  be  accrued  as  an  ex- 
pense for  that  year  and  deducted  from  gross  income  in  its  return. 
(C.  B.  4,  page  141;  O.  D.  794.) 

Rentals  paid  by  professional  men  and  others. — Under  the 

title,  "Business  expenses  of  the  professional  man"  (page  862). 
will  be  found  a  full  discussion  of  this  topic. 

Business    Expenses  Distinguished  from  Capital  Outlay 

Organization  and  similar  expenses. — The  Treasury  rulings 
forbid  the  deduction  of  attorneys'  fees,  accountants'  fees, 
fees  paid  to  state  authorities  and  other  expenditures  usually 
grouped  under  the  phrase  "organization  expenses."  On  this 
point  the  rulings  are  in  direct  conflict  with  good  accounting 
practice. 


(jo8  DEDUCTIONS 

Regulation.  Expenses  of  the  organization  of  a  corporation, 
such  as  incorporation  fees,  attorneys'  and  accountants'  charges,  are 
ordinarily  capital  expenditures,  but  where  such  expenditures  are 
limited  to  purely  incidental  expenses,  a  taxpayer  may  charge  such 
items  against  income  in  the  year  in  which  they  are  incurred.  (Art. 
582.) 

The  foregoing  regulation,  unlike  the  same  article  in  Regu- 
lations 45,"  accords  at  least  in  part,  with  the  following,  which 
may  be  taken  as  a  fair  reflection  of  present  accounting  prac- 
tice : 

Formerly  if  the  expenses  incurred  in  the  organization  of  the 
company  (such  as  incorporation  fees,  legal,  engineering  and  other 
expenses,  engraving  bonds  and  stock  certificates,  transfer  fees  and 
stamps,  etc.)  were  more  than  could  fairly  be  charged  into  current 
expenses,  it  was  considered  permissible  to  spread  such  charges  over 
a  term  of  years,  preferably  three,  but  not  more  than  five.  Sentiment 
is  changing  as  to  the  wisdom  of  spreading  these  expenses  over  more 
than  three  years.  The  best  practice  is  to  charge  off  immediately  every- 
thing which  has  no  tangible  or  residual  value.  The  benefit  from  such 
items  cannot  be  compared  to  advertising  and  exploitation  expenses.  It 
is  a  fallacy  to  assume  that  stock  certificates,  incorporation  expenses, 
etc.,  have  any  of  the  attributes  of  an  asset;  and  so  the  sooner  the 
cost  appears  in  the  expense  account,  the  better. 

The  old  theory  of  deferring  part  of  the  charge  to  income  was 
sound  enough,  but  the  rule  has  been  abused;  and  so  we  now  find  ap- 
portionments over  five  years  or  longer.  In  some  cases  all  organiza- 
tion expenses,  using  the  term  in  its  broadest  sense,  are  permanently 
capitalized.  The  author  advocates  charging  off  all  such  expenses  as 
they  are  incurred. *^- 

If  the  expenses  are  actual  and  are  incurred  in  good  faith, 
they  constitute  deductions  which  should  be  allowable  for  the 
period  during  which  they  appear  on  the  books  as  charges  to 
expenses.  If  a  corporation  actually  capitalizes  the  items,  of 
course  it  must  not  claim  credit  for  the  deduction;  but  if  it  fol- 
lows proper  and  now  almost  settled  corporate  practice,  this 
class  of  expenditures  should  appear  in  its  books  as  ordinary 
expenses.  If  state  laws  are  complied  with  and  the  usual  fees 
are  charged  and  paid,  certainly  such  expenses  are  necessary 


"  [Former  Procedure]  For  text  and  criticism  of  past  practice,  see 
Income  Tax  Procedure,   1921,  pages  719-720. 

"'Auditing,  Theory  and  Practice  (3rd  edition),  R.  H.  Montgomery, 
page  576. 


FOR   EXPENSES  909 

to  the  operation  of  the  corporation.  The  fact  that  the  items 
are  not  recurring  ones  seems  to  have  had  something  to  do 
with  the  former  procedure  of  the  Treasury.  Anyone  famihar 
with  corporate  affairs  knows  that  thousands  of  items  occur 
once  only,  but  nevertheless  are  ordinary  and  necessary. 

Expenses  incurred  in  selling  capital  stock. — 

Regulations If    the    stock    is    sold    at    a    discount,    the 

amount  of  the  discount  is  not  a  loss  deductible  from  gross  income. 
.    .    ...      (Art.  543;  Reg.  45,  Art.  542.) 

Any  and  all  expenses  incidental  to  or  connected  with  the  selling 
of  the  capital  stock  (common  or  preferred)  of  a  corporation  for  the 
purpose  of  raising  capital  to  be  by  it  invested  in  property  or  em- 
ployed in  the  business  for  which  the  corporation  is  organized  are  not 
an  "expense  of  operation  and  maintenance"  within  the  meaning  of 
this  title,  and  such  expense  is  not  an  allowable  deduction  from  the 
gross  income,  for  the  reason  that  such  an  expense  is  incurred  in  a 
capital  transaction;  that  is,  the  raising  of  capital  to  be  invested  or 
employed  in  the  business (Reg.  33,  1918,  Art.  145.) 

The  comments  on  organization  expenses"^  apply  to  the 
foregoing  regulation.  Of  course  discounts  on  capital  stock 
are  not  business  expenses;  but  ordinary  expenses  of  securing 
capital  should  not  be  capitalized.  If  it  is  not  proper  to  capital- 
ize an  expense  item  it  should  be  an  allowable  deduction  as  a 
business  expense. 

Regulation A  holding  company  which  guarantees  divi- 
dends at  a  specified  rate  on  the  stock  of  a  subsidiary  corporation  for 
the  purpose  of  securing  new  capital  for  the  subsidiary  and  increas- 
ing the  value  of  its  stock  holdings  in  the  subsidiary  may  not  deduct 
amounts  paid  in  carrying  out  this  guaranty  in  computing  its  net  in- 
come, but  such  payments  may  be  added  to  the  cost  of  its  stock  in  the 
subsidiary (Art.  582.) 

Assessments  on  stock. — The  following  ruling  holds  that 
voluntary  assessments  paid  by  security  holders  are  not  deducti- 
ble by  them  as  business  expense : 

Regulation Amounts  to  be  assessed  and  paid  under  an 

agreement  between  bondholders  or  stockholders  of  a  corporation,  to 

"■'  See  page  907. 


9IO 


DEDUCTIONS 


be  used  in  a  reorganization  of  the  corporation,  are  investments  of 
capital  and  not  deductible  for  any  purpose  in  returns  of  income. 
....  An  assessment  paid  by  a  stockholder  of  a  national  bank  on 

account  of  his  statutory  liability  is  ordinarily  not  deductible 

(Art.  293.) 

Ruling.  The  payment  of  a  statutory  assessment  under  State  law 
against  a  taxpayer  as  a  stockholder  of  a  bank  is  not  a  deductible  loss 
in  the  year  paid  but  is  an  additional  capital  expenditure  which  must 
be  added  to  the  original  cost  of  his  stock.  Gain  or  loss  can  not  be  de- 
termined until  the  stock  is  sold  or  otherwise  disposed  of  in  a  closed 
transaction.     (B.  Digest  30-21-1744;  A.  R.  R.  588.) 

An  answer  to  a  question  in  the  Primer  makes  the  general 
statement  that  "assessments  made  by  a  corporation  on  its 
capital  stock  are  regarded  as  further  investments  of  capital 
and  do  not  constitute  an  allowable  deduction  in  the  return  of 
the  individual."*"' 

If  the  assessments  result  in  losses,  credit  may  be  claimed 
for  the  payments.  If  sustained  prior  to  19 18  the  deductions 
w^ill  be  subject  to  certain  limitations.®^ 

In  another  answer,  the  Primer  states  that  in  the  case  of 
a  mutual  irrigation  company,  "assessments  in  proportion  to 
stockholdings  merely  to  raise  funds  to  keep  the  irrigation 
system  in  usable  condition  and  not  to  make  extensions  or 
betterments"  may  be  deducted.*^* 

Expenses  incurred  in  purchase  of  treasury  stock — part  of 
cost. — 

Ruling.  The  expenses,  exclusive  of  the  purchase  price,  incurred 
by  a  company  in  purchasing  its  own  stock  for  the  purpose  of  retire- 
ment or  holding  as  treasury  stock,  are  not  such  expenses  as  can  be 
classified  as  ordinary  and  necessary  expenses- incurred  in  carrying 
on  the  business,  and  hence  are  not  deductible  from  gross  income. 
These  expenses  are  to  be  considered  part  of  the  purchase  price  of  the 
stock  retired.     (C.  B.  4,  page  286;  O.  D.  852.) 

Legal  payments  by  corporations  fall  into  three  classes :  ( i ) 
capital  expenditures  which  have  a  continuing  benefit,  (2)  pay- 
ments to  stockholders,    (3)   necessary  expenses. 


'Income   Tax  Primer,   1918,  question  70. 

'  See  Chapter  XXIX,  "Deductions  for  Losses." 

'Income  Tax  Primer,  igiS,  question  71. 


FOR  EXPENSES 


911 


If  the  payments  on  account  of  stock  returned  to  the  treas- 
ury are  made  to  stockholders,  the  above  ruHng  is  sound.  If 
the  expenses  are  ordinary  and  necessary,  are  not  distributions 
to  stockholders,  nor  expenses  having  a  continuing  benefit,  they 
should  be  claimed  as  allowable  deductions. 

Deferred  charges — advertising,  etc. — 

Ruling.  A  corporation  conducted  in  its  taxable  year  a  national 
campaign  of  advertising  its  manufactured  product.  Inquiry  is  made 
as  to  whether  this  expense  of  advertising  must  be  charged  off  as  an  op- 
erating expense  during  the  year  in  which  it  was  incurred,  or  whether 
it  can  be  carried  as  a  deferred  asset  and  charged  off  over  a  period 
of  years. 

It  is  held  that  the  expenses  of  such  advertising  campaign  are 
deductible  as  a  business  expense  only  in  the  return  for  the  year  in 
which  such  expenses  were  paid  or  in  the  year  in  which  liability  there- 
for accrued,  if  the  books  of  the  company  are  kept  on  an  accrual  basis. 
(B.  38-21-1829;  O.  D.  1039.) 

It  has  been  the  custom  of  some  concerns  to  spread  extra- 
ordinary expenditures  over  a  period  of  years.  If  the  future 
will  assuredly  receive  some  benefit  therefrom,  the  policy  is 
sound  enough.  (See  "Organization  and  similar  •expenses, 
etc.,"  page  907.)  But  any  doubt  should  always  be  settled  in 
favor  of  an  immediate  absorption.  If  these  expenditures  are 
deductible  at  all,  the  proportion  actually  charged  to  profit  and 
loss  is  the  only  part  which  should  be  deducted  in  the  income 
tax  return.  In  other  words,  it  would  be  improper  to  deduct  all 
expenditures  in  one  year  if  in  the  books  of  account  a  propor- 
tion thereof  was  deferred  to  later  periods. 

Repairs  and  depreciation. — 

Regulation.  The  cost  of  incidental  repairs  which  neither  mate- 
rially add  to  the  value  of  the  property  nor  appreciably  prolong  its 
life,  but  keep  it  in  an  ordinarily  efficient  operating  condition,  may  be 
deducted  as  expense,  provided  the  plant  or  property  account  is  not 
increased  by  the  amount  of  such  expenditures.  Repairs  in  the  nature 
of  replacements,  to  the  extent  that  they  arrest  deterioration  and 
appreciably    prolong   the    life    of    the    property,    should    be    charged 

against  the  depreciation  reserve  if  such  account  is  kept (Art. 

i03-) 


(J  12 


DEDUCTIONS 


The  tendency  of  some  inspectors  is  to  question  deductions 
for  repairs  on  the  theory  that  the  usual  depreciation  allowances 
include  ordinary  maintenance."^  The  law  permits  deductions 
for  maintenance  and  operation  in  addition  to  depreciation. 
The  necessity  for  allowing  both  claims  is  very  well  expressed 
in  a  recent  decision. "^^     The  court  said : 

Decision.  It  will  thus  be  seen  that  the  deductions  allowed  are 
to  include,  not  only  ordinary  and  necessary  amounts  actually  paid 
out  in  the  operation  of  the  property,  but  also  the  amounts  paid  out 
in  the  maintenance  thereof,  and  in  addition  a  reasonable  sum  for 
depreciation,  if  any.  Now,  the  operation  of  a  business  or  property 
includes  payment  for  labor  and  materials  which  go  into  the  actual 
operation  thereof,  while  maintenance  means  the  upkeep  or  preserving 
the  condition  of  the  property  to  be  operated,  and  therefore,  in  my 
judgment,  includes  the  cost  of  ordinary  repairs  necessary  and  proper 
from  time  to  time  for  that  purpose.  "Depreciation,"  as  used  in  the 
statute  is  not  to  be  confused  with  ordinary  repairs.  It  is  intended 
to  cover  the  estimated  lessening  in  value  of  the  original  property,  if 
any,  due  to  wear  and  tear,  decay,  or  gradual  decline  from  natural 
causes,  inadequacy,  obsolescence,  etc.,  which  at  some  time  in  the 
future  will  require  the  abandonment  or  replacement  of  the  property, 
in  spite  of  ordinary  current  repairs. 

Equipment  purchased  on  so-called  rental  plan. — In  many 
cases  equipment  is  purchased  and  title  is  reserved  in  the 
vendors  until  final  payment  is  made.  In  the  meantime  the  pay- 
ments on  account  are  treated  as  rental. 

Technically,  the  payments  may  be  looked  upon  as  expenses 
because  failure  to  pay  the  final  instalment  might  result  in  the 
repossession  of  the  equipment  by  the  vendor,  but  in  the  case  of 
solvent  taxpayers  the  whole  transaction  is  merely  a  purchase 
on  the  instalment  plan.  The  entire  purchase  price  should  be 
set  up  as  an  asset  on  one  side  and  as  a  deferred  liability  on  the 
other.  Depreciation  should  be  written  off  as  if  the  equipment 
were  owned. 

If  the  rentals  are  charged  as  expenses  it  would  be  neces- 


®'  See  Chapter  XXXI,  "Deductions  for  Depreciation." 
'^'*  The  San  Francisco  &  Portland  Steamship  Co.  v.  Scott,  253  Fed.  854. 
(T.  D.  2773,  November  8,  1918.) 


FOR   EXPENSES  913 

sary  to  include  the  entire  purchase  price  (less  depreciation)  as 
taxable  income  for  the  year  when  title  passes. 

Cost  connected  with  title  to  property  not  deductible. — 

Regulation The  cost  of  defending  or  perfecting  title  to 

property  constitutes  a  part  of  the  cost  of  the  property  and  is  not  a 
deductible  expense (Art.  293.) 

The  cost  of  perfecting  title  is  a  proper  capital  charge,  but 
the  cost  of  defending  title  may  not  add  anything  to  the  value 
of  the  property.     If  not,  the  item  is  a  business  expense. 

Expenses    of    obtaining    return    of    property    from    Alien 

Property   Custodian   not   deductible. — 

Ruling.  Attorneys'  fees  paid  for  services  rendered  in  securing 
for  a  non-resident  alien,  the  return  of  property  and  income  from  the 
Alien  Property  Custodian,  are  not  allowable  deductions  from  gross 
income.  If  the  Alien  Property  Custodian  returned  property,  as  dis- 
tinguished from  money,  the  attorneys'  fees  should  be  treated  as  a 
part  of  the  cost  price  of  the  property.  If  the  Alien  Property  Cus- 
todian took  over  property,  converted  it  into  cash,  and  delivered  money 
to  the  taxpayer,  the  attorneys'  fees  constitute  an  offset  against  the 
selling  price.     (B.  Digest  39-21-1842;  O.  D.   1048.) 

It  is  unlikely  that  expenses  incurred  in  connection  with 
the  recovery  of  seized  property  add  to  its  value.  If  not,  such 
expenses  should  be  treated  as  business  expenses. 

Architect's  fee  not  a  business  expense. — 

Regulation The  amount  expended  for  architect's  serv- 
ices is  part  of  the  cost  of  the  building (Art.  293.) 

Cost  of  copyright  and  plates  not  deductible. — 

Regulation Amounts  expended  for  securing  a  copyright 

and  plates,  which  remain  the  property  of  the  person  making  the  pay- 
ments, are  investments  of  capital (Art.  293.) 

In  the  two  foregoing  cases  the  payments  are  properly 
designated  as  capital,  but  it  should  be  noted  that  the  items 
become  allowable  deductions  as  depreciation  when  spread  over 
a  term  of  years. ^^ 


See  Chapter  XXXI. 


914  DEDUCTIONS 

Title  abstract  companies — maintenance  of  records. — 

Rulings.  Title  abstract  companies  incur  relatively  large  and 
continuous  expenditures  in  keeping  their  plants  up  to  date,  such  as 
the  expense  of  adding  and  incorporating  in  the  plant  records  that  are 
being  made  daily  in  the  various  courts  and  in  the  Recorder's  office. 

These  records  which  are  added  to  and  incorporated  in  the  plant 
for  the  purpose  of  keeping  it  in  up  to  date  running  order  and  prevent- 
ing depreciation  are  in  the  nature  of  ordinary  and  necessary  repairs. 
The  expenses,  therefore,  incurred  in  making  such  records  are  current 
expenses,  and  as  such  are  deductible  for  the  year  in  which  incurred 
and  paid  or  accrued. 

Since  a  title  plant  is  not  an  asset  of  a  nature  which  gradually 
approaches  a  point  where  its  usefulness  is  exhausted,  but  is  an  asset 
of  a  more  or  less  permanent  character,  it  is  not  a  proper  subject  of  a 
depreciation  allowance.     (B.  36-21-1799;  O.  D.  1018.) 

The  cost  of  land  title  abstract  books  purchased  is  a  capital 
expenditure.  The  expenditure  for  them  may  not  be  deducted  as  a 
loss  by  reason  of  the  purchaser's  claim  that  they  are  of  no  service 
to  it  because  it  already  owns  another  set  of  the  same  records.  (B. 
39-21-1843;  O.  D.  1049.) 

Carrying  charges  on  real  estate. — A  distinction  must  be 
drawn  between  operating  expenses,  which  can  be  charged  as 
necessary  expenses  of  doing  business,  and  expenses  which  arise 
when  there  is  no  going  business  which  can  be  charged. 

Unproductive  real  estate  is  a  case  in  point.  There  may 
be  taxes,  interest  and  other  items  of  expense  to  be  taken  care 
of  and  no  income  out  of  which  the  payments  can  be  made. 

Capital  must  be  used  to  make  the  payments,  and  in  the 
circumstances  the  items  will  be  regarded  as  capital  expendi- 
tures. As  soon  as  a  property  is  being  operated  or  used  the 
capitalization  of  charges  must  cease,  even  though  the  property 
is  being  operated  at  a  loss.  If  a  property  is  only  partly  op- 
erated the  charges  may  be  partly  capitalized. 

When  several  properties  are  under  one  ownership,  it  is 
the  custom  to  absorb  the  charges  on  the  unproductive  prop- 
erties in  the  surplus  *  income  from  productive  property. 
There  is  no  objection  to  this  from  a  conservative  accounting 
point  of  view.  As  long  as  capital  gains  were  subject  to  high 
surtaxes,  it  was  in  many  cases  to  the  taxpayer's  advantage  to 


I 


FOR   EXPENSES  915 

capitalize  expenses  on  unproductive  property,  rather  than  to 
charge  them  off  immediately,  so  as  to  minimize  the  amount 
to  be  reported  as  taxable  profit  in  the  year  of  sale.  With  the 
low  rate  of  tax  on  capital  gains,  however,  it  will  now  be  to  the 
advantage  of  the  taxpayer  to  have  the  profit  on  realization 
as  large  as  possible  and  to  get  credit  from  year  to  year  against 
income  subject  to  high  surtax  rates  for  the  carrying  charges. 

Payments  for  goodwill  not  an  expense. — In  some  cases 
payments  are  made  which  are  of  the  nature  of  goodwill  rather 
than  expenses.  Such  payments  should  not  be  claimed  as  de- 
ductions even  though  it  is  decided  that  they  should  not  be 
capitalized.  Payments  to  a  retiring  partner,  when  in  excess 
of  reasonable  compensation  for  services  rendered,  should  be 
charged  to  goodwill  and  not  to  expenses. 

Payments  under  leases  or  to  officers  of  corporations  in 
excess  of  reasonable  compensation  for  the  use  of  property, 
or  for  services,  are  not  ordinary  or  necessary  expenses  of  a 
business. 

Payments  which  properly  are  chargeable  either  to  expenses 
or  to  capital,  such  as  development  and  establishment  expendi- 
tures, should  not  be  charged  on  the  books  as  expenses  unless 
it  is  proposed  to  claim  credit  therefor  as  allowable  deductions. 

Miscellaneous 

Lobbying  expenses  and  campaign  contributions  not  de- 
ductible.— 

Regulation Sums  of  money  expended  for  lobbying  pur- 
poses, the  promotion  or  defeat  of  legislation,  the  exploitation  of  prop- 
aganda, inchxding  advertising  other  than  trade  advertising,  and  con- 
tributions for  campaign  expenses,  are  not  deductible  from  gross  in- 
come.    (Art.  562.) 

Lobbying  expenses  will  probably  appear  under  legal  ex- 
penses and  will  no  doubt  be  allowed.  In  the  case  of  corpora- 
tions, campaign  contributions  are  illegal  and  should  not  ap- 
pear in  the  books.     The  words  "advertising  other  than  trade 


9l6  DEDUCTIONS 

advertising"  were  not  used  in  Regulations  33  which  were  in 
force  until  1919.  Advertising  Liberty  bonds  certainly  is  not 
trade  advertising,  but  has  been  allowed.  It  would  be  held 
that  any  advertising  for  the  good  of  a  business  would  be  an 
allow^able  deduction. 

Trading    stamps    expenditure    a    business    expense. — The 

Treasury  in  the  Regulations  45  and  62  has  provided  in  a  very 
definite  manner  for  the  deduction  of  trading  stamp  expense,  in 
effect  reversing  the  earlier  ruling  that  a  reserve  set  up  as  a 
liability  equal  to  the  redemption  value  of  the  stamps  is  not 
deductible. '° 

Regulation.  Where  a  taxpayer,  for  the  purpose  of  promoting 
his  business,  issues  with  sales  trading  stamps  or  premium  coupons 
redeemable  in  merchandise  or  cash,  he  should  in  computing  the  in- 
come from  such  sales  subtract  only  the  amount  received  or  receiv- 
able which  will  be  required  for  the  redemption  of  such  part  of  the 
total  issue  of  trading  stamps  or  premium  coupons  issued  during  the 
taxable  year  as  will  eventually  be  presented  for  redemption.  This 
amount  will  be  determined  in  the  light  of  the  experience  of  the  tax- 
payer in  his  particular  business  and  of  other  users  engaged  in  similar 
businesses.  The  taxpayer  shall  file  for  each  of  the  five  preceding 
years,  or  such  number  of  these  years  as  stamps  or  coupons  have 
been  issued  by  him,  a  statement  showing  (o)  the  total  issue  of  stamps 
during  each  year,  (6)  the  total  stamps  redeemed  in  each  year,  and 
(c)  the  percentage  for  each  year  of  the  stamps  redeemed  to  the 
stamps  issued  in  such  year.  A  similar  statement  shall  also  be  pre- 
sented showing  the  experience  of  other  users  of  stamps  or  coupons 
whose  experience  is  relied  upon  by  the  taxpayer  to  determine  the 
amount  to  be  subtracted  from  the  proceeds  of  sales.  The  Commis- 
sioner will  examine  the  basis  used  in  each  return,  and  in  any  case 
in  which  the  amount  subtracted  in  respect  of  such  stamps  or  coupons 
is  found  to  be  excessive  an  amended  return  or  amended  returns  will 
be  required.     (Art.  91;  Reg.  45,  Art.  88.) 

In  effect  the  foregoing  regulation  permits  the  deducting 
of  reserves  set  up  for  trading  stamps.  Likewise,  similar  re- 
serves should  be  allowed  for  cash  discounts  because  the  same 
principle  is  involved.      (See  page  451.) 


'"  [Former  Procedure]       A  reserve  set  up  was  not  deductible  under 
an  earlier  regulation.     (Reg.  33,   1918,  Art.   141.) 


FOR  EXPENSES 


917 


Maintenance  funds  required  by  law  should  be  deductible. — 

Ruling.  Payments  to  trustees  by  a  cemetery  corporation  during 
the  taxable  year  of  a  certain  percentage  of  the  proceeds  of  sales  of 
cemetery  lots  set  aside  for  a  maintenance  fund  to  be  controlled  solely 
by  the  trustees  thereof  are  not  deductible  from  the  gross  income  of 
the  corporation  even  though  such  payments  are  required  by  state 
law.     (C.  B.  2,  page  216;  O.  D.  529.) 

The  author  is  of  the  opinion  that  the  foregoing  ruling  is 
erroneous,  and  that  it  should  be  changed  to  accord  with  the 
principle  laid  down  in  article  567/^  whereby  banking  corpora- 
tions are  allowed  to  deduct  "depositors'  guaranty  funds"  when 
such  funds  are  required  by  law. 

Dues  paid  to  chambers  of  commerce  and  associations  de- 
ductible.— 

Ruling.  Membership  fees  or  dues  paid  by  individuals  and  cor- 
porations to  a  chamber  of  commerce  or  board  of  trade  are  deductible 
from  gross  income  as  a  business  expense  provided  the  membership 
is  employed  as  a  means  of  advancing  the  business  interests  of  the 
individual  or  corporation.     (C.  B.  2,  page  105;  O.  D.  421.) 

Likewise,  fees  paid  to  trade  associations  to  promote  the 
g'eneral  business  interests  are  also  deductible." 


& 


Payments  for  baseball  players. — 

Ruling.  An  amount  paid  by  a  baseball  club  to  another  baseball 
club  as  the  purchase  price  of  a  contract  between  such  club  and  a  player 
covering  the  services  of  the  player  for  a  period  of  more  than  one 
year  is  deductible  from  gross  income  during  the  life  of  the  contract, 
a  proportionate  part  of  the  price  paid  being  deductible  each  year. 
(C  B.  4,  page  142;  O.  D.  836.) 


Dues  paid  to  labor  unions. — 

Ruling.  Dues  paid  by  an  individual  to  an  organized  labor  union 
are  deductible  as  a  business  expense  in  computing  his  net  income  for 
income-tax  purposes.     (C.  B.  2,  page  105;  O.  D.  450.) 


"  See  page  902. 

"C.  B.  2,  page  I  OS;  O.  D.  496. 


9l8  DEDUCTIONS 

Fees  paid  to  secure  employment. — 

Ruling.  Fees  paid  to  secure  employment  are  considered  allow- 
able deductions  for  the  purpose  of  computing  net  Income  subject  to 
tax.     (C.  B.  3,  page  130;  O.  D.  579.) 


Bonus  paid  for  an  early  delivery  of  steamship. — 

Ruling.  A  bonus  was  paid  for  the  delivery  of  a  steamship  at 
a  date  earlier  than  that  stipulated  in  the  contract  for  its  construction 
and  the  question  is  presented  whether  the  amount  is  properly  charge- 
able as  a  business  expense  or  as  a  capital  expenditure. 

Held,  that  as  the  bonus  paid  for  delivery  at  a  date  earlier  than 
that  contracted  for  added  nothing  to  the  value  of  the  vessel  after 
the  contract  date  of  delivery  the  amount  so  paid  is  properly  charge- 
able as  a  business  expense  and  is  deductible  from  income  received 
between  the  date  of  delivery  of  the  vessel  and  the  date  it  would  have 
been  delivered  had  no  bonus  been  paid.    (C.  B.  3,  page  131 ;  O.  D.  664.) 


Earnings  paid  city,  etc.,  by  public  utility  an  expense. — 

Regulation In  the  case  of  a  public  utility  acquired,  con- 
structed, operated,  or  maintained  by  a  taxpayer  under  contract  with 
any  State,  Territory,  or  political  subdivision  thereof,  or  with  the  Dis- 
trict of  Columbia,  containing  an  agreement  that  a  portion  of  the  net 
earnings  of  such  public  utility  shall  be  paid  to  the  State,  Territory, 
or  political  subdivision  thereof,  or  the  District  of  Columbia,  the 
amount  so  paid  may  be  deducted  by  the  taxpayer  as  a  necessary  ex- 
pense in  transacting  business (Art.  87;  Reg.  45,  Art.  84.) 

Payments  by  railroads  to  Interstate  Commerce  Commis- 
sion.— 

Ruling.  Under  the  provisions  of  section  15 — A  of  the  Interstate 
Commerce  Act,  as  amended  by  the  Transportation  Act  approved  Feb- 
ruary 29,  1920,  railroad  corporations  are  required  to  pay  to  the  Inter- 
state Commerce  Commission  one-half  of  their  net  raihvay  operating 
income  in  excess  of  6  per  cent  on  their  invested  capital.  It  is  under- 
stood that  such  payments  are  absolute,  the  railroad  company  having 
no  present  or  future  rights  therein. 

Held,  that  any  sum  so  paid  may  be  deducted  in  the  taxable  year  in 
which  paid  or  accrued,  dependent  upon  whether  the  books  of  the 
corporation  are  kept  upon  a  cash  receipts  and  disbursements  or  ac- 
crual basis.      (B.  32-21-1762;  O,  D.  989.) 


1 


FOR   EXPENSES  919 

Amounts  paid  on  judgments  or  other  binding  adjudica- 
tions.— 

Regulation Judgments  or  other  binding  adjudication, 

such  as  decisions  of  referees  and  boards  of  review  under  workmen's 
compensation  laws,  on  account  of  damages  for  patent  infringement, 
personal  injuries,  or  other  cause,  are  deductible  from  gross  income 
when  the  claim  is  so  adjudicated'^  or  paid,  unless  taken  under  other 
methods  of  accounting  which  clearly  reflect  the  correct  deductions, 
less  any  amount  of  such  damages  as  may  have  been  compensated  for 
by  insurance  or  otherwise (Art.  ill.) 

The  present  regulations  are  very  definite  in  holding  that 
losses  which  occur  in  one  year  and  which  are  not  discovered 
until  a  later  year  cannot  be  deducted  in  the  later  year,  but 
are  only  deductible  as  of  the  time  when  they  actually  occurred. 
The  principle  applies  to  all  kinds  of  expenses.  Exception  is 
made  only  for  overlapping  items  which  do  not  materially  dis- 
turb the  income  for  any  one  year.  The  regulation  has  some 
merit  and  should  be  followed  in  most  cases,  but  greater  lati- 
tude should  be  given  to  taxpayers.  If,  in  the  opinion  of  the  lat- 
ter, true  net  income  for  the  taxable  year  can  be  stated  by  charg- 
ing items  as  an  expense  during  the  taxable  year,  taxpayers 
should  not  be  forced  to  make  amended  returns  for  prior  years. 


"  [Former  Procedure] 

Ruling.  A  corporation  was  sued  for  infringing  a  trade-name  cov- 
ering a  period  ending  in  1912.  Judgment  was  obtained  in  1916,  The 
Treasury  Department  holds  that  the  amount  of  this  judgment  should 
be  prorated  over  the  period  ending  in  1912,  according  to  the  income 
of  each  year.  Such  part  of  it  as  by  this  method  is  found  applicable 
to  the  income  of  the  corporation  for  the  period  1909  to  1912,  would  be 
referable  to  those  years  but  no  part  of  this  sum  would  be  deductible 
in  the  return  of  income  for  1916. 

The  same  corporation  also  paid  in  1916  an  additional  sum  as  con- 
sideration for  dismissal  of  a  pending  suit  for  interest  on  the  above 
judgment  from  the  date  of  the  decision  of  the  Circuit  Court  of  Ap- 
peals to  the  date  of  payment  and  for  the  unrestrained  use  of  the  trade- 
name in  question.  The  Treasury  Department  holds  that  if  this 
amount  "can  be  segregated  between  interest  and  use,  it  would  be  treated 
the  same  as  in  the  other  case,  for  the  period  subsequent  to  1912,  and  such 
part  thereof  as  shall  be  thus  found  applicable  to  the  1916  income  would 
be  deductible  in  the  return  of  income  for  that  year  under  the  respective 
heads  of  "business  expense"  and  "interest,"  and  if  segregation  has  not  been 
or  cannot  be  made,  the  entire  amount  may  be  treated  as  "business  expense" 
to  be  prorated  as  above  indicated."  (Substance  of  letter  to  The  Cor- 
poration Trust  Company,  signed  by  Commissioner  W.  H.  Osborn  and 
dated  February  9,  1917.) 


920 


DEDUCTIONS 


The  inevitable  result  would  be  that  for  years  to  come  taxpayers 
will  be  finding  that  expenses,  which  ordinarily  would  and 
should  be  charged  to  current  operating  accounts,  occurred  dur- 
ing the  years  1918  and  19 19  when  the  tax  rates  were  very  high 
and,  acting  under  the  letter  of  the  regulations,  amended  re- 
turns will  be  made  with  a  resulting  saving  in  tax. 

The  1922  regulations  appear  to  modify  the  rule  in  cases 
when  taxpayers  have  actually  provided  in  prior  periods  for 
losses  finally  determined  in  later  years.  It  is  provided  that 
judgments,  etc.,  are  deductible  in  the  years  when  paid  "unless 
otherwise  provided  for  by  the  taxpayer's  method  of  account- 
ing." It  is  to  be  hoped  that  this  refers  to  reserves  which  have 
been  set  up  for  accruing  and  estimated  losses  and  liabilities 
set  up  in  good  faith  in  order  to  reflect  true  net  income. 

Deductions  for  probable  but  uncertain  expenses. — 

Ruling.  A  report  of  a  master  in  chancery,  appointed  by  an 
interlocutory  decree  in  a  suit  for  damages  for  alleged  infringement 
of  a  patent,  assessing  damages  against  the  taxpayer,  which  report 
was  filed  during  the  taxable  year,  but  was  not  confirmed  until  the 
following  year  when  judgment  was  entered  on  the  report,  can  not 
be  regarded  as  a  determination  of  the  amount  of  the  claim,  and  no 
deduction  for  the  taxable  year  is  permissible  in  regard  to  the  judg- 
ment referred  to.     (C.  B.  i,  page  207;  S.  923.) 

The  question  involved  in  the  foregoing  is  a  difficult  one  to 
discuss.  If  it  appears  that  an  expense  has  been  incurred  but 
its  amount  is  doubtful,  good  accounting  practice  and  con- 
servative business  methods  demand  that  an  estimate  be  made 
and  entered  in  the  books.  It  would  be  a  dangerous  practice 
to  omit  a  liability  from  the  books  merely  because  the  exact 
amount  thereof  was  unknown.  The  law  permits  the  deduction 
of  necessary  business  expenses  and  expressly  approves  the 
accrual  system  of  accounting.  It  is  therefore  safe  to  assume 
that  when  during  a  taxable  year  an  expense  has  been  incurred 
or  when  it  is  so  probable  that  an  expense  has  been  incurred 
that  good  practice  requires  the  setting  up  of  the  transaction 
as  a  liability,  the  amount  of  the  expense  (even  though  it  is  an 


FOR   EXPENSES  921 

estimate)  when  entered  in  the  books  in  good  faith  will  be 
held  by  the  courts  to  be  deductible  in  the  same  period.  The 
controlling  idea  is  that  the  income  of  a  future  period  should 
never  have  to  bear  expenses  w'hich  belong  to  a  past  period. 
The  law  need  not  be  amended  to  effect  this.  The  author 
has  no  serious  criticism  to  make  of  the  practice  of  requir- 
ing amended  returns  so  long  as  the  Treasury  is  consist- 
ent, but  in  no  case  should  substantial  expenses  and  losses 
applicable  to  a  past  period  be  carried  forward  to  a  subsequent 
period  when  the  taxpayer  has  made  provision  for  such  ex- 
penses in  the  period  to  which  the  expenses  are  chargeable. 

Ruling.  A  reserve  to  cover  a  contingent  liability,  representing 
an  estimated  amount  of  claims  actually  outstanding  at  the  close  of  the 
year,  which  will  be  paid  on  account  of  loss  and  damage  to  freight 
and  injuries  to  persons,  is  not  dcductiljle.  Such  amounts  are  de- 
ductible only  for  the  year  when  the  claims  are  put  in  judgment  or 
paid.     (C.  B.  4,  page  142;  O.  D.  879.) 

Payments  to  trustee  for  the  ultimate  benefit  of  the  tax- 
payer not  deductible. — 

Ruling.  Pursuant  to  the  requirements  of  its  by-laws  a  corpora- 
tion entered  into  a  trust  agreement  under  the  terms  of  which  a  sum 
amounting  to  not  less  than  a  certain  per  cent  of  the  corporation's 
paid-in  capital  stock  must  be  turned  over  to  the  trustee  annually  until 
a  fund  has  accumulated  amounting  to  x  dollars,  inclusive  of  the  in- 
terest which  is  required  to  be  added  to  the  principal,  when  the  income 
therefrom  is  to  be  turned  over  annually  to  an  executive  committee 
of  the  corporation  for  a  purpose  related  to  the  business  of  the  cor- 
poration. 

Held,  that  the  amounts  paid  to  the  trustee  by  the  corporation  are 
not  deductible  from  its  gross  income. 

The  interest  accruing  to  the  fund  is  income  of  the  corporation 
which  should  be  reported  by  it  in  its  return.  (B.  Digest  39-21-1840; 
O.   D.   1047.) 

Attorney's  fees  paid  by  maker  of  illegal  sales,  not  deduc- 
tible.— Attorney's  fees  paid  by  a  proprietor  of  a  retail  busi- 
ness, who  was  fined  and  imprisoned  for  making  illegal  sales, 
have  been  held  to  be  personal." 


C.  B.  4,  page  209;  O.  D.  952. 


922 


DEDUCTIONS 


The  foregoing  ruling  holds  in  effect  that  gross  income 
earned  illegally  is  taxable.  The  theory  may  be  commendable 
but  it  is  doubtful  if  the  ruling  is  sound.  If  it  is,  many  other  de- 
ductions arising  from  illegal  transactions  would  not  be  de- 
ductible. 

It  has  also  been  held  that  a  fine  paid  by  a  corporation  for 
violation  of  the  Anti-Trust  Act  is  not  deductible  as  an  ordinary 
and  necessary  expense." 

'=1-4-45;  I.  T.  1174. 


CHAPTER    XXVII 

DEDUCTIONS  FOR  INTEREST 

The  passage  of  the  191 8  law  greatly  simplified  the  pro- 
cedure for  deducting  interest  paid.  Previous  laws  had  im- 
posed restrictions  upon  corporation  deductions  for  this  purpose, 
making  it  necessary  to  distinguish  interest  payments  very 
sharply  from  other  payments.^  The  only  change  in  the  1921 
law  is  that  the  restriction  on  interest  paid  to  carry  tax-exempt 
securities  is  extended  to  Victor}^  3^  per  cent  notes  not  owned 
by  original  subscribers. 

Deductions  allowed  to  individuals. — 

Law.  Section  214.  (a)  .  .  .  .  (2)  All  interest  paid  or  accrued 
within  the  taxable  year  on  indebtedness,  except  on  indebtedness  in- 
curred or  continued  to  purchase  or  carry  obligations  or  securities 
(other  than  obligations  of  the  United  States  issued  after  September 
24,  1917,  and  originally  subscribed  for  by  the  taxpayer)  the  interest 
upon  which  is  wholly  exempt  from  taxation  under  this  title;-    .... 

Deductions  allowed  to  corporations.^ — 

Law.  Section  234.  (a)  ....  (2)  All  interest  paid  or  accrued 
within  the  taxable  year  on  its  indebtedness,  except  on  indebtedness  in- 


'  The  arbitrary  restriction  imposed  by  the  1913  and  subsequent  laws, 
its  effect  and  the  proper  method  of  arranging  the  accounts  in  order  to 
prevent  unnecessary  burdens  are  fully  discussed  in  Income  Tax  Procedure, 
1919,  pages  454-463- 

"  [Former  Procedure] 

1917  Law.  Section  5.  "(a)  ....  Second.  All  interest  paid  within 
the  year  on  his  indebtedness  except  on  indebtedness  incurred  for  the  pur- 
chase of  obligations  or  securities  the  interest  upon  which  is  exempt  from 
taxation  as  income  under  this  title ;...." 

This  restriction  was  introduced  by  the  1917  law.  Before  that  time 
an  interest  deduction  was  not  disallowed  because  incurred  for  the  pur- 
chase of  tax-exempt  securities.  The  1918  law  introduced  the  words  "or 
carry"  in  speaking  of  tax-exempt  securities. 

^For  a  discussion  of  the  limitation  which  formerly  applied  in  the  case 
of  corporations,  see  Excess  Profits  Tax  Procedure,  1921. 


924 


DEDUCTIONS 


curred  or  continued  to  purchase  or  carry  obligations  or  securities  (other 
than  obligations  of  the  United  States  issued  after  September  24,  1917, 
and  originally  subscribed  for  by  the  taxpayer)  the  interest  upon  which 
is  wholly  exempt  from  taxation  under  this  title;   .... 

Regulation.  Interest  paid  or  accrued  within  the  year  on  in- 
debtedness may  be  deducted  from  gross  income,  except  that  interest 
on  indebtedness  incurred  or  continued  to  purchase  or  carry  securi- 
ties, such  as  municipal  bonds  and  first  Liberty  loan  3^^  per  cent  bonds, 
the  interest  upon  which  is  wholly  exempt  from  tax,  is  not  deductible. 
This  exception,  however,  does  not  apply  in  the  case  of  3%  per  cent 
Victory  notes  originally  subscribed  for  by  the  taxpayer,  and  interest 
on  indebtedness  incurred  to  purchase  or  carry  such  notes  is  deduct- 
ible. Since  other  obligations  of  the  United  States  issued  after  Sep- 
tember 24,  19 17,  are  not  wholly  exempt  from  taxation  under  this  title, 
interest  paid  on  indebtness  incurred  or  continued  to  purchase  such 
obligations  (whether  or  not  originally  subscribed  for  by  the  tax- 
payer) is  deductible  in  accordance  with  the  general  rule.     (Art.  121.) 

This  article  has  been  changed  so  as  to  provide  for  the  change 
in  the  deductibiHty  of  interest  paid  to  carry  3%%  Victory 
notes. 

Interest  which  is  deductible. — Ah  interest  paid  on  indebted- 
ness by  an  individual  or  a  corporation  is  deductible,  except 
interest  paid'  on  money  borrowed  to  purchase  or  carry  certain 
securities  the  interest  upon  which  is  wholly  exempt  from  taxa- 
tion. 

United  States  obligations  issued  prior  to  September  24, 
19 1 7,  including  first  or  3^  per  cent  Liberty  bonds,  are  ex- 
empt from  taxation  and  interest  on  money  borrowed  to  pur- 
chase or  carry  such  obligations  is  not  deductible.  This  date, 
September  24,  19 17,  marked  a  change  in  policy  by  the  United 
States  government.  The  understanding  was  that  after  that 
date  securities  entirely  exempt  from  taxation  were  not  to  be 
issued,  and,  consequently,  the  restriction  on  the  deduction  for 
interest  w^as  not  applied  to  interest  paid  on  money  borrowed  to 
carry  obligations  of  the  United  States  issued  thereafter.*    The 


*  [Former  Procedure]  The  1917  law  did  not  allow  as  a  deduction 
interest  paid  on  indebtedness  incurred  for  the  purchase  of  obligations 
of  the  United  States  issued  after  September  24,  1917,  to  the  extent  to 


FOR   INTEREST 


925 


3^^  per  cent  Victory  notes  issued  in  19 19  are  entirely  free 
from  taxation.  Sections  214  and  234  of  the  192 1  law  provide 
that  interest  on  money  borrowed  to  purchase  or  carry  the  3^ 
per  cent  notes  is  deductible  in  income  tax  returns  only  when 
the  notes  are  in  hands  of  original  purchasers.  When  the  cam- 
paign for  their  sale  was  being  made,  one  of  the  most  potent 
arguments  used  was  that  a  taxpayer  who  had  a  large  income 
from  other  sources  might  borrow  money  to  buy  the  tax-exempt 
Victory  notes  and  secure  a  net  return  on  a  margin  of  10  per 
cent  invested  in  the  bonds  of  as  much  as  26  per  cent  per  annum. 
In  some  cases  banks  advanced  100  per  cent  of  the  amount  re- 
quired to  buy  the  bonds  and  represented  to  taxpayers  that  they* 
would  realize  a  large  profit  (through  the  reduction  in  taxes) 
without  any  investment.  The  size  of  the  savings,  of  course, 
depended  on  several  factors:  (i)  the  market  price  of  the 
notes;  (2)  the  margin  required;  (3)  the  rate  of  interest 
charged  by  banks  on  the  loans;  and  (4)  the  size  of  the  tax 
rate. 

In  disallowing  the  deduction  of  interest  paid  to  carry  Vic- 
tory notes  other  than  original  subscriptions,  the  Treasury  can- 
not be  accused  of  a  breach  of  faith  because  the  representations 
made  were  only  in  connection  with  the  original  subscriptions 
to  the  various  issues  after  the  first.     The  mere  fact  that  other 


which  an}-^  part  of  the  interest  from  such  obligationis  was  tax-exempt. 
The  1917  law  entirely  omitted  the  reference  to  obligations  of  the 
United  States,  and  it  was  therefore  held  that  any  interest  paid  on 
indebtedness  in  respect  of  the  $5,000  of  second  Liberty  bonds  (the 
interest  on  which  principal  amount  of  bonds  was  exempt)  was  not 
deductible.  This  restriction  was  made  effective  by  the  following 
directions  in  section  E,  page  2  of  income  tax  form  1040  (revised  Jan- 
uary, 1 91 8)  : 

Interest  on  bonds  and  other  obligations  of  the  United  States 
ISSUED  SINCE  September  i,  1917. — 

Interest  paid.  "If  indebtedness  has  been  incurred  for  the  purchase 
of  such  obligations,  find  what  percentage  the  amount  of  such  obligations 
held  in  excess  of  $5,000  is  of  the  total  amount  of  such  obligations  held, 
and  enter  in  column  5  the  same  percentage  of  the  interest  paid  on  the 
indebtedness." 

Under  the   1918  law  interest  paid  on  money  borrowed  to  purchase 
or  carry  Victory  3^  per  cent  notes  was  fully  deductible. 


926  DEDUCTIONS 

than  original  subscribers  were  given  the  same  advantage  under 
the  19 18  law  was  really  a  gift  by  Congress,  which  it  was  quite 
at  liberty  to  withdraw  at  any  time  on  reasonable  notice. 

It  is  urged  that  Congress  commits  a  distinct  breach  of 
faith  in  retroactively  taking  away  the  deduction,  that  it  should 
have  been  continued  at  least  until  the  act  containing  its  repeal 
was  introduced  in  Congress. 

Interest  on  scrip  dividends  deductible. — 

Regulation.  Interest  paid  by  a  corporation  on  scrip  dividends 
is  an  allowable  deduction.  ..... 

.     Interest  on  certificates  of  deposit  deductible. — 

....  In  the  case  of  banks  and  loan  or  trust  companies,  interest  paid 
within  the  year  on  deposits  or  on  moneys  received  for  investment 
and  secured  by  interest-bearing  certificates  of  indebtedness  issued  by 
sucli  bank  or  loan  or  trust  company  may  be  deducted  from  gross 
income.     (Art.  564.) 

Interest  on  real  estate  mortgage  deductible. — 

Regulation Interest  paid  by  the  taxpayer  on  a  mortgage 

upon  real  estate  of  wliich  he  is  the  legal  or  equitable  owner,  even 
though  the  taxpayer  is  not  directly  liable  upon  the  bond  or  note  se- 
cured by  such  mortgage,  may  be  deducted  as  interest  on  his  indebted- 
ness  (Art.  121.) 

Should  discount  on  bonds  be  treated  as  payment  of 
interest  ? — Bonds  usually  sell  at  a  discount  because  the  inter- 
est is  fixed  at  a  lower  rate  than  the  purchasers  of  the  bonds 
think  the  debtor  corporation  should  pay.  Under  proper  ac- 
counting methods  the  discount  is  distributed  ratably  over  the 
life  of  the  bonds.  The  annual  interest  paid  plus  the  annual 
proportion  of  discount  together  form  the  true  cost. 

Regulation If  it   [a  corporation]   sells  its  bonds  at  a 

discount,  the  amount  of  such  discount  is  treated  in  the  same  way  as 
interest  paid,     ....      (Art.  563:) 

The  Treasury  in  the  past  treated  the  discount  as  a  loss;* 
therefore  the  discussion  of  bond  discounts  as  a  deduction  will 
be  found  in  Chapter  XXIX,  "Losses." 


'Article  135,  Regulations  No.  33. 


FOR   INTEREST  927 

Bank  of  deposit  may  deduct  interest  paid  on  de- 
posits EVEN  THOUGH  MOST  OF  THE  ASSETS  CONSIST  OF  TAX- 
EXEMPT  BONDS. — An  interesting  question  arises  in  the  case 
of  a  bank  which  pays  interest  on  deposits  and  invests  most  of 
its  assets  in  tax-exempt  bonds.  A  bank  had  capital  and  sur- 
plus of  $1,000,000  and  deposits  of  $10,000,000.  Its  funds 
were  so  invested  that  the  income  was  as  follows : 

From  tax-exempt  sources    (chiefly  municipals)  .  .     $300,000 
From  other  sources 350,000 

Total  income   $650,000 

Expenses : 

Interest  paid  to  depositors $250,000 

Expenses   100,000       350,000 

Net  income $300,000 


The  interest  from  tax-exempt  bonds  not  being  returnable 
the  bank  was  not  subject  to  the  federal  income  tax. 

Ruling.  It  is  the  ruling  of  this  office  that  a  bank  doing  a  com- 
mercial business  and  receiving  deposits  upon  which  it  pays  interest  is 
entitled  to  deduct  from  its  gross  income  shown  upon  its  annual  tax 
return  the  full  amount  of  interest  paid  to  its  depositors.  The  pay- 
ment of  such  interest  is  one  of  the  ordinary  and  necessary  expenses 
in  the  carrying  on  of  its  banking  business.  Although  the  deposits 
constitute  indebtedness  of  the  bank,  such  indebtedness  was  not  in- 
curred and  is  not  continued  for  the  purpose  of  purchasing  or  carrying 
obligations,  even  though  the  deposits  are  invested  in  bonds  or  other 
obligations  the  interest  upon  which  is  wholly  exempt  from  income  and 
excess  profits  tax.  (Letter  to  Lybrand,  Ross; Bros.  &  Montgomery, 
signed  by  Commissioner  Roper,  June  24,  1919.) 

Interest  on  overdue  federal  taxes  is  deductible. — 
Interest  accrues  very  rapidly  on  assessments  of  additional  taxes 
for  191 7  and  prior  years  which  are  the  subject  of  claims  in 
abatement.  Many  taxpayers,  when  additional  taxes  are  paid, 
treat  the  entire  payments  as  tax  payments.  Since  federal  taxes 
are  not  allowable  deductions  but  interest  is  fully  deductible,  it 
is  important  to  separate  the  payments. 

Ruling.    Interest  paid  or  accrued  under  the  provisions  of  section 


928  DEDUCTIONS 

250  (a),  (b)  and  (c),  Revenue  Act  of  1918  is  deductible  under  the 
provisions  of  section  214  (a)  2  or  section  234  (a)  2  in  computing-  net 
income.     (C.  B.  2,  page  227;  O.  922.) 

State  taxes  deductible  as  interest — when? — Not- 
withstanding the  phrase  '*or  any  other  tax  paid  pursuant  to 
the  contract"*'  a  regulation  has  been  issued  stating  that  a  cor- 
poration paying  a  state  tax  or  any  other  than  a  federal  tax 
for  someone  else  pursuant  to  its  agreement  may  deduct  such 
payment  as  interest  paid  on  indebtedness.  This  regulation 
is  as  follows: 

Regulation.  Corporations  may  deduct  taxes  from  gross  income 
to  the  same  extent  as  individuals,  except  that  in  the  case  of  corporate 
bonds  or  obhgations  containing  a  tax-free  covenant  clause,  the  cor- 
poration paying  a  Federal  tax,"  or  any  part  of  it,  for  some  one  else 
pursuant  to  its  agreeemnt  is  not  entitled  to  deduct  such  payment 
from  gross  income  on  any  ground.  In  the  case,  however,  of  cor- 
porate bonds  or  obligations  containing  an  appropriate  tax-free  cove- 
nant clause,  the  corporation  paying  a  State  tax  or  any  other  than  a 
Federal  tax  for  some  one  else  pursuant  to  its  agreement  may  deduct 
such  payment  as  interest  paid  on  indebtedness.^     (Art.  565.) 

The  foregoing  is  an  unusually  liberal  interpretation  of  the 
law. 

Bank  charges  on  tax-exempt  obligations  may  be  de- 
ducted.— 

Ruling.  Interest  paid  by  a  contractor  on  funds  advanced  by  a 
bank  and  discount  charged  by  the  bank  for  cashing  municipal  certi- 
ficates of  indebtedness  are  deductible  from  gross  income.  (B.  34-21- 
1778;  O.D.  999.) 

Interest  on  dividends  paid  by  court  order  deduc- 
tible.— 

Ruling.  Where  a  court  of  original  jurisdiction  entered  a  decree 
in  1917  requiring  a  corporation  to  distribute  dividends,  and  upon  an 


'  Section  234   (a-3). 

'  [Former  Procedure]  In  the  earlier  edition  of  Regulations  45  in 
place  of  the  phrase  "paying  a  federal  tax"  there  appears  this  expression 
"paying  a  tax  ....  whether  federal,  state  or  otherwise."  The  regulation 
was  inaccurate  as  state  taxes  are  and  always  have  been  deductible. 

*  Tax  paid  under  a  tax-free  covenant  clause  is  not  to  be  included  in  the 
gross  income  of  the  obligee.     See  page  678. 


FOR   INTEREST  929 

appeal  the  decree  was  affirmed  by  a  court  of  last  resort,  which  in  ad- 
dition to  confirming  the  decree  of  the  lower  court  awarded  interest 
on  the  amount  of  the  dividends  from  the  date  of  the  decree  of  the 
lower  court  to  the  date  of  payment,  such  interest  is  deductible  from 
the  gross  income  of  the  corporation  for  the  year  in  which  paid,  .... 
(C.  B.  4,  page  141;  O.  D.  778.) 

Interest  on  construction  is  deductible  if  not  capi- 
talized.— 

Ruling.  Interest  and  taxes  paid  by  a  corporation  in  connection 
with  the  construction  of  its  original  plant  are  deductible  from  its 
gross  income  under  the  Revenue  Act  of  1913,  even  though  such  pay- 
ments are  properly  chargeable  to  capital  account  and  are  so  charged 
by  the  corporation  on  its  books,  provided  the  corporation  amends 
its  returns  so  as  to  exclude  the  interest  and  taxes  so  deducted  from 
capital  account.     (C.  B.  i,  page  109;  S.  935.) 

Interest  which  is  not  deductible. — Generally  speaking,  the 
only  interest  on  borrowed  money  which  is  not  deductible  is 
that  paid  on  indebtedness  created  or  continued  to  purchase  or 
carry  state  and  municipal  bf)nds,  United  States  bonds  issued 
prior  to  September  24,  191 7  (including  Liberty  3/4's),  Farm 
Loan  bonds,  and  United  States  Victory  3^4's  not  originally 
subscribed  for. 

Interest  limitation  is  sound. — The  restriction  on  the 
deduction  is  sound.  It  was  made  imperative  by  the  establish- 
ment of  very  high  income  tax  rates.  So  long  as  the  rates  of  the 
tax  were  low,  there  was  no  appreciable  inducement  to  a  tax- 
payer to  borrow  money  with  which  to  buy  tax-exempt  se- 
curities. Under  very  high  surtax  rates  the  situation  changed. 
For  instance,  a  taxpayer  subject  to  income  taxes  aver- 
aging 40  per  cent  of  his  income  would  find  it  profitable 
to  buy  tax-exempt  securities  on  a  large  scale.  He  might 
purchase  $1,200,000  of  tax-free  3^  per  cent  bonds,  and 
borrow  against  them  $1,000,000'.  If  he  paid  4  per  cent  interest 
on  the  loan,  he  would  be  in  the  position  of  receiving  $42,000 
per  annum  not  subject  to  any  tax,  and  an  allowance  of  $40,- 
000.  which  would  be  a  clear  deduction  from  all  taxable  in- 


930 


DEDUCTIONS 


come.  If  $40,000'  of  his  income  was  subject  to  40  per  cent 
surtax  he  would  avoid  his  just  taxes  to  the  amount  of  $16,- 
000  for  the  year.  As  heretofore  stated,  such  saving  in  taxes 
is  possible  in  the  case  of  the  3^^  per  cent  Victory  bonds,  if 
originally  subscribed  for. 

Segregation  of  interest  paid  when  both  exempt  and 

NON-EXEMPT  SECURITIES  ARE  USED  AS  COLLATERAL. It  is  as- 
sumed that  a  borrower  would  use  tax-exempt  securities  (ex- 
cepting 3^  per  cent  Victory  bonds  originally  subscribed  for) 
as  collateral  only  when  no  other  collateral  is  available.  When 
the  collateral  consists  entirely  of  tax-exempt  securities,  no 
part  of  the  interest  paid  on  the  borrowed  money  is  deductible. 

When  the  collateral  consists  entirely  of  securities  not  tax- 
exempt  or  of  any  United  States  bonds  issued  after  September 
24,  1 91 7,  and  originally  subscribed  for  by  the  taxpayer,  the 
entire  interest  paid  is  deductible. 

When  the  collateral  consists  of  both  classes,  part  of  the 
interest  paid  is  deductible  and  part  is  not  deductible. 

There  are  at  least  two  methods  in  use  for  determining  the 
amount  of  deductible  interest  which  are  not  entirely  accurate : 

1.  By  claiming  as  deductible  the  same  proportion  of  the 
total  interest  paid  as  the  taxable  interest  received  on  bonds 
pledged  is  of  the  whole  amount  of  interest  received  on  such 
bonds. 

2.  By  averaging  by  the  month  the  relative  amounts  of 
principal  of  taxable  and  non-taxable  bonds  pledged  and  apply- 
ing the  result  for  the  year  to  the  interest  paid. 

Banking  houses  and  other  taxpayers  should,  whenever 
possible,  keep  their  securities  separated  so  that  those  not  tax- 
exempt  and  the  3^  per  cent  Victory  bonds  (if  originally  sub- 
scribed for  by  the  taxpayer)  will  be  used  before  any  others. 
When  feasible,  loans  should  be  wholly  secured  by  one  of  these 
two  classes.  This  will  insure  the  greatest  saving  in  taxes  and 
the  least  annoyance  in  bookkeeping. 

When  both  exempt  and  non-exempt  securities  must  be  used 


FOR   INTEREST 


931 


as  collateral  for  the  same  loan,  the  only  accurate  method  of 
segregating  the  interest  paid  is  the  following : 

3.  Since  collateral  loans  are  made  by  lenders  on  the  mar- 
ket value  of  the  securities  pledged,  and  not  on  their  par  value 
or  income-producing  basis,  interest  paid  on  loans  should  be 
apportioned  between  exempt  and  non-exempt  securities  in 
the  ratio  that  the  market  value  of  one  class  of  securities  bears 
to  the  other. 

Federal  taxes  assumed  by  corporation  issuing  tax- 
free  BONDS  NOT  deductible  AS  INTEREST. — When  collcction  at 
the  source  was  provided  for  in  the  19 13  law  it  was  found  that 
many  corporations  had  made  contracts  with  their  bondholders 
under  the  terms  of  which  the  corporations  agreed  to  pay  for  the 
bondholders  any  taxes  they  might  be  required  to  retain  out  of 
interest  due  the  bondholder.  These  contracts  were  supposed  to 
influence  favorably  the  terms  upon  which  bonds  could  be  sold. 
Under  such  a  theory  the  subsequent  imposition  of  a  tax  which 
falls  within  the  contractual  obligation  means  to  the  corpora- 
tions additional  cost  of  money  borrowed — hence  the  equivalent 
of  an  increased  interest  rate.  As  a  necessary  expense  of 
doing  business,  taxes  paid  on  this  account  should  be  an  allow- 
able deduction,  but  on  the  ground  that  the  payments  constitute 
the  voluntary  assumption  of  taxes  assessed  against  bondhold- 
ers and  not  the  corporations  the  latter  are  not  permitted  to 
claim  credit  for  the  payments  in  their  tax  returns  either  as 
interest  or  taxes. ^ 

Law.  Section  234.  (a)  ....  (3)  ....  (c)  ....  In  the 
case  of  obligors  specified  in  subdivision  (b)  of  section  221  no  deduction 
for  the  payment  of  the  tax  imposed  by  this  title  or  any  other  tax  paid 
pursuant  to  the  contract   ....   shall  be  allowed; 

Certain  ground  rents  not  deductible  as  interest. — 

Regulation Payments  made  for  Maryland  or  Pennsyl- 
vania ground  rents  arc  not  deductible  as  interest  but  may,  under  proper 
circumstances,  be  deducted  as  rent.     (Art.  121.) 


'Under  the  1921  law  the  obligees  do  not  have  to  include  such  taxes 
in  their  gross  income.  Prior  laws  did  not  contain  such  a  requirement  but 
the  Treasury  cstabHshed  it  by  regulation. 


932  DEDUCTIONS 

Ground  rent  is  defined  to  be  a  rent  reserved  to  himself 
and  his  heirs  by  the  grantor  of  land  out  of  the  land  itself. 
It  is  not  granted  like  an  annuity  or  a  rent  charge,  but  is  re- 
served out  of  the  conveyance  of  the  land  in  fee.  It  is  an  estate 
separate  from  the  ownership  of  the  ground,  and  is  held  to  be 
real  estate,  with  the  usual  characteristics  of  an  estate  in  fee 
simple — descendible,  devisable  and  alienable." 

A  rental  for  other  than  business  purposes  is  not  an  allow- 
able deduction  under  the  income  tax,  while  no  such  restriction 
applies  in  the  case  of  interest  payments.  The  refusal  to  per- 
mit ground  rents  such  as  those  described  to  be  deducted  as 
interest  is  to  prevent  rents  of  non-business  character  from 
being  deducted  under  the  guise  of  interest  payments. 

Dividends  on  preferred  stock  not  deductible  as  in- 
terest.— 

Regulation So-called  interest  on  preferred  stock,  which 

is  in  reahty  a  dividend  thereon,  can  not  be  deducted  in  arriving  at 
net  income."     (Art.  564.) 

Interest  paid  on  instalment  subscriptions  to  capi- 
tal STOCK  NOT  deductible. — When  interest  was  paid  on  the 
instalments  due  under  a  contract  to  subscribe  for  stock,  such 
interest  is  considered  as  a  distribution  of  profits  and  as  such 
is  not  deductible.^^ 

If  interest  is  paid  ratably  to  all  stockholders  it  might  be 
deemed  to  be  a  distribution  of  profits;  but  if  paid  to  some  on 
the  theory  of  borrowed  money  and  not  to  others,  the  interest 
payments  should  be  treated  as  fully  allowable. 

Interest  on  taxpayer's  own  capital^"  not  deduc- 
tible.— 

Regulation.  Interest  calculated  for  cost-keeping  or  other  pur- 
poses on  account  of  capital  or  surplus  invested  in  the  business  but 


"■"  Wilson  V.  Isemiuijcr,  185  U.  S.  55,  46  L.  Ed.  804,  22  S.  Ct.  573. 
"  See  page  705. 
"B.  32-21-1765;  O.  D.  991. 

"The  economic  term  for  so-called  interest  charged  against  oneself  as 
a  cost  or  carrying  charge  is  "imputed"  interest. 


FOR   INTEREST  933 

which  does  not  represent  a  charge  arising  under  an  interest-bearing 
obHgation,  is  not  an  allowable  deduction  from  gross  income.  (Art. 
122.) 

The  atithor  considers  this  position  to  be  entirely  sound/* 
Some  concerns  regard  interest  as  an  element  of  manufacturing 
cost,  and,  basing  inventory  valuations  on  such  so-called  costs, 
thereby  overstate  the  inventory  valuations.  It  is  like  pulling 
oneself  up  by  one's  own  boot-straps.  If  the  concern  deducts 
such  interest,  it  should  logically  account  for  it  immediately  as 
interest  received.  The  point  is  covered  more  fully  in  an 
earlier  Treasury  decision,  quoted  in  part  below. 

Ruling.  A  corporation  would  not  be  permitted  to  include  in 
its  deductions  the  rental  value  of  the  property  which  it  owns  and 
occupies  nor  would  it  be  permitted  to  deduct  from  gross  income  the 
interest  which  the  capital  invested  or  employed  would  earn  were  it 
otherwise  invested. 

It  therefore  follows  that  a  corporation  cannot  take  into  account 
as  a  part  of  the  cost  of  manufacture  any  possible  earnings;  that  is, 
earnings  which  might  accrue  on  its  capital  or  investment  had  such 
capital  been  so  placed  as  to  earn  a  given  rate. of  interest.  (T.  D. 
2137,  January  30,  1915.) 

Accounting  procedure. — 

Accrual  basis  is  permitted. — The  law  clearly  states 
the  right  of  a  taxpayer  to  return  on  either  a  paid  or  an  accrual 
basis.  Sections  214  and  234  specifically  state  that  "all  interest 
paid  or  accrued  zvithin  the  taxal^le  year  on  indebtedness"  shall 
be  allowed  as  a  deduction.  From  the  point  of  view  of  the  gov- 
ernment and  the  taxpayer  alike  it  is  desirable  that  the  in- 
terest deduction  should  be  based  upon  the  books  of  the  tax- 
payer, provided  always,  of  course,  that  the  books  are  kept 
properly  and  honestly.  Every  well-kept  set  of  books  reflects 
the  interest  accrued  during  the  year.  Interest  payments  may 
and  do  fluctuate.  Large  loans  may  fall  due  on  January  i  and 
have  interest  paid  on  December  31  in  one  year  and  on  January 
2  in  another  year.    Although  there  may  be  some  gain  or  loss  in 


^*  Auditing,  Theory  and  Practice  (3rd  edition),  by  R.  H.  Montgomery, 
page  155  et  seq. 


934  DEDUCTIONS 

taxes  in  the  year  when  a  change  is  made  from  one  basis  to  the 
other,  the  net  difference  between  the  accrual  and  the  paid  basis 
is  nothing  at  all  over  a  period  of  years,  unless  the  tax  rate 
changes," 

When  accrued  interest  is  not  deductible. — 

Ruling.  A  lumber  company  entered  into  a  contract  for  the  pur- 
chase of  a  timber  tract,  agreeing  to  pay  for  the  quantity  of  timber 
which  it  is  estimated  will  be  cut  each  year,  payment  to  be  made  at 
the  time  each  block  is  cut  at  a  certain  rate  per  thousand  feet,  plus 
interest  at  6  per  cent  per  annum  from  the  date  of  contract. 

Held,  that  inasmuch  as  the  interest  charge  did  not  accrue  and 
become  payable  until  the  timber  was  cut,  it  was  not  a  proper  deduction 
until  that  time.  The  agreement  is  an  executory  contract  to  purchase 
the  timber  and  no  interest   is   deductible   except  as  the  contract   is 


'"  [Former  Procedure]  The  1913  law  permitted  individuals  to 
deduct  "interest  paid  within  the  year"  (section  II,  B)  and  allowed 
corporations  to  deduct  interest  "accrued  and  paid  within  the  year" 
[section  II,  G  (b)  (third)].  In  its  interpretation  the  Treasury  held,  in 
the  case  of  corporations,  that  to  be  allowable  as  a  deduction,  interest 
must  be  both  accrued  and  paid  within  the  same  year  (T.  D.  1916). 
The  1916  law  used  the  phrase  "paid  within,  the  year"  in  describing  the 
interest  deductions  of  both  individuals  and  corporations  [section 
5  (a)  (second);  section  12  (a)  (third)].  The  same  law  permitted  the 
use  of  the  accrual  basis  by  corporations  [section  13  (d)].  The  ruling 
issued  to  cover  this  point  was  T.  D.  2433  (January  8,  1917). 

Prior  to  January  8,  1917,  the  government  insisted  that  the  inter- 
est allowance  be  reported  on  the  paid  basis.  This  worked  against  the 
government  and  in  favor  of  the  taxpayers,  although  the  latter  did  not 
seek  the  advantage.  On  the  contrary,  most  of  them  found  the  "paid" 
basis  very  objectionable  and  tried  to  change  it  and  in  many  cases 
made  up  their  returns  in  accordance  with  their  books  rather  than  in 
strict  adherence  to  the  law.  A  loss  to  the  government  occurred  be- 
cause the  tax  rates  increased. 

After  that  date  in  the  case  of  individuals  the  regulations  contented 
themselves  with  a  general  permission  to  make  a  return  on  a  basis 
other  than  that  of  actual  receipts  and  disbursements  if  the  basis 
clearly  reflected  the  income.  (Reg.  33,  1918,  Art.  24.)  In  the  case 
of  corporations,  on  the  other  hand,  the  utilization  of  the  accrual  basis 
for  interest  deductions  was   specifically  authorized   in  the   following: 

Regulation.  "  ....  If  the  accounts  of  the  company  are  kept  on  a 
basis  other  than  actual  receipts  and  disbursements,  the  amount  of  inter- 
est actually  accrued  at  the  contract  rate  ....  may  be  deducted,  provided 
it  is  so  entered  on  the  books  as  to  constitute  a  liability  against  the  assets. 
•  •  .  .  "  (Reg.  33,  1918,  Art.  180.) 


FOR    INTEREST  935 

executed.  The  interest  payment  does  not  constitute  an  operating 
expense  of  the  company,  but  enters  into  the  cost  of  the  lumber  pro- 
duced that  year.     (C.  B.  3,  page  149;  O.  D.  595.) 

Interest  paid  to  partners. — From  an  accounting  point 
of  view  interest  paid  to  partners  upon  contributed  capital  or  so- 
called  partnership  loans  is  an  expense  of  the  business  only  so 
far  as  the  partners  themselves  are  concerned.  Contributions 
by  general  partners  are  at  the  risk  of  the  business  so  far  as 
creditors  are  concerned,  and  it  is  customary  in  preparing  bal- 
ance sheets  to  combine  all  the  partners'  accounts  as  the  aggre- 
gate capital  of  the  partnership,  irrespective  of  how  the  balances 
appear  upon  the  firm's  books.  Under  income  tax  pro- 
cedure it  is  of  no  importance  to  the  government  whether  in- 
terest is  allowed  or  paid  to  partners*.  If  charged  on  one  side  of 
the  returns  as  an  expense,  the  same  amounts  appear  on  the 
other  side  as  income  and  the  tax  to  be  paid  is  not  affected. ^^ 


"  [Former  Procedure]  Under  the  excess  profits  tax  law  of  1917 
which  required  a  statement  of  invested  capital  and  a  determination  of 
partnership  profits  as  distinguished  from  the  individual's  net  income, 
it  made  a  decided  difference  whether  or  not  interest  on  partners'  loans 
or  capital  accounts  were  entered  as  a  business  expense. 

T.  D.  2613  (December  20,  1917),  published  as  bearing  on  the  excess 
profits  tax  only,  was  as  follows: 

Regulation.  "In  computing  net  income  for  purposes  of  the  excess 
profits  tax  a  partnership  will  be  allowed  to  deduct  amounts  paid  during 
the  year  to  an  individual  partner  as  interest  upon  any  bona  fide  loan,  but 
no  deduction  for  so-called  interest  upon  capital  will  be  recognized." 

Excess  profits  tax  returns  were  based  on  income  tax  returns.  Since  the 
provision  for  the  payment  of  interest  was  not  mandatory,  partnerships 
should  not  have  availed  themselves  of  the  privilege  unless  the  interest 
paid  to  partners  was  at  a  rate  substantially  greater  than  the  rate  of  ex- 
emption (7  to  9  per  cent)  allowed  on  capital  invested ;  otherwise  the  net 
tax  paid  to  the  government  would  have  been  greater  than  if  interest  paid 
to  partners  had  not  been  treated  as  an  expense  of  the  business,  because 
the  deduction  of  interest  as  an  expense  made  the  sum  lent  unavailable 
as  part  of  invested  capital. 

The  case  was  not  the  same  as  that  of  partners'  salaries.  The  allow- 
ance of  salaries  as  an  expense  of  the  business  did  not  diminish  the  ag- 
gregate capital  invested;  whereas  if  interest  on  partners'  loans  were 
treated  as  an  expense,  the  principal  amount  of  such  loans  must  have  been 


936  DEDUCTIONS 

Individual  interest  deduction  too  broad. — While  Congress 
may  be  criticized  because  of  its  former  policy  of  restricting 
corporation  interest  'deductions  too  narrowly,"  it  may  be 
criticized  on  the  other  hand  because  the  interest  deduction  per- 
mitted to  individuals  is  too  generous.  The  law  is  supposed  to 
proceed  on  the  theory  that  the  specific  exemptions  are  suffi- 
cient to  cover  minimum  personal  living  expenses — to  provide 
the  creature  comforts.  That  was  the  reason  given  for  not 
allowing  life  insurance  premiums  to  be  deducted. ^^  Living 
expenses  above  this  minimum  are  not  supposed  to  be  deduc- 
tible. But  if  a  man  borrows  money  to  buy  an  automobile, 
or  places  a  mortgage  on  his  house  because  he  is  living  be- 
yond his  means,  he  is  permitted  under  the  law  to  deduct  all 
such  interest  paid.  It  is  clearly  a  living  expense  and  theoreti- 
cally should  not  be  deductible.  It  would  seem  equitable  that 
the  law  should  permit  the  deduction  of  interest  payments 
only  where  the  interest-bearing  debt  was  incurred  in  the  pur- 
chase of  property  or  investments  for  income-producing  pur- 
poses. Such  a  provision  raises  some  practical  difficulties  such 
as  that  of  designating  the  particular  purposes  for  which  the 
proceeds  of  a  loan  are  used,  but  these  are  not  as  a  whole  in- 
surmountable. 


deducted  from  the  total  of  the  invested  capital  of  the  partnership  and 
tlie  benefit  of  the  deduction  of  7  to  9  per  cent  thereon  was  lost. 

It  was  not  suggested  that  the  books  of  account  should  be  changed 
to  conform  with  the  excess  profits  tax  returns.  It  was  not  expected  that 
the  latter  would  agree  with  the  books. 

"  See  page  923. 

"See  Chapter  XXVI,  "Deductions   for  Expenses.' 


CHAPTER  XXVIII 

DEDUCTIONS  FOR  TAXES 

The  19 1 8  revenue  law  was  generous  in  its  treatment  of  tax- 
payers, so  far  as  allowances  for  taxes  paid  were  concerned. 
The  changes  which  have  been  made  in  the  192 1  law,  while  op- 
erating in  the  main  to  reduce  the  benefit  that  may  be  claimed 
by  taxpayers,  are  still  of  so  reasonable  a  nature  that  no  great 
objections  can  be  raised  against  them,  with  the  exception  of 
excess  profits  tax  credits  which  will  be  mentioned  later. 

All  taxes  paid  in  this  country,  except  federal  income  tax 
and  certain  types  of  special  assessments,  are  still  allowable  in 
determining  the  amount  of  income  tax  payable,  either  as  de- 
ductions from  the  amount  upon  which  the  income  tax  is  to  be 
calculated,  or  else  as  a  credit  towards  the  amount  of  taxes 
payable. 

There  is  one  important  change  in  the  law  which  affects  both 
corporation  and  individuals  receiving  income  from  abroad,  and 
that  is  the  provision,  inserted  for  the  first  time,  that  the  foreign 
tax  allowed  as  a  credit  shall  not  exceed  the  same  average  rate 
on  the  foreign  income  which  the  United  States  income  and 
profits  taxes  are  on  the  total  income  from  both  foreign  and 
domestic  sources;  or,  as  the  law  puts  it,  that  the  credit  taken 
shall  not  exceed  the  same  proportion  of  tax  against  which 
credit  is  taken,  which  the  foreign  income  of  the  taxpayer  bears 
to  his  entire  net  income. 

The  provision  in  the  lav/  specifically  allowing  inheritance 
taxes  as  deductions  from  net  income  as  accrued  on  the  dUe 
date  thereof,  is  a  direct  result  of  the  Woodward  case  quoted 
on  page  961. 

Until  this  year,  aliens  resident  in  the  United  States  who 
were  subjects  of  a  foreign  country  could  deduct  the  amount  of 

937 


938  DEDUCTIONS 

"any  such  taxes  paid  during  the  taxable  year  to  such  country" 
if  certain  reciprocal  advantages  were  granted  to  American  citi- 
zens residing  in  that  country.  The  192 1  law  changes  this  to 
"the  amount  of  any  such  taxes  paid  during  the  taxable  year  to 
any  foreign  country  if  the  foreign  country  of  which  such  alien 
resident  is  a  citizen  or  subject  ....  allows  a  similar  credit 
to  citizens  of  the  United  States    .    .    .    ."   [sec.  222   (a-3)]. 

The  result  of  this  change  is  that  the  citizen  of  Canada,  for 
example,  who  formerly  could  only  obtain  credit  for  Canadian 
taxes,  may  now  obtain  credit  for  taxes  paid  to  countries  such 
as  Great  Britain  or  France,  which  have  no  reciprocal  clauses 
in  their  tax  laws.  This  means  that  the  credit  depends  entirely 
upon  the  attitude  of  the  government  of  which  the  resident  alien 
is  a  national. 

A  new  subsection^  provides  that  in  the  case  of  a  return 
made  for  a  1920-192 1  fiscal  year  the  credit  for  the  entire  fiscal 
year  is  to  be  determined  under  section  222,  a  deduction  to  be 
made  therefrom,  however,  for  any  credit  which  the  taxpayer 
has  already  taken. 

Taxes  Deductible 

Individuals. — 

Law.  Section  214.  (a)  That  in  computing  net  income  there  shall 
be  allowed  as  deductions:   .... 

(3)  Taxes  paid  or  accrued  within  the  taxable  year  except  (a) 
income,  war-profits,  and  excess-profits  taxes  imposed  by  the  authority 
of  the  United  States,  (b)  so  much  of  the  income,  war-profits  and 
excess-profits  taxes,  imposed  by  the  authority  of  any  foreign  country 
or  possession  of  the  United  States,  as  is  allowed  as  a  credit  under 
section  222,  (c)  taxes  assessed  against  local  benefits  of  a  kind  tending 
to  increase  the  value  of  the  property  assessed,  and  (d)  taxes  imposed 
upon  the  taxpayer  upon  his  interest  as  shareholder  or  member  of  a 
corporation,  which  are  paid  by  the  corporation  without  reimburse- 
ment from  the  taxpayer.  For  the  purpose  of  this  paragraph  estate, 
inheritance,  legacy,  and  succession  taxes  accrue  on  the  due  date  thereof 
except  as  otherwise  provided  by  the  law  of  the  jurisdiction  imposing 
such  taxes;  .... 


'  Section  222  (d). 


FOR   TAXES  939 

Corporations. — 

Law.  Section  234.  (a)  That  in  computing  the  net  income  of  a 
corporation  subject  to  the  tax  imposed  by  section  230  there  shall  be 
allowed  as  deductions:   .... 

(3)  Taxes  paid  or  accrued  within  the  taxable  year  except  (a) 
income,  war-profits,  and  excess-profits  taxes  imposed  by  the  authority 
of  the  United  States,  (b)  so  much  of  the  income,  war-profits  and 
excess-profits  taxes  imposed  by  the  authority  of  any  foreign  country 
or  possession  of  the  United  States  as  is  allowed  as  a  credit  under 
section  238,  and  (c)  taxes  assessed  against  local  benefits  of  a  kind 
tending  to  increase  the  value  of  the  property  assessed.  In  the  case  of 
obligors  specified  in  subdivision  (b)  of  section  221  no  deduction  for 
the  payment  of  the  tax  imposed  by  this  title,  or  any  other  tax  paid 
pursuant  to  the  contract  or  provision  referred  to  in  that  subdivision, 
shall  be  allowed  nor  shall  such  tax  be  included  in  the  gross  income 
of  the  obligee.  The  deduction  allowed  by  this  paragraph  shall  be 
allowed  in  the  case  of  taxes  imposed  upon  a  shareholder  or  member 
of  a  corporation  upon  his  interest  as  shareholder  or  member,  which 
are  paid  by  the  corporation  without  reimbursement  from  the  share- 
holder or  member,  but  in  such  cases  no  deduction  shall  be  allowed 
the  shareholder  or  member  for  the  amount  of  such  taxes.  For  the 
purpose  of  this  paragraph,  estate,  inheritance,  legacy,  and  succession 
taxes  accrue  on  the  due  date  thereof  except  as  otherwise  provided  by 
the  law  of  the  jurisdiction  imposing  such  taxes;-   .... 


'^  [Former  Procedure]  The  provisions  of  the  1913  law  relating  to 
individuals  read  simply  "all  national,  state,  county,  school  and  munici- 
pal taxes  paid  within  the  year,  not  including  those  assessed  against 
local  benefits."  (Section  II,  B,  third.)  The  corporation  section  of 
the  1913  law  was  as  follows :  "All  sums  paid  by  it  (viz.,  the  corporation) 
within  the  year  for  taxes  imposed  under  the  authority  of  the  United 
States  or  of  any  State  or  Territory  thereof,  or  imposed  by  the  govern- 
ment of  any  foreign  country."    [Section  II,  G  (b),  fourth.] 

Under  the  law  of  1913  taxes  paid  to  a  foreign  country  by  citizens  or 
alien  residents  of  the  United  States  were  not  allowable  deductions.  The 
provisions  of  the  law  for  the  deduction  of  taxes  applied  only  to  taxes 
paid  to  the  United  States,  or  to  some  state  or  political  subdivision  thereof 
in  the  United  States.  It  was  evidently  an  oversight  on  the  part  of  the 
framers  of  the  law.  In  his  report  of  December  6,  1915,  the  Commissioner 
of  Internal  Revenue  recommended  that  foreign  taxes  be  made  allowable 
deductions,  and  the  permission  was  granted  in  the  1916  law.  In  consider- 
ing returns  prior  to  1916,  this  change  in  the  law  must  be  kept  in  mind. 

1916  Law  (as  amended  in  1917).  Section  5.  "That  in  computing  net 
income  in  the  case  of  a  citizen  or  resident  of  the  United  States — 

"(a)  For  the  purpose  of  the  tax  there  shall  be  allowed  as  deduc- 
tions—  .... 


940 


DEDUCTIONS 


The  foregoing  section  provides  a  blanket  deduction  for 
all  taxes  except : 

1.  United  States  income,  war  profits  and  excess  profits 

taxes. 

2.  A  proportionate  part  of  income,  war  profits  and  excess 

profits  taxes  imposed  by  a  foreign  countr}^  or  pos- 
session  of   the   United    States.      [See    section    222 

(a-5)-] 

3.  Local  improvement  taxes. 

4.  Taxes  paid  pursuant  to  a  tax-free  covenant  in   cor- 

porate obligations.     (But  such  tax  may  be  credited 
against  the  total  tax  payable  by  the  obligee.) 

5.  Taxes  on  stockholdings,  paid  by  the  corporation  with- 

out reimbursement  from  the  owners  of  such  stock. 

Excess  profits  taxes  may  be  "credited." — 

Law.  Section  236.  That  for  the  purpose  only  of  the  tax  imposed 
by  section  230  [income  tax  rates]  there  shall  be  allowed  the  following 
credits:   .... 

(c)  The  amount  of  any  war-profits  and  excess-profits  taxes  im- 
posed by  Act  of  Congress  for  the  same  taxable  year.  The  credit  al- 
lowed by  this  subdivision  shall  be  determined  as  follows: 

(i)  In  the  case  of  a  corporation  which  makes  return  for  a  fiscal 
year  beginning  in  1920  and  ending  in  1921,  in  com.puting  the  income 
tax  as  provided  in  subdivision  (a)  of  section  205,  the  portion  of  the 
war-profits  and  excess-profits  tax  computed  for  the  entire  period  under 
clause  (i)  of  subdivision  (a)  of  section  335  shall  be  credited  against  the 
net  income  computed  for  the  entire  period  as  provided  in  clause  (i)  of 


"Third.  Taxes  paid  within  the  year  imposed  by  the  authority  of  the 
United  States  (except  income  and  excess  profits  taxes)  or  of  its  Terri- 
tories, or  possessions,  or  any  foreign  country,  or  by  the  authority  of  any 
State,  county,  school  district,  or  municipality,  or  other  taxing  subdivision 
of  any  State,  not  including  those  assessed  against  local  benefits." 

The  phrase  "except  income  and  excess  profits  taxes"  was  inserted  in 
the  1917  law.  The  provisions  of  the  1917  law  relating  to  deductions  for 
taxes  paid  were  exactly  the  same  for  individuals  and  for  corporations. 

1917  Law  (excess  profits  tax  credit).  Section  29.  "That  in  assess- 
ing income  tax  the  net  income  embraced  in  the  return  shall  also  be  credited 
with  the  amount  of  any  excess  profits  tax  imposed  b3'  Act  of  Congress 
and  assessed  for  the  same  calendar  or  fiscal  year  upon  the  taxpayer  and, 
in  the  case  of  a  member  of  a  partnership,  with  his  proportionate  share  of 
such  excess  profits  tax  imposed  upon  the  partnership." 


FOR   TAXES  941 

subdivision  (a)  of  section  205,  and  the  portion  of  the  war-profits  and 
excess-profits  tax  computed  for  the  entire  period  under  clause  (2)  of 
subdivision  (a)  of  section  335  shall  be  credited  against  the  net  income 
computed  for  the  entire  period  as  provided  in  clause  (2)  of  subdivision 
(a)  of  section  205. 

(2)  In  the  case  of  a  corporation  which  makes  return  for  a  fiscal 
year  beginning  in  192 1  and  ending  in  1922,  in  computing  the  income 
tax  as  provided  in  subdivision  (b)  of  section  205,  the  war-profits  and 
excess-profits  tax  computed  under  subdvision  (b)  of  section  335  shall 
be  credited  against  the  net  income  computed  for  the  entire  period  as 
provided  in  clause  (i)  of  subdivsion  (b)  of  section  205. 

The  method  of  calculation  of  excess  profits  taxes  payable 
is  fully  described  in  Excess  Profits  Tax  Procedure,  1921,  and 
the  Appendix  A  of  this  volume.  After  a  return  is  prepared 
showing  the  taxpayer's  net  income,  the  next  step  is  the  deter- 
mination of  the  amount  due  as  excess  profits  tax.  For  the  sole 
purpose  of  caclulating  the  amount  due  as  federal  income  tax, 
the  amount  of  the  excess  profits  tax  (accrued  but  not  paid) 
may  be  entered  as  an  allowable  deduction.  On  the  remaining 
balance  of  net  income,  the  federal  income  tax  is  to  be  assessed 
(see  Chapter  VII). 

"Net  income'"  is  specifically  defined  in  the  law.  After  net 
income  has  been  ascertained  the  excess  profits  tax  is  "credited" 
against  net  income  (in  fact  deducted  from  "net  income")  and 
on  the  balance  the  income  tax  is  imposed.  It  is  clear,  there- 
fore, that  in  determining  whether  or  not  a  corporation  is  en- 
titled to  the  specific  exemption  of  $2,000,  it  is  only  necessary 
to  consider  whether  the  "net  income"  is  $25,000  or  less.  The 
excess  profits  tax  is  not  considered  because  it  has  nothing  to 
do  with  determining  the  "net  income"  of  the  corporation,  which 
is  the  limiting  factor.  It  has  been  suggested  that  the  credit 
for  excess  profits  taxes  applies  against  the  net  income,  and,  if 
such  net  income  is  reduced  to  less  than  $25,000,  the  specific 
credit  can  be  taken.  No  justification  exists  for  such  an  inter- 
pretation. 

A  corporation  has  a  net  income  in  192 1  of  $27,000.  Its 
excess  profits  tax  is  v$4,ooo.  Income  tax  is  computed  as  fol- 
lows : 


542  DEDUCTIONS 

Net  Income  $27,000.00 

Less:    Credits: 

Excess   profits   tax $4,000.00 

Specific  credit    (not  applicable) 4,000.00 

Income  subject  to  tax $23,000.00 

Income  tax  at  10%  $  2,300.00 


The  fact  that  the  credit  of  $4,000  reduces  the  taxable 
income  to  $23,000  does  not  make  such  income  subject  to  the 
specific  credit  of  $2,000.  The  latter  is  deductible  only  when 
the  original  net  income  as  defined  in  the  law^  is  $25,000  or 
less. 

Foreign  taxes  paid  may  be  deducted  from  taxes  assessed 
in  United  States. — Subject  to  certain  restrictions  contained  in 
section  222,  quoted  below,  income  or  excess  profits  taxes  paid 
during  the  taxable  year  to  a  foreign  country  or  to  any  pos- 
session of  the  United  States  may  be  deducted  from  the  amount 
determined  to  be  due  to  the  United  States.  This  does  not  mean 
that  such  taxes  are  a  deduction  from  or  credit  against  net 
income,  but  that  the  items  are  a  deduction  from  the  amount 
of  taxes  otherwise  payable.  The  amount  to  be  credited  is  not 
to  exceed  the  same  proportion  of  the  tax  against  which  credit 
is  taken,  which  the  foreign  income  is  of  the  total  net  income 
[see  section  222    (a-5)   below]. 

Individuals. — 

Law.  Section  222.  (a)  That  the  tax  computed  under  Part  II  of 
this  title  shall  be  credited  with: 

(i)  In  the  case  of  a  citizen  of  the  United  States  the  amount  of 
any  income,  war-profits  and  excess-profits  taxes  paid  during  the  tax- 
able year  to  any  foreign  country  or  to  any  possession  of  the  United 
States;  and 

(2)  In  the  case  of  a  resident  of  the  United  States,  the  amount  of 
any  such  taxes  paid  during  the  taxable  year  to  any  possession  of  the 
United  States;  and 

(3)  In  the  case  of  an  alien  resident  of  the  United  States,  the 
amount  of  any  such  taxes  paid  during  the  taxable  year  to  any  foreign 

^  Section  232. 


FOR   TAXES 


943 


country,  if  the  foreign  country  of  which  such  alien  resident  is  a  citi- 
zen or  subject,  in  imposing  such  taxes,  allows  a  similar  credit  to 
citizens  of  the  United  States  residing  in  such  country;  and 

(4)  In  the  case  of  any  such  individual  who  is  a  member  of  a  part- 
nership or  a  beneficiary  of  an  estate  or  trust,  his  proportionate  share 
of  such  taxes  of  the  partnership  or  the  estate  or  trust  paid  during  the 
taxable  year  to  a  foreign  country  or  to  any  possession  of  the  United 
States,  as  the  case  may  be 

(b)  If  accrued  taxes  when  paid  differ  from  the  amounts  claimed 
as  credits  by  the  taxpayer,  or  if  any  tax  paid  is  refunded  in  whole  or 
in  part,  the  taxpayer  shall  notify  the  Commissioner,  who  shall  redeter- 
mine the  amount  of  the  tax  due  under  Part  II  of  this  title  for  the  year 
or  years  affected,  and  the  amount  of  tax  due  upon  such  redetermination, 
if  any,  shall  be  paid  by  the  taxpayer  upon  notice  and  demand  by  the 
collector,  or  the  amount  of  tax  overpaid,  if  any,  shall  be  credited  or 
refunded  to  the  taxpayer  in  accordance  with  the  provisions  of  section 
252.  In  the  case  of  such  a  tax  accrued  but  not  paid,  the  Commissioner 
as  a  condition  precedent  to  the  allowance  of  this  credit  may  require 
the  taxpayer  to  give  a  bond  with  sureties  satisfactory  to  and  to  be  ap- 
proved by  the  Commissioner  in  such  penal  sum  as  the  Commissioner 
may  require,  conditioned  for  the  payment  by  the  taxpayer  of  any 
amount  of  tax  found  due  upon  any  such  redetermination;  and  the  bond 
herein  prescribed  shall  contain  such  further  conditions  as  the  Com- 
missioner may  require. 

(c)  These  credits  shall  be  allowed  only  if  the  taxpayer  furnishes 
evidence  satisfactory  to  the  Commissioner  showing  the  amount  of 
income  derived  from  sources  without  the  United  States,  and  all  other 
information  necessary  for  the  verification  and  computation  of  such 
credits. 

(d)  If  the  taxpayer  makes  a  return  for  a  fiscal  year  beginning  in 
1920  and  ending  in  1921,  the  credit  for  the  entire  fiscal  year  shall,  not- 
withstanding any  provision  of  this  Act,  be  determined  under  the  pro- 
visions of  this  section;  and  the  Commissioner  is  authorized  to  disallow, 
in  whole  or  part,  any  such  credit  which  he  finds  has  already  been  taken 
by  the  taxpayer. 

Limitation  of  credit  for  taxes  paid  to  foreign  gov- 
ernments AND   possessions  OF   THE  UnITED   StATES. 

Law.  Section  222.  (a)  .  .  .  .  (5)  The  above  credits  shall  not 
be  allowed  in  the  case  of  a  citizen  entitled  to  the  benefits  of  section 
262;  and  in  no  other  case  shall  the  amount  of  credit  taken  under  this 
subdivision  exceed  the  same  proportion  of  the  tax,  against  which  such 
credit  is  taken,  which  the  taxpayer's  net  income  (computed  without  de- 
duction for  any  income,  war-profits  and  excess-profits  taxes  imposed  by 
any  foreign  country  or  possession  of  the  United  States)  from  sources 


944  DEDUCTIONS 

without  the  United  States  bears  to  his  entire  net  income   (computed 
v/ithout   such   deduction)    for   the  same   taxable  year 

Section  262  refers  to  those  receiving  most  of  their  income 
from  sources  within  United  States  possessions.  (See  Chapter 
XXXVI.) 

A  citizen  of  .Canada  residing  in  the  United  States  receives 
a  net  income  of  $40,000,  of  which  $20,000  is  net  income  in 
Canada  and  $20,000  is  net  income  in  the  United  States.  The 
Canadian  income  tax  is  $1,300.  The  net  income  from  sources 
without  the  United  States,  not  deducting  the  Canadian  income 
tax,  is  $20,000.  The  entire  net  income  from  all  sources  is 
v$40,ooo.  The  proportion  of  the  foreign  income  to  the  total 
income  is  ><.  The  United  States  tax  is  $1,800.  The  limit 
for  the  credit  for  foreign  credit  against  this  tax  is,  therefore, 
1/2  of  $1,800,  or  $900.  Hence,  the  taxpayer  cannot  take  credit 
for  the  full  $1,300  paid  to  the  Canadian  government,  but  only 
for  $900  thereof.  In  other  words,  the  maximum  credit  deduc- 
tible is  that  proportion  of  the  United  States  tax  which  the 
foreign  net  income  bears  to  the  total  net  income.  The 
maximum,  of  course,  cannot  exceed  the  actual  amount  of  the 
foreign  tax.  The  $400  of  foreign  tax  not  allowed  as  a  credit 
against  United  States  tax  is,  however,  allowed  as  a  deduction 
in  computing  total  net  income  [section  214  (a-3-b) ;  see 
page  938]. 

Taxes  on  foreign  dividends. — 

Ruling.  Where  under  a  foreign  income  tax  law  corporations 
are  required  to  withhold  a  fixed  percentage  of  the  total  amount  of 
dividends  paid  to  the  stockholders  in  this  country,  such  tax  being 
withheld  in  a  lump  sum,  although  imposed  upon  the  individual  stock- 
holders, the  amounts  withheld  not  being  itemized  by  the  foreign  gov- 
ernment, in  lieu  of  the  individual  tax  receipts  required  to  be  attached 
to  Form  11 16,  the  taxpayer  may  attach  to  the  return  on  Form  11 16 
his  affidavit  showing  the  number  of  shares  held  during  the  year, 
whether  or  not  any  of  the  shares  held  by  him  were  acquired  or  sold 
during  the  year,  giving  dates  and  number  of  shares  so  acquired  or 
sold;  the  total  number  of  shares  outstanding  on  which  the  dividend 
was  declared  regardless  of  whether  the  dividend  was  paid  to  citizens 
of  the  United  States  or  other  governments;  and  the  total  dividends 
paid  or  accrued  on  such  shares  during  the  year,  and  attach  to  and 


FOR   TAXES  945 

make  a  part  of  such  affidavit  a  certified  copy  of  the  tax  receipts 
from  the  foreign  tax  collector  showing  the  payment  of  the  tax 
en  bloc,  with  copies  of  any  other  documents  which  he  may  have 
that  will  serve  to  corroborate  the  facts  set  forth  in  such  affidavit. 

The  amount  of  the  credit  claimed  should  be  computed  by  dividing 
the  total  tax  withheld  by  the  total  number  of  shares  of  the  corpora- 
tion outstanding  and  multiplying  this  result  by  the  number  of  shares 
held  during  the  entire  year.  In  the  event  that  any  of  the  shares 
were  acquired  or  disposed  of  during  the  year,  an  adjustment  should 
be  made  showing  the  amount  of  taxes  properly  allocated  to  the 
dividends  received  after  acquisition  or  before  disposition  of  the 
stock.     (C.  B.  I,  page  i88;  O.  D.  232.) 

Countries  which  do  and  do  not  allow  United  States 

CITIZENS  who  are  RESIDENTS  A   CREDIT  FOR  THE  AMOUNT  OF 

INCOME  AND   PROFITS  TAXES   PAID   TO   THE  UNITED   StATES. 

Regulation,  (a)  The  following  is  an  incomplete  list  of  the 
countries  which  satisfy  the  similar  credit  requirement  of  section  222 
(a)  (3)  of  the  Revenue  Act  of  1921,  either  by  allowing  to  citizens 
of  the  United  States  residing  in  such  countries  a  credit  for  the  amount 
of  income,  war  profits,  or  excess  profits  taxes  paid  to  the  United 
States,  or  in  imposing  such  taxes,  by  exempting  from  taxation  the 
incomes  received  from  sources  within  the  United  States  by  citizens 
of  the  United  States  residing  in  such  countries :  Bulgaria,  Canada, 
Italy,  Newfoundland,  Salvador.  (&)  The  following  is  an  incomplete 
list  of  the  countries  which  do  not  satisfy  the  similar  credit  require- 
ment of  section  222  (a)  (3)  of  the  Revenue  Act  of  1921,  either  by 
allowing  no  credit  to  citizens  of  the  United  States  residing  in  such 
countries,  for  the  amount  of  income,  war  profits,  or  excess  profits 
taxes  paid  to  the  United  States,  or  because  such  countries  do  not  im- 
pose any  income,  war  profits,  or  excess  profits  taxes :  Argentina, 
Bahama,  Belgium,  Bermuda,  Bolivia,  Bosnia,  Brazil,  Chile,  China, 
Costa  Rica,  Dutch  Guiana,  Ecuador,  Egypt,  Finland,  France,"*  Great 


■'  [Former  Procedure]  The  following  special  decision  has  been  pub- 
lished affecting  taxes  paid  to  France : 

Ruling.  In  accordance  with  section  222  (a)  i  of  the  Revenue  Act  of 
1918,  an  American  citizen  may  credit  the  amount  of  Federal  tax  with  the 
amount  of  any  income,  war  profits,  and  excess-profits  taxes  paid  during 
the  taxable  year  to  France,  provided  such  tax  paid  to  France  is  on  income 
from  sources  therein.  If,  however,  the  tax  paid  to  the  Government  of 
France  is  imposed  on  an  amount  fixed  at  seven  times  the  rent  of  his  resi- 
dence in  France  (whether  because  he  actually  receives  no  income  or  in- 
sufficient income  from  France),  such  tax  would  be  considered  not  to  have 
been  imposed  on  income  from  sources  therein,  and,  therefore,  not  a  proper 
credit  under  section  222(a)  of  the  Act.  The  tax  would,  however,  be  a 
proper  deduction  under  section  214  (a)  3.     (B.  45-21-1911;  O.  D.  1093.) 

This   footnote  is  coiUinucd  on   next  page. 


946  DEDUCTIONS 

Britain  and  Ireland,  Guatemala,  Herzegovina,  India,  Jamaica,  Japan 
Montenegro,  Morocco,  New  Zealand,  Nicaragua,  Panama,  Paraguay, 
Persia,  Peru,  Portugal,  Rumania,  Santo  Domingo,  Serbia,  Siam, 
Straits  Settlements,  Sweden,  Switzerland,  Venezuela.  The  former 
names  of  certain  of  these  territories  are  here  used  for  convenience  in 
spite  of  the  actual  or  possible  change  in  the  name  or  sovereignty.  A 
resident  of  the  United  States  who  is  a  citizen  or  subject  of  any  country 
in  the  first  list  is  entitled,  for  the  purpose  of  the  total  tax  due  the 
United  States  for  1921  (as  to  fiscal  years  beginning  in  1920,  see  art. 
386)  and  subsequent  years,  to  a  credit  for  the  amount  of  any  income, 
war  profits,  and  excess  profits  taxes  paid  or  accrued  during  the  tax- 
able year  to  any  foreign  country.  If  he  is  a  citizen  or  subject  of  any 
country  in  the  second  list,  he  is  not  entitled  to  such  credit.  If  he  is  a 
citizen  or  subject  of  a  country  which  is  in  neither  list,  then  to  secure 
the  desired  credit  he  must  prove  to  the  satisfaction  of  the  Commis- 
sioner that  his  country  satisfies  the  similar  credit  requirement  of  the 
statute.     (Art.  385.) 

Portion  of  income  tax  paid  to  foreign  government 
LtY  citizen  or  resident  OF  United  States  not  allowed  as 
A  credit  is  an  ALLOWABLE  DEDUCTioN.-^The  limitation  on 
the  deduction  of  income  tax  by  a  citizen-resident  of  the  United 
States  imder  section  214  (a-3-a)  is  modified  under  section 
214  (a-3-b)  in  cases  wherein  a  citizen  or  resident  of  the 
United  States  is  taxed  by  the  authority  of  a  foreign  country 
on  income  derived  from  sources  entirely  within  the  United 
States.  A  citizen  of  the  United  States  residing  abroad  in  many 
cases  will  be  taxed  by  a  foreign  government  on  income  derived 
from  sources  within  the  United  States.  The  limitation  in  sec- 
tion 214  (a-3-a)  applies  only  to  income  and  profits  taxes  paid 
to  the  United  States.  Therefore  income  taxes  paid  to  foreign 
governments  Ijy  a  citizen  or  resident  of  the  United  States  are 


Ruling.  Any  income,  war  profits,  or  excess-profits  taxes  paid  by  a 
citizen  of  the  United  States  in  igi8  to  a  foreign  country,  with  respect  to 
income  received  from  sources  therein,  are  an  allowable  credit  under  section 
222  (a)  of  the  Revenue  Act  of  1918  against  the  amount  of  the  tax  due  to 
the  United  States  for  that  year,  provided  the  taxpayer's  books  of  account 
are  kept  on  a  cash-receipt  and  payment  basis  and  a  return  is  rendered  on 
that  basis;  if  the  taxpayer's  books  are  kept  on  an  accrual  basis,  and  his 
returns  are  so  rendered,  the  credit  for  taxes  paid  to  a  foreign  country  on 
income  received  from  sources  therein  will  lie  limited  to  taxes  accrued  in 
the  taxable  year  for  which  the  return  is  rendered.  (C.  B.  2,  page  196; 
O.  987.) 


FOR   TAXES  947 

allowable  deductions  from  gross  income  under  section  214 
(a-3-b),  to  the  extent  that  such  taxes  are  not  allowed  as  credits 
under  section  222^  and,  not  being  imposed  by  the  authority  of 
the  United  States,  do  not  fall  within  the  inhibition  in  section 
214  (a-3-a). 

Corporations. — 

Law.  Section  238.  (a)  That  in  the  case  of  a  domestic  corporation 
the  tax  imposed  by  this  title,  plus  the  war-profits  and  excess-profits 
taxes,  if  any,  shall  be  credited  with  the  amount  of  any  income,  war- 
profits,  and  excess-profits  taxes  paid  during  the  same  taxable  year  to 
any  foreign  country,  or  to  any  possession  of  the  United  States :  Provided, 
That  the  amount  of  credit  taken  under  this  subdivision  shall  in  no  case 
exceed  the  same  proportion  of  the  taxes,  against  which  such  credit  is 
taken,  which  the  taxpayer's  net  income  (computed  without  deduction 
for  any  income,  war-profits,  and  excess-profits  taxes  imposed  by  any 
foreign  country  or  possession  of  the  United  States)  from  sources  with- 
out the  United  States  bears  to  its  entire  net  income  (computed  without 
such  deduction)  for  the  same  taxable  year.  In  the  case  of  domestic 
insurance  companies  subject  to  the  tax  imposed  by  section  243  or  246, 
the  term  "net  income,"  as  used  in  this  subdivision  means  net  income 
as  defined  in  sections  245  and  246,  respectively. 

The  limitation  on  the  credit  mentioned  above  is  the  same 
as  in  the  case  of  citizens  or  residents.  For  detailed  compu- 
tation see  page  944. 

The  provisions  of  the  law  regarding  accrued  taxes  differing 
from  those  paid,  information  to  be  furnished,  and  fiscal  years 
are  the  same  for  corporation  as  for  individuals.  (See  page 
953-) 


"  [Former  Procedure]  Taxes  imposed  by  a  foreign  country  on  income 
from  sources  within  the  United  States  were  not  credits  against  the  tax  due 
to  the  United  States  under  the  1918  law.  Section  222  (a)  (i)  of  that  law 
specified  that  to  be  credits  such  taxes  must  have  been  assessed  on  "income 
derived  from  sources  therein." 

Ruling.  Income  and  war-profits  taxes  paid  to  a  foreign  country  by  a 
citizen  of  the  United  States  residing  in  such  foreign  country  on  income 
from  sources  within  the  United  States  can  not  be  treated  as  a  credit  for 
taxes  under  section  222.  Such  taxes  are  deductilile  under  section  214 
(a)  (3)  in  computing  net  income  in  his  return  to  the  United  States.  (C. 
P..  I,  page  188;  O.  D.  317.) 


948 


DEDUCTIONS 


Credit  for  taxes  when  domestic  corporation  owns 
control  in  foreign  subsidiary. 

Law.     Section  238 (e)"  For  the  purposes  of  this  section  a 

domestic  corporation  which  owns  a  majority  of  the  voting  stock  of  a 
foreign  corporation  from  which  it  receives  dividends  (not  deductible 
under  section  234)  in  any  taxable  year  shall  be  deemed  to  have  paid 
the  same  proportion  of  any  income,  war-profits,  or  excess-profits  taxes 
paid  by  such  foreign  corporation  to  any  foreign  country  or  to  any 
possession  of  the  United  States,  upon  or  v/ith  respect  to  the  accumu- 
lated profits  of  such  foreign  corporation  from  which  such  dividends 
were  paid,  which  the  amount  of  such  dividends  bears  to  the  amount 
of  such  accumulated  profits:  Provided,  That  the  credit  allowed  to  any 
domestic  corporation  under  this  subdivision  shall  in  no  case 
exceed  the  same  proportion  of  the  taxes  against  which  it  is 
credited,  which  the  amount  of  such  dividends  bears  to  the  am.ount 
of  the  entire  net  income  of  the  domestic  corporation  in  which  such 
dividends  are  included.  The  term  "accumulated  profits"  when  used  in 
this  subdivision  in  reference  to  a  foreign  corporation,  means  the  amount 
of  its  gains,  profits,  or  income  in  excess  of  the  income,  war-profits,  and 
excess-profits  taxes  imposed  upon  or  with  respect  to  such  profits  or  in- 
come; and  the  Commissioner  with  the  approval  of  the  Secretary  shall 
have  full  power  to  determine  from  the  accumulated  profits  of  what  year 
or  years  such  dividends  were  paid;  treating  dividends  paid  in  the  first 
sixty  days  of  any  year  as  having  been  paid  from  the  accumulated  profits 
of  the  preceding  year  or  years  (unless  to  his  satisfaction  shown  other- 
wise), and  in  other  respects  treating  dividends  as  having  been  paid 
from  the  most  recently  accumulated  gains,  profits,  or  earnings.  In 
the  case  of  a  foreign  corporation,  the  income,  war-profits,  and  excess- 
profits  taxes  of  which  are  determined  on  the  basis  of  an  accounting 
period  of  less  than  one  year,  the  word  "year"  as  used  in  this  subdivision 
shall  be  construed  to  mean  such  accounting  period. 

(f)  For  the  purposes  of  this  section  a  corporation  entitled  to  the 
benefits  of  section  262  shall  be  treated  as  a  foreign  corporation. 

In  order  to  prevent  a  domestic  corporation  securing  credit 
against  its  United  States  tax  for  foreign  income  and  profits 
taxes  paid  by  a  foreign  subsidiary  in  a  disproportionate  degree, 
a  limitation  similar  to  that  imposed  upon  taxpayers  paying 


°  [Former  Procedure]  Under  the  1918  law  [section  240  (c)]  the  for- 
eign income  tax  to  be  allowed  as  a  credit  was  such  tax  "paid,"  not  "accrued," 
within  the  taxable  year.  The  portion  of  such  tax  deductible  was  based  on 
the  ratio  of  the  dividends  received  from  such  foreign  corporation  to  its 
total  net  income.  The  limitation  imposed  was  that  such  credit  should  not 
exceed  the  amount  of  dividends  received  from  such  foreign  corporations. 
For  detailed  discussion  see  Income  Tax  Procedure,  1921,  pages  752-755. 


FOR   TAXES 


949 


foreign  income  taxes  directly  was  included  in  the  192 1  law. 
This  limitation  is  based  on  the  theory  that  the  foreign  tax 
credited  against  the  United  States  tax  should  be  at  the  same 
rate  with  respect  to  foreign  income  as  the  United  States  tax 
is  to  United  States  income.  In  other  words,  it  was  felt  that 
it  would  not  be  equitable  to  allow  credit  for  foreign  tax 
against  United  States  tax  if  the  foreign  taxes  were  imposed 
at  a  higher  rate  than  the  United  States  tax.  To  accomplish 
this  object  the  foregoing  provision  of  the  192 1  law  contains 
a  statement  of  a  maximum  limit  to  the  credit  for  foreign  tax, 
viz. :  the  proportion  of  United  States  tax  equal  to  the  ratio 
of  dividends  received  from  the  foreign  corporation  to  total 
net  income  (including  such  dividends)  of  the  domestic  cor- 
poration. 

To  illustrate  assume  the  following:  A  domestic  corpora- 
tion (A)  owns  the  entire  capital  stock  of  a  foreign  corpora- 
tion  (B)  : 

Net  income  of  A $100,000  (a) 

United  States  income  and  profits  taxes  payable  by  A $  10.500 

Net  income  of  B   $  20,000 

Foreign  income  and  profits  tax  payable  by  B 4,000 

Balance  of  accumulated  profits  available  for  dividends $  16,000  (b) 

Dividend  paid  by  B  to  A $  10,000  (c) 

Ratio  of  (c)  to   (b)=5/8     (d) 
Ratio  of   (c)   to   (a)  =  i/io   (e) 

The  foregoing  ratios  are  used  in  determining  whether  the 
limitation  of  tax  indicated  by  (e)  will  preclude  the  full  al- 
lowance indicated  by   (d). 

Foreign   taxes  paid   "with   respect  to  the  accumulated   profits"   of  $16,000, 

i.  e.,  $4,000. 
5^     (see    above)     thereof  =  foreign    taxes    allocated    to    dividend    paid    to 

United   States  parent   corporation    $2,500 

But  credit  must  not  exceed  i/io  of  United  States  tax  ($10,500)  ....  1,050 
Amount  of  foreign  tax  disallowed  as  a  credit   i,450 

It  would  seem,  therefore,  that  the  United  States  tax  pay- 
able by  the  domestic  corporation  would  be  $9,450  ($10,500 — 
$1,050).    In  other  words,  the  limitation  applies. 


95" 


DEDUCTIONS 


Section  238  (e)  states  that  the  ratio  for  the  hmitation  is  the 
"proportion  ....  which  the  amount  of  such  dividends  bears 
to  the  amount  of  the  entire  net  income  of  the  domestic  cor- 
poration." The  theory  is  that  the  United  States  corporation 
will  be  allowed  as  a  credit  against  the  United  States  tax  the 
foreign  tax  paid  with  respect  to  the  dividend  from  the  foreign 
corporation  included  in  the  United  States  corporation's  in- 
come, which  has  been  subjected  to  United  States  tax.  By 
limiting  the  credit,  however,  to  a  proportionate  part  of  the 
"taxes,  against  which  such  credit  is  taken,"  the  foreign  tax  is, 
in  effect,  reduced  to  the  same  rate  as  the  United  States  tax  on 
the  foreign  dividend.  If  the  rate  of  tax  imposed  by  the  for- 
eign country  is  higher  than  the  United  States  rate,  the  effect 
of  the  computation  is  to  allow  the  credit  at  the  lower  United 
States  rate.  If,  on  the  other  hand,  the  rate  of  foreign  tax  is 
lower  than  the  United  States  rate,  the  full  amount  of  foreign 
tax  would  be  allowed  with  respect  to  such  foreign  dividend. 

It  has  been  suggested  that  the  phrase  in  section  238  (e) 
"upon  or  with  respect  to  the  accumulated  profits  of  such  for- 
eign corporation  from  which  such  dividends  were  paid,"  might 
limit  the  credit  for  taxes  as  shown  in  the  above  illustration  to 
an  amount  allocated  to  the  $16,000  of  profits  remaining  after 
deduction  of  the  foreign  tax  of  $4,000.  Such  an  interpreta- 
tion of  the  law,  however,  is  not  warranted  because  the  entire 
amount  of  foreign  tax  was  paid  by  the  foreign  subsidiary  in 
respect  of  the  profits  remaining  available  as  dividends. 

It  is  important  also  to  note  the  difference  in  treatment  of 
the  deduction  from  United  States  income  of  any  part  of  the 
foreign  tax  disallowed  as  a  credit.  A  United  States  corpora- 
tion with  a  foreign  branch  (unincorporated)  is  permitted  to 
deduct  such  an  amount  as  section  234  (a-3)  provides  for  the 
deduction  of  "Taxes  paid  or  accrued  within  the  taxable  year 
except  .  .  .  .  (b)  so  much  of  the  income,  war  profits  and 
excess  profits  taxes  imposed  by  the  authority  of  any  foreign 
country  or  possession  of  the  United  States  as  is  allowed  as  a 
credit  under  section  238,  .  .  .  ."     But  a  United  States  cor- 


FOR   TAXES 


951 


poration  conducting"  its  foreign  business  through  a  foreign  sub- 
sidiary is  not  allowed  as  a  deduction  from  its  United  States 
income  any  foreign  tax  paid  by  the  foreign  subsidiary  which 
is  disallowed  as  a  credit  against  the  United  States  tax  of  the 
domestic  corporation. 

The  reason  for  this  is  that  the  deduction  for  taxes  paid, 
under  section  234  (a)  quoted  above,  is  allowed  only  to  the 
taxpayer  paying  such  taxes.  In  the  case  of  a  foreign  sub- 
sidiary the  foreign  tax  is  paid  by  such  foreign  corporation 
and  not  by  the  United  States  corporation. 

Regulation A     domestic     corporation     seeking     such 

credit  must  comply  with  those  provisions  of  subdivision  (a)  of  article 
383  which  are  applicable  to  credits  for  taxes  already  paid,  except  that 
in  accordance  with  article' 611  the  form  to  be  used  is  Form  11 18  in- 
stead of  Form  1116.'^ 

For  the  purposes  of  section  238  a  corporation  entitled  to  the  bene- 
fits of  section  262  is  treated  as  a  foreign  corporation.     (Art.  612.) 

Meaning  of  terms. — 

Regulation.  "Amount  of  ...  .  taxes  paid  during  the  taxable 
year"  means  taxes  proper  (no  credit  being  given  for  amounts  repre- 
senting interest  or  penalties)  paid  or  accrued  during  the  taxable  year 
on  behalf  of  the  individual  claiming  credit.  "Foreign  country"  in- 
cludes within  its  meaning  any  foreign  sovereign  state  or  self-govern- 
ing colony  (for  example,  the  Dominion  of  Canada),  but  does  not  in- 
clude a  foreign  municipality  (for  example,  Montreal)  unless  itself  a 
sovereign  State   (for  example,  Hamburg).     "Any  possession  of  the 


'  [Former  Procedure]  For  procedure  as  to  foreign  taxes  prior  to 
1916,  see  footnote,  page  939. 

Ruling.  A  domestic  corporation  owning  a  majority  of  the  voting 
stock  of  a  foreign  corporation  is  not  entitled  to  credit  for  taxes  paid  by 
such  foreign  corporation  to  any  foreign  country  or  possession  of  the  United 
States  which  are  not  actually  paid  within  the  taxable  year  of  the  domestic 
corporation.     (C.  B.  i,  page  237;  T.  B.  R.  36.) 

Space  does  not  permit  comment  on  the  foregoing  ruling.  It  may 
be  entirely  sound;  but  the  author  is  not  convinced  by  the  arguments 
in  the  detailed  ruling  that  Congress  intended  to  allow  credits  for  such 
taxes  ("many  foreign  taxes  which  accrued  prior  to  1918  remain  un- 
paid") paid  in  1918  and  in  subsequent  years,  although  they  accrued 
prior   to    1918. 


952 


DEDUCTIONS 


United  States"  includes,  among  others,  Porto  Rico,  the  Phihppines 
and  the  Virgin  Islands (Art.  382.) 

The  definition  in  the  foregoing  regulation  of  the  phrase 
"to  any  foreign  country,"  is  no  doubt  technically  correct,  but 
it  probably  does  not  carry  out  the  intention  of  Congress.  In 
the  first  edition  of  Regulations  45  the  term  used  was,  "any 
governmental  authority,"^  which  more  nearly  accords  with 
the  accepted  meaning  of  "any  foreign  country."  The  Treas- 
ury has  not  been  consistent  in  its  definitions  of  "foreign  gov- 
ernment" and  "foreign  country."  The  section  of  the  law  set- 
ting forth  the  items  not  included  in  gross  income  reads: 

Law.  Section  213.  That  for  the  purposes  of  this  title  ....  the 
term  "gross  income" — 

(b)   Does  not  include   .... 

(5)  The  income  of  foreign  governments  received  from  invest- 
ments in  the  United   States 

Article  86  reads  as  follows : 

Regulation.  The  exemption  of  income  of  foreign  governments 
applies  also  to  their  political  subdivisions (Art.  86.) 

There  is  no  sound  reason  why  "foreign  government"  in 
section  213  should  be  construed  to  include  political  subdivi- 
sions, whereas  the  term  "foreign  country"  used  in  sections 
222  and  238  is  construed  to  exclude  such  subdivisions. 

It  is  customary  to  refer  to  "state"  income  taxes  and  it  is 
quite  conceivable  that  in  a  federal  statute  state  income  taxes 
might  be  specifically  mentioned  as  being  deductible.  But  if 
subsequently  the  city  of  New  York  were  to  impose  an  income 
tax  and  a  taxpayer  who  had  been  paying  $1,000  to  the  state 
thereafter  paid  $500  to  the  state  and  $500  to  the  city  the 
courts  would  probably  hold  that  since  a  city  is  an  instrumental- 
ity of  a  state,  income  taxes  paid  to  a  city  would  be  deductible. 

If  a  citizen  of  the  United  States  who  now  pays  a  $1,000 


*  [Former  Procedure] 

Regvlatiox.  "  .  .  .  .  Foreign  country"  means  any  governmental  au- 
thority, not  that  of  the  United  States  or  any  part  or  possession  thereof, 
having  power  to  impose  such  taxes,  and  it  therefore  includes  a  self-govern- 
ing colony,  such  as  the  Dominion  of  Canada (Reg.  45,  April,  1919, 

Art.  382.) 


FOR   TAXES 


953 


income  tax  in  England  hereafter  should  pay  $500  direct  to 
the  British  government  and  $500  to  the  city  of  London  the 
regulation  would  prohibit  the  deduction  of  the  amount  paid 
to  London,  even  though  the  change  merely  represented  an 
adjustment  of  a  policy  of  apportionment. 

In  the  opinion  of  the  author  the  words  "to  any  foreign 
country"  mean  "to  any  foreign  country  or  any  subdivision 
of  a  foreign  country  which  has  or  may  receive  authority  to 
impose  an  income  tax." 

The  intention  of  the  law  was  to  reduce  the  burden  on  a 
citizen  of  the  United  States  who  might  be  taxed  very  heavily 
on  income  arising  in  a  foreign  country.  It  would  seem  to 
make  little  or  no  difference  whether  such  foreign  tax  were  im- 
posed by  a  municipality  or  by  a  recognized  sovereign  govern- 
ment. 

In  one  country  the  state  might  impose  income  taxes.  In 
another  country  with  a  different  tax  system,  income  taxes 
equally  onerous  might  be  laid  by  local  authorities  but  none 
by  the  state.  Congress  did  not  intend  to  discriminate  against 
one  system  in  favor  of  the  other. 

The  following  decision  has  recently  been  issued  : 

Ruling.  The  term  "foreign  country"  as  used  in  sections  238  (a) 
and  234  (a)  (3)  of  the  Revenue  Act  of  1918  is  held  to  mean  the 
composite  whole  made  up  of  all  the  subdivisions  of  a  foreign  State 
subject  to  the  same  central  control.  Each  of  the  subdivisions,  in  this 
sense,  is  not  a  "country"  but  a  part  of  a  "country."  The  Province 
of  British  Columbia,  therefore,  does  not  come  within  the  meaning 
of  the  term  "foreign  country"'  as  contemplated  by  the  statute. 

Amounts  of  mineral  tax  and  income  tax  paid  or  accrued  to  the 
Province  of  British  Columbia  by  a  domestic  corporation  are  deductible 
as  business  expenses  from  the  taxable  income  of  the  corporation.  (B. 
39-21-1844;  O.  D.  1050.) 

Procedure  for  securing  credit  for  foreign  taxes. — 

Regulation,  (a)  When  credit  is  sought  for  income,  war  profits 
or  excess  profits  taxes  paid  other  than  to  the  United  States,  the  in- 
come tax  return  of  the  individual  must  be  accompanied  by  Form 
1 116,  carefully  filled  in  with  all  the  information  there  called  for 
and  with  the  calculations  of  credits  there  indicated,  and  duly  signed 


954 


DEDUCTIONS 


and  sworn  to  or  affirmed.  When  credit  is  sought  for  taxes  already 
paid  the  form  must  have  attached  to  it  the  receipt  for  each  such  tax 
payment.  When  credit  is  sought  for  taxes  accrued  the  form  must 
have  attached  to  it  the  return  on  which  each  such  accrued  tax  was 
based.  This  receipt  or  return  so  attached  must  be  either  the  original, 
a  dupHcate  original,  a  duly  certified  or  authenticated  copy,  or  a  sworn 
copy.  In  case  only  a  sworn  copy  of  a  receipt  or  return  is  attached, 
there  must  be  kept  readily  available  for  comparison  on  request  the 
original,  a  duplicate  original  or  a  duly  certified  or  authenticated  copy, 
(b)  In  the  case  of  a  credit  sought  for  a  tax  accrued  but  not  paid,  the 
Commissioner  may  require  as  a  condition  precedent  to  the  allowance 
of  credit  a  bond  from  the  taxpayer  in  addition  to  Form  1116.  If 
such  a  bond  is  required,  Form  11 17  shall  be  used  for  it.  It  shall  be 
in  such  penal  sum  as  the  Commissioner  may  prescribe,  and  shall  be 
conditioned  for  the  payment  by  the  taxpayer  of  any  amount  of  tax 
found  due  upon  any  redetermination  of  the  tax  made  necessary  by 
such  credit  proving  incorrect,  with  such  further  conditions  as  the 
Commissioner  may  require.  This  bond  shall  be  executed  by  the  tax- 
payer, his  agent  or  representative,  as  principal,  and  by  sureties  sat- 
isfactory to  and  approved  by  the  Commissioner (Art.  383.) 

Form  1 1 16  provides  for  the  calculation  of  such  tax  in 
terms  of  foreign  money  and  its  conversion  into  United  States 
money,  but  does  not  state  what  rate  of  exchange  is  to  be 
used.  The  form  does  specify,  however,  that  claimant  must 
"attach  a  statement  describing  in  reasonable  detail  why  and 
how  he  determined  upon  this  particular  rate." 

The  Treasury  has  ruled"  in  the  case  of  income  credited 
that  the  rate  of  exchange  prevailing  at  the  time  the  amount^ 
were  credited  should  be  used.  This  is  of  importance  in  these 
days  of  highly  variable  exchange  rates.  It  therefore  seems 
proper  to  use  the  prevailing  exchange  rate  on  the  date  or 
dates  when  taxes  were  actually  paid  to  the  foreign  countries. 

Credit  for  foreign  taxes  under  fiscal  year  basis.^° — 
In  case  of  fiscal  years  1920  to  1921,  the  credit  is  computed 


°  Letter  to  Herbert  M.  Teets,  New  York,  N.  Y.,  signed  by  Deputy 
Commissioner  L.  F.  Speer,  dated  January  11,  1916;  also  C.  B.  3,  page  234; 
O.  D.  809. 

'"  [Former  Procedure] 

Ruling.  A  domestic  corporation  which  derives  its  entire  income  from 
operations  in  Cuba  and  keeps  its  books  on  an  accrual  basis,  may  file  on 
Form  II 18  a  "claim  for  credit"  of  the  amount  of  any  Cuban  income,  war 


FOR   TAXES  955 

for  the  full  year  under  the  192 1  law,  and  the  portion  thereof 
not  already  claimed  is  allowed  [section  238   (d)]. 

When  amounts  subsequently  paid  differ  from  ac- 
cruals.— 

Regulations.  In  case  credit  has  been  given  for  taxes  accrued,  or 
a  proportionate  share  thereof,  and  the  amount  that  is  actually  paid  on 
account  of  such  taxes,  or  a  proportionate  share  thereof,  is  not  the 
same  as  the  amount  of  such  credit,  or  in  case  any  tax  payment  cred- 
ited is  refunded  in  whole  or  in  part,  the  taxpayer  shall  immediately 
notify  the  Commissioner.  The  Commissioner  will  thereupon  redeter- 
mine the  amount  of  the  income  tax  of  such  taxpayer  for  the  year 
or  years  for  which  such  incorrect  credit  was  granted.  The  amount 
of  tax,  if  any,  due  upon  such  redetermination  shall  be  paid  by  the 
taxpayer  upon  notice  and  demand  by  the  collector.  The  amount  of 
tax,  if  any,  shown  by  such  redetermination  to  have  been  overpaid 
shall  be  credited  against  any  income,  war  profits  or  excess  profits 
taxes,  or  instalment  thereof,  then  due  from  such  taxpayer  under  any 
other  return,  and  any  balance  of  such  amount  shall  be  immediately 
refunded  to  him (Art.  384.) 

....  To  secure  such  a  credit  a  domestic  corporation  must  pursue 
the  same  course  as  that  prescribed  for  an  individual  by  article  383, 
except  that  form  1118  is  to  be  used  for  claiming  credit  and  form 
1119^^  for  the  bond,  if  a  bond  be  required.  For  the  redetermination 
of  the  tax,  when  a  credit  for  such  taxes  has  been  rendered  incorrect 
by  later  developments,  see  article  384,  all  of  the  provisions  of  which 
apply  with  equal  force  to  a  corporation  taxpayer.  For  credit  where 
taxes  are  paid  by  a  foreign  corporation  controlled  by  a  domestic  cor- 
poration, see  article  612.  A  claim  for  credit  in  such  a  case  is  also  to 
be  made  on  form  11 18.     (Art.  611.) 


profits  or  excess  profits  tax  accrued  for  the  fiscal  year  ended  June  30,  1918, 
and  apply  such  credit  against  its  Federal  income  and  profits  tax  for  the  same 
fiscal  period.  This  credit  should  be  prorated  with  reference  to  that  part  of 
the  fiscal  year  falling  within  the  calendar  year  1918.  If  the  1918  Federal 
tax  has  been  paid  without  claiming  this  credit  and  the  company  wishes 
to  credit  the  overpayment  against  the  1919  taxes,  Form  11 18  should  be 
accompanied  by  a  claim  for  refund  on  Form  46  and  possibly  a  claim  for 
credit  on  Form  47-A. 

A  claim  for  credit  on  Form  11 18  for  the  amount  of  Cuban  income, 
war  profits  or  excess  profits  tax  accrued  for  the  fiscal  year  ended  June  30, 
1919,  may  be  filed  and  applied  against  the  company's  Federal  tax  liability 
for  the  same  fiscal  period.     (C.  B.  2,  page  221;  O.  D.  406.) 

See  also  section  238  (c),  1918  law. 
"See  Appendix  of  Excess  Profits  Tax  Procedure,  1921,  for  reproduc- 
tion of  form. 


956 


DEDUCTIONS 


Forms  to  be  used  by  individuals  and  partnerships 
when  credit  for  foreign  taxes  is  claimed. 

Ruling.  A  domestic  partnership  has  leased  certain  of  its  patents 
to  a  British  licensee  for  a  fixed  royalty,  and  the  British  government 
requires  the  licensee  to  withhold  and  pay  to  it  the  British  income 
tax  on  the  royalty  payments. 

The  partners,  in  order  to  obtain  credit  for  such  tax  paid  to  the 
British  Government,  should  attach  to  the  return  of  the  firm  on  Form 
1065  a  claim  for  credit,  Form  11 18,  modified  throughout  by  substi- 
tuting the  word  "partnership"  for  the  word  "corporation."  In  lieu 
of  the  required  receipt  or  return,  a  copy  of  the  receipt  issued  to  the 
British  licensee  showing  the  payment  of  tax  made  to  the  British 
Government,  duly  attested  by  the  president  of  the  British  licensee, 
will  be  accepted.  The  individual  members  of  the  partnership  are 
required  to  attach  Form  11 16  to  their  individual  returns,  accompanied 
by  a  copy  of  the  receipt  issued  to  the  British  licensee  and  a  copy  of 
the  affidavit  made  by  the  president  of  the  British  licensee.  (C.  B.  3, 
page  220;  O.  D.  ■583.) 

When  a  partnership  pays  income  or  excess  profits  taxes 
to  a  foreign  country  the  tax  so  paid  is  not  to  be  included  as 
an  expense  in  form  1065,^^  but  is  to  be  allocated  to  the  individ- 
ual partners  on  the  same  basis  as  the  profits.  The  amounts 
may,  subject  to  the  limitations  already  mentioned,  be  deducted 
by  the  partners  from  the  fax  computed  on  their  individual 
returns.  Only  the  difference,  if  any,  between  the  foreign  tax 
so  credited  and  the  total  amount  of  such  foreign  tax,  is  to  be 
entered  in  form  1065  and  thus  be  deducted  from  gross  income 
in  computing  net  income  subject  to  United  States  income  tax. 

Massachusetts  trust  operating  property  in  a  for- 
eign COUNTRY. — Where,  under  the  laws  of  a  foreign  country, 
taxpayers  are  taxed  as  individuals,  although  in  this  country 
they  would  be  and  are  regarded  as  an  association,  the  individ- 
uals who  were  actually  assessed  by  the  foreign  government 
must  claim  credits  against  their  individual  income  taxes,  and 
the  association  not  having  paid  the  tax  cannot  claim  the  credit. 


^"  For  copy  of  form,  see  Appendix  B. 


FOR   TAXES  957 

Ruling.  A  Massachusetts  trust,  taxable  as  an  association,  owns 
and  operates  property  in  a  foreign  country,  which  does  not  recognize 
the  separate  entity  of  the  association  but  regards  it  as  a  partnership, 
the  shareholders  paying  income  tax  individually  to  the  foreign  country 
upon  their  respective  shares  of  the  net  profits  of  the  association. 

Held,  that  the  association  is  not  entitled  to  claim  under  the  Revenue 
Act  of  1918,  as  a  credit  on  Form  11 16,  the  amount  of  the  taxes  so  paid 
by  the  shareholder,  but  that  the  shareholders  who  paid  such  taxes  are 
entitled  to  the  credit  within  the  limitation  of  article  381,  Regulations 
45.     (B.  42-21-1872;  A.  R.  R.  643.) 

Tax  on  bank  stock,  etc.,  no  longer  deductible  by  share- 
holders.— Taxes  on  bank  stock  (or  similar  taxes  on  the  stock 
of  other  corporations)  paid  by  the  bank  are,  under  the  192 1 
law,  deductible  by  the  bank,  but  they  are  not  deductible  by 
the  shareholders.^^ 

Regulations.  Under  the  revenue  act  of  1921  banks  or  other 
corporations  paying  taxes  assessed  against  their  stockholders  on  ac- 
count of  their  ownership  of  the  shares  of  stock  issued  by  such  cor- 
porations, without  reimbursement  from  any  such  shareholder  or  mem- 
ber, may  deduct  the  amount  of  taxes  so  paid.  The  statute  specifically 
provides,  however,  that  in  such  cases  the  stockholders  may  not  deduct 
the  amount  of  the  taxes. ^*     (Art.  566.) 

In  computing  the  net  income  of  an  individual  no  deduction  is  al- 
lowed for  the  taxes  imposed  upon  his  interest  as  shareholder  or  mem- 
ber of  a  bank  or  other  corporation,  which  are  paid  by  the  corporation 
without  reimbursement  from  the  taxpayer (Art.  135.) 

Taxes  paid  under  secured  debt  laws  deductible. — 

Regulation Amounts  paid  to  States  under  secured  debts 

laws  in  order  to  render  securities  tax  exempt  are  deductible.     (Art. 
131-) 

Automobile  license  fees  deductible. — 

Regulation.    Automobile  license  fees  arc  ordinarily  taxes.     (Art. 

Ruling.  A  taxpayer  whose  books  are  kept  on  the  receipts  and 
disbursements  basis  may  deduct  from  gross  income  on  his  1919  return 


"  See  page  734  for  procedure  under  the  1913  law.  See  Income  Tax 
Procedure,  1921.  Under  the  1918  law,  stockholders  for  whom  a  corpora- 
tion paid  taxes  assessed  on  their  holdings,  were  required  to  report  such 
taxes  as  additional  dividend,  subject  to  surtax,  at  the  same  time  deducting 
the  item  under  "taxes"  in  computing  net  income.  But  see  Income  Tax 
Troccdiirc.  1921,  page  760  ct  scq.,  rulings  under  iyi8  law. 

"  Section  214  (a-3). 


958  DEDUCTIONS 

automobile  taxes  levied  against  him  by  the  State  of  Iowa  for  1919 
and  1920,  provided  he  actually  paid  such  taxes  during  1919.  If  the 
books  of  the  taxpayer  are  kept  on  the  accrual  basis,  then  only  the 
amount  of  such  tax  applicable  to  the  year  1919  may  be  taken  as  a 
deduction  in  preparing  his  1919  income  tax  return,  and  the  amount 
which  represents  the  1920  tax  may  be  deducted  on  such  taxpayer's 
1920  return,  notwithstanding  the  fact  that  he  actually  paid  the  tax 
for  both  years  in  1919.     (C.  B.  2,  page  116;  O.  D.  388.) 

Business,  excise  and  license  taxes  deductible. — 

Regulation business,     license,     privilege,     excise  .... 

taxes  paid  to  internal  revenue  collectors,  are  deductible  as  taxes 
imposed  by  the  authority  of  the  United  States,  provided  they  are  not 
added  to  and  made  a  part  of  the  expenses  of  the  business  or  the  cost 
of  articles  of  merchandise  with  respect  to  which  they  are  paid,  in 
which  case  they  can  not  be  separately  deducted.     (xA.rt.  132.) 

The  foregoing  regulation  does  not  operate  as  a  limitation 
upon  the  deduction,  but  merely  points  out  that  a  dealer  who 
pays  these  federal  taxes  must  not  deduct  them  twice. 

The  stipulation  that  the  taxes  be  paid  to  an  internal  revenue 
collector  must  be  regarded  as  explanatory.  It  must  not  be 
interpreted  to  mean  that  taxes  to  be  deductible  must  be  paid 
to  an  internal  revenue  collector.  It  simply  means  that  taxes 
so  paid  are  among  the  allowable  deductions. 

All  taxes  other  than  federal  income  and  profits  taxes  and 
local  assessments,  are  deductible  by  the  taxpayer  who  is  as- 
sessed for  them  and  responsible  for  their  payment.  The  actual 
payments  may  be  made  by  withholding  agents  as  in  the  case 
of  theater  tickets,  etc. 

When  the  tax  is  paid  to  the  collector  by  someone  other 
than  the  taxpayer,  the  latter  is  the  onl)-'  one  who  can  claim  the 
payment  as  a  deduction. 

Rulings.  The  Republic  of  Cuba  imposes  on  all  corporations 
operating  sugar  plantations  in  Cuba,  a  tax  of  a  certain  amount  on 
each  bag  of  sugar  produced.  Apparently  this  tax  is  based  on  pro- 
duction, not  on  income,  and  is  in  the  nature  of  an  excise  tax.  There- 
fore a  domestic  corporation  may  deduct  from  gross  income  in  its 
return  to  the  United  States  Government  the  amount  of  such  tax  paid 
to  the  Cuban  Government  but  may  not  claim  the  amount  as  a  credit 


FOR   TAXES 


959 


against  the  total  tax  due  to  the  United  States.     (C.  B.  2,  page  115; 
O.  D.  zi^-) 

Wholesale  liquor  dealers  who  exercised  their  option  of  including 
excise  taxes  in  cost  of  merchandise  in  calculating  inventory  may  not 
now  amend  such  inventory  and  treat  the  taxes  as  business  expenses. 
(C.  B.  I,  page  112;  O.  D.  137.) 

Excise  and  stamp  taxes  are  deductible  only  by  the  one 
against  whom  such  taxes  are  levied. — 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  February  28, 
1920,  in  which  you  inquire  as  to  the  taxpayer  who  is  entitled  to  the 
benefit  of  a  deduction  from  gross  income  in  respect  of  excise  and 
stamp  taxes  levied  by  the  federal  government. 

In  reply  you  are  advised  that  the  general  rule  which  applies  in 
respect  of  a  deduction  for  all  taxes  is  that  the  deduction  may  be 
taken  only  by  the  person  against  whom  such  taxes  are  levied.  The 
fact  that  one  person  ultimately  pays  a  tax  levied  upon  another  does 
not  give  such  person  a  right  to  the  benefit  of  the  deduction. 

As  to  the  person  against  whom  excise  and  stamp  taxes  are  levied, 
your  attention  is  directed  to  sections  900  to  907,  and  1006,  iioo  to 
1 107,  inclusive,  of  the  Revenue  Act  of  1918.  (Letter  to  Leslie, 
Banks  &  Company,  New  York,  N.  Y.,  signed  by  G.  V.  Newton, 
Acting  Assistant  to  the  Commissioner,  and  dated  March  6,  1920.) 

Customs  duties  deductible. — 

Regulation,  import  or  tariff  duties  paid  to  the  proper  customs 
officers  ....  are  deductible  as  taxes  imposed  by  the  authority  of  the 
United  States,  provided  they  are  not  added  to  and  made  a  part  of 
the  expenses  of  the  business  or  the  cost  of  articles  of  merchandise 
with  respect  to  which  they  are  paid,  in  which  case  they  can  not  be 
separately  deducted.     (Art.  132.) 

The  deduction  may  be  claimed  on  articles  intended  for  per- 
sonal or  family  use  as  well  as  by  dealers  who  btiy  to  resell. 

Stamp  and  similar  taxes  deductible. — 

Regulation stamp  taxes  paid  to  internal  revenue  col- 
lectors are  deductible (Art  132.) 

In  view  of  the  heavy  stamp  and  other  taxes  being  collected 
by  federal  and  state  authorities,  it  may  be  worth  while  for  tax- 
payers to  preserve  a  record  of  the  stamps  used  on  stock  trans- 
actions and  for  many  other  purposes.    The  payment  of  taxes 


960  DEDUCTIONS 

as  represented  by  stamp  purchases  is  plainly  an  allowable  de- 
duction. Stamp  taxes  on  certificates  of  stock  which  have  been 
sold  should  be  treated  as  taxes  and  not  as  a  deduction  from 
the  proceeds  of  sale/^  Taxes  payable  by  the  manufacturer 
are  not  deductible  by  the  ultimate  consumer. 

Luxury  and  excise  taxes. — The  1921  law  has  repealed 
many  of  the  luxury  and  excise  taxes^®  and  those  that  remain 
are  almost  all  payable  by  the  manufacturer.  In  view  of  this 
it  has  been  decided  to  omit  from  this  edition  of  Income  Tax 
Procedure  any  lengthy  discussion  on  this  subject  such  as  ap- 
peared in  the  editions  of  prior  years.  Although  the  number  of 
taxes  is  still  large,  the  test  for  their  deductibility  or  otherwise 
is  the  same  in  all  cases,  viz. :  Is  the  tax  levied  against  the  per- 
son desiring  to  make  the  deduction?  If,  as  in  the  case  of  club 
dues  or  admissions,  the  tax  is  levied  against  the  taxpayer,  the 
latter  can  deduct  it.  If  it  is  levied  against  the  manufacturer, 
he  includes  it  in  his  cost  of  production  and  the  consumer  is 
not  entitled  to  any  deduction;  even  if  the  manufacturer  passes 
the  tax  on  to  the  consumer  as  a  specific  item,  the  consumer 
cannot  deduct  it. 

Claims  where  accurate  records  of  tax  payments  not  kept. — 
Each  taxpayer  is  expected  to  return  every  dollar  of  taxable 


^^  [Former  Procedure]  Under  the  1918  law  taxable  income  was  the 
same  whether  tax  stamps  were  treated  as  expenses  or  as  taxes,  but  under 
the  1913  law  and  in  most  cases  under  the  1917  law  stock  losses  were  not 
deductible.  Hence  when  stamp  taxes  on  transfers  of  stock  were  treated 
as  deductions  from  proceeds  of  sales  (and  the  transaction  resulted  in  a 
loss),  credit  was  not  secured  for  the  item  of  stamp  taxes,  because  the 
cost  of  the  stamps  was  merged  in  the  stock  loss. 

'"  [Former  Procedure]  Under  the  1917  law  taxes  were  imposed  on  a 
large  variety  of  things  including  the  following:  facilities  (passenger  fares, 
freight,  express,  berths,  seats,  telegraph  and  telephone  messages),  promis- 
sory notes  (except  when  Lilicrty  bonds  were  used  as  collateral)  conveyances 
of  real  estate,  powers  of  attorney,  proxies,  admissions  to  theaters  and  other 
places  of  amusement,  and  dues  charged  by  social  and  similar  clubs. 

The  1918  law  modified  these  taxes  to  some  degree  and  added  the  lux- 
ury tax,  the  tax  on  the  retail  price  of  jewelry,  perfumes,  cosmetics,  etc. 
In  addition,  there  were  levies  against  a  greatly  extended  list  of  articles 
payable  by  the  producer  on  the  basis  of  the  wholesale  price  rather  than  by 
the  consumer  on  the  basis  of  the  retail  price. 


FOR   TAXES  961 

income  even  though  no  permanent  record  of  it  was  made. 
Similarly  a  taxpayer  ma}^  claim  credit  for  all  taxes  paid  if 
the  claim  is  made  in  good  faith  and  can  reasonably  be  sup- 
ported. Since  receipts  were  not  usually  given  by  those  who 
collected  the  taxes,  vouchers  cannot  be  furnished.  If  one's 
memory  is  trustworthy  no  objection  can  be  made  to  a  claim 
based  on  the  taxpayer's  statement. 

Ruling.  An  individual  may  claim  as  a  deduction  the  amount  of 
war  tax  paid  on  facilities  furnished  by  public  utilities,  which  include 
tax  on  railroad  and  steamship  fares,  and  the  war  tax  paid  on  admis- 
sions and  dues.  The  war  excise  taxes  imposed  by  section  904  and 
paid  by  the  purchaser  are  deductible,  but  the  war  excise  taxes  imposed 
by  section  900,  which  are  levied  against  and  paid  by  the  manufac- 
turer, producer,  or  importer,  are  not  deductible  by  the  individual 
purchaser.     (C.  B.  i,  page  112;  O.  D.  287.) 

Inheritance  taxes  deductible. — On  June  6,  192 1,  the  United 
.States  Supreme  Court  held"  that  when  Congress  included  all 
taxes^^  among  allowable  deductions  it  used  language  which 
is  to  be  taken  in  its  ordinary  meaning,  and  that  inheritance 
or  estate  taxes  paid  by  an  estate  may  be  deducted  from  taxable 
income. 

Decision.  The  act  of  1916  calls  the  estate  tax  a  "tax"  and  par- 
ticularly denominates  it  an  "estate  tax."  This  court  recently  has 
recognized  that  it  is  a  duty  or  excise  and  is  imposed  in  the  exertion 
of  the  taxing  power  of  the  United  States.  New  York  Trust  Co.  v. 
Eisner,  —  U.  S.  — .  It  is  made  a  charge  on  the  estate  and  is  to 
be  paid  out  of  it  by  the  administrator  or  executor  substantially  as 
other  taxes  and  charges  are  paid.  It  becomes  due  not  at  the  time 
of  the  decedent's  death,  as  suggested  by  counsel  for  the  Government, 
but  one  year  thereafter,  as  the  statute  plainly  provides.  It  does  not 
segregate  any  part  of  the  estate  from  the  rest  and  keep  it  from  pass- 
ing to  the  administrator  or  executor  for  purposes  of  administration, 
as  counsel  contend,  but  is  made  a  general  charge  on  the  gross  estate 
and  is  to  be  paid  in  money  out  of  any  available  funds  or,  if  there  be 
none,  by  converting  other  property  into  money  for  the  purpose. 


"  U.  S.  V.  Alan  H.  ll'oodzvani,  ct  ai.  (T.  D.  3x95;  C.  B.  4,  page  153). 

"The  suit  was  brought  under  the  1916  law  under  which  federal  income 
as  well  as  all  other  taxes  (except  those  lor  local  benefits)  were  allowable 
deductions.  Under  later  laws  tlie  only  exclusions  are  federal  income  and 
profits  taxes. 


962 


DEDUCTIONS 


The  author  consistently  held  in  all  former  editions  of  this 
book  that,  unless  and  until  the  law  restricts  the  deductions  of ' 
inheritance  or  estate  taxes,  the  amount  paid  by,  or  for,  an  es- 
tate is  an  allowable  deduction. 

Regulation.  Federal  estate  taxes,  paid  or  accrued  during  the 
taxable  year,  are  an  allowable  deduction  from  the  gross  income 
of  the  estate  in  computing  the  net  income  thereof  subject  to  tax. 
Such  taxes  are  deemed  to  have  accrued  on  the  due  date  thereof, 
namely,  one  year  after  the  decedent's  death,  except  in  any  case  where 
the  Commissioner  has  granted  an  extension  or  extensions  of  time  for 
payment,  such  taxes  are  then  deemed  to  have  accrued  on  the  due 
date  or  dates  of  such  extension  or  extensions. 

Estate,  succession,  legacy,  or  inheritance  taxes,  imposed  by  any 
State,  Territory  or  possession  of  the  United  States,  or  foreign  coun- 
try, are  deductible  by  the  estate,  subject  to  the  provisions  of  section 
214,  where,  by  the  laws  of  the  jurisdiction  exacting  them,  they  are 
imposed  upon  the  right  or  privilege  to  transmit  rather  than  upon 
the  right  or  privilege  of  the  heir,  devisee,  legatee,  or  distributee,  to 
receive  or  to  succeed  to  the  property  of  the  decedent  passing  to  him. 
Where  such  taxes  are  imposed  upon  the  right  or  privilege  of  the  heir, 
devisee,  legatee,  or  distributee,  so  to  receive  or  to  succeed  to  the 
property,  they  constitute,  subject  to  the  provisions  of  section  214, 
an  allowable  deduction  from  his  gross  income. 

Where,  in  accordance  with  a  direction  contained  in  the  testator's 
will,  the  taxes  upon  the  right  to  receive  any  particular  devise  or 
devises,  legacy  or  legafcies  are  so  payable  as  to  relieve  the  particular 
devisee  or  devisees,  legatee  or  legatees  from  the  burden  thereof, 
then  the  person  or  persons  entitled  to  the  fund  or  other  property  out  of 
which  payment  is  made  may  not  take  deduction  of  the  taxes  so  paid, 
but  deduction  thereof  is  available  only  by  such  devisee  or  devisees, 
legatee  or  legatees ;  each,  if  there  be  more  than  one,  being  authorized 
to  deduct  such  part  of  the  taxes  so  paid  as  he  would  otherwise  have 
been  entitled  to  do  had  there  been  no  such  testamentary  direction. 

Where  there  is  a  life  estate  and  a  remainder,  and,  by  the  laws  of 
the  jurisdiction  imposing  them,  the  taxes  in  respect  to  both  interests 
are  payable  out  of  the  remainder  interest,  with  no  legal  obligation 
imposed  whereby  the  remainderman  is  entitled  to  reimbursement, 
then  deduction  of  the  taxes  so  paid  may  be  taken  only  by  the  re- 
mainderman. Where,  in  the  case  of  an  annuity,  the  taxes  in  respect 
thereto  are,  by  the  laws  of  the  jurisdiction  imposing  them,  payable 
in  the  first  instance  out  of  the  fund  set  aside  for  creating  the  an- 
nuity, but  are  to  be  repaid  or  restored  to  such  fund  from  the  annuity, 
then  deduction  thereof  may  be  taken  only  by  the  annuitant. 

The  accrual  dates  of  such  taxes  shall  be  the  due  date  thereof  ex- 


FOR   TAXES  963 

cept  as  otherwise  provided  by  the  law  of  the  jurisdiction  imposing 
them.  Where  deduction  is  claimed  of  any  such  taxes,  the  amount 
thereof  and  the  name  of  the  State,  Territory,  or  possession  of  the 
United  States,  or  foreign  country,  by  which  they  liave  been  imposed 
shall  be  stated  in  the  return.     (Art.  134.) 

The  foregoing  regulations  recognize  that  taxes  accrued  as 
well  as  paid  may  be  deducted.  The  deduction  for  accrued  taxes 
is  not  limited  to  estates  which  keep  their  accounts  on  an  accrual 
basis,  because  the  law  [section  214  (a-3)]  provides  that  the 
allowable  deduction  is  for  taxes  paid  or  accrued,  and  specifies 
that  estate  taxes  accrue  ''on  the  due  date  thereof." 

The  regulation  points  out  the  conditions  under  which  the 
right  to  deduct  inures  to  the  estate  and  when  to  the  distributees. 
For  instance,  when  legacies  are  made  payable  free  of  tax,  and 
the  estate  pays  the  tax  for  the  legatee,  it  is  held  that  the  latter 
and  not  the  estate  is  entitled  to  the  deduction.  The  same  prin- 
ciple is  applied  to  remaindermen  and  annuitants.  The  deduc- 
tion is  complicated  by  the  procedure  in  the  local  jurisdiction 
in  which  the  estate  is  administered.  It  may  be  expected,  there- 
fore, that  the  foregoing  regulations  will  be  amended  from  time 
to  time. 

Taxes  paid  for  another  person — who  deducts? — Credit 
should  be  taken  for  taxes  by  the  owner  of  the  property  taxed; 
but  if  a  husband  pays  the  taxes  on  a  residence  the  title  to 
which  is  in  the  name  of  his  wife  there  appears  to  be  no  pro- 
hibition in  the  law  against  the  deduction  by  the  husband  in 
his  return.  Strictly  speaking,  the  payment  represents  a  gift 
to  the  wife  and  should  be  deducted  by  her. 

Tax  deductions  too  broad. — In  the  opinion  of  the  author 
not  all  taxes  deductible  under  the  law  are  proper  deductions. 
For  example,  a  tax  paid  upon  an  individual's  own  residence, 
the  rental  value  of  which  is  not  taxable,  is  an  allowable  de- 
duction, although  such  a  tax  clearly  is  a  living  or  personal  ex- 
pense. This  may  be  said  to  be  true  also  of  luxury  taxes  and 
of  import  duties  paid  by  individuals  on  goods  destined  for 


964  DEDUCTIONS 

their  personal  consumption.  It  would  be  more  equitable  if 
taxes  were  deductible  only  when  paid  on  income-producing 
property  or  on  property  acquired  for  income-producing  pur- 
poses. 

Taxes  Not  Deductible 

The  law  permits  the  deduction  from  gross  income  of  all 
taxes  levied  by  the  authorities  enumerated,  with  four  specific 
exceptions,  viz.,  the  federal  income  tax,  the  excess  profits  tax/" 
a  proportionate  part  of  foreign  income  and  excess  profits  taxes 
(which  are  a  credit  against  United  States  taxes),  and  certain 
types  of  special  assessments.  Consecjuently  the  procedure  at 
this  point  resolves  itself  largely  into  the  problem  of  determin- 
ing whether  or  not  particular  expenditures  are  taxes. 

Federal  income  tax  cannot  be  deducted. — In  191 7  the  prac- 
tice of  permitting  the  deduction  of  federal  income  taxes  was 
abandoned.^"    They  are  no  longer  deductible. 

In  the  period  of  low  rates  the  question  of  deducting  the 


"  The  excess  profits  tax  is  credited  against  net  income  in  computing 
the  income  tax. 

"™  [Former  Procedure] 

Deductibility  of  1916  income  taxes  accrued  on  portion  of  fiscal 
year  ending  in  1917. — Federal  income  taxes  were  deductible  before 
1917.  The  law  forbidding  the  deduction  was  passed  October  3,  1917. 
It  was  the  intention  of  Congress  to  apply  the  restriction  to  the  new  in- 
come and  excess  profits  taxes,  and  the  restriction  was  a  perfectly 
sound  one.  but  there  was  no  intention  to  forbid  a  taxpayer  to  take 
credit  for  accrued  1916  federal  income  taxes.  For  comments  and  sug- 
gestion, see  Income   Tax  Procedure,  1920,  pages  614-615. 

Ruling.  Additional  excise  taxes  assessed  against  a  corporation  under 
the  Revenue  Act  of  1909  and  paid  during  subsequent  years  are  allowable 
deductions  from  the  gross  income  reported  on  the  corporation's  return 
for  the  year  in  which  paid ;  but  income  taxes  assessed  under  the  Revenue 
Acts  of  1913  or  1916  are  deductililo  only  if  paid  prior  to  January  i,  1917. 
(C.  B.  I,  page  III ;  O.  D.  240.) 

The  foregoing  ruling  is  erroneous.  T.  D.  2433  (January  8,  1917)  per- 
mitted the  deductions  of  1916  taxes  accrued  December  31,  1916,  but  not  paid. 
The  regulation  has  not  been  rescinded,  Init  in  specific  cases  individuals  as 
well  as  corporations  have  been  permitted  to  make  the  deduction. 


FOR    TAXES  965 

income  tax  was  of  slight  practical  importance,  but  when  rates 
rose  to  a  level  where,  in  some  cases,  they  took  the  bulk  of 
the  taxpayer's  income,  the  situation  was  entirely  changed.  It 
may  appear  at  first  glance  that  the  allowance  or  prohibition 
of  the  deduction  would  make  no  net  financial  difference  to 
the  government,  because  it  could  raise  the  rates  to  compensate 
for  the  decrease  in  the  aggregate  tax  base.  But  as  a  mattef  of 
fact  the  allowance  of  this  deduction  would  cut  in  half  the 
total  possible  financial  productivity  of  the  income  tax.  Ap- 
proaching the  question  from  the  point  of  view,  not  of  the 
aggregate  yield,  but  of  the  distribution  of  the  burden  among 
the  taxpayers — the  individual  point  of  View — it  will  readily 
be  seen  that,  under  highly  progressive  rates,  the  allowance  of 
the  deduction  would  have  the  effect  of  providing  relief  to 
those  in  the  upper  surtax  classes  to  a  much  greater  extent 
both  absolutely  and  relatively  than  to  those  in  the  low^er  classes. 
It  would  operate  "to  flatten  out"  the  progressive  rates.  Again, 
during  a  period  when  incomes  are  fluctuating  violently  in 
amount  from  year  to  year  and  when  the  tax  rates  themselves 
change  with  the  seasons,  the  permission  to  deduct  income  tax 
payments  would  yield  very  uneven  results."^ 

Finally  the  argument  that  to  refuse  the  deductions  is  to 
levy  a  tax  on  a  tax  is  specious.  The  government  is  seeking  a 
standard  by  which  to  apportion  a  burden  and  it  decides  that 
this  apportionment  shall  be  according  to  net  incomes  as  they 
stand  before  the  burden  is  imposed — not  according  to  the 
amounts  remaining  after  provision  has  been  made  for  the  l3ur- 
den  which  it  is  seeking  to  impose.  There  should  be  no  objec- 
tion on  the  part  of  the  taxpayers  to  this  provision  in  the  law. 


"  Assume  two  men  with  equal  incomes  in  1919,  one  of  whom  in  1918 
had  the  same  income  as  in  1919,  while  the  other  that  year  had  no  income 
at  all.  In  1919,  the  first  man  would  he  taxed  much  less  than  the  second 
because  of  the  deduction  for  income  taxes  on  his  previous  year's  income. 
On  the  other  hand  in  1920,  if  we  assume  the  incomes  of  both  to  remain 
as  they  were  in  1919,  the  second  man  would  pay  less  than  the  first  man 
because  of  his  heavier  1919  taxes.  No  matter  how  long  the  two  might 
continue  to  receive  the  same  income,  they  would  never  pay  the  same  tax. 
With  rates  varying  from  year  to  year,  the  possibilities  of  inequality  would 
be  great. 


966  DEDUCTIONS 

.  Adjustment  of  taxes  of  prior  years. — When  there  is 
an  adjustment  of  returns  for  years  prior  to  191 7  and  the  in- 
come tax  is  redetermined,  the  additional  tax  paid  or  the  refund 
received  may  require  a  further  adjustment  of  taxes  for  the 
succeeding  year  or  years. 

Penalty  additions  to  taxes  may  or  may  not  be  de- 
ductible.— 

Ruling,  (a)  The  addition  to  tax  authorized  to  be  assessed  by 
section  3176,  Revised  Statutes,  as  amended,  on  delinquent  or  false 
and  fraudulent  returns  is  to  be  considered  a  penalty  and  not  a  tax 
except  for  purposes  of  collection. 

(b)  Such  an  addition  to  tax  made  on  excess  profits  tax  returns 
is  not  an  allowable  credit  in  arriving  at  the  net  income  subject  to 
normal  income  tax. 

(c)  The  payment  of  such  an  addition  to  tax  is  not  to  be  dis- 
allowed as  a  deduction  from  gross  income  in  obtaining  net  income 
on  the  ground  that  it  is  a  part  of  the  income  or  profits  tax  within 
the  provisions  of  law  forbidding  the  deduction  from  gross  income 
of  those  taxes. 

(d)  The  payment  of  an  addition  to  tax  for  delinquency  in  filing 
a  return  may  be  deducted  from  gross  income  as  a  business  expense 
when  such  an  addition  to  tax  is  an  incident  to  carrying  on  a  business 
or  trade.  The  payment  of  an  addition  to  tax  upon  a  false  or  fraudu- 
lent return  may  not  ordinarily  be  deducted  from  gross  income  as  a 
business  expense  and  may  never  be  deducted  in  the  case  of  an  indi- 
vidual who  himself  was  guilty  of  making  a  fraudulent  return.  (C.  B. 
I,  page  241 ;  O.  926.) 

Special   assessments    may    or   may   not   be    deductible. — 

Taxes  which  may  not  be  deducted  include  "those  assessed 
against  local  benefits  of  a  kind  tending  to  increase  the  value  of 
the  property  assessed."^"  The  provision  which  broadens  the 
deduction  so  as  to  include  assessments  which  do  not  increase 
the  value  of  the  property  appeared  for  the  first  time  in  the 
19 18  law  and  is  an  improvement  over   former  procedure.^^ 


'"Section  214  (a-3-c). 

'^  [Former  Procedure]  The  1918  law  was  the  same  in  this  respect  as 
the  present  law.  The  laws  of  1917  and  of  prior  years  excluded  as  deductions 
ail  taxes  assessed  against  local  benefits.     [See  1917  law,  section  5  (a),  third.] 

Regulation.  So-called  "taxes,"  more  properly  assessments,  paid  for 
local  benefits,  such  as  street,  sidewalk,  and  other  like  assessments,  imposed 


FOR   TAXES  967 

Regulation.  So-called  taxes,  more  properly  assessments,  paid 
for  local  benefits,  such  as  street,  sidewalk  and  other  like  improve- 
ments, imposed  because  of  and  measured  by  some  benefit  inuring 
directly  to  the  property  against  which  the  assessment  is  levied,  do 
not  constitute  an  allowable  deduction  from  gross  income.  A  tax  is 
considered  assessed  against  local  benefits  when  the  property  subject 
to  the  tax  is  limited  to  the  property  benefited.  Special  assessments 
are  not  deductible,  even  though  an  incidental  benefit  may  inure  to 
the  public  welfare.  The  taxes  deductible  are  those  levied  for  the 
general  public  welfare  by  the  proper  taxing  authorities  at  a  like  rate 
against  all  property  in  the  territory  over  which  such  authorities  have 
jurisdiction.  Assessments  under  the  statutes  of  California  relating  to 
irrigation  and  of  Iowa  relating  to  drainage,  and  under  certain  stat- 
utes of  Tennessee  relating  to  levees,  are  limited  to  property  benefited, 
and  when  it  is  clear  that  the  assessments  are  so  limited,  the  amounts 
paid  thereunder  are  not  deductible  as  taxes.  When  assessments  are 
made  for  the  purpose  of  maintenance  or  repair  of  local  benefits,  the 
taxpayer  may  deduct  the  assessments  paid  as  an  expense  incurred  in 
business,  if  the  payment  of  such  assessments  is  necessary  to  the  con- 
duct of  his  business.  When  the  assessments  are  made  for  the  purpose 
of  constructing  local  benefits,  the  payments  by  the  taxpayer  are  in 
the  nature  of  capital  expenditures  and  are  not  deductible.  Where 
assessments  are  made  for  the  purpose  of  both  construction  and  main- 
tenance or  repairs,  the  burden  is  on  the  taxpayer  to  show  the  allo- 
cation of  the  amounts  assessed  to  the  different  purposes.  If  the 
allocation  can  not  be  made,  none  of  the  amounts  so  paid  is  deductible. 
(Art.  133.)  24 

The  regulation  recognizes  the  distinction  between  capital 
expenditures  and  expense  as  constituting  the  dividing  line 
between  the  deductible  and  the  non-deductible  types  of  special 


because  of  and  measured  by  some  benefit  inuring  directly  to  the  property 
against  which  the  assessment  is  levied,  do  not  constitute  an  allowable 
deduction  from  gross  income.  Taxes  deductible  are  those  levied  for  the 
public  welfare  by  the  proper  taxing  authorities  at  a  like  rate  against  all 
property   in   the  territory   over   which   such   authorities   have   jurisdiction. 

Special  assessments,  such  as  are  hereinbefore  contemplated  and  which 
are  measured  upon  the  basis  of  the  benefit  flowing  directly  to  the  prop- 
erty, are  not  deductible,  even  though  an  incidental  benefit  may  inure  ♦^o 
the  public  welfare.     (Reg.  ^3.   1918,  Art.  194.) 

'*  [Former  Procedure]  The  editions  of  Regulations  45  published 
early  in  1919  included  the  following  sentence:  "Assessments  under 
Illinois  laws  relating  to  drainage  districts  are  not  limited  to  the  prop- 
erty benefited  and  assessments  so  paid  are  deductible."  The  expres- 
sion, in  the  sentence  which  discusses  the  statutes  of  several  states, 
"and  when  it  is  clear  that  the  assessments  are  so  limited,"  was  intro- 
duced by  T.  D.  2937.     Sec  C.  B.  i,  page  112;  O.  D.  928. 


968  DEDUCTIONS 

assessments.  But  it  also  goes  further  and  attempts  to  apply 
another  test  of  deductibility,  that  is,  whether  an  assessment 
which  is  not  of  the  nature  of  a  capital  expenditure  "is  neces- 
sary to  the  conduct  of  his  business."  The  regulation  does  not 
directly  state  that  such  assessments  when  imposed  against 
non-business  property  are  not  allowable  deductions,  but  it 
plainly  infers  this.  Whatever  can  be  said  for  its  equity,  such 
a  position  is  obviously  illegal.  The  law  itself  when  it  says 
'*Taxes  paid  ....  not  including  those  assessed  against  local 
benefits  .  .  .  ."  [section  214  (a-3)]  practically  defines  a  spe- 
cial assessment  as  a  tax.  and  when  such  assessments  are  not 
"of  a  kind  tending  to  increase  the  value  of  the  property 
assessed"  they  are  deductible,  irrespective  of  whether  they  can 
be  shown  to  be  business  expenses  or  not.  The  tax  on  a  tax- 
payer's residence  has  always  been  an  allowable  deduction. 
Under  the  19 18  law  taxes  assessed  against  local  benefits  which 
do  not  increase  the  value  of  the  property  were  also  made  al- 
lowable deductions,  and  the  192 1  law  is  like  that  of  1918  in 
this  respect. 

Assessments  which  do  not  increase  value  of  prop- 
erty ARE  deductible. — There  is  a  legal  and  economic  distinc- 
tion of  long  standing  between  taxes  and  special  assessments. 
This  distinction  is  based  upon  the  fact  that  the  special  assess- 
ments ordinarily  represent  the  purchase  price  of  equipping  the 
land  with  facilities,  commonly  called  '"improvements" — such 
as  street  paving,  side-walks,  sewers,  etc.  This  equipment  nor- 
mally results  in  a  "benefit  inuring  directly  to  the  property 
against  which  the  assessment  is  levied."  The  economic  basis 
for  the  non-allowance  of  such  assessments  consists  of  the  fact 
that  they  are  in  effect  expenditures  of  a  capital  nature.  But 
it  must  be  recognized  that  this  foundation  disappears  when 
the  special  assessments  are  levied  for  purposes  transitory  in 
character.  Moreover,  the  use  of  special  assessments  for  tran- 
sitory "service"  activities — such  as  lighting  and  cleaning 
streets,  snow  removal,  etc. — is  becoming  more  and  more  wide- 


FOR   TAXES  969 

spread.  These  are  essentially  expenses  and  they  become  al- 
lowable deductions  under  the  19 18  law. 

Types  of  special  assessments  which  can  be  deducted  will 
be  found  in  Massachusetts,  where  special  assessments  may  be 
levied  to  provide  funds  for  street  sprinkling,  for  protection  of 
trees  by  moth  extermination  and  for  current  expenses. 

Of  course,  the  element  of  depreciation  appears  in  most 
public  works,  but  the  distinction  to  be  made  is  whether  or 
not  the  improvement  is  one  which  is  properly  of  a  capital 
nature.     If  not,  the  taxes  paid  on  assessments  are  deductible. 

If  the  improvement  is  of  a  capital  nature  which  in  time 
requires  renewals,  depreciation  may  ])ossibly  be  claimed. 

Special  assessments  which  may  not  be  deducted. — In 
the  case  of  the  permanent  types  of  equipment,  such  as  sewers, 
streets,  etc.,  the  justice  of  placing  special  assessments  on  a 
different  basis  from  taxes  depends  upon  whether  their  nature 
as  capital  expenditures  is  recognized.  Theoretically,  the 
buyer  of  a  tract  of  land  makes  his  purchase  "on  notice"  that 
he  will  be  called  upon  to  pay  for  its  equipment  with  sewers, 
roads,  etc.,  by  the  special  assessment  method,  and  consequently 
he  makes  an  allowance  in  the  price  he  pays  for  the  land  for 
this  additional  expenditure  which  must  ultimately  be  made 
up  from  the  prices  he  will  receive  when  he  sells  the  lots.  It 
is  clear  that  he  should  be  permitted  to  include  all  such  ex- 
penditures for  special  assessments  as  capital  in  calculating  his 
taxable  gain  for  income  tax  purposes  when  he  has  sold  his  lots. 
Unless  he  fully  calculated  his  future  special  assessment  bur- 
den when  he  purchased  the  tract  he  vv'ill  suffer  a  loss.  The 
same  principle  applies  to  special  assessments  on  improved 
property. 

If  there  is  no  element  "tending  to  increase  the  value  of 
the  property"  the  payment  does  not  constitute  a  proper  capital 
item,  because  the  property  owner  would  not  expect  to  be  able 
to  add  the  assessment  to  the  price  of  the  property  in  case 
of  sale. 


970  DEDUCTIONS 

If  the  assessment  does  tend  to  increase  the  value  of  the 
property  it  is  not  a  deduction  for  income  tax  purposes,  but  it 
adds  to  the  capital  value  of  the  property  and  should  be  so  re- 
garded in  computing  the  gain  or  loss  in  case  of  sale. 

Ruling.  Amounts  expended  by  an  estate  on  account  of  special 
assessments  for  the  maintenance  or  repair  of  streets  or  for  sidewalk 
improvements  levied  upon  property  used  in  a  trade  or  business,  if 
the  same  is  necessary  in  the  conduct  of  such  trade  or  business,  con- 
stitute allowable  deductions. 

In  case  any  of  the  property  of  the  estate  is  used  for  residential 
purposes  by  anyone  beneficially  interested  in  the  estate,  the  amounts 
expended  in  payment  of  assessments  levied  upon  such  property  for 
maintenance  and  repairs  can  not  be  deducted  by  the  estate  unless 
the  rental  value  of  the  property  is  included  in  the  gross  income  of 
the  estate (C.  B.  3,  page  149;  O.  D.  613.) 

As  stated  on  page  968,  the  author  is  of  the  opinion  that 
taxes  assessed  for  local  benefits  which  do  not  increase  the 
value  of  the  property  assessed  are  deductible. 

Ruling.  Assessments  for  local  benefits  paid  by  a  tenant  for 
his  landlord  according  to  agreement  are  held  to  be  additional  rent 
paid  by  the  tenant,  and  therefore  deductible  from  his  gross  income. 
The  amount  so  received  by  the  landlord  is  taxable  income  to  him 
but  because  of  its  nature  is  not  an  allowable  deduction  from  his 
gross  income.     (C.  B.  2,  page  123;  O.  D.  373.) 

Certain  so-called  taxes  deductible  only  as  business 
EXPENSE. — In  some  places  charges  for  water  furnished  by  a 
municipality  are  known  as  taxes,  chiefly  because  they  are 
assessed  by  the  city  and  become  a  lien  on  real  estate  if  not  paid. 
Likewise,  in  certain  communities"^  "assessments"  are  laid  upon 
residents  to  raise  funds  for  fire  protection,  road  improvement, 
etc.  These  do  not  bear  the  stamp  of  government  action;  they 
do  not  become  a  lien  on  real  estate  when  not  paid;  and  they 
are  in  fact  voluntary  purchases  of  certain  services  and  equip- 
ment through  a  common  fund.  No  such  expenditures  are  de- 
ductible as  taxes  or  as  expenses  except  when  paid  as  an  inci- 


^For  definition  of  "political  subdivision,"  see  page  95i- .  The  definition 
is  of  importance  when  considering  items  of  doubtful  deductibility. 


FOR   TAXES  971 

dent  to  the  possession  of  income-producing  property  or  to  a 
business  carried  on  for  profit. 

Tax  on  undistributed  surplus  not  deductible. — 

Ruling.  Replying  to  your  comunication  of  March  14,  19 19, 
you  are  informed  that  the  10  per  cent  tax  which  was  imposed  on 
corporation's  undistributed  net  income  by  section  10  (b)  of  the 
Revenue  Act  of  September  8,  1916,  as  amended  by  the  Revenue  Act 
of  October  3,  191 7,  is  not  an  allowable  deduction  from  the  gross 
income  of  a  corporation  shown  on  an  income  tax  return.  (Letter 
to  The  Corporation  Trust  Company,  signed  by  Commissioner  Daniel 
C.  Roper,  and  dated  April   i,   1919.) 

The  10  per  cent  tax  was  a  tax  upon  income  and  for  that 
reason  was  not  deductible. 

Postage  not  deductible  as  a  tax. — 

Regulation Postage  is  not  a  tax  ....   (Art.   131.) 

Postage,  of  course,  is  deductible  as  a  necessary  business 
expense. 

Federal  tax  paid  by  corporations  under  tax-free  covenants 
not  deductible. — The  2  per  cent  federal  tax  on  "tax-free" 
bonds,  which  corporations  theoretically  withhold  at  the  source, 
is  held  to  be  paid  for  account  of  the  recipient  of  the  interest, "^ 
and  since  it  is  an  allowable  credit  to  the  recipient,  taxes  so  paid 
are  not  deductible  by  the  corporation.  In  Azotes  on  the  Rci'- 
enite  Act  of  1918,  the  Secretary  of  the  Treasury  suggested 
(page  22)  that  the  law  be  amended  to  provide  that  "such  tax 
may  be  deducted  by  the  obligor  as  interest." 

Regulation.  Corporations  may  deduct  taxes  from  gross  in- 
come to  the  same  extent  as  individuals,  except  that  in  the  case  of 
corporate  bonds  or  obligations  containing  a  tax-free  covenant  clause, 
the  corporation  paying  a  Federal  tax,  or  any  part  of  it,  for  someone 
else  pursuant  to  its  agreement  is  not  entitled  to  deduct  such  pay- 
ment from  gross  income  on  any  ground.  In  the  case,  however,  of 
corporate  bonds  or  obligations  containing  an  appropriate  tax-free 
covenant  clause,  the   corporation   paying  a   State  tax  or   any   other 


^'For  method  of  securing  advantage  of  the  deduction,  see  Chapter  XIX, 
"Income   from   Interest,"   page  678. 


972 


DEDUCTIONS 


than  a  Federal  tax  for  someone  else  pursuant  to  its  agreement  may 
deduct  such  payment  as  interest  paid  on  indebtedness.-'  Under  the 
revenue  act  of  1921  any  tax  paid  by  a  corporation  pursuant  to  a  tax- 
free,  covenant  clause  need  not  be  included  in  the  gross  income  of 
the  obligee.      (Art.  565.) 

The  last  sentence  of  this  article  is  new. 

Suggestion  to  corporations. — Corporations  having 
"tax-free"  covenant  bonds  are  under  no  necessity  to  pay  a  tax 
on  the  interest  of  such  bonds  as  are  held  by  persons  whose 
income  is  less  than  the  personal  exemption.  They  can  make 
a  saving  by  giving  close  attention  to  the  form  of  certificates 
filed  with  them  by  such  persons.  Many  bondholders  with  very 
small  incomes  are  not  careful  to  file  the  form  of  certificate 
which  claims  the  exemption.  Wherever  feasible  the  certificates 
claiming  exemption  should  be  substituted  for  those  not  claim- 
ing exemption. 

Ruling.  If  an  individual  who  received  during  1917  interest  on 
bonds  containing  a  tax  free  covenant  clause  was  not  liable  to  the  pay- 
ment of  normal  income  tax  for  that  year,  the  amount  of  tax  paid 
at  the  source  in  his  behalf  by  the  debtor  corporation  is  refundable  to 
the  debtor  corporation,  if  such  tax  was  not  actually  withheld  from 
the  individual  bondholder.  The  amount  of  any  income  or  excess 
profits  taxes,  or  any  installment  thereof,  shown  to  be  due  on  the  debtor 
corporation's  income  and  profits  tax  return  may  be  credited  with  the 
amount  of  the  excess  tax  in  question  paid  at  the  source.  (B.  46-21- 
1924;  O.  D.   1103.) 

Accrual  Method  Permitted 

Since  January  8,  1917,^^  when  T.  D.  2433,^^  (which  held 
that  under  the    1916  law,  effective  as  of  January   i,    1916, 


^  [Former  Procedure]  Article  193  of  Regulations  3^,  1918,  did  not 
state  specificallj-  that  "a  State  tax  or  any  other  than  a  federal  tax"  was 
deductible  as  interest. 

"  [Former  Procedure] 

Regulations.  Deductions  for  taxes,  however,  should  be  the  aggre- 
gate of  the  amounts  actually  paid,  as  shown  on  the  cash  book  of  the 
corporation.     (Reg.  33,   1914,  Art.   158.) 

Reserves  for  taxes  cannot  be  allowed,  as  the  law  specifically  provides 
that  only  such  sums  as  are  paid  within  the  year  for  taxes  shall  be  de- 
ducted.    (Reg.  33,  1914,  Art.  156.) 

■-■°  See  page  379. 


FOR   TAXES 


973 


accrued  liabilities,  such  as  taxes,  would  be  allowable  deduc- 
tions) was  issued,  the  regulations  have  permitted  the  deduction 
of  accruals  for  all  taxes  which  in  themselves  are  eligible  sub- 
jects for  deduction.  Furthermore,  the  192 1  law  plainly  states 
that  the  term  "paid"  means  "paid  or  accrued."""  Conse- 
quently, all  tax  reserves,  except  those  for  federal  income  and 
excess  profits  taxes  and  for  special  assessments,  are  deduc- 
tible. In  these  years  of  highly  fluctuating  profits,  proper  re- 
serves for  taxes  are,  of  course,  of  great  importance. 

Accrual  of  New  York  State  tax. — 

Ruling.  The  New  York  State  personal  income-tax  law,  passed 
May  14,  1919,  provides  for  the  imposition  of  an  annual  tax  upon 
income,  and  concludes  with  the  statement  that  "such  tax  shall  first 
be  levied,  collected,  and  paid  in  the  year  1920,  upon  and  with  respect 
to  the  taxable  income  for  the  calendar  year  1919,  or  for  any  taxable 
year  ending  during  the  year  19 19." 

A  taxpayer  of  the  state  of  New  York  who  keeps  his  accounts 
upon  the  accrual  basis,  may  ii%  rendering  his  federal  income  tax 
return  for  1919,  deduct  the  accrued  tax  for  his  fiscal  year  ended  in 
1919,  imposed  by  the  New  York  state  personal  income  tax  law,  pro- 
vided such  fiscal  year  ended  subsequent  to  May  14,  1919,  the  date 
of  passage  of  the  State  taxing  act.  In  case  his  fiscal  year  ended 
prior  to  May  14,  the  accrued  tax  would  not  be  deductible  in  his 
Federal  income  tax  return  for  1919  since  it  was  not  a  known  liability 
at  the  time  of  closing  his  accounts  for  such  fiscal  year. 

In  the  event  of  judicial  interpretation  of  the  New  York  state  per- 
sonal income  tax  law  which  would  have  the  effect  of  changing  the 
individual's  tax  liability  thereunder  it  would  be  necessary  for  him  to 
file  an  amended  return  for  Federal  income  tax  purposes.  (C.  B.  2, 
page  121;  O.  D.  505.) 

New  York  State  franchise  tax  to  be  prorated  when  report- 
ing on  a  calendar  year  basis. — 

Ruling.  The  New  York  State  franchise  tax,  imposed  for  the 
privilege  of  doing  business  in  that  State  for  the  fiscal  year  of  the 
State  ending  October  31,  1920,  is  based  on  1918  income,  but  is  not 
due  and  payable  until  a  later  date.  A  taxpayer  mailing  a  calendar- 
year  return  on  an  accrual  basis  may  deduct  two-twelfths  of  such  tax 
in  his  return  for  1919  and  ten-twelfths  in  his  return  for  1920.  (C.  B. 
2,  page  112;  O.  D.  371.) 


Section  200   (4). 


974 


DEDUCTIONS 


State  of  Wisconsin — surtax  for   1920. — 

Rui.iNC.  Chapter  459  of  the  Session  Laws  of  1921,  for  the  State 
of  Wisconsin  imposes  an  additional  surtax  on  net  income  in  excess 
of  $3,000,  retroactive  for  the  year  1920.  Inquiry  is  made  whether  tax- 
payers who  are  called  upon  to  pay  this  additional  tax  for  1920  are  en- 
titled to  recompute  their  Federal  income  tax  for  that  year,  taking 
into  consideration  the  additional  surtax  imposed  by  said  act  of  the 
Wisconsin  Legislature. 

Held,  that  since  the  surtax  was  not  such  a  known  liability  at  the 
time  of  closing  their  books  for  1920  as  to  justify  them  in  setting  up 
an  accrual  for  such  surtax,  it  is  not  an  allowable  deduction  from 
gross  income  for  1920,  but  is  deductible  by  the  taxpayers  in  the  year 
in  which  paid,  or  in  which  liability  therefore  accrued,  if  the  books 
of  the  taxpayers  are  kept  on  an  accrual  basis.  (B.  48-21-1949;  O  .D. 
1118.) 


[Former  Procedure] 

Munition  manufacturer's  tax — Title  III,  section  302  (c)  (d). 
Act  of  September  8,  1916. — 

Ruling,  i.  Only  taxes  and  interest  actually  paid  within  the  taxable 
year  may  be  deducted  from  gross  inccmie  in  munition  manufacturer's  tax 
returns  for  the  years  1916  and  1917. 

2.  Income  taxes  paid  for  191 5  in  1916  may  not  be  deducted  from 
gross  income. 

3.  Only  that  interest  is  deductible  which  was  actually  paid  within  the 
taxable  year  on  debts  or  loans  which  filled  both  of  two  requirements : 
(i)  That  they  were  contracted  to  meet  the  needs  of  the  munition  business 
and  (2)  that  the  proceeds  thereof  were  actually  used  to  meet  such  needs. 
Interest  paid  within  the  taxable  year  on  that  part  of  the  principal  used  in 
the  munition  business  in  1915,  if  an^^,  from  which  the  profit  is  not  returned 
for  the  purpose  of  the  munitions  tax,  is  not  deductible.  (C.  B.  4,  page  145; 
L.  O.  1057.) 

Method  of  computing  and  accounting  for  munition  manufac- 
turer's TAX  when  taxpayer's  ACCOUNTS  ARE  KEPT  ON  THE  ACCRUAL 
BASIS. — 

Ruling.  Where  a  corporation  in  1916  kept  its  accounts  on  the  accrual 
basis,  and  either  accrued  munitions  taxes  or  credited  amounts  to  a  reserve 
set  up  to  meet  such  taxes,  thus  taking  advantage  of  section  13  (d)  of  the 
Revenue  Act  of  1916,  it  became  bound  by  the  provisions  of  that  section 
and  Treasury  Decision  2433,  and  the  amounts  so  accrued  or  credited  must, 
in  computing  income  subject  to  tax  for  1916,  be  deducted  from  gross  in- 
come for  that  year,  and  not  for  1917,  during  which  year  such  munitions 
taxes  were  paid. 

Section  13  (»d)  of  the  Revenue  Act  of  1916  is  a  qualifying  section, 
and  when  accounts  of  a  corporation  are  kept  on  a  basis  other  than  that 
of  receipts  and  disbursements  it  qualifies  the  manner  of  making  deductions 
authorized  in  section  12  (a)  of  the  Act,  and  the  word  "paid"'  in  the  latter 
section  is  to  be  read  "paid  or  accrued"  depending  on  how  the  accounts  of 
the  corporation  are  kept.     (C.  B.  4,  page  147;  L.  O.  1059.) 


CHAPTER    XXIX 

DEDUCTIONS  FOR  LOSSES 

Preceding  chapters  discuss  the  deductions  for  expenses,  in- 
terest and  taxes.  The  new  concept  of  capital  gains  and  losses 
introduced  in  the  192 1  law  is  treated  in  Chapter  XVII.  It  re- 
mains to  discuss  the  deductions  embraced  within  the  compre- 
hensive term  "losses."  It  is  desirable  to  subdivide  this  sub- 
ject and  to  devote  separate  chapters  to  the  special  items,  namely, 
losses  due  to  bad  debts,  depreciation,  obsolescence,  depletion 
and  gifts.  (Chapter  XXX  to  XXXIV.)  Consequently  the 
subject  matter  of  this  chapter  is  a  residuum  consisting  of 
the  losses  due  to  general  and  miscellaneous  causes,  including 
fluctuation  in  market  values,  to  disasters  and  accidents  of  vari- 
ous kinds,  to  dishonesty,  to  faulty  judgment,  etc'.,  etc. 

Until  the  19 18  act  became  effective,  individuals  were  sub- 
ject to  a  very  definite  restriction  in  that  losses  incurred  by 
them  in  transactions  entered  into  for  profit  outside  their  regu- 
lar trade  or  business  were  deductible  only  to  an  amount  not 
exceeding  profits  arising  from  similar  transactions.^ 


'  [Former  Procedure]  The  provision  of  the  1913  law  relating  to 
the  deduction  of  losses  by  individuals  was  as  follows: 

1913  Law.  "Section  II  (b)  ....  fourth,  ....  losses  actually  sus- 
tained during  the  year,  incurred  in  trade  or  arising  from  fires,  storms  or 
shipwreck,  and  not  compensated   for  by  insurance  or  otherwise " 

The  1916  law  introduced  the  March  i,  1913,  basis  of  valuation  and 
the  provision  permitting  "ontside"  losses,  equal  to  profits  arising  from 
similar  transactions,  to  be  deducted. 

The  1916  and  1917  laws  contained  the  following: 

1916  Law.  "Section  5.  [Individuals]  ....  (a)  ....  Fourth.  Losses 
actually  sustained  during  the  year,  incurred  in  his  business  or  trade, 
or  arising  from  fires,  storms,  shipwreck,  or  other  casualty,  and  from 
theft,  when  such  losses  are  not  compensated  for  by  insurance  or  other- 
wise :  .  .  .  . 

"Fifth.  In  transactions  entered  into  for  profit  but  not  connected  with 
his  business  or  trade,  the  losses  actually  sustained  therein  during  the  year 
to  an  amount  not  exceeding  the  profits  arising  therefrom." 

975 


9/6 


DEDUCTIONS 


Until  recently  the  Treasury  has  restricted  the  word  "pro- 
fits" to  mean  only  those  gains  derived  from  the  sale  or  other 
disposition  of  the  investment  itself. 

The  Solicitor  in  a  recent  ruling  has  broadened  this  defini- 
tion :^ 

Ruling.  It  is  therefore  held  that  all  returns — e.g.,  dividends, 
rents,  interest,  surplus  from  sales,  etc. — actually  realized  within  the 
taxable  year  from  subordinate  endeavors  enteretl  into  for  profit  are 
"profits"  within  the  meaning  of  the  fifth  deduction,  sec.  5  (a),  Reve- 
nue Act  of  1916;  and  thai;  losses  actually  sustained  within  the  same 
taxable  year  by  reason  of  similar  transactions,  closed  and  completed, 
may  be  offset  to  the  extent  of  such  realized  profits.  (C.  B.  4,  page 
163;  L.  O.  1061.) 

The  foregoing  ruling  is  retroactive.  Taxpayers  who  had 
losses  in  19 17  which  were  not  deducted  because  of  the  regula- 
tions then  in  force,  may  now  file  claims  for  refund. 

The  1918  law  included  certain  "relief"  provisions^  designed 
to  prevent  hardship  during  the  period  following  the  war  from 
possible  violent  changes  in  inventory  values. 

The  administration  by  the  Treasury  of  the  section  relating 
to  declines  in  value  of  1918  inventories  has  restricted  the  relief 
to  far  less  than  Congress  intended  when  it  enacted  the  19 18 
law.  The  1921  law  contains  no  provision  similar  to  the  in- 
ventory loss  provision  contained  in  sections  214  (a- 12)  and 
234  (a-14)  of  the  1918  law.  Section  204  of  the  1918  law- 
was  so  narrowly  construed  by  the  Treasury  as  to  deprive  some 
taxpayers  of  relief  who  are  entitled  to  it.    The  1921  law  con- 


The  following  ruling  is  of  importance  of  those  whose  principal  occu- 
pation prior  to  1918  was  trading  on  margin : 

Ruling.  "An  individual  was  daily  in  touch  with  his  broker  during 
1917,  purchasing  and  selling  stocks  exclusively  on  margin,  sustaining  losses 
on  some  transactions  and  realizing  gains  on  others,  the  net  result  being  a 
loss. 

"Since  he  devoted  sufficient  time  and  attention  to  the  purchase  and 
sale  of  stocks  to  constitute  a  vocation,  and  since  all  purchases  and  sales 
were  made  on  margin,  thereby  indicating  that  the  shares  of  stock  were 
purchased  for  resale  and  not  as  an  investment,  it  is  held  that  the  amount 
of  the  loss  represents  an  allowable  deduction  in  computing  net  income  for 
1917."     (C.  B.  4,  page  157;  A.  R.  R.  404.) 

"See  also  Bulletin  32-21-1760;  A.  R.  R.  604. 

^  Section  214  (a-12)  for  individuals,  and  section  234  (a-14)  for  cor- 
porations. 


FOR   LOSSES  977 

tains  a  "net  loss"  provision*  similar  in  principle  to  section  204 
in  the  1918  law,  which  permits  the  application  of  the  loss  of 
one  year  against  the  net  income  of  a  later  year.  In  its  appli- 
cation, however,  the  192 1  "net  loss"  provision  differs  mate- 
rially from  the  corresponding  section  of  the  1918  law.  It  is 
discussed  at  the  end  of  this  chapter,  page  102 1  et  seq. 

The  chief  problems  to  be  discussed  in  this  chapter  are, 
therefore,  the  determination  of  procedure  under  these  special 
"relief"  provisions  and  the  establishment  of  the  standard  by 
which  to  measure  losses  due  to  diminution  in  values.  This 
second  problem  is  similar  to  that  discussed  in  Chapter  XVI, 
"Income  from  Exchanges  and  Sales  of  Property." 

Losses  Which  Are  Deductible 

In  a  broad  sense  there  are  no  limitations,  under  the  1921 
law,  upon  the  right  of  individuals  and  corporations  to  deduct 
all  losses  sustained  during  the  taxable  year. 1 921,  w^hether  or 
not  incurred  in  business  or  trade.  There  are  certain  require- 
ments such  as  those  regarding  transactions  entered  into  for 
profit,  "wash  sales,"  etc.,  but  in  general  all  losses  may  be  de- 
ducted. The  restrictions  are  fully  discussed  in  the  following 
pages. 

Individuals. — 

Law.  Section  214.  (a)  That  in  computing  net  income  there  shall 
be  allowed  as  deductions:  .... 

(4)  Losses  sustained  during  the  taxable  year  and  not  compensated 
for  by  insurance  or  otherwise,  if  incurred  in  trade  or  business; 

(5)  Losses  sustained  during  the  taxable  year  and  not  compensated 
for  by  insurance  or  otherwise,  if  incurred  in  any  transaction  entered  into 
for  profit,  though  not  connected  with  the  trade  or  business;  but  in  the 
case  of  a  nonresident  alien  individual  only  if  and  to  the  extent  that  the 
profit,  if  such  transaction  had  resulted  in  a  profit,  would  be  taxable  un- 
der this  title.  No  deduction  shall  be  allowed  under  this  paragraph 
for  any  loss  claimed  to  have  been  sustained  in  any  sale  or  other  dis- 
position of  shares  of  stock  or  securities  m.ade  after  the  passage  of  this 
Act  where  it  appears  that  within  thirty  days  before  or  after  the  date 

*  Section  204. 


978  DEDUCTIONS 

of  such  sale  or  other  disposition  the  taxpayer  has  acquired  (otherwise 
than  by  bequest  or  inheritance)  substantially  identical  property,  and 
the  property  so  acquired  is  held  by  the  taxpayer  for  any  period  after 
such  sale  or  other  disposition.  If  such  acquisition  is  to  the  extent  of 
part  only  of  substantially  identical  property,  then  only  a  proportionate 
part  of  the  loss  shall  be  disallowed; 

(6)  Losses  sustained  during  the  taxable  year  of  property  not  con- 
nected with  the  trade  or  business  (but  in  the  case  of  a  nonresident  alien 
individual  only  property  within  the  United  States)  if  arising  from  fires, 
storms,  shipwreck,  or  other  casualty,  or  from  theft,  and  if  not  com- 
pensated for  by  insurance  or  otherwise.  Losses  allowed  under  para- 
graphs (4),  (5),  and  (6)  of  this  subdivision  shall  be  deducted  as  of  the 
taxable  year  in  which  sustained  unless,  in  order  to  clearly  reflect  the 
income,  the  loss  should,  in  the  opinion  of  the  Commissioner,  be  ac- 
counted for  as  of  a  different  period.  In  case  of  losses  arising  from  de- 
struction of  or  damage  to  property,  where  the  property  so  destroyed 
or  damaged  was  acquired  before  March  i,  1913,  the  deduction  shall  be 
computed  upon  the  basis  of  its  fair  market  price  or  value  as  of  March 
I,  1913;  .... 

Corporations. — 

Law.  Section  234.  (a)  .  .  .  .  (4)  Losses  sustained  during  the 
taxable  year  and  not  compensated  for  by  insurance  or  otherwise;"'  un- 
less, in  order  to  clearly  reflect  the  income,  the  loss  should  in  the  opinion 
of  the  Commissioner  be  accounted  for  as  of  a  different  period.  No  de- 
duction shall  be  allowed  for  any  loss  claimed  to  have  been  sustained 
in  any  sale  or  other  disposition  of  shares  of  stock  or  securities  made 
after  the  passage  of  this  Act  where  it  appears  that  within  30  days  before 
or  after  the  date  of  such  sale  or  other  disposition  the  taxpayer  has  ac- 
quired (otherwise  than  by  bequest  or  inheritance)  substantially  iden- 
tical property,  and  the  property  so  acquired  is  held  by  the  taxpayer  for 


"  [Former  Procedure]  The  corresponding  clause  in  the  1913  law 
read: 

Law.  Section  II,  G  (b)  ....  "all  losses  actually  sustained  within 
the  year  and  not  compensated  by  insurance  or  otherwise." 

1916  Law.  "Section  12.  (a)  ....  Second.  All  losses  actually  sus- 
tained and  charged  oflf  within  the  year  and  not  compensated  by  insurance 
or  otherwise " 

It  should  be  noted  that  the  1916  law  reads  "actually  sustained  and 
charged  off."  The  words  "and  charged  off"  did  not  appear  in  the  sec- 
tion relating  to  individuals  and  were  inserted  in  the  corporation  sec- 
tion only  in  1916. 

The  1918  law  omitted  tlie  words  "and  charged  off"  which  formerly 
appeared,  but  it  is  to  be  assumed  that  losses  will  not  be  allowed  unless 
charged  off  by  items  or  through  reserves. 


FOR   LOSSES 


979 


any  period  after  such  sale  or  other  disposition,  unless  such  claim  is 
made  by  a  dealer  in  stock  or  securities  and  with  respect  to  a  trans- 
action made  in  the  ordinary  course  of  its  business.  If  such  acquisition 
is  to  the  extent  of  part  only  of  substantially  identical  property,  then 
only  a  proportionate  part  of  the  loss  shall  be  disallowed.  In  case  of 
losses  arising  from  destruction  of  or  damage  to  property,  where  the 
property  so  destroyed  or  damaged  was  acquired  before  March  i,  1913, 
the  deduction  shall  be  computed  upon  the  basis  of  its  fair  market  price 
or  value  as  of  March  i,  1913;   .... 

Regulation If  (i)  a  corporation  sells  its  capital  as- 
sets for  less  than  their  cost,  and  such  assets  were  acquired  before 
March  i,  1913,  then  if  the  fair  market  value  on  March  i,  1913,  less 
depreciation  subsequently  sustained  and  allowable  as  a  deduction  is 
less  than  the  amount  realized,  no  loss  is  deductible;  if  (2)  such  fair 
market  value  less  depreciation  subsequently  sustained  and  allowable 
as  a  deduction  is  greater  than  the  amount  realized,  but  the  amount 
realized  exceeds  original  cost,  no  loss  is  deductible;  if  (3)  the  amount 
realized  is  less  than  both  original  cost  and  the  value  of  March  i,  1913, 
less  depreciation  subsequently  sustained  and  allowable  as  a  deduction, 
the   deductible  loss   is  the   difference   between   such   amount   realized 

and  such  cost  or  March   i,  1913.  value,  whichever  is  lower 

(Art.  563.) 

Losses,  to  be  allowed  as  deductions,  must  meet  the  pro- 
visions of  the  law  that  they  have  been  actually  ''sustained." 
This  is  a  reasonable  requirement.  Most  concerns  charge  off 
or  provide  reserves  for  losses  as  and  when  losses  occur  and  the 
items  to  be  deducted  can  be  taken  directly  from  the  books. 
In  the  case  of  individuals  who  keep  no  books,  more  difficulty 
is  experienced. 

In  discussing  the  phrase  "losses  sustained''  the  regula- 
tions state  that  this  condition  "must  usually  be  evidenced  by 
closed  and  completed  transactions.""  This,  however,  does  not 
preclude  the  use  of  inventories  for  the  purpose  of  ascertaining 
gains  or  losses.  The  privilege  of  using  inventories,  long  per- 
mitted to  business  men  generally  in  the  case  of  merchandise, 
was  not  extended  to  dealers  in  securities  until  late  in 
191 7;  but  at  that  time  was  supported  by  an  opinion  of 
the  Attorney  General  who  advised  that  the  Supreme  Court 
in  a  case  under  the  1909  law  sanctioned  the  practice.     For  a 

•Reg.  62,  Art.  141. 


98o 


DEDUCTIONS 


full  discussion  of  inventories  the  reader  is  referred  to  Chapter 
XV,  page  452  et  seq.'' 

If  an  individual  is  engaged  in  business  on  his  own  account 
or  as  a  partner  and  the  year's  operations  result  in  a  net  loss, 
the  amount  of  such  loss  is  an  allowable  deduction  from  income 
from  other  sources  in  a  tax  return. 

The  Treasur}^  has  ruled  that  a  partnership  which  holds 
all  of  the  stock  of  a  corporation  and  provides  funds  to  liquidate 
losses  incurred  by  that  corporation,  may  not  deduct  such  pay- 
ments as  losses  of  the  partnership. 

In  the  case  of  a  partnership  which  incorporates  and  com- 
mences its  operations  as  a  corporation  during  a  taxable  year, 
the  loss  sustained  by  the  partnership  during  the  portion  of  the 
taxable  year  it  was  operating  cannot  be  deducted  from  the 
income  of  either  the  preceding  or  succeeding  taxable  year 
unless  the  circumstances  are  such  that  it  can,  and  does,  take 
advantage  of  section  330®  of  the  19 18  law  and  elects  to  be 
taxed  as  a  corporation  for  the  full  taxable  year.® 

Losses  may  be  deducted  in  year  sustained. — The  1921  law^° 
permits  losses  to  be  deducted  in  a  year  other  than  the  one  in 
which  the  loss  was  sustained. ^^ 


'  See   also  page   985. 

*  Section  229  of  the  1921  law  is  analagous  to  the  third  paragraph  of 
section  330  of  the  1918  law. 

»C.  B.  4,  page  54;  O.  D.  855.     See  also  B.  29-21-1736;  A.  R.  R.  571. 

'"Sections  214   (a-6)   and  234   (a-4). 

"  [Former  Procedure]  The  1918  and  prior  laws  did  not  contain  this 
specific  provision.  Losses,  however,  were  supposed  to  be  deducted  in  the 
year  when  sustained,  and  the  Commissioner  had  full  power  to  permit 
amended  returns  in  cases  where  the  discovery  was  in  a  later  year.  The 
following  ruling  illustrates  the  narrow  interpretation  of  the  1918  law. 

Ruling.  "The  M  Company  in  1918  delivered  under  a  bona  fide  sale 
goods  guaranteed  as  to  quality  until  July  i,  1919.  On  inspection  of  a  por- 
tion of  the  goods  in  May,  1919,  they  were  found  unsuitable,  and  to  save 
loss  resulting  from  a  complete  inspection  a  compromise  resale  to  the  M 
Company  was  effected  at  the  original  purchase  price  less  certain  con- 
cessions. 

"Held,  that  the  M  Company  may  not  take  into  its  inventory  as  of 
December  31,  1918,  the  goods  delivered  in  that  year  and  that  the  resale 
established  a  basis,  in  the  taxable  year  1919,  for  determining  loss."  (C.  B.  4, 
page  47;  A.  R.  M.  129.) 


FOR   LOSSES  981 

Regulation.  As  a  general  rule  losses  allowed  under  paragraphs 
(4)>  (5)»  ^i^d  (6)  of  this  subdivision  shall  be  deducted  as  of  the  tax- 
able year  in  which  sustained.  In  exceptional  circumstances^  however, 
in  order  to  avoid  injustice  to  the  taxpayer  and  to  more  clearly  reflect 
his  income,  the  Commissioner  may  permit  a  loss  to  be  accounted  for 
as  of  a  year  other  than  the  one  in  which  sustained.  For  example,  an 
embezzlement  or  a  shipwreck  may  occur  in  1921  but  not  become  known 
until  1922  and  in  such  a  case  income  may  be  more  clearly  reflected 
by  accounting  for  the  loss  as  of  1922  rather  than  of  1921.  If  a  tax- 
payer desires  to  account  for  a  loss  as  of  a  period  other  than  the  one 
in  which  actually  sustained,  he  shall  attach  to  his  return  a  statement 
setting  forth  his  request  for  consideration  of  the  case  by  the  Com- 
missioner, together  with  a  complete  statement  of  the  facts  upon  which 
he  relies.  However,  in  his  income  tax  return  he  shall  deduct  the  loss 
only  for  the  taxable  year  in  which  actually  sustained.  Upon  the  audit 
of  the  return  the  Commissioner  will  decide  whether  the  case  is  within 
the  exception  provided  by  the  statute ;  if  not  within  the  exception  the 
loss  will  be  allowed  only  as  of  the  taxable  year  in  which  sustained. 
The  allowance  of  a  deduction  for  a  loss  in  a  year  other  than  the  one  in 
which  sustained  is  entirely  within  the  discretion  of  the  Commissioner 
and  he  will  consider  exercising  this  discretion  only  in  exceptional 
cases.  A  shrinkage  in  the  value  of  the  taxpayer's  stock  in  trade,  as 
reflected  in  his  inventory,  is  not  such  a  loss  as  is  contemplated  by  the 
provision  of  the  statute  authorizing  the  Commissioner  to  allow  the 
deduction  of  a  loss  for  a  taxable  year  other  than  the  one  in  which 
sustained.     (Art.  146.) 

The  vvord  "sustained"  as  used  in  the  law  is  of  doubtful 
meaning.  If  used  in  its  ordinary  meaning  taxpayers  should 
not  be  permitted  to  shift  losses  to  periods  not  affected.  If  the 
word  is  synonymous  with  "discovered"  it  is  quite  proper  that 
losses  discovered  in  one  year  should  not  be  related  back  to  the 
period  when  sustained.  The  illustrations  used  in  Art.  146 
indicate  that  the  word  "sustained"  is  synonymous  with  "be- 
come known,"  and  therefore  with  "discovered." 


[Former  Procedure — Continued] 

It  is  obvious,  in  the  foregoing  ruling,  that  the  loss  arose  in  1918.  The 
true  net  income  could  only  be  determined  by  filing  an  amended  return. 
It  is  assumed  that  the  loss  was  an  extraordinary  one ;  otherwise  it  should 
have  been  absorbed  in  1919. 


982  DEDUCTIONS 

Determination  and  Measurement  of  Property 
Losses 

The  determination  and  measurement  of  losses  due  to  a 
diminution  in  the  value  of  property  involve  the  same  problems 
of  procedure  as  those  which  are  discussed  in  detail  for  the 
determination  and  measurement  of  profits  from  transactions 
in  property.  (See  Chapter  XVII.)  It  happens  that  the  im- 
portant cases  which  have  been  decided  by  the  Supreme  Court 
have  arisen  from  additional  assessments  imposed  by  revenue 
officers  because  of  alleged  failure  to  report  property  gains  in 
full,  but  the  principles  established  in  these  decisions  apply 
with  equal  force  to  property  losses. 

Property  acquired  before  March  i,  19 13. — The  19 16  law 
in  referring  to  individuals  specifically  declared  "that  for  the 
purpose  of  ascertaining  the  loss  sustained  from  the  sale  or 
other  disposition  of  property,  real,  personal  and  mixed,  ac- 
quired before  March  first,  nineteen  hundred  and  thirteen,  the 
fair  market  price  or  value  of  such  property  as  of  March  first, 
nineteen  hundred  and  thirteen,  shall  be  the  basis  for  deter- 
mining the  amounts  of  such  loss  sustained. "^^  Using  practi- 
cally the  same  language,  section  10  of  the  1916  law  established 
this  basis  for  corporations  also.  In  other  words,  only  losses 
sustained  after  March  i,  19 13,  are  deductible.  The  principle 
laid  down  in  the  19 18  law  was  the  same.^^ 


"[Former  Procedure]  The  1913  law  did  not  contain  this  specific 
provision  and  for  a  time  there  was  doubt  as  to  proper  procedure.  Under 
the  1913  rulings  losses  when  deductible  were  prorated  over  the  whole  time 
the  property  was  held,  and  that  part  of  the  loss  apportioned  to  the  taxable 
period  appeared  in  the  annual  returns.  The  apportionment  was  made  as  of 
January  i,  1909,  in  the  case  of  corporations  and  March  i,  1913,  in  the  case 
of  individuals.  This  procedure  was  disputed  and  there  were  many  un- 
settled cases.  These  may  now  be  adjusted  in  the  light  of  the  Supreme  Court 
decisions  discussed  in  detail  in  Chapter  XVII. 

"  [Former  Procedure]  It  will  be  noticed  that  in  the  following  ruling 
under  the  1918  law  no  consideration  was  given  to  the  cost  of  property 
acquired  prior  to  March  i,   1913. 

RuLiXG.  "A  taxpayer  who.  prior  to  March  i,  1913,  purchased  bonds 
which  had  a  market  value  as  of  March  i,  1913,  above  par,  and  which  were 
redeemed  at  par  in  1919  is  entitled  to  deduct,  as  a  loss  in  1919,  the  diflfer-. 


FOR   LOSSES  983 

The  1 92 1  law/*  however,  restricts  losses  deductible  in 
respect  of  sales  or  other  disposition  of  property  acquired  prior 
to  March  i,  191 3,  to  the  lesser  of  the  differences  between 
the  sale  price  and  the  cost  or  March  i,  1913,  value,  respectively. 

Shortly  stated  and  eliminating  depreciation,  obsolescence 
and  depletion  (which  the  law  states  are  to  be  calculated  upon 


ence  between  the  market  value  on  March  i,  1913,  and  the  value  received 
in  1919  upon  the  maturity  of  the  bonds."     (C.  B.  2,  page  132;  O.  D.  506.) 

Under  the  1921  law  the  loss  would  be  allowed  as  computed  in  the  above 
ruling,  only  if  the  cost  prior  to  March  i,  1913,  was  equal  to  the  value  of 
the  bonds  at  that  date.  If  the  cost  was  less  than  March  i,  1913,  value  the 
deductible  loss  would  be  correspondingly  reduced. 

An  important  question  to  be  considered  is  whether  this  restriction  of 
the  1921  law  is  to  be  deemed  to  be  interpretive  of  the  corresponding  loss 
provisions  in  previous  laws.  During  1921  the  Supreme  Court  decided  in 
the  cases  of  Goodrich  v.  Edwards  and  Brcivstcr  v.  Walsh,  that  an  apparent 
profit  representing  the  difference  between  value  at  March  i,  1913,  and  sub- 
sequent sale  price  was  taxable  only  to  the  extent  that  it  exceeded  original 
cost  of  the  property.  In  other  words,  only  actually  realized  income  was 
intended  to  be  or  could  be  taxed.  The  Solicitor  General,  in  a  brief  filed  in 
these  cases,  contended  that  if  the  taxable  gain  should  be  limited  to  the 
excess  of  sale  price  over  value  at  March  i,  1913,  or  cost,  whichever  was 
higher,  the  allowance  for  losses  should  be  restricted  to  the  difference  be- 
tween value  at  March  i,  1913,  or  cost,  whichever  was  lower. 

The  court,  however,  expressed  no  opinion  with  respect  to  the  manner  in 
which  losses  should  be  computed  as  this  question  was  not  at  issue. 

Nevertheless,  immediately  after  the  decisions  in  the  Goodrich  and 
Brewster  cases  (prior  to  the  passage  of  the  1921  law),  the  Treasury  amended 
its  regulations  pertaining  to  the  determination  of  profits  or  losses  on  sales 
of  property  acquired  prior  to  March  i,  1913,  embodying  therein  the  method 
of  computation  now  prescribed  by  the  1921  law.  In  the  author's  opinion 
these  regulations  were  illegal.  The  basis  of  taxing  gains  must  be  governed 
by  the  sixteenth  amendment ;  there  is  no  inhibition  regarding  allowable 
deductions.  Congress  could  allow  taxpayers  to  deduct  150  per  cent  of 
losses  if  it  cared  to,  but  it  could  not  increase  taxable  income  i  per  cent. 
As  the  1918  and  prior  laws  permitted  deductions  on  the  basis  of  March  i, 
1913,  values  irrespective  of  cost,  the  allowance  stands  until  December  31, 
1920,  when  it  was  taken  away  by  the  1921  law. 

Taxpayers  who  prior  to  1921  were  entitled  to  larger  deductions  for 
losses,  if  based  on  the  language  of  the  1918  and  prior  laws,  than  are 
allowed  under  the  Treasury's  regulations  as  amended  in  1921,  should  pay 
under  protest  any  taxes  assessed  on  the  latter  basis.  The  question  has  not 
been  decided  in  court  but  it  is  of  sufficient  importance  to  litigate. 

'*  Section  202    (b). 


984 


DEDUCTIONS 


March  i,  1913,  value  irrespective  of  prior  cost),  any  appre- 
ciation at  March  i,  19 13,  which  does. not  continue  until  reali- 
zation cannot  be  allowed  as  a  deduction.     This  is  fair  enough. 

A  bond  cost  $700  in  1910;  its  market  value  was  $900  on 
March  i,  191 3 ;  it  is  sold  for  $700  in  1922.  There  is  no  allow- 
able deduction  for  the  apparent  loss,  based  on  March  i,  19 13, 
value.  If  sold  for  $600  there  is  an  allowable  loss  of  $100. 
If  the  value  of  the  bond  on  March  i,  1913,  was  $600,  and  it 
is  sold  for  $500,  the  allowable  loss  is  only  $100,  whereas  the 
actual  loss  as  compared  with  cost  is  $200.  In  practice  the 
1921  law  restricts  allowable  losses  to  March  i,  1913,  values 
when  such  values  were  below  cost,  and  to  cost  when  cost  was 
lower  than  March  i,  19 13,  value,  under  the  theory  that  what- 
ever taxpayers  had  on  March  i,  19 13,  was  their  capital.  The 
law  works  equitably  as  long  as  full  deduction  can  be  made 
when  any  part  of  such  capital  is  lost.  But  when  deduction  is 
denied  because  March  i,  1913,  value  is  less  than  cost  and  de- 
duction is  also  denied  because  appreciation  at  March  i,  1913, 
did  not  continue,  the  comment  "fair  enough"  applied  to  the 
latter  contingency  is  w'ithdrawn  because  the  principle  of  capi- 
tal value  March  i,  19 13,  irrespective  of  cost  is  departed  from. 

The  measure  of  deductible  losses  is  not  the  same  as  that 
of  taxable  gains;  but  as  the  computation  in  case  of  gains  is  so 
nearly  like  the  computation  in  the  case  of  losses,  it  is  easier 
to  discuss  and  illustrate  the  computation  in  one  place.  There- 
fore, the  discussion  will  be  found  on  page  569  et  seq. 

Property  acquired  after  March   i,   1913. — ■ 

Regulation.  For  the  purpose  of  ascertaining  the  gain  or  loss 
from  the  sale  or  exchange  of  property,  the  basis  is  the  cost  of  such 
property,  or  in  the  case  of  property  which  should  be  included  in  the 
inventory,  its  latest  inventory  value (Art.  1561.) 

Determination  of  value  on  March  i,  1913 — The  pro- 
cess of  determining  the  value  at  March  i,  1913,  of  prop- 
erty purchased  before  that  date  is  fully  discussed  in  Chapter 


FOR   LOSSES  985 

XVII.  Suffice  it  to  say  here  that  the  question  is  of  enough 
importance  to  justify  the  collection  of  data  which  may  serve 
to  establish  true  values  as  of  that  date.  In  the  absence  of 
such  data  the  Treasury  would  probably  have  assumed  (prior 
to  the  1 92 1  law)  that  the  March  i,  19 13,  value  was  the  same 
as  original  cost  less  depreciation.  In  view  of  the  new  defini- 
tion of  losses  deductible  upon  disposition  of  property  acquired 
prior  to  March  i,  1913,  which  is  contained  in  the  1921  law 
[Section  202  (b)],  it  is  quite  conceivable  that  the  taxpayer 
may  be  required  by  the  Treasury  to  prove  that  the  March  i, 
19 1 3,  value  was  at  least  equal  to  cost  of  the  property  before 
allowing  a  loss  claimed  for  difference  between  cost  before 
and  sale  price  after  March,  1913. 

The  1 92 1  law  provides  that  exchanges  and  reorganiza- 
tions are  closed  transations  (a)  when  property  received  has  a 
readily  realizable  market  value,  and  (not  "or")  (b)  the  prop- 
erty received  is  of  a  different  nature  than  that  parted  with.^^' 
These  requirements  are  fully  discussed  on  page  536  ct  seq., 
and  need  not  be  repeated.  Shortly  stated,  losses  cannot  be 
deducted  unless  there  is  a  closed  transaction.^® 

Establishment  of  loss  by  inventory  method. — Inventories 
are  now  prescribed  as  "necessary  in  every  case  in  which  the 
production,  purchase  or  sale  of  merchandise  is  an  income- 
producing  factor."^''  Prior  to  191 7  the  use  of  inventories  was 
])ermitted  for  the  purpose  of  establishing  gains  or  losses  only 
in  the  case  of  merchants  and  manufacturers.  For  a  full  dis- 
cussion of  this  subject  the  reader  is  referred  to  Chapter  XV. 
Permission  to  use  the  inventory  method  has  been  extended  to 


'°  [Former  Procedure]  The  1918  law,  section  202  (b),  provided  that 
"when  property  is  exchanged  for  other  property,  the  property  received  in 
exchange  shall  for  the  purpose  of  determining  gain  or  loss  be  treated  as  the 
equivalent  of  cash  to  the  amount  of  its  fair  market  value,  if  any." 

"For  discussion  of  closed  transactions  see  also  Income  Tax  Procedure, 
1 921,  page  793  and  Chapter  XV. 

"  See  page  453. 


986  DEDUCTIONS 

dealers  in  securities.     Valuation  at  "cost  or  market  whichever 
is  the  lower"  is  permitted/^ 

Inventoried  shrinkage  in  securities  deductible  only 
BY  DEALERS. — Stocks  and  bonds  owned  by  others  than  dealers 
may  not  be  revalued  periodically  and  losses  may  not  be  charged 
off  by  the  inventory  method.  Neither  can  amounts  invested  in 
foreign  money  be  so  treated  when  merely  due  to  a  fall  in  ex- 
changed^ Excepting  when  investments  became  worthless,^'' 
they  must  mature  or  be  sold  to  establish  a  loss. 

Regulation.  A  person  possessing  stock  of  a  corporation  can  not 
deduct  from  gross  income  any  amount  claimed  as  a  loss  merely  on 
account  of  shrinkage  in  value  of  such  stock  through  fluctuation  of  the 
market  or  otherwise.  The  loss  allo\val)Ie  in  such  cases  is  that  actually 
suffered  when  the  stock  is  disposed  of (Art.  144.) 

When  deduction  for  shrinkage  may  not  be  claimed 

BY  holders  of  life  OR  TERMINABLE  INTERESTS. 

Regulation.  No  deduction  shall  be  allowed  in  the  case  of  a  life 
or  a  terminable  interest  acquired  by  gift,  bequest,  or  inheritance, 
where  the  estate  or  trust  is  entitled  to  a  deduction  under  the  statute 
but  there  is  no  reduction  of  the  income  of  the  life  or  terminable  in- 
terest. For  example,  an  estate  or  a  trust  in  a  certain  State  sells 
securities  at  a  loss;  if,  under  the  laws  of  that  State,  the  beneficiary 
suffers  no  actual  loss,  then  even  though  the  estate  or  trust  is  permitted 
to  deduct  such  loss  in  making  its  return,  the  beneficiary  whose  income 
has  not  been  diminished  thereby  is  not  entitled  to  a  deduction  on  ac- 
count of  such  loss  but  must  include  in  his  return  the  full  amount  dis- 
tributed or  distributable (Art.  295.) 


'*  [Former  Procedure]  Before  December  19.  1917,  shrinkage  in  the 
value  of  securities  was  not  allowed  as  a  deduction  even  when  they  were  the 
stock-in-trade  of  a  dealer.  This  position  is  illustrated  by  the  following 
Treasury  decision  : 

Regulations.  "This  ruling,  in  so  far  as  it  relates  to  depreciation 
....  is  not  to  be  construed  as  recognizing  any  gain  or  loss  due  to 
fluctuations  in  the  market  value  or  arbitrary  changes  in  the  book  value 
of  securities  and  like  assets,  the  gain  or  loss  with  respect  to  which  will 
be  determined  only  when  such  assets  mature,  or  are  sold  or  disposed  of 
— that  is,  when  there  is  a  completed,  a  closed,  transaction."  (T.  D. 
2077,  November  21,  1914.) 

"Losses  of  this  character  are  only  ascertainable  when  the  securities 
mature,  are  disposed  of,  or  cancelled."     (T.  D.  2152,  February  12,  1915.) 

^«C.  B.  4,  page  155;  O.  D.  764. 

"■"  See   page   988. 


FOR    LOSSES  987 

Section  215  (b)"''  of  the  1921  law,  on  which  the  above 
article  is  based,  enacted  into  law  the  procedure  laid  down  by 
the  Treasury  in  article  347  of  Regulations  45.  That  article 
gave  effect  to  an  interpretation  for  which  there  was  little  or 
no  warrant  in  the  law  itself." 

German  investments — when  determined  worthless. — When 
securities  bought  in  Germany  for  300,000  marks  (value  at 
time  of  purchase  $9,000)  are  sold  for  500,000  marks  (value 
at  time  of  sale  $5,000),  the  loss  of  $4,000  is  deductible  from 
income.^^ 

Ruling.  Receipt  is  acknowledged  of  your  letter  of  the  loth  inst., 
in  which  you  state  an  American  corporation  owns  some  German 
investments.  You  desire  to  be  advised  whether  or  not  this  corpora- 
tion can  charge  ofif  such  investments  as  an  actual  loss  and  deduct  the 
same  in  preparing  its  return  of  annual  net  income  with  the  under- 
standing that  any  amounts  subsequently  received  will  be  credited  to 
income  in   subsequent  years. 

In  reply  you  are  informed  that  the  tax  law  makes  an  allowance 
for  a  deduction  from  gross  income  of  all  losses  actually  sustained 
by  a  corporation  during  the  year  for  which  the  return  is  made. 
However,  in  the  case  you  mention  it  does  not  appear  that  a  loss 
which  is  definitely  known  has  been  sustained  from  a  closed  and 
completed  transaction.  Therefore,  it  is  necessary  to  hold  that  the 
American  corporation  in  question  can  not  deduct  an  amount  repre- 
senting a  part  or  the  whole  of  the  German  investments  inasmuch  as 
at  best  this  deduction  would  be  merely  estimated  and  not  a  loss  from 
a  closed  and  completed  transaction.  (Letter  to  Lybrand,  Ross  Bros. 
&  Montgomery,  New  York,  signed  by  Deputy  Commissioner  L.  F. 
Speer,  and  dated  September  18,  1918.) 

Russian  investments. — 

Ruling.  Because  of  disturbed  political  conditions  in  Russia 
there  is  little  hope  that  bonds  of  the  Imperial  Internal  Russian  4 
per  cent  loan  of  1894  will  be  redeemed.  A  holder  of  such  bonds 
which  were  purchased  in  1916,  who  was  unsuccessful  in  finding  a 
market  for  them  during  the  year  1919,  is  entitled  to  a  deduction 
from  his  gross  income  for  that  year  to  the  extent  of  the  amount 
actually    paid    for    them,    provided,    however,    that    such    amount    is 


"See   Chapter  XXXVII    for  text. 

"This  question  was  discussed  at  some  length  in  Incnme  Tax  Procedure, 
1921,  pages  1040-1046. 

^C.  B.  4,  page  234;  O.  D.  809. 


988 


DEDUCTIONS 


charged  off  the  taxpayer's  accounts  for  tlie  year  1919  and  a  cor- 
responding reduction  made  in  his  surplus  account.  (  C.  B.  3.  page  167; 
O.  D.  748.) 

Losses  on  Liberty  bonds  distributed  in  dividends. — The 
recipieiit  of  a  dividend  paid  in  Liberty  bonds  or  other  securi- 
ties should  return  the  dividend  for  taxation  at  the  market 
value  of  the  securities  at  the  time  of  their  receipt."*  The  cor- 
poration paying  the  dividend  should  charge  to  dividend  ac- 
count the  market  value  of  the  securities  distributed.  If  the 
market  value  at  time  of  distribution  is  less  than  the  price  paid 
for  the  securities,  the  difference  should  be  charged  off  as  a 
loss. 

The  Treasury  held  in  an  earlier  ruling  that  such  a  loss  is 
not  an  allowable  deduction,"^  on  the  ground  that  a  transaction 
conducted  by  a  corporation  with  its  stockholders  is  not  of  a 
character  to  affect  the  amount  of  its  net  income.  This  argu- 
ment was  inconsistent  with  the  Treasury's  rulings,  to  the 
effect  that  the  corporate  entity  must  be  disregarded  when  used 
to  avoid  the  payment  of  tax  on  income.  This  inconsistency 
was  evidently  recognized,  since  in  a  later  ruling^®  the  Treasury 
allowed  as  a  deduction  the  net  difference  between  the  market 
value  at  March  i,  1913,  of  securities  and  their  value  when 
distributed  as  a  dividend  in  191 7. 

When  deduction  may  be  claimed  for  shrinkage. — 

Regulation However,  if  stock  of  a  corporation  be- 
comes worthless,  its  cost  or  other  basis  determined  under  section  202 
may  be  deducted  by  the  owner  in  the  taxable  year  in  which  the  stock 
became  worthless,  provided  a  satisfactory  showing  of  its  worthlessness 
be  made,  as  in  the  case  of  bad  debts.  Where  banks  or  other  corpora- 
tions which  are  subject  to  supervision  by  Federal  authorities  (or  by 
State  authorities  maintaining  substantially  equivalent  standards)  in 
obedience  to  the  specific  orders  or  general  policy  of  such  supervisory 
officers  charge  off  stock  as  worthless  or  write  it  down  to  a  nominal 
value,  such  stock  shall,  in  the  absence  of  affirmative  evidence  clearlv 


'-*  See  article  1544,  page  579. 
='C.  B.  I,  page  28;  O.  D.  262. 
''  C.  B.  4.  page  27 ;  A.  R.  R.  435. 


FOR   LOSSES  989 

establishing  the  contrary,  be  presumed  for  income  tax  purposes  to  be 
worthless.-'    ....      (Art.  144.) 

Heretofore  when  a  taxpayer  has  had  worthless  stocks  he 
has  been  compelled  to  go  through  the  farce  of  selling  them  to 
someone  for  a  dollar  before  the  loss  could  be  deducted. 

Losses  on  sales  of  securities.— There  has  never  been  any 
question  as  to  the  deductibility  of  losses  sustained  by  corpora- 
tions arising  out  of  the  sales  of  securities  (treasury  assets) 
at  less  than  cost,  because  there  were  no  limitations  in  the  sec- 
tions of  the  laws  relating  to  corporations  such  as  formerly  ap- 
plied to  individuals.  But  a  loss  must  be  actually  "sustained" 
to  be  an  allowable  deduction.  It  must  have  more  evidence 
than  a  book  entry  to  support  it. 

When  sales  of  assets  are  made  to  stockholders  at  less  than 
book  value  the  burden  of  proof  is  on  the  corporation  to  show 
that  the  sales  prices  are  fair  and  reasonable.  Otherwise  it 
can  hardly  be  held  that  an  actual  loss  has  been  sustained. 

If  sales  to  stockholders  are  made  at  less  than  book  value, 
and  also  at  less  than  market  or  fair  value,  the  stockholders 
have,  in  effect,  made  a  "bargain"  purchase.  If  sales  by  the 
individuals  are  made  subsequently  at  prices  higher  than  cost 
the  resulting  profit  no  doubt  will  be  reported,  but  such  pro- 
cedure will  not  offset  the  fictitious  loss  created  on  the  cor- 
poration's books  if  the  corporation  has  taxable  income  sub- 
ject to  the  excess  profits  tax.  Corporations  selling  securi- 
ties to  their  own  stockholders  at  less  than  fair  or  market 
value  cannot  expect  to  secure  credit  for  any  book  loss  created 
thereby. 

If,  however,  the  corporation  is  not  permitted  to  deduct  the 
loss,  the  stockholders  cannot  be  charged  with  having  made  a 
bargain  purchase,  and  upon  any  resale  they  would  be  taxable 


■''  [Former  Procedure]  Reg.  45  (iyi8),  Art.  144,  specifically  excluded 
"dealers  in  securities"  from  the  provisions  of  that  article.  The  omission 
in  the  present  article  has  no  significance  in  that  "dealers  in  securities"  are 
allowed  to  inventory  their  securities  on  hand. 


990  DEDUCTIONS 

only  upon  the  price  realized  in  excess  of  the  book  value  of  the 
securities  as  shown  by  the  books  of  the  corporation.^^ 

The  basis  for  determining  the  loss  when  securities  of  the 
same  issue,  which  were  bought  at  different  prices,  are  sold  at  a 
loss  is  given  on  page  587. 

Ruling,  (i)  Where  a  new  corporation  is  organized  having 
the  same  stockholders  with  the  same  stockholdings  as  the  old  cor- 
poration, to  which  the  old  corporation  transfers  a  large  amount  of 
stocks  and  bonds  at  a  loss,  less  than  one  per  cent  of  the  purchase 
price  being  paid  in  cash  and  the  balance  being  paid  for  by  notes 
secured  by  the  stocks  and  bonds  sold,  possession  of  which  was  re- 
tained by  the  old  corporation  with  power  of  sale  in  case  of  default, 
the  new  corporation  having  no  other  assets,  the  whole  transaction 
will  be  regarded  as  a  sham  and  a  subterfuge  to  evade  taxation  and 
the  loss  will  be  denied (C.  B.  3.  page  160;  L.  O.  1035,  re- 
vised.) 

In  the  foregoing  ruling  the  Treasury  did  not  hesitate  to 
disregard  the  corporate  entities. 

Contributions  by  stockholders. — The  stockholders  of  a  cor- 
poration "on  the  verge  of  bankruptcy"  in  1920  surrendered 
70  per  cent  of  their  stock  to  the  creditors.  The  owner  of  100 
shares  had  paid  $10,000  for  it;  he  retained  30  shares.  The 
Treasury  held  that  the  30  shares  must  be  carried  as  worth 
$10,000  "until  the  stock  now  held  is  sold  or  otherwise  dis- 
posed of,  or  becomes  worthless,  in  whole  or  in  part."^**  The 
ruling  fails  to  pass  on  the  allowable  deduction.  In  view  of 
the  imminence  of  bankruptcy,  it  would  seem  that  the  $10,000 
had  become  worthless  "in  part"  at  least,  to  the  extent  of  $7,000. 

Assessments  on  stock. — 

Regulation An  assessment  paid  by  a  stockholder  of  a 

national  bank  on  account  of  his  statutory  liability     ....   may  in 
certain  cases  represent  a  loss (Art.  293.) 


-*  Reg.   62,   Art.    147.      For    full   discussion    see   page   994. 
^1-3-33;  I-T.  1 168. 


FOR    LOSSES 


991 


Application  of  tax-free  distributions  in  computing 
losses. — 

Law.  Section  201.  ....  (b)  ....  If  any  such  tax-free  distri- 
bution has  been  made  the  distributee  shall  not  be  allowed  as  a  deduc- 
tion from  gross  income  any  loss  sustained  from  the  sale  or  other  dis- 
position of  his  stock  or  shares  unless,  and  then  only  to  the  extent  that, 
the  basis  provided  in  Section  202  exceeds  the  sum  of  (i)  the  amount 
realized  from  the  sale  or  other  disposition  of  such  stock  or  shares,  and 
(2)  the  aggregate  amount  of  such  distributions  received  by  him 
thereon 

Regulation A  distribution  made  by  a  corporation  out 

of  earnings  or  profits  accumulated  or  increase  in  value  of  property 
accrued  prior  to  March  i,  1913,-"'^  is  exempt  from  tax,  even  if  in  excess 
of  the  cost  or  other  basis  provided  in  articles  1561-1563  and  1568,  of  the 
stock  on  which  declared.  However,  where  any  tax-free  distribution 
out  of  earnings  or  profits  accumulated  or  increase  in  value  of  property 
accrued  prior  to  March  i,  1913,  has  been  made,  the  distributee  can  not 
deduct  any  loss  from  the  sale  or  other  disposition  of  the  stock  unless 
and  then  only  to  the  extent  that  the  cost,  or  other  basis,  exceeds  the 
sum  of  (i)  the  amount  realized  from  the  sale  or  other  disposition  of 
the  stock,  and  (2)  the  aggregate  amount  of  such  distributions  re- 
ceived by  him  thereon. 

Example. — A  purchased  certain  stock  subsequent  to  March  i, 
1913,  for  $10,000  and  received  in  1921  a  distribution  thereon  of  $2,000, 
paid  out  of  the  earnings  of  profits  of  the  corporation  accumulated 
prior  to  March  i,  1913.  This  distribution  does  not  constitute  taxable 
income  to  A.  If  A  subsequently  sells  the  stock  for  $6,000  a  deductible 
loss  of  $2,000  is  sustained.  If  he  sells  the  stock  for  $12,000,  a  tax- 
able gain  of  $2,000  is  realized.  No  gain  or  loss  is  recognized  if  he 
sells  the  stock  for  an  amount  ranging  between  $8,000  and  $10,000 
(Art.   1543.) 

In  the  foregoing  example  the  question  of  whether  cost  or 
value  at  March  i,  19 13,  is  to  be  used  as  a  basis  for  computing 
gain  or  loss  is  not  considered  since  the  stock  was  acquired  after 
March  i,  1913. 

Assume  A  owns  100  shares  of  stock  purchased  in  19 10  for 
$10,000,  and  that  at  March  i,  191 3,  the  value  of  such 
stock  was  $15,000.  In  1918  and  1919,  A  receives  $2,000, 
"dividends"  paid  out  of  earnings  accumulated  prior  to  March 


""  See  pages  715-718. 


992 


DEDUCTIONS 


I,  1913,  or  out  of  appreciation  accrued  at  that  date.'^  In  1921, 
A  sells  his  100  shares  for  $7,000.  Under  section  202,^^  A 
would  determine  his  loss  by  deducting  the  sales  price  ($7,000) 
from  the  cost  ($10,000)  (since  the  March  i,  19 13,  value 
$15,000  is  higher  than  cost).  The  resulting  loss  is  $3,000. 
But  "the  amount  realized  from  the  sale"  ($7,000)  plus  the 
tax-free  "dividends"  ($2,000),  or  a  total  of  $9,000,  when 
compared  with  the  cost  ($10,000),  results  in  a  loss  of  only 
$1,000.  In  other  words,  the  loss  which  would  ordinarily 
be  deductible  ($3,000)  is  reduced  by  the  aggregate  amount 
of  the  tax-free  "dividends"  ($2,000). 

In  case  a  gain  is  realized,  the  tax-free  distributions  are 
ignored.  If  in  the  illustration  above  the  100  shares  had  been 
sold  in  1 92 1  for  $20,000,  the  profit  would  be  $5,000  (excess 
of  sales  price,  $20,000,  over  ]\Iarch  i,  19 13,  value  $15,000). 

Stated  in  tabular  form  we  have  : 


Case  "A" 


(a) 

Cost  of 
Stock- 
before 
1913 
$10,000 


(b) 
Value  of 

Stock 
March  i, 

1913 
$15,000 


(c) 

Tax-free 
'Dividends 


$2,000 


(d) 
Sale 
Price 


$7,000 


(e) 
Loss 
under 
Section  202 
(a-d) 

$3,000 


(f) 

Loss  to  be 

Reported  in 

Tax  Return 

(a-c-d) 

$1,000 


Case 

"B" 

(a) 

(b) 

(c) 

(d) 

(e) 

(f) 

Cost  of 

Value  of 

Tax-free 

Sale 

Gain 

Gain  to  be 

Stock 

Stock 

"Dividends" 

Price 

under 

Reported  in 

before 

March  i. 

Section  202 

Tax  Return 

1913 

1913 

(d-b) 

same  as  (e) 

$10,000 

$15,000 

$2,000 

$20,000 

$5,000 

$5,000 

It  is  well  to  note  that  if  the  sales  price  falls  between  the 
reduced  basis  (cost,  or  market  value  March  i,  191 3,  minus 
tax-free  dividends)  and  said  basis  before  reduction  by  the 
amount  of  tax-free  dividends,  no  gain  or  loss  is  recognized. 
For  example,  if  in  case  A  above,  the  sales  price  had  been  $9,000, 


^'  For  discussion  of  appreciation  realized  through  depletion  charges,  see 
Chapter   XXXIII. 
''  See   page  569. 


FOR   LOSSES 


993 


there  would  be  no  loss.  In  case  B  above,  if  the  sales  price  had 
l)een  $14,000,  there  would  be  no  gain  because  the  sales  price 
lies  between  cost  ($10,000)  and  value  March  i,  1913,  ($15,- 
000).  In  the  latter  case  the  tax-free  "dividend"  ($2,000)  is 
ignored. ^^ 

"Wash  sales"  for  the  purpose  of  establishing  losses. — So 
long  as  accrued  losses  (shrinkage  in  values  of  securities)  are 
not  deductible  until  "evidenced  by  closed  transactions"  it  is 
only  natural  that  attempts  should  be  made  to  convert. paper 
losses  into  actual  losses  in  order  to  obtain  the  benefit  of  the 
deduction.  If  securities  are  sold  at  a  loss  to  a  bona  fide  buyer, 
with  no  agreement  to  repurchase  nor  any  similar  agreement, 
the  loss  has  been  legally  established  and  becomes  an  allowable 
deduction.  Sales  through  a  stock  exchange  are  actual  and 
completed  transactions  because  the  seller  has  no  control  over 
the  buyer.  Subsequent  repurchase  of  a  similar  amount  of  se- 
curities does  not  affect  the  bona  fides  of  the  transaction  be- 
cause the  buyer  takes  a  chance  of  having  to  pay  a  higher  price 
and  the  transaction  is  in  fact  a  new  deal.^^ 

Nevertheless  the  following  section  of  the  1921  law  must 
be  considered : 


^^For  illustrations  of  gain  or  loss  from  liquidating  dividends,  see  Art. 
1545,  page  749- 

"  [Former  Procedure]     Prior  to  the  passage  of  the  1921  law,  "sales 

to  establish  losses"  were  not  in  most  cases  questioned  by  the  Treasury,  as 
is  evidenced  by  the  following  ruling  issued  in  1919: 

Ruling.  If  a  taxpayer  makes  an  actual  bona  fide  sale  of  securities 
at  a  loss  in  1918,  the  loss  is  deductible  even  though  the  taxpayer  repur- 
chases the  securities  in  the  succeeding  year  at  the  same  price  for  which 
they  were  sold.  However,  the  burden  of  proof  will  be  on  the  taxpayer  to 
show  that  the  sale  was  not  fictitious.     (C.  B.  i,  page  124;  O.  D.  103.) 

In  another  case  a  taxpayer  offered  stock  at  public  auction,  with  in- 
structions to  buy  it  in  for  his  account  if  there  were  no  other  bidders.  It 
was  bought  in  for  his  account  at  a  nominal  price.  The  Treasury  held 
that  "the  facts  failed  to  disclose  an  actual  sale  of  the  stock  in  question. 
....  A  person  cannot  be  both  seller  and  purchaser  in  the  same 
transaction."  (I-S-53;  I-  T.  1181.)  Under  the  1921  law  such  a  loss 
would  also  be  disallowed  because  of  the  repurchase  "within  30  days." 


gg^  DEDUCTIONS 

Law.  Section  214.  (a)  ....  there  shall  be  allowed  as  deduc- 
tions : 

(5)  ....  No  deduction  shall  be  allowed  under  this  paragraph  for 
any  loss  claimed  to  have  been  sustained  in  any  sale  or  other  disposition 
of  shares  of  stock  or  securities  made  after  the  passage  of  this  Act  where 
it  appears  that  within  thirty  days  before  or  after  the  date  of  such  sale 
or  other  disposition  the  taxpayer  has  acquired  (otherwise  than  by  be- 
quest or  inheritance)  substantially  identical  property,  and  the  property 
so  acquired  is  held  by  the  taxpayer  for  any  period  after  such  sale  or 
other  disposition.  If  such  acquisition  is  to  the  extent  of  part  only  of 
substantially  identical  property,  then  only  a  proportionate  part  of  the 
loss  shall  be  disallowed;     .... 

The  following  regulation  outlines  the  procedure  under  the 
1 92 1  law: 

Regulation.  An  individual,  other  than  one  in  the  trade  or  busi- 
ness of  buying  and  selling  securities,  or  a  corporation,  other  than  a 
dealer  in  stocks  or  securities,  can  not  deduct  any  loss  claimed  to  have 
been  sustained  from  the  sale  or  other  disposition  of  stock  or  securi- 
ties made  after  November  23,  1921,  if  within  30  days  before  or 
after  the  date  of  such  sale  or  other  disposition  the  taxpayer  has 
acquired  (otherwise  than  by  bequest  or  inheritance)  substantially 
identical  property,  and  the  property  so  acquired  is  held  by  the  tax- 
payer for  any  period  after  such  sale  or  other  disposition.  If  such  ac- 
quisition is  to  the  extent  of  part  only  of  substantially  identical  prop- 
erty, then  only  a  proportionate  part  of  the  loss  shall  be  disallowed. 
....  This  provision  is  designed  to  prevent  a  taxpayer  who  owns 
securities,  other  than  one  in  the  trade  or  business  of  buying  and 
selling  securities,  from  selling  and  immediately  repurchasing  them  or 
from  purchasing  substantially  identical  property  and  immediately 
selling  the  original  securities  and  claiming  as  a  deduction  in  com- 
puting net  income  the  so-called  "loss"  sustained  therefrom.  Gain 
or  loss,  however,  is  realized  in  the  case  of  the  "short  sale."  Under 
this  section  a  taxpayer  owning  a  hundred  shares  of  stock  in  the  X 
company,  who  purchases  another  hundred  shares  of  stock  in  the  X 
company  and  within  30  days  thereafter  sells  the  first  purchased  stock 
of  the  X  company,  can  not  deduct  in  computing  net  income  any  loss 
claimed  to  have  been  sustained  from  the  transaction ;  if  he  sells  the 
entire  200  shares  of  stock,  a  gain  or  loss  from  both  transactions  is 
realized  at  that  time ;  and  if  he  sells  the  stock  of  the  X  company  in- 
cluded within  the  second  purchase  a  gain  or  loss  is  realized  thereby. 
(Art.    I47-) 

The  192 1  law  and  the  regulations  are  fair  enough  and  will 
not  result  in  any  great  hardships. 


FOR   LOSSES  995 

It  is  to  be  noted  that  sales  made  on  or  prior  to  November 
23,  1 92 1,  (the  date  the  1921  law  was  passed)  are  not  affected 
by  the  above  provision.  The  status  of  such  sales  is  the  same 
as  it  would  have  been  under  previous  laws. 

The  foregoing  section  applies  to  individuals  but  there  is 
a  similar  provision  applicable  to  corporations"^  which  includes 
the  statement,  however,  that  the  loss  is  to  be  allowed  if  "such 
claim  is  made  by  a  dealer  in  stock  or  securities,  and  with  re- 
spect to  a  transaction  made  in  the  ordinary  course  of  its  busi- 
ness." The  section  quoted  above,^®  applicable  to  individuals, 
does  not  contain  a  similar  statement  because  individuals  or 
partnerships  recognized  as  dealers  in  securities  would  not 
claim  deductions  for  their  losses  on  securities,  under  section 
214  (a-5),  but  under  section  214  (a-4),  which  latter  section 
allows  a  deduction  for  "losses  ....  incurred  in  trade  or 
business."  Section  214  (a-4)  does  not  contain  the  thirty-day 
limitation  on  re-acquirement  of  securities  sold  at  a  loss. 

Where  deductions  are  not  allowed  under  section  214  (a-5) 
or  234  (a-4),  the  securities  acquired  are  deemed  to  have  taken 
the  place  of  the  securities  sold.  In  the  case  of  subsequent 
sale  of  the  acquired  securities  the  cost  or  March  i,  1913,  value, 
of  the  original  securities  would  form  the  basis  of  loss  sus- 
tained or  gain  derived  therefrom.  [See  Section  202  (d-3)  of 
the  law,  and  article  1567.] 

Losses  arising  from  the  sale  of  property  acquired  by  gift. — 
Prior  to  1921,  deductible  losses  arising  from  the  sale  of  prop- 
trty  by  donees  were  comparatively  easy  to  determine.  Losses 
consisted  of  the  difference  between  the  value  of  gifts  when 
received  and  the  proceeds  of  sales.  Under  the  192 1  law  the 
basis  of  loss^^  is  "the  same  as  that  which  it  would  have  in  the 
hands  of  the  donor  or  the  last  preceding  owner  by  whom  it 
was  not  acquired  bv  gift." 


'"  Section  234  (a-4). 
"Section  214  (a-5). 
"  Section  202  (a-2). 


996  DEDUCTIONS 

In  discussing  gains  realized  by  donees,^^  the  difficulty  of 
securing  information  was  mentioned.  It  will  no  doubt  be  more 
difficult  to  secure  data  from  donors  regarding  gifts  when 
values  have  declined.  In  such  cases  donees  will  fail  to  receive 
the  benefit  of  deductions  to  which  they  are  entitled. 

It  may  be  that  any  loss  will  be  denied  on  the  ground  that 
the  transaction  was  not  entered  into  for  profit,  but  the  Treasury 
has  specifically  ruled  that  losses  arising  from  property  ac- 
quired by  gift  or  inheritance  may  be  deducted. ^^ 

The  provision  of  the  law  is  of  doubtful  legality  and  ex- 
pediency but  its  evolution  will  be  interesting. 

Congress  may  have  invented  a  new  method  of  reducing  taxes. 
A  taxpayer  not  subject  to  tax,  owning  investment  property 
greatly  depreciated  in  value,  may  make  a  gift  of  such  prop- 
erty to  another  taxpayer  subject  to  high  surtax  rates  and  the 
latter  may  sell  the  property  and  claim  a  very  large  loss. 

Losses  in  speculation. — If  a  taxpayer  buys  "futures,"  hop- 
ing to  sell  the  contracts  at  a  profit,  and  instead  is  compelled 
to  sell  at  a  loss  and  claims  credit  for  the  loss  in  his  income 
tax  return,  it  becomes  specifically  an  unlimited  deduction  under 
the  192 1  law,  and  would  also  have  become  so  under  the  1918 
law.  Under  the  1913  law  the  loss  would  not  have  been  de- 
ductible. Under  the  19 16  and  19 17  laws  the  loss  would  have 
been  deductible  to  an  amount  of  profits  derived  from  similar 
transactions. *° 

Losses  on  sale  of  capital  assets. — The  chapters  on  appre- 
ciation in   values    (XVTI)    and  sales  and  exchanges    (XVI) 


^'  See  page  623. 

^  See  page  620. 

*"  [Former  Procedure] 

Decision.  "Losses  incurred  by  a  member  of  a  partnership,  engaged  in 
manufacturing  jute  bags  and  bagging,  through  his  individual  dealings  on 
a  cotton  exchange  are  not  incurred  in  trade  within  the  meaning  of  section 
II,  subdivision  B  of  the  act  of  1913,  and  therefore  are  not  deductible  in 
computing  net  taxable  income  under  that  act."  Mente  v.  Eisner,  266  Fed. 
161 ;  T.  D.  3029. 


FOR   LOSSES  997 

deal  with  the  principles  which  underlie  the  deductibility  of 
losses  as  well  as  the  taxability  of  profits.  It  is  therefore  un- 
necessary to  repeat  under  this  subject  heading  the  comments 
which  are  found  in  the  chapters  mentioned. 

Losses  must  be  sustained  bona  fide. — The  Treasury  has 
ruled  that  when  property  acquired  by  gift  is  transferred  or 
ostensibly  sold  for  considerably  less  than  its  actual  value,  the 
difference  between  actual  value  and  the  sales  price  is  a  gift 
and  is  not  an  allowable  loss  to  the  donor.*^  The  ruling  is 
sound.  Deductions  for  losses  should  be  those  sustained  bona 
fide. 

Losses  due  to  scrapping  of  buildings  and  machinery  de- 
ductible.— 

Regulation.  Loss  due  to  the  voluntary  removal  or  demolition 
of  old  buildings,  the  scrapping  of  old  machinery,  equipment,  etc.,  in- 
cident to  renewals  and  replacements  will  be  deductible  from  gross 
income  in  a  sum  representing  the  difference  between  the  cost  of 
such  property  demolished  or  scrapped  and  the  amount  of  depreciation 
sustained  with  respect  to  the  property  prior  to  its  demolition  or 
scrapping,  and  allowable  as  a  deduction  in  computing  net  income. 
....    (Art.   142.) 

Depreciation  is  an  allowable  deduction  but  not  a  com- 
pulsory deduction.  If  insufficient  or  no  depreciation  has  been 
charged  over  a  term  of  years,  it  is  true  that  a  strictly  accurate 
method  of  accounting  would  call  for  the  reopening  of  accounts 
for  the  entire  past  period,  the  restatement  thereof  and  the 
preparation  of  revised  profit  and  loss  accounts.  But  business 
could  not  be  conducted  that  way.  Neither  can  it  be  expected 
that  tax  returns  for  past  periods  can  be  amended  every  time 
an  item  applicable  to  prior  years  turns  up.  The  foregoing 
regulation  if  strictly  construed  would  call  for  amended  re- 
turns for  as  many  years  as  elapsed  during  the  time  when  in- 
sufficient or  no  depreciation  was  charged.  If  the  amount  in- 
volved is  substantial,  amended  returns  must  and  should  be 


C.  B.  4,  page  45;  O.  D.  847. 


998  DEDUCTIONS 

prepared.  The  regulation,  however,  can  hardly  be  intended  to 
control  the  usual  adjustments  which  are  always  necessary  in 
dealing  with  depreciation,  because  exact  rates  will  never  be 
available.  In  most  cases  it  will  be  sufficient  to  charge  off  the 
entire  book  loss  during  the  period  in  which  it  is  ascertained. 
The  law  itself  seems  to  permit  this. 

Ruling.  When  property  is  discarded  and  salvaged,  the  deprecia- 
tion allowance  plus  the  salvage  value  may  slightly  exceed  or  fall 
slightly  below  the  cost  of  the  property.  In  the  case  of  a  gain  over 
cost  this  must  be  treated  as  income.  If  the  depreciation  allowance 
plus  salvage  falls  below  the  cost,  the  difference  may  be  treated  as  a 
loss. 

The  fact  that  a  taxpayer  in  past  years  neglected  to  allow  for  suffi- 
cient depreciation  does  not  make  the  resulting  discrepancy  between 
the  book  values  of  equipment  and  its  salvage  value  at  the  time  it  is 
retired  from  service  deductible  as  a  loss  within  the  intent  of  Section 
II  G(b)  second,  act  of  October  3,  1913.  In  such  cases  the  taxpayer 
may  avail  himself  of  a  larger  deduction  for  depreciation  by  submit- 
ting amended  returns  for  previous  years,  and  showing  that  the  pre- 
vious depreciation  rate  was  not  reasonable.  (C.  B.  i,  page  120; 
S.  1217.) 

Cost  of  demolishing  old  building  on  new  site  not  deductible 

as  loss. — 

Regulation When    a   taxpayer    buys    real    estate    upon 

which  is  located  a  building  which  he  proceeds  to  raze  with  a  view 
to  erecting  thereon  another  building,  it  will  be  considered  that  the 
taxpayer  has  sustained  no  deductible  loss  by  reason  of  the  demoli- 
tion of  the  old  building,  and  no  deductible  expense  on  account  of 
the  cost  of  such  removal,  the  value  of  the  real  estate,  exclusive  of 
old  improvements,  being  presumably  equal  to  the  purchase  price  of 
the  land  and  building  plus  the  cost  of  removing  the  useless  building. 
(Art.  142.) 

This  regulation  is  sound  because  all  so-called  expenses  in 
construction  enterprises  are  proper  capital  expenditures,  and 
the  cost  of  demolition  of  an  old  building  is  a  capital  charge. 
This  rests  on  the  principle  that  there  can  be  no  operating  loss 
or  expense  in  a  new'  business  until  after  the  business  com- 
mences to  operate. 

Rulings.     A  taxpayer  sustains  no  deductible  loss  in  the  demoli- 


FOR   LOSSES 


999 


tion  of  80  per  cent  of  his  building  for  the  purpose  of  reconstruction. 
The  amount  expended  is  an  investment  of  capital  and  should  be 
considered  as  a  part  of  the  cost  of  reconstruction.  (C.  B.  4,  page 
164;  O.  D.  yyi.) 

Improved  real  estate  consisting  of  several  frame  dwellings  was 
purchased  primarily  for  the  purpose  of  enlarging  a  business  plant. 
No  deductible  loss  was  sustained  by  reason  of  the  sale  of  the  build- 
ings apart  from  the  land  for  their  salvage  value,  notwithstanding  the 
fact  that  the  taxpayer  would  have  paid  considerably  less  for  the 
property  had  it  been  aware  at  the  time  of  purchase  of  a  fire  regula- 
tion, then  in  effect,  which  prohibited  the  moving  of  the  buildings. 
The  value  of  the  land  exclusive  of  the  buildings  is  presumed  to  be 
equal  to  the  purchase  price  of  the  land  and  buildings  less  the  amount 
received  as  salvage.     (B.  37-21-1816;  O.  D.  1031.) 


Business  Losses 

The  language  of  the  statute  is  so  broad  in  dealing  with 
business  losses  that  the  problems  of  procedure  are  few  and 
simple. 

Losses  incurred  in  transactions  entered  into  for  profit.-^— 

Under  section  214  (a-5)  of  the  1921  law  an  individual  may 
deduct  all  net  losses  "if  incurred  in  any  transaction  entered 
into  for  profit,  though  not  connected  with  the  trade  or  busi- 
ness." The  chief  factors  which  decide  the  deductibility  of  this 
dass  of  losses  are : 

1.  The  loss  must  be  an  actual  one.  It  must  be  more 
than  conjectural.  Generally  speaking,  the  taxpayer  must  be 
"out  of  pocket"  the  amount  of  the  loss. 

2.  The  loss  must  have  been  sustained  during  the  tax- 
able year.  If  at  the  end  of  the  preceding  taxable  year  a  tax- 
payer had  mentally  "charged  off"  a  loss,  it  would  not  come 
within  the  Treasury's  interpretation  of  when  a  loss  occurs. 
The  Treasury  in  its  regulations  dealing  with  a  closed  trans- 
action fixed  the  date  practically  at  the  time  of  the  obsequies 
and  not  at  the  time  of  death.  For  example,  if  a  taxpayer  pur- 
chased stock  for  $100  a  share  in  1921  and  sold  it  on  January 
2,    1922,    for  $1    a  share,  the   Treasury  holds  that  the  loss 


looo  DEDUCTIONS 

was  not  sustained  until  1922,  even  though  the  value  of  the 
stock  on  December  31,  192 1,  was  the  same  as  on  January  2, 
1922. 

3.  The  transaction  must  have  been  undertaken  for  profit. 
If  a  man  buys  an  automobile  for  pleasure  purposes  at  one 
price  and  sells  it  for  a  lower  price,  the  loss  sustained  is  not 
deductible.  If  a  man  buys  or  builds  a  residence  for  his  own 
occupancy  and  sells  it  for  less  than  cost,  the  Treasury  holds 
that  the  loss  is  not  deductible.*^ 

4.  As  heretofore  stated,  it  must  be  a  net  loss.  Any  in- 
surance, etc.,  received  must  be  credited  against  the  gross  loss 
sustained. 

Rulings.  Section  214  (a)  5,  Revenue  Act  of  1918,  does  not 
contemplate  that  a  distinction  shall  be  made  between  an  investment 
in  property  or  securities  with  the  object  of  deriving  an  income  from 
the  capital  employed,  and  an  investment  which  is  made  for  the  pur- 
pose of  realizing  a  profit  on  the  resale  of  the  property  or  securities 
purchased.     (C.  B.  i,  page  124;  O.  D.  138.) 

A  loss  sustained  from  the  sale  of  property  acquired  by  gift,  be- 
quest, devise,  or  descent  (whenever  property  so  acquired  is  as  a 
matter  of  fact  acquired  for  purposes  of  profit)  is  a  deductible  loss 
from  gross  income.  Ordinary  investment  property  so  acquired  is  to 
be  treated  as  having  been  acquired  for  purposes  of  profit  unless  the 
conduct  of  the  recipient  furnishes  evidence  to  the  contrary.  (C.  B.  i, 
page  122;  T.  B.  R.  35.) 

If  a  taxpayer  purchases  royalty  interests  in  tracts  of  oil  land 
(not  including  title  to  the  land  itself)  and  such  interests  prove  worth- 
less, as  evidenced  by  all  wells  drilled  proving  dry  or  failing  after 
producing  very  small  quantities  of  oil,  the  loss  sustained  is  an  allow- 
able deduction  from  gross  income.     (C.  B.  2,  page  128;  O.  D.  375.) 


Losses  arising  from  cancellation  of  contracts. — 

Ruling The  question   under   consideration   is   whether   a 

sum  paid  in  1919  by  a  company  to  be  relieved  from  a  contract  for  de- 
livery of  goods  in  19 18  and  1919  is  deductible  in  1918,  the  year  in 
which  the  matter  was  negotiated,  though  the  final  agreement  and 
adjustment  and  payment  was  not  made  until   1919 


Reg.  62,  Art.  141.     See  page  1002. 


FOR   LOSSES  lOOl 

In  the  present  case  the  amount  to  be  paid  for  the  cancellation  of 
the  contract  was  not  determined  nor  paid  until  1919.  The  loss  was 
not  a  closed  and  completed  transaction  until  that  time.  Negotiations 
were  entered  into  in  1918,  but  the  final  outcome  of  the  same  or  the 
amount  to  be  paid  as  liquidated  damages,  was  not,  and  from  the 
nature  of  things  would  not  be,  known  until  the  final  agreement  and 
adjustment  had  been   made 

It  is  held  that  where  a  corporation  pays  liquidated  damages  in 
1919  to  be  relieved  from  the  terms  of  a  contract  which  called  for  the 
delivery  of  goods  in  1918  and  1919,  the  loss  so  incurred  is  deductible 
from  gross  income  for  the  year  1919  rather  than  1918.  (C.  B.  i, 
page  217;  S.  983.) 

The  foregoing  ruling  may  be  sound  when  apphed  to  the 
specific  facts  in  the  case  under  review.  The  general  prin- 
ciples laid  down  are,  however,  subject  to  criticism. 

In  the  case  of  government  contracts  canceled  prior  to  but 
unsettled  at  December  31,  1918,  the  Treasury  took  the  position 
in  Regulations  45  that  upon  settlement  thereof  after  1918  any 
additional  profit  must  be  accounted  for  in  1918.*^ 

The  foregoing  ruling  holds  to  the  contrary.  Since  the 
Treasury  shifts  its  position  according  to  the  nature  of  the 
case,  it  is  not  wise  to  apply  general  principles  to  any  case. 

In  a  later  ruling  it  is  held  that  amended  returns  may  be 
made  to  adjust  items  applicable  to  prior  years.** 

Losses  sustained  by  individuals. — Losses  deductible  by  an 
individual  are  described  in  the  law  by  three  phrases :  first, 
losses  incurred  in  trade  or  business;  second,  net  losses  sus- 
tained in  transactions  not  connected  with  trade  or  business, 
when  the  transactions  were  entered  into  for  profit;  third,  net 
losses  sustained  in  transactions  not  connected  with  trade  or 
business  if  arising  from  fire,  storm,  shipwreck  or  other  casu- 
alty or  from  theft. 

In  all  the  foregoing  it  will  be  noted  that  the  losses  must 
be  "net"  losses — that  is,  the  actual  money  loss  sustained  by  the 
taxpayer.     If  reimbursed  in  whole  or  in  part  by  an  insurance 


■"''For  adjustment  of  government  contracts,  see  page  532,  Chapter  XV. 
"C.  B.  3,  page  147;  A.  K.  K.  273. 


I002  DEDUCTIONS 

company  or  compensated  in  any  other  way,  the  loss  is  not  a 
net  loss  except  as  to  any  part  not  reimbursed. 

This  is  not  intended  to  mean  that  the  taxpayer  cannot  de- 
duct a  loss  based  upon  a  revaluation.  This  point  is  covered 
on  page  569.  It  may  be  further  amplified  in  case  the  bene- 
ficiary of  an  estate  subsequently  sells  stocks,  bonds  or  any 
kind  of  property  at  a  price  less  than  the  fair  market  or  ap- 
praised price  at  the  time  when  the  property  was  received. ^^ 
The  measure  of  deduction  is  based  entirely  upon  the  valuation 
at  the  time  when  the  property  changed  hands,  and  the  loss  is 
just  as  much  deductible  by  the  beneficiary  of  the  estate  as  if 
the  beneficiary  had  paid  in  cash  the  amount  of  the  appraised 
value.  This,  of  course,  is  subject  to  a  general  rule  that  de- 
preciation must  be  always  taken  into  consideration,  but  the 
rule  depends  on  whether  depreciation  is  an  allowable  deduc- 
tion or  not.*** 

Furthermore,  the  loss  must  be  a  property  loss.  Losses 
from  casualties,  thefts  and  other  causes  produce  consequential 
losses  which  are  in  addition  to  and  grow  out  of  property 
losses,  but  the  words  "arising  from"  cannot  be  construed 
broadly  enough  to  include  anything  but  the  loss  of  property 
itself. 

Rulings.  An  amount  paid  by  a  former  director  of  a  bank  in 
compromise  of  a  suit  against  him  by  a  receiver  for  dereliction  and 
neglect  of  duty  as  such  director  is  deductible  as  a  loss  within  the 
meaning  of  section  214  (a)  of  the  Revenue  Act  of  1918.  (B.  45- 
21-1908;  O.  D.  1091.) 

Damages  paid  by  a  taxpayer  engaged  in  the  real  estate  business 
pursuant  to  a  judgment  against  him  for  misrepresentation  of  land 
sold  are  deductible  from  gross  income  under  section  214  (a)  4  of  the 
Revenue  Act  of  1918.      ( B.  29-21-1734;  O.  D.  978.) 

Loss  on  sale  of  individual's  residence. — 

Regulation A  loss  on  the  sale  of  residential  property 

is  not  deductible   unless  the  property  was  purchased  or  constructed 


Regarding  losses  on  gifts,  see  page 
See  page   573. 


FOR   LOSSES 


1003 


by  the   taxpayer   with   a   view   to   its   subsequent   sale   for   pecuniary 
profit (Art.  141.) 

If  a  taxpayer  buys  or  builds  or  inherits  a  house  (which  he 
occupies  as  a  residence),  and  sells  it  for  less  than  cost,  or 
value  March  i,  1913,  it  cannot  be  claimed  that  the  loss  has  been 
sustained  in  trade  or  business.  Profits  from  any  source  are 
taxable,  but  losses  are  deductible  only  to  the  extent  mentioned. 
If,  however,  the  house  is  destroyed  by  casualty  and  not  com- 
pensated by  insurance,  the  actual  loss  is  deductible  since  it 
happens  to  fall  within  a  specific  provision  of  the  law. 

Rulings.  A  loss  sustained  by  an  individual  from  the  sale  of 
residential  property  is  deductible  in  determining  net  income  for  pur- 
poses of  the  Revenue  Act  of  1918  only  when  the  property  was  pur- 
chased or  constructed  by  him  with  a  view  to  its  subsequent  sale  for 
pecuniary  profit.  The  intent  in  purchasing  or  constructing  the  prop- 
erty is  a  question  of  fact  determinable  in  each  case  by  evidence 
which  should  be  submitted  with  the  return.  (C.  B.  i,  page  117; 
O.  780.) 

A  loss  resulting  from  the  sale  of  a  taxpayer's  residence  caused  by 
the  acceptance  of  a  business  proposition  requiring  his  removal  to 
another  part  of  the  country  is  not  a  loss  incurred  in  business  or 
trade  which  is  deductiljle  under  the  Revenue  Act  of  1917.  (C.  B.  2, 
page  129;  A.  R.  R.  96.) 

The  subletting  of  an  apartment  by  a  tenant  on  account  of  being 
required  to  make  his  residence  in  another  city  is  held  not  to  be  a 
"transaction  entered  into  for  profit."  Therefore  any  loss  sustained 
through  such  transaction  is  not  deductible  from  gross  income.  (C. 
B.  I,  page  124;  O.  D.  42.) 

The  last  quoted  ruling  is  not  sound  and  should  be  con- 
trasted with  a  more  recent  office  decision  wherein  it  was  held 
that  a  taxpayer  who  lives  in  an  apartment  where  it  was  the 
custom  of  the  residents  to  sublease  their  apartments  for  the 
summer  months,  may  deduct  the  rent  paid  during  the  time  the 
apartment  was  sublet. ■*' 

Ruling.  A  taxpayer  purchased  ])i()])erty  in  1917  for  use  as  a 
personal  residence,  for  which  he  paid  14.1'  dollars.  He  made  additions 
and  betterments  costing  4.1-  dollars.  He  used  the  property  as  a  per- 
sonal residence  until    1919,  when  he  moved  elsewhere  and  rented  it. 


"  B.  50-21-1972;  O.  D.  1 134. 


I004 


DEDUCTIONS 


In  1920  he  sold  the  property  for  I3>^a'  dollars,  and  claimed  a  deduction 
of  4y2X  dollars  as  a  loss  arising  from  the  sale. 

It  is  held  that  if  a  loss  is  deductible  at  all  it  is  deductible  under 
section  214  (a)  5  of  the  Revenue  Act  of  1918  as  a  loss  sustained  in 
a  transaction  entered  into  for  profit.  However,  the  mere  renting  of 
property  purchased  without  the  intention  at  the  time  of  purchase  of 
making  a  pecuniary  profit  thereon  does  not  constitute  a  "transac- 
tion entered  into  for  profit"  within  the  meaning  of  the  statute,  and 
as  the  taxpayer  in  the  instant  case  purchased  the  property  for  a 
home,  it  was  not  his  intention  at  the  time  to  subsequently  sell  it  for 
profit.  It  is  therefore  held  that  any  loss  sustained  is  not  deductible 
for  the  purposes  of  the  Revenue  Act  of  1918.  (B.  52-21-1992;  O. 
D.  1 148.) 

The  question  may  well  be  raised,  however,  whether,  after 
a  taxpayer  has  discontinued  using  a  dwelHng  for  his  resi- 
dence and  rents  it  to  others,  he  has  not  at  that  time  entered 
into  a  transaction  for  profit — the  ownership  of  the  dwelHng 
no  longer  representing  property  held  for  personal  use  but  ah 
income-producing  investment — so  that  if  any  loss  w^ere  sus- 
tained upon  eventual  sale  of  the  property  it  would  be  properly 
deductible. 

Losses  of  the  nature  of  personal  expense  not  deductible 
at  all. — It  should  be  observed,  first  of  all,  that  certain  indi- 
vidual losses  are  not  covered  by  any  of  the  law's  provisions. 
The  law  apparently  considers  as  personal  expense  such  losses 
as  are  not  incurred  in  business  or  trade,  nor  due  to  casualty 
or  theft,  nor  incurred  in  transactions  entered  into  for  profit 
outside  one's  own  business.  The  Primer  gives  the  following 
examples  of  losses  of  this  non-deductible  type. 

Rulings.  John  Doe,  while  driving  an  automobile,  ran  down  and 
injured  another  person.  He  either  paid  over  a  certain  sum,  or  paid 
a  judgment  rendered  against  him,  in  settlement  of  the  injury  done. 
Can  he  claim  the  amount  so  paid  as  a  loss? 

No.  It  was  not  a  loss  which  was  incurred  in  the  conduct  of  his 
business  or  trade,  or  which  resulted  from  a  transaction  entered  into 
for  profit.''^     {Income  Tax  Primer,  1918,  question  81.) 

A  professional  man  or  a  merchant  owns  and  operates  a  ''fancy 


C.  B.  4,  page  159;  A.  R.  R.  444. 


FOR   LOSSES  1005 

stock  farm."  The  expenses  of  operation  exceed  the  gross  receipts. 
Can  the  difference  be  claimed  as  a  deduction  under  the  head  of 
'"losses"? 

No.  It  is  held  that  where  a  farm  is  operated  for  purposes  of 
recreation  or  pleasure,  and  not  primarily  for  profit,  but  as  a  hobby, 
that  farm  is  not  to  be  classed  as  a  commercial  enterprise,  that  it  does 
not  form  a  part  of  its  owner's  business  or  trade  and  until  it  is  placed 
upon  a  profit-paying  basis  the  gross  receipts  are  not  to  be  reported 
under  "gross  income"  and  the  expenses  are  not  to  be  claimed  as  a 
deduction.  This  ruling,  of  course,  precludes  the  claiming  of  the 
difference  between  the  two  amounts  as  a  loss.  (Income  Tax  Primer, 
1918,  question  85.) 

Individual's  share  of  partnership  losses  deductible. — 

Regulation.  Where  the  result  of  partnership  operation  is  a  net 
loss,  the  loss  will  be  divisible  between  the  partners  in  the  same  pro- 
portion as  net  income  would  have  been  divisible,  and  may  be  used 
as  a  deduction  by  the  individual  partners  in  their  returns  of  income. 
(Reg.  33,  1918,  Art.  30.) 

The  loss  must  be  as  ascertained  at  the  end  of  the  fiscal 
year  of  the  partnership.  If  an  individual  has  not  changed  his 
taxable  year  from  the  calendar  year  (as  he  is  permitted  to 
do)  to  a  fiscal  year  which  agrees  with  that  of  his  firm,  never- 
theless the  item  of  deduction  representing  his  share  of  the 
partnership  loss  will  be  the  amount  shown  by  the  partnership 
books,  and,  if  a  loss  has  accrued  to  the  partnership  between  the 
end  of  its  fiscal  year  and  December  31,  the  individual  must 
not  claim  credit  therefor  until  the  following  year.  By  that 
time  the  apparent  loss  to  December  31  may  be  absorbed  by 
profits  thereafter.  The  point  to  observe  is  that  the  amount 
of  the  deduction  should  agree  exactly  with  the  partnership 
books  (subject  to  adjustment  for  tax-exempt  interest,  etc.) 
as  closed  for  one  full  fiscal  year.*^ 

Individual's  share  of  corporation  losses. — When  an  indi- 
vidual is  compelled  to  pay  all  or  part  of  a  corporation's  losses 
it  is  important  to  consider  the  transaction  from  the  points  of 
view  of  both  sides.     It  has  been  decided  that  a  debt  forgfiven 


See   Chapter   XXIV,   page   803   et  scq. 


Rx^i  DEDUCTIONS 

is  iu>t  income  to  tlio  (.lobior.  If  not  income  to  the  debtor,  be- 
cause it  was  a  t;iTt,  it  would  not  be  deductible  by  the  giver.''° 

In  many  cases,  however,  the  giver  is  fully  justified  in 
wishing  to  deduct  the  payment  as  a  loss  and  is  not  concerned 
with  how  the  debtor  treats  it. 

When  payments  are  made  to  a  corporation  to  pay  its  debts 
or  to  wipe  out  a  deficit  or  for  any  reason  other  than  that  of 
furnishing  new  capital  to  continue  in  business,  the  giver  should 
specify  that  the  amounts  paid  to  the  corporation  are  loans 
or  advances  and  not  additional  payments  of  capital.  If  the 
loans  cannot  be  repaid  the  amounts  advanced  may  be  charged 
off  as  bad  debts. 

Regulation.  The  cancellation  and  forgiveness  of  indebtedness 
is   dependent   on   the   circumstances    for   its   effect.     It   may    amount 

to  a  payment  of  income  or  to  a  gift  or  to  a  capital  transaction 

(Art.  50.) 

Ruling.  The  surrender  of  stock  for  the  purpose  of  wiping  out 
an  operating  deficit  can  not  be  made  the  basis  of  a  deduction  in  the 
returns  of  the  individual  stockholders.     (C.  B.  i,  page  126;  O.  D.  216.) 

If  the  foregoing  ruling  is  sound  (which  is  doubtful,  because 
some  elements  of  a  realized  loss  are  present)  the  stockholders 
should  be  able  by  sale  or  otherwise  to  conform  to  the  tech- 
nical requirements  of  the  Treasury  and  establish  the  loss. 

Losses  in  illegal  transactions  may  be  deductible. — The 
Treasury  has  taken  the  position  that  profits  arising  out  of  illegal 
transactions  are  taxable,  but  the  new-  regulations  are  silent  as 
to  deductions  for  losses  sustained  on  illegal  transactions.''^ 
Section  214  (a-5)  specifically  permits  the  deduction  of  all 
losses  if  incurred  in  "'any  transaction  entered  into  for  profit." 

As  stated  on  page  447,  recent  federal  law^s  have  omitted 
the  word  "lawful"  and  income  from  gambling  transactions 
is  unquestionably  taxable.    If  a  taxpayer  enters  into  an  illegal 


'""IJ.  S.  V.  Orcgon-ll'ashiiifjfon  R.  &  Nav.  Co.,  251  Fed.  211,  1918. 
"  [Former  Procedure]     Reg.   45.    Art.    141,    provided   that    "losses    in 
illegal  transactions  are  not  deductible." 


FOR   LOSSES  1007 

transaction  he  naturally  hopes  to  make  a  profit  out  of  it. 
If  such  profit  is  realized  it  is  taxable.  If  it  results  in  a  loss, 
under  the  law  it  would  seem  to  be  a  deduction.  The  law  does 
not  say  "any  lawful  transaction,"  but  does  say  "any  transac- 
tion." 

When  gambling  is  lawful  losses  are  deductible. — 

Ruling It    is    accordingly    held    that:      (i)   The    entire 

amount  of  winnings  from  all  wagering  contracts  should  be  returned 
in  gross  income  under  section  213  (a)  of  the  Revenue  Act  of  1918, 
irrespective  of  the  nature  of  the  transaction,  whether  legal  or  illegal 
and  notwithstanding  the  laws  of  the  state  in  which  such  contracts 
are  made. 

(2)  If,  under  the  laws  of  the  state  in  which  the  wagering  con- 
tract is  made  betting  or  gambling  is  prohibited,  such  transactions  are 
illegal  and  no  deduction  may  be  claimed  under  section  214  (a-5)  of 
the  statute  for  losses  sustained  in  such  illegal  transactions,  but  if  the 
laws  of  the  state  in  which  the  wagering  contract  is  made  do  not 
prohibit  betting  or  gambling,  such  transactions  are  lawful  and  the 
entire  amount  of  the  losses  sustained  in  the  transactions  may  be 
deducted  from  gross  income  under  section  214  (a-5).  (Letter  to 
The  Cor  joration  Trust  Company,  signed  by  Acting  Commissioner 
Paul  F.  Myers,  and  dated  July  12,  1920.) 

It  would  seem  from  the  foregoing  that  losses  at  Monte 
Carlo  are  fully  deductible. 

I^osses  which  are  considered  capital  expenditures. — A  cor- 
poration, in  order  to  obtain  possession  of  its  property,  and 
faced  with  a  lawsuit,  compromised  with  a  third  party  by  pay- 
ing an  amount  in  settlement  of  certain  claims. 

Ruling.  The  Committee  finds  that  an  amount  paid  by  the  M 
Corporation  to  C  in  191 7  either  constituted  the  purchase  price  of  the 
interest  which  he  had  acquired  through  the  arrangement  originally 
entered  into  before  incorporation  between  A  and  B^  stockholders, 
and  himself,  or  that  the  amount  was  paid  to  him  by  way  of  compromise 
to  perfect  the  title  of  the  corporation  to  certain  property.  In  either 
event  it  was  not  a  loss  nor  was  it  properly  chargeable  to  the  current 
expenses  of  the  year.  It  was  a  capital  expense  and  recoverable 
through  depletion  and  depreciation  deductions  over  the  life  of  the 
property.     (B.  51-21-1982;  A.  R.  R.  701.) 


ioo8  DEDUCTIONS 

Losses  Arising  from  Fire,  Casualties,  Theft,  etc. 

The  law  includes  among  the  allowable  deductions,  in  the 
case  of  individuals  and  corporations,  all  "property"  losses 
"arising  from  fires,  storms,  shipwreck  or'  other  casualty  or 
from  theft,  and  if  not  compensated  for  by  insurance  or  other- 
wise." Such  losses  are  deductible  in  full  by  an  individual 
irrespective  of  whether  or  not  the  property  lost  was  invested 
in  a  business  or  trade. "^^ 

Ruling.  If  an  automobile  is  purchased  with  the  intention  of 
using  it  in  a  business  and  it  is  appropriated  to  business  uses  primarily 
a  loss  sustained  through  its  sale  may  be  deducted  in  computing  net 
income  notwithstanding  its  occasional  use  for  pleasure  purposes. 
(C.  B.  4,  page  163;  O.  D.  943.) 

Since  there  is  provision  in  the  law  for  business  losses,  and 
since  Congress  provided  also  for  "other"  losses,  it  may  be  pos- 
sible to  include  losses  due  to  destruction  of,  or  damage  to, 
automobiles,  yachts  and  all  sorts  of  personal  property.  The 
author  is  of  the  opinion  that  such  losses  should  be  held  to  be 
personal  or  family  expenses,  and  not  the  sort  of  property 
losses  properly  deductible;  but  if  Congress  has  deliberately 
provided  otherwise,  taxpayers  cannot  be  criticized  for  claim- 
ing the  deduction. 

RuLiNG-s.  A  loss  sustained  by  reason  of  the  damage  of  a  pleasure 
automobile,  due  to  an  accident  attributable  to  the  icy  condition  of 
the  streets,  is  not  deductible  under  the  provisions  of  section  214  (a) 
6  of  the  Revenue  Act  of  1918,  as  a  loss  sustained  by  "other  casualty." 
(C.  B.  3,  page  158;  O.  D.  629.) 

A  loss  may  be  claimed  by  the  owner  of  a  business  truck  demolished 
in  collision  with  a  pleasure  car  provided  that  the  truck  was  in  use 


"[Former  Procedure]  Under  the  1913  law  the  Treasury  took  the 
opposite  position.  Thus  T.  D.  2005  (July  8,  1914)  definitely  asserts 
that  only  those  losses  are  deductible  which  are  sustained  during  the 
tax  year  "in  trade."  Section  5  [a]  fifth,  of  the  1916  law  permitted  a 
limited  deduction  of  losses  in  transactions  entered  into  for  profit  but 
not  connected  with  one's  business  or  trade. 

The  words  "other  casualty"  and  "theft"  appeared  first  in  the  1916 
law  [section  5  (a)].  The  phrase  "and  from  theft"  in  the  1916  law  is 
superseded  by  the  phrase  "or  from  theft"  in  the  1918  law,  but  the  change 
is  purely  verbal. 


FOR    LOSSES  1009 

in  connection  with  the  business  of  the  taxpayer  at  the  time  of  the 
collision.  No  deduction  may  be  claimed  by  the  owner  of  the  pleasure 
car  wrecked  in  the  collision.     (C.  B.  4,  page  160;  O.  D.  857.) 

The  reason  for  disallowing  the  losses  claimed  in  the  cases 
covered  by  the  foregoing  rulings  is  not  clear.  The  law  states 
that  deductions  are  to  be  allowed  for  "losses  sustained  .... 
of  property  not  connected  with  the  trade  or  business  .... 
if  arising  from  ....  casualty  .  .  .  ."  An  automobile  is 
surely  "property,"  whether  used  for  business  or  pleasure  pur- 
poses. A  "casualty"  is  defined  in  the  Standard  Dictionary  as 
"a  .  .  .  .  serious  accident  .  .  .  .  ;  that  which  occurs 
by  chance:  chance."  Both  the  cases  covered  by  the  foregoing 
rulings  would  seem  to  come  within  the  scope  of  section  214 
(a-6). 

Rulings.  A  ring  lost  by  its  owner  and  owing  to  the  circum- 
stances attending  the  loss  he  is  in  doubt  as  to  whether  it  was  stolen 
or  merely  misplaced  or  lost  from  his  finger. 

Unless  he  can  establish  the  fact  that  the  ring  was  stolen  no  deduc- 
tion can  be  allowed  on  account  of  the  loss. 

Such  a  loss  does  not  come  within  the  meaning  of  the  term  "other 
casualty"  as  used  in  section  214  (a)  6  of  the  Revenue  Act  of  1918. 
This  term  embraces  losses  arising  through  the  action  of  natural 
physical  forces  and  which  occur  suddenly,  unexpectedly,  and  with- 
out design  of  the  one  suffering  the  loss.  (C.  B.  2,  page  130;  O. 
D.  526.) 

A  taxpayer  employed  a  contractor  to  build  his  house.  The  con- 
tractor absconded,  leaving  certain  bills  for  material  used  in  the  con- 
struction of  the  house  unpaid,  and  the  taxpayer  was  required  to  pay 
such  bills. 

Held,  that  the  additional  amount  paid  represents  additional  cost 
of  the  building  and  is  not  deductible  as  a  loss.  (C.  B.  4,  page  213; 
O.  D.  925.) 

The  amounts  misappropriated  by  a  guardian  of  a  minor  in  the 
years  1917,  1918,  and  1919  are  allowable  deductions  for  those  years 
under  the  provisions  of  the  Revenue  Act  of  19 16,  as  amended  by  the 
Act  of  1917  and  the  Revenue  Act  of  1918.  (B.  50-21-1974;  A.  R. 
M.  144.) 

Determination  of  the  loss  deductible. — 

Regulation When  loss  is  claimed  through  the  destruc- 
tion of  property  by  fire,  flood,  or  other  casualty,  the  amount  deductible 


lOio  DEDUCTIONS 

will  be  the  difference  between  the  cost  of  the  property,  less  proper 
adjustment  for  depreciation,  and  the  salvage  value  thereof.  In  the 
case  of  property  acquired  before  March  i,  1913,  however,  the  de- 
ductible loss  is  the  difference  between  the  fair  market  value  of  the 
property  as  of  that  date,  less  proper  adjustment  for  depreciation,  and 
the  salvage  value  thereof.  In  any  event  the  loss  should  be  reduced 
by  the  amount  of  any  insurance  or  other  compensation  received. 
.'.   .   .    (Art.  141.) 

Rulings.  A  taxpayer's  personal  residence  located  on  a  beach  was 
damaged  by  a  storm,  which  washed  away  part  of  the  foundation  and 
so  undermined  the  building  as  to  render  its  destruction  certain  if  it 
was  not  immediately  removed.  In  removing  the  building  to  a  safer 
location  it  was   further   damaged. 

The  damage  caused  by  the  direct  action  of  the  storm  and  by  the 
removal  to  avoid  further  probable  damage  is  held  to  have  arisen 
from  storm  and  deductible  from  gross  income  as  a  loss  within  the 
meaning  of  section  214(a)  6  of  the  Revenue  Act  of  1918.  If  the 
building  was  moved  to  prevent  further  loss  from  the  storm  in  ques- 
tion, the  expense  of  moving  it  is  also  deductible  as  a  loss;  but  if  it 
was  moved  to  prevent  probable  losses  from  future  storms,  the  ex- 
pense of  moving  it  is  regarded  as  a  capital  expenditure  and  should 
be  added  to  the  cost  of  the  building  in  computing  profit  in  the  event 
of  its  sale,  since  the  removal  to  a  safer  locality  presumably  increased 
its  value.     (C.  B.  3,  page  159;  O.  D.  698.) 

Damage  to  the  flooring  and  furniture  in  the  residence  of  a  tax- 
payer caused  by  the  freezing  and  bursting  of  water  pipes,  and  not 
compensated  for  by  insurance,  constitutes  a  deductible  loss.  The 
amount  of  such  loss  is  the  difference  between  the  cost  of  the  flooring 
and  furniture  (or  the  fair  market  value  on  March  i,  1913,  if  acquired 
prior  thereto,  and  such  value  was  less  than  the  cost),  less  depreciation 
sustained  thereon,  prior  to  the  casualty,  and  the  salvage  value  of 
the  property.     (B.  43-21-1885;  O.  D.  1076.) 

The  Treasury  has  held  that  when  depreciation  has  not  been 
an  allowable  deduction,  as  in  the  case  of  a  taxpayer's  resi- 
dence, depreciation  need  not  be  considered  in  determining  the 
gain  or  loss  arising  from  the  sale  of  the  residence."  It  would 
appear  that  the  same  principle  should  apply  when  determining 
losses  in  cases  such  as  the  one  covered  by  the  ruling  immedi- 
ately preceding. 

^''  See  page  581. 


FOR   LOSSES  lOll 

Damages  for  personal  injury. — 

Ruling.  Plaintiff  recovered  damages  on  account  of  injuries 
sustained  in  a  fall  occasioned  by  reason  of  tripping  over  a  wire 
stretched  along  the  curb  in  front  of  defendant's  residence. 

Held,  that  the  amount  paid  by  the  defendant  does  not  constitute 
a  loss  from  "other  casualty"  within  the  meaning  of  section  214  (a)  6 
of  the  Revenue  Act  of  1918,  and  that  he  may  not  deduct  it  from  his 
gross  income  for  income  tax  purposes.  (C.  B.  4,  page  155;  O.  D. 
779-) 

Accounting  procedure. — Losses  by  fire,  storm,  etc.,  not 
compensated  by  insurance  should  be  ascertained  without  delay 
and  proper  entries  should  be  made  therefor  on  the  books.  The 
law  specifically  permits  the  deduction  of  such  losses  "sustained 
during  the  year."  This  means  the  taxable  year,  fiscal  or 
calendar,  of  the  individual  or  corporation.  If  at  the  time  of 
closing  the  books  it  is  known  that  a  loss  has  occurred  and  no 
adjustment  has  been  made,  the  closing  of  the  books  should 
be  deferred  until  an  adjtistment  shall  have  been  made,  because 
the  loss  will  not  be  an  allowable  deduction  in  the  next  period. 
If  the  delay  is  for  a  considerable  time  a  tentative  return  can 
be  made  and  later  an  amended  final  return  can  be  substituted 
therefor. 

Ruling.  When  an  insured  loss  occurs  in  one  taxable  year  and  the 
insurance  is  not  recovered  during  that  year  the  taxpayer  should  com- 
pute his  loss  by  deducting-  from  the  total  loss  the  estimated  amount  of 
the  recoverable  insurance.  The  loss  so  determined  should  be  de- 
ducted from  the  taxpayer's  gross  income  of  the  year  in  which  the 
loss  was  sustained.  If  subsequent  events  demonstrate  that  this  esti- 
mate was  substantially  incorrect,  an  amended  return  should  be  filf.d 
correcting  the  mistake.     (  C.  B.  i,  page  123;  T.  B.  R.  55.) 

Losses  by  theft  and  embezzlement. — Losses  by  theft"'*  are 


^*  [Former  Procedure]  The  following  ruling  made  in  1919  should  be 
read  in  conjunction  with  Art.  146  of  Reg.  62. 

Ruling.  A  loss  incurred  by  a  corporation  through  embezzlement  is  an 
allowable  deduction  from  gross  income  for  the  year  in  which  the  embezzle- 
ment occurred.  Where  the  embezzlement  is  not  discovered  in  the  taxable 
year  but  is  later  discovered  and  admitted  by  the  embezzler,  a  part  of 
the  money  being  promptly  recovered,  the  amount  so  recovered  tends  to 
diminish  the  amount  of  allowable  deductions  on  account  of  the  embezzle- 


1012  DEDUCTIONS 

now  specifically  mentioned  in  the  law  among  those  which  may 
he  deducted.'^'* 

If  recent  newspaper  reports  are  trustworthy  there  will  be 
many  claims  by  individuals  not  in  the  liquor  trade,  for  losses 
from  theft  of  liquors.  The  regulations  hold  that  such  losses 
constitute  allowable  deductions.  The  basis  of  deduction  is 
cost,  not  market  value. 

Rulings.  A  loss  incurred  by  a  corporation  through  the  embez- 
zlement of  securities  held  in  bailment  is  an  allowable  deduction  from 
gross  income  of  the  year  in  which  the  liability  accrued,  i.  e.,  when 
demand  was  made  by  the  bailors  for  the  return  of  the  securities  and 
replacement  thereof  was  made  by  the  corporation.  (C.  B.  3,  page 
158;  A.  R.  R.  269.) 

A  loss  sustained  by  a  corporation  through  burglary  in  191 7  is  de- 
ductible in  the  taxpayer's  return  for  that  year  only,  although  the 
question  as  to  whether  a  burglary  insurance  company  should  repay 
all  or  any  part  of  the  loss  to  the  company  was  not  finally  determined 
by  the  courts  until  1919.     (C.  B.  4,  page  143;  A.  R.  R.  542.) 

A  forwarded  to  his  brother  B,  i^x  dollars  to  be  used  in  the  pur- 
chase of  a  bank.  During  the  negotiations  for  the  purchase,  C  ab- 
sconded with  the  money.  A  expended  x  dollars  as  interest  upon  the 
sum  lost,  which  was  a  loan,  and  x  dollars  in  apprehending  the  thief. 
A's  brother  is  unable  to  make  good  the  loss  and  no  recovery  can  be 
had  from  C. 

Held,  that  A  is  entitled  to  deduct  the  amount  of  I5.r  dollars  as  a 
business  loss  and  in  addition  the  interest  payment  advanced  to  secure 
the  loan.  The  amount  expended  in  apprehending  the  thief,  however, 
is  regarded  as  a  personal  expense  and  may  not,  therefore,  be  de- 
ducted.    (C.  B.  3,  page  156;  O.  D.  571.) 

During  1916,  A  was  induced  by  B,  who  represented  himself  as 
an    agent    of    a    manufacturing    corporation,    to    invest    lo.r    dollars. 


ment  for  the  year  in  which  the  embezzlement  occurred,  and  is  ordinarily 
not  returnable  as  income  in  the  year  when  received.  (C.  B.  i,  page  118; 
O.  845.) 

°°  It  is  interesting  to  note  that  in  England  losses  by  embezzlement  by 
an  employee  have  only  recently  come  to  be  recognized  as  allowable  de- 
ductions. 

"A  loss  by  reason  of  embezzlement  by  an  employee  used  to  be  looked 
upon  as  a  loss  by  stratagem,  and  not  one  connected  with,  or  arising  out  of, 
trade,  and  it  used  to  be  said  that  the  amount  could  not  be  deducted.  Such 
a  loss,  however,  is  now  for  income  tax  purposes  deemed  an  expense  of  the 
year  in  which  it  is  written  off  in  the  books."  Murray  and  Carter,  Income 
Tax  Practice,  page  281. 


FOR    LOSSES  1013 

represented  by  two  notes  of  5.r  dollars  each,  in  stock  of  the  pro- 
posed corporation.  A  was  to  be  made  foreman  of  the  proposed  plant 
and  the  notes  were  to  be  paid  by  him  out  of  the  salary  he  was  to 
receive  from  the  corporation.  B's  representations  were  later  found 
to  be  false  and  after  discounting  one  of  A's  notes  he  absconded  with 
the  proceeds  thereof,  A  having  succeeded  in  recovering  the  other 
note.  An  investigation  of  the  transaction  was  made  in  1916  and 
it  was  then  found  that  the  parties  who  had  put  money  into  the 
enterprise  would  realize  nothing  from  it.  During  1917,  A  paid  x 
dollars  on  the  note  discounted  at  the  bank  and  renewed  it  for  4x 
dollars,  which  amount  he  paid  in  1918,  and  claimed  as  a  loss  in 
computing  his  net  income  for  that  year.  The  question  is  raised  as 
to  the  year  in  which  the  loss  is  properly  deductible. 

Assuming  that  A  kept  his  books  on  a  cash  receipts  and  disburse- 
ments basis,  it  is  held  that  he  would  not  be  in  a  position  to  deduct 
any  loss  until  he  had  actually  paid  the  note,  thereby  evidencing  a 
completed  and  closed  stock  transaction.  A  may  deduct  the  pay- 
ments on  the  note  in  computing  net  income  for  the  years  in  which 
such  payments  were  made.  The  fact  that  the  loss  was  discovered  in 
1916  is  immaterial,  because  the  date  of  discovery  does  not  determine 
the  date  on  which  the  loss  was  sustained.     (I-3-32;  I.  T.  1167.) 


Corporate  Losses  In  Issuance  and  Redemption  of 
Securities 

Discount  on  bonds  sold — a  loss  which  may  be  prorated. — 
When  a  corporation  sells  bonds  at  less  than  par,  it  is  because 
the  nominal  rate  of  interest  as  expressed  in  the  bonds  is  less 
than  the  market  rate.  If  a  corporation  has  a  high  credit  and 
there  is  a  favorable  market  for  securities,  it  will  secure  the 
advantage  of  a  low  rate  of  interest.  Its  5  per  cent  bonds  may 
sell  at  no.  If,  however,  the  market  is  not  so  favorable,  even 
though  the  credit  of  the  company  be  unimpaired,  its  5  per 
cent  bonds  may  sell  at  90.  In  both  cases,  if  one  assumes  the 
credit  of  the  company  to  remain  constant,  it  is  the  market  rate 
of  interest  current  at  the  time  which  governs  the  price  of  the 
bonds.  Proper  accounting  calls  for  a  reflection  of  the  actual 
interest  cost  spread  evenly  over  the  life  of  the  bonds,  and 
this  is  readily  accomplished  by  adjusting  the  mterest  account. 

The  regulations  which  formerly  considered  such  discounts 
as  losses  rather  than  interest,  now  provide  that   (except  for 


11)14 


DEDUCTIONS 


discounts  on  bonds  purchased  prior  to  1909  and  charged  off) 
they  niay  be  prorated  equitably  over  the  Hfe  of  the  bonds. 

Regulations.  Discount  on  bonds  issued  and  sold  prior  to  the 
year  1909,  if  such  discount  was  then  charged  against  surplus  or 
against  the  income  of  the  year  in  which  the  bonds  were  sold,  is  held 
not  to  be  deductible  from  the  income  of  subsequent  years,  for  the 
reason  that  the  charging  off  prior  to  January  i,  1909,  of  the  entire 
amount  of  the  discount  constitutes  a  closed  transaction,  and  such 
transaction  can  not  be  reopened  for  the  purpose  of  reducing  the 
taxable  income  of  a  corporation  for  subsequent  years  by  deducting 
therefrom  an  aliquot  part  of  the  discount.  (C  &■  A.  R.  R.  v.  U.  S., 
Court  of  Claims;  Reg.  33,  1918,  Art.  149.) 

(i)  (a)  If  bonds  are  issued  by  a  corporation  at  their  face  value, 
the  corporation  realizes  no  gain  or  loss,  (b)  If  thereafter  the  cor- 
poration purchases  and  retires  any  of  such  bonds  at  a  price  in  excess 
of  the  issuing  price  or  face  value,  the  excess  of  the  purchase  price 
over  the  issuing  price  or  face  value  is  a  deductible  expense  for  the 
taxable   year 

(2)    (a)   If    bonds    are    issued   by    a   corporation    at    a    premium, 

[and]   (b)  If  thereafter  the  corporation  purchases  and  retires 

any  of  such  bonds  at  a  price  in  excess  of  the  issuing  price  minus  any 
amount  of  premium  already  returned  as  income,  the  excess  of  the 
purchase  price  over  the  issuing  price  minus  any  amount  of  premium 
already  returned  as  income  (or  over  the  face  value  plus  any  amount 
of  premium  not  yet  returned  as  income)  is  a  deductible  expense  for 
the  taxable  year 

(3)  (a)  If  bonds  are  issued  by  a  corporation  at  a  discount, 
the  net  amount  of  such  discount  is  deductible  and  should  be 
prorated  or  amortized  over  the  life  of  the  bonds,  (b)  If  thereafter 
the  corporation  purchases  asd  retires  any  of  such  bonds  at  a  price  in 
excess  of  the  issuing  price  plus  any  amount  of  discount  already  de- 
ducted, the  excess  of  the  purchase  price  over  the  issuing  price  plus 
any  amount  of  discount  already  deducted  (or  over  the  face  value 
minus  any  amount  of  discount  not  yet  deducted)  is  a  deductible 
expense  for  the  taxable  year (Art.  545.) 

The  foregoing  follows  very  closely  the  language  of  article 
544  of  Regulations  45. 

When  bond  discount  has  been  capitalized  at  the  time  of 
issuance  of  the  bonds  (as  was  frequently  done  and  approved 
by  public  service  commissions  not  many  years  ago),  and  when 
such  discount  has  not  been  otherwise  amortized,  it  appears  to 


FOR   LOSSES 


1015 


be  permissible  for  income  tax  purposes  to  write  off  annually 
the  pro  rata  amount. 

When  bond  discount  was  charged  to  profit  and  loss  dur- 
ing the  year  in  which  the  bonds  were  issued  (if  since  1909), 
or  during  subsequent  years,  in  amounts  greater  than  the  proper 
proportion,  it  seems  to  be  permissible  to  prepare  and  submit 
amended  returns  for  such  years,  or  upon  any  reopening  of  a 
corporation's  books  by  the  Treasury  to  make  claim  for  ad- 
justment. 

Ruling.  A  corporation  which  issued  its  bonds  at  a  discount  and 
improperly  charged  the  discount  to  profit  and  loss  may  correct  its 
books  to  show  the  discount  treated  as  interest  paid  in  advance  to  be 
amortized  over  the  life  of  the  bonds.  Amended  returns  reflecting 
correction  in  the  books  may  be  filed.     (C.  B.  i,  page  224;  O.  D.  iii.) 

Decisions  under  the  1909  law, — The  foregoing  regulations 
are  those  prescribed  by  the  Treasury  under  its  authority  to 
permit  and  require  accounts  to  be  kept  on  a  basis  which  prop- 
erly reflects  the  true  net  income  of  taxpayers. 

Under  the  1909  law  the  Treasury's  hands  were  more  or 
less  tied.  The  law  as  written  required  accounts  to  be  kept 
strictly  on  a  cash  receipt  and  payment  basis.  Therefore  the 
decisions  of  the  courts  under  the  1909  law  are  of  interest  only 
in  connection  with  returns  for  periods  prior  to  January  i,  1913. 

Baldwin  Locomotive  Co.  v.  McCoach. — 

Ruling.  The  decision  of  the  United  States  Circuit  Court 
of  Appeals  for  the  Third  Circuit,  in  the  case  of  the  Baldwin  Loco- 
motive Works  V.  McCoach,  Collector  (221  Fed.  59),  holds  that  if  the 
loss  sustained  by  selling  its  own  bonds  at  a  discount  is  an  expense 
of  the  business  of  a  corporation,  the  expense  will  not  be  paid  until 
the  maturity  of  the  bonds,  and  should  therefore  be  prorated  over  the 
life  of  the  bonds.     (T.  D.  2185,  April  i,  1915.) 

Southern  Pacific  R.  R.  Co.  v.  Muenter. — • 

Ruling.  Where  a  corporation  sold  bonds  at  a  discount  dur- 
ing 1906,  1907  and  1908  no  deduction  from  gross  income  for  the 
years  1909,  1910  and  191 1  of  sums  set  aside  by  the  corporation  to 
pay  such  discount  at  the  maturity  of  the  bonds  is  permitted  under 


lOi6  DEDUCTIONS 

the  provisions  of  section  38,  Act  of  August  5,  1909,  authorizing 
corporations  to  deduct  from  gross  income  "(second)  all  losses  actu- 
ally sustained  within  the  year  .  .  .  ."  and  "(third)   interest  actually 

paid   within  the  year  on   its   bonded   or   other   indebtedness " 

(260  Fed.  837.)     (T.  D.  2944,  November  8,  19 19.) 

It  will  be  noted  that  the  court  strictly  construed  the  terms 
"losses  actually  sustained  within  the  year"  and  "interest  actu- 
ally paid  within  the  year." 

Loss  on  bonds  sold  or  paid  at  maturity. — When  the  amount 
received  from  the  sale  or  redemption  of  bonds  purchased  prior 
to  March  i,  191 3,  is  less  than  cost,  or  fair  market  value  March 
I,  19 1 3,  (whichever  was  lower)  the  difference  is  an  allowable 
deduction  as  a  loss.  If  purchased  on  or  after  March  i,  191 3, 
the  deduction  allowed  is  the  difference  between  cost  and  the 
amount  realized  by  sale  or  redemption.^*' 

It  should  be  remembered  that  there  has  been  a  great  de- 
cHne  in  the  price  of  bonds  since  March  i,  1913,  so  that  prac- 
tically all  bonds  purchased  or  otherwise  acquired  prior  to  that 
time  would  show  a  loss  if  sold  at  this  time. 

Regulation If  it  (a  corporation)   retires  its  bonds  at 

a  price  in  excess  of  the  issuing  price,  such  excess  may  usually  be 
deducted  as  expense (Art.  563.) 

If  bonds  were  purchased  at  a  discount  or  premium  and 

the  taxpayer  has  amortized  the  difference  between  par  and 

purchase  price,  the  amount  of  the  loss  is  based  on  the  book 

values  and  not  on  original  cost,  except  as  the  value  at  March 

I,  19 1 3,  may  necessitate  further  adjustment. 

Ruling.  Amortization  of  premium  or  discount  on  bonds  as  con- 
templated in  articles  544,  563,  and  848,  Regulations  45,  is  not  per- 
missible in  the  case  of  the  purchaser  of  bonds.  The  purchase  price 
of  the  bond,  even  though  different  from  par  represents  the  investment. 
When  the  bonds  mature  or  are  sold  the  basis  for  determining  the 
gain  or  loss  is  their  purchase  price,  or  their  fair  market  value  as  at 
March  i,  1913,  if  acquired  prior  to  that  date.  (C.  B.  2,  page  211; 
O.  D.  475-) 


'^^  Subject  to  modification  by  provisions  of  section  202  (a-2)  of  1921  law 
as  to  property  sold  after  December  31,  1920.  This  modification  did  not 
appear  in  the  1918  law. 


FOR   LOSSES  1017 

The  foregoing  ruling  is  at  variance  with  good  accounting 
practice.  A  bank  bought  7  per  cent  bonds  at  no  in  1910. 
In  1920  the  bonds  were  paid  off  at  par.  If  all  the  premium 
had  been  amortized  the  books  would  show  no  loss  in  1920, 
but  under  the  ruling  a  loss  could  be  claimed. 

Ruling.  Where  bonds  mature  serially,  a  proper  proportion  of 
the  total  discount  and  expenses  should  be  allocated  to  each  series  and 
each  series  then  treated  as  a  separate  unit.  The  deduction  applicable 
to  each  series  should  be  prorated  equally  over  the  life  of  the  bonds 
constituting  the  series,  provided,  hov^^ever,  that  if  the  corporation  re- 
tired any  of  the  bonds  before  maturity,  the  deduction  for  that  year 
should  be  increased  by  an  amount  equivalent  to  the  amount  which 
would  ordinarily  be  deducted  during  the  succeeding  years  on  ac- 
count of  those  particular  bonds  if  they  had  not  been  prematurely 
retired.     (C.  B.  4,  page  276;  O.  D.  936.) 

Premium  on  capital  stock  redeemed  not  a  deductible  loss. — 

Ruling.  This  ofifice  is  in  receipt  of  your  letter  of  the  6th  instant, 
in  which  you  ask  for  information  on  the  following  question :  "A 
corporation  in  1912  issued  preferred  stock  for  par.  It  was  provided 
on  the  certificates  that  said  stock  was  redeemable  at  no.  The  com- 
pany exercised  its  option  and  redeemed  the  stock  at  no  by  calling 
it  in.  The  difference  appeared  on  the  books  as  a  reduction  of  un- 
divided profits.     Is  this  difference  a  lawful  deduction?" 

In  reply  you  are  informed  that  this  office  will  hold  that  the 
redeeming  of  the  stock  at  a  price  in  excess  of  par  represents  a  capital 
transaction  in  which  there  can  be  no  gain  or  loss  to  the  corporation, 
and  therefore  the  difference  between  the  selling  price  of  the  stock 
and  the  price  at  which  it  was  redeemed  will  not  be  deductible  in  a 
return  of  annual  net  income.  (Letter  to  a  subscriber  of  The  Cor 
poration  Trust  Co.,  signed  by  Deputy  Commissioner  ,G.  E.  Fletcher, 
and  dated  April  11,   1917.) 

Regulations.  The  proceeds  from  the  original  sale  by  a  cor- 
poration of  its  shares  of  capital  stock,  whether  such  proceeds  are  in 
excess  of  or  less  than  the  par  value  of  the  stock  issued,  constitute 
the  capital  of  the  company.  If  the  stock  is  sold  at  a  premium,  the 
premium  is  not  income (Art.  543.   Reg.  45,  Art.  542.) 

A  corporation  sustains  no  deductible  loss  from  the  sale  of  its 
capital  stock (Art.  563.) 

The  purchase  or  redemption  by  a  corporation  of  its  own 
capital  stock  is  an  operation  of  a  nature  entirely  different  from 


IOi8  DEDUCTIONS 

that  involved  in  the  retirement  of  bonds.  The  purchase  or 
retirement  of  bonds  at  a  premium  involves  a  payment  to  a 
creditor.  As  explained  above,  the  premium  is  nothing  but 
a  net  expense  spread  over  the  life  of  the  bonds.  Payments 
to  stockholders,  on  the  other  hand,  must  be  out  of  profits  (un- 
less liquidation  is  in  progress).  Such  payments  are  usually 
in  the  form  of  dividends,  but  in  the  numerous  instances 
when  corporations  purchase  their  own  shares  at  a  premium, 
this  premium  in  effect  is  a  payment  to  a  stockholder.  Most 
states  forbid  a  corporation  to  buy  its  own  stock  except  out 
of  surplus.  Since  the  payment  of  a  premium  on  shares  is  the 
equivalent  of  a  dividend,  there  is  no  ground  whatever  for  a 
claim  that  such  premiums  should  be  allowable  deductions  in 
an  income  tax  return.  In  no  sense  of  the  w-ord  is  such  a  pay- 
ment capital.  Although  not  an  allowable  deduction  from  net 
income,  premiums  on  stock  can  be  paid  only  from  profits 
and  that  is  the  method  always  followed. 

Consequently  the  author  cannot  agree  wath  the  Treasury 
when  it  says  that  the  payment  of  the  premium  in  redeeming 
stock  is  "a.  capital  transaction  in  which  there  can  be  no 
gain  or  loss  to  the  corporation."  He  does  agree,  however, 
with  the  conclusion  that  such  payments  are  not  deductible 
As  such  payments  are  not  allowable  deductions  to  the  cor- 
poration, and  must,  therefore,  be  charged  direct  to  surplus, 
it  can  be  claimed  that  a  distribution  of  profits,  equivalent  to  a 
dividend,  has  been  made.  The  corporation  will  have  paid  the 
normal  income  tax  thereon  and  should  notify  its  stockholders 
of  that  fact  so  that  they  may  enter  the  receipt  of  the  premiums 
as  a  dividend  and  thus  avoid  the  normal  tax. 


Losses  of  Holding   Companies — Accounting 
Procedure 

The  interests  owned  by  holding  companies  in  affiliated  or 
subsidiary  companies  are  usually  represented  by  holdings  of 
capital  stock,  bonds  or  other  forms  of  indebtedness  such  as 


FOR   LOSSES 


1019 


promissory  notes,  open  book  accounts,  etc.  When  a  holding 
company  desires  to  reflect  on  its  books  the  profits  or  losses 
of  its  subsidiaries,  it  does  so  by  the  accrual  and  reserve 
method,"  or  by  writing  up  or  down  the  book  valuations  of 
the  stocks  or  obligations  owned. 

Under  existing  rulings,  a  mere  writing  down  of  valua- 
tions is  not  an  allowable  deduction.  But  many  transactions 
ordinarily  reflected  by  a  change  in  valuations  are  more  prop- 
erly recorded  as  "losses  which  are  immediately  deductible." 
If  a  subsidiary  loses  money  and  the  holding  company  advances 
funds,  which  in  effect  are  used  to  make  good  the  deficit,  and 
it  is  not  likely  that  the  subsidiary  can  repay  the  advance,  it 
becomes  a  bad  debt  on  the  books  of  the  holding  company  and 
should  be  charged  off  as  a  loss.  The  192 1  law  specifically 
authorizes  the  Commissioner  to  allow  a  deduction  for  a  bad 
debts  reserve;  when  he  is  satisfied  that  a  debt  is  recoverable 
only  in  part,  he  may  allow  it  to  be  charged  off  in  part. 

Transactions  of  this  kind  are  sometimes  improperly  han- 
dled. For  example,  the  advance  from  the  holding  company 
to  the  subsidiary  is  often  treated  as  a  gift  from  one  to  the 
other.  If  this  were  really  so,  the  holding  company  could  not 
claim  it  as  an  allow-able  deduction  (because  gifts  are  not  de- 
ductible) ;  but  in  fact  this  is  not  a  gift.  It  is  on  the  part  of  the 
holding  company  one  of  the  necessary  expenses  incurred  in 
its  business  or  a  loss  of  similar  nature.  Holding  companies 
are  formed  to  make  money.  When  they  lose  in  transactions 
from  which  profits  were  expected  to  arise,  it  is  a  trade  loss — 
not  a  gift  in  the  nature  of  a  beneficence  or  anything  of  that 
sort.  Therefore  at  the  time  when  such  transactions  are  en- 
tered, the  true  state  of  affairs  should  be  disclosed  and  inad- 
vertent mention  of  a  8:ift  should  be  avoided.''^ 


^^  Auditing,  Theory  and  Practice  (3rd  edition),  by  R.  H.  Montgomery, 
page  347  et  seq. 

°*  [Former  Procedure]  Article  115  of  Regulations  33,  1918,  re- 
quired that  earnings  of  subsidiaries  taken  up  on.  the  books  of  tiie  hold- 
ing company  be  returned  as  income.  If  the  regulations  were  sound, 
then  the  converse  must  be  good  practice:  that  is,  where  losses  of  sub- 
sidiaries are  taken  up  each  month  on  the  books  of  the  holding  com- 


I020  DEDUCTIONS 

Decision.  (Syl.)  Where  a  railroad  company  upon  being  pro- 
Iiibitcd  by  State  law  from  owning  and  operating  docks  and  channels, 
organized  a  terminal  company  for  that  purpose,  of  which  it  owned  all 
shares  of  stock  except  such  as  were  necessary  to  qualify  directors,  and 
advanced  as  loans  to  it  from  year  to  year  sums  sufficient  to  cover  its 
deficit,  the  railroad  company  may  not  deduct  as  operating  expenses,  in 
computing  net  income  for  the  measure  of  the  corporation  excise  tax 
imposed  by  the  Act  of  August  5,  1909,  the  amount  of  such  advances 
made  during  a  taxable  year. 

Where  interest  on  loans  made  by  parent  corporation  to  its  sub- 
sidiary accrued  from  year  to  year,  but  was  not  paid,  the  amount 
thus  accrued  during  a  taxable  year  cannot  be  considered  income  to 
the  parent  company  within  the  meaning  of  the  Act  of  August  5, 
1909.    (Walker  v.  Gulf  and  Interstate  Ry.  Co.  of  Texas,  269  Fed.  885.) 

The  191 8  law  provides  for  consolidated  returns  in  all 
cases  in  which  one  corporation  controls  another  or  an  indi- 
vidual controls  two  or  more  corporations.  Therefore,  when 
consolidated  returns  are  made,  the  loss  of  one  subsidiary  op- 
erates as  a  credit  against  the  profit  of  another  and  no  adjust- 
ments need  be  made  in  the  books. 

It  would  not  be  wise,  however,  to  depend  on  the  desired 
adjustment  being  made  through  the  medium  of  consolidated 
returns.  State  income  tax  returns  wull  require  accurate  re- 
ports from  subsidiaries  and  in  many  cases  no  report  at  all  will 
be  required  from  the  parent  company  or  an  affiliated  company. 

Limitation  nn  losses  incurred  in  transactions  outside  busi- 
ness or  trade. — Under  the  19 18  and  1921  laws  all  losses  in- 
curred in  trade,  or  arising  from  transactions  entered  into  for 
profit,  are  deductible,  but  under  former  laws  there  were  limit- 
ations on  the  deductions. 

For  several  years  the  author  has  contended  that  the  Treas- 
ury did  not  properly  interpret  the  earlier  laws  and  that 
many  losses  which  were  disallowed  were  in  fact  allowable 
deductions.  During  191 9  a  case  was  decided  in  a  United 
States  district  court  wherein  the  court  held  that  the  Treas- 


pany,  they  could  be  claimed  as  allowable  deductions.  As  the  author 
questioned  the  soundness  of  the  ruling  as  it  affects  income,  the  same 
criticism  applies  where  there  is  a  loss. 


FOR   LOSSES  I02I 

ury  was  in  error  in  disallowing  a  loss  which  the  taxpayer 
claimed  as  having  been  incurred  in  trade.  The  taxpayer  re- 
ceived a  large  block  of  stock  in  an  industrial  company  to 
whose  affairs  she  evidently  devoted  some  time  and  attention. 

Decision.  The  transactions  ....  were  complicated  in  charac- 
ter, involved  a  very  large  sum  of  money,  and  must  have  required 
much  of  her  time  and  attention,  and  I  am  of  the  opinion  that  they 
were  of  the  character  contemplated  by  Congress  as  "incurred  in 
trade."  [Bryce  et  al.  v.  Keith,  Collector,  257  Fed.  133  (March  26, 
I9i9)-1 

Ruling.  Where  a  corporation  is  authorized  by  its  charter  or 
certificate  of  incorporation  to  purchase  stocks  on  a  margin,  and 
where  there  are  no  laws  in  the  State  where  it  trades  in  stocks  making 
marginal  stock  transactions  by  corporations  illegal,  if  it  sustains  a 
loss  as  a  result  of  marginal  trading  in  stocks,  such  loss  may  be 
deducted  in  computing  its  net  income,  if  sustained  during  the  taxable 
year  and  not  compensated  for  by  insurance  or  otherwise,  unless  it 
appears  affirmatively  that  the  transaction  was  merely  colorable  and 
no  bona  fide  purchase  of  stock  was  made. 

Where  a  corporation  suffers  losses  as  a  result  of  its  ultra  vires 
act  no  deduction  for  such  losses  may  be  made  in  computing  its  net 
income.     (C.  B.  2,  page  212;  O.  968.) 


"Relief"  Provisions  of  the  1921   Law  * 

The  radical  changes  expected  in  business  conditions  as  a 
result  of  the  cessation  of  the  war  made  it  seem  imperative  that 
losses  arising  from  readjustments  of  inventories,  which  might 
occur  within  a  few  months  thereafter,  should  be  spread  over  a 
longer  period  of  time.    Similar  conditions  existed  in  the  case  of 


"  [Former  Procedure]  Provision  was  made  in  the  1918  law  [sections 
214  (i2-a)  and  234  (14-a)]  whereby  losses  resulting  from  a  subsequent 
decline  of  a  material  amount  in  the  value  of  the  1918  inventory,  might  be 
deducted  from  the  net  income  of  that  taxable  year  and  the  tax  be  re- 
computed. An  allowance  for  rebates  was  also  permitted.  A  full  discussion 
of  this  subject  will  be  found  in  Income  Tax  Procedure,  1921,  page  787  et 
seq.  As  a  condition  to  the  allowance  of  a  claim  under  this  provision,  the 
Treasury  illegally  requires  that  the  disposition  of  the  entire  inventory  at 
the  close  of  the  IQ18  taxable  year  be  shown  and  that  a  net  loss  on  the 
inventory  must  have  been  incurred.  (Bulletin  30-21-1745;  A.  K.  R.  544.) 
For  rulings  dealing  with  rebates,  see 

Bulletin  31-21-1753;   A.   R.   R.   590. 
31-21-1754;  A.  R.  R.   130. 
"         42-21-1871 ;   O.  D.    1067. 


1022  DEDUCTIONS 

losses  arising  from  sales  or  depreciation  of  plant  and  equip- 
ment acquired  for  war  purposes.  To  meet  these  difficulties 
the  1 918  law  provided  certain  so-called  relief  measures  de- 
signed to  assist  in  the  re-establishment  of  normal  conditions. 
Referring  to  these  provisions  Senator  Simmons  said :"" 

In  addition  to  the  relief  amendments  placed  in  the  income  tax 
title,  but  affecting  profits  taxes  as  well  as  income  taxes,  amendments 
relating  to  amortization  and  obsolescence,  shrinkage  in  inventories, 
and  so  forth,  the  Senate  added  a  general  relief  clause  investing  more 
or  less  discretion  in  the  Commissioner  of  Internal  Revenue  and  the 
Advisory  Tax  Board  for  relief  in  cases  clearly  establishing  injustice, 
inequality  or  discrimination.  The  House  conferees  accepted  these 
provisions  of  the  Senate. 

Law.     Section  204 (b)  If  for  any  taxable  year  beginning 

after  December  31,  1920,  it  appears  upon  the  production  of  evidence 
satisfactory  to  the  Commissioner  that  any  taxpayer  has  sustained  a 
net  loss,  the  amount  thereof  shall  be  deducted  from  the  net  income 
of  the  taxpayer  for  the  succeeding  taxable  year;  and  if  such  net  loss 
is  in  excess  of  the  net  income  for  such  succeeding  taxable  year,  the 
amount  of  such  excess  shall  be  allowed  as  a  deduction  in  computing 
the  net  income  for  the  next  succeeding  taxable  year;  the  deduction 
in  all  cases  to  be  made  under  regulations  prescribed  by  the  Commis- 
sioner with  the  approval  of  the  Secretary 

There  are  two  principal  points  of  difference  between  the 
foregoing  provision  and  the  similar  provision  of  the  1918  law : 

1.  The  19 18  law  permitted  the  application  of  the  loss  first 
against  income  of  the  preceding  taxable  year  (involving  a  re- 
computation  of  the  preceding  year's  tax  and  a  refund  of  that 
previously  paid)  and  the  application  against  the  following 
year's  income  of  any  excess  of  loss  over  income  of  the  pre- 
ceding year,  whereas  the  192 1  law  permits  application  of  loss 
of  one  taxable  year  only  against  income  of  one  or  two  suc- 
ceeding years. 

2.  The  net  loss  provision  of  the  1921  law  is  continuing 
in  its  character,  whereas  that  in  the  1918  law  related  only  to 
net  losses  sustained  in  the  years  ended  October  31,  November 
30  or  December  31,  respectively,  of  19 19. 

It  will  be  observed  that  neither  the  19 18  nor  the  1921  law 


'"February  11,  1919,  Congressional  Record,  page  3776. 


FOR   LOSSES  1023 

makes  any  provision  whatever  for  offsetting  losses  sustained 
in  1920  against  the  income  of  either  preceding  or  succeeding 
years. 

Definition  of  "net  loss." — 

Law.  Section  204.  (a)  That  as  used  in  this  section  the  term 
"net  loss"  means  only  net  losses  resulting  from  the  operation  of  any 
trade  or  business  regularly  carried  on  by  the  taxpayer  (including 
losses  sustained  from  the  sale  or  other  disposition  of  real  estate, 
machinery,  and  other  capital  assets,  used  in  the  conduct  of  such  trade 
or  business) ;  and  when  so  resulting  means  the  excess  of  the  deductions 
allowed  by  section  214  or  234,1^1  as  the  case  may  be,  over  the  sum  of 
the  following:  (i)  the  gross  income  of  the  taxpayer  for  the  taxable 
year,  (2)  the  amount  by  which  the  interest  received  free  from  taxation 
under  this  title  exceeds  so  much  of  the  interest  paid  or  accrued  within 
the  taxable  year  on  indebtedness  as  is  not  permitted  to  be  deducted 
by  paragraph  (2)  of  subdivision  (a)  of  section  214  or  by  paragraph 
(2)  of  subdivision  (a)  of  section  234,  (3)  the  amount  by  which  the 
deductible  losses  not  sustained  in  such  trade  or  business  exceed  the 
taxable  gains  or  profits  not  derived  from  such  trade  or  business,  (4) 
amounts  received  as  dividends  and  allowed  as  a  deduction  under  par- 
agraph (6)  of  subdivision  (a)  of  section  234,  and  (5)  so  much  of  the 
depletion  deduction  allowed  with  respect  to  any  mine,  oil  or  gas  well 
as  is  based  upon  discovery  value  in  lieu  of  cost 

Section  204  does  not  apply  unless  a  "net  loss"  has  been 
sustained.  When  a  taxpayer's  profit  and  loss  account  shows 
a  loss,  as  that  term  is  commonl)^  used,  further  consideration  is 
essential  in  order  to  determine  "net  loss." 

Regulation.  The  term  "net  loss"  as  used  in  the  statute  means 
only  a  net  less  resulting  from  the  operation  during  the  taxable  year 
of  any  trade  or  business  regularly  carried  on  by  the  taxpayer.  In- 
cluded therein  are  losses  from  the  sale  or  other  disposition  of  real 
estate,  machinery,  and  other  capital  assets  used  in  the  conduct  of 
such  trade  or  business.  In  order  to  be  entitled  to  claim  an  allowance 
for  a  "net  loss"  the  taxpayer  must  have  suffered  an  actual  net  loss 
in  a  trade  or  business  during  the  taxable  year.  The  amount  properly 
allowable  may  be  neither  the  loss  reflected  upon  the  return  filed  for 
the  purpose  of  the  income  tax  nor  the  net  loss  shown  by  the  tax- 
payer's profit  and  loss  account,  but  is  to  be  computed  according  to  the 
statute,  as  follows. 


*'  Providing  for  deductions  allowed  individuals   (section  214)   and  cor- 
porations  (section  234). 


I024  DEDUCTIONS 

(i)    In  the  case  of  an  individual,  it  is  the  amount  by  which  the  de- 
ductions allowed  under  section  214,  excluding: 

((7)  the  amount  by  which  the  deductible  losses  not  sustained 
in  such  trade  or  business  exceed  the  taxable  gain  or  profits  not 
derived  from  such  trade  or  business ; 

(b)  so  much  of  the  depiction  deduction  with  respect  to  any 
mine,  oil,  or  gas  well  as  represents  the  excess  of  value  based 
upon  discovery  subsequent  to  February  28,  1913,  over  cost  or 
value  as  of  March  i,  1913;  and 

(c)  the  amount  of  deductions  allowed  under  section  214  not 
connected  with  the  trade  or  business, 

exceeds  the  sum  of  the  following: 

(a)  the  gross  income  of  the  taxpayer  for  the  taxable  year 
as  computed  under  section  213;  and 

(b)  the  amount  by  which  the  interest  received  free  from 
taxation  under  the  provisions  of  the  Act  exceeds  so  much  of  the 
interest  paid  or  accrued  within  the  taxable  year  on  indebtedness 
as  is  not  allowed  as  a  deduction  under  section  214  (a)    (2). 

(2)  In  the  case  of  a  corporation,  it  is  the  amount  by  which  the 
deductions  allowed  under  section  234,  excluding: 

(a)  the  amount  received  as  dividends  and  allowed  as  a  de- 
duction under  section  234  (a)    (6)  ;  and 

(b)  so  much  of  the  depletion  deduction  with  respect  to  any 
mine,  oil  or  gas  well  as  represents  the  excess  of  value  based  upon 
discovery  subsequent  to  February  28,  1913,  over  cost  or  value 
as  of  March  i,  1913, 

exceeds  the  sum  of  the  following : 

(a)  the  gross  income  of  the  taxpayer  for  the  taxable  year 
as  computed  under  section  233 ;  and 

(b)  the  amount  by  which  the  interest  received  free  from 
taxation  under  the  provisions  of  the  Act  exceeds  so  much  of  the 
interest  paid  or  accrued  within  the  taxable  year  on  indebtedness 
as  is  not  allowed  as  a  deduction  under  section  234  (a)   (2). 

In  computing  statutory  "net  loss"  the  following  restrictions  are 
to  be  noted : 

(i)  Interest  received  by  the  taxpayer  on  obligations  or  securities, 
the  interest  from  which  is  exempted  from  taxation  must  be  included 
in  income,  but  this  amount  may  first  be  reduced  by  the  amount  of 
any  interest  paid  by  the  taxpayer  on  money  used  to  purchase  or 
carry  such  obligations  or  securities. 

(2)  Where  depletion  is  computed  upon  the  basis  of  discovery 
value  in  lieu  of  cost  or  value  as  of  March  i,  1913,  in  making  the 
computation,  the  deductions  are  reduced  by  that  portion  of  the  de- 


FOR    LOSSES  1025 

pletion   representing  the   excess  of   the   discovery    value   over   actual 
cost  or  value  as  of  March  i,  1913 (Art.  1601.) 

Computation  of  "net  loss." — 

The  following  official  illustration  is  so  clear  that  it  needs 
no  extended  comment.  The  net  losses  to  be  carried  forward 
are  taxpayer's  business  losses.  Therefore  the  statutory  net 
loss  as  shown  in  the  illustration  agrees  with  the  net  loss  shown 
by  the  taxpayer's  books. 

Taxpayers  may  have  an  apparent  loss  in  1921  which  they 
hope  will  serve  as  an  offset  against  net  income  in  1922  or  1923. 
But  careful  consideration  must  be  given  to  what  constitutes 
statutory  net  loss  before  they  can  be  certain  that  the  loss  or 
any  part  thereof  is  a  loss  applicable  against  the  income  of 
succeeding  years  under  the  provisions  of  the  law. 

Regulation.  The  method  of  computation  of  net  losses  as  out- 
lined in  article  1601  may  be  illustrated  as  follov^s:  A,  an  individual 
conducting-  a  trade  or  business,  finds  the  following  facts  relative  to 
a  taxable  year; 

(a)  His  deductions  as  computed  under  section  214  amount  to 
$100,000. 

(b)  Includetl  in  the  deduction  is  an  item  of  $10,000  for  loss  by 
fire  of  property  occupied  by  him  as  a  residence  and  not  used  in  con- 
nection with  his  trade  or  business. 

(c)  Deductible  losses  on  account  of  transactions  entered  into  for 
profit  outside  of  the  trade  or  business  are  $3,000. 

(d)  Taxable  gains  from  transactions  entered  into  for  profit  and 
not  connected  with  the  trade  or  business  are  $5,000. 

(e)  Donations  to  the  Red  Cross  are  included  in  the  deductions 
in  the  amount  of  $1,000. 

(/)  Depletion  is  claimed  in  the  amount  of  $2,000,  of  which  $500 
is  based  upon  the  value  of  the  mineral  in  the  mine  as  of  March  i, 
1913,  and  $1,500  is  attributable  to  increase  in  valuation  on  account  of 
discovery  subsequent  to  February  28,  1913. 

(g)  His  entire  gross  income  as  computed  under  section  213  is 
$50,000. 

(h)  Interest  received  from  municipal  bonds  exempted  from  tax- 
ation by  section  213  (b)    (4)   amounted  to  $10,000. 

(i)  Interest  was  paid  upon  money  borrowed  to  carry  municipal 
bonds  in  the  amount  of  $S,ooo,  which  amount  is  not  deductible  in 
accordance  with  section  214  (a)    (2)  : 


1026  DEDUCTIONS 

Total  deductions  {a)    $100,000 

Deduct : 

Loss  by   fire  (b)    $10,000 

Other  losses  (c)    3,ooo 


Total  loss  outside  business 13,000 

Less :  Gain  outside  business   ((/) 5,000 


Excess  of  deductible  losses  not  sus- 
tained in  trade  or  business  over 
taxable  gains  or  profits  not  derived 

from  such  trade  or  business 8,000 

Donations   (e)    i ,000 

Depletion  on  basis  of  value  after 

discovery     (/)    $2,000 

Less:  Portion  based  on  value  as 

of  March  i,  1913 500 


Portion  of  depletion  repre- 
senting discovery  value  in 
excess  of  cost  or  value  as 
of  Alarch  i,  1913 1.500 


Total  exclusion   from  deductions 10,500 

Total    expenses   directly   attributable   to    the 

conduct  of  the  trade  or  business $89,500 

Gross  income   (g)    $  50,000 

Add:   Non-taxable  interest  received    (h)..   $10,000 
Less :  Interest  paid  on  money  borrowed  to 

carry  municipal  bonds    (/)    8,000        2,000     52,000 


Statutory  net  loss   $37,500 

(Art.  1605.) 

"Net  loss"  of  taxpayer  having  fiscal  year. — 

Law.     Section  204 (d)   If  it  appears,  upon  the  production 

of  evidence  satisfactory  to  the  Commissioner,  that  a  taxpayer  having  a 
fiscal  year  beginning  in  1920  and  ending  in  1921  has  sustained  a  net 
loss  during  such  fiscal  year,  such  taxpayer  shall  be  entitled  to  the 
benefits  of  this  section  in  respect  to  the  same  proportion  of  such  net 
loss  which  the  portion  of  such  fiscal  year  falling  within  the  calendar 
year  1921  is  of  the  entire  fiscal  year. 

Regulation.  The  provisions  of  section  204  relative  to  net  losses 
are  not  retroactive  and  apply  only  to  taxable  years  beginning  after 
December  31,  1920,  with  the  following  exception:  Where  a  taxpayer 
has  a  fiscal  year  beginning  in  1920  and  ending  in  1921,  if  the  tax- 
payer produces  evidence  showing  to  the  satisfaction  of  the  Com- 
missioner that  a  "net  loss"  has  been  sustained  during  such  fiscal 
year,  the  benefits  of  section  204  shall  apply  to  the  same  proportion 
of  such  net  loss  as  the  portion  of  stich  fiscal  year  falling  within 
the  calendar  year  192 1  is  of  the  entire  fiscal  year.  The  net  loss 
shall   be   first   computed   ;is   prescribed  in   articles    1601    and    1605    for 


FUR    LOSSES  1027 

the  entire  fiscal  year  ending"  in  1921  in  accordance  with  this  Act 
as  in  effect  on  Jannary  1,  1921.  The  net  loss  allowable  shall  be  the 
same  proportion  of  the  net  loss  for  the  entire  fiscal  year  as  the  por- 
tion of  the  fiscal  year  falling  within  the  calendar  year  1921  is  of 
the  entire  fiscal  year.     (Art.  1604.) 

The  foregoing  provision  merely  extends  a  proportionate  de- 
duction to  taxpayers  whose  fiscal  years  include  only  part  of  the 
year  1921. 

Can  net  loss  of  period  of  less  than  twelve  months  be  car- 
ried forward? — Section  204  (a),  which  provides  for  the  carry- 
ing forward  of  net  losses,  mentions  tlie  period  during^  which 
the  loss  occurs  as  "any  taxable  year  beginning  after  December 
31,  1920."  Section  204  (d)  provides  that  fiscal  year  concerns 
may  carry  forward  that  part  of  net  losses  which  accrue  after 
December  31,  1920. 

Section  226  provides  for  returns  for  periods  less  than 
twelve  months.  Section  226  (a)  deals  with  changes  in  fiscal 
periods  and  permits  returns  for  less  than  twelve  months.  Sec- 
tion 226  (b)  and  (c)  deal  with  the  rates  of  tax  and  method  of 
computation  when  returns  are  made  for  part  of  a  taxable 
year.  There  is  no  specific  provision  in  the  192 1  law''^  which 
deals  with  carrying  forward  net  losses  when  changes  in  fiscal 
years  occurred  during  192 1  or  which  may  occur  thereafter. 
It  is,  however,  clear  that  the  intention  of  Congress  is  to  extend 
the  deduction  in  every  case.  There  is  no  inhibition  against 
the  deduction  when  fiscal  year  changes  result  in  returns  for 
less  than  twelve  months.     Section  200   (T )  provides  that  the 


°'"'  [Former  Procedure]  Tlie  iyi8  law  (section  204)  provided  lliat 
losses  in  "any  taxable  year  beginning  after  October  31,  1918,  and  ending 
prior  to  January  i,  1920,"  might  under  certain  conditions  be  applied  to 
prior  or  subsequent  periods.  As  the  intention  of  Congress  was  clear  to 
limit  deductions  to  the  period  and  dates  mentioned,  the  provision  has  been 
strictly  construed.  The  ruling  of  the  Attorney  General  regarding  this 
matter  will  be  found  in  C.  B.  3,  page  83;  T.  D.  3044;  see  also  Bulletin  30-21- 
1745;  A.  R.  R.  554. 

The  Treasury  has  held  that  in  order  to  be  entitled  to  the  benefits  of 
section  204  of  the  IQ18  law  "The  loss  must  be  for  a  full  taxable  year  (12 
months)."      (1-6-66;  A.  R.  R.  743.) 

For  other  rulings  and  comment  see  Income  Tax  Procedure,  1921,  pages 
784-787. 


iojS  deductions 

term  "  'taxable  year'  means  the  calendar  year,  or  the  fiscal 
year  ending  during  such  calendar  year."  Concerns  starting 
business  must  select  the  calendar  year  or  fiscal  year  basis. 

This  usually  requires  a  first  return  covering  less  than 
twelve  months.  It  would  have  been  more  satisfactory  if  sec- 
tion 200  (i)  had  specifically  provided  that  in  the  case  of  new 
concerns  and  those  changing  fiscal  periods  the  term  "taxable 
year''  should  include  the  first  return  after  starting  business  or 
after  changing  fiscal  periods,  but  in  view  of  the  intention  of 
Congress  to  extend  the  deduction  to  all  taxpayers,  there  should 
be  no  discrimination  against  those  whose  first  fiscal  periods 
fortuitously  are  less  than  twelve  months. 

The  provisions,  or  the  intent,  to  tax  for  part  of  a  fiscal 
period,  even  though  it  is  not  a  taxable  year,  are  broad  enough 
to  carry  the  implication  that,  if  fully  taxable  for  part  of  a 
period,  taxpayers  are  fully  entitled  to  the  proportionate  part 
of  any  benefits  which  apply  to  a  "taxable  year." 

Section  204  (d)  may  be  deemed  to  control  the  action  of 
the  Commissioner  in  extending  the  right  to  carry  forward  net 
losses  even  though  the  net  loss  period  is  less  than  twelve 
months.  The  case  is  not  analogous  to  the  procedure  under 
the  19 18  law,  wherein  the  precise  dates  within  which  the  loss 
was  realized  were  prescribed.  The  reason  for  this  was  that 
the  Armistice  was  signed  on  November  11,  1918,  and  net 
losses  w^ere  applied  to  the  period  w^hich  it  was  assumed  was 
specifically  affected.  The  provision  in  the  192 1  law  is  intended 
to  apply  to  all  net  losses  sustained  after  January  i,  1921. 

Partnerships,  beneficiaries  and  insurance  companies  al- 
lowed benefit  of  net  loss  provision. — 

Law.  Section  204.  .  .  .  .  (c)  The  benefit  of  this  section  shall 
be  allowed  to  the  members  of  a  partnership  and  the  beneficiaries  of  an 
estate  or  trust,  and  to  insurance  companies  subject  to  the  tax  imposed 
by  section  243  or  246,  under  regulations  prescribed  by  the  Commissioner 
with  the  approval  of  the  Secretary 

In  the  case  of  a  partnership  the  deduction  would  be  avail- 
able to  the  individual  partners  in  the  same  proportion  as  the 


FOR  LOSSES 


1029 


partnership  income  is  allocated  to  them.*^^  A  member,  how- 
ever, cannot  segregate  the  net  loss  from  other  income  and 
carry  it  forward  independently.  To  receive  the  benefits  of 
the  provision  a  member  of  a  partnership  must  sustain  a  loss 
after  including  his  entire  income  from  all  business  sources.** 

Claim  for  net  loss  to  be  filed  with  succeeding  year's  re- 
turn.— 

Regulation.  A  taxpayer-  sustaining  a  "net  loss"  such  as  set 
forth  in  section  204,  for  any  taxable  year  ending  after  December  31, 
1920,  may  file  a  claim  therefor  with  his  return  for  the  subsequent 
taxable  year.  Such  claim  should  contain  a  concise  statement  setting 
forth  the  amount  of  the  net  loss  and  all  pertinent  facts  relative  thereto, 
including  a  schedule  showing  computation  of  the  net  loss  in  accord- 
ance with  section  204  and  articles  1601  and  1605  of  these  regulations. 
If  the  evidence  furnished  satisfies  the  Commissioner  that  the  taxpayer 
has  sustained  a  "net  loss"  the  amount  of  such  net  loss  may  be  de- 
ducted from  the  net  income  of  the  taxpayer  for  the  succeeding  tax- 
able year  and  if  such  net  loss  is  in  excess  of  the  net  income  for 
such  succeeding  taxable  year  the  amount  of  such  excess  shall  be  car- 
ried over  and  credited  against  the  net  income  for  the  succeeding  tax- 
able year.     (Art.  1602.) 


*^  But  see  page  803. 
"  C.  B.  2,  page  58 ;  O.  D.  430.    • 

[Former  Procedure]     The  discussion  of  the  limitation  on  losses  under 
former  laws  is  necessarily  exhaustive  and  must  be  omitted  from  this  vol- 
ume.    See  Income  Tax  Procedure,  1920,  pages  660-664.     Also  see  previous 
editions.     For  Treasury  rulings  in   1920  and   1921,  see: 
C.  B.  3,  page  156;  A.  R.  R.  242. 
C.  B.  3,  page  317;  A.  R.  M.  96. 
Bulletin  44-21-1891 ;  O.  D.  1080. 
Bulletin  43-21-1880;  O.  D.  1071. 
C.  B.  4.  page  47;  O.  D.  932. 
Bulletin  13-21-1528;  A.  R.  R.  435. 


CHAPTER    XXX 

DEDUCTIONS  FOR  BAD  DEBTS 

Two  important  changes  are  lonnd  in  the  192 1  law  regard- 
ing bad  debts.     Taxpayers  for  the  first  time^  may  now  deduct : 

1.  A  reasonable  addition  to  a  reserve  for  bad  debts. 

2.  Part  of  a  debt  which  is  not  fully  recoverable. 

Taxpayers  may  continue  on  the  old  l)asis,  i.e.,  they  may  de- 
duct only  those  bad  deljts  ascertained  to  be  worthless  and 
charged  off  during  the  year.  This  chapter  will  deal  with 
the  procedure  to  be  followed  when  reserves  are  maintained, 
with  the  types  of  bad  debts  which  may  be  fully  deducted,  and 
with  the  determination  of  the  deductibility. 

Law.  Section  214.  [Individuals]  (a)  That  in  computing  net  in- 
come there  shall  be  allowed  as  deductions: 

(7)  Debts  ascertained  to  be  worthless  and  charged  off  within  the 
taxable  year  (or  in  the  discretion  of  the  Commissioner,  a  reasonable 
addition  to  a  reserve  for  bad  debts) ;  and  when  satisfied  that  a  debt 
is  recoverable  only  in  part,  the  Commissioner  may  allow  such  debt 
to  be  charged  off  in  part 

The  deduction  for  corporations  [section  234  (a-5)]  is 
exactly  the  same. 

Regulation.  Bad  debts  may  be  treated  in  either  of  two  ways — 
( I  j  by  a  deduction  from  income  in  respect  of  debts  ascertained 
to  be  worthless  in  whole  ov  in  part,  or  (2)  by  a  deduction  from  in- 
come of  an  addition  to  a  reserve  for  bad  debts.  For  the  year  1921 
taxpayers  may,  regardless  of  their  previous  practice,  elect  either  of 
these  two  methods  and  will  be  required  to  continue  the  use  in  later 
years  of  the  method  so  elected  unless  permission  to  change  to  the 
other  method  is  granted  by  the  Commissioner (Art.  151.) 


'[Former  Procedure]  The  1913,  1916  and  1917  laws  read:  "debts 
due  to  the  taxpayer  actually  ascertained  to  be  worthless  and  charged  off 
within  the  year."     The  change  in  the  1918  law  was  merely  verbal. 

The  author  has  always  contended  that  a  reasonable  addition  to  a  reserve 
for  bad  debts  was  legal  under  1918  and  prior  laws  and  should  have  been 
allowed.  For  full  discussion,  see  Income  Tax  Procedure,  1921,  pages  833- 
836. 

1030 


FOR    BAD   DEBTS  1031 

Bad  debt  deductions  for  the  taxable  year  1921. — The  fol- 
lowing regulation  aims  first  to  place  both  classes  of  taxpayers, 
i.e.,  those  who  in  prior  years  maintained  reserves  and  those 
who  did  not,  on  the  same  basis. 

Regulation.  Taxpayers  who  have,  prior  to  1921,  maintained 
reserve  accounts  for  bad  debts  may  deduct  a  reasonable  addition  to 
such  reserves  in  lieu  of  a  deduction  for  specific  bad-debt  items. 
Taxpayers  who  have  not  heretofore  maintained  such  reserve  accounts 
may  now  elect  to  do  so,  and  in  such  case  shall  proceed  to  determine 
the  amount  of  the  reserve  that  should  reasonably  have  been  set  up 
as  at  December  31,  1920  (which  shall  not  be  deducted  in  computing 
net  income),  and  in  respect  of  1921  and  subsequent  years  may  add  a 
reasonable  addition  to  such  reserve  and  deduct  the  amount  in  com- 
puting taxable  net  income (Art.   I55-) 

Taxpayers  who  did  set  up  reserves  in  ])ri()r  years  presum- 
ably will  have  at  the  beginning  of  the  faxal)lc  year  T921  a  re- 
serve for  bad  debts,  the  credits  to  which,  when  made,  were 
not  deducted  in  prior  income  tax  returns.  Therefore,  when 
taxpayers  who  have  not  heretofore  maintained  reserves  set  up 
the  proper  reserve  for  bad  debts  at  January  i,  1921,  or  the 
beginning  of  their  fiscal  years,  they  are  not  permitted  to  de- 
duct the  charge  therefor  from  income.  The  proper  charge  is 
to  surplus  account.  The  adjustments  which  afTect  the  income 
account  should  be  made  at  the  end  of  the  taxable  period. 

Regulation Where    a    reserve    account    is    maintained, 

debts  ascertained  after  December  31,  1920,  to  be  worthless  in  whole 
or  in  part,  (a)  if  such  debts  were  outstanding  at  December  31,  1920, 
should  be  charged  against  the  reserve  and  may  be  deducted  from  in- 
come, in  accordance  with  article  151;  (b)  if  such  debts  arose  after 
December  31,  1920,  should  be  charged  against  the  reserve,  and  not 
deducted  from  income.  What  constitutes  a  reasonable  addition  to  a 
reserve  for  bad  debts  must  be  determined  in  the  light  of  the  facts, 
and  will  vary  as  between  classes  of  business  and  with  conditions  of 
business  prosperity.  A  taxpayer  using  the  reserve  method  should 
make  a  statement  in  his  return  showing  the  volume  of  his  charge 
sales  (or  other  business  transactions)  for  the  year  and  the  percentage 
of  the  reserve  to  such  amount,  the  total  amount  of  notes  and  accounts 
receivable  at  the  beginning  and  close  of  the  taxable  year,  and  the 
amount  of  the  debts  which  have  been  ascertained  to  be  wholly  or  par- 
tially worthless  and  charged  against  the  reserve  account  during  the 
taxable  year.     (Art.  155.) 


,032  DEDUCTIONS 

Tlie  foregoing  regulation  permits  in  effect  a  double  deduc- 
tion for  bad  debts  in  the  year  1921,  viz. : 

1.  Accounts  outstanding  at  December  31,    1920,   which 

proved  to  be  worthless  in  1921. 

2.  Accounts  arising  from   192 1   business  which  upon  a 

reasonable  estimate  may  be  deemed  to  be  bad. 

In  the  years  after  192 1,  only  the  addition  (for  the  current 
year)  to  the  reserve  for  bad  debts  is  deductible.  This  might 
leave  in  the  reserves  amounts  representing  debts  arising  prior 
to  January  i,  1921,  which  would  never  appear  as  allowable 
deductions.  Taxpayers  may  reasonably  assume,  however,  that 
uncollected  debts  which  arose  prior  to  1921,  and  which  could 
not  be  collected  in  1921,  are  all  bad  at  December  31,  1921. 

Reserves  for  Bad  Debts 

It  may  be  assumed  that  taxpayers  in  active  business  carry 
reserves  for  bad  debts  and  that  those  who  are  not  in  active 
business  do  not. 

Those  who  are  not  required  under  good  accounting  prac- 
tice to  keep  books  on  an  accrual  basis  are  not  affected  by  the 
1 92 1  law.  When  a  debt  is  bad,  it  may  be  charged  off.  Tax- 
payers who  do  not  keep  books  on  an  accrual  basis  should  not 
ordinarily  attempt  to  charge  off  only  part  of  a  debt. 

When  accounts  are  kept  on  an  accrual  basis,  a  reserve  for 
bad  debts  is  set  up  annually  or  oftener.  For  the  taxable  year 
192 1  the  addition  to  the  reserve  may  be  claimed  as  a  deduction. 

The  year  192 1  is  one  of  transition  from  the  former  prac- 
tice of  deducting  from  income  only  those  debts  ascertained  to 
be  worthless  and  charged  off,  to  the  new  procedure  of  deduc- 
ting from  income  the  addition  to  a  reserve  for  bad  debts. 
Therefore,  under  the  new  procedure  we  must  consider  the 
deductibility  of : 

I.  Debts  ascertained  to  be  bad  in  192 1  applying  to  sales 
of  previous  years. 


FOR   BAD    DEBTS 


1033 


2.  Additions  to  a  reserve  for  bad  debts  to  include  192 1 
transactions. 

Under  the  new  regulations,^  taxpayers  may  now  deduct  for 
the  year  1921  the  items  in  (i)  as  well  as  those  in  (2).  Be- 
ginning in  1922,  the  deduction  in  the  income  account  for  the 
year  as  stated  in  the  books  of  account  and  in  the  tax  returns 
will  agree  for  the  first  time  since  191 3. 

Accounting  procedure. — When  taxpayers  have  not  main- 
tained reserves  for  bad  debts  and  desire  now  to  conform  to 
good  accounting  practice  and  the  regulations,  the  following 
procedure  is  suggested : 

1.  Set  up  a  reserve  for  bad  debts  before  closing  the  books 
as  of  December  31,  1921,  which  is  to  be  credited  with: 

(a)  The  amount  of  the  reserve  which  should  have  been 

set  up  December  31,  1920. 

(b)  An  allowance  for  uncollectible  accounts  arising  from 

the  business  of  192 1,  based  on  the  same  percentage 
of  the  1 92 1  charge  sales  which  the  uncollectible 
accounts  were  of  the  charge  sales  for  the  previous 
three  or  five  years. ^ 

2.  Charge  against  the  reserve  suggested  above  all  the 
accounts  determined  to  be  uncollectible  and  charged  off  during 
1921 : 

(a)  The  aggregate  of  accounts  accrued  prior  to  January 

I,  1921. 

(b)  The  aggregate  of  accounts  accrued  during  1921. 

3.  The  allowable  deduction  for  bad  debts  in  1921  returns 


''T.  D.  3262  (issued  December  21,  1921)  did  not  permit  the  deduction 
of  both  items  in  (a)  and  (b).  It  is  assumed  that  as  Art.  155  of  Reg.  62 
(see  page  1031)  appeared  after  T.  D.  3262  and  before  any  returns  for  1921 
were  made,  T.  D.  3262  should  be  wholly  ignored. 

"  This  allowance  must  be  adequate  to  provide  for  (a)  the  losses  which 
experience  indicates  will  probably  be  sustained  on  accounts  arising  from 
1921  sales  which  are  uncollected  at  December  31,  1921,  and  (b)  any  ac- 
counts for  1921  sales  which  were  determined  to  be  uncollectible  and  written 
off  on  or  before  December  31,  1921. 


I034  DEDUCTIONS 

is  2  (a)  plus  I  (b).  For  subsequent  years  the  deduction 
is  1  (b)  for  the  current  year.  When  taxpayers  have  main- 
tained reserves  in  prior  years,  the  deduction  for  income  tax 
purposes  is  exactly  the  same  as  outlined  above. 

iVt  the  end  of  each  year  after  192 1  there  would  be  credited 
to  the  reserve  simply  a  percentage  on  the  charge  sales  of  the 
year;  all  accounts  finally  decided  within  the  year  to  be  un- 
collectible would  be  written  off  against  the  reserve  plus  specific 
extraordinary  items,  in  whole  or  in  part,  which  are  not  in- 
cluded in  the  normal  percentage.  After  192 1  it  would  not  be 
necessary  to  distinguish  as  to  the  year's  sales  from  which 
the  written-off  accounts  arose. 

The  192 1  law  provides  that  debts  that  are  bad  "in  part" 
may  be  deducted,  and  the  new  regulations  state  that:  "Partial 
deductions  will  be  allowed  with  respect  to  specific  debts  only." 

At  the  end  of  each  year  the  balance  in  the  reserve  account 
naturally  will  have  to  be  reviewed  for  the  purpose  of  deter- 
mining whether  the  percentage  used  in  computing  the  credit 
to  the  reserve  for  the  year  is  adequate  or  whether  it  may  be 
either  too  high  or  too  low,  in  view  of  more  recent  experience. 
The  percentage  will,  of  course,  need  to  be  modified  to  whatever 
extent  additional  experience  indicates  to  be  necessary. 

From  the  foregoing  it  is  apparent  that  taxpayers  who  have 
not  heretofore  maintained  reserves  for  bad  debts  should  imme- 
diately adopt  the  reserve  basis.  In  effect,  they  will  secure  a 
double  deduction  for  192 1.  Taxpayers  already  maintaining 
reserves  will  secure  a  like  benefit. 

Effect  on  invested  capital  of  establishing  reserve  for  bad 
debts  at  beginning  of  1921. — Taxpayers  who  previously  have 
not  maintained  reserves,  if  electing  the  reserve  method,  must 
set  up  "the  reserve  that  should  reasonably  have  been  set  up 
as  at  December  31,  1920  (which  shall  not  be  deducted  in  com- 
puting net  income)."  The  charge  will  be  to  surplus.  The  re- 
serve may  be  included  as  invested  capital  from  the  beginning 
of  the  year,  even  though  the  amount  of  such  reserve  will  be  de- 


FOR   BAD    DEBTS  IO35 

ducted  in  effect  from  1921  income  through  charging  to  such 
reserve  during  1921  those  accounts  outstanding  at  the  begin- 
ning of  the  year  which  prove  in  192 1  to  be  bad.  Such  bad 
debts,  under  article  155/  may  be  deducted  from  1921  income. 
The  reserve  at  tlie  beginning  of  the  year  is  regarded  as  segre- 
gated surphis.  The  charges  against  such  reserve  affect  the  192 1 
income  and  therefore  do  not  serve  to  reduce  invested  capital 
for   192 1. 

Again,  the  reserve  set  u[)  at  the  beginning  of  1921  will  imt 
be  deducted  from  accounts  receivable  in  computing  admissible 
assets,  which  means  that  the  percentage  of  inadmissibles  will 
be  smaller/' 

Only  Bona  Fide  Debts  Deductible 

If  an  item  claimed  as  a  bad  debt  partakes  of  the  nature  of 
a  gift  more  than  of  that  of  a  loan,  or  if,  arising  during  a  pe- 
riod when  it  could  or  should  have  been  reported,  it  has  not 
been  included  in  the  federal  tax  reports  as  gross  income,  it  is 
not  deductible  as  a  bad  debt. 

Loans  to  friends  or  relatives. — A  question  in  the  Income 
Tax  Primer  reads  as  follows : 

Ruling.  If,  on  account  of  friendship  or  relationship  I  advanced 
a  certain  sum  to  assist  a  needy  friend  or  relative,  and  at  the  time  such 
advance  was  made  I  had  little  or  no  reason  to  expect  that  the  amount 
so  advanced  would  ever  be  returned,  may  I  now  claim  a  deduction 
to  cover  such  advance? 

No.  Such  an  advance,  partaking,  as  it  does,  somewhat  of  the 
nature  of  a  philanthropic  donation  or  a  goodwill  offering,  is  not  held 
to  constitute  a  bona  fide  debt.  {Income  Tax  Frimcr,  1918,  question 
94-) 

Where  the  element  of  gift  is  absent,  the  Treasury  permits 
the  deduction. 

Ruling.     A  certain  taxpayer  was  notified  by  his  bank  that  a  note 


*  See   page    103 1. 

°  For  discussion  of  the  treatment  of  reserves  for  bad  debts  in  respect 
to  inadmissible  assets,  see  Chapter  IX  of  Appendix  A. 


1036 


DEDUCTIONS 


had  gone  to  protest  and  that  he,  as  one  of  the  indorsers,  was  Hable  for 
the  payment  thereof.  In  order  to  defend  a  relative  who  had  forged 
the  indorsement,  the  taxpayer  gave  the  bank  another  note  of  the  same 
face  value.  The  taxpayer  made  arrangements  with  his  relative 
whereby  the  relative  was  to  pay  the  amount  of  the  note  on  the  in- 
stallment plan.  The  relative,  however,  made  no  payments  in  the 
year  19 19  and  payment  could  not  be  enforced  since  he  had  no  assets. 
During  that  year  the  taxpayer  paid  the  note  in  full  to  the  bank  and 
deducted  as  a  bad  debt  for  the  year  1919  the  difference  between  the 
amount  paid  the  bank  and  the  amount  by  which  lie  had  been  reim- 
bursed by  his  relative. 

Held,  that  the  amount  deducted  is  allowable  since  it  represented 
a  debt  due  from  the  relative  and  not  a  gift  to  him.  (C.  B.  4,  page 
173;  O.  D.  934.) 

Income  corresponding  to  bad  debt  must  have  been  re- 
ported in  tax  returns. — 

Regulation.  Worthless  debts  arising  from  unpaid  wages,  sal- 
aries, rents,  and  similar  items  of  taxable  income  will  not  be  allowed 
as  a  deduction  unless  the  income  such  items  represent  has  been 
included  in  the  return  of  income  for  the  year  in  which  the  deduction 

as  a  bad  debt  is  sought  to  be  made  or  in  a  previous  year 

(Art.   152.) 

This  regulation  applies  particularly  to  taxpayers  who  have 
rendered  returns  based  on  cash  receipts  and  payments.  It  is 
well  illustrated  by  the  following  quotation  from  the  Income 
Tax  Primer: 

Ruling.  A  professional  man  earned  a  fee  in  1916.  As  he  keeps 
no  books,  he  reports  his  income  for  tax  purposes  on  an  actual  receipt 
basis.  As  this  fee  has  never  been  reported  as  income,  can  it  be 
claimed  as  a  deduction  if  collection  can  not  be  made? 

No ;  never  having  been  returned  as  income  it  can  not  be  claimed 
as  a  deduction.     {Income  Tax  Primer,  1918,  question  96.) 

It  must  be  understood,  however,  tiiat  the  rulings  quoted 
do  not  debar  one  from  claiming  the  deduction  of  an  item  as 
a  bad  debt,  even  though  the  corresponding  income  has  not 
been  reported,  in  case  the  account  arose  before  the  federal  in- 
come tax  laws  were  in  force.  The  effective  date  for  corpora- 
tions, under  the  excise  tax  law,  is  January  i,  1909,  and  for 
individuals,  under  the  general  income  tax  law,  it  is  March 


FOR   BAD   DEBTS 


1037 


I,  19 1 3.  Debts  existing  and  carried  as  good  on  these  dates 
may  be  treated  as  allowable  deductions  if  subsequently  found 
to  be  uncollectible.  The  entire  amount  may  be  deducted  in 
the  return  of  the  year  during  which  the  debt  was  found  to  be 
bad. 

Special  Types  of  Bad  Debts — How  Valued 

Bankruptcy  claim — extent  to  which  deductible. — 

Regulation.  ....  Only  the  difference  between  the  amount  re- 
ceived in  distribution  of  the  assets  of  a  bankrupt  and  the  amount  of 
the  claim  may  be  deducted  as  a  bad  debt. 

Claims  against  decedent's  estate — extent  to  which  deduc- 
tible.— 

The  difference  between  the  amount  received  by  a  creditor  of  a 
decedent  in  distribution  of  the  assets  of  the  decedent's  estate  and  the 

amount   of    his    claim    may    be    considered    a    worthless    debt 

(Art.  152.) 

Debt  ascertained  to  be  bad  after  decedent's  death. — 

Ruling.  The  amount  paid  by  the  administrator  as  the  decedent's 
share  of  a  note  upon  which  he  was  a  coindorser,  which  amount  was 
not  determined  at  the  time  of  the  decedent's  death,  is  not  deductible 
in  the  return  for  the  decedent,  but  is  deductible  by  the  administrator, 
if  the  debt  is  uncollectible,  in  his  return  for  the  estate  for  the  taxable 
year  in  which  it  was  paid  and  charged  off  on  his  books. 

The  difference  between  the  amount  paid  by  the  administrator  in 
taking  up  paper  indorsed  by  the  decedent  and  the  appraised  value  of 
the  claim  subrogated  to  the  administrator  is  not  deductible  by  the 
administrator  until  the  claim  has  been  disposed  of  and  the  transac- 
tion is  closed  and  cunipleted.     ( C.   B.  2,  page  137;  ().  D.  556.) 

Accounts  receivable  purchased — basis  for  deduction, — 

Regulation A    purchaser   of   accounts   receivable    which 

can  not  be  collected  and  are  consequently  charged  oft'  the  books  as 
bad  debts  is  entitled  to  deduct  them,  the  amount  of  deduction  to  be 
based  upon  the  price  he  paid  for  them  and  not  upon  their  face  value. 
(Art.  152.) 

Notes  receivable — basis  for  deduction. — 

Regulation If  a  taxpayer  computes  his  income  upon  the 

basis  of  valuing  his  notes  or  accounts  receivable  at  their  fair  mar- 


1038  DEDUCTIONS 

ket  value  when  received,  which  may  be  less  than  their  face  value,  the 
amount  deductible  for  bad  debts  in  any  case  is  limited  to  such  original 
valuation (Art.   151.) 

The  entry  of  notes  at  less  than  their  face  value  is  equiva- 
lent to  the  creation  of  a  reserve  for  bad  debts.  The  Treasury- 
denied  the  privilege  to  taxpayers  evidently  when  it  was  not  their 
"practice"  to  take  up  the  notes  at  market  value. 

Ruling.  When  a  merchant  has  notes  receivable  for  goods  sold 
and  grants  the  purchaser  an  extension  of  time  within  which  to  pay 
the  notes,  the  Bureau  is  without  authority  to  permit  him  to  treat  the 
fair  market  value  of  the  notes  as  the  price  for  which  the  goods 
were  sold  or  to  deduct  from  gross  income  as  a  loss  the  difference 
between  the  face  value  of  the  notes  and  their  fair  market  value  at 
the  time  they  originally  became  due.  (B.  Digest  30-21-1742;  O.  D. 
979-) 

The  192 1  law  takes  care  of  the  foregoing  situation,  as 
the  notes  evidently  were  bad  in  part.*^ 

Regulation.  Where  bonds  purchased  before  March  i,  1913,  de- 
preciated in  value  between  the  date  of  purchase  and  that  date,  and 
were  in  a  later  year  ascertained  to  be  worthless  and  charged  ofif,  the 
owner  is  entitled  to  a  deduction  in  that  year  equal  to  the  value  of  the 
bonds  on  March  i,  1913.  Bonds  purchased  since  February  28,  1913, 
when  ascertained  to  be  worthless,  may  be  treated  as  bad  debts  to  the 
amount  actually  p-aid  for  them."  Bonds  of  an  insolvent  corporation 
secured  only  by  a  mortgage  from  which  on  foreclosure  nothing  is 
realized  for  the  bondholders  are  regarded  as  ascertained  to  be  worth- 
less not  later  than  the  year  of  the  foreclosure  sale,  and  no  deduction 
for  a  bad  debt  is  allowable  in  computing  a  bondholder's  income  for 
a  subsequent  year (Art.  154.  ) 

A  new  provision  is  found  in  article  154  of  Regulations  62, 
permitting  taxpayers  to  deduct  part  of  the  cost  of  bonds  when 
it  can  be  shown  that  the  holder  will  recover  a  smaller  amount. 
This  is  in  accordance  with  the  statute,  which  permits  "part" 
of  a  debt  to  be  deducted.  Bonds  of  traction  companies  whose 
hope  of  revival  is  small  are  examples. 


"  See  page  1030. 

'Reg.  45,  Art.  154  (1919  edition),  read:  "but  not  exceeding  their 
amortized  value  if  purchased  at  a  premium."  Since  the  Treasury  did  not 
permit  the  premium  on  bonds  purchased  to  be  amortized,  the  limitation  was 
unnecessary.     (B.  17-20-887;  O.  D.  475.) 


FOR   BAD    DEBTS 


1039 


Regulation A  taxpayer  (otlicr  than  a  dealer  in  securi- 
ties) possessing  debts  evidenced  by  bonds  or  other  similar  obligations 
can  not  deduct  from  gross  income  any  amount  merely  on  account 
of  market  fluctuation.  Where  a  taxpayer  ascertains,  however,  that 
due,  for  instance,  to  the  financial  condition  of  the  debtor,  or  conditions 
other  than  market  fluctuation,  he  will  recover  upon  maturity  none 
or  only  a  part  of  the  debt  evidenced  by  the  bonds  or  other  similar 
obligations  and  is  able  to  so  demonstrate  to  the  satisfaction  of  the 
commissioner,  he  may  deduct  in  computing  net  income  the  uncollecti- 
ble part  of  the  debt  evidenced  by  the  bonds  or  other  similar  obliga- 
tions.    (Art.  154.) 

Debts  held  prior  to  March  i,  1913 — basis  for  deduction. — 

Regulation To  authorize  a  deduction  for  a  bad  debt  on 

account  of  notes  held  prior  to  March  i,  1913,  their  value  on  that  date 
must  be  established.''     (Art.  154.) 

Obviously  if  a  taxpayer  in  1921  charged  off  a  debt  which 
had  been  carried  as  good  since  March  i,  191 3,  it  would  l^e 
reasonable  to  inquire  whether  or  not  on  that  date  the  debt 
was  deemed  to  be  good.  But  the  mere  fact  that  on  that  date 
there  was  some  doubt  as  to  its  value  would  not  mean  that 
the  deduction  was  an  improper  one  in  1921.  Until  the  passage 
of  the  192 1  law,  the  Treasury  always  held  that  no  debt  could 
be  charged  off  until  it  was  100  per  cent  bad.  Subsequent 
transactions  with  a  debtor  would  indicate  prima  facie  that  the 
debt  was  collectible  at  March  i,  1913. 

Debts  Must  Be  Actually  Ascertained  to  be  Worthless 
in  Whole  or  in  Part 

The  law  specifies  that  a  debt  to  be  deductible  as  bad  must 
be  "ascertained  to  be  worthless''  [section  214  (a-7)],  and  it 
also  specifies  that  "the  Commissioner  ma}^  allow  such  debt  to  be 
charged  off  in  part." 


"  [Former  Procedure] 

Regulation.  "All  debts  representing  amounts  that  became  due 
and  payable  prior  to  March  i,  1913,  and  not  ascertained  to  be  worthless 
prior  to  that  date,  whether  representing  income  or  a  return  of  capital,  are 
held  to  be  allowable  deductions,  under  paragraph  B  of  the  law,  in  a  return 
of  income  for  the  year  in  which  they  are  actually  ascertained  to  be  worth- 
less and  are  charged  off."     (T.  D.  2224,  July  13,  1915.) 


I040 


DEDUCTIONS 


When  is  a  debt  worthless? — in  describing  the  deductions 
permitted  to  individuals  the  regulations  set  up  the  following 
general  standards. 

Debts  entirely  worthless. — 

Regulations.''  ....  Where  the  surrounding  circumstances  in- 
dicate that  a  debt  is  worthless  and  uncollectible  and  that  legal  action  to 
enforce  payment  would  in  all  probability  not  result  in  the  satisfaction 
of  execution  on  a  judgment,  a  showing  of  these  facts  will  be  sufficient 
evidence  of  the  worthlessness  of  the  debt  for  the  purpose  of  de- 
duction  (Art.  151.) 

Debts  partly  worthless.^" — 

Regulations Where  all  the  surrounding  and  attending  cir- 
cumstances indicate  that  a  debt  is  worthless,  either  wholly  or  in  part, 
the  amount  which  is  worthless  and  charged  off  or  written  down  to 
a  nominal  amount  on  the  books  of  the  taxpayer  shall  be  allowed  as  a 
deduction  in  computing  net  income.  There  should  accompany  the  return 
a  statement  showing  the  propriety  of  any  deduction  claimed  for  bad 
debts.  No  deduction  shall  be  allowed  for  the  part  of  a  debt  ascer- 
tained to  be  worthless  and  charged  off  prior  to  January  i,  1921,  un- 
less and  until  the  debt  is  ascertained  to  be  totally  worthless  and  is 
finally  charged  off  or  is  charged  down  to  a  nominal  amount,  or  the 
loss  is  determined  in  some  other  manner  by  a  closed  and  completed 
transaction.  Before  a  taxpayer  may  charge  off  and  deduct  a  debt 
in  part,  he  must  ascertain  and  be  able  to  demonstrate,  with  a  reason- 
able degree  of  certainty,  the  amount  thereof  which  is  uncollectible. 
....  In  determining  whether  a  debt  is  worthless  in  whole  or  in 
part  the  Commissioner  will  consider  all  pertinent  evidence,  including 
the  value  of  the  collateral,  if  any,  securing  the  debt  and  the  financial 
condition  of  the  debtor.  Partial  deductions  will  be  allowed  with  re- 
spect to  specific  debts  only.     .    .    .■  .    (Art.  151.) 

If  part  of  a  debt  was  ascertained  to  be  worthless  and  was 
charged  off  prior  to  192 1,  the  Treasury  under  previous  prac- 
tice would  not  allow  the  deduction.  The  entire  amount  had 
to  be  worthless  and  be  charged  off.  It  appears  that  the  Treas- 
ury wall  not  now  allow  the  partial  write-off,  previously  denied, 


'  [Former  Procedure]  The  following  sentence  in  Reg.  45.  Art.  151, 
which  does  not  appear  in  Reg.  62,  indicates  former  procedure :  "An  account 
merely  written  down  ....  is  not  deductible." 

"*  [Former  Procedure]  For  rulings  when  compositions  and  other  set- 
tlements were  made,  see  Income  Tax  Procedure,  1921,  pages  829-831. 


FOR   BAD   DEBTS 


IO41 


to  be  deducted  in  the  return  until  the  entire  amount  of  such 
debt  is  ascertained  to  be  totally  worthless. 

For  example,  if  an  account  for  $1,000  was  written  down 
to  $600  in  1920,  the  $400  deduction  was  disallowed  if  claimed 
in  the  1920  return.  It  would,  however,  form  part  of  the 
reserve  set  up  as  of  January  i,  192 1,  and  if  not  collected  by 
December  31,  192 1,  the  entire  $1,000  would  no  doubt  be 
deductible  in   1921. 

When  debtor  corporation  becomes  insolvent. — The 
statements  in  the  foregoing  regulation  are  couched  in  terms 
broad  enough  to  include  all  debts  due  the  individual  whether 
from  corporations  or  from  other  individuals. 

Ruling.  An  insolvent  corporation  was  lieavily  indebted  to  A,  its 
majority  stockholder.  A  agreed  to  take  as  payment  of  the  company's 
indebtedness  to  him,  the  free  assets  of  the  company  and  to  assume  its 
liabilities  other  than  its  bonded  indebtedness.  This  transaction  is 
considered  a  cancellation  of  the  debt  due  to  A  and  any  loss  sustained 
by  him  is  deductible  only  in  the  return  for  the  year  when  the  trans- 
action took  place,  and  not  when  the  assets  were  disposed  of  subse- 
quently. The  measure  of  the  loss  would  be  the  difference  between 
the  liabilities  assumed  including  the  debt  to  himself,  and  the  value 
of  the  assets  at  the  time  received  by  A.  (C.  B.  2,  page  138;  A.  R. 
R.  30.) 

In  the  following  ruling  the  solvency  of  the  corporation 
was  in  doubt.  Under  the  192 1  law,  in  such  cases  taxpayers 
would  be  justified  in  charging  off  the  debt  in  part. 

Ruling.  In  1917,  A  loaned  to  a  corporation  loar  dollars,  taking 
a  note  secured  by  a  mortgage  upon  real  estate  against  which  there 
were  two  prior  mortgages,  and  in  his  1918  return  he  deducted  this  in- 
debtedness as  a  bad  debt  and  the  question  is  raised  as  to  the  justifica- 
tion of  the  deduction.  The  debtor  held  at  the  end  of  1918  this  prop- 
erty, said  to  have  been  worth  75.^-  dollars,  which  value  was  established 
by  an  appraisal  made  by  B,  a  disinterested  person,  who  later  purchased 
the  property.  A  second  property  held  by  the  debtor  at  the  end  of 
1918,  consisted  of  land  of  the  value  of  yx  dollars,  which  property 
was  held  by  the  corporation  as  late  as  June,  1920.  Against  these  two 
properties,  having  a  combined  value  of  82^-  dollars,  there  rested  at 
the  end  of  1918  a  total  indebtedness  of  yix  dollars  (of  which  53.1-  dol- 
lars consisted  of  mortgages  prior  to  A's),  leaving  the  net  worth  of 


1042  DEDUCTIONS 

the  corporation  i  i.r  dollars.     The  corporation  was  a  going  concern  at 
the  end  of  191 8. 

Held,  that  A,  under  the  circumstances,  was  not  justified  in  claim- 
ing that  the  entire  debt  was  worthless  at  the  close  of  1918,  nor  that 
a  substantial  part  thereof  would  not  be  recovered,  though  from  his 
knowledge  of  conditions  as  they  existed  at  the  end  of  1918,  he  was 
undoubtedly  justified  in  believing  that,  should  foreclosure  occur,  his 
loan  of  lo.r  dollars  would  result  in  a  loss.  (C.  B.  4,  page  172; 
A.  R.  R.  365.) 

If  soon  after  the  dose  of  1918,  A's  judgment  of  the  worth- 
Icssness  of  the  debt  was  verified,  the  subsequent  event  would 
be  affiriuative  evidence  that  the  deduction  in  19 18  was  proper. 

Loss  due  to  seizure  of  property  by  Russian  Soviet  govern- 
ment.— 

Rulings.  A  in  1916  and  1917  purchased  through  a  New  York 
bank  certain  credits  in  two  Russian  banks.  Subsequently  A  made 
several  efforts  to  communicate  with  these  banks  but  without  success, 
and  the  New  York  bank  is  unofiicially  informed  that  these  particular 
banks  were  taken  over  in  the  latter  part  of  1917  by  the  Russian  Fed- 
erated Soviet  Republic  and  their  assets  dissipated,  confused,  and  de- 
stroyed. The  taxpayer  has  claimed  the  amounts  paid  for  these  credits 
as  a  loss  in  his  return  for  1918. 

The  Committee  is  of  opinion  from  what  is  a  matter  of  common 
knowledge,  and  from  the  statement  made  as  to  the  endeavor  to  com- 
municate with  the  debtors  and  the  information  received  as  to  the 
banks'  practical  abandonment  of  their  business,  that  the  taxpayer 
was  justified  in  charging  off  these  credits  in  1918  as  a  total  loss. 
(C.  B.  3,  page  165;  A.  R.  M.  64.) 

Bank  deposits  in  Russian  banks  can  not  be  considered  as  worth- 
less for  the  purpose  of  claiming  a'  deductible  loss  in  a  return  for  the 
taxable  year  1919.  The  Bureau  is  informed  that  Russian  rubles  in 
the  form  of  bank  deposits  were  sold  during  the  latter  months  of  1919, 
which  would  indicate  that  they  were  not  at  that  time  worthless.  (C. 
B.  2,  page  137;  O.  D.  535.) 

In  order  that  a  taxpayer  may  claim  as  a  deduction  Russian  rubles 
owned  by  him  and  deposited  in  a  Russian  bank,  it  is  necessary  for 
him  to  submit  evidence  establishing  the  fact  that  the  bank  in  which 
the  deposits  were  made  has  lost  its  identity  as  a  banking  institution  or 
that  it  has  been  taken  over  by  the  Soviet  Government  and  its  funds 
requisitioned,  confiscated,  or  dissipated.  (C.  B.  4,  page  173;  O.  D. 
923-) 


FOR   BAD   DEBTS  IO43 

Accounts  uncollectible  because  of  moratorium  in  Cuba. — 

Ruling.  As  a  result  of  the  moratorium  in  Cuba  certain  accounts 
due  from  customers  there  were  uncollectible  at  the  close  of  the 
taxable  year  1920.  Held,  that  these  accounts  can  not  be  deducted 
as  bad  debts  until  it  has  been  definitely  ascertained  that  they  are 
worthless  and  are  charged  off  the  books.  (C.  B.  4,  page  173;  O.  D. 
891.) 

Under  the  1921  law  taxpayers  may  make  a  reasonable  esti- 
mate of  the  amount  uncollectible  in  such  a  case  and  deduct  such 
amount  from  income.  The  loss  claimed  must  be  determined 
with  respect  to  each  account  separately. 

Depreciation  of  collateral  security. — When  a  debtor  who 
has  put  up  collateral  is  known  to  be  unable  to  pay  and 
the  collateral  security  is  worth  substantially  less  than  the 
amount  of  the  debt,  there  is  no  good  reason  why  the  taxpayer 
should  be  compelled  to  sell  the  collateral,  or  make  a  "wash" 
sale  of  it,  in  order  to  charge  off  the  loss  which  has  been  sus- 
tained. 

It  is  clear,  under  the  1921  law,  than  an  accrued  loss  of 
50  per  cent  of  a  debt,  when  determined  by  recognized  methods 
of  accounting,  is  as  deductiljle  as  a  loss  of  100  per  cent.^^ 

Bankruptcy  as  a  test. — 

Regulation Bankruptcy   is  generally  an  indication  of 

the  worthlessness  of  at  least  a  part  of  an  unsecured  and  unpreferred 
debt..  Actual  determination  of  worthlessness  in  bankruptcy  cases  is 
sometimes  possible  before  and  at  other  times  only  when  a  settlement  in 
bankruptcy  shall  have  been  had.^-  Where  a  taxpayer  ascertained 
a  debt  to  be  worthless  and  charged  it  off  in  one  year,  the  mere  fact 
that  bankruptcy  proceedings  instituted  against  the  debtor  are  ter- 
minated in  a  later  year,  confirming  the  conclusion  that  the  debt  is 
worthless,  will  not  authorize  shifting  the  deduction  to  such  later 
year.     In  the   case   of   debts   existing  prior   to   March    i,    1913,  only 


"  See  also  C.  B.  3,  page  167 ;  A.  R.  R.  352. 

'-  [Former  Procedure]  Article  8  of  Regulations  33,  1918,  stated 
that  the  "determination  of  worthlessness  in  such  cases  is  possible  only 
when   settlement  in  bankruptcy  shall  have  been  had." 

Article  151,  Reg.  45,  read:  "Bankruptcy  may  or  may  not  be  an  indi- 
cation of  the  worthlessness  of  a  debt." 


I044  DEDUCTIONS 

their  value  on  that  date  may   be  deducted  upon  subsequently  ascer- 
taining them  to  be  worthless (Art.  151.) 

The  new  regulation  distinguishes  "unsecured  and  unpre- 
ferred  debts"  from  others,  indicating  that  in  practically  all 
cases  of  bankruptcy  there  may  immediately  be  charged  off 
at  least  a  part  of  "unsecured  or  unpreferred  debts." 


Foreclosure  sale  on  a  mortgage.^  ^ — 

Regulation.  Where  mortgaged  or  pledged  property  is  lawfully 
sold  (whether  to  the  creditor  or  other  purchaser)  for  less  than  the 
amount  of  the  debt,  and  the  mortgagee  or  pledgee  ascertains  that 
the  portion  of  the  indebtedness  remaining  unsatisfied  after  such  sale 
is  wholly  or  partially  uncollectible,  and  charges  it  off,  he  may  deduct 
such  amount  as  a  bad  debt  for  the  taxable  year  in  which  it  is  ascer- 
tained to  be  wholly  or  partially  worthless  and  charged  off.  Where 
a  taxpayer  buys  in  mortgaged  or  pledged  property  for  the  amount 
of  the  debt,  no  deduction  shall  be  allowed  for  any  part  of  the  debt. 
Gain  or  loss  is  realized  when  the  property  bought  in  is  sold  or 
disposed  of. 

Accrued  interest  may  be  included  as  part  of  the  deduction  only 
when  it  has  previously  been  returned  as  income.     (Art.   153.) 

The  foregoing  regulation  recognizes  that  the  purchase  of 
inortgaged  property  by  the  mortgagee  for  less  than  principal 
and  accrued  interest,  demonstrates  that  the  debt  is  bad  "in 
part"  and  such  "part"   may  be  deducted. 

The  Treasury  has  held  that  upon  foreclosure,  when  the 
proceeds   were  sufficient   only  to   satisfy   the  first   mortgage, 


"  [Former  Procedure] 

Regulation.  "Where  under  foreclosure  a  mortgagee  buys  in  the  mort- 
gaged property  and  credits  the  indebtedness  with  the  purchase  price,  the 
difiference  between  the  purchase  price  and  the  indebtedness  will  not  be 
allowable  as  a  deduction  for  a  bad  debt,  for  th?"  property  which  was  secur- 
ity for  the  debt  stands  in  the  place  of  the  debt.  The  determination  of  loss 
in  such  a  situation  is  deferred  until  the  property  is  disposed  of,  except 
where  a   purchase   money   mortgage   is    foreclosed   by   the  vendor   of   the 

property Only  where  a  purchaser  for  less  than  the  debt  is  another 

than  the  mortgagee  may  the  difference  between  the  debt  and  the  net  pro- 
ceeds from  the  sale  be  deducted  as  a  bad  debt."     (Reg.  45,  Art.  153.) 

T.  D.  3264  and  3265  (both  dated  December  21,  1921)  amended  the 
regulations  under  the  1918  and  1917  laws,  respectively,  to  read  in  accord- 
ance with  Reg.  62,  Art.  153,  quoted  above. 


FOR   BAD   DEBTS  IO45 

the  amount  of  the  second  mortgage  may  be  charged  off  if  action 
against  the  mortgagor  would  be  useless/* 

When  a  creditor  bids  up  to  the  amount  of  his  claim  when 
property  is  offered  for  sale,  it  is  prima  facie  evidence  of  its 
value,  and  the  regulation  is  in  order.  But  if  it  can  be  shown 
that  the  property  acquired  is  not  worth  the  amount  of  the 
claim,  and  that  the  bid  was  merely  formal,  the  law  permits 
the  deduction  of  any  part  of  the  debt  which  is  bad. 

Recoveries.— In   some  cases  debts  presumably   "definitely 

ascertained  to  be  worthless"  have  unexpectedly  proved  to  be 

collectible  in   whole   or  in   part.     The   following  regulations 

provide  for  the  taxation  of  such  collections. 

Regulations Bad  debts  or  accounts  charged  off  subse- 
quent to  March  i,  191 3,  because  of  the  fact  that  they  were  deter- 
mined to  be  worthless,  which  are  subsequently  recovered,  whether  or 
not  by  suit,  ccfnstitute  income  for  the  year  in  which  recovered,  re- 
gardless of  the  date  when  the  amounts  were  charged  off 

(Art.  51.) 

....  Any  amount  subsequently  received  on  account  of  a  bad 
debt  or  on  account  of  a  part  of  such  debt  previously  charged  off, 
and  allowed  as  a  deduction  for  income  tax  purposes,  must  be  included 

in  gross  income  for  the  taxable  year  in  which  received (Art. 

151.) 

If  collections  are  made  from  accounts  charged  off  prior 
to  March  i,  191 3,  it  may  be  assumed  that  on  that  date  there, 
was  due  at  least  as  much  as  the  amount  collected,  exclusive 
of  interest.  Therefore  there  can  be  no  element  of  taxable 
income  in  such  recoveries  except  as  to  interest  accrued  after 
March  i,  19 13.  The  requirement  that  recoveries  from  ac- 
counts arising  out  of  transactions  since  March  i,  1913,  be 
included  in  current  income  instead  of  reopening  the  accounts 
and  returns  of  prior  years,  is  reasonable. 

Loss  of  endorser  or  guarantor — when  determined. — Upon 
the  failure  of  the  maker  of  a  note  to  take  it  up  at  maturity,  the 
endorser  may  have  to  pay  and  thereupon  a  debt  due  to  the 


Bulletin  42-20-1244;  O.  D.  687. 


1046  DEDUCTIONS 

endorser  arises.  Strictly  speaking,  it  may  not  be  ''ascertained 
to  be  worthless"  immediately,  but  everyone  knows  that  ordi- 
narily the  chances  are  at  least  99  to  i  that  it  will  be  a  bad 
debt  and  usually  it  takes  very  little  time  to  reach  this  con- 
clusion. After  allowing  a  reasonable  time  in  which  to  ascer- 
tain why  the  maker  does  not  make  good,  the  endorser  should 
charge  it  off  as  a  bad  debt,  taking  credit  for  it  in  his  return. 
The  right  to  deduct  the  bad  debt  is  governed  by  the  regu- 
lations cited.  There  is  no  requirement  that  the  obligation  to 
pay  a  note  as  endorser  or  guarantor  shall  have  arisen  from 
business  or  trade,  so  that  the  restrictions  of  past  years  as  to 
losses  would  not  apply  in  any  case. 

Ruling.  Where  a  person  purchases  bonds  for  another,  guar- 
anteeing said  bonds  against  any  loss,  and  a  loss  occurs  due  to  subse- 
quent insolvency  of  the  corporation  issuing  same,  and  the  guarantor 
makes  good  the  loss,  the  same  is  not  deductible  within  the  meaning  of 
section  214,  article  141,  of  the  Revenue  Act  of  1918,  unless  such 
loss  occurs  in  trade  or  business  or  in  a  transaction  entered  into  for 
profit.     (C.  B.  I,  page  125;  O.  D.  241.) 

The  author  does  not  agree  with  the  foregoing  ruling.  It 
is  difficult  at  times  to  distinguish  between  a  bad  debt  and  a 
loss,  but  when  a  debt  to  the  taxpayer  is  created  and  the  debt 
becomes  bad,  the  law  permits  a  deduction  therefor  in  all  cases. 

Liability  as  endorser  at  March  i,  191 3. — 

Ruling.  The  records  in  the  case  show  that  in  the  year  190- 
and  subsequent  thereto,  A  indorsed  certain  notes  issued  by  the 
M  Company  and  also  certain  notes  issued  by  the  N  Company,  which 
companies  became  insolvent  prior  to  March  i,  1913,  and  A  there- 
upon became  liable  as  indorser  for  payment  of  said  notes,  since 
which  time  he  has  made  certain  payments  of  principal  and  interest. 

....  it  appears  clear  that  A  has  never  become  primarily  liable 
for  payment  of  the  principal  of  the  said  notes  or  the  interest  thereon, 
nor  has  he  ever  given  any  written  agreement  to  make  such  payment. 
As  the  original  notes  became  due  they  were  renewed,  in  the  names 
of  the  original  makers  and  were  indorsed  by  A.  Had  the  latter,  upon 
default  in  payment  of  the  notes  prior  to  March  i,  1913,  then  given 
his  own  note  or  notes  in  payment,  a  debt  would  have  been  created 
upon  his  part  which  would  have  precluded  the  allowance  of  deduc- 
tions claimed  to  cover  payments  made  in  liquidation  of  his  own  notes, 


FOR   BAD   DEBTS  IO47 

inasmuch  as  payments  made  in  liquidation  of  an  indebtedness  created 
prior  to  March  i,  1913,  can  not,  under  the  provisions  of  any  income 
tax  law  enacted  since  that  date,  be  allowed  as  deductions. 

In  the  opinion  of  the  Committee,  A  suffered  no  actual  loss  through 
his  indorsement  of  the  said  notes  until  he  made  his  first  payment  in 
liquidation  of  their  principal  and  interest  thereon.  When  a  payment 
was  made  it  created  a  debt  in  his  favor  due  from  the  makers  of  the 
notes,  which  debt  was  at  the  time  it  was  so  created  definitely  known 
to  be  worthless  and  uncollectible.  Each  additional  payment  created 
an  additional  bad  debt. 

In  view  of  the  foregoing  the  Committee  recommends  that  the 
action  of  the  Income  Tax  Unit  in  disallowing  the  deductions  claimed 
by  A  for  the  years  1917,  1918,  and  1919  to  cover  amounts  paid  in 
liquidation  of  the  said  notes  and  interest  thereon  be  reversed,  and 
that  the  said  deductions  be  allowed  in  the  amounts  as  claimed.  (B. 
38-21-1837;  A.  R.R.  479-) 

The  reasoning  in  the  foregoing  ruHng  would  apply  to 
transactions  after  March  i,  1913,  as  well,  and  enable  taxpayers 
to  take  a  deduction  as  payments  are  made  on  the  theory  that 
each  payment  ''creates"  a  debt  from  the  maker,  which  is 
known  to  be  worthless. 

Bad  debts  of  banks  and  other  corporations,  under  govern- 
ment supervision. — A  new  provision  is  found  in  the  regula- 
tions under  the  1921  law,  as  follows: 

Regulation Where  banks  or  other  corporations  which 

are  subject  to  supervision  by  Federal  authorities  (or  by  State  authori- 
ties maintaining  substantially  equivalent  standards)  in  obedience  to 
the  specific  orders,  or  in  accordance  with  the  general  poHcy  of  such 
supervisory  officers,  charge  off  debts  in  whole  or  in  part  such  debts 
shall,  in  the  absence  of  affirmative  evidence  clearly  establishing  the 
contrary,  be  presumed,  for  income-tax  purposes,  to  be  worthless  or 
recoverable  only  in  part,  as  the  case  may  be.     (Art.   151.) 

Illegal  wari-^ants  received  by  bank. — 

Ruling.  A  bank  received  illegal  warrants  from  the  auditor  of  a 
political  subdivision  of  a  State  in  payment  of  promissory  notes  which 
it  held  against  the  auditor  and  the  treasurer.  The  treasurer  made 
payment  of  the  warrants  by  checks  drawn  on  an  account  of  the  sub- 
division at  the  bank.  In  compromise  of  the  claim  of  the  subdivision 
for  the  money  misappropriated  the  bank  paid  x  dollars,  which  amount 
it  set  up  as  a  claim  against  the  officials  in  a  special  account  of  bills 


1048 


DEDUCTIONS 


receivable.  Tlie  bank  brought  suit  against  the  ex-officials,  and  sev- 
eral years  later,  in  1919,  final  judgment  against  the  bank  was  ren- 
dered. Upon  the  rendition  of  the  judgment,  the  bank  in  1919  charged 
off  a  portion  of  the  debt  and  carried  the  remainder  in  the  profit  and 
loss  account  as  a  debit  balance. 

Held,  that  the  entire  amount  actually  lost  by  the  bank  is  deductible 
as  a  bad  debt  in  1919. 

Held  also,  that  the  court  costs,  attorney's  fees,  and  other  expenses 
incurred  in  attempting  to  collect  the  amount  paid  under  the  com- 
promise agreement  are  proper  deductions  from  the  income  of  the 
year  in  which  such  expenses  were  incurred.  (B.  Digest  27-21-1713; 
O.  D.  965.) 


Debts  Must  Be  Charged  Off  Within  the  Year 

Charging  off  bad  debts. — The  1921  law  requires  in  the 
case  of  individuals  and  corporations  that  bad  debts  must  be 
charged  off  within  the  taxable  year.^°  These  words  w^ould 
seem  to  require  that  actual  book  entries  be  made  by  both 
corporations  and  individuals  in  case  they  desire  to  claim  de- 
ductions for  bad  debts.  However,  the  answer  to  question  90 
of  the  Income  Tax  Primer  interpreting  the  191 7  law  which 
used  the  same  phrase  in  describing  the  conditions  which  are 
necessary  to  claim  a  debt  as  a  deduction  reads :  "If  hooks  are 
kept  it  must  be  charged  off  within  the  year,"  plainly  inferring 
that  it  is  still  deductible  when  no  books  at  all  are  kept. 

"Within  the  year." — The  phrase  "within  the  year"  refers 
to  "the  year  for  which  the  return  is  made."^"  To  be  deductible 
the  debts  must  be  charged  off  or  included  in  a  reserve  which 
is  charged  off. 

In  the  case  of  corporations,  deductions  for  bad  debts  prior 
to  the  19 18  law  were  classified  as  business  losses  and  these, 
it  will  be  recalled,  had  to  be  "actually  sustained  and  charged 
off  within  the  year."     [1917  law,  section  12  (a)  second.] 


"^  [Former  Procedure]     The   igi3,  1916,   1917  and  1918  laws  all  con- 
tained a  similar  requirement. 
"Reg.  33,  1918,  Art.  151. 


FOR   BAD    DEBTS  1049 

The  term  "within  the  taxable  year"  should  be  construed 
in  an  accounting  sense,  that  is,  if  books  of  account  are  closed 
as  of  December  31  and  an  entry  written  in  the  books  during 
January  is  dated  December  31,  the  entry  is  deemed  to  have 
been  made  within  the  year  ended  December  31. 


CHAPTER     XXXI 

DEDUCTIONS  FOR  DEPRECIATION 

Depreciation  is  a  decline  in  the  value  of  property  such  as 
may  reasonably  be  expected  to  occur  as  a  result  of  wear  and 
tear  and  gradual  obsolescence.  It  is  due  to  the  possession  and 
use  of  assets,  and  therefore  is  a  part  of  the  cost  of  operation. 
P.  D.  Leake  defines  it  as  "expired  outlay  upon  productive 
plant."  The  phrase  "accrued  renewals"  sometimes  used  to 
describe  depreciation  is  illuminating.  It  is  to  be  noted  that 
depreciation  is  usually  treated  as  a  comprehensive  term  which 
includes  all  declines  of  the  nature  described  above. 

The  Treasury's  definition  is : 

RuJ.iNG.  Depreciation  means  the  gradual  reduction  in  the  value 
of  property  due  to  physical  deterioration,  exhaustion/  wear  and  tear 
through  use  in  trade  or  business.     (Bulletin  "'F,'"  page  5.) 

The  192 1  law  does  not  use  the  word  "depreciation"'  at  all 
in  describing  the  deduction  permitted  under  this  head. 

Law.  Section  J14  (a-8)  [Individuals]:  Section  234  ( a-7)  [Cor- 
porations]. That  in  computing  net  income  there  shall  be  allowed  as 
deductions : 

A  reasonable  allov>ance  for  the  exhaustion,  wear  and  tear  of  prop- 
erty used  in  the  trade  or  business, ^  including  a  reasonable  allowance 
for  obsolescence.     In  the  case  of  such  property  acquired  before  March 


'  [Former  Procedure]  1913  law.  (Individuals)  Section  II  B.  Sixth. 
"A  reasonable  allowance  tor  the  exhaustion,  wear  and  tear  of  property 
arising  out  of  its  use  or  employment  in  the  business." 

(Corporations)  Section  II  G  (b).  "A  reasonable  alluwance  for  depre- 
ciation by  use,  wear  and  tear  of  property,  if  any." 

1916  law.     (Individuals)  The  words  "or  trade"  were  added. 

(Corporations)  The  words  "actually  sustained  and  charged  off"  were 
inserted. 

The  1917  law  made  no  change. 

1918  law.  Section  214  (a-8).  A  reasonable  allowance  for  the  exhaus- 
tion, wear  and  tear  of  property  used  in  the  trade  or  business,  including  a 
reasonable  allowance  for  obsolescence. 

Section  234  (a-7)  for  corporations  reads  exactly  the  same  as  for  in- 
dividuals. 

1050 


FOR   DEPRECIATION  IO51 

I,   1913,  this   deduction  shall  be   computed  upon  the   basis  of  its  fair 
market  price  or  value  as  of  March  i,  1913;  .... 

The  last  sentence  quoted  above  was  added  in  the  1921  law. 

Law.  Section  215  (a)  That  in  computing  net  income  no  deduc- 
tion shall  in  any  case  be  allowed  in  respect  of — 

I  Individuals  j  (2)  Any  amount  paid  out  for  new  buildings  or  for 
permanent  improvements  or  betterments  made  to  increase  the  value 
of  any   property   or   estate;  .... 

(3)  Any  amount  expended  in  restoring  property  or  in  making 
good  the  exhaustion  thereof  for  which  an  allowance  is  or  has  been 
made;-   .... 

The  Hmitation  on  deductions  by  corporations  (section 
235)  is  the  same  as  for  individuals  stated  in  section  21  c^  quoted 
above. 

In  the  regulations  of  the  Treasury  depreciation  "applies 
to  that  which  is  subject  to  wear  and  tear,  to  decay  or  decline 
from  natural  causes,  to  exhaustion,  and  to  obsolescence  due 
to  the  normal  progress  of  the  art,  as  where  machinery  or  other 
property  must  l)e  replaced  by  a  new  invention,  or  due  to  the 
property  becoming  inadequate  to  the  growing  needs  of  the 
business."^  What  may  be  termed  ordinary  obsolescence  will 
be  discussed  in  this  chapter.  Separate  chapters  in  this  book 
are  devoted  to  extraordinary  obsolescence  and  to  depletion.* 
It  will  be  clear  from  the  context  whether  depreciation  is  used 
in  the  inclusive  or  in  the  restricted  sense. 

Depreciation  is  often  treated  as  though  no  accurate  esti- 
mate of  the  life  of  assets  were  possible,  with  the  result  that  in 
some  cases  excessive  reserves  are  created  and  in  other  cases 
there  are  no  reserves  at  all.  Perhaps  the  controlling  reason  for 
this  variation  of  practice  is  a  desire  to  utilize  this  as  an  elastic 
factor  to  bring  about  a  desired  effect  on  the  balance  sheet  and 
the  profit  and  loss  statement.     In  some  cases  it  is  also  felt 


^Subsections  (2)  and  (3)  are  substantially  the  same  as  in  the  1913, 
1916,  1917  and  1918  laws. 

"Art.  162,  Reg.  62.  Art.  159  of  Reg.  33,  1918,  differentiated  depreciation 
from  "depletion,  obsolescence  and  other  losses." 

*  See  Chapter  XXXII,  "Deductions  for  Obsolescence,"  and  Chapter 
XXXIII,  "Deductions  for  Depletion." 


1052 


DEDUCTIONS 


that  excessive  book  valuations  may  favorably  affect  the  insur- 
ance adjustment  in  case  of  fire,  but  this  fallacy  is  gradually 
losing  ground.  The  recent  improvement  in  methods  of  allow- 
ing for  depreciation  can  be  traced  in  large  part  to  the  installa- 
tion of  cost  systems,  which  have  brought  about  an  increasing 
recognition  of  this  factor  as  a  necessary  cost  of  production. 
Another  powerful  influence  in  the  direction  of  accurate  and 
adequate  reserves  has  been  the  enactment  of  federal  and  state 
income  and  other  tax  laws  calling  for  returns  of  net  profits. 
Altogether  there  has  in  recent  years  been  a  general  awakening 
to  the  fact  that  depreciation  is  a  vital  issue  in  correct  account- 
ing. 

There  are  still  wide  differences  of  opinion  as  to  the  amount 
of  the  allowance  which  should  be  made  from  time  to  time. 
Net  profit  means  only  one  thing  in  the  vocabulary  of  the  pro- 
fessional auditor — a  meaning  which  should  be  universally 
recognized — and  that  is  the  excess  of  income  over  operating 
costs,  expenses  and  losses.  It  cannot  be  determined  by  taking 
into  account  all  the  income  and  a  part  only  of  the  charges 
against  income.  Full  provision  for  depreciation  must  be  in- 
cluded among  the  costs  of  operation,  or  the  result  may  not 
be  accepted  as  representing  net  profit.  Statements,  some- 
times encountered  in  published  reports,  to  the  effect  that  a 
corporation  has  realized  net  profits  amounting  to  a  certain 
sum  and  that  out  of  these  profits  an  allowance  for  deprecia- 
tion has  been  made  are  both  misleading  and  illogical. 

It  is  an  unfortunate  fact  that  the  efforts  of  accountants 
to  secure  the  establishment  of  proper  depreciation  reserves 
have  in  some  respects  been  retarded  and  hampered  by  the  atti- 
tude of  certain  inspectors  in  the  administration  of  the  income 
tax  law.  Part  of  the  difficulty  has  been  due  to  a  mistaken 
general  policy  on  the  part  of  the  government  in  favor  of 
strict  limitations  on  depreciation.  In  the  first  place,  reserves 
for  this  purpose,  if  found  in  the  future  to  be  too  large,  will 
be  ultimately  taxable  for  any  excess,  and,  in  any  case,  the 
government  cannot  afford  in  the  long  run  to  ignore  sound 


FOR    DEPRECIATION  1053 

economic  principles  in  determining  net  income.  Perhaps 
the  greatest  share  of  the  trouble  is  due  to  the  action  of  in- 
competent inspectors  who  sometimes  arbitrarily  insist  upon 
a  reduction  of  reserves  to  insufficient  amounts.  Fortunately 
their  action  is  rarely  sustained  by  the  officers  of  the  Treas- 
ury, whose  recent  attitude  in  the  matter  of  depreciation  and 
depletion  has  been  in  accord  with  good  accounting  practice. 

Applicability  of  rates  of  depreciation  used  in  prior  years. — 

Taxpayers  who  use  substantial  rates  of  depreciation  have  some- 
times been  embarrassed  by  examiners  who  applied  the  rates 
used  in  191 7  and  191 8  to  their  plant  accounts  for  many  years 
prior.  In  some  cases  this  application  of  the  rates  practically 
wiped  out  the  plant  account  as  at  January  i,  19 17,  (except 
for  the  additions  of  the  years  immediately  preceding)  and  thus 
greatly  reduced  the  allowable  invested  capital  for  excess  and 
war  profits  purposes. 

Such  a  method,  of  course,  is  inaccurate  and  falls  of  its  own 
weight.  In  most  cases  it  is  possible  to  prove  that  on  January  i, 
191 7,  the  actual  value  of  the  plant,  without  taking  apprecia- 
tion into  consideration,  greatly  exceeded  the  theoretical  valua- 
tion. Such  result  does  not  in  itself  prove  that  because  the 
rates  are  incorrect  as  applied  to  prior  years  they  are  also  in- 
correct as  applied  to  191 7  and  1918. 

The  rates  are  incorrect  as  applied  to  prior  years  because 
during  those  years  the  renewals,  repairs,  maintenance  and 
capital  outlays  charged  to  operations  greatly  reduced  the 
reserve  necessary  to  reflect  accurately  the  net  going  value  of 
the  plant  on  the  books  of  account. 

One  concern  charging  high  dei)reciation  rates  for  20  years 
prior  to  1917  might  show  the  same  net  plant  values  at  the  end 
of  the  period  as  a  concern  which  charged  off  no  depreciation, 
as  such,  during  the  entire  period. 

The  La  Belle  Iron  Works  decision^  clearly  holds  that  tax- 

'41  Sup.  Ct.  528. 


1054 


DEDUCTIONS 


payer's  actual  investment  at  January  i,  191 /,  is  the  proper 
measure  of  invested  capital,  irrespective  of  book  entries. 

During  the  past  year  the  Treasury  has  recognized  that  the 
practice  of  examiners  in  revising  depreciation  allowances  set 
u\)  on  taxpayer's  books  or  of  making  purely  theoretical  allow- 
ances where  specific  depreciation  allowances  had  not  formerly 
l)een  set  up  as  such  in  the  taxpayer's  accounts,  was  an  improper 
act,  and  that  the  plant  values  at  January  i.  1917,  should,  with 
respect  to  depreciation  accrued  prior  to  that  date,  be  accepted 
as  they  appear  in  the  taxpayer's  l)Ooks  unless  the  revenue  agents 
can  |)roduce  affirmative  evidence  that  the  book  values  of  plant 
are  in  excess  of  their  actual  value  at  the  beginning  of  the 
taxable  year.  The  full  text  of  the  memoranda  published  by 
the  Treasury  on  this  subject  appears  in  Chapter  VIII  of  Ap- 
pendix A.  Prior  to  the  enactment  of  the  191 7  law,  it  made 
little  difference  to  many  concerns,  from  a  tax  point  of  view, 
what  rates  of  depreciation  were  charged.  Furthermore,  dur- 
ing 191 7  and  19 1 8  there  were  good  reasons  for  greatly  increas- 
ing depreciation  rates  over  those  formerly  used. 

The  British  War  Ministry  cannot  be  charged  with  holding 
a  brief  for  American  manufacturers ;  therefore  the  rates  of 
depreciation  suggested  in  official  memoranda  of  the  War 
Ministry  are  of  great  interest  as  having  direct  bearing  on 
conditions  in  the  United  States.  When  normal  rates  of  de- 
preciation on  machinery  were  yyi  per  cent  per  annum,  it  was 
suggested  that  there  be  allowed  the  following  additions : 

Addition  for  unskilled  labor  up  to  50% 3M% 

Addition  for  overtime 1 1 14 

Total  additions   15% 

Normal  rate   73/2 

Total   22i^% 

Maximum  allowance 25% 

Engineers  of  the  War  Department  of  the  United  States 
reported  that  the  British  additional  rates  were  too  liberal  and 


FOR    DEPRECIATION-  '  1055 

recommended  that  the  maximum  to  be  used  in  the  foregoing 
example  be  fixed  at  15  per  cent. 

Taxpayers  whose  accounts  are  being  examined  should  give 
careful  attention  to  the  actual  conditions  during  191 7  and 
1 9 18  and  when  special  depreciation  was  warranted  by  exist- 
ing conditions,  as  compared  with  previous  practice,  they 
should  insist  on  proper  allowances. 

Conditions  Precedent  to  Allowance  for  Depreciation 

The  general  provision  in  the  regulations  which  sets  forth 
the  conditions  which  must  be  met  before  a  deduction  for  de- 
preciation is  allowed  reads  as  follows: 

Regulation.  A  reasonable  allowance  for  the  exhaustion,  wear 
and  tear,  and  obsolescence  of  property  used  in  the  trade  or  business 
may  be  deducted  from  gross  income.  For  convenience  such  an  al- 
lowance will  usually  be  referred  to  as  depreciation,  excluding  from 
the  term  any  idea  of  a  mere  reduction  in  market  value  not  resulting 
from  exhaustion,  wear  and  tear,  or  obsolescence.  The  proper  al- 
lowance for  such  depreciation  of  any  property  used  in  the  trade  or 
business  is  that  amount  which  should  be  set  aside  for  the  taxable 
year  in  accordance  with  a  reasonably  consistent  plan  (not  necessarily 
at  a  uniform  rate)  by  which  the  aggregate  of  such  amounts  for  the 
useful  life  of  the  property  in  the  business  will  suffice,  with  the  salvage 
value,  and  having  due  regard  for  expenditures  made  ,  for  current 
upkeep,  at  the  end  of  such  useful  life  to  provide  in  place  of  the 
property  its  original  cost   (not  replacement  cost),  or  its  value  as  uf 

March  i,  1913,  if  acquired  jjy  the  taxpayer  before  that  date 

(Art.    161.) 

"Useful  life,"  as  used  in  the  above  regulation,  has  been 
interpreted  by  the  Treasury  to  mean  "the  period  of  time  over 
which  an  asset  may  be  used  for  the  purpose  for  which  it  was 
acquired."     (C.  B.  4,  page  178;  O.  D.  845.) 

It  is  proper  that  taxpayers  should  adopt  a  consistent  plan 
and  they  should  adhere  to  it  until  actual  conditions  call  for  a 
change.  If  it  is  calculated  that  machinery  depreciates  a  given 
percentage  under  certain  conditions,  it  is  not  inconsistent  to 
change  the  percentage  when  conditions  change. 


1056  DEDUCTIONS 

Property  depreciated  must  not  be  for  personal  use. — 

Regulation The  deduction  of  an  allowance  for  depre- 
ciation is  limited  to  property  used  in  the  taxpayer's  trade  or  busi- 
ness  (Art.   162,) 

To  quote  the  language  of  the  Treasury : 

Ruling.  If  used  chiefly  for  pleasure,  no  depreciation  deduction 
is  allowable.     (Bulletin  "F,"  page  6.) 

In  the  case  of  the  farmer  the  regulations  expressly  permit 
depreciation  on  all  farm  buildings  "other  than  a  dwelling  occu- 
pied by  the  owner.'"^ 

Depreciation  of  residence. — When  a  residence  is  used  part 
of  the  year  by  the  owner  and  is  rented  for  part  of  the  year, 
depreciation  will  be  an  allowable  deduction  for  the  period  of 
the  year  when  used  for  income-producing  purposes.  The 
depreciation  is  not  necessarily  based  on  the  proportion  of  time 
during  which  the  property  is  rented,  because  the  actual  depreci- 
ation during  such  time  may  be  greater  than  during  the  time  of 
occupancy  by  the  owner.  If  the  taxpayer  owns  a  summer  cot- 
tage and  rents  it  for  three  months  during  the  summer  and 
occupies  it  personally  during  one  month,  it  may  be  that  the 
entire  annual  depreciation  should  be  deducted  since  the  facts 
would  indicate  that  the  property  as  a  whole  is  held  for  in- 
come-producing purposes  and  that  the  occupancy  by  the  owner 
for  a  short  period  is  merely  incidental.  The  test,  however, 
would  be  the  actual  circumstances  in  each  case. 

Regulation No  such  allowance  may  be  made  in  respect 

of  ...  .  building  used  by  the  taxpayer  solely  as  his  residence,  nor 
in  respect  of  furniture  or  furnishings  therein,  personal  effects,  or 
clothing;  ....   (Art.  162.) 

Residence  used  partly  for  business — or  sublet. — 

Ruling.  If  a  portion  of  the  residence  is  used  for  business  pur- 
poses, as  in  the  case  of  a  physician  or  any  other  professional  man 
who  has  his  office  in  his  home,  a  proportionate  part  of  the  deprecia- 


'Art.  171;  see  Chapter  XXXIX. 


FOR    DEPRECIATION  1057 

tion  sustained  may  be  deducted,  the  amount  to  be  based  generally 
on  the  ratio  of  the  number  of  rooms  used  for  business  purposes  to 
the  total  number  of  rooms  in  the  building.  The  same  principle  is 
applicable  if  a  taxpayer  rents  a  portion  of  his  personal  residence  to 
other  individuals.  Under  such  conditions,  however,  the  taxpayer 
must  include  in  his  gross  income  any  amounts  received  as  rentals. 
A  taxpayer  who  is  not  allowed  a  deduction  for  depreciation  of  his 
personal  residence  may,  in  case  he  sells  the  property,  disregard 
depreciation  in  computing  any  taxable  profit  derived  from  the  trans- 
action. 

If  a  taxpayer  owns  residential  property  and  rents  it  to  other  in- 
dividuals, he  is  entitled  to  a  deduction  for  depreciation  of  the  rented 
property  even  though  the  property  is  not  used  in  his  principal  trade 
or  business  but  must  include  in  gross  income  the  entire  amount  re- 
ceived as  rentals.     (Bulletin  "F,"  pages  7  and  8.) 

"Cost"  of  residence  is  not  reduced—by  deprecia- 
tion.— 

Ruling.  Inasmuch  as  no  deduction  for  depreciation  of  the  per- 
sonal residence  of  a  taxpayer  is  allowable  in  his  income  tax  returns, 
a  taxpayer  in  determining  the  gain  or  loss  arising  from  the  sale  of 
his  personal  residence,  continuously  occupied  by  him  as  such,  is  not 
required  to  reduce  the  cost  of  the  property  or  its  fair  market  value 
as  at  March  i,  1913,  by  the  depreciation  sustained.  (B.  30-20-1085; 
O.  D.  600.) 

Property  which  may  be  depreciated.' — 

Regulation.  The  necessity  for  a  depreciation  allowance  arises 
from  the  fact  that  certain  property  used  in  the  business  gradually 
approaches  a  point  where  its  usefulness  is  exhausted.  The  allow- 
ance should  be  confined  to  property  of  this  nature.  In  the  case  of 
tangible  property,  it  applies  to  that  which  is  subject  to  wear  and 
tear,  to  decay  or  decline  from  natural  causes,  to  exhaustion,  and  to 
obsolescence  due  to  the  normal  progress  of  the  art,  as  where  machinery 
or  other  property  must  be  replaced  by  a  new  invention,  or  due  to  the 
property  becoming  inadequate  to  the  growing  needs  of  the  business.  It 
does  not  apply  to  inventories  or  to  stock  in  trade,  nor  to  land  apart 
from  the  improvements  or  physical  development  added  to  it.  It  does 
not  apply  to  bodies  of  minerals  which  through  the  process  of  removal 
suffer  depletion,  other  provisions  for  this  being  made  in  the  statute. 
....      (Art.  162.) 


'  For  depreciation   of  land,  see  page   1098. 

For  depreciation  of  farm  buildings,  equipment  and  livestock,  see  Chap- 
ter XXXIX,  "Farmers." 


1058  DEDUCTIONS 

Potential  earning  power  not  subject  to  deprecia- 
tion.— 

Ruling.  The  potential  earning  capacity  of  an  individual,  his  in- 
ventive genius  or  his  literary  ability  may  not  be  made  the  basis  of  an 
allowance  for  depreciation.     (Bulletin  ''F,"  page  6.) 

Replacements  and  renewals  must  not  be  twice  deducted. — 
Expenditures  for  the  upkeep  of  property  range  by  imper- 
ceptible gradations  from  the  most  insignificant  repairs  to  the 
replacement  of  the  largest  and  most  costly  units.  The  law, 
of  course,  intends  that  all  such  expenditures  shall  be  deducted, 
but  the  necessity  arises  of  distinguishing  between  those  which 
shall  be  deducted  annually  as  expenses  and  those  for  which 
provision  shalt  be  made  through  cumulative  depreciation 
allowances.  In  making  this  distinction,  care  must  be  taken  to 
avoid  the  double  deduction  of  expenses.  The  problem  is  com- 
plicated by  the  fact  that  minor  repairs  are  made  upon  the  most 
expensive  machines.  While  theoretically  it  may  be  conceivable 
that  depreciation  rates  might  under  some  conditions  be  so 
delicately  adjusted  as  to  provide  completely  and  perfectly  for 
the  entire  upkeep  of  a  machine  or  other  piece  of  property, 
as  a  practical  matter  it  is  so  difficult  as  to  be  impossible.  The 
accountant's  solution  is  to  draw  a  somewhat  arbitrary  line 
between  the*  small  incidental  items  of  repair,  replacement  and 
maintenance  and  the  heavy  items  of  renewal  and  replacement, 
charging  the  first  group  to  expense  and  the  second  to  depre- 
ciation reserves.  The  depreciation  rates  are  calculated  with 
this  assumption  in  mind  and  consequently  depreciation  re- 
serves should  be  kept  free  from  charges  except  those  for  un- 
questioned renewals  or  replacements  of  major  parts.  The 
regulations  satisfactorily  cover  this  point  in  the  following 
statement. 

Regulations Property  kept  in  repair  may,  nevertheless, 

be  the  subject  of  a  depreciation  allowance (Art.   162.) 

The  cost  of  incidental  repairs  which  neither  materially' add  to 
the  value  of  the  property  nor  appreciably  prolong  its  life,  but  keep 
it   in    an   ordinarily   efficient   operating   condition,    may   be   deducted 


FOR    DEPRECIATION  1 059 

as  expense,  provided  the  plant  or  property  account  is  not  increased 
by  the  amount  of  such  expenditures.  Repairs  in  the  nature  of 
replacements,  to  the  extent  that  they  arrest  deterioration  and  appre- 
ciably prolong  the  life  of  the  property,  should  be  charged  against 
the  depreciation  reserve  if  such  account  is  kept (Art.  103.) 

The  Treasury  in  its  latest  rulings  recognizes  the  necessity 
for  proper  repair  and  depreciation  charges. 

Ruling.  Accordingly,  amounts  paid  for  repairs  are  not  allowable 
deductions  if  they  are  duplications  of  allovi^ances  for  depreciation. 
It  does  not  follow,  however,  that  there  may  not  be  in  the  same  case 
allowable  deductions  both  for  depreciation  and  payment  for  repairs. 
As  a  rule,  property  that  has  been  subject  to  use  even  though  main- 
tained in  serviceable  condition  by  repair  has  a  shortened  expectancy 
of  usefulness.  In  such  case  there  may  be  a  deduction  for  payments 
for  repairs  and  also  a  deduction  for  loss  due  to  depreciation  of  the 
property  which  occurred  despite  the  maintenance  of  such  property 
in  repair.     (Bulletin  "F,"  page  29.) 

Closely  related  to  this  question  is  the  treatment  of  ex- 
penditures for  making  improvements.  This  is  discussed  in 
the  following  decision  of  a  United  States  Circuit  Court  which 
holds  that  improvements  which  are  not  permanent  in  char- 
acter are  deductible  as  expense : 

Decision.  (Syl.)  Amounts  expended  by  a  business  corporation  in 
enlarging  or  making  improvements  in  its  office  or  premises,  not  in  the 
nature  of  permanent  improvements  to  the  property,  but  to  facilitate 
the  transaction  of  a  growing  business,  should  properly  be  deducted 
as  necessary  expenses  of  the  business.  (Connecticut  Mutual  Life 
Insurance  Co.  v.  Eaton,  218  Fed.  206.) 

The  principle  outlined  in  the  law  and  regulations  appears 
to  be  clear,  but  considerable  difficulty  has  arisen  in  its  appli- 
cation because  of  the  refusal  of  revenue  inspectors  to  allow 
in  some  cases  for  both  repairs  and  depreciation,  on  the  ground 
that  the  former  includes  the  latter.  The  practice  is  not  uni- 
form, the  inspectors  frequently  differing  in  their  interpreta- 
tion of  charges  which  may  be  either  repairs  or  renewals. 
Naturally,  they  incline  to  the  conclusion  that  where  there 
is  a  doubt,  the  expenditure  is  a  charge  against  the  reserve, 
but  good  business  practice  requires  that  in  case  of  doubt  the 


loOo  DEDUCTIONS 

repairs  be  charged  to  operating  expenses.  The  true  issue  is 
merely  the  avoidance  of  a  double  charge  against  income. 

Inspectors  have  been  known  to  hold  that  where  a  part 
of  a  machine  which  must  be  replaced  frequently,  such  as  a 
shuttle  or  a  bobbin,  which  forms  part  of  a  loom,  wears  out  or 
breaks,  the  replacement  of  such  part  should  be  charged  against 
depreciation  reserve,  since  this  is  intended  to  cover  "deteriora- 
tion of  property  on  account  of  its  use,  wear  and  tear."  In 
some  concerns  parts  of  this  sort  are  termed  "supplies,"  and 
as  such  are  charged  directly  to  cost  of  manufacturing.  Upon 
the  original  acquisition  of  a  loom,  its  entire  cost,  including 
installation  of  every  part  and  action,  ready  to  run,  is  charged 
to  capital.  The  same  rule  applies  to  a  sewing  machine.  First 
cost  would  include  a  machine  equipped  with  needles,  but  it  is 
not  customary  to  set  up  a  depreciation  reserve  for  the  re- 
newal of  needles.  As  purchased  they  are  charged  to  supplies, 
or  some  similar  account,  and,  subject  to  stock  on  hand  at  the 
beginning  and  end  of  the  period,  all  purchases  are  charged  to 
cost  of  manufacture,  not  to  repairs.  There  is  a  sHght  error 
here  which  is  too  trivial  to  consider  in  practice,  but  one 
that  evidently  worries  some  inspectors.  It  is,  that  the  re- 
newal of  a  needle,  costing  perhaps  one-tenth  of  one  cent, 
should  be  charged  to  depreciation  reserve,  instead  of  supplies, 
because  the  first  cost  of  the  sewing  machine  was  charged  to 
plant.  But  this  would  be  an  impossible  procedure,  because  re- 
newals of  this  character  are  frequent.  Therefore,  the  only 
error  lies  in  the  fact  that  a  small  part  of  the  machine,  assumed 
to  have  a  life  of,  say,  ten  years,  may  have  been  renewed  from 
time  to  time  up  to  the  end  of  the  useful  life  of  the  machine. 
Accountants   must   disregard  such   fine  distinctions. 

Some  manufacturing  plants  and  mills  produce  in  their  own 
shops  various  parts  of  looms  and  other  machines  used  to  manu- 
facture the  principal  products  of  the  mills.  These  parts  range 
from  the  largest  to  the  smallest  unit  of  each  machine,  so  that 
over  a  period  of  years  the  looms  are  continually  being  re- 
newed, particularly  where  the  policy  of  the  mill  management 


FOR    DEPRECIATION  I061 

is  to  maintain  the  plant  at  the  peak  of  operating  efficiency. 
In  such  cases  complete  analyses  of  the  cost  records  should 
he  kept  in  order  to  distinguish  replacement  items  from  those 
which  are  "incidental  repairs." 

Depreciation  of  leased  machinery. — 

Ruling.  The  M  Company  owns  certain  apparatus  which  it  leases 
tinder  contracts  for  a  period  of  years  at  an  agreed  rental.  The  con- 
tracts provide  that  the  lessor  shall  maintain  the  apparatus  for  the 
])eriod  of  the  contract  without  charge  to  the  lessee  and  that  the  ap- 
paratus shall  remain  the  property  of  the  lessor.  Although  the  ap- 
])aratus  is  of  some  value  at  the  expiration  of  the  lease,  such  value  is 
less  than  the  cost  of  its  removal  and  it  is  therefore  abandoned  by 
the  lessor  at  the  expiration  of  the  lease. 

The  expenditure  for  labor  incident  to  the  installation  of  the  ap- 
])aratus,  being  possible  of  allocation  thereto,  and  the  cost  of  the  mate- 
rial entering  into  the  installation  are  held  to  be  capital  expenditures, 
recoverable  through  depreciation  spread  over  the  term  of  the  origi- 
nal lease.  If  the  apparatus  had  a  salvage  value  at  the  expiration  of 
the  lease  it  would  be  necessary  to  take  this  value  into  consideration 
in  computing  deductions  for  depreciation  as  provided  in  article  161 
of  Regulations  45.     (B.  44-21-1894;  O.  D.   1082.) 

The  costs  of  maintaining  the  apparattis  under  the  terms  of 
the  contract  are,  of  course,  chargeable  against  current  income. 

Depreciation  of  railway  roadway  off.set  by  mainten- 
ance AND  appreciation. — In  a  recent  case,^  the  court  held 
that: 

Decision.      (Syl.)      i.  Deductions — Depreciation— Loss   in   Value 
of  Roadbed  of  Railroad. 

No  deduction  for  depreciation  in  value  of  the  roadway  of  a  rail- 
road may  be  taken  where,  because  of  repairs,  renewals  and  replace- 
ments, the  roadway  as  a  whole  is  as  valuable  at  the  end  of  the  tax- 
able year  as  at  the  beginning. 

2.  Deductions — Depreciation. 

The  depreciation  which  may  be  deducted  in  determining  net 
income  is  the  decrease  in  intrinsic  value  due  to  wear  and  tear,  decay, 
obsolescence,  etc.,  of  the  physical  property  suffered  during  the  tax- 
able year  as  distinguished  from  the  market  value. 


^Nashville,  Chattanooga  and  St.  Louis  Ry.  Co.  v.   U.  S..  269  Fed.  351; 
certiorari  denied,  65  L.  Ed.  — . 


1q52  DEDUCllONS 

3.  Deduction — Depreciation — Loss  in  \^alue  of  Separate  Units 
— Appreciation  of  Other  Units. 

The  roadway  must  be  considered  as  a  whole  in  determining 
whether  depreciation  has  been  sustained,  and  the  loss  in  value  of 
separate  units  of  the  roadway  may  be  offset  by  appreciation  in  other 
units. 

4.  Evidence — Sufficiency   of   Repairs,   Renewals,    and   Replace- 
ments to  Offset  Depreciation. 

There  was  sufficient  evidence  that  the  repairs,  renewals,  and  re- 
placements made  oft'set  any  loss  in  value,  and  that  the  roadway  had 
not  decreased  in  value,  to  justify  the  trial  court  in  refusing  to  direct 
a  verdict. 

The  decision  of  the  court  reads  in  part  as  follows : 

Decision It    was    was    admitted   'by    defendant's    chief 

engineer  that  the  expenditures  for  1909  "kept  the  road  in  a  normal 
condition  to  carry  on  its  business,"  that  "its  normal  condition  was  a 
good  condition,"  and  that  the  expenditures  "had  made  good  the  nor- 
mal amount  of  depreciation."  There  was  testimony  by  competent 
witnesses  of  railway  experience  that  "there  may  be  depreciation  in 
the  units  comprising  the  roadway,  track,  and  structures  of  the  rail- 
road, while  there  is  no  depreciation  in  the  machine  as  a  whole;"  also 
that  it  is  possible  "to  maintain  the  roadway,  track,  and  structures  so 
that  there  will  be  no  depreciation  if  we  consider  the  roadway,  track, 
and  structures  as  a  composite  whole;"  also  that  "the  service  life  of  any 
normally  operated  and  normally  and  well  maintained  railroad  is  per- 
petual, and  it  is  maintained  in  the  condition  of  property  serving  its 
purpose  by  annual  renewals  and  replacements."  The  testimony,  con- 
sidered as  a  whole,  tended  to  support  the  conclusion  that  the  amounts 
expended  by  defendant  during  the  years  in  question  for  repairs,  re- 
newals, and  replacements  should  and  would  have  fully  oft'set  the  de- 
preciation in  the  various  units,  and  that  the  defendant's  railway  and 
structures  were,  as  a  whole,  maintained  throughout  the  years  in  ques- 
tion in  fully  as  good  condition,  and  were  of  fully  as  great  intrinsic 
value  as  at  the  beginning  of  the  respective  years.  The  jury  would 
have  been  clearly  justified  in  inferring  from  the  testimony  of  de- 
fendant's chief  engineer,  taken  as  a  whole,  that  the  value  of  the  road- 
way had  not  depreciated  during  the  two  years  in  question ;  in  other 
words,  that  the  repairs  and  renewals  that  had  been  made  were  of 
such  a  character  as  to  leave  the  road  at  the  end  of  each  year  of  value 
equal  to  that  at  the  beginning  of  the  year.  That  officer's  testimony 
so  impressed  the  trial  judge,  who  stated  his  opinion  from  the  evi- 
dence that  "there  is  no  reasonable  deduction  for  depreciation  estab- 
lished." Defendant  did  not  directly  controvert  the  situation  so  shown. 
Its  chief,  if  not  its  only  reliance,  seems  to  have  been  on  the  proposi- 


FOR   DEPRECIATION  1063 

tion  that  in  spite  of  it  all  there  was  inevitable  annual  depreciation  in 
some  of  the  perishable  elements  not  entirely  renewed  or  replaced,  so 
justifying  the  contention  that  for  this  reason  there  was  depreciation 
within  the  meaning  of  the  Act,  even  though  the  roadway  as  a  whole 
had  not  decreased  in  value.  To  this  argument,  as  already  said,  we 
can  not  assent.  It  follows  that  the  trial  judge  rightfully  refused  to 
instruct  verdict  for  defendant. 

With  reference  to  appreciation  offsetting  depreciation,  the 
court  in  the  same  case  said : 

The  contention  on  which  defendant  seems  to  rest  its  chief  criti- 
cism seems  to  be  that,  notwithstanding  the  roadway  as  a  whole  was 
intrinsically  just  as  valuable  at  the  end  of  the  year  as  at  the  beginning 
of  the  year,  that  is  to  say,  although  depreciation  in  given  units 
had  been  fully  overcome  by  appreciation  in  others,  the  railway  com- 
pany would  still  be  entitled  to  credit  for  depreciation  in  such  indivi- 
dual units  as  had  depreciated.  We  think  this  contention  of  defen- 
dant not  sustained  by  reason  or  authority,  and  that  the  court  cor- 
rectly charged  the  true  criterion.  If,  as  is  not  entirely  clear,  it  is 
meant  to  further  suggest  that  the  consideration  of  functional  (as 
distinguished  from  physical)  depreciation  was  not  allowed  by  the 
charge  to  be  taken  into  account,  the  suggestion  is  plainly  without 
merit.  Not  only  did  the  court  define  the  roadway  as  including  "struc- 
tures connected  with  the  roadway,  such  as  stations,  tool  houses  and 
matters  of  that  sort,"  but  it  included  in  depreciation  a  lessening  of 
original  values,  "due  to  wear  and  tear,  decay,  gradual  decline  from 
obsolescence,  that  is,  getting  out  of  date  and  inadequacy."  In  our 
opinion  the  jury  was  given  the  correct  rule  for  determining  the  ex- 
istence or  nonexistence  of  depreciation,  which  accords  with  the  "or- 
dinary and  usual  sense"'  of  that  term  "as  understood  by  business  men." 
Von  Baumhach  v.  Sargent  Land  Co.,  242  U.  S.  503,  524.  To  say  that 
property  can  depreciate  without  impairment  of  either  intrinsic  value 
or  efficiency  is  to  our  minds  a  solecism. 

The  foregoing  opinion  accords  neither  with  good  accounting 
principles,  nor  with  the  position  of  the  Treasury.  The  case 
was  hrought  under  the  1909  law  and  may  not  be  considered  as 
a  precedent  for  procedure  under  subsequent  laws.  It  is  inserted 
at  this  point  as  an  ilhistration  of  the  uncertainty  of  court  deci- 
sions.   It  is  a  Circuit  Court,  not  a  Supreme  Court,  decision. 

Certain  repairs  are  properly  capital  expenditures. 
— Although  it  is  an  accepted  rule  that  repairs  and  all  other 
expenses  of  maintenance  should  be  charged  against  profit  and 


1064  DEDUCTIONS 

loss,  an  exception  to  this  rule  is  found  in  cases  where  partly 
worn-out  or  run-down  plants  are  purchased  with  the  intention 
on  the  part  of  the  new  owners  to  rehabilitate  them  so  that  they 
can  be  operated  efficiently.  It  may  be  assumed  that  the  pur- 
chase price  takes  the  poor  condition  of  the  plant  into  consid- 
eration, in  which  case  the  entire  cost  of  repairs  and  renewals 
may  properly  be  capitalized. 

Regulation.  Amounts  paid  for  increasing  the  capital  value  or 
for  making  good  the  depreciation   (for  which  a  deduction  has  been 

made)    of   property   are   not   deductible    from   gross   income 

(Art.    293.) 

If  the  replacements  are  of  a  pcnnanent  nature  they  are 
chargeable  to  capital. 

Ruling.  The  amount  expended  by  a  taxpayer  during  any  tax- 
able year  or  period  for  improvements,  replacements,  or  renewals  of  a 
permanent  nature  is  a  capital  investment  and  is  not  deductible  from 
his  gross  income  for  such  taxable  year  or  period.  The  amount  so 
expended  should  be  charged  directly  to  the  property  account  or  to 
the  depreciation  reserve  account,  dependent  upon  how  depreciation 
charges  are  treated  in  the  books  of  account,  and  a  pro  rata  portion 
thereof  deducted  as  depreciation  each  year  of  the  life  of  such  im- 
provements,   replacements,    or    renewals.      (Bulletin    "F,"    page   29.) 

Depreciation  must  be  entered  upon  the  books  of  a  cor- 
poration.— Neither  the  1921,  nor  the  19 18.  law  specifies  that 
depreciation  must  be  charged  off  on  the  books  of  an  individual 
or  a  corporation,"  but  in  other  sections  of  the  law  the  Commis- 
sioner is  given  ample  i)ower  to  enforce  proper  accounting 
methods.  It  may  be  assumed,  therefore,  that  all  corporations 
and  all  individuals  who  keep  books  must  enter  depreciation  on 
their  books  or  it  will  not  be  allowed  as  a  deduction.  The  re- 
striction is  a  proper  one.'"     The  author  has  no  sympathy  for 


"  Sec  page    1050. 

'"  [Former  Procedure]  Such  a  restriction  upon  corporations  was  con- 
tained in  section  12   (a),  second,  of  the  1916  law. 

The  1913  law  contained  no  such  provision,  but  the  Treasury  never- 
theless ruled  that  "in  order  to  be  allowable  ....  the  loss  .  .  .  must 
be  so  entered  upon  the  books  of  the  company  as  to  constitute  a  lia- 
bility against  its  assets."  (Letter  to  collectors,  August  27,  1914.)  This 
ruling,  while  it  did  not  follow  the  law,  conformed  to  correct  account- 


FOR    DEPRFXIATION  1065 

any  corporation  which  is  not  vvilhng  to  have  its  income  tax 
returns  agree  with  its  Ijooks.  The  regulations  of  significance 
follow : 

Regulation.  A  depreciation  allowance,  in  order  to  constitute  an 
allowable  deduction  from  gross  income,  must  be  charged  ofif.  The 
particular  manner  in  which  it  shall  be  charged  off  is  not  material, 
except  that  the  amount  measuring  a  reasonable  allowance  for  depre- 
ciation must  be  either  deducted  directly  from  the  book  value  of  the 
assets  or  preferably  credited  to  a  depreciation  reserve  account,  which 
must  be  reflected  in  the  annual  balance  sheet.  The  allowances  should 
be  computed  and  charged  off  with  express  reference  to  specific  items, 
units,  or  groups  of  property,  each  item  or  unit  being  considered 
separately  or  specifically  included  in  a  group  with  others  to  which 
the  same  factors  apply.  The  taxpayer  should  keep  such  records  as 
to  each  item  or  unit  of  depreciable  property  as  will  permit  the  ready 
verification  of  the  factors  used  in  computing  the  allowance  for  each 
year  for  each  item,  unit,  or  group.     (Art.  169.) 

Banks  may  keep  additional  records  for  depreciation 

purposes. 

Ruling.  Held,  that  where  banks  under  Federal  or  State  statute 
are  required  to  submit  periodically  to  the  Comptroller  of  the  Cur- 
rency or  to  the  State  Banking  Commissioner  a  statement  of  financial 
condition,  additional  records  and  books  may  be  kept  which  reflect 
the  correct  investment  account  and  net  income  for  income  and  ex- 
cess profits  tax  purposes  and  that  any  adjustments  made  thereon 
with  respect  to  the  banking  house  furniture  and  fixtures,  depreciation, 
etc.,  should  be  accepted  as  meeting  the  requirements  of  the  law  and 
regulations  for  income  and  excess  profits  tax  pn''"oses.  ( C.  B.  4, 
page  64;  A.  R.  R.  Z77-) 

The  reason  for  this  ruling  is  that  the  statements  rendered 
to  the  federal  or  state  authorities  frequently  include  adjust- 
ments, for  instance,  the  writing  down  of  investments  to  market 


ing.  Accurate  accounting  requires  that  depreciation  be  shown  on  the 
books,  but  the  mere  existence  of  the  book  record  does  not  make 
actual  depreciation  more  or  less.  The  courts  rightly  took  the  position 
that  if  a  definite,  easily  proven  diminution  of  value  had  occurred,  the 
mere  non-entry  of  it  on  books  of  account  could  not  possibly  serve  to 
negative  the  fact.  As  in  so  many  other  matters,  the  Treasury  was  incon- 
sistent in  its  ruling  on  the  book  record  of  depreciation,  because,  in  gen- 
eral, it  took  the  proper  position  that  book  records  are  subordinated  to 
facts,  while  in  this  respect  its  position  was  that  the  fact  is  subordinated 
to  the  book  record. 


io66  DEDUCTIONS 

values  or  the  inclusion  in  expenses  of  additions  to  the  banking 
house  or  its  equipment,  which  are  not  permissible  for  income 
tax  returns. 

Only  charges  applicable  to  current  year  deductible. — Re- 
cent rulings  have  now  settled  beyond  question  the  principle 
that  only  those  depreciation  charges  which  are  properly  appli- 
cable to  the  current  year  may  be  deducted  in  that  year,  and 
any  readjustment  must  be  made  by  filing  amended  returns 
(see  page  1067).     The  Treasury  has  ruled: 

Rulings.  The  deduction  for  depreciation  and  obsolescence  allow- 
able in  the  return  for  any  taxable  year  or  period  is  an  amount  suffi- 
cient to  cover  the  reduction  in  value  of  property  through  exhaustion, 
wear  and  tear  through  use  in  the  trade  or  business  during  such  tax- 
able year  or  period.  The  fact  that  depreciation  and  obsolescence  have 
been  sustained  in  prior  years  but  were  not  claimed  as  a  deduction  in 
returns  of  net  income  will  not  warrant  the  deduction  of  an  increased 
amount  during  the  current  year.  The  taxpayer's  remedy  lies  in  filing 
amended  returns  for  prior  years  in  which  such  deductions  may  be 
claimed  and  claims  for  refund  of  excess  taxes  paid.  (Bulletin  "F," 
page  35-) 

....  It  is  further  held  that  since  the  general  plan  of  both  the 
income  and  profits  taxes  is  to  levy  a  tax  upon  an  annual  basis,  and 
as  there  is  no  authority  in  the  statute  for  offsetting  against  income 
received  in  one  year,  losses  sustained  in  a  prior  year  by  reason  of 
depreciation,  except  as  provided  in  sections  204,  214  (a)  12,  and  234 
(a)  14  of  the  statute,  only  such  depreciation  as  was  sustained  during 
the  taxable  periods  covered  by  the  returns  may  be  claimed.  (C.  B.  4, 
page  180;  O.  D.  948.) 

A  regulations^  makes  specific  provision  for  an  alteration 
in  the  rate  of  depreciation  in  cases  where  the  life  of  the  prop- 
erty has  been  underestimated,  but  does  it,  not  by  reconstructing 
the  entire  depreciation  history  of  the  property  with  readjust- 
ments in  the  returns  for  previous  years,  but  rather  by  dis- 
tributing the  remaining  portion  of  the  value  not  covered  by 
depreciation  over  the  estimated  remaining  life  of  the  property. 
It  would  seem  that  the  converse  of  this  would  also  apply, 
viz.,  that  if  the  life  of  the  property  was  overestimated,  the 


"Art.   166;   see  page   1081. 


FOR   DEPRECIATION  1067 

rate  of  depreciation  should  be  increased  during  the  remain- 
ing years  of  its  Hfe  sufficiently  to  cover  the  loss. 

Good  accounting  practice  requires  that  lump  sum  purchases 
be  segregated  on  the  books  of  account.  It  is  better  to  open 
too  many  accounts  than  too  few,  because  experience  demon- 
strates the  fact  that  depreciation  is  more  easily  ascertained 
by  the  use  of  a  number  of  ledger  accounts  than  when  undivided 
property  or  plant  accounts  are  kept. 

When  it  is  impossible  definitely  to  allocate  the  cost,  it 
should  be  prorated  on  some  equitable  basis  or  by  a  new 
appraisal  made  as  of  date  of  acquisition. 

Amended  returns  may  be  necessary. — It  may  be  neces- 
sary to  prepare  amended  returns  from  19 13  to  the  time  when 
the  adjustments  are  made.  If  the  amount  involved  is  substan- 
tial there  is  no  other  way  of  correcting  the  former  erroneous 
practice. 

The  regulations  are  fair  and  reasonable  in  that  taxpayers 
are  required  to  make  each  year's  returns  include  accrued  de- 
preciation for  only  one  year.  The  adjustment  of  accounts 
will  work  out  to  the  advantage  of  the  government  and  to  the 
disadvantage  of  the  taxpayer  if  the  depreciation  allowance 
is  decreased  during  a  period  of  high  taxes  and  vice  versa. 
But  taxpayers  should  keep  in  mind  that  actual  depreciation,  in 
almost  all  cases,  was  far  greater  during  the  years  191 7  and 
1918  than  during  the  pre-war  period. ^^ 

Amended  returns  acceptable  to  Treasury. — If  orig- 
inal returns  were  made  in  good  faith,  they  may  be  corrected  if 
found  to  be  erroneous.  The  following  ruling  also  requires 
that  any  depreciation  allowance  claimed  must  be  entered  on  the 
taxpayer's  books. 

Ruling.  The  statement  ....  to  the  effect  that  the  depreciation 
allowance  must  be  charged  off  before  it  can  be  deducted  does  not 
mean  that  depreciation  sustained  during  one  year  may  be  charged 
out  of  the  income  of  another  year  for  income  tax  purposes;  neither 


See  page  1053  et  seq. 


io68  DEDUCTIONS 

does  it  mean  that  failure  to  deduct  depreciation  before  closing  ac- 
counts for  the  year  will  prevent  its  ultimate  deduction  by  the  tax- 
payer. It  means  that  if  the  taxpayer  inadvertently  neglected  to  make 
the  proper  entries  on  his  books  before  closing  them  for  the  year 
during  which  the  depreciation  was  sustained  and  failed  to  make  the 
proper  deduction  from  gross  income  in  his  return  for  that  year,  he 
may  reopen  his  books,  make  the  proper  adjustment  entries  on  them, 
and  file  an  amended  return  showing  the  proper  deduction  for  depre- 
ciation, provided  bad  faith  or  gross  negligence  was  not  shown  in 
the  preparation  of  his  original  return  and  in  the  manner  in  which 
he  kept  his  accounts.     (Bulletin  "F,"  pages  33-34.) 

Depreciation  should  be  based  on  cost  or  value  March  i, 
1913- — The  192 1  law  specifically  provides  that  in  the  case  of 
property  acquired  before  March  1,  1913,  the  value  as  of  that 
date  is  the  proper  basis  for  estimating  depreciation.  If  the 
property  was  purchased  after  March  i,  1913,  the  cost  of  the 
property  is  the  basis  for  computing  depreciation.  In  the  case, 
however,  of  property  received  as  a  gift  after  March  i,  19 13, 
and  before  December  31,  1920,  depreciation  is  based  on  the 
fair  market  value  of  the  property  at  the  time  of  the  gift.^^ 

Regulation.  The  capital  sum  to  be  replaced  by  depreciation 
allowances  is  the  original  cost  of  the  property  in  respect  of  which  the 
allowance  is  made,  except  that  in  the  case  of  property  acquired  by  the 
taxpayer  prior  to  March  i,  1913,  the  capital  sum  to  be  replaced  is 
the  fair  market  value  of  the  property  as  of  that  date.  In  the  absence 
of  proof  to  the  contrary,  it  will  be  assumed  that  such  value  as  of 
March  i,  1913,  is  the  cost  of  the  property  less  depreciation  up  to 
that  date.  To  this  sum  should  be  added  from  time  to  time  the  cost 
of  improvements,  additions  and  betterments,  the  cost  of  which  is  not 
deducted  as  an  expense  in  the  taxpayer's  return,  and  from  it  should 
be  deducted  from  time  to  time  the  amount  of  any  definite  loss  or 
damage  sustained  by  the  property  through  casualty,  as  distinguished 
from  the  gradual  exhaustion  of  its  utility  which  is  the  basis  of  the 
depreciation  allowance (Art.  164.) 

This  rule,  of  course,  departs  somewhat  from  the  usual 
accounting  procedure  because  of  the  insertion  of  March  i, 
1913,  as  the  date  for  establishing  a  value  for  purposes  of  de- 
preciation.    The  ordinary  practice  is  to  take  original  cost, 

*^  See  page  620. 


FOR    DEPRECIATION  I069 

determine  a  liberal  depreciation  rate  and,   when  the  reserve 
equals  the  original  cost,  discontinue  depreciation. 

Ruling.  Prior  to  the  approval  of  Treasury  Decision  2754  (Au- 
gust 23,  1918)  depreciation  allowances  were  required  to  be  based  on 
the  cost  of  the  property.  This  Treasury  decision  authorized  deprecia- 
tion deductions  based  on  the  value  of  property  as  of  March  i,  1913,  if 
acquired  prior  thereto.  The  basis  in  the  case  of  property  acquired  on 
or  after  that  date  remained  unchanged. 

In  an  opinion  rendered  by  the  Solicitor  of  Internal  Revenue  it 
was  held  that  Treasury  Decision  2754  is  applicable  to  returns  for 
1913  and  all  subsequent  years.  This  Treasury  decision  was  based  on 
a  prior  opinion  of  the  Solicitor  of  Internal  Revenue  in  which  it  was 
held  that  the  depreciation  charges  allowable  for  any  year  represent 
the  portion  of  the  gross  income  of  the  year  necessary  to  make  good 
a  capital  shrinkage,  that  the  charges  should  therefore  be  such  as  to 
amount  in  the  aggregate  during  the  life  of  the  depreciating  property 
to  the  value  of  that  property  as  a  capital  asset;  and  that  under  the 
United  States  Supreme  Court  decisions  in  Doyle  v.  Mitchell  Brothers 
Co.,  247  U.  S.  179,  and  Lynch  v.  Turrish,  247  U.  S.  221,  this  capital 
value  should  be  determined  as  of  March  i,  1913.  (Bulletin  "F," 
page  19.) 

If  March  i,  1913,  value  was  substantially  in  excess  of  the 
cost  less  depreciation  to  that  date,  amended  returns  for  sub- 
sequent years  embodying  revised  depreciation  allowances  would 
1)e  in  order. 

Future  replacement  ccst  not  a  factor. — 

Ruling.  Replacement  value  of  property  can  not  be  substituted 
for  the  cost  of  the  property  as  the  cost  of  replacement  at  a  time  some 
years  in  the  future  is  a  speculative  figure  which  can  not  be  used  as 
a  basis  for  determining  an  annual  depreciation  charge.  The  deprecia- 
tion charge  will  replace  the  amount  of  the  original  capital  outlay, 
which  may  be  more  or  less  than  adequate  to  replace  the  item  to  which 
it  applies.  If  less  than  adequate,  new  capital  must  be  provided  from 
surplus  or  otherwise  to  effect  the  replacement.  (B.  21-19-524;  O.  D. 
283.) 

Depreciation  computation  in  case  of  reorganiza- 
tions.— 

Ruling.  A  corporation  engaged  in  refining  gasoline  was  liqui- 
dated and  its  assets  including  automobiles,  office  furniture  and  equip- 
ment, and  absorption  gasoline  plants,  were  transferred  to  a  partner- 
ship  organized   by    its   stockholders.      The   question    is    raised    as   to 


lO^o  iDEDUCTIONS 

whether  the  partnership  shall  base  its  claim  for  depreciation  upon  the 
original  cost  of  the  assets  or  upon  their  original  cost  less  depreciation 

charged  off  by  the  corporation If,   in  the   liquidation  of  the 

corporation,  the  fair  market  value  as  of  the  date  of  the  distribution  of 
the  assets  received  by  any  stockholder,  was  in  excess  of  the  cost  of 
his  stock  or  its  fair  market  value  as  of  March  i,  1913,  if  it  was 
acquired  prior  to  that  date,  the  amount  of  the  excess  represented 
taxable  income  subject  to  both  the  normal  and  the  additional  tax  for 
the  year  of  its  receipi..  The  fair  market  value  of  the  assets  as  of  the 
date  of  liquidation  of  the  corporation  will  be  held  to  be  the  cost  of 
the  assets  to  the  stockholders  who,  as  partners,  turned  the  assets  over 
to  the  partnership,  and  will  be  the  basis  for  determining  the  deprecia- 
tion allowance  to  be  claimed  each  year  with  respect  to  such  assets. 
....   (B.  34-20-1148;  O.  D.  639.) 

The  foregoing  ruling  is  based  upon  the  principle  of  a 
"closed  transaction."  If  a  transfer  of  title  constituted  a  "con- 
tinuing" transaction,  this  change  in  the  depreciation  base 
would  not  be  permitted.^* 

When  assets  are  transferred,  care  should  be  taken  to  trans- 
fer them  at  gross  book  value  and  not  after  deducting  any 
reserve  that  may  have  been  set  up  on  the  books  of  the  old 
firm.  In  some  cases  revenue  agents  have  computed  depre- 
ciation on  such  net  figures  at  the  old  rates.  This  of  course 
results  in  much  smaller  depreciation  deduction  for  the  tax- 
able year  of  the  new  concern.  If  the  net  value  of  the  assets 
is  used,  the  rate  of  depreciation  should  be  increased  to  reduce 
the  assets  to  salvage  value  at  the  end  of  their  useful  hfe. 

Revaluation  as  of  January  i,  1909,  applicable  to  corpora- 
tion excise  tax  only. — In  all  cases  relating  to  depreciation 
during  the  period  January  i,  1909,  to  February  28,  1913, 
the  fair  value  of  property  at  January  i,  1909,  is  still  a' factor. 

As  to  19 1 3  and  subsequent  years,  both  for  the  purpose  of 
determining  taxable  profits  on  sales  and  allowances  for  de- 
preciation, corporations  may  revalue  their  assets  as  of  March 
I,  191 3,  whether  or  not  a  similar  revaluation  was  made  at 
January  i,  1909.    If  the  value  at  March  i,  191 3,  was  in  ex- 


For  discussion  of  what  constitutes  a  "closed  transaction,"  see  page  536. 


FOR   DEPRECIATION  1071 

cess  of  the  January  i,  1909,  valuation,  no  tax  is  imposed 
thereon  even  though  realization  takes  place  after  March   i, 

1913- 

Assets  revalued  on  a  corporation's  books  as  of  January 
I,  1909,  in  an  amount  in  excess  of  the  book  value  at  that  date, 
revalued  again  as  of  March  i,  191 3,  in  an  amount  in  excess  of 
the  January  i,  1909,  valuation  and  sold  since  March  i,  1913, 
at  a  still  greater  value,  will  be  taxable  only  on  the  difference 
between  the  March  i,  191 3,  value  and  the  price  realized. 

No  tax  on  appreciation  can  now  be  collected  under  the 
1909  law,  and  no  tax  can  be  collected  under  the  191 3  and 
later  laws  on  any  appreciation  which  accrued  prior  to  March 
r,  1913/' 

Depreciation  of  depreciable  and  non-depreciable  property 
acquired  after  March  i,  1913. — 

Regulation In  the  case  of  the  acquisition  on  or  after 

March  i,  1913,  of  a  combination  of  depreciable  and  nondepreciable 
property  for  a  lump  price,  as,  for  example,  land  and  buildings,  the 
capital  sum  to  be  replaced  is  limited  to  that  part  of  the  lump  price 
which  represents  the  value  of  the  depreciable  property  at  the  time  of 
such  a'cquisition.     (Art.   164.) 

When  depreciation  deduction  results  in  deficit. — 

Ruling.  Corporate  taxpayers  in  some  cases  compute  their  net 
income  for  the  taxable  period  without  having  made  allowance  for 
depreciation  and  then  distribute  the  entire  net  income  so  computed 
to  their  stockholders  so  that  the  books  show  no  surplus  or  undivided 
profits.  In  such  cases  if  a  corporation  subsequently  desires  to  avail 
itself  of  the  privilege  of  deducting  an  allowance  for  depreciation  in 
its  return  for  such  taxable  period  it  must  first  reopen  its  books  and 

make  the  appropriate  charges It  will  then  be  placed   in  the 

position  of  having  paid  a  dividend  from  a  depreciation  reserve  or 
from  capital  to  the  extent  that  the  amount  of  dividend  paid  exceeds 
the  true  net  income,  meaning  the  net  income  after  making  proper 
charges  for  depreciation.  The  amount  of  the  excess  will  be  deemed 
a  distribution  in  partial  liquidation  and  taxed  accordingly  to  the 
stockholders,  and  the  invested  capital  of  the  corporation  for  excess 
profits  purposes  will  be  deemed  to  have  been  reduced  to  the  same 


"For  discussion  of  taxability  of  dividends  paid  from  realized  appre- 
ciation, see  page  715.  ' 


10-2  DKDUCTIONS 

extent  in  accordance  with  article  86o'«  of  Regulations  45.     (Bulletin 
"F,"  page  35.) 

Ruling.  In  computing  the  taxable  net  income  of  a  corporation, 
it  can  not  be  denied  a  deduction  on  account  of  depreciation  actually 
sustained  and  charged  off,  even  though  after  paying  dividends  there 
remains  an  amount  of  surplus  and  earnings  insufficient  to  cover  de- 
preciation. In  such  case  the  book  value  of  the  assets  must  be  re- 
duced by  an  amount  equal  to  the  difference  between  the  amount  of  the 
depreciation  actually  sustained  and  charged  off  and  the  amount  of 
the  earnings  and  surplus  available  for  depreciation  at  the  end  of  the 
taxable  period.     (C.  B.  4,  page  180;  A.  R.  M.  112.) 

When  the  depreciation  cledtiction  is  in  excess  of  the  net 
earnings,  a  net  loss  results  which  under  the  192 1  law  may 
be  carried  forw^ard  to  a  subsequent  year.'" 

Depreciation  in  cases  of  permanent  discontinuance. — 

Regulation.  If  the  use  of  any  property  in  the  business  is  per- 
manently discontinued,  although  no  sale  or  other  disposition  of  the 
property  has  taken  place,  a  determination  of  any  gain  or  loss  may 
be  made;  but  any  deduction  in  respect  of  any  loss  thereon  must  be 
disclosed  in  the  taxpayer's  return  for  the  year  in  M^hich  the  determi- 
nation is  made  and  a  full  statement  of  the  facts  and  the  basis  upon 
which  the  computation  is  calculated  must  be  attached  to  the  return. 
Upon  a  sale  or  other  disposition  of  the  property,  the  consideration 
received  shall  be  compared  with  the  amount  of  the  estimated  salvage 
value  used  in  computing  the  gain  or  loss  as  above  provided,  and  the 
amount  of  the  difference  shall  be  treated  as  a  gain  or  loss,  as  the 
case  may  be,  of  the  year  in  which  the  sale  or  other  disposition  was 
made (Art.  170.) 

A  loss  arising  from  discontinuing  the  use  in  business  of 
depreciable  property  may  be  due  to  obsolescence.  That  sub- 
ject is  discussed  in  Chapter  XXXII. 

Depreciation  claimed  by  fiduciaries  and  beneficiaries. — 
The  procedure  is  prescribed  by  the  Treasury  as  follows : 

Ruling.  An  individual  who  receives  income  from  a  trust  estate 
may  not  deduct  from  gross  income  in  his  individual  income  tax  return 
any  amount  representing  depreciation  of  property  belonging  to  the 
estate.    However,  under  the  Revenue  Act  of  1918  it  is  permissible  for 


'"See  page  Excess  Profits  Tax  Procedure,  1921,  page  251. 
"  Net  losses  are  discussed  on  pages  1021-1029. 


FOR    DEPRECIATION  I073 

the  fiduciary  in  ascertaining  tlie  net  income  of  the  estate  or  trust  for 
which  he  acts  to  deduct  a  reasonable  allowance  to  cover  the  deprecia- 
tion sustained  during  the  taxable  year,  whether  or  not  the  terms  of 
the  will  or  agreement  creating  the  estate  or  trust  or  a  decree  of 
court  provide  for  taking  care  of  the  depreciation  which  may  be 
sustained  on  the  property  held  in  trust. 

Estates  and  trusts  are  under  certain  circumstances  treated  as  a 
unit,  and  in  other  cases  may  represent  an  aggregate  of  distinct  inter- 
ests to  all  of  which  the  fiduciary  is  responsible.  Irrespective  of 
whether  the  estate  or  trust  is  or  is  not  treated  as  a  unit,  the  fiduciary 
in  computing  the  net  income  upon  which  he  is  required  to  pay  the  tax 

may    claim   a    deduction    for    depreciation '-      (Bulletin    "F," 

pages  32-33.) 

Depreciation  of  property  acquired  by  gift. — 

Ruling.  If  a  taxpayer  acquires  depreciable  property  by  gift, 
bequest,  or  devise,  and  uses  it  for  purposes  of  trade  or  business,  he  is 
entitled  to  a  deduction  from  gross  income  for  depreciation  of  such 

property the  deduction  is  based  on  the  fair  market   price  or 

value  of  the  property  at  the  date  when  acquired,  or  if  acquired  prior 
to  March  i,  1913,  its  fair  market  price  or  value  as  of  that  date,  and 
its  remaining  useful  life  in  the  trade  or  business,  proper  adjustment 
being  made  from  time  to  time  by  reason  of  improvements,  additions, 
betterments,  or  losses  since  acquirement  or  since  March  i,  1913. 
(Bulletin  "F,"  pages  9  and  19.) 

The  foregoing  applies  to  property  acquired  by  gift  before 
December  31.  1920. 

Section  202  (a-2)  of  the  1921  law  provides  that,  for  the 
purpose  of  computing  gain  or  loss  on  subsequent  sale,  property 
acquired  by  gift  after  December  31.  1920,  is  to  be  deemed 
to  have  the  same  cost  or  March  i.  19 13,  vahie  (if  acquired 
prior  thereto)  as  if  still  in  the  hands  of  the  donor.^**  The 
question  arises  as  to  what  value  the  donee  should  use  for  depre- 
ciation purposes  in  case  the  gift  consists  of  depreciable  property. 
The  donee. might  conceivably  use  one  of  two  values : 

(a)  Valite  at  date  of  gift. 

(b)  Cost  to  donor  or  March  i,  1913,  value  if  acquired 

by  the  donor  prior  thereto. 


"See   discussion    of    depreciation    allowances   to    beneficiaries,    Chapter 
XXXVII. 

'°  See  page  619. 


1074 


DEDUCTIONS 


In  case  (a)  the  donee  would  be  basing  depreciation  on  an 
appreciated  or  depreciated  value  as  compared  with  the  cost 
to  the  donor  which,  under  section  202  (a-2)  is  now  assumed 
to  be  the  cost  to  the  donee.  It  would  seem  that  if  (b)  is  to  be 
the  basis  on  which  the  donee  must  compute  gain  or  loss  in  case 
of  sale,  the  Treasury  will  use  the  same  basis  for  depreciation 
purposes. 

Depreciation  divisible  between  joint  owners. — 

Ruling.  A  joint  owner  of  inherited  property,  collecting  rents 
and  profits  from  such  property  and  managing  the  property  on  behalf 
of  all  the  owners,  pursuant  to  an  oral  agreement,  is  an  agent  and  not 
a  fiduciary.  It  is,  therefore,  necessary  for  each  of  the  joint  owners 
to  file  an  income  tax  return  and  account  for  his  share  of  the  income 
from  the  property  in  addition  to  income  received  by  him  from  other 
sources.  In  preparing  such  returns  each  joint  owner  may  claim  as  a 
deduction  for  each  year  his  proportionate  share  of  the  depreciation 
allowance  for  such  year  with  respect  to  the  property  held  in  joint 
ownership. ^^ 

Reserves  for  Depreciation 

According  to  the  regulations  the  particular  manner  in 
which  the  depreciation  allowed  as  a  deduction  pursuant  to 
the  law  is  entered  on  the  taxpayer's  books,  is  not  material 
except  that  the  amount  "must  be  either  deducted  directly  from 
the  book  value  of  the  assets  or  preferably  credited  to  a  depre- 
ciation reserve  account,^^  which  must  be  reflected  in  the  annual 
balance  sheet."     (Art.  169.) 

Use  of  depreciation  reserves. — The  Treasury  no  longer 
holds  the  very  narrow  view  it  once  held  as  to  the  investment 
of  depreciation  reserves  in  the  concern's  own  plant. 

The  amounts  reserved  for  depreciation  need  not  be  spe- 
cifically invested. 

Ruling.  While  the  presumption  is  that  amounts  credited  to  these 
accounts  will  be  used  to  make  good  the  loss  sustained,  either  through 


^  Bulletin  "F."  page  33. 

"  [Former  Procedure]      For    discussion    of    former    regulations    see 
Income  Tax  Procedure,  1918,  pages  364-366. 


FOR   DEPRECIATION  I075 

a  renewal  or  replacement  of  the  property  or  a  return  of  capital,  there 
is  no  requirement  of  law  that  the  funds  represented  by  these  reserve 
liabilities  shall  be  held  intact  or  remain  idle  against  the  day  when 
they  may  be  used  in  making  good  the  depreciation  of  the  property 
with  respect  to  which  the  deduction  is  claimed  or  in  restoring  the 
capital  invested  in  the  depreciated  assets.     (Bulletin  "F,"  page  34.) 

Rates  of  Depreciation — General 

The  law  in  regard  to  rates  specifies  merely  that  the  de- 
preciation allowances  shall  be  "reasonable,"  and  the  Treas- 
ury very  sensibly  makes  no  attempts  to  fix  specific  rates  which 
shall  be  considered  satisfactory. 

Regulation.  The  capital  sum  to  be  replaced  should  be  charged 
off  over  the  useful  life  of  the  property  either  in  equal  annual  install- 
ments or  in  accordance  with  any  other  recognized  trade  practice, 
such  as  an  apportionment  of  the  capital  sum  over  units  of  produc- 
tion. Whatever  plan  or  method  of  apportionment  is  adopted  must 
be  reasonable  and  must  have  due  regard  to  operating  conditions  dur- 
ing the  taxable  period.  While  the  burden  of  proof  must  rest  upon 
the  taxpayer  to  sustain  the  deduction  taken  by  him,  such  deductions 
must  not  be  disallowed  unless  shown  by  clear  and  convincing  evidence 
to  be  unreasonable.  The  reasonableness  of  any  claim  for  deprecia- 
tion shall  be  determined  upon  the  conditions  known  to  exist  at  the 
end  of  the  period  for  which  the  return  is  made.--     (Art.  165.) 


^Methods  of  determining  depreciation  allowances: 
I.  The  fixed  percentage  basis.     This  method  is  the  most  popular 
and  is  the  one  in  general  use.     It  is  applied  as  follows: 

(a)  On  a  flat  basis,  e.g.,  if  the  life  of  a  machine  is  ten  years,  one- 
tenth,  or  ID  per  cent,  is  charged  off  annually. 

(b)  On  a  reducing  scale  basis,  i.e.,  a  rate  is  ascertained  which, 
when  applied  to  the  original  cost  and  the  diminished  value  thereof  as 
periodically  determined,  will  reduce  the  book  value  to  scrap  value  at 
the  end  of  the  machine's  estimated  life. 

2.  Sinking  fund  method.  If  it  is  proposed  to  set  aside  such  a  sum 
periodically  as  will  equal  the  original  cost  of  a  machine  (less  scrap 
value)  at  the  end  of  its  estimated  life,  it  is  customary,  after  taking 
into  consideration  the  average  rate  of  interest  which  can  be  secured, 
to  pay  into  a  fund  a  fixed  amount  periodically.  The  aggregate  thereof, 
together  with  the  accumulated  interest,  will  equal  the  amount  required 
to  renew  the  machine  in  question.  This  method  is  in  practice  seldom 
followed. 

There  is  good  authority,  however,  for  its  use  where  a  single  large 
piece  of  property,  such  as  an  office  building,  apartment  house  or  ship 
is  being  operated  which  is  eventually  to  be  replaced. 

3.  Production  method.  A  method  of  making  depreciation  allow- 
ances  which   has   its   advantages    under   certain   conditions   is   that   of 


10/6 


DEDUCTIONS 


Ruling.  It  is  the  opinion  of  this  office  that  neither  the  opening 
nor  the  closing  balance  of  the  asset  accounts  is  the  proper  value 
upon  which  to  base  depreciation  allowances  for  any  taxable  year  in 
which  improvements,  additions,  or  betterments  have  been  made  to  de- 
preciable property  or  in  which  depreciable  assets  have  been  abandoned 
or  scrapped.  If  the  opening  balance  is  used  in  such  cases  the  tax- 
payer will  not  be  given  the  benefit  of  a  deduction  for  the  amount 
of  depreciation  sustained  in  the  taxable  year  on  the  additions  made 
during  the  year,  while  a  deduction  would  be  allowed  for  a  full 
year's  depreciation  on  the  assets  discarded  during  the  year.  On  the 
other  hand,  if  depreciation  is  computed  upon  the  closing  balance,  the 
taxpayer  would  not  be  allowed  a  deduction  for  any  depreciation 
sustained  during  the  year  upon  the  assets  abandoned,  while  a  deduc- 
tion would  be  allowed  for  a  full  year's  depreciation  upon  the  assets 
acquired  during  the  year.  This  office  is  also  of  the  opinion  that 
in  such  cases  the  proper  allowance  for  depreciation  of  the  assets 
acquired  or  discarded  during  the  year  is  that  proportion  of  the  de- 
preciation of  such  assets  for  the  entire  taxable  year  which  the  por- 
tion of  the  year  during  which  the  assets  were  used  in  the  trade  or 
business  bears  to  the  full  taxable  year. 

It  is  held,  therefore,  that  depreciation  should  be  computed  for 
the  entire  taxable  year  only  upon  those  assets  which  were  properly 
included  in  the  opening  balances  of  the  depreciable  asset  accounts 
and  which  were  not  abandoned  or  scrapped  during  the  taxable  year. 
Depreciation  should  be  computed  on  each  asset  discarded  during  the 
year  at  the  proper  annual  rate  for  the  period  from  the  beginning 
of  the  year  to  the  date  tlie  asset  was  abandoned,  and  upon  each  im- 
provement,  addition,   or   betterment   made   during  the   year   the   cost 


charging  an  established  rate  per  unit  of  output.  This  is  especially 
applicable  in  the  case  of,  say,  a  blast  furnace  where  the  frequency  with 
which  the  linings  will  need  to  be  renewed  depends  on  the  extent  to 
which  the  furnace  is  being  used.  If  it  is  being  nm  at  full  capacity 
night  and  day,  the  wear  on  the  linings  is  obviously  much  greater  than 
if  the  furnace  were  not  in  continual  use  during  the  entire  fiscal  period. 
Another  species  of  depreciation  which  may  be  said  to  come  under 
the  above  caption  is  that  caused  in  a  plant  by  the  exhaustion  of  the 
mines  or  timber  lands  for  the  operation  of  which  the  plant  was  con- 
structed. Most  of  the  value  of  coke  ovens,  for  instance,  is  gone  when 
the  mines  for  which  they  were  constructed  are  worked  out.  Conse- 
quently, in  determining  the  amount  to  be  written  off  for  depreciation 
of  mining  and  lumbering  plants,  the  factor  of  the  probable  future  out- 
put of  the  mines  or  lands  will  be  an  important  one  and  it  will  fre- 
quently be  found  advisable  to  base  the  plant  depreciation  charge  on 
the  output.  Certainly  this  should  be  done  where  it  is  evident  that 
the  plant  will  outlive  the  exhaustion  of  the  mines  or  lands.  In  such 
cases  the  depreciation  charges  should  be  sufficient  to  absorb  the 
entire  cost  of  the  plant,  less  residual  value,  by  the  time  the  mines  or 
lands  are  exhausted,  even  though  at  that  time  the  plant  may  still  be 
in  good  operating  condition.  Of  course,  any  actual  residual  value 
must  be  considered. 


FOR    DEPRECIATION 


1077 


of  which  is  not  detkictible  from  gross  income  as  a  business  expense, 
at  the  proper  annual  rate  for  that  portion  of  the  taxable  year  inter- 
vening between  the  date  the  improvement,  addition,  or  betterment 
was  made  and  the  close  of  the  taxable  year.  It  is  to  be  understood, 
of  course,  that  if  in  any  case  the  improvements,  additions,  or  better- 
ments made  or  the  assets  discarded  were,  during  the  taxable  year, 
so  numerous  and  in  such  small  amounts  that  the  time  and  labor  in- 
volved in  computing  depreciation  in  this  manner  upon  each  separate 
improvement,  addition,  or  betterment  or  asset  abandoned  would  be 
so  disproportionate  to  the  resulting  change  in  tax  liability  as  not  to 
warrant  depreciation  being  so  computed,  such  changes  in  the  depre- 
ciable assets  may  be  consirlered  to  have  occurred  ratably  during  the 
year  and  depreciation  computed  upon  the  average  of  the  opening 
and  closing  balances  of  the  asset  account,  such  average  being  deter- 
mined by  adding  together  the  balances  at  the  beginning  and  end  of 
the  taxable  year  and  dividing  by  2.     (I-2-18;  I.  T.  1158.) 

The  foregoing  ruling  merely  states  the  rule  that  deprecia- 
tion can  only  be  taken  on  "property  used  in  the  trade  or  busi- 
ness,""' and  that  where  changes  take  place  during  the  year 
in  the  amount  of  deprecial)le  property,  effect  must  be  given 
thereto. 

Depreciation  methods  approved  by  Treasury. — The  Treas- 
ury has  approved  only  two  methods,  but  is  willing  to  adopt 
other  methods  if  they  are  found  to  be  more  accurate. 

Fixed  percentage  method. — 

Ruling The  "fixed  percentage"  method  as  applied  by  the 

Commissioner  contemplates  that  the  annual  depreciation  deductions 
with  respect  to  any  property  should  be  equal ;  that  the  rate  of  depre- 
ciation should  be  assumed  to  be  uniform  during  the  useful  life  of 
the  property,  as  compared  with  the  so-called  "fractional  method^ 
weighted  years,"  "declining  balance  method — scientific  or  unscien- 
tific," "revaluation  method,"  and  "sinking  fund  method,"  the  use  of 
which  is  advocated  by  accountants,  but  none  of  which  have  been 
approved  in  their  entirety  by  the  Commissioner  for  income  tax  pur- 
poses.    (Bulletin  "F,"  page  31.) 

Production  method. — 

Ruling.  The  only  other  method  which  has  been  approved  by 
the  Commissioner  is  an   apportionment  of  the  depreciation  charges 


Section  214  (a-8). 


1078  DEDUCTIONS 

over  the  total  amount  of  work  to  be  performed  or  over  units  of  pro- 
duction. For  example,  a  contractor  may  purchase  machinery  for 
use  only  in  performing  a  certain  contract,  which  machinery  will  be 
worthless  or  have  little  or  no  salvage  value  upon  completion  of  the 
contract  on  which  he  will  be  engaged  for  the  whole  of  one  taxable 
year  and  half  of  the  succeeding  taxable  year.  But  the  number  of 
units  of  work,  or  percentage  of  completion  accomplished  during  the 
first  period  of  12  months  and  during  the  second  period  of  six  months, 
may  be  equal.  The  contract  may  call  for  the  making  of  an  excava- 
tion, and  the  same  number  of  yards  may  be  excavated  during  each  of 
the  above  periods.  Under  such  circumstances,  if  the  contractor  re- 
turns his  gross  income  each  year  on  the  basis  of  percentage  of  com- 
pletion of  the  contract,  he  will  be  permitted  to  spread  the  total 
amount  of  the  depreciation  allowance  equally  over  the  two  periods, 
deducting  half  of  the  total  amount  in  his  return  for  the  first  12 
months,  and  the  other  half  in  his  return  for  the  succeeding  taxable 
period. 

If  the  contractor  had  returned  his  income  on  some  basis  other 
than  that  of  percentage  of  completion  of  the  contract,  it  would  have 
been  necessary  for  him  to  modify  his  basis  for  computing  the  de- 
preciation allowances.  Thus,  if  the  gross  income  was  returned  on 
the  basis  of  time  required  for  completion  of  the  above  contract,  two- 
thirds  of  the  gross  income  being  reported  in  the  return  for  the  first 
12  months,  and  the  other  third  reported  in  the  return  for  the  suc- 
ceeding period;  in  that  case  two-thirds  of  the  total  depreciation 
allowance  would  be  deducted  in  the  return  for  the  first  period  and 
the  remainder  in  the  next  return.     (Bulletin  "F,"  page  31.) 

The  intention  of  the  foregoing  illustration  is  to  permit  an 
equitable  deduction  for  depreciation.  When  the  allocation 
mentioned  does  not  work  equitably,  it  is  permissible  to  adopt 
a  method  which  reflects  the  true  net  income  for  each  period. 

Dependence    upon    life    of   enterprise    as    a    whole. — The 

''number  of  years  constituting  its  life"  and  the  permissible 
revaluation  as  of  March  i,  1913,  are  vitally  affected  in  the 
case  of  some  types  of  property  by  the  life  of  the  enterprise 
in  which  it  is  used.  In  the  case  of  a  mine  or  an  oil  or  a  gas  well, 
the  deposit  may  be  exhausted  before  the  expiration  of  the  nor- 
mal life  of  some  of  the  buildings  and  machinery.  The  regula- 
tions provide  that  in  the  case  of  oil  and  gas  properties  the  de- 
preciation shall  be  such  "an  amount,  based  upon  its  cost  (or  fair 
market  value  as  of  March  i,  1913,  if  acquired  prior  to  that 


FOR   DEPRECIATION 


1079 


date),  equitably  distributed  over  its  useful  life,  as  will  bring 
such  property  to  its  true  salvage  value  when  no  longer  useful 
for  the  purpose  for  which  such  property  was  acquired."^*  A 
somewhat  similar  provision  is  made  in  the  case  of  mining 
properties'^  and  timber  properties.^"  In  the  case  of  a  building 
constructed  on  leased  land,  if  "the  life  of  the  improvement  is 
less  than  the  life  of  the  lease,  the  depreciation  may  be  taken 
by  the  lessee,  instead  of  treating  the  cost  as  rent."^^  This, 
of  course,  is  basing  the  depreciation  rate  on  the  life  of  the 
improvement,  rather  than  on  the  duration  of  the  lease. 

Ruling.  Held,  ....  that  the  cost  of  the  new  boilers,  less  sal- 
vage value,  may  be  recovered  by  annual  deductions  spread  over  the 
period  of  the  estimated  remaining  timber  supply,  it  being  assumed  that 
at  the  end  of  this  period  the  cost  of  removing  the  boilers  to  a  new 
timber  region  will  be  more  than  their  worth  in  the  new  location. 
.    .    .    .      (C.  B.  4,  page  179;  O.  D.  871.) 

Enterprises  affected  by  the  close  of  the  war. — The 
"useful  life"  of  much  war  property  did  not  extend  beyond 
the  end  of  the  war.  What  is  the  proper  term  to  use  for  the 
accruing  expense  or  cost  incident  to  idle  plant?  If  depreciation 
were  permitted  only  for  wear  and  tear  of  a  plant  constructed 
to  manufacture  war  materials,  which  has  not  been  used  since 
the  war  ended,  the  owner  would  be  in  a  bad  way. 

Many  contracts  let  by  the  government  itself  specifically 
provided  for  extraordinary  depreciation  rates  to  be  included 
as  part  of  the  cost  of  production  of  war  materials.  The  muni- 
tions tax  law  permitted  the  amortization  of  plants  used  for  war 
purposes  over  the  estimated  war  production. 

The  192 1  law  re-enacts  the  provisions  of  the  1918  law 
which  takes  care  of  depreciation  due  to  war  conditions. ^^  As 
the  loss  is  one  due  to  extraordinary  obsolescence,  the  matter 
is  fully  discussed  in  Chapter  XXXII. 


""See   Art.    225,    page    1107. 
""Art.  224;   see  page   1105  el  scq. 
''"  Art.  227 ;  see  page  1234. 
""Reg.  45,  Art.  109;  see  page  903. 
"Sections  214   (a-9),  and  234  (a-8). 


Io8o  DEDUCTIONS 

Depreciation  of  plant  or  equipment  devoted  to  war  pur- 
poses acquired  before  April  6,  1917,  is  also  discussed  in  Chap- 
ter XXXII. 

Depreciation  a  local  issue. — The  taxpayer  must  take  local 
conditions  into  account  in  considering  rates  of  depreciation. 
In  one  locality  boilers  may  depreciate  7^  per  cent  annually; 
in  another  the  rate  may  be  1 5  per  cent ;  and  the  variation  may 
be  entirely  legitimate.  It  is  not  merely  a  question  of  the  qual- 
ity of  the  boilers.  No  engineer  or  boiler  manufacturer  can 
give  an  intelligent  estimate  unless  he  knows  the  use  to  which 
the  boiler  is  subjected,  the  climate,  the  water,  the  class  of 
labor,  the  probabilities  of  shut-downs,  etc.  A  similar  situation 
exists  in  the  case  of  almost  all  other  classes  of  property  which 
depreciate  by  wear  and  tear.  Therefore,  wherever  rates  of  de- 
preciation are  mentioned  in  this  chapter,  they  must  be  taken 
as  suggestions  only  and  be  treated  as  rough  approximations 
of  what  may  be  expected  under  normal  conditions. 

A  table  of  depreciation  rates  applicable  to  specific  depre- 
ciable assets,  with  the  names  of  the  authorities  for  the  rates 
given,  may  be  found  at  the  end  of  this  chapter  (page  1123). 

Depreciation  rate  affected  by  "overtime"  or  "overload." — 

When  machinery  is  run  "overtime"  there  is  little  opportunity 
properly  to  repair  and  maintain  the  machines.  Moreover,  a 
two-shift  system  means  divided  responsibility,  and  with  divided 
responsibility  the  machinery  is  sure  to  suffer.  New  workmen 
and  those  on  night  duty  are  often  less  efficient  than  the  regular 
staff  and  there  is  a  consequent  ill  effect  upon  the  machines.^® 
In  spite  of  all  this  some  inspectors  have  been  reluctant  to  al- 
low special  depreciation  when  a  plant  was  being  run  "over- 
time."    Consequently  the  following  is  of  great  interest: 

Ruling.  It  is  recognized  also  that  property,  for  example,  manu- 
facturing machinery,  may  be  subject  to  extraordinary  depreciation 
due  to  being  operated   overtime,  at  an  overload,  or  being  used   for 


For   British   practice,   see  page   1054. 


FOR    DEPRECIATION  io8l 

some  purpose  for  which  it  is  not  adapted.  Under  such  conditions,  a 
taxpayer  may  deduct  in  addition  to  the  amount  measuring  the  depre- 
ciation under  normal  conditions,  a  further  sum  to  provide  for  the 
extraordinary  depreciation.  Jt  does  not  necessarily  follow  that  if  a 
machine  operated  normally  for  8  hours  a  day,  is  operated  for  i6 
hours  a  day,  it  will  depreciate  twice  as  rapidly  as  when  operated 
under  normal  conditions.  The  estimate  of  the  extraordinary  depre- 
ciation should  be  made  by  the  taxpayer  according  to  his  judgment  and 
experience  and  will  be  subject  to  the  approval  of  the  Commissioner. 
(Bulletin  "F,"  page  27.) 

Adjustment  of  rates  used  in  former  years. — The  author 
believes  that  deductions  for  depreciation  claimed  and  allowed 
in  returns  during  the  years  preceding  the  taxable  year  should 
be  reopened  only  under  special  conditions.  Corporations  and 
individuals  subject  to  the  taxes  in  force  during  those  years 
were  on  notice  from  the  government  as  to  the  basis  of  the 
allowable  deductions  and  were  also  on  notice  from  ac- 
countants and  bankers  that  proper  provision  for  depreciation 
^should  be  made.  What  was  done  at  the  time,  while  the 
facts  were  fresh  in  mind,  should  stand  unless  an  explain- 
able mistake  was  made.  Depreciation  rates  should  be  neither 
played  with  nor  juggled.  The  rates  of  an  income  tax 
should  not  (because  they  do  not)  determine  depreciation  rates. 
Unless  the  Commissioner  is  convinced  that  a  meritorious 
case  exists,  he  should  not  permit  amended  returns  to  be  made. 

When,  however,  it  is  discovered  that  depreciation  was  in- 
correctly calculated  to  a  substantial  amount  in  prior  years, 
it  is  not  good  accounting  practice  to  make  the  adjustment  in 
the  taxable  and  subsequent  years.  It  is  not  fair  either  to  the 
government  or  to  the  taxpayer. 

Regulation.  If  it  develops  that  an  error  was  made  in  estimating 
the  useful  life  of  the  property,  the  plan  of  computing  depreciation 
should  be  modified  and  the  balance  of  the  cost  of  the  property,  or  its 
fair  market  value  as  of  March  1,  191 3,  not  already  provided  for 
through  a  depreciation  reserve  or  deducted  from  book  value,  should 
be  spread  over  the  estimated  remaining  life  of  the  property.  Inas- 
much as  under  the  provisions  of  the  income  tax  Acts  in  efifect  prior  to 
the  Revenue  Act  of  1918  deductions  for  obsolescence  of  property  were 
not  allowed  except  as  a  loss  for  the  year  in  which  the  property  was 


io82  DEDUCTIONS 

sold  or  permanently  abandoned,  a  taxpayer  may  for  1918  and  sub- 
sequent years  revise  the  estimate  of  the  useful  life  of  any  property 
so  as  to  allow  for  such  future  (not  past)  obsolescence  as  may  be 
expected  from  experience  to  result  from  the  normal  progress  of  the 
art (Art.   166.) 

Under  the  foregoing  regulation,  obsolescence  which  has 
not  been  absorbed  in  depreciation  charges,  and  which  is  ac- 
knowledged to  have  "accrued"  prior  to  1918,  can  never  be 
deducted.    For  discussion  see  page  1130. 

Excessive  rates — negHgence  not  imputed. — 

Ruling If  understatements  of  taxable  net  income  in  re- 
turns are  due  to  charging  off  depreciation  in  excess  of  an  amount 
deemed  reasonable  by  the  Commissioner,  negligence  or  intent  to 
defraud  will  not  be  imputed  to  the  taxpayer  unless  the  position  taken 
is  so  unreasonable  as  to  indicate  gross  carelessness  or  bad  faith. 
(Bulletin  "F,"  page  27.) 

Special  depreciation  of  excessive  costs. — Ample  provision 
has  been  made  for  special  depreciation  of  plants  and  equipment 
constructed  or  purchased  "for  the  production  of  articles  con- 
tributing to  the  prosecution  of  the  present  war."'°  The 
question  arises  as  to  what  provision,  if  any,  has  been  made 
for  plants  which  cannot  qualify  in  the  war  work  class. 

Commencing  in  191 5,  almost  all  classes  of  materials  ad- 
vanced in  price  until  the  cost  of  erecting  and  equipping  a 
plant  was  perhaps  double  what  it  had  been  before  the  war. 

For  example,  take  a  plant  which  cost  a  million  dollars  to 
build  and  equip  in  1913.  The  plant  is  duplicated  in  1918  at  a 
cost  of  two  millions.  What  rates  of  depreciation  shall  be 
charged  during  1919  on  the  two  plants?  If  the  proper  aver- 
age rate  on  the  old  plant  is  8  per  cent,  is  that  the  proper  rate 
on  the  new  plant?  Is  $160,000  per  annum  for  the  new  plant 
the  equivalent  of  $80,000  for  the  old  plant?  Strictly  speak- 
ing, it  is  equivalent  because  depreciation  rates,  when  accu- 
rate, are  based  on  the  effective  life  of  the  plant,  and  if  re- 
serves at  the  rate  of  8  per  cent  per  annum  will  provide  a  fund 


See  Chapter  XXXII. 


FOR   DEPRECIATION  1083 

sufficient  to  recoup  the  cost  of  the  plant  as  it  wears  out,  no 
higher  rate  is  permitted  under  a  strict  interpretation  of  the 
existing  law. 

There  is,  however,  a  sound  foundation  for  a  claim  to  extra 
depreciation  on  the  part  of  those  who  have  erected  plants 
during  this  period  of  high  prices,  even  when  the  plant  will  not 
become  obsolete  after  the  war.^^  It  can  be  assumed  that  any- 
one who  built  a  plant  under  the  conditions  which  have  existed 
during  the  recent  past  did  so  because  he  counted  upon  being 
able,  through  the  profits  of  this  abnormal  period,  to  write  off 
that  part  of  the  cost  of  the  plant  which  was  clearly  super- 
normal so  that  he  might  be  on  the  same  cost  basis  after  the 
return  of  peace  as  the  proprietors  of  other  plants  built  before 
or  after  the  period  of  very  high  prices. 

The  foregoing  argument  must  not  be  construed  to  support 
increases  in  current  depreciation  rates  where  the  cost  of  the 
property  involved  was  normal  although  recently  purchased,  nor 
in  any  case  where  the  property  was  acquired  prior  to  191 5. 

Depreciation  of  plant  or  equipment  acquired  before  April 
6,  1917. — The  foregoing  comments  refer  in  general  to  all 
classes  of  plant  and  equipment  no  matter  when  purchased. 
The  192 1  law  re-enacts  the  provisions  of  the  1918  law  which 
provide  full  relief  for  losses  on  plant  and  equipment  acquired 
after  April  6,  1917;  but  no  special  relief  for  losses  arising  out 
of  the  subsequent  fall  in  value  of  property  acquired  at  the 
high  prices  which  prevailed  after  1915  and  before  April  6,  1917, 
is  found  in  the  law.  The  Commissioner,  however,  may  hold 
that  a  reasonable  allowance  for  depreciation  as  applied  to 
special  conditions  means  a  higher  allowance  than  under  ordin- 
ary conditions. 

It  is  almost  safe  to  assume  that  all  plants  erected  during 
19 1 6  and  early  in  191 7  were  operated  under  adverse  condi- 


"'  See   Chapter  XXXII.     For  a  discussion  of  the  use  of  replacement 
funds  in  the  case  of  losses  through  war  hazards,  see  Chapter  XV. 


1084  DEDUCTIONS 

tions  and  that  the  actual  depreciation  which  took  place  was 
probably  double  normal  depreciation. 

Depreciation  Rates  and  Practice — Specific  Suggestions 

In  the  pages  which  follow,  information"-  is  given  which  is 
intended  to  serve  as  a  guide  in  deciding  in  what  cases  and  at 
what  rates  depreciation  shall  be  charged.  The  topics,  which 
are  arranged  in  alphabetical  order,  deal  in  some  cases  with 
specific  objects  or  classes  of  objects  and  in  other  cases  with 
types  of  enterprises.  The  list  is  not  intended  to  be  and  ob- 
viously cannot  be  complete.  The  variations  of  the  rates  in 
some  of  the  cases  given  indicate  the  futility  of  trying  to  set 
uniform  rates  applicable  to  given  objects  under  all  conditions. 

The  theory  of  depreciation  is  that  there  should  be  a  return 
of  the  investment  by  the  end  of  the  useful  service  life  of  the 
asset.    The  rate  should  be  fixed  accordingly. 


"  The  general  sources  are,  for  American  practice,  Auditing,  Theory 
and  Practice  (3rd  edition),  by  R.  H.  Montgomery,  pages  621-654;  and  for 
British  practice,  Income  Tax  Practice,  by  Murray  and  Carter. 

Contrary  to  the  practice  in  this  country  the  British  Treasury  arrives 
at  definite  agreements  with  taxpayers  regarding  the  general  rate  of  deprecia- 


FOR    DEPRECIATION 


1085 


tion  which  shall  apply  in  various  industries.  The  following  table  gives  the 
latest  available  list  of  British  "agreed  rates  of  depreciation"  (see  "The 
Taxation  of  Excess  Profits  in  Great  Britain,"  by  Robert  Murray  Haig, 
The  American  Economic  Review,  Supplement,  December,  1920)  : 

Schedule  of  Agreed  Rates  of  Depreciation 


Industry,   &c. 


Per 

cent 


Prime  Cost  or 
Written-down  Value 


Nature  of  Plant 


Electric  Light  Un- 
dertakings 


Written-down  Value      Cables. 

"  "  Plant   and    machinery. 


Flax  Spinning  and 
Linen  Weaving 
(Ireland) 


7 'A 


Written-down  Value 


Machinery  and  plant  (except 
accessory  plant  such  as  pirns, 
pirn  cages,  spools,  belting, 
driving  ropes,  damask  cards, 
designs,  patterns,  models,  fur- 
niture  and   fixtures). 


Flour   Milling 


S  Written-down  Value       Engines,   boilers   and   main   shaft- 

ing. 
7%  "  "  Other  machinery. 


Gas     Undertakings  3 

other  than  those  10 

owned  by  mu- 
nicipal or  other 
public  authorities 


Written-down  Value 


Gasholders. 

Meters,    cookers  and   gas   fires. 


Motor  Omnibuses"^ 

20 

Written-down 

Value 

Motor   omnibuses. 

Paper  Mills 

hA 

"                ' 

• 

Machinery   working  day   only. 
Machinery  working  day  and  night. 

Printing 

7V2 
10 

Written-down 

Value 

Engines,    boilers    and    shafting. 
Printing   and    binding   machines. 
Type. 

Railway  Wagons^ 

s 

Written-down 

Value 

Railway   wagons. 

Shipping^ 

4 
3 

l^rime  Cost. 
Prime  Cost. 

Steamships. 
Sailing  vessels. 

Steel  Manufacturers* 

15 

Written-down 

Value 

Machinery  and  plant  used  in  the 
manufacture  of   steel. 

Timber  Merchants,  5 

Saw  Millers,  and 
Manufacturers  of  7J^ 

Timber  Goods 


Written-down  Value 


Engines,    boilers,    main    shafting. 

General  saw-milling  plant  and 
machinery. 

Traction  engines,  tractors,  motor- 
cars, and   haulage   plant. 


Tramways" 


Written-down  Value 


Permanent  way. 

Cables. 

Cars   and   other   rolling   stock. 

General      pl^t     and      machinery, 

including    standards,     brackets, 

and  work-shop  tools. 


'  The  rate  of  20  per  cent  is  to  be  re-considered  at  the  expiration  of  four  years  com- 
mencing with   1916-17.     This  rate  does  not  apply  to  commercial   motor  vehicles. 

^  The  allowance  applies  to  all  wagons  owned  by  traders.  In  the  case  of  railway  com- 
panies  the   method   adopted    is    to   allow    the    actual   cost    of    renewals    year   by    year. 

'  With  regard  to  ships  purchased  at  secondhand  at  prices  in  excess  of  the  written- 
down  value  at  the  date  of  purchase,  the  following  arrangements  have  recently  been 
made: — -(o)  The  allowance  is  made  on  the  actual  cost  price  of  the  ship  to  the  owner  for 
the  time  being  without  regard  to  the  prime  cost  to  a  previous  owner.  (b)  The  rate 
of  depreciation  allowable  is  calculated  by  reference  to  the  reasonable  expectation  of  the 
life  of  the  ship  at  the  date  of  purchase   from  the   previous  owner. 

*  The  rate  of  15  per  cent  represents  5  per  cent  for  normal  wear  and  tear,  and  10  per 
cent   for  the   additional  wear  and   tear  arising  from   war  conditions. 

*  An  allowance  per  mile  of  track  based  upon  the  estimated  life  of  the  permanent  way. 


lo86  DEDUCTIONS 

Alterations  and  improvements. — In  some  cases  alterations 
are  charged  as  an  expense,  being  regarded  as  in  the  nature  of 
repairs.^^  Tliis  practice  is  not  always  correct.  Many  altera- 
tions are  in  the  nature  of  improvements,  and  improvements 
are  capital  expenditures.  This  is  the  position  taken  by  the 
Treasury  as  is  shown  by  the  following  quotation : 

Regulations.  No  deduction  from  gross  income  may  be  made  for 
any  amounts  paid  out  for  new  buildings  or  for  permanent  improve- 
ments or  betterments  made  to  increase  the  value  of  any  property,  or 
for  any  amounts  expended  in  restoring  property  or  in  making  good 
the  exhaustion  thereof  for  which  an  allowance  for  depreciation  or 
depletion  or  other  allowance  is  or  has  been  made,  ....   (Art.  581.) 

....  (3)  In  any  case  in  which  the  cost  of  capital  assets  is 
being  recovered  through  deductions  for  wear  and  tear,  depletion  or 
obsolescence  any  expenditure  (other  than  ordinary  repairs)  made  to 
restore  the  property  or  prolong  its  useful  life  should  be  added  to 
the  property  account  or  charged  against  the  appropriate  reserve  and 
not  to  current  expenses.     (Art.  24. J 

The  author  reiterates  his  advice  that  liberal  allowances 
should  be  made  for  repairs  and  depreciation,  and  that  no  ex- 
penditures should  be  charged  to  capital  if  there  is  any  doubt 
about  the  items.  Sometimes  so-called  alterations  may  prop- 
erly be  charged  off  as  a  necessary  expense  of  the  business. 
If  so,  some  name  other  than  alterations  should  be  found  for 
the  expense. 

Ruling.  Expenditures  by  a  taxpayer  in  altering  a  building  to 
conform  to  a  street  widening,  which  alteration  does  not  increase  the 
value  of  the  building,  constitute  a  business  expense  for  the  year  in 
which  such  expenditures  are  incurred,  deductible  only  in  the  return  of 
net  income  for  that  year,  and  any  division  of  such  deduction  so  as  to 
spread  the  same  over  the  returns  for  a  period  of  years,  whether  called 
a  depreciation  charge  or  otherwise,  is  unauthorized.  (Bulletin  "F," 
page  8.) 

If  the  expenditures  in  such  cases  are  substantial  or  exceed 


*' Decision.  (Syl.)  "Amounts  expended  by  a  business  corporation 
in  enlarging  or  making  improvements  in  its  office  or  premises,  not  in  the 
nature  of  permanent  improvements  to  the  property,  but  to  facilitate  the 
transaction  of  a  growing  business,  should  properly  be  deducted  as  necessary 
expenses  of  the  business."  {Connecticut  Mutiuil  Life  Insurance  Co.  v. 
Eaton,  218  Fed.  206;  affirmed.  223  Fed.  1022.) 


FOR   DEPRECIATION  1087 

the  income  or  if  the  alterations  make  the  building  unusable 
for  a  considerable  period,  it  is  possible  that  the  cost  should 
be  capitalized.  Any  damages  collected  would  be  an  offset 
against  the  cost. 

Apartment  houses. — See  "Buildings"  (below). 

Automobiles. — Under  ordinary  conditions  the  rate  of  de- 
preciation on  automobiles  should  be  fixed  at  not  less  than  20 
per  cent  per  annum.  This  rate  has  been  adopted  by  the  tax 
commission  of  one  of  the  states.  The  Primer  states  that 
"the  estimated  lifetime  ....  of  automobiles  used  for  busi- 
ness or  farm  purposes  and  farm  tractors"  is  "four  to  five 
years. "^*  A  rate  of  depreciation  based  on  an  estimated  life 
of  three  years  may  not  be  excessive  if  adequate  provision  is 
made  for  residual  value.  In  the  oil  industry  the  Treasury 
allows  33/^  per  cent.^^ 

While  five  years  may  appear  to  be  a  high  estimate  for  the 
life  of  the  average  automobile  it  must  be  remembered  that  the 
nature  of  the  asset  permits  repairs  to  be  made  on  so  extensive 
a  scale  as  to  reduce  materially  the  necessity  of  complete  re- 
newals. Tires  are  frequently  renewed,  motors  are  replaced 
and  in  some  cases  (e.g.,  the  taxicab  companies)  bodies  are 
entirely  rebuilt.  Depreciation,  therefore,  as  distinct  from  re- 
pairs and  renewals,  may  l)e  a  smaller  factor  than  appears  at 
first  glance.  Of  course,  full  allowance  nuist  be  made  for 
"accrued"  wear  and  tear. 

In  some  cases  estimates  of  depreciation  are  based  on 
mileage : 

The  second  illustration,  supplied  by  a  manufacturer  of  metal 
products,  indicates  that  an  estimate  of  depreciation  based  on  expected 
performance  can  become  very  exact.  This  company  calculates  its 
depreciation  on  Ford  cars  used  by  its  salesmen  at  2  cents  a  mile  and 
reports  that  the  last  thirty  cars  sold,  exchanged  or  scrapped  showed 


^*  Income  Tax  Pritner,  1918,  question  99. 

^'Manual  for  the  Oil  and  Cas  Industry  (revised  August,  1921),  page  64. 


io88  DEDUCTIONS 

an  average  depreciation   of    1.9  cents  per  mile   and  that  these  thirty 
cars  were  operated  between  five  and  six  hundred  thousand  miles. ^^ 

Regulation No  such  allowance  may  be  made  in  respect 

of    automobiles   or   other    vehicles    used    chiefly    for    pleasure,  .... 
(Art.    162.) 

Books — business  and  professional. — The  Treasury  rules 
that  the  cost  of  professional  books  is  not  a  business  expense 
but  is  an  investment  of  capital  against  which  depreciation  may 
be  charged.''  Roughly  speaking,  books  in  a  technical  library 
depreciate  at  a  rate  sufficiently  rapid  to  justify  charging  off  the 
total  year's  purchases  in  the  case  of  libraries  which  are  being 
kept  up  to  date.  This  obviates  the  necessity  of  an  annual 
revaluation  of  the  library. 

This  plan  has  been  approved  by  examiners  who  have  satis- 
fied themselves  that  the  deduction  for  new  books  did  not 
exceed  reasonable  depreciation  on  the  entire  library. 

Buildings. — Obviously  no  general  rate  applies  to  build- 
ings, since  methods  of  construction,  materials  used,  purposes, 
etc.,  afifect  the  wear  and  tear  incident  to  use.  In  a  case  re- 
lating to  depreciation  of  apartment  houses,  the  government 
allowed  3  per  cent  (see  below).  Perhaps  this  was  a  fair  rate 
under  laws  which  excluded  the  factors  of  inadequacy,  change 
in  character  of  neighborhood  and  other  items  of  obsolescence. 
Under  the  192 1  law^''  obsolescence  must  be  taken  into  consider- 
ation. Three  per  cent  is  the  rate  frequently  used  by  manu- 
facturers for  slow-burning  brick  structures;  and  2  per  cent 
is  the  minimum  rate  for  concrete,  brick  and  steel  fireproof 
structures.  "Perhaps  23/2  per  cent  is  more  nearly  correct. 
Where  walls  are  subjected  to  unusual  strain  or  vibration,  a 
rate  of  not  less  than  4  per  cent  should  be  used. 

In  a  state  in  which  the  sul^ject  has  been  carefully  studied,  a 


'""Depreciation — Its   Tmitiiicnt   in   Production.  Chamber  of   Commerce 
of  U.  S.,  October  15,  1921. 
""  Bulletin  "F,"  page  11. 
"*  Obsolescence  was  first  allowed  under  the  1918  law;  see  page  1130. 


FOR   DEPRECIATION  1089 

rate  of  2  to  2)4  per  cent  for  cement  or  brick  buildings  and 
3  to  5  per  cent  for  wooden  buildings  has  been  adopted. 

The  National  Machine  Tool  Builders'  Association  uses 
these  rates :  brick  buildings,  3  per  cent ;  frame  buildings,  5  per 
cent. 

The  Treasury  states : 

Ruling.  A  frame  building  may  remain  serviceable  for  a  period 
of  20  to  30  years,  while  a  building  of  steel,  concrete,  and  stone  con- 
struction may  have  a  life  of  50  to  100  years.     (Bulletin  "F,"  page  7.) 

In  the  case  of  an  apartment  house  the  jury  found  that 
3  per  cent  was  a  proper  rate  of  depreciation."^  This  was 
the  rate  allowed  by  the  government,  while  the  plaintiff  claimed 
5  per  cent.  The  apartment  house  is  situated  at  No.  320  West 
84th  Street,  New  York,  a  very  desirable  location.  The  jury 
was,  of  course,  influenced  by  the  charge  of  the  court,  which 
was  in  part  as  follows : 

There  is  no  question  that  the  plaintiff  was  entitled  to  a  deduc- 
tion for  wear  and  tear  of  this  building,  and  the  government  allowed 
him,  I  believe,  3  per  cent — he  claims  5  per  cent — and  the  question 
for  you  to  determine  is  whether  he  is  entitled  to  any  greater  allow- 
ance for  depreciation  over  and  above  what  the  government  allowed 
him,  which   is  3  per  cent. 

The  burden  would  be  upon  him  reasonably  to  satisfy  you  from 
the  evidence  that  he  was  entitled  to  an  allowance  of  an  amount 
greater  than  3  per  cent  in  order  to  obtain  that  allowance  because, 
as  I  say,  he  is  the  plaintiff  asserting  the  claim 

The  allowance  is  for  wear  and  tear  when  it  relates  to  a  building 
....  that  means  the  physical  deterioration  that  a  building  suffers 
during  the  tax  year;  it  does  not  include  the  depreciation  in  value 
due  to  a  loss  in  rental  value,  because  of  modern  buildings  going  up 
with  better  facilities  than  the  old  building  had — that  is  not  the  idea. 

The  Treasury  takes  the  following  general  position  on  the 
question  of  depreciation,  which  api)lies  particularly  to  the  case 
of  buildings : 

Regulation No    modification    of    the    method    should    be 

made  on  account  of  changes  in  the  market  value  of  the  property 
from  time  to  time,  such  as,  on  the  one  hand,  loss  in  rental  value  of 
the  buildings   due  to  deterioration   of   the   neighborhood,   or,   on  the 


Cohen  V.  John  Z.  [.owe,  Jr.,  2,34  Fed.  474  (i()i6). 


1090 


DEDUCTIONS 


other,  appreciation  due  to  increased  demand.  The  conditions  affect- 
ing such  market  values  should  be  taken  into  consideration  only  so 
far  as  they  affect  the  estimated  useful  life  of  the  property.    (Art.  166.) 

The  foregoing  regulation  refers  exclusively  to  deprecia- 
tion. When  change  in  the  character  of  a  neighborhood  or 
other  causes  result  in  an  ascertainable  loss  the  claim  for  de- 
preciation (which  now  includes  ordinary  obsolescence)  should 
be  correspondingly  increased."'" 

Buildings  under  construction. — When  buildings,  par- 
ticularly factories,  are  partly  completed  the  question  arises  as 
to  the  date  from  which  to  compute  depreciation.  In  most 
cases  the  construction  account  is  not  closed  until  the  building 
is  entirely  completed,  even  though  a  considerable  portion  of  it 
may  have  been  in  use  for  some  time.  It  has  been  suggested 
that  the  depreciation  should  be  based  upon  an  average  date, 
except  in  cases  in  which  depreciation  could  not  be  said  to  com- 
mence until  actual  completion. 

The  same  reasoning  would  apply  to  items  other  than 
buildings,  such  as  storage  tanks,  etc.,  which  are  carried  in 
construction  account  until  a  group  of  units  is  completed.  Ac- 
counting practice,  however,  requires  that  all  costs  of  con- 
struction be  capitalized  until  operations  commence;  therefore 
the  allowance  for  depreciation  on  an  uncompleted  plant,  no 
part  of  which  is  in  use,  would  be  debited  and  credited  to  the 
same  account. 

Ruling.  The  term  "useful  life"  as  used  in  article  161,  Regu- 
lations 45,  is  interpreted  to  mean  the  period  of  time  over  which  an 
asset  may  be  used  for  the  purpose  for  which  it  was  acquired.  In  the 
case  of  a  new  building,  this  period  starts  at  the  time  the  building  is 
completed  and  capable  of  being  used.  Buildings  under  construction 
are  not  subject  to  a  depreciation  allowance  for  income  tax  purposes. 
(C.  B.  4,  page  178;  O.  D.  845.) 

The  foregoing  ruling  is  broad  enough  to  include  cases 
in  which  a  building  may  be  partly  occupied  before  being  en- 


'  For  full  discussion  of  obsolescence  of  Iniiklings,  see  page  1140. 


FOR   DEPRECIATION 


1091 


tirely  completed.     In  such  cases  partial  depreciation  should  be 
computed  from  the  date  of  such  partial  occupancy. 

The  following  extracts  from  a  recent  address  by  a  recog- 
nized authority  on  real  estate  and  buildings  emphasize  the 
need  for  special  study  of  each  particular  case.*^ 

The  principal  reason  that  depreciation  was  never  considered  as 
an  important  question  up  to  the  time  that  the  fireproof  building  came 
into  existence  was  a  settled  belief  that  New  York  land  values  would 
always  increase  not  less  than  2%  per  annum  and  many  such  owners 
as  O.  B.  Potter  declared  that  there  would  never  be  a  time  when  well- 
located  New  York  real  estate  would  not  increase  2%  in  value  every 
year.  For  this  reason  they  felt  perfectly  contented  to  let  their  build- 
ings run  down  on  the  theory  that  sooner  or  later  a  better  class  of 
building  would  be  required  and  that  there  was  no  profit  in  making 
substantial  outlays  for  the  maintenance  of  old  buildings. 

When  it  was  found  that  New  York  real  estate  could  depreciate 
in  value  much  faster  than  it  had  appreciated,  the  problem  of  depre- 
ciation began  to  demand  respectful  attention. 

When  we  ask  what  is  the  probable  length  of  life  of  a  modern 
building  it  is  like  asking  an  insurance  examiner  what  is  the  probable 
life  of  a  man.  The  insurance  examiner  replies  "tell  me  the  history 
of  the  man,  of  his  father  and  mother,  of  his  habits,  of  his  occupation 
his  physical  condition,  and  I  will  tell  you,  barring  accidents,  what 
his  probable  life  will  be."  In  considering  the  probable  life  of  a  steel 
structure  or  of  an  ordinary  building,  the  problem  must  be  approached 
in  the  same  way.  Who  built  the  building?  Who  maintains  it?  How 
were  its  foundations  laid?  What  is  its  use?  To  attempt  to  sum  up 
the  problem  of  depreciation  for  any  building  requires  that  we  take 
into  consideration,  first,  the  design  of  the  building  and  of  its  founda- 
tions ;  second,  the  type  as  adapted  to  its  locality  and  purpose ;  third, 
its  construction  and  material ;  fourth,  its  operation  and  maintenance. 

Anyone  who  attempts  to  pass  judgment  without  this  information 
is  merely  guessing  in  the  dark.  As  an  illustration  of  what  I  mean, 
take  the  case  of  a  hotel,  10  stories,  50  x  100,  built  in  the  very  finest 
way  at  a  cost  of  $225,000  by  an  experienced  investor  and  apparently 
good  for  a  life  of  40  years.     It  is  located  at  157  W.  124th  St. 

This  splendid  building  depreciated  so  fast  that  it  had  to  be  de- 
stroyed as  a  hotel  in  seven  years.  Why?  Because  it  was  misplaced 
and  was  a  failure.  It  cost  $50,000  to  convert  it  into  a  storage  ware- 
house and  it  became  a  perfect  building  and  good  for  perhaps  50 
years  for  this  purpose,  provided  it  is  reasonably  maintained.  But 
suppose  it  is  neglected  and  abused,   its  automobile   elevator  allowed 


"  "Depreciation  of  Buildings,"  by  Frank  Lord,  vice-president,  Cross  & 
Brown  Co.,  New  York  City. 


icr)2  DEDUCTIONS 

to  wear  out  and  no  repairs  made  to  keep  it  up  to  a  reasonable  standard 
of  usefulness,  how  much  can  its  natural  life  be  shortened?  The 
building,  —  West  —  Street,  was  worth  $48,000  one  year  ago. 
The  tenant  spent  $9,000  on  it  and  it  is  worth  $72,000  today  or  50% 
appreciation. 

Who  is  to  judge  of  these  conditions  and  what  is  his  judgment 
worth  and  who  will  accept  it?  If  we  say  that  the  life  of  a  hotel 
is  30  years;  of  an  office  building  40  years;  of  a  loft  building  50 
years;  of  an  apartment  house  25  years,  of  a  non-fireproof  structure, 
or  a  mill  construction  35  years,  who  is  to  successfully  contradict 
us  and  on  what  conditions  of  use  or  abuse,  of  care  or  neglect,  of 
bad  management  or  wise  management,  is  all  this  to  be  decided?  In 
my  opinion,  the  plan  of  estimating  2^0;^  on  the  mortgage  is  an- 
other way  of  guessing  on  broad  general  lines  because  in  every  case 
land  value  is  part  of  the  mortgage  and  leaves  haphazard  the  pro- 
portion the  building  represents. 

Look  at  the  beautiful  Blair  Building  at  24  Broad  Street  and 
ask  me  how  much  this  superb  building  in  a  superb  locality  with  a 
generous  upkeep  will  depreciate  and  I  will  reply  that  a  structure 
under  such  ideal  conditions  may  last  for  60  years  not  only  be- 
cause its  design  and  construction  are  ideal,  but  its  owners  are 
ideal.  The  same  may  be  said  of  the  new  Stock  Exchange  and 
the  Bankers  Trust  Building  opposite,  but  when  you  have  named 
20  or  25  buildings  downtown  and  a  dozen  uptown,  headed  by  the 
U.  S.  Rubber  Building,  you  have  exhausted  the  list  of  preferred 
risks  and  there  are  all  sorts  of  grades  and  conditions  to  be  class- 
ified. I  do  not  say  that  they  can  not  be  properly  classified  and  a 
reliable  grading  arrived  at,  for  purposes  of  estimating  probable 
depreciation,  but  as  a  practical  question,  the  labor  and  cost  is  too 
great  and  in  the  end  it  comes  back  to  definite  considerations  to 
be  weighed  for  each  building  as  to  its  birth,  life  and  history 
coupled  with  engineering  knowledge  and  judgment,  and  summed 
up  by  real  estate  experience  and  honest  appraisal. 

In  the  absence  of  this  kind  of  knowledge  and  appraisal,  we 
must  be  content  to  accept  the  method  generally  adopted  of  taking 
3%  for  brick  and  stone  and  4%  for  frame  buildings  as  a  fair 
measure  of  depreciation,  and  where  the  danger  signals  are  flying 
adapt  our  own  judgment  to  each  particular  problem. 

The  most  pronounced  cause  of  loss  in  real  estate  has  been  the 
failure  of  owners  to  set  aside  each  year  3  to  5%  of  their  income  to 
make  extraordinary  repairs  and  to  replace  worn  out  buildings.  When 
they  find  their  income  reduced  to  the  vanishing  point,  they  consult 
their  lawyers  who  in  turn  consult  some  chance  real  estate  broker  who 
advises  a  sale  for  land  value.  The  property  is  sold  to  some  wise 
speculator  who  remodels  it  at  a  third  of  its  original  cost  and  rents 
it  to  such  advantage  that  it  pays  better  than  ever  before,  proving  that 


FOR    DEPRECIATION 


1093 


the  depreciation  that  wiped  out  the  former  owner's  equity  was  the 
depreciation  of  had  management  and  neglect. 

For  fully  20  years  I  have  heen  advising  investors  to  put  5%  of 
their  net  income  into  a  sinking  fund  to  meet  this  prohlem,  and  one 
investor  who  had  adopted  this  practice  told  me  that  one  property  had 
paid  for  itself  out  of  surplus  earnings  above  7%  on  his  invested 
capital. 

If  I  asked  this  gathering  what  Bethlehem  Steel  shapes  were  and 
their  difference  from  fabricated  steel  and  what  effect  they  had  on 
the  cost  and  on  the  life  of  a  building  probably  not  one  quarter  of 
those  present  could  answer.  Yet  nothing  could  be  more  instructive 
than  to  have  one  of  Mr.  Schwab's  young  engineers  spend  an  hour 
with  us  in  describing  the  Bethlehem  process  and  what  it  means  to 
building  construction.  Another  unknown  factor  in  large  buildings 
is  whether  they  are  wind  braced  or  not. 

There  are  many  such  factors  in  the  constitution  of  a  building 
buried  securely  from  sight  which  go  to  the  heart  of  the  matter,  and 
a  life  insurance  examiner  might  as  well  try  to  pass  an  applicant  by 
looking  at  him  and  talking  politics  with  him  as  for  one  of  us  to 
decide  conclusively  what  should  l)e  the  depreciation  of  various  types 
of  structures  from  such  general  knowledge  as  may  be  obtained  with- 
out careful  investigation  of  a  good  builder  and  a  capable  engineer, 
coupled  with  experienced  real  estate  judgment  of  the  probable  fitness 
of  the  building  for  the  future  and  who  its  owner  and  manager  is 
to  be. 

Cash  registers. — The  average  Hfe  of  a  good  cash  register 
is  from  ten  to  twenty  years,  although  some  are  in  use  to-day 
which  were  sold  more  than  twenty  years  ago.  The  reduction 
in  value  during  the  eaily  years  is  heavy,  as  with  typewriters, 
and  machines  are  frequently  exchanged.  This  is  due  to  in- 
adequacy more  than  to  depreciation.  If  an  annual  rate  is 
to  be  constant  over  the  expected  effective  life  of  the  machines, 
it  would  be  unwise  to  fix  it  at  less  than  15  per  cent. 

Chemical  industry. — In  the  chemical  industry  buildings 
depreciate  about  2^  to  3  per  cent.  The  machinery  and  equip- 
ment depreciation  depends  largely  upon  the  nature  of  the 
product  manufactured,  the  average  being  about  15  per  cent. 

Containers. — In  certain  kinds  of  business,  such  as  brew- 
eries,  milk   depots,   spring-water   distribution,   bakeries,   etc.. 


I094 


DEDUCTIONS 


considerable  numbers  of  containers,  such  as  casks,  kegs,  bot- 
tles, cases,  cracker  tins,  etc.,  are  owned,  which  are  used  prin- 
cipally for  convenience  of  transportation  and  are  supposed 
to  be  returned  when  empty.  As  to  these,  no  specific  rate  of 
depreciation  can  be  fixed.  Each  case  must  be  considered  on 
its  merits.  Rates  given  in  the  table  on  page  1 123  are  suggestive 
of  good  practice. 

At  balancing  time  an  accurate  inventory  should  be  taken, 
if  possible,  but  if  not  practicable,  it  will  be  necessary  to  make 
a  calculation  as  to  the  number  required  for  the  normal  opera- 
tion of  the  business.  An  inspection,  of  the  reserve  supply 
will  serve  as  a  check  on  the  book  valuation.  In  many  cases 
concerns  go  on  the  assumption  that  all  such  containers  are  in 
possession  of  someone  who  will  in  due  course  return  them, 
but  experience  proves  that  considerable  numbers  are  lost, 
broken  or  stolen,  and  that  to  carry  these  as  stock  on  hand  is 
inaccurate. 

Contracts. — The  Treasury  now  recognizes  the  position 
which  the  author  has  held  for  several  years,  viz.,  that  any  kind 
of  property,  tangible  or  intangible,  may  be  amortized,  depre- 
ciated or  depleted  either  on  the  basis  of  market  value  at  March 
I,  191 3,  or  upon  cost  since  that  time.  The  regulations  are  quite 
as  liberal  as  could  be  desired." 

If  an  automobile  dealer  secures  a  valuable  contract  from 
a  manufacturer,  and  turns  it  over  to  a  corporation,  the  latter 
may  claim  as  a  deduction  the  cost  of  the  contract  spread  over 
its  life;  but  in  this  case  as  in  all  other  similar  cases  the  cor- 
poration cannot  claim  the  deduction  unless  the  payment  for 
the  contract  was  made  in  good  faith  and  for  proper  considera- 
tion, and  where  there  was  any  community  of  interest  between 
the  dealer  and  the  company,  the  former  would  be  compelled 
to  return  as  taxable  income  the  purchase  price  of  the  contract 
which  the  corporation  claims  to  have  paid  to  him. 


^■Art.    163;  see  page   1097. 


FOR    DEPRECIATION  IO95 

Copyrights. — Copyrights  may  be  charged  off  under  the 
same  procedure  as  patents,  except  that  the  term  is  28  years, 
which  term,  under  certain  circumstances,  may  be  renewed 
for  another  28  years.  As  most  copyrights  diminish  rapidly 
in  value,  depreciation  should  not  be  based  on  their  life.  Reval- 
uation of  each  one  is  the  only  satisfactory  solution.  A  list  of 
copyrights  owned  should  be  compiled.  Inquiry  based  on  this 
list  will  develop  evidence  as  to  the  actual  worth  of  the  asset. 
The  Treasury  is  attempting  to  base  the  depreciation  on  cost 
or  March  i,  191 3,  value  spread  over  the  term  of  the  copy- 
right or  the  life  thereof  remaining  after  date  of  acquirement 
or  March  i,  I9I3.'*"'' 

Ruling It  is  furlher  held  that  depreciation  of  a  patent 

or  copyright  acquired  prior  to  March  i,  1913,  can  be  taken  on  the 
basis  of  the  market  value  as  of  March  i,  1913,  only  when  affirmative 
and  satisfactory  evidence  of  such  value  is  offered  and,  in  the  absence 
of  such  evidence  the  depreciation  allowance  must  be  based  upon  the 
cost 

Held  also,  that  in  view  of  the  foregoing  and  in  accordance  with 
article  167  of  Regulations  45,  the  annual  allowance  for  depreciation 
of  the  copyright  should  be  computed  by  an  apportionment  of  the 
cost  of  the  copyright  over  its  life  since  its  grant,  and  such  cost  must 
be  limited  to  the  author's  actual  capital  outlay  in  securing  the  copy- 
right, including  the  actual  cost  to  the  author  of  produicng  the  book 
covered  by  the  copyright,  but  not  including  any  amount  representing 
the  value  of  the  author's  own  time  and  labor.  (B.  27-21-1721 ;  O.  D. 
966.) 

Costumes — theatrical. — 

Regulation properties  and  costumes  used  exclusively  in 

a  business,  such  as  a  theatrical  business,  may  be  the  subject  of  a 
depreciation  allowance.''*     (Art.  162.) 

If  adapted  for  "occasional"  personal  use,  claim  for  de- 
preciation is  still  allowable,  but  consideration  must  be  given 
to  the  value  of  the  personal  use,  depreciation  in  regard  to 
which  is  not  deductible. 


Art.  167. 
See  page 


1096 


DEDUCTIONS 


Electrotypes,  woodcuts,  etc. — The  arguments  urged  in  case 
of  patterns  (see  page  11 14)  apply  with  equal  force  to  electro- 
types, woodcuts,  etc.  Conservative  publishers  charge  off  al- 
most the  entire  cost  of  plates  as  a  direct  cost  of  a  first  edition 
and  are  careful  to  revalue  the  balance  of  the  account  frequently. 
If  a  book  or  other  publication  is  successful,  the  cost  of  plates, 
etc.,  can  be  readily  absorbed  in  its  cost;  but  if  it  is  not  suc- 
cessful, no  new  orders  can  be  expected  and  it  would  be  folly 
to  carry  the  plates  on  the  balance  sheet  at  any  valuation  ex- 
cept as  scrap  metal.  A  number  of  bankruptcies  have  occurred 
in  the  publishing  business  through  disregard  of  this  principle. 

Formulas. — 

Ruling.  Formulas  are  not  a  character  of  property  subject  to  an- 
nual depreciation  deductions  in  a  taxpayer's  return;  however,  if  after 
acquisition,  a  formula  is  found  to  be  worthless,  its  cost  may  be 
charged  off  in  toto  in  the  taxpayer's  return  for  the  year  in  which  its 
worthlessness  was  discovered.     (C.  B.  3,  page  169;  A.  R.  R.  339.) 

Foundries. — Depreciation  does  not  average  more  than  4 
per  cent  on  foundry  buildings.  Depreciation  on  foundry 
equipment,  with  the  exception  of  flasks,  patterns  and  core 
boxes,  should  average  not  more  than  about  5  per  cent;  while 
on  the  articles  mentipned  the  rate  should  range  from  10  to  20 
per  cent.  A  high  rate  is  necessitated  by  the  fact  that  many 
patterns  become  obsolete  because  they  are  made  in  an  ex- 
perimental way. 

Furniture  and  fixtures. — Furniture  and  fixtures  have  little 
residual  value,  and  conservative  concerns  charge  off  by  far 
the  larger  proportion  of  the  cost.  In  most  establishments 
many  items,  such  as  partitions,  special  shelving,  etc.,  are 
charged  to  the  fixture  account.  When  frequent  alterations 
and  changes  are  made,  most  of  such  expenditure  is  in  the 
nature  of  repairs  and  should  be  charged  off  at  the  time.  If 
charged  to  an  asset  account,  it  should  be  distributed  ratably 
over  a  few  years'  operations. 


FOR   DEPRECIATION 


1097 


If  it  is  important  to  write  off  actual  depreciation  only, 
it  will  be  found  that  15  per  cent  per  annum  represents  a 
fair  average  allowance.  The  tax  commissioner  of  one  of  the 
states  has  adopted  a  standard  rate  of  10  per  cent,  but  in  ex- 
ceptional cases  allows  as  much  as  25  per  cent. 

Usually  in  a  going  business,  assets  are  not  treated  on  the 
basis  of  realization  values,  but  in  the  case  of  furniture  and 
fixtures  so  many  changes  are  made  to  suit  the  convenience 
and  whims  of  executives  and  clerks,  and  offices  are  moved  so 
often  from  one  place  to  another,  that  these  assets  have  a  most 
uncertain  value. 

Leaving  out  of  consideration  the  complex  question  as  to 
what  are  and  what  are  not  landlord's  fixtures,  it  may  be  laid 
down  as  a  general  rule  that  the  minimum  rate  of  depreciation 
upon  machinery  and  fittings  erected  upon  leasehold  property 
should  be  sufficient  to  wipe  off  the  book  value  before  the  ex- 
piration of  the  lease.  In  the  case  of  machinery,  etc.,  which 
will  not  become  landlord's  fixtures,  a  less  rate  may  be  per- 
mitted, but  it  is  imperative  that  in  such  a  case  it  be  clearly 
understood  and  agreed  what  are  to  be  the  landlord's  fixtures 
and  what  are  not. 

Goodwill. — No  claim  for  depreciation,  as  such,  of  goodwill, 
trade-marks  or  trade-brands  should  or  will  be  allowed,  but 
when  goodwill  was  purchased  or  had  a  value  March  i,  1913, 
and  later  declines  in  value  on  account  of  such  causes  as  state 
or  national  prohibition,  depreciation  in  the  nature  of  obsoles- 
cence will  be  allowed. ^^ 

Regulation.  Intangibles,  the  use  of  which  in  the  trade  or  busi- 
ness is  definitely  limited  in  duration,  may  be  the  subject  of  a  deprecia- 
tion allowance.  Examples  are  patents  and  copyrights,  licenses  and 
franchises.''^    Intangibles,  the  use  of  which  in  the  business  of  trade  is 

"  See  page  1144. 

"  [Former  Procedure]  In  the  preliminary  edition  of  Regulations 
45  among  the  examples  of  intangibles  subject  to  depreciation  was 
"limited  leases."  The  item  was  omitted  in  the  April  17,  1919,  edition 
and  in  the  amendment  of  October  7,  1919.  The  omission  of  the  re- 
striction on  an  allowance  for  goodwill,  etc.,  arises  out  of  an  allow- 
able deductions  for  obsolescence  of  goodwill,  etc.     See  page  1132. 


1098 


DEDUCTIONS 


not  so  limited,  will  not  usually  be  a  proper  subject  of  such  an  allowance. 
If,  however,  an  intangible  asset  acquired  through  capital  outlay  is 
known  from  experience  to  be  of  value  in  the  business  for  only  a 
limited  period,  the  length  of  which  can  be  estimated  from  experi- 
ence with  reasonable  certainty,  such  intangible  asset  may  be  the  sub- 
ject of  a  depreciation  allowance,  provided  the  facts  are  fully  shown 
in  the  return  or  prior  thereto  to  the  satisfaction  of  the  Commis- 
sioner.    (Art.  163.) 

The  regulation  fails  to  state  that  the  value  of  the  property 
at  March  i,  191 3,  is  subject  to  depreciation  even  though  the 
asset  was  not  acquired  by  capital  outlay. 

Hat  factories. — The  depreciation  on  hat  factory  buildings 
is  about  2^  per  cent;  on  equipment  from  4^/4  to  10  per  cent; 
while  on  the  molds  used  in  the  business  it  is  the  same  as  on  the 
patterns  in  a  foundry.'*^ 

Horses. — Horses  become  less  valuable  not  only  through 
age  but  also  through  hard  usage.  If  depreciation  is  calculated 
on  an  annual  percentage  basis,  the  allowance  should  usually 
be  from  10  to  25  per  cent  of  the  cost.  The  alternative  method 
of  basing  depreciation  on  periodical  revaluations  is  favored  by 
many  because  it  makes  possible  a  closer  approximation  of 
actual  deterioration.  Certainly,  in  the  case  of  horses,  valua- 
tions can  be  established  more  accurately  than  in  the  case  of 
most  assets.  Fairly  frequent  revaluations  are  therefore  de- 
sirable. 

Intangible  property. — Intangible  property  is  held  to  be 
subject  to  depreciation  and  obsolescence.  (See  discussion 
under  "Leaseholds,"  page  1099  and  "Goodwill,"  page  1097.) 

Land. — The  regulations  deal  with  depreciation  in  the  value 
of  land  as  follows : 

Regulation The  allowance  ....  does  not  apply  .... 

to  land  apart  from  the  improvements  or  physical  development  added 
to  it.^8   ....      (Art.  162.) 

"See  pages   1088  and   1114. 

"See  Chapter  XXXIII,  "Deductions  for  Depletion." 


FOR   DEPRECIATION 


1099 


Generally  speaking,  land  does  not  depreciate.  Declines  in 
values  are  not  allowable  deductions  until  sales  are  made,  ai 
which  time  the  resulting  losses  may  be  deducted  as  losses,  and 
not  as  depreciation.  But  if  it  can  be  shown  that  depreciation, 
as  the  term  is  used  in  the  law,  actually  occurs  in  land  values, 
credit  may  be  claimed,  even  though  the  foregoing  regulation 
would  seem  to  indicate  otherwise.  ^ 

The  law*''  permits  "a  reasonable  allowance  for  the  exhaus- 
tion, wear  and  tear  of  property  used  in  the  trade  or  business." 

It  would  therefore  seem  that  if  land  which  is  used  in  the 
business  of  farming  depreciates  in  value  because  of  its  employ- 
ment, and  not  because  of  fluctuations  from  other  causes,  credit 
may  be  claimed  therefor. 

If  a  farmer  were  to  produce  successive  crops  from  his  land 
without  being  able  to  restore  the  land  to  its  former  fertility 
it  would  be  inequitable  to  compel  him  to  return  for  taxation 
the  value  of  the  crops  produced  and  prohibit  the  taking  of 
credit  for  one  of  the  chief  items  of  cost  of  production — and 
depreciation  in  the  value  of  land  due  to  exhaustion  can  hardly 
be  called  anything  but  an  operating  cost. 

Declines  in  values  due  to  erosion  may  more  properly  be 
dealt  with  as  losses,  but  the  law.  seems  to  have  specifically 
provided  for  depreciation  due  to  exhaustion.  ■ 

Leaseholds. — No  mention  of  leaseholds  is  made  in  the 
1916,  191 7,  1918  or  192 1  income  tax  laws.  Because  of  the  im- 
portance of  this  class  of  assets  the  Treasury  has  issued  com- 
prehensive regulations  dealing  with  its  treatment.  Many  kinds 
of  property  are  operated  under  leases  which  may  be  held  or 
sold  to  others.  A  leasehold  becomes  the  personal  property 
of  the  lessee  or  purchaser.  Its  value  or  cost  is  an  integral 
part  of  his  investment.  The  owner  uses  or  employs  the  prop- 
erty until  its  value  is  exhausted. 

Regulation.  Where  a  leasehold  is  acquired  for  business  purposes 
for  a  specified  sum,  the  purchaser  may  take  as  a  deduction  in  his  re- 


"  Section  214  (a-8). 


Iioo  DEDUCTIONS 

turn  an  aliquot  part  of  such  sum  each  year,  based  on  the  number  of 
years  the  lease  has  to  run (Art.  109.) 

By  reason  of  the  temporary  character  of  a  leasehold  its 
cost  may  be  amortized  during  the  term  of  its  Hfe  from  the 
date  of  purchase  or  from  March  i,  19 13,  so  that  an  equal  por- 
tion of  its  cost  or  of  its  value  on  March  i,  1913,  shall  be 
charged  against  the  operations  of  each  year. 

A  leasehold  is  property.  Section  325  (a)  of  the  192 1  law- 
specifies  leaseholds  as  tangible  property  for  the  purpose  of  the 
excess  profits  tax  law.  Neither  can  it  be  denied  that  a  lease- 
hold loses  its  value  by  the  mere  effluxion  of  time.  Conse- 
quently it  is  not  only  proper  but  necessary  that  its  amortization 
be  recorded  on  the  books  of  its  owner. 

In  a  ruling  of  the  Committee  of  Appeals  and  Review  the 
nature  of  a  lease  is  well  described  : 

Ruling The   facts  appear  to  be  that  this   company  was 

organized  with  a  small  amount  of  capital  stock,  none  of  which  was 
paid  up,  and  later  it  secured  a  lease  to  wharf  property,  no  bonus 
being  paid  for  the  lease.  The  business  of  the  company  is  the  sublet- 
ting of  this  leased  property. 

It  is  clear  that  the  income  of  the  company  is  derived  chiefly  from 
the  possession  of  a  capital  asset  which  is  not  capital  in  name  only, 
but  a  real  tangible  asset,  to  wjit,  its  lease  upon  the  wharf  property. 
....      (C.  B.  3,  page  341;  A.  R.  R.  315.) 

Depreciation  allowed  lessee. — 

Ruling.  Ordinarily  an  allowance  for  depreciation  may  be  taken 
only  on  account  of  property  owned  by  the  taxpayer  and  used  in 
trade  or  business  and  may  not  be  taken  on  account  of  property  of 
which  he  is  merely  the  lessee.  This  will  not  preclude  the  deduction 
each  year  by  the  lessee  of  an  aliquot  part  of  the  cost  or  the  bonus 
paid  for  the  lease.  In  the  case  of  additions,  improvements,  or  bet- 
terments to  the  property  made  at  the  expense  of  the  lessee,  which, 
according  to  the  terms  of  the  lease,  revert  to  the  lessor  at  the  termi- 
nation of  the  lease,  the  lessee  may  apportion  the  cost  of  such  addi- 
tions, etc.,  over  the  life  of  the  lease  and  deduct  an  aliquot  part  thereof 
each  year.  If,  however,  the  life  of  improvements  for  business  pur- 
poses made  at  the  expense  of  a  lessee  is  less  than  the  life  of  the  lease, 
depreciation  may  be  taken  by  the  lessee  instead  of  treating  the  cost 


FOR   DEPRECIATION  IIOI 

as  additional  rent.-''^  Stockliolders  of  a  corporation  are  not  entitled  to 
deduct  in  their  individual  returns  any  amount  on  account  of  depre- 
ciation of  the  property  of  the  corporation  from  which  they  receive 
dividends.     (Bulletin  "F,"  page  32.) 

The  foregoing  covers  only  the  period  subsequent  to  March 
I,  1913.  When  a  lease  executed  prior  thereto  had  an  ascer- 
tainable value  on  that  date  the  value  is  capital  and  may  be 
returned  to  the  lessee  free  from  tax.  This  principle  is  recog- 
nized in  the  following  ruling. 

Value  of  lease  at  March  i,  191 3,  may  be  used  for 
depreciation  purposes. 

Ruling.  The  M  Company  obtained  a  lease  in  189 —  covering  a 
period  of  99  years,  for  which  it  pays  nothing  except  the  stipulated 
annual  rent.  The  question  raised  is  whether  the  company  may  set 
up  the  value  of  said  lease  as  of  March  i,  1913,  and  charge  off  de- 
preciation over  the  remaining  term  of  the  lease. 

In  the  case  of  a  lease  held  by  the  original  lessee,  who  acquired  it 
prior  to  March  i,  1913,  without  any  payment  other  than  a  stipulated 
annual  rent,  the  presumption  is  that  the  lease  had  no  value  as  at 
March  i,  1913.  Under  this  presumption  there  is  no  basis  for  a  de- 
preciation deduction.  This  presumption  can  be  overcome  only  by 
evidence  showing  conclusively  that  the  lease  had  a  value  as  of 
March  i,  1913,  for  depreciation  purposes.  There  is  no  prescribed 
method  by  which  the  value  of  a  lease  as  of  March  i,  1913,  in  excess 
of  its  presumptive  value  as  at  that  date  may  be  established.  The 
burden  is  upon  the  taxpayer  to  establish  the  basis  for  depreciation 
to  the  satisfaction  of  the  bureau.     (C.  B.  3,  page  145 ;  O.  D.  720.) 

In  many  cases  evidence  regarding  the  value  of  a  lease  on 
March  i,  19 13,  can  be  readily  secured. 

When  lessee  must   return   property  unimpaired. — 

Ruling.  The  M  Company  leased  to  the  O  Company  certain 
street  railway  properties. 

By  the  terms  of  the  lease  the  lessee  is  required  to  return  the  leased 
properties  to  the  lessor  at  the  end  of  the  lease  in  the  same  condition 
they  were  in  at  the  date  of  the  lease. 

All  of  the  stock  of  the  lessor  company  is  owned  by  the  lessee  com- 
pany.    Inquiry  is  made   whether   for   Federal   income   tax   purposes. 


'"  For    obsolescence    of    improvements    on    leased    land,    see    Chapter 
XXXII. 


II02  DEDUCTIONS 

the  lessee  company  may  charge  depreciation  of  the  leased  properties 
on  its  books. 

Held,  that  inasmuch  as  tlie  properties  leased  must  be  returned  to 
the  lessor  company  at  the  end  of  the  term  of  the  lease  in  the  same 
order  and  condition  as  they  were  in  at  date  of  lease,  there  will  be 
no  depreciation  of  such  properties  while  in  the  lessee's  possession 
and  therefore  no  deductions  by  the  lessee  for  depreciation  will  be 
allowed.  Amounts  expended  to  keep  the  properties  in  good  condition 
and  repair  are  deductible  as  business  expenses  in  the  returns  of  lessee 
corporation  for  the  years  in  which  such  amounts  are  expended. 
(B.  35-21-1794;  O.  D.  1014.) 

The  foregoing  ruling  is  not  sound.  Assume  that  before 
the  end  of  the  lease  a  large  part  of  the  equipment  is  scrapped 
in  a  single  year  because  it  has  worn  out.  The  lessee  would 
have  to  replace  it.  The  Treasury  would  not  permit  the  replace- 
ment to  be  charged  to  income  as  "repairs."  Although  depre- 
ciation actually  accrues  year  by  year,  the  Treasury  under  the 
ruling  would  deny  the  deduction,  and  neither  the  lessee  nor 
lessor  would  get  the  benefit  clearly  provided  by  the  law.  This 
reasoning  is  based  on  the  fallacious  theory  that  repairs  and 
maintenance  offset  depreciation.^^ 

Machinery  and  equipment. — While  specifically  declaring 
that  "each  taxpayer  must  determine  the  probable  lifetime  of 
his  property  without  regard  to  the  ....  figures  given,"  the 
Primer  makes  the  statement  that  "the  estimated  lifetime  of 
ordinary  machinery  is  ten  years. "'^^ 

So  many  factors  affect  the  length  of  the  life  of  machinery 
that  the  only  satisfactory  solution  is  to  assign  to  each  machine 
its  own  individual  rate  of  depreciation.  What  that  rate  shall 
be  must  be  determined  by  experience  with  similar  machines 
in  similar  circumstances.  These  circumstances  vary  widely. 
Two  machines  exactly  alike  in  the  beginning  may  show  a  con- 
siderable difference  in  length  of  life  and  service  when  installed 
in  different  plants.  An  uneven  or  unstable  foundation  may 
shorten  the  life  of  one  machine.     Cleanliness  and  lubrication, 


"  See  page  1059. 

"'' Income  Tax  Primer,  1918,  question  99. 


FOR    DEPRECIATION 


1 103 


care  and  skill  in  operation  and  continuity  of  service  are  im- 
portant factors.  Climatic  conditions  often  enter  to  compli- 
cate the  problem,  machinery  in  some  sections  of  the  country 
deteriorating  more  rapidly  from  this  cause  than  in  other  sec- 
tions. Again  the  policy  relative  to  repairs  and  maintenance 
affects  aggregate  renewal  costs.  A  high  standard  of  upkeep 
means  lower  depreciation  rates.  Often  a  considerable  part  of 
the  ordinary  wear  and  tear  for  which  depreciation  reserves 
are  created  is  charged  to  operating  expenses  in  the  form  of  re- 
pairs and  maintenance.  Small  parts  of  machines  are  con- 
stantly wearing  out  or  breaking  and  are  being  renewed  as  an 
expense.  Sometimes  nearly  every  part  of  a  machine  is  re- 
newable and  in  such  a  case  it  is  quite  conceivable  that  at  the 
end  of  five  or  six  years  the  machine  may  be  so  largely  renewed 
as  to  be  about  as  good  as  new.  Where  a  condition  of  this  sort 
exists  the  depreciation  rate  should  be  lowered. 

It  is  apparent  that  no  hard-and-fast  rule  can  be  laid  down. 
The  nearest  possible  approach  to  a  general  rule  is  to  state  that 
in  addition  to  charging  all  repairs  and  part  renewals  to  operat- 
ing expense,  from  7^  to  I2}4  per  cent  should  be  written  off 
annually  from  the  original  cost  to  provide  for  normal  de- 
preciation. When  double  shifts  are  made  necessary  the  rate 
is  increased.  In  certain  cases  engineers  have  estimated  that 
the  increase  in  rates  due  to  overtime  and  "diluted  labor"  is 
from  50  to  100  per  cent. 

In  the  case  of  a  heavy  machine  tool  the  life  is  usually  con- 
sidered to  be  from  fifteen  to  twenty  years,  ignoring  the  ques- 
tion of  obsolescence;  yet  the  rate  of  the  National  Machine 
Tool  Builders — which  is  10  per  cent  and  is  for  favorable  con- 
ditions and  applies  to  the  total  original  value  and  not  to  a 
decreasing  value — should  be  given  weight. 

It  is  invariably  desirable  that  a  subsidiary  ledger  be  kept 
containing  details  not  included  in  the  machinery  accounts  of 
the  general  ledger.  Such  detailed  records  not  only  assist  in 
the  calculation  of  rates  of  depreciation  but  they  are  also  of 


1 104 


DEDUCTIONS 


great  value  in  determining  the  amount  to  be  written  off  in  case 
of  a  sale  or  fire^^ 

Mine  equipment. — A  company  mining  bituminous  coal 
claimed  depreciation  on  the  following  basis : 

Mine   equipment    6  2/3% 

Power  houses   and   machinery....  62/3 

Tipples,  inclines  and  screens 62/3 

Saw  mill   62/3 

Tenement  houses   5 

Buildings  and  other  houses 5 

The  inspector  refused  to  allow  the  deduction  because  the  de- 
preciation was  not  entered  on  the  books,  but  on  appeal  to 
Washington  the  rates  were  passed  as  reasonable.  In  this  case, 
the  quantity  of  coal  in  the  ground  was  sufficient  to  warrant 
waiting  off  depreciation  on  an  estimated  life  of  twenty  years. 
The  quantity  of  unmined  coal  must  always  be  taken  into  con- 
sideration. 

Regulations,  (a)  All  expenditures  for  development,  rent,  and 
royalty  in  excess  of  net  receipts  from  minerals  sold  shall  be  charged 
to  capital  account  recoverable  through  depletion,  while  the  mine  is 
in  the  development  stage.  Expenditures  made  in  order  to  maintain 
the  mine  at  its  normal  output  shall  be  deducted  as  an  expense  in  the 
year  in  which  the  expenditure  is  made  or  accrues.  Any  expenditure 
for  extraordinary  development  and  equipment,  such  as  stripping, 
shaft  sinking,  tunneling,  and  other  work  beyond  that  necessary  to 
maintain  the  mine  at  its  normal  production  or  output  should  be 
carried  forward  and  apportioned  and  deducted  as  an  operating  ex- 
pense in  the  years  to  which  it  is  applicable. 

(b)  All  expenditures  for  plant  and  equipment  shall  be  charged 
to  capital  account  recoverable  through  depreciation,  while  the  mine 
is  in  the  development  stage.  Thereafter  the  cost  of  major  items  of 
plant  and  equipment  shall  be  capitalized,  but  the  cost  of  minor  items 
of  equipment  and  plant,  necessary  to  maintain  the  normal  output,  and 
the  cost  of  replacement  may  be  charged  to  current  expense  of  oper- 
ation       (Art.  222.) 

"  In  a  well-known  English  compilation,  the  depreciation  rates  of 
"American-made"  machinery  are  from  ^  of  I  per  cent  to  2  per  cent  higher 
than  on  the  same  class  of  machinery  manufactured  in  England.  No  ex- 
planation is  given.  This  is  of  interest  when  quotations  from  English 
reports  or  decisions  are  used  as  precedents. 


FOR   DEPRECIATION  II05 

(a)  The  Act  provides  that  deductions  for  depreciation  of  im- 
provements "according  to  the  peculiar  conditions  in  each  case"  may 
be  taken  by  a  taxpayer  owning  or  leasing  mining  property.  This 
is  deemed  to  include  exhaustion  and  wear  and  tear  of  the  property 
used  in  mining  of  deposits,  inchiding  a  reasonable  allowance  for 
obsolescence   .... 

(b)  It  shall  be  optional  with  the  taxpayer,  subject  to  the  approval 
of  the  Commissioner,  (i)  whether  the  value  of  the  mining  property 
plus  allowable  capital  additions  but  minus  estimated  salvage  value 
shall  be  recovered  at  a  rate  established  by  current  exhaustion  of 
mineral,  or  (2)  whether  the  value  of  the  mineral  deposit  on  the  basic 
date  plus  allowable  capital  additions  shall  be  recovered  through  de- 
pletion and  the  cost  of  plant  and  equipment. less  the  estimated  salvage 
value  shall  be  recovered  by  reasonable  charges  for  depreciation 
at  the  rate  determined  by  its  physical  life  or  its  economic  life  or, 
according  to  the  peculiar  conditions  of  the  case,  by  a  method  satis- 
factory to  the  Commissioner. 

Estimated  physical  life. — 

(c)  The  estimated  physical  life  of  a  plant  or  unit  thereof  ("includ- 
ing buildings,  machinery,  apparatus,  roads,  railroads  and  other  equip- 
ment and  improvements  whose  principal  use  is  in  connection  with 
the  mining  or  treatment  or  other  necessary  handling  of  mineral 
products)  may  be  defined  as  the  estimated  time  such  plant,  or  unit, 
when  given  proper  care  and  repair,  can  be  continued  in  use  despite 
physical  deterioration,  decay,  wear  and  tear. 

Estimated  economic  life. — 

(d)  The  estimated  economic  life  of  a  plant  or  unit  thereof  is 
the  estimated  time  during  which  the  plant  or  unit  may  be  utilized 
effectively  and  economically  for  its  intended  purposes  and  may  be 
limited  by  the  life  of  the  property  or  of  that  portion  of  the  mineral 
deposits  which  it  serves  but  can  never  exceed  the  physical  life. 

Adjustment  of  depreciation  reserves. — 

(e)  Any  difiference  between  the  salvage  value  of  plant  and  equip- 
ment and  the  depreciated  value  remaining  at  the  termination  of  mining 
operations  shall  be  returned  as  profit  or  loss  in  the  year  in  which 
it  is  realized. 

Salvage  value  of  equipment. — 

(/)  Nothing  in  these  regulations  shall  be  interpreted  as  mean- 
ing that  the  value  of  a  mining  plant  and  equipment  may  be  reduced 
by  depreciation  deductions  to  a  sum  below  the  value  of  the  salvage 
when   the   property   shall   have   become   obsolete   or   shall  have   been 


llo6  DEDUCTIONS 

abandoned  for  the  purpose  of  mining.  In  estimating  the  salvage 
value  of  the  equipment  at  the  end  of  its  estimated  economic  Hfe  due 
consideration  may  be  given  to  its  specialized  character  and  the  cost 
of  dismounting  and  dismantling  and  transporting  it  to  market. 

Land  may  not  be  depreciated. — 

(g)  Nothing  in  these  regulations  shall  be  interpreted  to  permit 
expenditures  charged  to  expense  in  any  taxable  year  or  any  part  of 
the  value  of  land  for  purposes  other  than  mining  to  be  recovered 
through  depletion  or  depreciation.     (Art.  224.) 

Expenditures  which  benefit  the  future. — It  is 
claimed  by  many  competent  mining  engineers  that  good  prac- 
tice in  the  mining  industry  permits  the  charging  to  mainten- 
ance of  expenditures  for  improvements  the  benefits  and  ad- 
vantages of  which  extend  over  a  period  of  years.  Under 
ordinary  accounting  practice  all  expenditures  which  benefit 
the  future  should  be  set  up  as  deferred  assets  and  allocated 
to  the  succeeding  periods  which  realize  the  benefits. 

The  recent  federal  tax  laws  recognize  that  general  principles 
may  be  modified  in  a  trade  or  business.  When  the  modi- 
fications are  accepted  as  controlling  and  as  good  practice  by 
a  majority  of  concerns  in  such  industry,  general  principles 
are  superseded.  The  custom  of  charging  improvements  to 
maintenance  does  not  extend  to  original  development  and  equip- 
ment, but  is  limited  to  expenditures  which  are  made  after  mines 
are  in  operation.  The  theory  is  that  after  operations  have 
begun  practically  all  so-called  improvements  "are  really  noth- 
ing but  expenses  required  to  keep  the  property  from  depreci- 
ating."'* 

Development  costs. — Under  article  223,  a  taxpayer  is 
given  the  option  of  charging  to  expense  or  capitalizing  ex- 
ploration expenditures,  "drilling  of  wells,  building  of  pipe 
lines,  and  development  .  .  .  ."  The  election  once  made  is 
held  to  be  binding  in  subsequent  years. 

Rulings.  A  corporation  which  in  1916  and  1917  exercised  its 
option   and  charged  to  capital   account  such   expenditures  as  wages, 


'J.  R.  Finlay,  The  Cost  of  Mining,  page  65. 


FOR    DEPRECIATION  II07 

fuel,  repairs,  hauling,  etc.,  in  connection  with  the  exploration  of 
property,  drilling  of  wells,  etc.,  may  not  subsequently  amend  its  re- 
turns covering  such  period  so  as  to  transfer  such  items  to  operating 
expenses  to  accord  with  their  treatment  in  its  1918  return.  (C.  B.  4, 
page  199;  O.  D.  796.) 

Held,  that  under  article  223,  Regulations  45,  the  exercise  by  a 
taxpayer  of  his  option  to  charge  cost  of  drilling  wells  to  operations 
precludes  a  revision  of  the  accounts  to  treat  such  items  as  capital 
expenditures.     (C.  B.  4,  page  200;  A.  R.  M.  no.) 

Where  a  parent  company  which  owns  the  stock  of  a 
subsidiary  company  elected  under  article  223,  Regulations  45,  to 
charge  as  operating  expenses,  the  expense  incurred  by  it  during  the 
period  in  which  it  operated  oil  leases,  the  subsidiary  company,  to 
which  the  oil  leases  were  sold,  is  bound  by  the  election  of  the  parent 
organization  and  must  charge  development  and  exploration  expenses 
made  by  it  in  connection  with  such  oil  leases  and  properties  to  oper- 
ating expenses.     (  B.  34-21-1781;  O.  D.  1002.) 

In  permitting"  items,  which  are  ordinarily  regarded  as  capi- 
tal to  be  charged  to  expense,  the  Treasury  recognizes  the  haz- 
ardous character  of  the  oil  industry. 

Depreciation  of  equipment  of  oil  and  gas  wells. — 

'  Regulation.  Both  owners  and  lessees  operating  oil  and/or  gas 
properties  will,  in  addition  to  and  apart  from  the  deduction  allow- 
able for  depletion  or  as  hereinbefore  provided,  be  permitted  to 
deduct  a  reasonable  allowance  for  depreciation  of  physical  prop- 
erty, such  as  machinery,  tools,  equipment,  pipes,  etc.,  so  far  as 
not  in  conflict  with  the  option  exercised  by  the  taxpayer  under 
article  223.  The  amount  deductible  on  this  account  shall  be 
such  an  amount  based  upon  its  cost  (or  fair  market  value  as  of  March 
I,  1913,  if  acquired  prior  to  that  date)  equitably  distributed  over  its 
useful  life  as  will  bring  such  property  to  its  true  salvage  value  when  no 
longer  useful  for  the  purpose  for  which  such  property  was  acquired. 
Accordingly,  where  it  can  be  shown  to  the  satisfaction  of  the  Com- 
missioner that  the  reasonable  expectation  of  the  economic  life  of  the 
oil  or  gas  deposit  with  which  the  property  is  connected  is  shorter  than 
the  normal  useful  life  of  the  physical  property,  the  amount  annually 
deductible  for  depreciation  may  for  such  property  be  based  upon 
the  length  of  life  of  the  deposit (Art.  225.) 

Detailed  classifications  of  both  oil  and  gas  well  equipment 
and  the  rates  of   depreciation   applicable   thereto   have  been 


iio8  DEDUCTIONS 

published  by  the  Treasury.''^  So  far  as  is  known  this  is  the 
only  industry  for  which  the  government  has  officially  sug- 
gested classifications  and  rates. 

The  Treasury  suggests  that  well  equipment  be  depreciated 
at  the  same  rate  as  that  at  which  the  oil  or  gas  reserves  are 
depleted.  The  reason  for  this  method  in  preference  to  a 
straight  line  rate  of  depreciation  such  as  lo  per  cent  a  year, 
is  that  after  a  well  has  produced  for  a  few  years  there  is  prac- 
tically no  salvage  value  to  the  casing  and  tubing.  Casing  and 
tubing  are  the  large  and  small  sizes  of  pipe  which  are  put 
into  a  well  to  protect  the  oil  or  gas  from  physical  encroach- 
ments in  its  passage  from  the  producing  sand  to  the  mouth  of 
the  well. 

If  a  well  has  produced  for  five  years,  under  ordinary  cir- 
cumstances the  casing  and  tubing  would  be  useful  for  sev- 
eral years  more  if  left  in  the  well  and  the  w^ell  continued  to  pro- 
duce. If  the  well  ceases  to  produce  and  the  casing  and  tubing 
are  pulled  out,  they  may  not  be  in  such  a  condition  as  to  war- 
rant the  expense  of  transporting  them  any  distance,  espe- 
cially over  a  rough  country,  and  putting  them  into  another 
well  for  the  remainder  of  their  life.  Furthermore,  the  opera- 
tions of  pulling  out  casing  and  putting  it  down  into  a  well  are 
hazardous  both  as  to  the  expense  which  may  be  involved  and 
the  risk  of  injuring  the  material.  The  recommendation  of 
the  Treasury  to  depreciate  the  well  equipment  at  the  same 
rate  as  the  mineral  contents  are  depleted  is  reasonable. 

There  may  be  circumstances  under  which  this  method  of 
depreciation  will  not  apply.  Some  producers  pull  the  outer 
casing  as  soon  as  a  well  begins  to  produce,  and  use  it  in  pipe 
lines  or  other  wells.  When  the  newly  drilled  well  turns  out 
to  be  a  dry  hole,  that  is,  it  produces  no  oil  or  gas,  probably 
all  the  casing  and  tubing  will  be  pulled.  Equipment  rapidly 
deteriorates  under  these  conditions.  In  these  instances  the 
rate  recommended  by  the  Treasury  will  not  apply,  and  the 


Manual  for  the  Oil  and  Gas  Industry,  1921,  page  63. 


FOR   DEPRECIATION 


I109 


equipment  must  be  depreciated  at  a  high  rate  for  the  period 
during  which  it  has  been  in  the  well. 

Orchards. — See  page  1414. 

Organization  expenses. — Such  expenses  may  not  be  de- 
ducted by  way  of  depreciation.^"  For  comments  on  this  point 
see  page  907. 

Patents. — A  patent  derives  its  value  from  the  fact  that  it 
is  a  monopoly.  The  moment  the  monopoly  ceases  because  of 
the  termination  of  the  patent  term,  the  value  is  wiped  out.  It  is 
true  that  in  many  cases  the  momentum  gained  during  the 
period  of  legal  monopoly  may  give  a  marketing  advantage 
which  is  of  some  value  for  a  considerable  period  after  the  ex- 
piration of  the  term  of  the  patent,  but  this  is  an  asset  closely 
akin  to  goodwill  and  as  such  -is  not  of  a  nature  suited  to  serve 
as  a  basis  for  the  establishment  of  depreciation  reserves.  In 
other  words  a  proportionate  part  of  cost  or  value  March  i, 
1913,  of  a  patent  should  be  charged  off  periodically  so  that 
the  cost  may  be  completely  extinguished  by  the  expiration 
date.  Since  patents  in  this  country  are  issued  for  a  term  of  17 
years,  17  should  constitute  the  maximum  number  of  annual 
instalments. 

Life  more  than  17  years  when  application  was 
PENDING  March  i,  1913. — When  an  application  for  a  patent 
was  pending  March  i,  191 3,  and  the  patent  was  issued  and 
dated  March  i,  19 15,  the  appraised  value  of  the  patent  March 
I,  191 3,  subject  to  depreciation  should  be  spread  ratably  over 
19  years.  The  capital  value  at  March  i,  19 13,  is  the  amount 
to  be  returned  through  depreciation  charges,  and  it  is  obvious 
that  the  property  which  existed  at  that  date  had  a  remaining 
life  of  19  years  and  not  17  years. 

Of  course,  it  by  no  means  follows  that  a  patent  possesses 


'Bulletin   "F,"   page    12.      See  page  907. 


mo  DEDUCTIONS 

value  during-  its  whole  life.  Revaluations  should  be  made  fre- 
quently. They  often  reveal  the  desirability  of  readjusting 
depreciation  rates  and  of  charging  off  sums  as  losses."  It  may 
be  that  the  process  covered  by  the  patent  has  become  obsolete 
or  that  the  article  made  is  not  in  demand  or  is  salable  at  a  price 
too  low  to  justify  its  manufacture.  Again,  if  a  patent  is  pur- 
chased after  part  of  its  term  has  expired,  the  rate  should  be 
based  upon  the  unexpired  term  only. 

A  patent  which  has  been  leased  and  not  purchased  should 
not  be  treated  as  an  asset  except  to  the  extent  of  its  actual 
cost  in  fees,  etc.,  unless  acquired  before  March  i,  19 13.  To 
capitalize  a  patent  lease  purchased  since  March  i,  1913,  at 
any  sum  in  excess  of  cost  would  be  as  incorrect  as  to  capitalize 
goodwill  in  excess  of  cost,  although  one  or  the  other  is  a 
latent  asset  in  every  paying  concern. 

Regulation.  In  computing  a  depreciation  allowance  in  the  case 
of  a  patent  or  copyright,  the  capital  sum  to  be  replaced  is  the  cost 
(not  already  deducted  as  current  expense)  of  the  patent  or  copy- 
right or  its  fair  market  value  as  of  March  i,  1913,  if  acquired  prior 
thereto.  The  allowance  should  be  computed  by  an  apportionment  of 
the  cost  of  the  patent  or  copyright  or  of  its  fair  market  value  as  of 
March  i,  1913,  over  the  life  of  the  patent  or  copyright  since  its 
grant,  or  since  its  acquisition  by  the  taxpayer,  or  since  March  i, 
1913,  as  the  case  may  be.  If  the  patent  or  copyright  was  acquired 
from  the  Government,  its  cost  consists  of  the  various  Government 
fees,  cost  of  drawings,  experimental  models,  attorney's  fees,  etc., 
actually  paid.  If  a  corporation  purchased  a  patent  and  paid  for  it 
in  stock  or  securities,  its  cost  is  the  fair  market  value  of  the  stock 
or  securities  at  the  time  of  the  purchase (Art.   167.) 

In  many  cases  the  market  value  of  securities  indicates  the 
fair  market  value  of  the  assets  purchased  with  such  securities, 
but  in  many  other  cases  the  value  of  the  asset  and  the  value  of 
the  securities  issued  therefor  vary  to  a  considerable  extent. 
The  chief  reason  for  the  variation  is  that  the  securities  issued 
may  be  part  of  a  larger  issue  or  sales  may  be  made  under 
favorable  or  unfavorable  conditions. 

'■  See  page  652.  _  •  ?■       V 


,  FOR   DEPRECIATION  I  ill 

Depreciation  based  on  fair  market  value  at  march 

I,   1913  — 

Regulation Depreciation  of  a  patent  can  be  taken  on 

the  basis  of  the  fair  market  value  as  of  March  i,  1913,^^  only  when 
affirmative  and  satisfactory  evidence  of  such  value  is  offered.  Such 
evidence  should  whenever  practicable  be  submitted  with  the  return. 
....   (Art.  167.) 

"Satisfactory"  evidence  is  a  reasonable  requirement  and 
must  be  met.  The  taxpayer  is  entitled  to  produce  evidence  of 
subsequent  development  and  success  as  bearing  on  the  probable 
value  at  March  i,  191 3.  The  estimates  of  inventors  and 
others  as  to  values,  while  not  conclusive,  are  prima  facie 
evidence  when  it  appears  that  such  estimates  were  made  in 
good  faith. 

The  value  placed  upon  patents  by  competition  is  difficult 
to  ascertain  but  is  sometimes  available.  The  testimony  of 
those  who  have  valued  patents,  bought  and  sold  them  or  par- 
ticipated in  negotiations,  is  admissible. '^° 

Rate  to  be  used  when  patent  becomes  obsolete. — 

Regulation If  the  patent  becomes  obsolete  prior  to  its 

expiration  such  proportion  of  the  amount  on  which  its  depreciation 
may  be  based  as  the  number  of  years  of  its  remaining  life  bears 
to  the  whole  number  of  years  intervening  between  the  date  when 
it  was  acquired  and  the  date  when  it  legally  expires  may  be  deducted, 
if  permission  so  to  do  is  specifically  secured  from  the  Commis- 
sioner. Owing  to  the  difficulty  of  allocating  to  a  particular  year 
the  obsolescence  of  a  patent,  such  permission  will  be  granted  only 
if  affirmative  and  satisfactory  evidence  that  the  obsolescence  oc- 
curred in  the  year  for  which  the  return  is  made  is  submitted  to  the 
Commissioner (Art.  167.) 

When  patent  right  is  extended.- — A  corporation  ac- 
quired patent   rights   for  a  period  of  23.5   months.      Subse- 


°'  [Former  Procedure]  Depreciation  was  permitted  only  on  the 
basis  of  actual  cost  thereof  and  not  on  estimated  value  as  of  March  i, 
1913  (Reg.  2,2),  1918,  Art.  174),  but  for  some  years  the  author  has  con- 
tended that  the  March  i,  1913,  value  was  permitted  by  the  law.  (See 
Income  Tax  Procedure,  1919.  pages  572-573.) 

"^  For  full  discussion  of  value  at  March  i,  i<)i3,  see  page  651. 


1 1 12  DEDUCTIONS  / 

quently  a  new  right  to  extend  for  a  period  of  eight  years  was 
secured.  The  taxpayer  claimed  the  right  to  spread  the  depre- 
ciation over  the  remaining  eight  years,  which  the  Treasury 
denied. 

Ruling.  In  the  determination  of  the  depreciation  allowance 
which  may  be  claimed  in  the  19 17  return  of  the  taxpayer,  two  factors 
must  be  known  and  are  apparent  in  the  record,  to  wit:  the  cost  of 
the  asset,  and  its  life,  as  determined  by  the  period  for  which  the 
right  under  which  the  company  operated  in  1917,  was  to  run. 

These  factors  as  shown  by  the  record  are:  cost  of  asset,  x  dollars; 
and  life  of  asset,  23.5  months. 

It  is  the  opinion  of  the  Committee,  therefore,  that  the  depreciation 
allowance  to  which  the  taxpayer  is  entitled  for  the  calendar  year  1917 
is  an  amount  which  bears  the  same  ratio  to  x  dollars  as  twelve  months 
(the  taxable  year)  bears  to  23.5  months  (the  total  period  or  life  of 
the  asset).     (B.  44-21-1893;  A.  R.  R.  520.) 

Patent  litigation  deductible  as  expense.®" — 

Ruling The    conclusion    of    the    committee    is    that    the 

amounts  expended  by  the  corporation  in  the  instant  case  in  litigation, 
after  the  patent  had  been  secured  by  B  and  had  been  transferred  to 
the  corporation,  constitute  necessary  operating  expenses  and  should 
not  be  capitalized (C.  B.  2,  page  105;  A.  R.  R.  98.) 

When  depreciation  not  taken  in  prior  years. — 

Regulation The   fact  that  depreciation   has  not  been 

taken  in  prior  years  does  not  entitle  the  taxpayer  to  deduct  in  any 
taxable  year  a  greater  amount  for  depreciation  than  would  other- 
wise be  allowable (Art.  167.) 

The  preliminary  edition  of  art.  167,  Reg.  45,  provided 
that  "a  taxpayer  may  elect  not  to  take  a  depreciation  allowance 
but  such  election  if  made  is  final  and  will  control  the  returns 
for  all  subsequent  years."  It  is  a  fair  statement  that  nothing 
is  final  in  income  tax  practice,  even  regulations,  because  the 
sentence  quoted  was  omitted  from  the  April  17,  19 19,  edition 
of  the  regulations. 

Taxpayers  cannot  be  estopped  from  revising  accounting 
procedure  when  it  is  discovered  that  past  procedure  did  not 
properly  reflect  net  income. 


See  Chapter  XXVI. 


FOR   DEPRECIATION  1113 

A  patent  may  be  purchased  for  $100,000.  It  may  have 
ten  years  to  run.  During  the  first  few  years  after  purchase 
development  work  may  be  going  on,  there  may  be  no  gross 
income  or  net  income,  and  it  may  be  decided  that  no  deprecia- 
tion has  taken  place,  consequently  none  is  charged.  After  sev- 
eral years  the  commercial  use  of  the  patent  begins  and  gross  in- 
come is  received.  It  may  then  be  decided  that  depreciation 
should  be  charged.  Surely  it  could  not  be  held  that  any  de- 
preciation in  the  earlier  years  had  taken  place. 

Ruling In  January,  1902,  the  M  Company,  then  a  newly 

organized  corporation,  acquired  ownership  of  eight  patents  issuing 
therefor  to  A,  the  patentee,  goox  dollars  of  stock  of  the  corporation. 
This  amount  was  subsequently  increased  2x  dollars  by  expenses  of 
acquisition.  The  patents  so  acquired,  except  one,  issued  in  1900, 
had  expired  prior  to  January  i,  1917,  but  as  of  March  i,  1913,  all 
but  one  were  in  effect No  depreciation  was  taken  by  the  tax- 
payer on  the  patents  which  were  capitalized,  until  the  year  1917, 
when  1/17  of  the  book  value  was  charged  to  expenses  notwith- 
standing the  fact  that  all  except  one  of  them  had  expired  prior  to 
January  i,  1917 

The  basis  for  deduction  authorized  ....  is  the  return  of  capital 
on  an  asset,  the  use  of  which  in  the  trade  or  business  is  definitely 
limited  in  duration.  The  taxpayer  did  not  elect,  during  the  life  of 
the  patents  acquired  in  1902,  to  provide  for  this  return  of  capital. 
Had  he  made  this  provision  his  surplus  for  invested  capital  pur- 
poses under  the  Revenue  Act  would  have  been  correspondingly  re- 
duced. 

He,  therefore,  can  not  now  claim  in  a  high  taxable  year,  after 
the  expiration  of  the  life  of  the  patents,  an  amount  equivalent  to 
one-seventeenth  of  the  cost,  thereby  securing  the  benefit  not  only 
of  a  reduction  in  his  taxable  income  for  the  year  1917,  but  the  advan- 
tage of  the  investment,  which  in  value  is  subject  only  to  the  definite 

limitations  prescribed  by  the  Act  and  the  regulations (C. 

B.  3,  page  172;  A.  R.  M.  95.) 

It  was  possible,  however,  for  the  corporation  to  revalue 
any  new  patents  acquired  prior  to  March  i,  1913,  and  unex- 
pired on  that  date.  Depreciation  on  such  revaluation  would  be 
allowed. 

It  is  legitimate  and  legal  to  make  changes  in  bookkeeping 
methods  and  take  advantage  of  deductions  under  laws  which 
impose  high  tax  rates,  irrespective  of  the  taxpayers'  former 
methods. 


1 1 14 


DEDUCTIONS 


Life    of    patent    or   trade-mark    in    foreign    coun- 
tries."^— 

Country  Term  of  Patent  Term  of  Trade-Mark 

Great  Britain 16    years.        Extended    from     14    years 

by  act   of   Parliament,    1919 14  years  renewable. 

France 5,   10,  or   15   years  from  filing  of  appli- 
cation   IS  years  renewable. 

Germany 15  years  from  next  day   after  filing.... 10  j'ears  renewable. 

Russia 15   years    i   to  10. 

Canada 18  years    General  unlimited ;  special 

'  25  years  renewable. 

Australia 14   years    14  years  renewable. 

Austria 15   years    10  years  renewable. 

Switzerland 10  years  for  cliemical   process.  20  years  renewable. 

15  years  from  filing. 

Sweden 15  years  from  filing 10  years  renewable. 

Denmark 15   years    10  years  renewable. 

United  States 17   years    20  years  renewable. 


Patterns,  drawings,  models,  designs,  etc. — The  difficulty 
which  the  accountant  encounters  in  the  proper  valuation  of 
such  patterns  as  are  successful  is  to  persuade  proprietors  to 
accept  valuations  which  are  reasonably  conservative.  Where 
patterns  are  used  for  stock  or  regular  output,  their  value  de- 
pends upon  their  life  and  upon  the  probability  of  renewed  use. 
Where  acquired  or  made  for  special  jobs,  the  residual  value 
is  small,  and  the  life  of  the  patterns  should  be  considered  co- 
extensive with  the  life  of  the  jobs  themselves.  In  every  case 
items  such  as  these  should  be  looked  upon  wnth  suspicion,  and 
convincing  proof  must  be  adduced  before  placing  any  material 
sum  on  their  account  as  an  asset.  An  auditor  often  meets 
with  strong  opposition  in  his  efforts  to  reduce  these  items  to 
reasonable  amounts,  for  they  represent  the  skill  and  often 
the  affections  of  the  proprietors,  who  dislike  to  see  their  value 
depreciated  on  the  books.  But  the  public  demand  is  fickle, 
and  patterns  must  be  made  to  suit  the  changing  taste.  Even 
what  appear  to  be  standard  patterns  for  stable  businesses  often 
change  rapidly.  Engineers  make  almost  as  many  alterations 
in  their  "styles"  as  do  milliners.  When  the  demand  ceases 
most  of  the  old  patterns  should  be  scrapped.  This  rule  applies 
to  hardware  designs  as  well  as  to  patterns  for  women's  dresses. 


"Bulletin  45-20-1293;  O.  D.  721. 


FOR   DEPRECIATION 


1115 


An  analysis  of  the  sales,  showing  articles  made  from  spe- 
cific patterns,  is  evidence  that  the  patterns  have  a  life  beyond 
the  year  in  which  their  cost  was  incurred.  Such  an  analysis 
is  particularly  useful  in  those  cases  in  which  repeat  orders 
are  received  sometimes  several  years  after  the  original  sale 
was  made.  Patterns  used  only  rarely  are  often  scrapped  and 
new  ones  made  as  occasion  requires.  In  such  instances  the 
drazving  has  the  value. 

The  charges  against  this  account  are  usually  cumulative, 
i.e.,  they  follow  the  output  almost  automatically,  thus  indicat- 
ing that  most  of  the  old  patterns,  etc.,  are  obsolete  or  have 
been  discarded.  Usually  depreciation  charges  should  equal 
the  annual  expenditures  for  new  patterns,  etc.  Wherever 
feasible,  the  conservative  course  is  to  write  down  the  book 
value  to  $1. 

Earlier  regulations"^  have  required  that  expenditures  for 
successful  patterns,  etc.,  must  be  capitalized  and  specifically 
written  off,  the  charge  being  based  on  their  effective  life. 
The  regulations  under  both  the  19 18  and  1921  laws  give  to 
the  taxpayer  the  option  of  charging  off  such  items  as  expenses 
or  of  capitalizing  them. 

Regulation.  A  taxpayer  who  has  incurred  expenses  in  his 
business  for  designs,  drawings,  patterns,  models,  or  work  of  an  ex- 
perimental nature  calculated  to  result  in  improvement  of  his  facili- 
ties or  his  product,  may  at  his  option  deduct  such  expenses  from 
gross  income  for  the  taxable  year  in  which  they  are  incurred  or 
treat  such  articles  as  a  capital  asset  to  the  extent  of  the  amount  so 
expended.  In  the  latter  case,  if  the  period  of  usefulness  of  any  such 
asset  may  be  estimated  from  experience  with  reasonable  accuracy,  it 
may  be  the  subject  of  depreciation  allowances  spread  over  such  esti- 
mated period  of  usefulness.  The  facts  must  be  fully  shown  in  the 
return  or  prior  thereto  to  the  satisfaction  of  the  Commissioner.  Ex- 
cept for  such  depreciation  allowances  no  deduction  shall  be  made  by 
the  taxpayer  against  any  sum  so  set  up  as  an  asset  except  on  the  sale 
or  other  disposition  of  such  assets  at  a  loss  or  on  proof  of  a  total  loss 
thereof.     (Art.  168.) 

Ruling.  The  cost  of  tracings,  patterns,  and  flasks  necessary  in 
the  business  of  a  corporation   was  charged  to  expense   from    1909 


'■■Reg.  33,  1918,  Arts.  175-177- 


Iii6  DEDUCTIONS 

to  1912,  no  new  equipment  of  that  nature  having  been  acquired  sub- 
sequently. In  order  to  restore  the  value  of  such  equipment  to  capital 
account  for  the  purpose  of  computing  depreciation  deductions,  the 
corporation  had  an  appraisal  made  in  1920,  of  the  value  as  of  March 
I,  1913,  of  such  equipment  still  in  existence  and  use,  based  on  the 
cost  of  reproduction  of  the  equipment  as  of  March  i,  19 13,  such  cost 
less  depreciation  from  original  acquisition  being  treated  as  the 
value  as  of  March  i,  1913.  In  the  absence  of  other  evidence  of 
value,  the  Committee  approves  this  method  of  valuation  and  recom- 
mends its  acceptance,  provided  proper  adjustment  of  the  erroneous 
charges  to  expense  from  1909  to  1912,  be  made  in  amended  returns 
for  those  years.     (C.  B.  3,  page  173;  A.  R.  R.  2^2.) 

Printing. — The  depreciation  of  printing  plants  is  about 
the  same  as  that  in  the  textile  industry  (see  page  1 1 19)  with  the 
exception  of  type,  printers'  tools,  electrotypes,  plates,  etc.,  on 
which  from  10  to  25  per  cent  should  be  applied  annually. 
Some  authorities  recommend  a  rate  as  high  as  25  per  cent  on 
type  and  electroplates. 

Professions— physician's  claims  for  depreciation. — In  New 
York  a  physician  made  the  following  claims  for  depreciation 
which  were  allowed : 

Residence,  brick  construction,  on  part  occupied  as  offices 

only    5% 

Automobile    20 

Books    20 

Instruments   25 

Office  furniture 20 

Country  residence,  wood  construction,  on  part  occupied 

as  offices  only 10 

Radium — no  depreciation  allowed. — 

Ruling.  Since  the  full  life  of  radium  has  been  scientifically 
estimated  at  such  an  extended  period  and  since  no  appreciable  de- 
preciation results  from  its  continued  use  as  a  therapeutic  agent,  the 
depreciation  occurring  during  the  lifetime  of  any  individual  owner  is 
practically  negligible.  It  is  held,  therefore,  that  radium  which  is  used 
as  a  therapeutic  agent  is  not  subject  to  depreciation  for  income  tax 
purposes  and  its  cost  must  be  treated  as  a  capital  expenditure.  The 
return  of  capital  will  be  realized  upon  its  sale  or  other  disposition. 
(C.  B.  4,  page  178;  O.  D.  837.) 


FOR    DEPRECIATION  III7 

Railroad  sidings. — 

Ruling.  A  railroad  company  constructed  a  siding  to  connect 
the  property  of  the  ,M  Company  with  its  raih'oad.  A  part  of  tlic 
siding  on  land  of  the  M  Company  is  owned  by  the  M  Company.  The 
cost  was  borne  by  the  M  Company  and  is  recoverable  through  de- 
preciation allowances. 

A  part  of  the  siding  on  land  of  the  railroad  company  is  owned  by 
the  railroad  company.  The  cost  was  borne  by  the  M  Company  and 
is  a  business  expense  deductible  for  the  year  in  which  it  was  incurred. 
(Also  sec.  214  (a)   i,  art.  loi.)      (B.  Digest  36-21-1800:  O.  D.  1019.) 

Shipping  industry. — Prior  to  1920  satisfactory  Ameri- 
can rates  applicable  to  this  industry  weVe  not  available.  The 
rates  claimed  by  ship-owners  were   far  from  uniform."^ 

Bulk  freight  steamships — Great  Lakes. — 

Ruling.  Three  per  cent  is  held  to  be  a  reasonable  allowance 
for  depreciation  of  bulk  freight  steamships  on  the  Great  Lakes; 
however,  when  due  to  peculiar  conditions,  it  can  be  definitely  deter- 
mined that  the  established  rate  of  depreciation  will  not  be  sufficient 
to  return  all  of  the  capital  invested,  as  at  the  date  of  acquisition 
or  March  i,  1913,  whichever  is  later,  by  the  time  the  vessel  will 
be  rendered  useless,  an  addition  to  the  regular  rate  to  cover  obso- 
lescence, may  be  allowed.  The  amount  of  this  addition  must  be 
determined  upon  the  basis  of  the  facts  in  each  particular  case;  that 
is,  the  type  of  the  vessel  ift  question,  the  fitness  for  possible  use  in 
other  lines  of  transportation  and  the  date  when  it  can  be  definitely 
foreseen  that  she  will  be  no  longer  commercially  useful  in  this  par- 
ticular line  of  traffic. 

This  rule  does  not  necessarily  apply  to  steamers  engaged  in  other 
lines  of  traffic,  for  the  reason  that  there  are  distinct  differences  in 
the  method  of  construction  and  the  matter  of  operation  of  package 
freighters  and  passenger  steamers  and  the  bulk  freighters  under 
consideration.     (C.  B.  2,  page  139;  .\.  R.  R.  27.) 

With  reference  to  increasing  the  rate  on  account  of  ac- 
cruing obsolescence,  the  Treasury  in  the  detailed  ruling  held : 

....  obsolescence  should  be  limited  to  those  cases  where  it  can 
be  shown  that  a  type  of  vessel  has  been  developed  so  much  more 
economical  than  existing  types,  that  no  other  than  the  new  type  will 
be  built  in  future,  and  that  a  sufficient  number  of  the  new  type  to 
meet  traffic  requirements  will   in   all   reasonable  probability  be  built 


For  British  rates  see  Income  Tax  Procedure,   1920,  pages  733-735. 


Iii8  DEDUCTIONS 

within  a  certain  definite  period,  thereby  forcing  the  older  type  out  of 
useful  existence. 

Some  of  the  United  States  Shipping  Board  vessels  were 
operated  under  charters  which  gave  the  charterers  the  option  to 
purchase  the  vessels.  The  initial  cost  of  re-conditioning,  which 
was  borne  Iw  the  charterers,  was  applied  on  the  purchase  price, 
less  depreciation  at  the  rate  of  7^  per  cent  per  annum. 

SlIIP-S    REQUISITIONED    BY    SHIPPING    BoARD. 

Ruling.  Ships  in  process  of  construction  under  contract  were 
requisitioned  by  the  Shipping  Board,  completed,  and  then  recon- 
veyed  to  the  company  from  which  they  were  requisitioned  for  an 
amount  in  excess  of  the  contract  price  of  the  ships.  Held,  that  the 
entire  cost  of  the  ships  is  a  capital  expenditure  recoverable  by  al- 
lowances for  depreciation,  obsolescence,  and  amortization  to  the  ex- 
tent allowable  under  the  Revenue  Act  of  1918  and  Regulations  45, 
and  that  the  excess  of  the  cost  over  the  contract  price  is  not  de- 
ductible as  a  loss  or  a  business  expense.  (C.  B.  4,  page  179; 
O.  D.  851.) 

Ste.\m  .schooners. — Depreciation  of  steam  schooners 
engaged  in  the  coastwise  lumber  trade  was  fixed  at  5  per 
cent.*'* 

Soap  industry. — Depreciation  in  this  industry  is  about  the 
same  as  in  chemical  factories.*'^ 

Textile  industry. — In  the  textile  industry  the  depreciation 
of  buildings  is  somewhat  heavy  owing  to  the  vibration  of  the 
machines.  The  rate  assigned  to  the  machinery  is  often  made 
high  because  of  the  likelihood  of  obsolescence  and  the  introduc- 
tion of  new  appliances.  The  average  depreciation  provides 
for  about  3  per  cent  on  the  building,  if  of  fireproof  brick  con- 
struction, and  6  per  cent  on  the  machinery. 

There  is  a. wide  variance  in  practice  as  to  the  depreciation 
of  textile  machinery.  In  some  districts  where  machines,  per- 
haps fifty  years  old,  are  giving  good  service  today,  the  disposi- 


Bulletin  42-20-1245 ;  A.  R.  R.  279. 
''  See  page  1093. 


FOR   DEPRECIATION 


1 1 19 


tion  is  toward  low  rates.  In  this  industry  the  continual  re- 
newal of  many  different  parts  of  a  loom  serves  to  reduce  the 
depreciation  rate.  Experience  proves,  however,  that  some  of 
these  old  machines  are  "pets,"  while  more  modern  machines 
which  have  been  worn  out  and  replaced  several  times  in  the 
same  period  are  forgotten.  A  writer  in  the  Textile  World 
Record  suggested  3^  per  cent  as  a  rate  for  cotton  and  woolen 
machinery,  including  spinning  and  weaving  machinery.  A 
large  Boston  firm  of  textile  mill  engineers  uses  these  rates : 

Woolen  and  worsted  machinery 2-23/^% 

^  Cotton    machinery 3 

Dyeing    and    similar    machinery    subjected    to     acid 
fumes,    etc 5 

Timber  industry.'"' — Specific  provision  is  made  in  the  reg- 
ulations regarding  depreciation  of  property  used  in  a  timber 
project  when  the  probable  life  of  the  asset  exceeds  that  of  the 
project  itself.  The  same  rules  as  apply  in  the  case  of  mining, 
oil  and  gas  projects  apply  here,  viz.,  that  the  life  of  the 
project  shall  be  considered  a  limiting  factor,  due  allowance 
being  made  for  salvage  value. 

Ruling.  A  lumber  company  contracts  to  cut  and  saw  the  timber 
on  a  certain  tract  of  land,  the  estimated  time  required  being  two 
years.  It  erects  buildings  and  installs  equipment  which  by  reason 
of  prohibitive  cost  of  removal  will  be  worth  only  the  salvage  value 
upon  completion  of  the  contract.  The  cost  of  the  property  and 
equipment  may  be  charged  off  and  deducted  as  depreciation  allow- 
ances on  the  basis  of  the  time  required  to  complete  the  contract,  or 
in  the  proportion  that  the  amount  of  timber  cut  and  sawed  each 
year  bears  to  the  total  amount  of  timber  available.  (Bulletin  "F," 
pages  31,  32.) 

Depreciation   of  timber  .  plants,   improvements  and 

equipment. 

Regulations.  In  the  case  of  a  timber  property  held  for  future 
operation  by  an  owner  having  no  substantial  income  from  the  property 
or  from  other  sources,  all  expenditures  for  administration,  protec- 
tion,  and  other   carrying  charges   prior  to   production   on  a  normal 


"For    regulations   rtlating   to   depletion    of   tinilicr   lands,    see   Chapter 
XXXIII. 


II20  DEDUCTIONS 

basis  shall  be  charged  to  capital  account;  after  such  a  property  is 
on  a  normal  production  basis  such  expenditures  shall  be  treated  as 
current  operating  expenses.  In  case  a  taxpayer,  who  has  a  substantial 
income  from  other  sources,  owns  a  timber  property  which  is  not 
yet  on  a  normal  production  basis,  he  may,  at  his  option,  charge  such 
expenditures  with  respect  to  such  timber  property  to  capital,  or  treat 
them  as  current  operating  expenses,  but  whichever  system  is  adopted 
must  be  followed  until  permission  to  change  to  the  other  system  is 
secured  from  the  Commissioner.  In  the  case  of  timber  operations 
all  expenditures  prior  to  production  for  plants,  improvements,  and 
equipment,  and  thereafter  all  major  items  of  plant  and  equipment 
shall  be  charged  to  capital  account  for  purposes  of  depreciation. 
After  a  timber  operation  has  been  developed  and  equipped  and  has 
reached  its  normal  output  capacity,  the  cost  of  additional  minor 
items  of  equipment  and  the  cost  of  replacement  of  minor  items 
of  worn-out  and  discarded  plant  and  equipment  may  be  charged 
to  current  operating  expenses,  ....  unless  the  taxpayer  elects  to 
write  off  such  expenditures  through  charges  for  depreciation;  how- 
ever, the  method  adopted  must  be  followed  consistently  from  year  to 
year.     (Art.  231.) 

The  cost  or  value  as  of  March  1,  1913,  as  the  case  may  be,  of 
development  not  represented  by  physical  property  having  an  inven- 
tory value,  and  such  cost  or  value  of  all  physical  property  which 
has  not  been  deducted  and  allowed  as  expense  in  the  returns  of  the 
taxpayer,  shall  be  recoverable  through  depreciation.  It  shall  be 
optional  with  the  taxpayer,  subject  to  the  approval  of  the  Commis- 
sioner, (o)  whether  the  cost  or  value,  as  the  case  may  be,  of  the 
property  subject  to  depreciation  shall  be  recovered  at  a  rate  estab- 
lished by  current  exhaustion  of  stumpage,  or  (b)  whether  the  cost 
or  value  shall  be  recovered  by  appropriate  charges  for  depreciation 
calculated  by  the  usual  rules  for  depreciation  or  according  to  the 
peculiar  conditions  of  the  taxpayer's  case  by  a  method  satisfactory 
to  the  Commissioner.  In  no  case  may  charges  for  depreciation  be 
based  on  a  rate  which  will  extinguish  the  cost  or  value  of  the  prop- 
erty prior  to  the  termination  of  its  useful  life.  Nothing  in  these 
regulations  shall  be  interpreted  to  mean  that  the  value  of  a  timber 
plant  and  equipment,  so  far  as  it  is  represented  by  physical  property 
having  an  inventory  value,  may  be  reduced  by  depreciation  deduc- 
tions to  a  sum  below  the  value  of  the  salvage  when  the  plant  and 
equipment  shall  have  become  obsolete  or  worn  out  or  shall  have 
been  abandoned,  or  that  any  part  of  the  value  of  cut-over  land 
may   be    recoverable    through    depreciation.     (Art.    232.) 

In  the  computation  of  depreciation  it  is  recognized  that 
"the  reasonable  expectation  of  the  economic  Hfe"  may  increase 


FOR    DEPRECIATION  I12i 

the  amount  of  depreciation.     This  principle  also  applies  to 
depletion  charges. '^' 

Tools,  jigs,  dies,  etc. — As  a  rule  the  practice  of  depreciat- 
ing small  tools  by  means  of  a  percentage  cannot  be  followed 
satisfactorily.  So  many  such  tools  are  used  up,  lost  or  stolen, 
that  an  inventory  should  be  made  periodically  and  all  the  tools 
on  hand  should  then  be  revalued.  If  this  plan  is  followed  for 
several  years  and  a  trustworthy  rate  of  depreciation  is  secured, 
it  may  be  feasible  to  omit  the  revaluation  for  a  year  or  two,  ap- 
plying the  rate  previously  ascertained.  The  tax  commissioner 
of  one  of  the  states  has  adopted  rates  varying  from  25  to  50 
per  cent  or,  as  an  alternative,  the  entire  cost  of  replacements. 

In  many  manufacturing  concerns  the  item  of  tools,  jigs, 
dies,  etc.,  not  standard  equipment,  is  a  large  one  and  the 
tendency  is  to  overvalue  it.  Heavy  depreciation  should  be  ap- 
plied, because  most  of  such  equipment  is  made  or  adapted  for 
special  uses,  and  the  inevitable  changes  in  types  and  styles  of 
production  require  corresponding  changes  in  the  tools.  As 
stated  heretofore  under  "Patterns,  drawings,  models,  designs, 
etc.,"  (page  11 14),  the  book  value  shall  be  written  down  very 
rapidly.  The  minimum  rate  should  not  be  less  than  20  per 
cent. 

Edward  N.  Hurley,  former  chairman  of  the  Federal  Trade 
Commission,  urges  that  special  tools  be  charged  off  practically 
at  once,  and  states  that  the  neglect  to  depreciate  this  account 
rapidly  enough  has  been  responsible  for  many  failures. 

Typewriters. — In  the  average  ofihce,  the  life  of  a  good  type- 
writer, if  properly  cared  for,  is  from  three  to  five  years. 
In  some  offices  the  machines  are  turned  in  and  new  ones 
purchased  every  two  or  three  years.  Such  typewriters  are 
repaired  and  resold  and  are  used  several  years  more  by  those 
who  buy  them  second-hand.     Repairs  are  not  profitable  after 

"^  Sec  page  1231. 


1 122  DEDUCTIONS 

the  inachiiies  have  been  used   from  six  to  eight  years.     An 
annual  depreciation  rate  of  20  per  cent  is  conservative. 

Uniforms — naval  and  military. — Under  the  provisions  of 
article  291  of  Regulations  62,*^^  the  cost  of  an  officer's  uniform 
is  not  deductible  from  income,  as  it  is  deemed  to  take  the  place 
of  clothing  required  in  civilian  life.  It  has  now  been  decided 
that  for  the  same  reason  depreciation  cannot  be  claimed  on 
uniforms. 

Ruling.  A  deduction  may  not  be  claimed  to  cover  depreciation 
in  the  value  of  uniforms  by  an  officer  of  the  Navy.  (B.  Digest  32- 
21-1761 ;  A.  R.  R.  594.) 

A  taxpayer  claimed  the  same  allowance  as  is  granted  in 
the  case  of  theatrical  costumes,*^^  on  the  ground  that  uniforms 
should  be  classed  as  business  assets.  The  Committee  on  Ap- 
peals and  Reviews  held,  however,  that  since  they  may  be  worn 
on  other  than  official  occasions,  such  as  weddings,  receptions, 
etc.,  they  are  not  used  exclusively  for  "business  purposes." 

Wagons,  trucks,  etc. — In  the  case  of  wagons  it  will  be 
found  that  8  to  10  per  cent  per  annum  is  an  ample  allowance, 
provided  that  all  repairs,  renewals  of  parts  and  maintenance 
are' charged  to  operating  expenses. 

Wood-working  industry. — On  buildings  and  equipment  in 
the  wood-working  industry  the  depreciation  is  low — about  2 
or  3  per  cent  on  buildings  and  6  per  cent  on  equipment. 


See  page  867. 

See  Art.   162,  qvioted  on  page  1056. 


FOR   DEPRECIATION 


1 123 


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1124 


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FOR   DEPRECIATION 


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H     H 


CHAPTER  XXXII 

DEDUCTIONS    FOR   EXTRAORDINARY 
OBSOLESCENCE  AND  AMORTIZATION 

The  1921  law  re-enacts  the  provisions  of  the  1918  law  with 
respect  to  deductions  for  obsolescence  and  amortization,  with 
certain  changes  imposing  a  limitation  on  the  filing  of  amortiza- 
tion claims  after  192 1,  and  fixing  a  definite  date,  March  3, 
1924,  before  which  amortization  allowances  must  be  deter- 
mined/ 

Ordinary  obsolescence  is  usually  merged  with  depreciation 
and  is  discussed  in  the  preceding  chapter.  In  this  chapter 
extraordinary  obsolescence  and  amortization  will  be  consid- 
ered. 

Obsolescence 

Law.  Section  214.  (a)  That  in  computing  net  income  there 
shall  be  allowed  as  deductions:     .... 

(8)   A    reasonable   allowance    for    ....  obsolescence;^ 

The  Treasury  prior  to  19 18  allowed  as  deductions  realized 
obsolescence.  As  such  deductions  could  have  been  made  as 
losses,  whether  or  not  obsolescence  as  such  was  specified  in 
the  law,  the  reason  for  the  specific  mention  of  obsolescence 
in  the  1918  law  was  to  permit  the  accrual  of  obsolescence 
"so  as  to  allow  for  such  future  obsolescence  as  may  be  ex- 
pected from  experience  to  result  from  the  normal  progress 
of  the  art.'" 

Under  the  most  recent  rulings  so-called  "ordinary  obso- 
lescence," viz.,  that  obsolescence  which  is  accruing  but  which 


'  See  page  1150. 

-  This   section   deals    with    individuals.      .Section    234    (a-7)    applies    the 
same  language  to  corporations. 
'Art.  166. 

1 130 


FOR    OBSOLESCENCE   AND   AMORTIZATION  1131 

cannot  be  definitely  ascertained,  is  to  be  included  in  the  annual 
depreciation  allowances  rather  than  in  a  specific  reserve  for 
obsolescence. 

Federal  income  tax  laws  prior  to  1918  contained  no  ref- 
erence to  obsolescence  and  amortization  but  conditions  in 
1918  required  that  explicit  authority  should  be  given  to  the 
Treasury  to  grant,  and  to  taxpayers  to  deduct,  adequate  al- 
lowances for  losses  which  might  not  otherwise  be  permitted. 

The  sudden  end  of  the  World  War  in  191 8  is  responsible 
for  many  problems  which  have  not  yet  been  solved.  All  tax- 
payers who  increased  their  plant  facilities  prior  to  November, 
1918,  whether  or  not  for  strictly  war  purposes,  must  make  an 
early  decision  regarding  the  effect  of  post-war  conditions. 

Facilities  of  any  kind  "for  the  production  of  articles  con- 
tributing to  the  prosecution  of  the  present  war"  if  acquired 
or  constructed  after  April  6,  191 7,  are  the  subject  of  a  special 
deduction,  but  taxpayers  whose  facilities  do  not  come  within 
the  technical  meaning  of  section  234  (a-8)  nevertheless  are 
entitled  [under  section  234  (a-7)]  to  "a  reasonable  allowance 
for  the  exhaustion,  wear  and  tear  of  property  used  in  the  trade 
or  business,  including  a  reasonable  allowance  for  obsolescence." 

The  author  believes  that  sufficient  consideration  has  not 
been  given  to  the  extraordinary  cost  of  facilities  acquired  after 
1915,  the  extraordinary  wear  and  tear  of  all  facilities  during 
191 7  and  1918.  and  the  extraordinary  diminution  in  value  of 
such  facilities  as  compared  with  post-war  conditions.  When 
claims  for  amortization  allowances  under  section  234  (a-8) 
are  rejected  on  technicalities,  it  may  be  found  that  equivalent 
deductions  may  be  made  under  section  234   (a-7). 

Regulation.  A  reasonable  allowance  for  the  exhaustion,  wear 
and  tear  and  obsolescence  of  property  used  in  the  trade  or  business 
may  be  deducted  from  gross  income.  For  convenience  such  an  allow- 
ance will  usually  be  referred  to  as  depreciation,  excluding  from  the 
term  any  idea  of  a  mere  reduction  in  market  value  not  resulting 
from  exhaustion,  wear  and  tear,  or  obsolescence (Art.  161.) 


1 132 


DEDUCTIONS 


Obsolescence  as  described  above  has  been  discussed  in 
the  preceding  chapter.  Obsolescence  which  may  be  said  to 
be  "realized"  is  considered  in  the  following  pages. 

The  foregoing  regulation  accords  with  proper  account- 
ing methods.  Depreciation  allowances  set  up  by  conservative 
concerns  were  always  supposed  to  be  sufficient  to  include  ade- 
quate provision  for  ordinary  obsolescence.  It  follows  that 
in  fact  deductions  were  made  for  obsolescence.  The  law 
now  definitely  sanctions  the  deductions  which  taxpayers  have 
been  making  and  the  Treasury  has  been  allowing  for  some 
years. 

Treasury  Procedure  as  to  Obsolescence 

Under  previous  laws  the  Treasury  allowed  as  deduc- 
tions reserves  for  depreciation,  but  did  not  allow  reserves 
specifically  for  obsolescence. 

Reserves  for  obsolescence  which  appeared  on  taxpayers' 
books  at  the  beginning  of  the  taxable  year  ending  in  191 8 
were  not  allowable  as  deductions  under  earlier  income  tax 
laws.  In  order  to  avoid  great  annoyance  and  possible  com- 
plications in  the  future  it  would  be  proper  in  most  cases  to 
transfer  obsolescence  reserves  as  of  January  i,  1918,  to  sur- 
plus account.  Commencing  with  that  date,  obsolescence  re- 
serves should  reflect  allowances  claimed  and  allowed  for  in- 
come tax  purposes. 

Duplicate  deductions  must  be  avoided. — No  well-regulated 
concern  would  charge  off  the  same  item  of  plant  or  equipment 
more  than  once,  but  on  this  point  the  law  contains  a  special 
warning.  Care  must  be  taken  that  any  allowances  for  depre- 
ciation or  obsolescence  or  amortizations  claimed  and  allowed 
in  returns  for  years  prior  to  the  taxable  year  be  not  claimed 
again.*  This,  however,  does  not  apply  to  amounts  claimed  in 
previous  years  but  not  allowed. 


Law,  section  215    (a-3). 


FOR    OBSOLESCENCE    AND    AMORTIZATION  1133 

Present  Accounting   Practice  as   to  Obsolescence' 

The  author  beheves  the  position  assumed  by  the  Treasury 
in  regard  to  obsolescence  prior  to  the  enactment  of  the  19 18 
law  was  essentially  sound.  He  is  not  prepared  to  support  the 
contention  of  certain  accountants  that  extraordinary  obso- 
lescence, like  depreciation,  is  an  item  of  prime  cost. 

To  the  extent  that  an  allowance  for  ordinary  obsolescence 
has  been  merged  with  depreciation  it  is  entirely  proper  to 
charge  the  combined  allowance  to  operating  expenses.  The 
attempt  to  anticipate  extraordinary  obsolescence  should  be 
from  profits  and  not  from  current  income. 

Uncertainty  of  obsolescence. — Ordinary  depreciation  is 
certain  and  cannot  be  avoided  any  more  than  death  or  taxes. 
It  accrues  from  day  to  day.  One  can  see  it.  Obsolescence 
when  applied  to  the  future  (there  is  no  difference  of  opinion 
as  to  the  treatment  of  known  obsolescence)  is  a  matter  which 
is  more  difficult  of  estimate  than  depreciation.  No  one 
knows  when  it  will  come.  In  some  cases,  where  expected,  it 
has  not  materialized.  In  many  instances,  where  not  expected, 
it  has  come  almost  at  once.  It  is  true  that  it  has  occurred  in 
the  past  on  a  great  scale.  Most  modern  machinery  has  super- 
seded other  machinery  which  was  not  worn  out,  and  many  a 
plant,  only  ten  years  old,  that  counted  on  a  twenty-year  life 
for  its  equipment,  f(jr  which  a  depreciation  reserve  was  set  up 
on  that  basis,  has  not  been  able  to  renew  the  machinery  out 
of  the  reserve.  It  is  also  true  that  in  view  of  the  rapid  strides 
in  all  the  mechanical  sciences,  obsolescence  is  Hkely  to  continue 
indefinitely  to  be  a  serious  factor  in  the  ultimate  cost  of  pro- 
ducing manufactured  goods.  Unevenness  of  practice  should 
be  avoided.  One  man  should  not  be  permitted  to  guess  that 
his  machinery,  having  an  estimated  etTective  life,  under  normal 
conditions,  of  ten  years,  will  become  obsolete  and  have  to  be 
replaced  within  two  years.     Nor  should  another,  owning  the 


"See  Audiliiiij,    Theory  and   Practice    (3rd   edition),   b}'  R.   H.   Mont- 
gomery, page  329. 


1 134 


DEDUCTIONS 


same  kind  of  machinery,  be  permitted  to  make  his  guess  four 
years.  The  makers  of  the  machinery  might  testify  that  it 
would  perform  full  service  for  ten  years.  When  claims  for 
obsolescence  are  reasonable  they  should  and  will  be  allowed. 
When  unreasonable  the  claimant  deserves  to  be  penalized. 

Conflict  of  opinion  as  to  proper  practice. — Some  account- 
ants flatly  contend  that  it  is  practicable  and  desirable  to 
provide  for  all  obsolescence  allowances  as  operating  expense. 
Others,  impressed  by  the  fact  that  obsolescence  frequently 
represents  a  large  item  of  cost  or  expense,  while  not  wishing 
to  include  it  as  a  direct  operating  expense,  desire  to  provide 
for  this  charge  at  a  point  in  the  accounts  before  an  operating 
or  net  profit  is  shown.  Against  this  it  is  argued  that  if  obso- 
lescence cannot  be  reduced  to  enough  of  a  certainty  to  make 
a  periodical  allowance  for  it,  there  is  a  strong  reason  for  omit- 
ting it  as  an  element  of  prime  cost.  If  it  can  be  estimated 
closely  enough  to  set  aside  a  definite  amount,  the  author  thinks 
it  should  be  called  depreciation  rather  than  obsolescence.  If 
a  close  estimate  cannot  be  made  the  allowance  should  go  in 
the  accounts  as  an  extraordinary  expense,  rather  than  as  an 
ordinary   operating   expense. 

Extraordinary  Obsolescence 

The  foregoing  relates  to  so-called  "ordinary  obsolescence." 
The  regulation  as  to  extraordinary  obsolescence  is  as  follows : 

Regulation.  When,  through  some  change  in  business  conditions, 
the  usefuhiess  in  the  business  of  some  or  all  of  the  capital  assets  is 
suddenly  terminated,  so  that  the  taxpayer  discontinues  the  business 
or  discards  such  assets  permanently  from  use  in  such  busi- 
ness, he  may  claim  as  a  loss  for  the  year  in  which  he  takes  such 
action  the  difference  between  the  cost,  or,  if  acquired  prior 
to  March  i,  1913,  fair  market  price  or  value  as  of  that  date  of  any 
assets  so  discarded  (less  any  depreciation  sustained  and  al- 
lowable as  a  deduction  in  computing  net  income)  and  its  salvage 
value  remaining.  This  exception  to  the  rule  requiring  a  sale  or 
other  disposition  of  property  in  order  to  establish  a  loss  requires 
proof    of    some    unforeseen    cause    by    reason    of    which    the    property 


FOR   OBSOLESCENCE   AND   AMORTIZATION  1135 

has  been  prematurely  discarded,  as,  for  example,  where  an  in- 
crease in  the  cost  of  or  other  change  in  the  manufacture  of 
any  product  makes  it  necessary  to  abandon  such  manufacture,  to 
which  special  machinery  is  exclusively  devoted,  or  where  new 
legislation  directly  or  indirectly  makes  the  continued  profitable  use 
of  the  property  impossible.  This  exception  does  not  extend  to  a 
case  where  the  useful  life  of  property  terminates  solely  as  a  result  of 
those  gradual  processes  for  which  depreciation  allowances  are  author- 
ized. It  does  not  apply  to  inventories  or  to  other  than  capital  assets. 
The  exception  applies  to  buildings  only  when  they  are  permanently 
abandoned  or  permanently  devoted  to  a  radically  different  use,  and 
to  machinery  only  when  its  use  as  such  is  permanently  abandoned. 
Any  loss  to  be  deductible  under  this  exception  must  be  charged  off 

on  the  books  and  fully  explained  in  returns  of  income (Art. 

143- ) 

The  author  believes  that  the  foregoing  requirement  to  use 
as  a  basis  for  obsolescence  the  cost  of  property  acquired  since 
March  i,  1913,  is  in  accord  with  the  law. 

When  the  property  was  acquired  before  March  i,  191 3,  the 
deduction  for  obsolescence,  as  shown  in  article  143,  is  based 
on  cost  or  value  at  March  i,  1913,  "whichever  is  lower" — 
"less  any  depreciation  sustained."  Assume  that  equipment 
costing  $40,000  having  an  estimated  life  of  twenty  years  was 
acquired  in  1905.  Its  value  at  March  i,  191 3,  is  $30,000  and 
it  is  scrapped  at  the  end  of  1921.  The  March  i,  1913,  value  is 
held  by  the  Treasury  not  to  be  the  proper  basis  to  use  for  de- 
termining the  amount  of  obsolescence  deductible  because,  after 
deducting  depreciation  to  March  i,  191 3,  cost  is  lower  than 
actual  value  at  that  date. 

Depreciation  sustained  at  date  of  sale  or  discard  based  on 
original  cost  is  $34,000  (seventeen  years  at  $2,000  per  year) 
and  depreciated  cost  therefore  is  $6,000  in  192 1.  Depreciation 
to  1 92 1  based  on  March  i,  191 3,  value  is  approximately  $22,- 
500  (nine  years  at  $2,500  per  year).  The  March  i,  19 13, 
value  is  therefore  reduced  by  depreciation  to  $7,500.** 


'For  illustration  of  effect  of  depreciation  on  cost  and  March  i,  1913, 
values,  see  page  573. 

[Former  Procedure]  In  1917  tlie  deduction  for  obsolescence  realized 
was  Iiased  on  cost,  less  depreciation  and  salvage.     (Reg.  33,  Arts.  178-179.) 

The  regulations  issued  under  the  1918  law  based  the  deduction  on  cost, 
or  value  at  March  i,  1913,  in  case  of  property  acquired  prior  thereto,  "less 
any  depreciation  allowances"  and  salvage  valne.     (Reg.  45,  Art.  143.) 


1130  DEDUCTIONS 

If  sold  for  $i,ooo,  the  amount  to  be  charged  off  is  $5,000, 
provided  article  143  and  section  202  (1>2)  of  the  law  are 
applicable.  But  202  (b-2)  is  a  general  provision  of  the  law 
and  does  not  control  any  specific  provision.  Actual  value  at 
March  i,  191 3,  is  the  proper  basis  for  obsolescence  under  sec- 
tion 214  (a-8),  therefore  if  actual  value  at  March  i,  191 3.  is 
$30,000,  and  $22,500  has  been  charged  off  since,  the  deduction 
under  section  214  (a-8)  clearly  is  $6,500,  not  $5,000.  The 
principle  is  not  changed  because  the  machine  is  sold  instead  of 
l3eing  discarded. 

If  discarded  the  deduction  undoubtedly  is  $7,500.  It  would 
be  ridiculous  to  hold  that  l)y  selling  a  machine  for  $1,000 
the  deduction  for  obsolescence  is  reduced  from  $6,500  to 
$5,000.  In  years  of  high  tax  rates  it  would  put  a  premium 
on  junking  good  machinery.  It  would  be  a  violation  of  every 
known  business  and  economic  theory  of  efficiency. 

The  Treasury  in  article  143  attempts  to  relate  section 
202  (b),  which  governs  the  taxable  status  of  the  sale  of  prop- 
erty in  general,  to  a  section  of  the  law  which  has  no  reference 
to  general  gains  or  losses.  Even  if  there  is  a  relation,  the 
specific  provisions  of  section  214  (a-8)  must  control.  Under 
the  latter  section  value  at  March  i,  1913,  is  the  value  to  be 
recovered  through  depreciation  and  obsolescence.  If  not  re- 
covered in  one  year  it  may  be  in  another  year.  If  depreciable 
property  is  sold,  any  value  at  Alarch  i,  1913,  which  has  not 
been  recovered  may  be  charged  oft'  in  the  year  of  final  disposi- 
tion, not  as  a  loss  but  as  final  depreciation  or  obsolescence. 
The  sale  or  discarding  of  a  machine  is  the  final  test  of  these 
allowances.  If  the  calculations  were  accurate  there  would  be 
no  cjuestion  of  loss  or  gain;  if  inaccurate  the  balance  is  not 
a  gain  or  a  loss,  it  is  a  correction  ui  the  inaccuracies.  The 
law  does  not  require  taxpayers  to  go  back  and  adjust  the  ac- 
counts of  all  prior  years,  but  permits  a  reasonable  adjustment 
in  the  year  of  determination. 

The  theory  of  a  limitation  on  losses  as  contained  in  sec- 
tion 202    (I))    is  that  tax])ayers  whose  property  had  appreci- 


FOR    OBSOLESCENCE    AND    AMORTIZATION  1137 

ated  in  value  at  March  i,  1913,  shall  not  receive  the  benefit 
of  losses  which  represent,  in  effect,  nothing  more  than  failure 
to  realize  something  which  as  appreciation  formed  part  of 
their  capital  at  March  i,  19 13,  but  which  subsequently  depre- 
ciates in  value.  The  section  applies  to  property  such  as  stocks 
and  bonds  which  fluctuate  in  value ;  it  does  not  apply  to  de- 
preciable property  which  is  the  subject  of  depreciation  and 
obsolescence  allowances  specifically  permitted." 

Obsolescence  accrued  prior  to  taxable  year  not  deduc- 
tible.— 

Ruling A   number   of   5,000-ton   bulk    freigbters   were 

constructed  in  1900.  In  1910  the  docks  in  tbe  larger  harbors  along 
the  Great  Lakes  were  greatly  enlarged  and  improved  so  that  only 
vessels  of  10,000  tons  capacity  or  larger  could  be  conveniently  or 
economically  accommodated.  As  a  result  of  this  condition  the  larger 
and  newer  type  of  vessels  could  carry  freight  at  a  cheaper  rate  than  * 
the  5,000-ton  vessels,  and  began  at  that  time  to  dominate  the  lake 
trade  and  displace  the  smaller  types.  The  physical  life  of  the  5,000- 
ton  vessels  is  generally  conceded  to  be  33  years.  However,  for  the 
reasons  above  stated,  they  have  all  been  abandoned  or  will  be  aban- 
doned by  the  close  of  the  year  1921.  Their  salvage  value  is  estimated 
at  20  per  cent.  In  the  past  depreciation  has  been  allowed  at  the 
rate  of  3  per  cent,  in  accordance  with  A.  R.  R.  27  (C.  B.  2,  p.  139.) 
The  owners  now  claim  that  20  per  cent  of  the  cost  of  the  vessels 
remains  on  their  books  as  a  loss  by  reason  of  obsolescence  and  seek 
to  deduct  this  20  per  cent  loss  during  the  years  1918,  1919,  1920,  and 
1921 

.  :  .  .  This  office  has  consistently  ruled  that  items  of  income 
received  or  accrued  during  any  given  taxable  year  must  be  returned 
for  that  year,  and  that  losses  incurred  in  one  taxable  year  can  not 
be  deducted  from  the  income  of  other  taxable  years.  It  has  been 
held  that  the  failure  to  take  depreciation  in  any  taxable  year  does 
not  entitle  the  taxpayer  to  deduct  in  any  other  taxable  year  a  greater 
amount  for  depreciation  than  would  otherwise  be  allowed  (Art.  167, 
Reg.  45).  Article  166  of  Regulations  45  provides:  "Inasmuch  as 
under  the  provisions  of  the  income  tax  Acts  in  effect  prior  to  Revenue 
Act  of  1918  deductions  for  obsolescence  of  property  were  not  al- 
lowed except  as  a  loss  for  the  year  in  which  the  property  was  sold 
or  permanently  abandoned,  a  taxpayer  may  for  191 8  and  subsequent 
years  revise  the  estimate  of  the  useful  life  of  any  property  so  as  to 


'See  Sections  214  (a-8)   and  234   (a-7). 


1 1 38  DEDUCTIONS 

allow  for  such  future  obsolescence  as  may  be  expected  from  ex- 
perience to  result  from  the  normal  progress  of  the  art."  It  will  be 
noted  that  this  article  provides  only  for  future  obsolescence. 

There  appears  to  be  nothing,  therefore,  in  the  Act  or  in  the  regu- 
lations which  indicates  that  it  was  intended  that  obsolescence  which 
accrued  in  taxable  years  prior  to  1918  could  be  accumulated  and 
deducted  from  gross  income  in  years  subsequent  to  that  date ;  or 
that  Congress  had  any  intention  that  this  particular  provision  should 
be  given  a  retroactive  effect  beyond  January  i,  1918. 

The  contention  of  the  taxpayer  is  directly  opposed  to  this  well- 
established  construction  of  the  Act  and  ought  not,  in  the  judgment 
of  this  office,  to  be  conceded 

The  facts,  as  indicated  by  the  affidavits  of  the  tax- 
payer, show  that  obsolescence  began  in  1910,  when  the  larger  vessels 
began  to  displace  the  5,000-ton  freighters.  Any  loss  due  to  obsolescence 
should,  therefore,  be  spread  over  the  period  from  1910  to  the  date 
of  abandonment  (L.  O.  862;  C.  R.  i,  p.  127),  and  it  follows  from 
what  has  been  said  above  that  only  that  portion  of  such  obsolescence 
which  accrued  subsequent  to  January  i,  1918,  can  be  taken  in  returns 
for   19 1 8  and  subsequent  years. 

Any  further  loss  not  taken  care  of  by  depreciation  and  obso- 
lescence and  not  compensated  for  by  insurance  or  otherwise  may  be 
taken  in  the  year  in  which  the  vessels  are  sold  or  scrapped. 

It  is  concluded  that  obsolescence  which  accrued  prior  to  January 
I,  1918,  may  not  be  deducted  in  income  and  excess-profits  tax  returns 
for  1918  and  subsequent  taxable  years.  (B.  31-21-1752;  Sol.  Op. 
114.) 

The  foregoing  seems  to  mean  that  obsolescence  accruing 
from  1910  to  1917  inclusive  is  not  a  deduction  in  those  years, 
nor  may  it  be  taken  in  the  year  when  the  vessels  are  disposed  of, 
under  the  theory  that  in  the  year  of  disposal  the  only  allowable 
deduction  in  that  year  is  for  the  obsolescence  which  accrues 
in  the  same  year.    Also  see  article  166;  page  1081. 

The  author  wholly  disagrees  with  the  statement  of  the 
Solicitor  that  Congress  intended  that  the  allowance  for  obso- 
lescence in  the  1918  law  is  a  limitation  of  the  deduction. 
Stated  otherwise,  the  Solicitor  contends  that  deductions  for 
realized  obsolescence  theretofore  allowed  by  the  Treasury 
under  laws  which  did  not  mention  obsolescence  were  outlawed 
by  the  19 18  law. 

\>ssels  were  constructed  in  1900  costing  $1,000,000  with 


FOR    OBSOLESCENCE    AND    AMORTIZATION 


II39 


an  estimated  life  of  thirty-three  years.  From  1900  to  19J7 
depreciation  accrued  was  allowed  on  a  basis  of  the  estimated 
life  of  the  vessels.  In  1921  the  vessels  were  sold  for  $200,000. 
In  1918  it  was  known  that  the  vessels  would  be  obsolete  in 
1921.  The  opinion  allows  obsolescence  for  the  years  1918 
to  192 1  inclusive  on  the  basis  of  obsolescence  spread  over  the 
period  19 10  to  1921,  which  leaves  a  considerable  book  value 
after  the  sale.  The  opinion  states  that  the  book  balance  which 
represents  the  excess  of  obsolescence  above  depreciation  for 
the  3^ears  19 10  to  191 7  may  not  be  written  off  as  obsolescence 
in  192 1,  but  fails  to  state  whether  or  not  it  may  be  charged 
off  in  192 1  as  a  loss.  The  reference  to  each  year's  accounts 
being  complete  in  itself  indicates  that  the  only  loss  which 
arises  in  the  year  192 1  is  the  year's  share  of  the  obsolescence. 
Under  the  opinion  the  net  effect  of  the  19 18  law  is  to 
decrease  the  allowable  deduction  for  losses  arising  from  obso- 
lescence. No  such  meaning  can  be  read  into  the  law  nor  into 
the  intention  of  Congress.  The  allowance  tor  obsolescence 
was  inserted  in  the  191 8  law  in  conference.  As  with  other 
sections  of  the  1918  law,  the  intention  of  Congress  was  to 
extend  and  amplify  deductions.  It  is  absurd  to  construe  the 
obsolescence  allowance  as  a  foreclosure  of  a  right  to  claim 
obsolescence,  yet  that  is  precisely  what  the  Solicitor's  opinion 
holds. 

When  business  is  discontinued. — 

Ruling.  The  undepreciated  cost  of  a  dam  constructed  for  the 
purpose  of  creating  an  ice  lake  by  a  corporation  which  later  discon- 
tinued the  ice  business,  the  dam  showing  a  substantial  salvage  value 
remaining,  was  charged  off  the  taxpayer's  books.  The  taxpayer  con- 
tended that  this  was  a  "loss  of  useful  value"  as  contemplated  by  ar- 
ticle 143  of  Regulations  45. 

The  Committee  is  of  the  opinion  that  property  so  improved  can 
not,  as  a  matter  of  fact,  be  valueless,  and  that  there  is  no  evidence 
establishing  a  real  determinable  and  determined  loss  within  the 
meaning  of  article  143.     (C.  B.  4,  page  165;  A.  R.  R.  498.) 

Since  the  business  was  discontinued,  it  is  difficult  to  be- 
lieve that  no  obsolescence  occurred  in  an  asset  that  apparently 


1 140 


DEDUCTIONS 


was  valueless  for  any  other  type  of  business.  The  taxpayer, 
however,  must  have  failed  to  show  that  there  was  an  actual 
loss  in  value. 

Buildings. — 

Ruling.  No  amount  may  be  charged  off  in  any  year  in  antici- 
pation of  obsolescence  of  a  building  which  may  become  obsolete  five 
or  ten  years  later.  However,  a  certain  amount  of  obsolescence  may 
be  claimed  from  the  time  that  it  becomes  certain  that  at  a  definite 
future  date  the  building  will  be  obsolete.  The  figure  representing 
obsolescence  should  be,  approximately,  the  difference  between  the 
fair  market  value  of  the  building  as  of  March  i,  1913,  or  its  cost  if 
acquired  after  that  date,  less  depreciation,  and  the  estimated  salvage 
value.  This  obsolescence  should  be  spread  over  the  period  from  the 
time  such  obsolescence  becomes  certain  until  the  building  becomes 
obsolete  and  should  be  claimed  in  the  returns  filed  for  those  years. 
For  instance,  the  fair  market  value  of  a  building  March  i,  1913,  was 
$30,000.  Its  depreciated  value  December  31,  1918,  was  represented 
by  $18,000,  and  its  estimated  salvage  value  will  be  $5,000  in  1920. 
At  that  time  (Dec.  31,  1918)  it  was  definitely  determined  and  certain 
that  in  1920  the  building  would  have  to  be  torn  down  and  rebuilt, 
due  to  its  inadequacy  to  meet  the  growing  needs  of  the  industry  it 
housed.  The  difference  between  the  depreciated  value  December  31, 
1918,  namely,  $18,000,  and  its  estimated  salvage  value  of  $5,000  rep- 
resents obsolescence.  This  amount  of  $13,000  should  be  spread  over 
the  years  covering  the  period.  1919  and  1920,  and  deductions  claimed 
accordingly  on  the  returns  filed  for  those  years.  In  cases  where 
obsolescence  is  claimed  it  must  be  supported  by  facts  which  will 
enable  this  office  to  determine  whether  such  claim  is  proper  and 
allowable.     ( C.  B.  2,  page  138;  O.  D.  381.) 

Some  of  the  factors  contributing  to  the  obsolescence  of 
buildings  are : 

1.  Changing  trade  centers. 

2.  Change  of  fashion  or  design. 

3.  Improved  methods  of  planning,  construction  and  oper- 

ation. 

4.  Better  lighting  and  ventilating. 

5.  .Vppreciation  of  land  values  demanding  greater  interest 

return. 


FOR    OBSOLESCENCE    AND    AMORTIZATION  114T 

An  eminent  real  estate  authoril)'  has  stated  f 

The  change,  to  a  marked  extent,  from  the  old,  simple  types  of 
buildings  to  the  modern  complex  form,  may  be  said  to  have  taken 
place  about  25  or  possibly  30  years  ago  and  it  was  probably  not  for 
another  10  years  that  all  interested  in  real  estate,  in  mortgages  and 
in  construction,  realized  fully  that  a  new  problem,  that  of  the  loss  of 
value  in  great  buildings  through  changing  hotel  and  trade  centers, 
through  wear  and  tear,  through  change  of  fashion  in  design,  improve- 
ments in  method  of  construction  and  operation,  of  planning  and  de- 
signing, was  a  great,  a  serious  problem. 

Apartment  houses. — 

....  It  was  first  discovered  in  large  apartment  houses  that 
tenants  generally  deserted  an  apartment  as  being  obsolete  within  8  or 
10  years.     Hotels  became  old  in   12  or   15  years,  due  to  better   and 

finer     buildings     being     constructed As     apartment     house 

planning  and  building  progressed  to  a  point  where  it  was  no  longer 
possible  to  improve  in  planning  and  in  appointments  and  in  fireproof 
construction  and  especially  when  over-production  ceased,  the  fashion 
of  deserting  the  so-called  old  apartments  changed,  and  it  is  now 
conceded  that  a  well  kept  and  well  managed  apartment  house  may 
hold  its  own  with  the  new  houses  as  they  are  built  and  maintain 
their  earning  power  for  20  or  30  years  instead  of  8  or  10. 

There  is  an  apartment  house  in  New  York  City  now  being- 
constructed  that  has  begun  to  depreciate  before  it  is  born.  It  will 
always  be  a  liability  as  the  planning  and  waste  of  money  on  four  in- 
terior tower  stairways,  needless  hallways  and  extravagant  construc- 
tion at  a  time  of  high  building  costs  dooms  it  to  a  heavy  depreciation 
in  value  and  usefulness  through  inability  to  compete  with  well 
planned,  carefully  built  structures  of  the  same  class.  This  building 
should  have  an  allowance  for  depreciation  of  5%. 

Fireproof  buildings. — 

At  first  it  was  generally  believed  that  a  fireproof  building  was 
good  for  100  years  and  depreciation  was  hardly  thought  of.  It  soon 
became  evident  that  with  the  vast  investment  for  elevators  and  ma- 
chinery, for  plumbing  and  fine  appointments,  and  with  the  changing 
demands  and  types  of  architecture,  there  was  a  probability  that  the 
new  would  be  obsolete  in  a  comparatively  short  time.  How  short  a 
time  no  one  knew,  but  it  was  evident  from  the  rapid  passing  of  the 
new  apartment  houses  into  a  condition  of  obsolescence  that  deprecia- 
tion was  the  most  serious  question  involved  in  this  new  form  of 
building. 


*■  Extracts  from  paper  (;n  "Depreciation"  by  Frank  Lord,  Vice-president 
Cross  &  Brown  Co.,  New  York  City. 


11^2  DEDUCTIONS 

Loft  buildings. — 

Take  for  illustration  an  ordinary  old  type  of  5  story  loft  build- 
ing. The  average  building  of  this  type  with  its  rope  hoistway  and  a 
single  set  of  plumbing  on  each  floor  was  uniformly  built  between 
1840  and  1890  for  about  $30,000,  sometimes  for  $25,000,  in  a  flimsy 
way,  and  sometimes  for  $35,000  in  a  superior  way,  many  of  them 
with  stout  walls  and  yellow  pine  beams.  Such  a  building  might 
depreciate  in  the  first  ten  years  of  its  existence  from  its  first  cost 
of  $30,000  to  a  value  of  $25,000  or  an  average  of  ij^%  per  annum, 
thereafter  it  would  depreciate  possibly  1%  per  annum  and  at  the 
end  of  20  years  would  be  worth  $20,000.  Another  10  years  might 
reduce  it  to  a  value  of  $18,000,  but  the  probabilities  are  that  it  would 
remain  steadily  worth  $20,000  after  its  first  20  years  of  existence, 
owing  to  substantial  upkeep. 

The  reason  for  this  stability  lies  in  its  measuring  up  in  style 
to  the  prevailing  standard  of  architecture  of  its  day  and  the  fact  that 
the  unchanging  demands  of  business  kept  it  from  becoming  obsolete. 
Its  simplicity  of  construction,  its  honest,  enduring  qualities,  kept  it 
fairly  on  a  par  with  its  competitors  and  gave  it  equal  rank  with  the 
newer  buildings  for  rental  income. 

With  a  little  outlay  they  could  be  restored  to  their  old  time  re- 
spectability and  be  made  as  serviceable  as  in  their  prime.  As  a 
matter  of  fact  these  old  buildings  have  a  value  today  of  $25,000  to 
$35,000  and  are  earning  so  well  for  their  owners  that  they  are  con- 
tent to  take  their  revenues  of  6%  to  10%  and  never  think  of  the 
gradual  destruction  they  are  bringing  upon  themselves  by  forcing 
the  larger  and  more  progressive  merchants  to  seek  modern  facilities 
in  districts  uptown  where  such  buildings  are  the  rule  rather  than  the 
exception. 

Effect  of  appreciation  in  land  values. — 

When  the  20  story  Gillander  building,  25  x  100,  at  the  northwest 
corner  of  Wall  and  Nassau  Streets  was  only  10  years  old  it  was  torn 
down  to  make  way  for  the  Bankers'  Trust  Building.  It  had  become 
obsolete  because  the  land  could  earn  much  more  if  given  a  higher  class 
of   building. 

In  1885  old  buildings  at  the  southwest  corner  of  Wall  and  Broad 
Streets  were  torn  down  for  the  erection  of  the  Wilkes  Building,  which 
in  1920  was  demolished  to  permit  the  new  24  story  Stock  Exchange  to 
take  its  place.  Here  was  a  fine  building  fully  able  to  do  good  work 
for  another  20  years  cut  off  at  the  age  of  35  years  not  for  any  real 
decay  and  disability  but  because  it  could  earn  only  30%  of  what  a 
higher  building,  extending  to  less  prominent  and  valuable  land  ad- 
joining can  earn. 

If,  for  example,  a  certain  5-story  building  is  paying  9%  net  on 


FOR   OBSOLESCENCE   AND   AMORTIZATION 


"43 


$80,000  and  by  demolishing  the  building  and  erecting  a  12  story  struc- 
ture at  a  cost  of  $135,000  plus  $80,000  for  the  land,  the  new  building 
will  pay  only  7%  net  on  $215,000,  the  old  building  paying  9%  has  not 
depreciated  but  is  in  a  state  of  efficiency  and  should  be  maintained  in 
this  form  so  long  as  no  better  return  could  be  obtained  from  a  new 
building. 

Change  from  retail  to  wholesale  district. — 

Depreciation  is  not  necessarily  a  slow  process  which  may  be 
covered  by  an  allowance  of  3  or  5%.  There  may  be  50  or  100%  de- 
preciation in  a  single  year,  as  when  23rd  Street  changed  from  a  re- 
tail to  a  wholesale  district  and  buildings  25  x  100  each,  capable  of 
earning,  say  $30,000  a  year,  became  unrentable  and  a  liability,  so 
that  one  owner  of  a  building  covering  7  lots  demolished  it  to  'save 
taxes.  Only  a  year  or  so  before  this  building  had  a  value  of 
$200,000  to  $250,000  (as  a  retail  building)  which  depreciated  entirely 
not  through  wearing  out  so  much  as  through  unfitness  and  inability 
to  produce  revenue. 

In  the  largest  cities  the  enactment  of  "zoning"  laws  is  serv- 
ing to  give  relief  in  those  cases  where  in  the  past  a  sudden 
change  might  be  wrought  as  in  the  last  instance  cited  above, 
and  must  be  considered  in  any  estimate  of  probable  obso- 
lescence. 

Fixtures. — In  some  types  of  business,  such  as  retail  candy 
stores,  restaurants,  etc.,  the  volume  of  business  achieved  is, 
to  an  important  extent,  dependent  upon  the  character  and  ap- 
pearance of  the  equipment  and  the  attractiveness  of  the  furni- 
ture and  fixtures  with  which  the  visitor  finds  himself  sur- 
rounded. The  demand  of  the  public  for  elaborateness  and 
lavish  display  in  this  regard  is  a  constant  and  potent  factor; 
and  competition  in  that  direction  imposes  the  necessity  of  pleas- 
ing the  public,  as  otherwise  there  would  be  an  immediate  and 
pronounced  decline  in  patronage.  In  respect  of  fixtures  of 
this  nature,  the  ordinary  depreciation  rates  would  not  ade- 
quately represent  the  loss  of  useful  value  accruing,  and  a 
very  material  allowance  should  each  year  be  made  for  obso- 
lescence. 


1144 


DEDUCTIONS 


Change  under  relp:asing  or  upon  moving. — 

Ruling.  A  taxpayer  in  rearranging  his  business  property  in  ac- 
cordance with  a  lease,  permanently  abandoned  certain  office  furni- 
ture and  fixtures,  only  a  portion  of  the  cost  of  which  had  been  de- 
ducted as  depreciation.  The  portion  of  the  cost  not  so  deducted,  less 
salvage  value  of  the  property,  is  deductible  as  a  loss  of  useful  value 
under  article  143  of  Regulations  45.  (  C.  B.  4,  page  164;  A.  R.  R. 
469.) 

Obsolescence  of  intangible  property. — 

Ruling.  Obsolescence  is  not  ordinarily  applicable  in  the  case 
of  intangibles  but  will  be  allowed  in  exceptional  cases,  as  in  the  case 
of  the  discontinuance  of  a  going  business  because  of  the  exhaustion 
of  its  source  of  supply,  where  the  cost  of  the  good  will,  or  its  value 
as  of  March  i,  1913,  if  acquired  prior  to  that  date,  can  be  definitelv 
shown  and  the  period  of  its  obsolescence  determined  with  reasonable 
accuracy. 

To  sustain  a  claim  for  deduction  for  obsolescence  of  good  will 
it  must  be  shown  that  the  good  will  will  be  of  no  value  at  the  close  of 
an  approximately  definite  period,  and  that  the  taxpayer  will  be  forced 
to  discontinue  the  business  and  be  unable  to  continue  in  any  similar 
business. 

An  allowance  for  obsolescence  of  good  will  will  be  made  only 
in  connection  with  such  good  will  as  is  assignable,  as  distinguished 
from  good  will  attaching  to  individuals  owning  or  conducting  a  busi- 
ness, or  to  the  premises  at  which  it  is  or  was  conducted;  and  no 
allowance  for  obsolescence  will  be  granted  in  any  case  where,  in  con- 
nection with  the  operation  of  the  business,  the  good  will  will  be 
valuable  in  another  business  after  the  termination  of  the  business  in 
which  the  taxpayer  is  engaged. 

A  corporation  engaged  in  the  business  of  sampling  ores  is  en- 
titled to  a  deduction  for  obsolescence  not  only  of  its  plant  and  equip- 
ment but  for  value  of  good  will  existing  and  having  a  definitely 
established  value  as  of-  March  i,  1913,  or  acquired  thereafter  by 
capital  outlay,  if  it  can  be  shown  that  the  plant  and  equipment  will 
be  useless  and  the  good  will  of  no  value  at  the  close  of  an  approxi- 
mately definite  period  by  reason  of  exhaustion  of  the  ores  on  which 
its  business  depends.     (C.  B.  2,  page  141;  O.  D.  472.) 

Extraordinary  obsolescence  due  to  prohibition. — As  stated 

in  the  regulation  already  quoted  (article  143),^  an  exception  to 
the  rule  "requiring  a  sale  or  other  disposition  of  property  in 

"See   page    1134. 


FOR    OBSOLESCENCE    AND    AMORTIZATION  1145 

order  to  establish  a  loss"  is  made  "where  new  legislation  di- 
rectly or  indirectly  makes  the  continued  profitable  use  of  the 
property  impossible." 

A  concrete  illustration  of  loss  occasioned  by  new  legisla- 
tion is  that  caused  by  state  and  national  prohibition.  When 
the  slavery  question  was  a  live  issue  there  were  many  who 
thought  that  slave  owners,  who  had  vested  property  interests 
in  slaves,  should  not  be  deprived  of  their  property  without 
compensation.  Likewise  there  are  many  who  think  that  those 
who  had  acquired  property  rights  in  the  liquor  business  should 
not  be  subjected  to  loss  without  compensation. 

As  with  the  slavery  question,  public  sentiment  is  opposed 
to  governmental  compensation  for  losses  sustained  by  the 
liquor  interests,  but  when  property  losses  due  to  prohibition 
are  established  those  sustaining  the  losses  are  entitled  to  deduc- 
tions therefor  in  their  income  and  excess  profits  tax  returns.^" 

Property  used  in  the  manufacture  of  articles 
affected  by  prohibition. 

Ruling.  Property  consisting  of  a  plant,  including  equipment 
for  the  manufacture  of  beer  bottles,  which  because  of  restrictions 
and  regulations  by  the  United  States  government  on  the  brewery 
industry  can  not  be  sold  and  in  consequence  the  factory  had  to  be 
closed,  has  to  the  extent  the  property  or  plant  was  constructed  for 
the  manufacture  of  beer  bottles  and  is  not  suited  or  adapted  for 
any  other  purpose  without  reconstruction,  become  obsolete.  The 
corporation  to  that  extent  is  entitled  to  a  deduction  for  obsolescence. 
So  much  of  the  shrinkage  in  value  of  the  plant,  if  any,  as  is  not 
thus  due  to  obsolescence  can  not  be  claimed  as  a  deduction  for  loss 
until  the  property  is  sold  or  becomes  worthless  and  the  loss  is  defi- 
nitely ascertained.     (C.  B.  i,  page  133;  O.  D.  125.) 

Property  used  in  a  "related"  business.— 
Ruling.  In  order  that  a  taxpayer  may  be  allowed  a  deduction  for 
obsolescence  for  any  given  period,  it  is  essential  that  the  use  of  the 
property  should  have  been  abandoned  during  such  period  or  that  it 
become  certain  that  the  property  must  be  abandoned  at  a  definite 
future  date.  Therefore,  where  the  use  of  property  is  continued  in  a 
related  enterprise  under  the  same  ownership,  there  is  no  abandonment, 


'"For  regulations,  rulings  and  illustrations  see  Income  Tax  Procedure, 
1920,  pages  743-74Q- 


1 146  DEDUCTIONS 

nor  is  it  possible  to  say  at  the  time  of  conversion  that  the  property 
must  be  abandoned. 

Amounts  expended  in  remodehng  a  building  for  the  manufactur- 
ing of  a  different  product  are  capital  expenditures  and  can  not  be 
taken  as  a  loss  or  an  expense.     (B.  Digest  34-21-1780;  O.  D.  looi.) 

The  foregoing  ruling  is  not  sound,  if  as  appears,  the 
brewing  company  intended  to  abandon  its  business  upon  pro- 
hibition becoming  effective  and  entered  upon  the  manufac- 
ture of  cereal  beverages  while  awaiting  the  future  of  the  Vol- 
stead Act.  It  would  have  been  easy  to  go  through  the  form 
of  a  sale,  and  thus  do  indirectly  what  the  law  allows  as  a 
direct  deduction.  Taxpayers  cannot  be  penalized  for  an  at- 
tempt to  secure  a  temporary  use  of  property,  the  effect  of  which 
is  beneficial  both  to  taxpayers  and  the  government. 

Vineyards. — 

Ruling.  No  deduction  representing  extraordinary  loss  due  to 
prohibition  legislation  is  allowable  in  the  case  of  vineyards  unless 
such  legislation  necessitates  the  abandonment  of  the  vineyard.  If 
the  vineyard  is  abandoned,  the  amount  deductible  as  a  loss  is  the 
cost  of  the  vineyard,  or  its  fair  market  value  as  at  March  i,  1913, 
if  acquired  prior  to  that  date,  plus  cost  of  subsequent  improvements, 
less  any  depreciation  previously  charged  off  and  any  salvage  value. 
No  deduction  is  permitted  on  account  of  land.  If,  by  reason  of  legis- 
lation passed  in  1918,  the  abandonment  of  the  vineyard  occurs  in 
1919,  the  loss  deduction  may  be  equally  divided  between  1918  and 
1919,  since  the  law  prohibits  the  utilization  of  the  1919  crop,  and 
1919  income  is  to  be  attributed  to  the  manufacture  and  sale  of  vintage 
of  1918  and  earlier  years.     (C.  B.   i,  page  125;  O.  D.  102.) 

GOODW^ILL. 

Ruling.  Where  a  corporation  engaged  in  the  wholesale  liquor 
business  continued  to  make  sales  in  1918  it  will  not  be  permitted 
to  deduct  in  its  1917  return  an  amount  representing  the  entire  value 
of  its  good  will  since  it  did  not  actually  sustain  a  determinable  loss 
of  such  amount  in  the  year  191 7.     (C.  B.  3,  page  156;  A.  R.  R.  185.) 

The  comments  made  above  on  the  Treasury's  ruling  that 
\vhere  a  related  business  is  continued  no  deduction  for  obso- 
lescence is  permitted,  also  apply  as  to  the  following: 

Ruling.  Liquor  dealers  who  continued  in  a  similar  trade  or  busi- 
ness after  prohibition  legislation  became  effective  are  not  entitled  to  a 


FOR    OBSOLESCENCE    AND    AMORTIZATION  1147 

deduction    for    obsolescence    of    llicir    intangibles    such    as   good    will, 
trade-marks,  and  trade  brands.     (C.  B.  4,  i)age  I7<S;  O.  D.  818.) 

The  Committee  has  rtiled  in  a  recent  case  that  the  good- 
will of  an  agent  for  wine-growers  was  of  a  personal  nature 
and  for  that  reason  no  claim  for  obsolescence  could  be  made. 

Ruling.  The  Committee  has  had  under  consideration  the  appeal 
of  A  from  the  action  of  the  Income  Tax  Unit  in  disallowing  as  a 
deduction  from  gross  income  in  1918  an  item  of  42.1-  dollars,  repre- 
senting a  deduction  for  obsolescence  of  good  will. 

The  record  indicates  that  A  filed  a  return  for  the  calendar  year 
1918  disclosing  a  net  income  of  48.7  dollars  and  a  tax  due  of  gx  dol- 
lars. A  claim  for  abatement  in  amount  of  3.^'  dollars  was  filed  in 
September,  1919,  against  the  unpaid  balance  of  tax  due  on  the  origi- 
nal return  for  1918,  and  a  claim  for  refund  of  6x  dollars,  the  amount 
paid  on  the  original  return  for  this  year,  was  also  filed.  Subse- 
quently a  claim  for  credit  of  x  dollars  was  filed,  which  was  the 
amount  of  tax  due  on  the  1919  return  of  the  appellant,  with  a  request 
that  the  claim  for  refund  be  reduced  by  this  amount. 

The  claims  were  based  on  a  deduction  for  obsolescence  of  good 
will  as  of  March  i,  1913,  which  amount  was  computed  by  determin- 
ing the  average  profit  and  invested  capital  for  the  years  1905  to  1912, 
inclusive,  allowing  a  6  per  cent  return  on  the  average  invested  capital 
for  this  period  and  capitalizing  the  excess  on  a  10  years'  purchase 
basis.  The  amount  thus  determined  was  then  prorated  over  a  period 
of  23H  months  from  February  i,  1918,  to  January  16,  1920,  and  22/47 
of  the  total  applied  as  a  deduction  in  the  year  1918.  The  claims  thus 
filed  were  rejected  by  the  Income  Tax  Unit  for  the  reason  that  the 
evidence  showed  the  appellant  to  be  engaged  in  a  business  similar 
to  the  liquor  business  and  accordingly  the  good  will  could  not  be 
considered  obsolete. 

During  the  year  19 18,  and  for  approximately  30  years  prior  there- 
to, the  appellant  was  engaged  in  the  business  of  a  merchandise 
broker,  acting  as  agent  for  wine  growers  and  selling  only  to  the 
largest  wholesale  liquor  dealers.  The  business,  which  started  from 
nothing,  increased  from  year  to  year  until  in  the  year  19 17  the  sales 
amounted  to  about  36^-  gallons.  In  the  year  1918,  with  prohibition 
threatened,  sales  dropped  to  22.1-  gallons,  and  in  1919,  with  prohibi- 
tion assured,  sales  approximated  2x  gallons.  The  appellant  was  able 
to  do  a  considerable  volume  of  business  between  April  and  Novem- 
ber of  1920.  However,  this  business  was  done  with  one  customer, 
all  of  his  other  customers  having  liquidated  and  gone  out  of  business 
prior  to  January  16,  1920.  It  was  stated  at  a  hearing  held  before 
the  Committee  that  the  one  customer  who  remained  in  business  after 
January    16,    1920,   is   now    understood   and  generally   believed   to   be 


1 148  DEDUCTIONS 

liquidating  and  preparing  to  go  out  of  business.  No  sales  have 
been  made  to  this  customer  since  1920.  The  appellant  was  able  to 
make  a  few  scattered  sales  during  1921,  but  they  were  not  sufficient 
to  meet  the  nominal  expense  of  maintaining  an  office. 

The  principal  asset  of  the  business  was  the  good  will  which  the 
appellant  built  up  by  reason  of  his  knowledge  of  conditions  and 
characteristics  peculiar  to  the  wine  business  during  the  long  period 
he  was  engaged  in  business.  The  good  will  thus  established,  it  is 
contended,  is  now,  due  to  adverse  legislation,  practically  worthless. 
All  but  one  of  his  former  customers  are  out  of  the  market  and 
prospects  for  the  future  business  are  uncertain  and  problematical. 
It  is  not  expected  that  the  few  sales  it  is  possible  to  make  will  be  more 
than  sufficient  to  meet  the  nominal  expense  of  maintaining  an  office. 
Section  214(a)  of  the  Revenue  Act  of  1918  provides — 
That  in  computing  net  income  there  shall  be  allowed  as  deductions : 

(8)  A  reasonable  allowance  for  the  exhaustion,  wear  and  tear 
of  property  used  in  the  trade  or  business,  including  a  reasonable  al- 
lowance for  obsolescence. 

The  question  as  to  the  deductibility  of  obsolescence  of  intangible 
assets,  such  as  good  will,  trade-marks,  trade  brands,  etc.,  was  de- 
cided in  T.  B.  R.  44  (C.  B.  i,  p.  133),  wherein  it  was  held  that 
a  deduction  for  obsolescence  of  intangible  assets  may,  within  certain 
definite  limitations,  be  taken  in  computing  taxable  net  income.  The 
Committee,  in  Memorandum  34  (C.  B.  2,  p.  31),  has  outlined  a 
method  which,  in  the  absence  of  better  evidence,  may  be  utilized  in 
determining  the  value  of  intangibles  as  of  March  i,  19 13. 

Inasmiich  as  the  question  of  the  deductibility  of  obsolescence  of 
good  will  has  been  decided  in  the  affirmative  and  a  practical  method 
has  been  suggested  for  the  determination  of  its  value  (when  not 
specifically  paid  for  as  such),  it  would  appear  that  in  the  instant  case 
the  only  question  for  the  Committee  to  decide  is  whether  the  fore- 
going facts  afford  the  appellant  a  basis  for  claiming  obsolescence  of 
good  will  as  a  deduction. 

In  order  to  sustain  such  a  claim  it  is  essential  that  the  value  of 
the  good  will,  in  respect  of  which  a  deduction  for  obsolescence  is 
claimed,  has  been  destroyed  or  will  be  destroyed  by  prohibition  legis- 
lation; that  the  good  will  in  question  is  assignable  as  an  asset  and 
that  it  will  not  be  valuable  in  continuing  a  lawful  business  after 
prohibition  becomes  effective. 

There  is  unquestionably  no  doubt  that  due  to  the  enactment  of  ad- 
verse legislation  the  appellant  will  ultimately  be  forced  to  abandon 
his  business  as  a  profitable  means  of  making  a  livelihood.  The  sales 
made  by  the  appellant  in  1921  were  hardly  sufficient  to  meet  expenses, 
and  with  prospects  no  better  for  the  year  1922,  it  is  apparent  that  the 


FOR    OBSOLESCENCE    AND    AMORTIZATION  1149 

natural  processes  of  the  prohibition  laws  have  finally  accomplished 
what  they  set  out  to  accomplish.  It  is  true  that  this  result  was  not 
finally  effected  on  January  16,  1920,  as  might  have  been  expected. 
The  first  stages  of  decay  set  in  about  the  beginning  of  1918.  They 
were  not  sft'  clearly  seen  then  as  they  are  now  but  the  processes  were 
at  work  continuously  and  culminated  when  prohibition  was  enforced, 
although  by  reason  of  temporary  liberal  administration  of  the  law 
the  surface  indications  were  not  finally  extinguished  until  1921.  In 
the  opinion  of  the  Committee  the  foregoing  conditions  lead  to  a 
reasonable  assumption  that  the  business  of  the  appellant  has  been 
destroyed  by  reason  of  prohibition  legislation. 

The  good  will  built  up  by  the  appellant  during  the  long  period  he 
was  engaged  in  business,  in  the  opinion  of  the  Committee,  would  be 
of  little  or  no  value  in  carrying  on  a  lawful  business  not  affected  by 
prohibition  legislation.  With  one  exception  all  of  his  former  cus- 
tomers are  out  of  business,  and  with  his  experience  and  knowledge 
restricted  to  the  commercial  traffic  in  wine  it  is  exceedingly  doubtful 
that  the  good  will  developed  in  connection  with  the  operation  of  his 
former  business  would  be  of  value  in  carrying  on  a  legitimate  enter- 
prise. 

The  principal  factor  contributing  toward  the  success  and  pros- 
perity of  the  appellant's  business  was  the  knowledge  of  conditions 
and  characteristics  peculiar  to  the  wine  business  gained  by  him  dur- 
ing many  years  of  experience.  Likewise,  the  principal  asset  of  the 
appellant  is  attributable  to  the  same  fund  of  knowledge.  There  was 
apparently  no  competition  in  the  particular  business  of  the  appellant. 
Practicalh^  all  of  his  sales  were  made  to  less  than  20  customers.  The 
success  and  prosperity  of  the  appellant  depended  entirely  upon  his 
ability  to  capitalize  his  principal  asset,  which,  by  reason  of  its  pecu- 
liar and  personal  character,  could  not  have  been  separated  from  him. 
The  Committee  has  carefully  considered  the  ^nature  of  the  good  will 
claimed  by  the  appellant  and  has  come  to  the  conclusion  that  it  is  of 
such  a  personal  character  as  to  be  w^ithout  value  as  an  assignable 
asset  and  accordingly  fails  to  meet  the  most  essential  test  necessary 
to  sustain  a  claim  for  obsolescence  of  good  will. 

It  is,  therefore,  recommended  in  the^  appeal  of  A,  that  the  action 
of  the  Income  Tax  Unit  in  disallowing  an  item  of  42.r  dollars,  repre- 
senting a  deduction  for  obsolescence  of  good  will,  be  sustained  and 
the  appeal  accordingly  denied.      (I-4-42;  A.  R.  R.  722.) 


Amortization  of  Plant,  etc.,  Used  for  War  Purposes 

The  1921  law  re-enacts  the  [jnn-isions  of  the  1918  law  with 
respect  to  a  deduction  for  amortization  of  war  facilities,  but 
contains  two  important  changes : 


ii^o  DEDUCTIONS 

1.  The  time  limitation  on  the  deduction  is  fixed  at  March 

3.  1924- 

2.  Claim   for  amortization  must  be  filed  not  later  than 

date  for  filing  1921   return.  "^ 

Law.^^  ....  In  the  case  of  buildings,  machinery,  equipment, 
or  other  facilities,  constructed,  erected,  installed,  or  acquired,  on  or 
after  April  6,  1917,  for  the  production  of  articles  contributing  to  the 
prosecution  of  the  war  against  the  German  Government,  and  in  the 
case  of  vessels  constructed  or  acquired  on  or  after  such  date  for  the 
transportation  of  articles  or  men  contributing  to  the  prosecution  of 
such  war,  there  shall  be  allowed,  for  any  taxable  year  ending  before 
March  3,  1924  (if  claim  therefore  was  made  at  the  time  of  filing  re- 
turn for  the  taxable  3'ear  1018,  1919,  1920,  or  1921)  a  reasonable  de- 
duction for  the  amortization  of  such  part  of  the  cost  of  such  facilities 
or  vessels  as  has  been  borne  by  the  taxpayer,  but  not  again  including 
any  amount  otherwise  allowed  under  this  title  or  previous  Act  of 
Congress  as  a  deduction  in  computing  net  income.  At  any  time  be- 
fore March  3,  1924,  the  Com.missioner  may,  and  at  the  request  of  the 
taxpayer  shall,  reexamine  the  return,  and  if  he  then  finds  as  a  result 
of  an  appraisal  or  from  other  evidence  that  the  deduction  originally 
allowed  was  incorrect,  the  income,  war-profits,  and  excess-profits  taxes 
for  the  year  or  years  affected  shall  be  redetermined;  and  the  amount 
of  tax  due  upon  such  redetermination,  if  any,  shall  be  paid  upon 
notice  and  demand  by  the  collector,  or  the  amount  of  tax  overpaid, 
if  any,  shall  be  credited  or  refunded  to  the  taxpayer  in  accordance 
with  the  provisions  of  section  252;   .... 

In  accordance  with  a  Joint  Resolution  of  Congress  dated 
March  3,  192 1,  the  latter  date  is  to  be  considered  as  marking 
the  termination  of  the  war  between  the  United  States  and 
Germany,  and  for  purposes  of  the  1918  law  is  held  to  be 
the  date  from  which  the  three-year  period  for  amortization 
purposes  runs.'-  Since  taxable  years  may  not  end  on  any  day 
except  the  last  date  of  the  month, '^  the  new  regulations  state 
the  limitation  date  as  February  29,  1924,    (article  181). 


"Section  214  (a-9),  individuals;  section  234  (a-8)  corporations. 
"Letter  dated  March  22,  1921,  signed  l)y   Carl  A.  Mapes,  Solicitor  of 
Internal  Revenue. 
"  See  page  64. 


FOR    OBSOLESCENCE   AND    AMORTIZATION  1151 

Deductions  may  be  made  in  returns  up  to  February  29, 
1924.— 

Regulation.  An  allowance  for  amortization  may  be  deducted 
only  in  returns  filed  for  taxable  years  ending  on  or  before  February 
29,  1924 (Art.  i8r.) 

When  claim  for  amortization  must  be  filed. — Returns  for 
192 1  on  the  calendar  year  basis  are  due  March  15,  1922.  In 
the  case  of  fiscal  years  ended  in  192 1  it  is  believed  that  the 
Treasury  will  extend  to  them  the  same  privilege  as  accorded 
calendar  year  taxpayers,  and  accept  amortization  claims  within 
a  reasonable  period.  It  is  advisable  to  submit  claims  on  or 
before  March  15,  1922,  that  being  the  date  which  calendar 
year  taxpayers  are  supposed  to  observe.  If  it  is  not  feasible 
to  file  claims  by  that  date,  extensions  of  time  should  be  re- 
quested. 

Regulation Such  allowance  with  respect  to  any  period 

of  time  subsequent  to  December  31,  1920,  may  be  deducted  only  if  a 
claim  for  amortization  (unmistakably  differentiated  from  all  other 
claims  for  wear,  tear,  obsolescence,  and  loss)  was  made  at  the  time 
of  filing  the  return  for  the  taxable  year  1918,  1919,  1920  or  1921. 
....      (Art.  181.) 

Any  extensions  of  time  for  filing  192 1  returns  will  auto- 
matically extend  the  date  when  final  claims  may  be  filed. 

The  regulation  is  not  clear  as  to  the  period  affected  by 
the  final  claims.  The  regulations  cannot  limit  the  deduction 
which  the  law^  allows.  It  is  clear  that  the  deduction  is  for 
"any"  taxable  year  commencing  with  19 18  and  ending  Febru- 
ary 29,  1924.  The  gross  income  against  which  the  deduction 
applies  depends  on  the  facts  of  each  case. 

Meaning  of  "amortization." — To  amortize  means  "to  de- 
stroy; kill;  deaden."^*  Therefore  a  reasonable  deduction  for 
amortization  means  a  deduction  sufficient  to  destroy  or  kill 
or  deaden  the  values  on  the  books  which  represent  plant  or 
equipment  used  for  war  purposes.     If  the  effective  or  usable 


"  Standard  Dictionary. 


1  T52 


DEDUCTIONS 


value  has  disappeared  enlirel)-,  the  Ixx^k  vahie  must  be  entirely 
killed  (amortized),  if  the  effective  or  usa1)le  value  has  only 
partly  disappeared,  the  Ijook  value  must  be  killed  (amortized) 
to  an  extent  which  will  leave  a  remaining  book  value  repre- 
senting only  the  actual  worth  of  the  asset. 

The  law  is  not  aml)iguous,  but  if  it  were,  the  statement 
of  Senator  Simmons,  made  in  respect  to  the  similar  provision 
under  the  19 18  law,  would  make  clear  the  proper  method  of 
determining  the  amount  of  amortization  which  the  law  allows.^' 

Procedure  under  the  Treasury  Regulations 

No  part  of  the  field  of  income  tax  procedure  has  been  so 
prolific  of  different  sets  of  regulations  as  that  of  amortization. 
The  preliminary  regulations  were  issued  soon  after  the  1918 
law  was  passed,  and  reflected  the  wording  of  the  law.  The 
regulations  issued  April  17,  1919,  attempted  to  narrow  the 
scope  of  the  deduction.  The  Treasury  evidently  considered  that 
the  first  regulations  were  too  liberal,  and  regretted  it.  Next 
came  T.  D.  3123  (issued  January  28,  1921)  which  recog- 
nized that  the  amortization  deductions,  instead  of  being  allo- 
cated entirely  to  1918  and  1919,  might  be  extended  to  subse- 
quent vears.  Finally,  we  have  a  fourth  set  of  regulations  under 
the  1 92 1  law.^*' 

What  the  taxpayer  must  show. — The  successive  steps 
under  the  new  reoulations  mav  be  summarized  as  follows : 


^°  Senator  Simmons  in  discussing  this  point  in  the  Senate,  February  11, 
1919,  said : 

"I  can  answer  the  Senator  generally  by  saying  that  if  by  reason  of 
the  investment  of  his  profits  in  an  extension  of  his  yards  he  has  con- 
structed a  plant  which  was  necessary  in  time  of  war  to  meet  the  demands 
which  were  made  upon  him  at  that  time  for  production,  but  which  after 
the  termination  of  the  war  has  depreciated  in  value  because  not  needed; 
in  that  case,  under  the  amortization  provision  he  will  be  allowed  to  amor- 
tize to  the  full  extent  of  the  depreciation  in  value.  Of  course,  if  there 
is  salvage  he  would  be  allowed  to  amortize  only  down  to  the  salvage 
value."     (Congressional  Record.  February  17,  1919,  page  3774.) 

'"For  details  of  prior  regulations  and  rulings,  see  Income  Tax  Proce- 
dure, 1921,  pages  907-922. 


FOR    OBSOLESCENCE   AND    AMORTIZATION  1153 

(a)  Statement  of  facilities  to  be  amortized  must  show 
that  they  were  constructed,  erected,  installed  or  acquired  on 
or  after  April  6,  191 7. 

(b)  The  facilities  in  (a)  were  for  th-e  "production  of 
articles  contributing  to  prosecution  of  the  war,"  and  in  the 
case  of  vessels  "for  the  transportation  of  articles  or  men  con- 
tributing to  the  prosecution  of  such  war." 

(c)  Classification  of  the   facilities  under   (a)   into   those 

(i)  Sold  or  discarded,  or  which  will  be  sold  or 
discarded  before  March  3,  1924. 

(2)  Retained  as  part  of  the  taxpayer's  going  busi- 
ness. 

(d)  Valuation  of  property  in   (c)  : 

(i)  Itemis  in  (c-i)  are  taken  at  actual  sale  price, 
or  at  estimated  fair  market  value  at  date 
property  will  be  sold  or  discarded. 

(2)  Items  in  (c-2)  are  taken  at  estimated  "value 
in  use"  to  taxpayer. 

(e)  Cost  less  value  in  (d)  will  give  total  amortization 
deduction  which  is  spread  over  the 

(f)  Amortization  period,  divided  as  follows: 

(i)  For  property  in  (c-i):  "Between  January  i, 
1918^'  and  the  date  when  the  property  was 
or  will  be  sold  or  permanently  discarded  as 
a  war  facility"    (article   185). 

(2)  For  property  in  (c-2)  :  "Between  January  i, 
1918^^  and  the  actual  or  estimated  date  of 
cessation  of  operation  as  a  war  facility" 
(article  185). 

(g)  The  amortization  deduction  (e)  separately  computed 
as  to  the  two  classes  of  property  in  (c)  is  spread  over  the 
amortization  period  (f)  in  the  proportion  that  the  net  income 
(computed  without  benefit  of  the  amortization  allowance)  for 


''....  or    if    the    property    was    actpiired    subsc(nicnt    to    that    elate, 
January  i,  of  tlie  vear  in  which  acquired"    (article   i8s). 
"Ibid. 


II54 


DEDUCTIONS 


each  of  the  years  in  the  amortization  period  (f)  is  to  total 
net  income  of  such  period.  When  there  are  both  classes  of 
property  i.e.,  (c-i)  and  (c-2),  to  be  considered,  the  amortiza- 
tion period  must  "be  computed  separately  for  each  class  of 
property. 

Meaning  of  term  "articles  contributing  to  the  prosecution 
of  the  war." — 

Regulation The  allowance  may  be  deducted  only  by 

taxpayers  who  after  April  6,  1917,  have  constructed  or  otherwise  ac- 
quired plant  or  other  facilities  for  the  actual  production  of  articles 
contributing  to  the  prosecution  of  the  war.  It  is  not  sufficient,  to 
entitle  the  taxpayer  to  the  allowance,  that  the  nature  of  his  business 
is  such  as  to  contribute  to  the  production  of  articles.  For  example, 
a  taxpayer,  such  as  a  railroad,  whose  business  activities  are  confined 
to  transportation  (other  than  water  transportation)  is  not  entitled 
to  the  allowance.  A  taxpayer,  the  nature  of  whose  business  is  the 
actual  production  of  articles,  however,  may  claim  the  allowance 
with  respect  to  the  cost  of  all  buildings,  machinery,  equipment  or 
other  facilities  which  were  constructed  for  use  or  which  were  used  in 
connection  with  the  production  of  such  articles,  both  in  the  acquisition 
and  transportation  of  raw  material,  the  actual  process  of  manufacture 
or  other  conversion,  and  the  transportation  and  marketing  of  the 
finished  product (Art.  183.) 

The  changes  in  the  foregoing  regulation  are  based  on  a 
decision  contained  in  B.  45-21-1909;  L.  O.  1074.  The  second 
sentence  of  the  regulation  is  restrictive  to  a  degree  not  justified 
by  the  opinion  which  follows  : 

Railroad  denied  AMORTizATicfisr  deduction. — 

Ruling The   M   railroad  at  the  breaking  out   of  the 

war  was  doing  a  normal  business  for  a  road  of  its  size.  In  1915 
certain  manufacturers  constructed  various  plants  in  the  vicinity  of  the 
road.  It  is  stated  that  the  only  outlet  for  the  productions  of  these 
plants  was  the  M  railroad,  and,  in  order  to  enable  the  road  adequately 
to  handle  the  output  of  such  plants,  as  well  as  to  transport  thousands 
of  workers  to  and  from  their  work,  it  was  necessary  for  it  to  provide 
additional  facilities.  From  the  year  1915  the  railroad's  expenditures 
for  additional  facilities,  consisting  of  tracks,  stations,  additions  to 
stations,  locomotives,  and  passenger  cars  steadily  increased,  and  in 
1917  they  amounted  to  i^.r  dollars,  which  was  increased  in  1918 
by  an  expenditure  of  sV^.r  dollars.     It  was  found  impossible  to  obtain 


FOR   OBSOLESCENCE   AND   AMORTIZATION  1155 

the  services  of  the  O  company's  repair  shops,  and,  by  reason  of  the 
refusal  of  that  company  to  make  such  repairs,  it  became  necessary 
for  the  railroad  to  erect  certain  buildings  and  plants.  The  taxpayer 
calls  attention  to  the  fact  that  these  facilities,  necessitating  this  ad- 
ditional investment,  vi^ere  absolutely  necessary  in  the  prosecution  of 
the  war,  and  that  they  were  constructed  and  acquired  solely  for  war 

purposes 

It  is  recognized  by  Congress  that  the  phraseology  used  in  the 
statute  in  regard  to  the  amortization  allowance  on  buildings,  ma- 
chinery, equipment,  and  war  facilities  is  not  sufficiently  broad  to 
admit  of  an  allowance  of  facilities  used  for  transportation.  The  Act 
as  originally  passed  by  the  House,  ....  in  respect  to  amortiza- 
tion, ....  did  not  contain  the  language  in  respect  to  ships  now 
found  in  the  statute  but  provided  for  the  allowance  in  the  following 
language : 

In  the  case  of  buildings,  machinery,  equipment,  or  other  facilities 
constructed,  erected,  installed,  or  acquired  on  or  after  April  6,  19 17, 
for  the  production  of  articles  contributing  to  the  prosecution  of  the 
war  there  may  be  allowed  a  reasonable  deduction  for  the  amortization 
or  such  part  of  the  cost  of  such  facilities  as  has  been  borne  by  the 
taxpayer,  *  *  *. 

In  the  report  of  the  Senate  Committee  on  Finance  dated  December 
6,  1918,  the  following  remarks  are  made  in  respect  to  amortization: 

In  the  paragraph  relating  to  amortization  allowance  (section  214 
(a)  and  section  234  (a)  8),  it  was  feared  that  the  language  was 
not  broad  enough  to  include  vessels  devoted  to  war  purposes,  and  pro- 
vision has  therefore  been  made  for  amortization  allowance  in  the 
case  of  vessels  constructed  or  acquired  on  or  after  April  6,  1917,  for 
the  transportation  of  articles  or  men  contributing  to  the  prosecution 
of  the  present  war. 

The  amendment  referred  to  in  the  Senate  committee  report  re- 
sulted in  the  existing  provisions  of  the  statute. 

Therefore,  Congress  recognized  that  the  language  used  in  the 
first  part  of  the  section  was  not  sufficient  to  embrace  transportation 
facilities  and  advisedly  broadened  the  section  only  in  so  far  as  I0 
include  ships. 

While  the  additional  facilities  purchased  by  the  M  Railroad  Com- 
pany enabled  it  to  meet  the  extraordinary  demands  occasioned  by 
the  war,  they  are  not  such  facilities  as  may  be  said  to  have  been  used 
for  the  production  of  munitions  manufactured  by  the  companies 
whose  plants  were  built  in  the  vicinity  of  its  right  of  way.  Trans- 
portation can  not  be  regarded  as  a  part  of  production  and  tliis  i.^ 
evidently  the  construction  which  Congress  intended  should  be  [)Ut 
upon  the  statute (B.  45-21-1909;  L.  O.  1074.) 

In  the  foregoing  ruling  the  legislative  history  of  the  1918 


1 1 56 


DEDUCTIONS 


law  is  reviewed.  The  provision  in  the  192 1  law  is  similar. 
The  conclusion  is  drawn  that,  since  Congress  had  feared  the 
191 8  law  might  not  fully  cover  vessels  and  made  specific  pro- 
vision therefor,  other  types  of  transportation  are  excluded. 
The  author  believes  this  conclusion  is  not  justified  by  the  word- 
ing of  the  law,  and  is  a  very  narrow  interpretation  which  will 
not  be  substained  by  the  courts.^"  Congress  has  evinced  a 
disposition  to  deal  more  liberally  with  the  amortization  ques- 
tion. For  example,  note  the  following  which  explains  the 
extension  of  the  privilege  of  the  amortization  deduction  to 
those  making  at  time  of  filing  the  1920  and  192 1  returns. 
The  House  had  originally  Hmited  it  to  those  filing  claims  with 
their  19 18  and  19 19  returns. 

Amendment  No.  188.-"  This  amendment  inserts,  for  the  reason 
explained  in  connection  with  amendment  No.  3,  the  paragraph  of  exist- 
ing law  relating  to  the  deduction  for  amortization  of  war  facilities 
and  vessels  but  limits  such  deduction  to  any  taxable  year  ended  be- 
fore March  3,  1924,  and  allows  it  for  such  years  only  if  claim  was 
made  at  the  time  of  filing  return  for  the  taxable  year  1918  or  1919. 
The  House  recedes  with  an  amendment  permitting  the  deduction  also 
in  the  case  of  claims  filed  at  the  time  of  filing  returns  for  the  tax- 
able years  1920  and  1921. 

The  only  statement  of  importance  in  the  opinion  is  that 
the  facilities  of  a  railroad  cannot  be  said  to  have  been  acquired 
'Tor  the  production  of  articles  contributing  to  the  prosecu- 
tion of  the  war."  The  opinion  holds  that  it  was  the  specific 
reference  to  vessels  which  had  more  bearing  than  any  other 
factor  in  the  case.  In  another  case  it  probably  will  be  found 
that  the  words  "contributing  to"  will  be  the  controlling  factor. 

When  amortization  is  permitted  it  must  relate  to  plant 
or  equipment  acquired  *Tor  the  production  of  articles  con- 
tributing to  the  prosecution  of  the  war."  The  words  "con- 
tributing   to"    are    almost    the    broadest    and    most    elastic 


"The  Standard  Dictionary  defines  "article"  as  a  particular  object  or 
substance;  as  an  article  of  food. 

""Extract  from  Confcroicc  Report  (Representative  J.  W.  Fordiicy), 
November  ig,  1921,  page  25,  explaining  the  amendment  of  the  amortization 
provision,  section  214  (a-9). 


FOR    OBSOLESCENCE   AND   AMORTIZATION 


I157 


which  C(jukl  be  used.  If  a  mining  company,  after  April 
6,  19 1 7,  erected  a  new  smelter  which  was  used  to  smelt 
copper  ore,  which  in  turn  went  to  a  refinery,  then  to  brass 
works,  then  to  an  automobile  company  for  use  on  a  truclc, 
which  was  used  to  transport  goods  on  the  highways  to  relieve 
the  freight  congestion,  the  smelter  undoubtedly  contributed  to 
the  prosecution  of  the  war.  The  evidence  here  is  that  through 
the  War  Industries  Board  copper  was  supposed  to  be  allotted 
only  to  those  who  were  engaged  in  essential  industries. 

Any  industry  which  was  regulated  by  the  War  Industries 
Board  can  secure  evidence  as  to  the  degree  of  its  contribution. 
J.  Leonard  Replogle,  chief  of  the  steel  section  of  the  Board, 
said  that  steel  for  corset  stays  and  poker  chips  was  unes- 
sential. That  would  be  evidence  competent  to  eliminate  the 
manufacturers  of  corsets  and  poker  chips  from  the  benefits 
of  the  amortization  privilege.  Between  manufacturers  of 
these  luxuries  or  so-called  non-essentials  and  the  manufac- 
turers of  rifles  there  is  too  broad  a  range  to  permit  one  to  lay 
down  a  definite  rule. 

The  War  Industries  Board  issued  priority  certificates  and 
clearance  privileges  to  those  who  were  deemed  to  be  contribut- 
ing to  the  prosecution  of  the  war.  In  some  cases  if  a  small 
surplus  of  raw  materials  existed  it  was  allotted  to  uses  which 
were  not  deemed  to  be  essential.  Fuel  and  transportation 
were  denied  to  those  whose  products  were  deemed  to  be  of  less 
importance  than  others.  At  no  time  during  the  war,  however, 
was  any  authoritative  list  prepared  which  furnished  complete 
information.  About  the  time  of  the  signing  of  the  Armistice 
certain  lists  had  been  prepared  and  others  were  in  process  of 
preparation  defining  less  essential  products. 

Each  taxpayer  is  entitled  to  prepare  his  own  case  and  make 
claim  based  on  the  conditions  which  actually  confronted  him 
at  and  after  April  6,  19 17. 

Building  permits  were  difficult  to  obtain  and  the  purchase 
of  equipment  was  even  more  difficult.  The  mere  fact  that  a 
permit  was  secured  or  machinery  was  purchased  and  installed 


II58 


DEDUCTIONS 


after,  say,  January,  1918,  is,  in  the  opinion  of  the  author, 
prima  facie  evidence  that  the  new  plant  or  additions  to  existing 
plant  or  the  new  equipment  or  additions  to  existing  equipment 
were  for  the  purpose  of  contributing  to  the  prosecution  of  the 
war.  Prior  to  that  time  restrictions  were  not  in  force,  except 
to  a  limited  extent,  but  the  demand  for  war  materials  was  so 
great  and  the  sentiment  against  non-essential  work  so  strong 
that  at  almost  any  time  after  April  6,  191 7,  the  mere  fact  that 
buildings  were  erected  and  machinery  was  purchased  is  strong 
evidence  that  they  were  intended  to  contribute  to  the  prosecu- 
tion of  the  war.  The  cost  of  buildings  and  equipment  was  so 
much  above  pre-war  prices  that  those  who  were  not  engaged 
in  war  work  were  deterred  from  making  commitments. 

Ruling.  Machinery,  equipment,  or  other  facilities  erected  or 
acquired  on  or  after  April  6,  191 7,  for  the  production  or  manufac- 
ture of  sugar  is  considered  as  contributing  to  the  prosecution  of 
the  war,  and  the  cost  may  be  amortized  in  accordance  with  the 
provisions  of  section  234  (a)  (8)  of  the  Revenue  Act  of  1918. 
(C.  B.  I,  page  221 ;  O.  D.  259.) 

Property  which  may  be  amortized. — The  general  provision 

is  similar  to  that  in  the  old  regulation. 

Regulation.  The  taxpayer  may  deduct  from  gross  income  a 
reasonable  allowance  for  amortization  of  the  cost  of  buildings, 
machinery,  equipment,  or  other  facilities,  constructed,  erected,  in- 
stalled, or  acquired  on  or  after  April  6,  1917,  for  the  production  of 
articles  contributing  to  the  prosecution  of  the  war  against  the  Ger- 
man Government,  and  of  vessels  constructed  or  acquired  on  or  after 
such  date  for  the  transportation  of  articles  or  men  contributing  to 
the  prosecution  of  such  war (Art.   183.) 

It  may  be  assumed  that  the  words  "German  Government" 
are  fully  inclusive  of  the  Austrian  Government. 

Regulation In  the  case  of  facilities  the  construction, 

erection,  installation  or  acquisition  of  which  was  commenced  before 
April  6,  19 17,  and  completed  subsequent  to  that  date  amortization 
will  be  allowed  with  respect  only  to  that  part  of  the  cost  incurred  on  or 
after  April  6,  1917,  and  which  was  (or  should  have  been)  properly 
entered  on  the  books  of  the  taxpayer  on  or  after  that  date.     (Art  183.) 


FOR    OBSOLESCENCE   AND   AMORTIZATION 


I159 


In  the  regulations  provision  is  not  made  for  war 
facilities  acquired  prior  to  April  6,  191 7,  (the  date  of  our  en- 
trance into  the  war).  Facilities  acquired  before  that  date  for 
war  work  for  the  other  Allied  nations  would  seem  therefore 
to  be  excluded,  even  though  subsequently  used  to  produce 
articles  for  the  United  States  government. 

No  limit  is  set  on  the  date  after  April  6,  19 17,  that  war 
facilities  might  be  acquired.  'For  example,  if  contracts  for 
buildings  were  entered  into  prior  to  the  Armistice  and  the 
work  was  not  completed  until  1919,  amortization  could  still 
be  claimed  on  such  building. 

Allowances  for  amortization  as  part  of  cost  or  in  settle- 
ment of  claims  to  be  included  in  income. — 

Regulation All  allowances  made  to  a  taxpayer  by  a 

contracting  department  of  the  Government,  or  by  any  other  con- 
tractor, for  amortization  specifically  as  such,  shall  be  treated  as  a 
reduction  of  the  cost  of  the  taxpayer's  plant  investment.  Further 
amortization  is  allowable  only  in  respect  of  such  reduced  cost. 
Where  no  such  allowance  has  been  made  the  amount  of  amortization 
to  be  allowed  as  a  deduction  from  gross  income,  for  the  purpose  of 
the  tax,  shall  be  computed  in  accordance  with  the  provisions  of  articles 
181  to  189,  pursuant  to  which  the  deduction  must  be  made,  and  not 
upon  the  basis  of  any  amount  contractually  or  otherwise  determined. 
(Art.  181.) 

The  foregoing  regulation  is  in  accord  with  the  law  and 
with  good  accounting  practice. 

The  regulation  recognizes  amortization  which  has  been 
allowed  by  some  other  department  of  the  government.  The 
refusal  of  the  Treasury  prior  to  1922  to  accept  settlements 
made  by  the  War  and  Nav}^  Departments  occasioned  much 
difficulty  in  the  preparation  of  claims.  Taxpayers  are  justi- 
fied in  placing  great  weight  on  appraisals  and  allowances  offi- 
cially determined  by  the  government.  It  will  be  found  that 
the  courts  will  place  equal  weight  on  such  settlements.  Never- 
theless it  is  within  the  power  of  the  Commissioner  to  require 
that  all  claims  for  amortization  be  submitted  in  a  form  accept- 
able to  the  Treasury,  provided  always  that  the  requirements  are 


ii6o  DEDUCTIONS 

reasonable.  If  not  reasonable,  taxpayers  should  submit  claims 
conforming-  to  the  law  itself.  Obviously  the  regulations  should 
be  complied  with  to  every  possible  extent.  If  the  settlements 
by  the  War  and  Navy  Departments  do  not  reflect  the  full 
amortization  contemplated  by  the  1918  and  192 1  laws,  the 
limitation  in  the  regulations  may  be  ignored. 

Depreciation  allowances. — 

Regulation.  The  allowance  for  amortization  shall  be  inclusive 
of  all  depreciation  during  the  amortization  period  on  property  sub- 
ject to  amortization.  (See  art.  186.)  Depreciation  will  be  allowed, 
beginning  at  the  close  of  the  amortization  period,  upon  property  the 
cost  of  which  has  been  partly  amortized,  but  shall  be  limited  to 
the  value  of  such  property  after  the  amortization  allowance  has 
been  deducted.  Property  which  has  been  amortized  to  its  scrap  value 
shall  not  further  be  subject  to  depreciation.     (Art.  182.) 

The  old  regulation  (before  amendment  in  1921)  contained 
the  clause,  "Depreciation  for  any  taxable  period  after  Decem- 
ber 31,  191 7  should,  therefore,  not  be  claimed  with  respect 
to  property  as  to  which  an  allowance  for  amortization  is 
claimed."  Taxpayers  were  led  to  believe  that  depreciation 
could  not  be  claimed  on  the  unamortized  balance  of  property 
with  respect  to  which  amortization  had  been  claimed  in  1918 
and  1 919  returns.  The  new  regulation  omits  this  clause  and 
there  is  now  no  doubt  that  depreciation  on  any  unamortized 
property  can  be  claimed  the  same  as  on  any  other  depreciable 
property. 

Computation  of  loss. — 

Regulation.  The  total  amount  of  the  amortization  allowance  is 
the  difference  between  the  original  cost  of  the  property  if  con- 
structed, erected,  installed,  or  acquired  on  or  after  April  6,  1917;  or 
if  acquired  partly  before  and  partly  after  April  6,  1917,  then  that 
part  of  the  cost  incurred  on  or  after  April  6,  1917,  and  properly 
entered  on  the  books  of  the  taxpayer  on  or  after  that  date,  less 
any  amounts  deducted  for  depreciation,  losses,  etc.,  prior  to  Jan- 
uary I,  1918,  and  the  value  of  the  property  on  either  of  the  bases 
indicated  below : 

(i)  In  the  case  of  property  which  has  been  sold  or  permanently 
discarded,    or    which    will    be    sold    or    permanently    discarded    before 


FOR    OBSOLESCENCE   AND    AMORTIZATION  1161 

March  3,  1924,  the  vakie  shall  i)c  the  actual  sale  price  or  estimated 
fair  market  value  as  of  the  date  when  the  property  was  or  will  be 
permanently  discarded,  plus  a  reasonable  allowance  for  depreciation 
in  case  the  property  is  used  in  the  taxpayer's  business  after  the  close 
of  the  amortization  period.  Such  fair  market  value  shall  be  established 
by  investigation  of  engineers  of  the  Bureau  of  Internal  Revenue, 
if  such  investigation  is  deemed  advisable. 

(2)  In  the  case  of  property  not  included  in  (i)  above,  the  value 
shall  be  the  estimated  value  to  the  taxpayer  in  terms  of  its  actual 
use  or  employment  in  his  going  business,  such  value  to  be  not  less 
than  the  sale  or  salvage  value  of  the  property  and  not  greater  than 
the  estimated  cost  of  replacement  under  normal  postwar  conditions 
less  depreciation  and  depletion.  Upon  the  basis  of  the  costs  prevail- 
ing at  the  latest  prewar  date  at  which  a  reasonably  normal  market 
existed,  the  Commissioner  shall  in  respect  of  basic  material  and  labor 
costs  determine  and  publish  ratios  of  estimated  postwar  costs  of 
replacement,  and  a  taxpayer  shall  use  such  ratios  in  computing  a 
claim  for  a  tentative  allowance  for  amortization.  Such  tentative 
allowance  may  be  redetermined  on  or  before  March  3,  1924,  at  the 
request  of  the  taxpayer  or  by  the  Commissioner. 

Special  record  of  all  property  falling  in  (i)  above,  must  be  pre- 
served by  the  taxpayer,  and  the  Commissioner  must  be  notified  with  the 
next  tax  return  (a)  if,  after  having  been  in  good  faith  permanently  dis- 
carded or  dismantled,  property  shall  in  any  case  be  restored  to  use 
because  of  conditions  not  foreseen  or  anticipated  at  the  time  it  was 
discarded;  or  (b)  of  the  selling  price,  if  sold.     (Art.  184.) 

Property  described  in  clause  (i)  of  article  184  is  that 
sold  or  discarded,  or  which  will  be  sold  or  discarded  before 
March  3,  1924. 

Property  described  in  clause  (2)  of  the  same  article  is 
that  retained  as  part  of  the  taxpayers'  going  business. 

The  principal  change  in  the  new  regulation  as  compared 
with  that  issued  as  part  of  T.  D.  3123  (issued  January  28, 
1921)^^  is  the  elimination  of  sentence  reading:  "for  the  pur- 
pose of  returns  made  in  1919,  the*  preliminary  estimate  of 
the  amount  of  such  amortization  shall  not,  in  any  case,  have 
exceeded  25%  of  the  cost  of  the  property."  The  author  con- 
tended that  such  a  provision  was  not  legal. " 


"  [Former  Procedure]  T.  D.  3123  (Art.  184)  eliminated  the  restric- 
tive clause  limiting  the  deduction  for  facilities  it  was  known  vvonld  be  dis- 
carded in  the  future,  to  those  to  be  discarded  "before  the  last  inslallnient 
payment  of  the  tax"  covered  by  the  1919  returns. 

"See  Income  Tax  Procedure,  1921,  pages  920-922. 


Il62  DEDUCTIONS 

Also  the  reference  to  determining  the  amortization  allow- 
ance "upon  the  basis  of  stable  post-war  conditions"  has  been 
modified.  As  the  author  stated  in  a  previous  edition,  no  one 
seems  to  have  been  able  to  advise  taxpayers  what  are  "stable 
post-war  conditions."  Tlie  reference  to  pre-war  data  is  inter- 
esting, and  if  fair  to  taxpayers  may  be  accepted  as  a  reasonable 
method  of  fixing  stable  post-war  prices. 

Period  to  which  loss  is  apportioned. — 

Regulation.  The  amortization  allowance  shall  be  apportioned 
(a)  in  cases  where  the  property  was  employed  in  the  production  of 
articles  contributing  to  the  prosecution  of  the  war,  over  the  respective 
accounting  periods  of  the  taxpayer,  having  reasonable  regard  to  his 
gross  and  net  income,  and  where  separately  ascertainable  the  in- 
come from  the  facilities  upon  which  amortization  is  claimed,  between 
January  i,  1918  (or  if  the  property  was  acquired  subsequent  to  that 
date,  January  i  of  the  year  in  which  acquired),  and  the  actual  or 
estimated  date  of  cessation  of  operations  as  a  war  facility,  and  (b)  in 
cases  where  the  property  was  not  completed  in  time  for  use  in  the 
production  of  articles  contributing  to  the  prosecution  of  the  war,  on 
the  basis  of  the  expenditures  made  on  accotmt  of  which  amortization 
is  allowed (Art.  185.) 

Estimate  of  net  income  for  "amortization  period" 

required basis  of  apportionment.— 

Regulation All  taxpayers   claiming   an   allowance   for 

amortization  shall  compute  the  amount  of  their  claims  applicable  to 
each  accounting  period  between  January  i,  19 18,  to  the  date  specified 
above.  Taxpayers  reporting  on  the  fiscal  year  basis  shall  (a)  in  all 
computations  based  upon  1918  rates  for  years  ending  in  1918  and  1919 
use  the  amount  of  such  allowance  apportioned  to  the  calendar  year 
1918;  (&)  in  all  computations  based  upon  1919  rates  for  a  year  be- 
ginning in  1918  and  ending  in  1919,  use  the  amount  of  such  allowance 
apportioned  to  the  calendar  year  1919;  (c)  in  all  computations  for  a 
year  beginning  in  1919  and  ending  in  1920,  use  the  number  of  twelfths 
of  the  allowance  apportioned  to  each  calendar  year  falling  within  such 
fiscal  year  that  there  are  months  of  such  calendar  year  falling 
within  such  fiscal  year;  (d)  in  all  computations  based  upon  1920 
rates  for  a  year  beginning  in  1920  and  ending  in  1921,  use  the 
amount  of  such  allowance  apportioned  to  the  calendar  year  1920; 
(e)  in  all  computations  based  upon  1921  rates  for  years  ending  in 
192 1  or  1922,  use  the  amount  of  such  allowance  apportioned  to  the 


FOR    OBSOLESCENCE   AND   AMORTIZATION  1163 

calendar  year  1921  ;  (/)  in  all  compulations  based  upon  1922  rates 
for  a  year  beginning  in  1921  and  ending  in  1922,  use  the  amount  of 
such  allowance  apportioned  to  the  calendar  year  1922;  (g)  and  in 
all  computations  for  subsequent  fiscal  years  use  the  number  of 
twelfths  of  the  allowance  apportioned  to  each  calendar  year  falling 
within  such  fiscal  year  that  there  are  months  in  such  calendar  year 
falling  within  such  fiscal  year.     (Art.  185.) 

The  law  imposes  no  limitation  on  the  amount  of  amorti- 
zation to  be  deducted  in  any  one  year,  nor  does  it  state  that 
the  entire  amortization  must  be  claimed  as  a  deduction  against 
one  year's  income.  The  intent  of  the  law  would  seem  to  be  to 
permit  taxpayers  who  erected  plants  for  war  purposes  to  write 
off,  as  quickly  as  possible,  the  excess  cost  of  such  plants  over 
normal  or  pre-war  cost  and  to  apply  such  write-off  in  reduc- 
tion of  income  reported  for  taxation.  Until  such  excess 
cost  has  been  written  off  there  is  no  income  which  should  be 
taxed.  Until  the  excess  has  been  written  off  such  taxpayers  are 
not  on  an  equal  basis  with  other  taxpayers  who  constructed 
their  plants  before  the  war  and  made  no  new  capital  expendi- 
tures to  assist  in  the  prosecution  of  the  war.  Furthermore 
the  deduction  for  amortization  is  not  actually  being  fully  al- 
lowed if  in  part  or  in  whole  it  is  included  in  a  tax  return  to 
an  amount  in  excess  of  the  net  income  determined  prior  to 
the  application  of  the  amortization  deduction. 

Assuming  that  the  amortization  allowance  exceeds  the  net 
income  of  19 18,  it  would  seem  logical  to  apply  the  net  income 
of  each  year  from  1918  onward  against  the  amortization  al- 
lowance and  to  tax  income  only  after  the  amortization  has 
been  fully  applied  against  income. 

It  would  of  course  defeat  the  purpose  of  the  relief  intended 
if  a  taxpayer  were  required  to  take  the  amortization  deduction 
in  a  period  when  he  had  no  net  income.  Such  was  not  the 
intention  of  the  law.  It  was  assumed  that  war  facilities  pro- 
duced an  income  while  being  used  and  that  if  their  profitable 
use  was  diminished  by  the  end  of  the  war  there  should  be  an 
adjustment  of  the  apparent  profits  equal  to  the  loss  sus- 
tained. 


1 164  DEDUCTIONS 

If  a  taxpayer  required  several  months  in  1919  to  secure  a 
market  or  use  for  war  facilities  and  during  those  months  the 
facilities  were  not  producing  a  profit,  the  entire  loss  should  be 
charged  to  1918. 

The  method  laid  down  in  article  185  may  work  equita- 
bly in  some  cases.  If  the  application  of  the  method  to  a  par- 
ticular case  does  not  yield  to  the  taxpayer  a  reasonable  deduc- 
tion for  amortization,  some  other  method  should  be  used. 

Taxpayers  should  prepare  an  estimate  of  the  loss  sustained 
and  then  apply  the  loss  to  the  period  affected.  The  accounts 
should  be  adjusted  accordingly  and  if  the  result  is  not  the  same 
as  would  be  produced  by  the  conflicting  methods  in  the  regu- 
lations the  taxpayer  will  have  to  look  to  the  courts  for  a  cor- 
rect interpretation  of  the  law. 

Taxpayer's  books  and  statements. — 

Regulation.  Claims  for  amortization  must  be  unmistakably  dif- 
ferentiated in  the  return  from  all  other  claims  for  wear,  tear  obsoles- 
cence, and  loss.  If  Government  or  other  contracts  taken  by  the  tax- 
payer contained  recognition  of  amortization  as  an  element  in  tlie 
cost  of  production,  copies  of  such  contracts  shall  be  filed  with  tbe 
taxpayer's  return,  together  with  a  statement  and  description  of  any 
sums  received  on  account  of  amortization  and  the  basis  upon  which 
tlTey  were  determined.  In  any  case  in  which  an  allowance  has  been 
made  for  amortization  of  cost  the  taxpayer  will  not  be  allowed  to 
restore  to  his  invested  capital  for  the  purpose  of  the  war-profits  and 
excess-profits  tax  any  portion  of  the  amount  covered  by  such  allow- 
ance.    (Art.  186.) 

The  statement  in  the  old  regulation  that,  "No  such  claim 
will  be  allowed  unless  it  is  reflected  in  any  accounts  submitted 
by  the  taxpayer  to  stockholders  and  in  any  credit  statements 
by  the  taxpayer  to  banks,  and  is  given  full  efifect  on  his  finan- 
cial books  of  account,"  is  eliminated. 

It  is  a  reasonable  requirement  that  a  taxpayer's  books 
should  reflect  all  transactions.  AMien  claim  for  amortization 
is  made,  the  loss  should  (so  far  as  feasible  in  advance  of  final 
determination  of  the  allowances)  be  charged  against  the  period 
to  which  it  belongs. 


FOR    OBSOLESCENCE   AND   AMORTIZATION  1165 

In  subiiiitting  lliial  claims  which  may  modify  prior  claims 
and  an  early  adjustment  of  the  whole  matter  is  contemplated, 
it  may  be  desirable  to  await  hnal  adjudication  before  mak- 
ing further  adjustments  in  the  books. 

Estimates  to  be  adjusted  before  March  3,  1924. — 

Regulation.  A  redetermination  of  the  deduetion  allowed  on 
account  of  amortization  may,  or  at  the  request  of  the  taxpayer  shall, 
be  made  by  the  Commissioner  at  any  time  before  March  3,  1924,  and 
if  as  a  result  of  an  appraisal  or  from  other  evidence  it  is  found  that 
the  deduction  originally  allowed  was  incorrect,  the  amount  of  tax  due 
for  each  taxable  year  during  the  amortization  period  will  be  adjusted 
by  additional  assessment  or  by  refund.      (Art.  187. ) 

It  should  always  be  kept  in  mind  that  the  original  claim 
was  based  on  an  estimate,  except  in  the  case  of  sale  or  some 
other  definite  means  of  determination. 

Taxpayers  may  present  to  the  Commissioner  their  claim 
for  a  redetermination  at  any  time  prior  to  March  3,  1924." 
Until  the  Commissioner  announces  his  final  determination, 
taxpayers  need  not  consider  the  matter  is  ready  for  final  ad- 
judication. When  such  final  determination  is  announced,  tax- 
payers have  a  statutory  right  of  appeal,  at  which  time,  and 
not  before,  the  rights  of  taxpayers  to  revise  their  claims  will 
end. 

When  it  is  found  that  the  estimate  was  too  large  or  too 
small  the  facts  should  be  reported  without  delay  and  the  taxes 
of  the  prior  years  should  be  redetermined. 

When  an  original  estimate  of  loss  proves  to  be  excessive, 
because  facilities  believed  to  be  of  lessened  value  at  the  end 
of  the  taxable  year  19 19  have  subsequently  increased  in  value, 
amended  returns  should  of  course  be  made. 

But  if  on  subsequent  sale  facilities  should  be  sold  for  more 
than  book  value,  exclusive  of  amortization,  the  profit  realized 
should  be  reported  as  of  the  period  of  sale  and  only  the 
amount  of  amortization  restored  to  the  original  period.  This 


See  also  C.  B.  i,  page  140;  A.  K    M.  lu. 


Il66  DEDUCTIONS 

accords  with  the  usual  rule  that  appreciation  in  value  should 
not  be  reported  until  realized. 

Regulation.  In  the  case  of  the  bona  fide  sale  of  amortized  prop- 
erty before  March  3,  1924,  the  sale  price  thereof  will  be  considered 
as  reflecting  the  correctness  or  incorrectness  of  the  amortization  al- 
lowance made,  due  allowance  being  made  for  depreciation  sustained 
since  the  close  of  the  amortization  period.       (Art.  188.) 

Detailed  information  to  support  claim  must  be  filed. — 

Regulation.  The  taxpayer's  claim  for  amortization  must  be 
complete  and  comprehensive  in  all  respects.  The  commissioner  will 
not  entertain  claims  which  do  not  clearly  set  forth  full  data  with  re- 
spect to  the  property  which  it  is  desired  to  amortize. 

To  assist  the  taxpayer  in  compiling  this  information  the  Commis- 
sioner has  prepared  Guide  Form  1007-M,  which  explains  in  detail 
the  manner  in  which  claims  for  amortization  should  be  presented. 
A  copy  of  this  guide  form  will  be  furnished  to  the  taxpayer  upon 
application  to  the  Commissioner.     (Art.  189.) 

The  Treasury  requires  comprehensive  data  as  to  original 
cost,  depreciation  sustained,  when  acquired  or  constructed, 
proof  as  to  "value  in  use,"  and  the  various  computations  nec- 
essary to  allocate  the  deduction  to  the  proper  years.  A  copy 
of  the  Guide  Form  1007-M  referred  to  above  will  be  found 
in  the  Appendix. 


CHAPTER    XXXIII 

DEDUCTIONS  FOR  DEPLETION 

The  1 92 1  law  re-enacts  the  provisions  of  the  19 18  law 
regarding  depletion.  "A  reasonable  allowance  for  depletion" 
is  permitted  in  the  case  of  those  industries  with  wasting  assets 
because  of  the  exhaustion  of  the  minerals,  oil,  timber,  etc. 
The  allowance  represents  a  return  of  capital.  While  the  pro- 
vision permitting  a  "discovery"  value  as  a  basis  for  depletion 
(in  case  of  properties  "discovered"  on  or  after  March  i,  1913) 
is  retained  in  the  new  law,  a  limitation  on  securing  the  benefit 
of  the  full  amount  of  such  depletion  is  now  imposed.  The 
effects  of  this  limitation  are  (a)  to  prevent  carrying  forward 
into  a  succeeding  year  (as  a  net  loss — see  section  204)  any 
excess  of  depletion  based  on  '-'discovery"  value  over  net  in- 
come from  the  property,  and  (b)  to  deny  the  offsetting  of 
such  excess  depletion  against  income  from  other  sources,  such 
as  income  from  investments  or  from  the  operation  of  another 
property.  In  the  case  of  oil  wells,  the  "discovery"  feature  is 
doubtless  invoked  in  respect  of  many  properties  acquired  since 
March  i,  1913.  As  in  so  many  of  the  other  so-called  "cushion" 
provisions  of  the  income  tax  laws,  Congress  having  first  given 
the  taxpayer  relief  in  one  provision,  proceeds  to  take  away, 
in  another  provision,  much  of  the  benefit.  On  the  other  hand, 
it  may  be  assumed  that  "discovery"  values  may  well  be  so 
high  that  the  depletion  charge,  in  a  year  of  depression,  may 
easily  exceed  all  income  from  the  property.  In  any  event 
the  taxpayer  will  receive  the  benefit  of  "discovery"  depletion 
up  to  the  amount  of  the  income  from  the  property,  should  such 
depletion  be  greater  than  the  income  from  the  property. 

Law.  Section  214.  (a-io)  [Individuals]  Section  234.  (a-9) 
[Corporations.]  That  in  computing  net  income  there  shall  be  allowed 
as   deductions: 

In   the   case  of  mines,   oil   and   gas  wells,   other  natural   deposits, 

1 167 


11(38  DEDUCTIONS 

and  timber,  a  reasonable  allowance  for  depletion  and  for  depreciation 
of  improvements,  according  to  the  peculiar  conditions  in  each  case, 
based  upon  cost  including  cost  of  development  not  otherwise  de- 
ducted: Provided,  That  in  the  case  of  such  properties  acquired  prior 
to  March  i,  1913,  the  fair  market  value  of  the  property  (or  the  tax- 
payer's interest  therein)  on  that  date  shall  be  taken  in  lieu  of  cost 
up  to  that  date:  Provided  further,  That  in  the  case  of  mines,  oil  and 
gas  wells,  discovered  by  the  taxpayer,  on  or  after  March  i,  1913,  and 
not  acquired  as  the  result  of  purchase  of  a  proven  tract  or  lease, 
where  the  fair  market  value  of  the  property  is  materially  dispropor- 
tionate to  the  cost,  the  depletion  allowance  shall  be  based  upon  the 
fair  market  value  of  the  property  at  the  date  of  the  discovery,  or 
within  thirty  days  thereafter:  And  provided  further.  That  such  deple- 
tion allowance  based  on  discovery  value  shall  not  exceed  the  net  income, 
computed  without  allowance  for  depletion,  from  the  property  upon 
which  the  discovery  is  made,  except  where  such  net  income  so  com- 
puted is  less  than  the  depletion  allowance  based  on  cost  or  fair  market 
value  as  of  March  i,  1913;  such  reasonable  allowance  in  all  the  above 
cases  to  be  made  under  rules  and  regulations  to  be  prescribed  by  the 
Commissioner  with  the  approval  of  the  Secretary.  In  the  case  of 
leases  the  deductions  allowed  by  this  paragraph  shall  be  equitably  ap- 
portioned between  the  lessor  and  lessee;   ...    J 

Nothing  more  could  be  asked  by  any  owner  or  lessee  of 
natural  deposits  than  "a  reasonable  allowance  for  depletion," 
but  the  interests  of  lessor  and  lessee  should  be  separated. 

The  theory  of  depletion  is  comparatively  simple,  viz.,  pro- 
vision must  be  made  for  the  return  of  capital  invested  in 
natural  resources  which  are  being  exhausted.  The  capital  to 
be  returned  is  original  cost,  or  value  as  at  Alarch  i,  1913,  if 
acquired  prio-r  thereto,  or  in  certain  cases  a  "discovery"  value 
if  acquired  after  March  i,  19 13.  This  involves  a  periodical 
chargp  against  the  gross  earnings  realized  from  the  product, 
of  such  amounts  as  will  in  the  aggregate  equal  the  original 
outlay  by  the  time  the  property  shall  have  been  exhausted. 
It  is  in  the  application  of  the  theory,  or  rather  in  securing  the 


'  [Former  Procedure]  The  1921  law  is  the  same  as  the  1918  law, 
with  the  exception  that  the  clause,  '\ind  provided  further,  That  such  deple- 
tion allowance  based  on  discovery  value  shall  not  exceed  the  net  income, 
computed  without  allowance  for  depletion,  from  the  property  upon  which 
the  discovery  is  made,  except  where  .such  net  income  so  computed  is  less 
than  the  depletion  allowance  based  on  cost  or  fair  market  value  as  of 
March  i,  1913;"  did  not  appear  in  the  1918  law. 


FOR   DEPLETION  1 169 

requisite  data,  tliat  the  practical  difficulties  are  encountered. 
Two  fundamental  facts  must  be  estal^lished,  as  follows : 

(a)  Value  of  the  property  at  March  i,  191 3,  if  acquired 

prior   thereto,   or   within   thirty   days   after   "dis- 
covery" if  acquired  after  March  i,  1913;'  and 

(b)  The   number   of   units   of   principal   product   in   the 

property  at  valuation  date. 

The  depletion  unit  [a  -^-  b]  multiplied  by  the  number  of 
units  produced  during  the  year,  gives  the  depletion  deduction 
for  the  taxable  year. 

As  soon  as  the  reserve  for  depletion  equals  the  capital  in- 
vestment, no  further  charges  can  be  made,  no  matter  how 
much  more  produgt  may  be  recovered.  The  excess  is  all  in- 
come and  must  be  so  returned. 

The  language  of  the  1921  law"  is  broad  enough  to  permit 
the  full  deduction  demanded  by  the  theory  of  depletion. 


*  If  the  property  was  acquired  after  March  i,  1913,  and  no  "discovery" 
value  is  claimed,  cost  is  used  as  factor   (i). 

^  [Former  Procedure]  Under  the  1909  law  no  deduction  could  be 
made  for  depletion.  The  language  of  the  statute  that  "all  losses  sus- 
tained within  the  year  ....  including  a  reasonable  allowance  for 
depreciation  of  property"  (section  38,  Second)  was  interpreted  by 
the  Supreme  Court  of  the  United  States  as  not  permitting  the  deduc- 
tion of  allowances  of  this  type  (Von  Baumbach,  Collector,  v.  Sargent 
Land  Co.,  242  U.  S.  503).  The  Bureau  of  Internal  Revenue,  acting  upon 
this  decision,  reassessed  corporations  which  under  this  law  claimed 
depletion  allowance.  For  a  full  discussion  and  criticism  of  this  decision 
see  Income  Tax  Procedure,  1918,  pages  406-408. 

The  1913  law  permitted  "in  the  case  of  mines  a  reasonable  allowance 
for  depletion  of  ores  and  all  other  natural  deposits,  not  to  exceed  5  per 
centum  of  the  gross  value  at  the  mine  of  the  output  for  the  year  for 
which  the  computation  is  made"  [section  II  G  (b)].  The  Supreme  Court 
of  the  United  States  held  that  this  5  per  cent  limitation  was  constitu- 
tional even  though  it  might  be  inadequate  to  provide  fully  for  depletion 
and  as  a  consequence  might  result  in  the  tax  being  levied  not  only  on  the 
profit  but  also  in  part  upon  gross  product  or  capital.  {Stanton  v.  Baltic 
Mining  Company,  240  U.  S.  103.)  For  a  full  discussion  of  the  pro- 
cedure under  this  limitation  of  the  1913  law,  see  Income  Tax  Procedure, 
191 8,  pages  402-406. 


II70  DEDUCTIONS 

The  latest  regulations*  of  the  Treasury  reflect  the  general 
principles  to  be  observed  in  arriving  at  proper  valuation,  the 
determination  of  the  proper  number  of  mineral  units  embraced 
therein,  and  proper  depletion  charges. 

The  major  problem,  however,  is  to  assemble  the  tre- 
mendous amount  of  data  required  to  support  the  valuations 
to  the  satisfaction  of  the  Treasury.  Fortunately,  many  min- 
ing companies  have  excellent  records  from  which  the  data 
regarding  assay  values,  recovery  of  metal  contents,  costs, 
proper  rates  of  discounts  in  the  case  of  mines,  and  the  other 
factors  can  be  compiled  and  stated. 

In  arriving  at  the  depletion  rate,  consideration  must  also 
be  given  to  the  effect  that  the  value  established  for  depletion 
may  have  on  invested  capital,  particularly  a§  to  paid-in  surplus,^ 
as  well  as  its  effect  on  the  distributions  to  stockholders  in  the 
form  of  dividends  free  from  tax.® 

Practically,  it  will  be  found  in  every  case  that  where  an 
attempt  is  being  made  to  establish  the  proper  depletion  rate, 
a  series  of  problems,  as  indicated  above,  follows  in  the  train  of 
what  theoretically  is  quite  a  simple  matter.  When  a  company 
owns  a  series  of  mining  claims  it  is  often  a  question  as  to  how 
much  should  be  taken  in,  in  those  cases  where  the  ore  is  not 
blocked  out,  and  how  much,  if  any,  in  the  future  may  be 
brought  in  under  the  discovery  provision. 


The  1916  law,  unchanged  in  1917,  [section  5,  Eighth  (a),  individuals, 
and  section  12  (a),  Second,  corporations]  was  as  follows: 

"(a)  In  the  case  of  oil  and  gas  wells  a  reasonable  allowance  for 
actual  reduction  in  flow  and  production  to  be  ascertained  not  by  the  flush 
flow,  but  by  the  settled  production  or  regular  flow;  (b)  in  the  case  of 
mines  a  reasonable  allowance  for  depletion  thereof  not  to  exceed  the  mar- 
ket value  in  the  mine  of  the  product  thereof,  which  has  been  mined  and 
sold  during  the  year  for  which  the  return  and  computation  are  made, 
such  reasonable  allowance  to  be  made  in  the  case  of  both  (a)  and  (b) 
under  rules  and  regulations  to  be  prescribed  by  the  Secretary  of  the 
Treasury:  Provided,  That  when  the  allowances  authorized  in  (a)  and 
(b)  shall  equal  the  capital  originally  invested,  or  in  case  of  purchase  made 
prior  to  March  first,  nineteen  hundred  and  thirteen,  the  fair  market  value 
as  of  that  date,  no  further  allowance  shall  be  made " 

*  Reg.  62,  promulgated  February  15,  1922. 
^  See  Appendix  A,  Chapter  X. 

*  See  page  715. 


FOR   DEPLETION 


1171 


Depletion,  at  the  option  of  the  taxpayer,  is  made  to  em- 
brace recovery  of  capital  expenditures  other  than  for  ore,  and 
this  gives  rise  to  questions  of  what  are  really  capital  items  in 
a  business  of  the  character  peculiar  to  wasting  assets,  and 
what  is  properly  chargeable  to  expense. 

General  procedure  in  case  of  depletion. — 

Basis  of  depletion  allowance. — The  first  step  in  de- 
termining the  depletion  deduction  is  to  establish  a  proper  valu- 
ation of  the  property  at  March  i,  191 3,  if  acquired  prior 
thereto,  or  at  the  ''discovery''  date,"  if  acquired  after  March  i, 
1913,  and  a  "discovery"  is  claimed,  for  it  is  on  these  respective 
values  that  depletion  is  based,  except  that  if  a  property  was 
acquired  after  March  i,  1913,  and  a  "discovery"  is  not  claimed, 
the  depletion  deduction  is  based  on  cost.  For  purposes  of 
invested  capital,  it  is  sometimes  necessary  to  obtain  a  valua- 
tion at  the  date  the  property  was  paid  in,  if  such  value  is  in 
excess  of  the  stock  issued  therefor,  as  par  value  of  the  stock 
in  many  cases  was  only  a  nominal  amount.  In  the  last-men- 
tioned case,  if  the  property  was  acquired  prior  to  March  i, 
1913,  depletion  for  the  period  prior  to  March  i,  1913,  would 
be  computed  on  the  basis  of  the  value  of  the  property  at  the 
date  paid  in,  plus  allowable  capital  additions.  Beginning  with 
March  i,  191 3,  depletion  would  be  computed  on  the  value  at 
that  date,  which  usually  includes  a  large  amount  of  apprecia- 
tiofi  in  value.  For  instance,  an  individual  may  have  purchased 
coal  lands  in  1908  at  $400  per  acre  and  thereafter  may  have 
charged  off  periodically  against  product  such  an  allowance  as 
would  reasonably  write  off  the  cost  before  the  tract  was  ex- 
hausted. If  the  value  of  the  unmined  coal  appreciated,  and 
it  could  be  demonstrated  that  on  March  i,  1913,  the  fair  value 
was  $800  per  acre,  subsequent  to  that  date  the  charge  for  de- 
pletion should  be  doubled. 

When  such  a  condition  exists,  the  proper  procedure  is  to 
debit  the  property  account  and  credit  an  account  called  "Sur- 

'  See  page  1194. 


1172  DEDUCTIONS 

plus  arising-  from  rca])|)raisement  of  propertv.''  The  prop- 
erty account,  as  so  valued,  will  then  be  the  basis  of  depletion 
charges.  An  adjustment  should  be  made  to  have  the  account 
properly  reflect  the  necessary  charges  to  the  beginning  of  the 
taxable  year,  and  thereafter  the  annual  charges  should  be 
accurately  calculated.  If  such  an  account  is  created  it  will  be 
desirable  to  transfer  therefrom,  once  a  year,  to  the  regular 
surplus  account,  an  amount  representing  the  difference  be- 
tween the  aggregate  depletion  actually  charged  and  the  amount 
which  would  have  been  charged  on  the  basis  used  before 
revaluation.  The  chief  reason  for  making  such  transfer  is 
that  the  item  "invested  capital"  as  defined  by  the  excess  profits 
tax  law  does  not  recognize  appreciation  arising  out  of  re- 
valuations unless  a  sale  takes  place,  but  cash  realizations  of 
any  part  of  the  profit  on  assets  reappraised  are  additions  to 
invested  capital,  commencing  with  the  dates   of  realization. 

In  a  recent  ruling"^  the  Treasury  held  that  appreciation  ac- 
crued prior  to  March  i,  1913,  and  realized  subsequently,  repre- 
sents "profits  earned  during  the  year,"^  and  therefore  cannot 
be  included  as  invested  capital  in  the  year  in  which  realized. 
The  theory  that  such  realized  appreciation  is  a  profit  of  the 
current  year  also  w^ould  subject  to  tax  any  cash  dividends 
paid  from  such  realized  appreciation.  These  points  are  fully 
discussed  on  pages  718-725. 

For  a  method  of  separating  ledger  accounts  so  that  surplus 
accrued  before  and  after  March  i,  1913,  will  be  properly 
segregated,  see  page  582. 

Regulation.  Sections  214  (a)  (10)  and  234  (a)  (9)  provide 
that  taxpayers  shall  be  allowed  as  a  deduction  in  computing  net  in- 
come in  the  case  of  natural  deposits  a  reasonable  allowance  for  de- 
pletion of  mineral  and  for  depreciation  of  improvements.  These 
paragraphs  of  the  statute  are  not  materially  different  from  the  cor- 
responding paragraphs  of  the  Revenue  Act  of  1918.  These  pro- 
visions of  the  statute  ....  do  not  apply  to  or  affect  the  regulations 
covering  invested  capital,  losses,  accounting  methods,  etc. 


■  Sec  page  721. 

°  Section  326   (a-3). 


I'OR  I)I<:i'i,e:tk)N  1173 

The  essence  of  these  provisions  of  the  statute  is  that  the  owner  of 
mineral  deposits,  whether  freehold  or  leasehold,  shall,  within  the 
limitations  prescribed,  secure  through  an  aggregate  of  annual  deple- 
tion and  depreciation  deductions  the  return  of  either  (a)  the  cost  of 
his  property  if  acquired  subsequent  to  March  i,  1913,  or  (  b)  the  value 
of  his  property  on  the  basic  date,  plus  subsequent  allowable  capital 
additions  ....  but  not  including  land  values  for  purposes  other 
than  the  extraction  of  minerals (Art.  201.) 

The  following  definitions  indicate  some  of  the  conditions 
attending  a  proper  valuation,  and  make  the  distinction  between 
the  "minerals"  which,  as  shown  hereinafter,  are  valued  on  one 
basis  and  the  physical  equipment  which  is  usually  taken  at  de- 
preciated cost,  plus  the  valtie  of  the  land,  which  in  some  cases 
may  be  available  for  agriculture.  The  value  of  land  for  other 
than  mineral  purposes  is  not  to  be  recovered  through  depletion 
charges/" 

Definitions. — 

Regulation.  When  used  in  these  articles  ....  covering  de- 
pletion and  depreciation — 

Basic  date. — 

(a)  The  term  "basic  date"  indicates  the  date  of  valuation,  i.  e., 
March  i,  1913,  in  the  case  of  property  acquired  prior  thereto;  the  date 
of  acquisition  in  the  case  of  property  acquired  on  or  after  March 
I,  1913;  or  the  date  of  discovery,  or  within  thirty  days  thereafter,  in 
the  case  of  discovery. 

Fair  market  value. — 

(b)  The  "fair  n]arket  value"  of  a  property  is  that  amount  which 
would  induce  a  willing  seller  to  sell  and  a  willing  buyer  to  purchase. 

Mineral  property, — 

(c)  A  "mineral  property"  or  "property"  is  the  mineral  deposit, 
the  development  and  plant  necessary  for  its  extraction,  and  so  much  of 
the  surface  as  is  reasonably  expected  to  be  underlaid  with  the  min- 
eral. The  value  of  a  mineral  property  is  the  combined  value  of  its 
component  parts. 

"'  Sec  page  1174. 


1 174 


DEDUCTIONS 


Mineral  deposit.- 


(d)  A  "mineral  deposit"  refers  to  "minerals  only,"  such  as  the 
"ores  only"  in  the  case  of  a  mine,  to  the  "oil  only"  in  the  case  of  an 
oil  well,  and  to  the  "gas  only"  in  the  case  of  a  gas  well,  and  to  the  "oil 
and  gas"  in  the  case  of  a  well  producing  both  oil  and  gas.  The  value 
of  a  mineral  deposit  is  its  cost;  or  it  is  the  value  of  the  mineral  prop- 
erty, less  the  value  of  the  plant,  equipment,  and  surface  of  the  land 
for  purposes  other  than  mineral  production. 

Minerals. — 

(e)  "Minerals"  include  ores  of  the  metals,  coal,  oil,  gas  and 
such  nonmetallic  substances  as  abrasives,  asbestos,  asphaltum,  barytes, 
borax,  building  stone,  cement  rock,  clay,  crushed  stone,  feldspar, 
fluorspar,  fuller's  earth,  graphite,  gypsum,  limestone,  magnesite,  marl, 
mica,  mineral  pigments,  peat,  potash,  precious  stones,  refractories, 
rock  phosphate,  salt,  sand  and  gravel,  silica,  slate,  soapstone,  soda, 
sulphur,  and  talc. 

Operating  profit. — 

(/)  "Operating  profit"  is  the  net  income  from  mineral  production 
before  depletion  and  depreciation  are  deducted.  It  is  distinct  from 
net  income (Art.  201.) 

Cost  when  used  as  basis  must  be  bona  fide.-— 

Regulation.  In  any  case  in  which  a  depletion  or  depreciation 
deduction  is  computed  on  the  basis  of  the  cost  or  price  at  which  any 
mine,  mineral  deposit,  mineral  right  or  leasehold  was  acquired,  the 
owner  or  lessee  will  be  required  to  show  that  the  cost  or  price  at 
which  the  property  was  bought  was  fixed  for  the  purpose  of  a  bona 
fide  purchase  and  sale,  by  which  the  property  passed  to  an  owner  in 
fact  as  well  as  in  form  other  than  the  vendor.  No  fictitious  or  inflated 
cost  or  price  will  be  permitted  to  form  the  basis  of  any  calculation 
of  a  depletion  or  depreciation  deduction,  and  in  determining  whether 
or  not  the  price  or  cost  at  which  any  purchase  or  sale  was  made  rep- 
resented the  actual  market  value  of  the  property  sold,  due  weight 
will  be  given  to  the  relationship  or  connection  existing  between  the 
person  selling  the  property  and  the  buyer  thereof.      (Art.  205.) 


Valuation  of  Mines 

Since  in  most  cases  the  depletion  deduction  will  be  based 
on  the  value  at  March  i,  1913,  or  on  the  "discovery"  value 
claimed    for  properties   acquired   thereafter,  a   discussion   of 


FOR   DEPLETION 


1 175 


some  of  the  particular  problems  involved  is  pertinent  at  this 
point.  Comments  on  the  regulations  dealing  with  valuation 
are  made  particularly  with  reference  to  mines.  Special  con- 
siderations bearing  on  the  valuation  of  oil  and  gas  wells  fol- 
low. The  regulations  dealing  with  timber  are  also  considered 
in  this  chapter. 

In  the  early  days  of  the  administration  of  the  191 7  and 
1918  laws  when  the  matter  of  the  depletion  allowance  first 
became  of  such  vital  importance,  the  Treasury  attempted  to 
place  a  value  on  mining  properties  gauged  by  the  value  of 
shares  of  capital  stock^^  at  or  about  the  date  as  of  which 
the  valuation  for  depletion  was  to  be  made.  These  attempts, 
it  is  believed,  proved  so  unsatisfactory,  that  the  Treasury, 
following  recognized  engineering  methods,  is  applying  gen- 
erally a  method  based  on  the  present  value  of  anticipated  earn- 
ings, as  stated  hereinafter.  Some  of  the  bases  of  valuation 
have  been  stated  as  follows : 

Method  of  valuation. — 

Regulation,  (a)  Where  the  fair  market  value  of  the  property 
at  a  specified  date  in  lieu  of  the  cost  thereof  is  the  basis  for  deple- 
tion and  depreciation  deductions,  such  value  must  be  determined, 
subject  to  approval  or  revision  by  the  Commissioner,  by  the  owner  of 


•  "  "But  we  must  remember  that  mines  are  not  staples  like  the  metals  they 
produce  and  that  market  quotations  upon  them  are  of  a  different  order  from 
quotations  on  staples.  Thus  lead  in  a  warehouse  is  always  marketable.  It 
is  as  good  as  any  other  lead.  Its  price  varies  between  certain  limits,  of 
course,  but  the  market  value,  whatever  it  is,  is  always  there.  But  there  is 
no  such  certitude  or  permanence  about  the  stock  of  the  mine.  Today  it  may 
be  in  high  favor;  five  years  from  now  it  may  be  worth  twice  as  much,  or 
nothing  at  all,  and  the  quotations  bear  no  definite  relation  to  the  price  of 
metal,  but  are  influenced  strongly,  often  decisively  by  other  factors. 

"Again,  we  can  never  be  certain  that  the  valuation  of  stocks  by  market 
quotation  represents  the  same  action  in  all  cases.  Many  properties  are  not 
on  the  market  at  all.  Of  those  actually  before  the  public,  some  may  b^  in 
high  esteem,  skillfully  advertised  and  distributed  among  a  large  number 
of  holders;  others  may  be  scarcely  noticed,  with  few  holders,  few  transfers, 
and  the  market  may  be  merely  nominal.  It  is  conceivable  that  the  highly 
advertised  stock  might  bring  twice  the  price  of  the  obscure  one,  even 
though  both  have  the  same  actual  merit. 

"I  think  these  considerations  are  generally  conceded  to  be  convincing 
reasons  for  subjecting  the  valuation  of  mines  to  a  searching  and  independ- 
ent review  every  time  such  property  becomes  the  object  of  any  important 
transaction."     (J.  R.  Finlay,  Cost  of  Mining,  1920  edition,  page  44.) 


1 1 76  DEDUCTIONS 

the  property  in  the  ligiit  of  the  conditions  and  circumstances  known 
at  that  date,  regardless  of  later  discoveries  or  developments  in  the 
property  or  subsequent  improvements  in  methods  of  extraction  and 
treatment  of  the  mineral  product.  The  value  sought  should  be  that 
established  assuming  a  transfer  between  a  willing  seller  and  a  will- 
ing buyer  as  of  that  particular  date.  The  Commissioner  will  lend 
due  weight  and  consideration  to  any  and  all  factors  and  evidence 
having  a  bearing  on  the  market  value,  such  as  cost,  actual  sales  and 
transfers  of  similar  properties,  market  value  of  stock  or  shares, 
royalties  and  rentals,  value  fixed  by  the  owner  for  purpose  of  the 
capital-stock  tax,^"  valuation  for  local  or  State  taxation,  partnership 
accountings,  records  of  litigation  in  which  the  value  of  the  property 
was  in  question,  the  amount  at  which  the  property  may  have  been  in- 
ventoried in  probate  court  and,  in  the  absence  of  better  evidence, 
disinterested  appraisals  by  approved  methods.  Valuations  by  analytic 
appraisal  methods,  such  as  the  present  value  method,  are  not  entitled 
to  great  weight:  (i)  If  the  value  of  a  mineral  deposit  can  be  de- 
termined upon  the  basis  of  cost  or  replacement  value,  (2)  if  the 
knowledge  of  the  presence  of  the  mineral  has  not  greatly  enhanced 
the  value  of  the  mineral  property,  (3)  if  the  removal  of  the  mineral 
does  not  materially  reduce  the  value  of  the  property  from  which  it  is 
taken,  or  (4)  if  the  profits  arising  from  the  exploitation  of  the  min- 
eral deposit  are  wholly  or  in  great  part  due  to  the  manufacturing  or 
marketing  ability  of  the  taxpayer,  or  to  extrinsic  causes  other  than 
the  possession  of  the  mineral  itself.  Where  the  fair  market  value 
must  be  ascertained  as  of  a  certain  date,  anahi:ic  appraisal  methods 
will  not  be  used  if  the  fair  market  value  can  reasonably  be  deter- 
mined by  any  other  method (Art.  206.) 

The  difficulty  is  that  most  profitable  mining  properties 
have  not  changed  hands  since  March  i,  1913.^^  In  a  consid- 
erable number  of  oil  properties  valuation  must  be  made  after 
that  date,  where  there  has  been  no  change  of  ownership,  but 
a  "discovery"  value  is  claimed.  Actual  sales  are  often  not  a 
criterion.  The  author  knows  of  a  mine  which  was  sold  re- 
cently at  a  price  very  much  above  what  similar  properties  in 
the  same  district  had  sold  for.  The  purchaser,  however, 
basing  his  action  on  a  different  operating  policy  than  was  used 
in  the  district,  and  on  more  intensive  exploration  work,  be- 


*^The  connection  of  the  capital  stock  tax  law  with  fair  values  of  min- 
erals on  March  i,  1913,  is  remote,  to  say  the  least,  in  view  of  the  fact  that 
the  first  report  under  the  capital  stock  tax  law  was  not  due  until   1917. 

"  L.  C.  Graton,  Federal  Taxation  of  Mines,  jiage  29. 


FOR    DEPLETION 


I177 


lieved  the  property  worth  considerably  more  than  the  price 
at  which  similar  properties  had  changed  hands,  and  backed  up 
his  belief  by  purchase. 

The  ordinary  methods  of  determining  values  by  comparing 
sales  of  similar  property  have  been  fully  discussed  in  Chapter 
XVII.  The  insufficiency  of  such  methods  in  valuing  natural 
resources  is  well  expressed  by  an  eminent  authority  :^* 

It  is  a  matter  of  common  knowledge  that  in  the  case  of  mines  and 
oil  and  gas  wells,  and  to  some  extent  as  to  timber,  many  of  the  ordi- 
nary evidences  of  value  are  not  good  criteria,  as  properties  are 
not  similar  and  the  value  of  one  does  not  indicate  the  value  of  its 
neighbor.  Of  two  adjacent  mines  one  may  be  worth  millions  and  the 
other  be  a  liability;  of  two  adjacent  wells,  one  may  be  a  gusher  and 
the  other  dry;  one  timber  lot  may  be  first  growth  pine,  and  the  ad- 
joining  one   second   growtli    hardwood. 

The  attempt  is  made  to  fix  the  actual  sale  value  of  a  coal 
property  by  examining  the  price  at  which  other  property  simi- 
lar to  that  under  consideration  is  sold.  This  method  is  derived 
from  existing  methods  of  real  estate  valuation  and,  from  an 
engineer's  point  of  view,  is  acceptable  only  when  checked  or 
supplemented  by  a  valuation  on  some  other  basis.  Such  checks 
may  demonstrate  that  recent  sales  were  not  made  at  the  actual 
value  of  the  properties  sold.^' 

In  the  case  of  coal  lands  where  the  value  has  been  based 
on  the  results  of  sales  of  neighboring  properties,  it  will  be 
advisable  to  have  such  valuations  supported  by  other  methods 
of  valuation. 

Present  value  method. — 

Factors  to  be  con.sider]-:i). — In  arriving  at  the  value  of 
a  property  by  the  present  value  method,  it  has  been  stated'" 
that :  "The  general  principle  at  the  root  of  the  matter  is  that 
the  annual  dividends  must  yield  a  good  annual  interest  on 
the  stmi   invested,   and  also  permit  a  certain   sum   to  ])e  set 


"R.  V.  NorrLs,  Tlw  Tci.viilion  of  Income  from  IVastiiifj  .Isscls. 

'■''C.  E.  Grunsky,  Valualion.  Drprcrialion  and  ihc  Rate  Base,  page  ^.jy. 

'"J.  R.  Finlay,  Cost  of  Minhu)  (1920  edition),  page  2y. 


II78 


DEDUCTIONS 


aside  each  year,  which  securely  invested  at  compound  interest, 
will  repay  the  investment  when  dividends  cease  on  the  exhaus- 
tion of  the  mine." 

Regulation (&)   To  determine  the  fair  market  value 

of  a  mineral  property  by  the  present  value  method,  the  essential  fac- 
tors must  be  determined  for  each  deposit  included  in  the  property. 
The  factors  are  (i)  the  total  quantity  of  mineral  in  terms  of  the 
principal  or  customary  unit  (or  units)  paid  for  in  the  mineral  product 
marketed,  (2)  the  average  quality  or  grade  of  the  mineral  reserves, 
(3)  the  expected  percentage  of  extraction  or  recovery  in  each  process 
or  operation  necessary  for  the  preparation  of  the  crude  mineral  for 
market,  (4)  the  probable  operating  life  of  the  deposit  in  years,  (5) 
the  unit  operating  cost,  i.e.,  cost  of  production  exclusive  of  deprecia- 
tion and  depletion,  and  (6)  the  rate  of  interest  commensurate  with 
the  risk  for  the  particular  deposit.  When  the  deposit  has  been  suffi- 
ciently developed  these  factors  may  be  determined  from  past  operat- 
ing experience.  In  the  application  of  factors  derived  from  past  ex- 
perience full  allowance  should  be  made  for  probable  future  varia- 
tions in  the  rate  of  exhaustion,  quality  or  grade  of  the  mineral,  per- 
centage of  recovery,  costs  of  production,  and  selling  price  of  the 
product  marketed  during  the  expected  operating  life  of  the  mineral 
deposit (Art.  206.) 

The  natural  resources  subdivision  claims  that  the  present 
value  of  anticipated  earnings  is  being  used  for  very  few  coal 
valuations  at  the  present  time,  that  acre  values  (based  on  sales) 
and  ro3'alties  are  being  generally  used  in  computing  depletion 
for  coal  mines. 

The  present  value  method  has  been  the  subject  of  the  fol- 
lowing comment:" 

As  the  fair  value  of  a  property  at  any  date  is  the  present  value 
of  the  future  earnings  discounted  to  that  date,  depletion  could  logic- 
ally be  taken  as  a  percentage  of  earnings  for  each  year,  such  per- 
centage being  the  present  value  of  an  annuity  of  $1  per  year  for  the 
estimated  life  of  the  property,  divided  by  the  number  of  years  esti- 
mated life.  This  would  return  the  actual  value  of  the  property  as  of 
the  basic  date,  as  the  actual  earnings  year  by  year  instead  of  the  esti- 
mated earnings  would  be  used  in  the  calculations  of  value. 

The  maximum  life  should  be  limited  to  45  years,  and  interest  rates 
fixed  for  the  different  industries. ^^ 


"  R.  V.  Norris,  The  Taxation  of  Income  from  Wasting  Assets. 
^'  Oil  and  gas  wells  in  the  United  States  rarely  show  a  maximum  life 
of  more  than  twenty  years. 


FOR   DEPLETION 


1 179 


This  leaves  only  the  probable  life  as  a  factor  to  be  determined 
and  errors  in  that  would  not  be  serious,  as  when  100  per  cent  deple- 
tion had  been  paid  the  deduction  for  depletion  should  cease. 

Bearing  directly  on  this  point  are  the  following  conclu- 
sions of  the  American  Institute  of  Mining  and  Metallurgical 
Engineers  Mines  Taxation  Committee: 

A  proper  value  of  a  mining  property  is  the  present  value  of  the 
prospective  net  earnings  taking  into  account  probable  variations  in  out- 
put and  value,  discounted  by  recognized  sinking  fund  methods  at  a 
fair  rate  of  interest  with  sinking  fund  at  4  per  cent  interest,  or  by 
calculations  by  standard  annuity  methods.  But  other  recognized 
methods  of  valuation  acceptable  to  the  Department  may  be  used. 

In  lieu  of  estimated  net  earnings,  where  mining  on  a  royalty  basis 
is  customary,  royalty  prices  may  be  used  in  valuation,  taking  into 
consideration  the  trend  of  such  prices. 

As  taxpayers,  engineers  and  accountants,  during  the  past 
year,  have  had  more  definite  and  practical  experience  in  the 
application  of  the  so-called  present  value  method  described 
above,  a  question  has  arisen  as  to  the  propriety  of  the  4  per 
cent  sinking  fund  requirement.  The  provision  for  such  a 
sinking  fund  in  the  discount  rate  results  in  a  lower  present 
value  of  the  anticipated  profits  and  hence  a  lower  depletion 
deduction.     As  stated  by  one  of  the  foremost  authorities : 

In  the  practical  conduct  of  mines  or  mining  companies,  sinking 
funds  for  amortization  of  capital  are  never  established.  In  the  vast 
majority  of  mines  of  the  class  under  discussipn_,  the  ultimate  duration 
of  life  is  unknown,  and  therefore  there  is  no  basis  upon  which  to 
formulate  such  a  definite  financial  policy  even  were  it  desired.  Were 
it  possible  to  arrive  at  the  annual  sum  to  be  set  aside,  the  stock- 
holders of  the  mining  type  would  prefer  to  do  their  own  reinvest- 
ment.^® 

Furthermore,  the  introduction  of  the  sinking  fund  feature 
really  increases  the  rate  of  return  on  the  capital  invested.  The 
rate  of  interest  is  discussed  later  on  in  this  chapter,  but  at 
this  point,  in  considering  the  validity  of  the  sinking  fund,  it  is 
pertinent  to  quote  the  following  illuminating  explanation  i^" 


"H.  C.  Hoover,  Principles  of  Mining,  page  44. 

-''L.  C.  Graton,  Federal  Taxation  of  Mines,  page  33. 


ll8o  DEDUCTIONS 

Let  us  assume  tliat  our  prospective  buyer  coucludes  in  a  given 
case  under  consideration,  that  he  should  have  lo  per  cent  on  his 
money  each  year,  in  addition  to  a  depletion  installment  calculated 
eventually  to  return  his  capital  sum.  As  a  matter  of  fact,  regard- 
less of  whether  he  spends  it  outright  or  invests  it  in  something  else 
or  places  it,  as  theoretically  intended,  in  a  sinking  fund  for  the  posi- 
tive redemption  of  capital,  his  annual  depletion  installment,  if  actually 
received,  continually  reduces  his  stake  remaining  invested  in  the  risky 
mining  enterprise ;  yet  if  everything  goes  well  and  his  original  as- 
sumptions on  the  basis  of  which  the  valuation  was  reached  prove  to 
be  justified,  he  will  be  receiving  a  lo  per  cent  return  on  his  entire 
initial  capital  through  the  last  year  when  only  a  small  fraction  of 
that  capital  is  invested  in  the  lo  per  cent  risk  and  the  major  part  has 
been  used  in  some  other  way.  In  reality,  therefore,  he  received  on 
the  average  distinctly  more  than  lo  per  cent  on  the  capital  that  is  at 
risk. 

The  elimination,  therefore,  of  the  sinking  fund  requirement 
would  remedy  the  situation,  for  the  problem  then  wotild  be  the 
simple  one  of  finding  the  present  value  of  an  annuity.  The 
proposition  of  thus  providing  for  return  of  capital,  without 
a  theoretical  sinking  fund,  has  been  stated  as  follows  :^^ 

One  way  is  shown  by  the  following  table  in  which  a  sum  of 
money  is  returned  to  an  investor  in  equal  installments,  which  are 
supposed  to  be  part  interest  and  part  principal.  The  part  that  rep- 
resents the  return  of  principal  each  year  is  deducted  from  the  original 
sum,  and  for  the  next  year  interest  is  calculated  only  on  the  di- 
minished principal ;  but,  since  the  yearly  installments  are  equal, 
as  the  yearly  interest  requirements  diminish,  the  part  applying  to 
the  return  of  principal  will  increase  so  that  the  extinction  of  capital 
becomes  progressively  more  and  more  rapid. 

It  seems  clear  from  the  following  amortization  table  that 
if  the  Treasury  retains  the  sinking  fund  requirment.  above  dis- 
cussed, and  thus  reduces  the  taxpayer's  value  for  depletion,  it 
mtist  be  more  liberal  in  its  allowance  of  interest  rates  used  to 
represent  the  expected  rate  of  earning  or  return  on  the  invest- 
ment.    This  qtiestion  is  discussed  later  in  this  chapter. 


"'J.  F.  Finlay,  Cost  of  Mining,  page  66.  For  a  discussion  as  to  the 
decreasing  net  investment  in  a  mine,  see  R.  H.  Montgomery,  Auditing, 
Theory  and  Practice   (3rd  edition  1921),  page  211. 


FOR   DEPLETION  ngi 

Amortization   Table — 5  per  cent 

Showing  number  of  years  in  which  $1,000  is  returned  at  5  per 
cent  if  annual  recovery  is  $100  and  return  of  5  per  cent  is  allowed 
for  an  actual  investment  remainine:  at  besfinnins:  of  each  vear. 


I'ears 

Amortized 

Interest 

Balances 

Initial 

investment   

$1,000.00* 

I 

$50.00 

$50.00 

950.00 

2 

52.50 

47.50 

897.50 

3 

55-12 

44.88 

842.38 

4 

57.88 

42.12 

784.50 

5 

60.77 

39.23 

y^ziz 

6 

63.81 

36.19 

659.92 

7 

67.00 

3300 

592.92 

8 

70.35 

29.65 

522.57 

9 

73.87 

26.13 

448.70 

10 

77.56 

22.44 

371.14 

II 

81.44 

18.56 

289.70 

12 

85.51 

14.49 

204.19 

13 

89.79 

10.21 

114.40 

14 

94.28 

5.72 

20.12 

15 

98.99 

1. 01 

*Tlie  exact   present   value   of   $ioo    per   annum   for   fifteen   years    at    5    per   cent    is 

$i>037.96.  Th'e  present  value  of  $100  per  annum  computed  on   the   basis  of  an   annual 

return   of  5    per    cent,    with    reinvestment    earnings    of    4    per    cent    per    annum,    is    only 
$1,000.58. 

When  factors  are  uncertain. — 

Regulation (c)  Mineral  deposits  for  which  these  fac- 
tors may  not  be  determined  with  reasonable  accuracy  from  past 
operating  experience  may,  with  the  approval  of  the  Commissioner, 
be  valued  in  a  similar  manner;  but  the  factors  must  be  deduced  from 
concurrent  evidence  such  as  the  general  type  of  the  deposit,  the 
characteristics  of  the  district  in  which  it  occurs,  the  habit  of  the 
mineral  deposits  in  the  property  itself,  the  intensity  of  mineralization, 
the  rate  at  which  additional  mineral  has  been  disclosed  by  exploita- 
tion, the  stage  of  the  operating  life  of  the  property,  and  other  evi- 
dence tending  to  establish  a  reasonable  estimate  of  the  required 
factors (Art.  206.) 

It  is  recognized  that  in  many  cases  the  factors  ideally  nec- 
essary for  a  scientific  a])plication  of  the  present  value  method 
will  not  be  found.  In  such  instances  it  may  become  necessary 
to  consider  the  operating  history  of  the  property  after  March 
I,  191 3,  to  determine  average  assays,  gross  values,  costs,  pro- 
duction, etc.  These  can  be  checked  with  the  operating  results 
obtained  by  other  mines  in  the  district.     It  is  well  to  supple- 


Il82  DEDUCTIONS 

ment  such  data  with  comprehensive  maps,  showing  the  geology 
and  workings. 

There  readily  comes  to  mind  the  case  of  many  ore  deposits  in 
limestone  where,  because  of  the  commonly  irregular  distribution 
of  the  orebodies  and  the  heavy  character  of  the  ground  when  the 
altered  rock  is  exposed  to  the  air,  it  is  customary  to  carry  develop- 
ment work  not  far  ahead  of  current  extraction.  In  the  matter  of 
valuation  on  the  basis  of  exposed  or  proved  ore  such  mines  are 
clearly  at  a  disadvantage  with  extensively  developed  mines  like  the 
porphyry   coppers.^- 

Method  of  determining  factors. — 

Regulation (d)  Mineral  deposits  of  different  grades,  lo- 
cations, and  probable  dates  of  extraction  in  a  mineral  property  shall 
be  valued  separately.  The  mineral  content  of  a  deposit  shall  be  deter- 
mined in  accordance  with  article  208.  In  estimating  the  average 
grade  of  the  developed  and  prospective  mineral,  account  should  be 
taken  of  probable  increases  or  decreases  as  indicated  by  the  operating 
history.  The  rate  of  exhaustion  of  a  mineral  deposit  should  be  de- 
termined with  due  regard  to  the  limitations  imposed  by  plant  capacity, 
by  the  character  of  the  deposit,  by  the  ability  to  market  the  mineral 
product,  by  labor  conditions,  and  by  the  operating  program  in  force  or 
definitely  adopted  at  the  basic  date  for  future  operations.  The  operat- 
ing life  of  a  mineral  deposit  is  that  number  of  years  necessary  for 
the  exhaustion  of  both  the  developed  and  prospective  mineral  con- 
tent at  the  rate  determined  as  above.  The  operating  cost  includes 
all  current  expense  of  producing,  preparing,  and  marketing  the 
mineral  product  sold  (due  consideration  being  given  to  taxes)  ex- 
clusive of  allowable  capital  additions  as  defined  in  article  222,  and 
deductions  for  depreciation  and  depletion,  but  including  cost  of  re- 
pairs and  replacements  necessary  to  maintain  the  plant  and  equip- 
ment at  its  rated  capacity  and  efficiency.  This  cost  of  repairs  and 
replacements  is  not  to  be  confused  with  the  depreciation  deduction 
by  which  the  cost  or  value  of  plant  and  equipment  is  returned  to  the 
taxpayer  free  from  tax.  In  general  no  estimates  of  these  factors 
will  be  approved  by  the  Commissioner  which  are  not  supported  by  the 
operating  experience  of  the  property  or  which  are  derived  from  dif^ 
ferent  and  arbitrarily  selected  periods (Art.  206.) 

The  foregoing  regulation  indicates  some  of  the  practical 
problems  encountered.  If  the  deposits  vary  considerably  as 
to  grade,  it  would  be  manifestly  unfair  to  the  taxpayer  to  allow 
only  a  rate  of  depletion  based  on  high  and  low  grade  ores, 


L.  C.  Gratoii,  Federal  Taxation  of  Mines,  page  28. 


FOR    DEPLETION  X183 

when  the  high  grade  only  is  being  mined.  On  the  other  hand. 
in  a  case  where  the  assays  wxre  high  at  March  i,  19 13,  but 
in  later  years  declined,  the  Treasury  does  not  confine  itself 
to  what  was  known  at  March  i,  191 3,  but  has  been  known 
to  take  the  average  of  a  period  of  years  thereafter  which  was 
supposed  to  be  representative.  Care  must  be  taken,  however, 
to  see  that  the  period  selected  is  really  representative  and  not 
prejudicial  to  the  taxpayer. 

The  life  of  the  mine  affects  the  value  through  the  discount 
factor  applied — a  long  life  giving  a  low  value,  and  a  short 
life  a  high  value.  Some  of  the  factors  which  would  determine 
the  life  are  indicated  in  the  regulation  and  require  detailed 
evidence  to  support  them.  An  operating  program  as  at  the  date 
of  valuation,  even  if  not  fully  carried  out  subsequently,  would 
be  admissible. 

Intensive  production  means  that  the  units  of  mineral  will  be 
taken  out  sooner,  and  as  appears  from  the  table  on  page  1181, 
the  annual  income  in  the  earlier  years  contains  a  greater  ele- 
ment of  profit,  and  thus  affords  the  basis  for  an  increased  value 
of  the  mine.  The  earlier  the  mineral  is  removed  and  converted 
into  cash,  the  less  is  the  amount  of  discount  that  needs  to  be 
deducted  from  the  expected  gross  realization  to  reduce  to  pres- 
ent value  at  March  i,  1913. 

The  costs  need  particularly  to  be  analyzed  and  any  ab- 
normal items  not  indicative  of  probable  future  costs  excluded. 

The  selling  price  of  the  product  averaged  over  a  period 
of  years,  in  order  to  obtain  a  normal  price,  must  be  considered. 
Variations  in  the  price,  particularly  under  abnormal  condi- 
tions, such  as  have  affected  silver  under  the  Pittman  Act,  and 
copper  during  the  past  year  with  a  very  great  decrease  in  pro- 
duction, must  be  fully  weighed. 

Determination  of  quantity  of  ore  in  mine.^'' — 
REGiJLATibN.     Every  taxpayer  claiming  a  deduction  for  depletion 
for  a  given  year  will  be  required  to  estimate  or  determine  with  respect 


"^For  former  procedure  and  comments  thereon,  sec  Income  Tax  Pro- 
cedure, 1919,  pages  598-602,  1148-1156   (Supp.). 


ii84 


DEDUCTIONS 


to  eacli  separate  jM-operty  the  total  units  (acres,  tons,  pounds,  ounces,  or 
other  measure)  of  mineral  products  reasonably  known  or  on  good  evi- 
dence believed  to  have  existed  in  the  ground  on  the  basic  date,  ac- 
cording to  the  method  current  in  the  industry  and  in  the  light  of 
the  most  accurate  and  reliable  information  obtainable.  Preference 
shall  be  given  in  the  selection  of  a  unit  of  estimate  to  the  principal 
unit  (or  units)  paid  for  in  the  product  marketed.  The  estimate  of 
the  recoverable  units  of  the  mineral  products  in  the  property  for  the 
purposes  of  valuation  and  depletion  shall  include  as  to  both  quantity 
and  grade  (a)  the  ores  and  minerals  "in  sight,"  "blocked  out,"  "de- 
veloped," or  "assured,"  in  the  usual  or  conventional  meaning  of  these 
terms  in  respect  to  the  type  of  the  deposit,  and  (b)  ""probable""  or 
■'prospective"  ores  and  minerals  (in  the  corresponding  sense)  ;  that  is, 
ores  and  minerals  that  are  believed  to  exist  on  the  basis  of  good  evi- 
dence although  not  actually  known  to  occur  on  the  basis  of  existing  de- 
velopment ;  but  "probable"  or  "prospective"  ores  and  minerals  may  be 
computed,  for  purposes  of  this  valuation,  (c)  as  to  quantity,  only  in 
case  they  are  extensions  of  known  deposits  or  are  new  bodies  or- 
masses  whose  existence  is  indicated  by  geological  or  other  evidence 
to  a  high  degree  of  probability,  and  (d)  as  to  grade,  of  such  richness 
only  as  accords  with  the  best  indications  available.  If  information 
subsequently  obtained  clearly  shows  the  estimate  to  have  been  mate- 
rially erroneous,  it  may  be  revised  with  the  approval  of  the  Com- 
missoner.      (Art.   208.) 

Ill  the  foregoing  instructions  it  is  provided  that  the  esti- 
mate must  include  minerals  "assured"  and  may  include  pro- 
spective or  probable  quantities.  In  making  this  estimate  due 
consideration  should  be  given  to  the  comments  on  pages  123 1 
to  1233.  In  some  cases  estimates  of  possible  future  extraction 
have  been  so  large  (thus  extending  the  prospective  removal 
over  an  excessively  long  period)  as  to  make  the  annual  deple- 
tion allowance  a  negligible  factor.  Such  a  result  proves  the  in- 
accuracy of  the  estimate,  as  purchases  of  mines  are  not  made 
on  such  a  basis. 

The  substance  of  article  208  has  been  the  subject  of  com- 
ment as  follows  :"* 

Quantities  are  required  to  be  estimated  as  of  March  i,  1913.  In 
making  such  an  estimate  any  engineer  would  make  his  estimate  up  to 
the  date  of  examination,  and  reduce  to  the  basic  date  by  adding  the 
units  produced  between  the  basic  date  and  the  date  of  examination. 

°*  R.  V.  Norris,  The  Taxation  of  Income  from  Wasting  Assets. 


FOR   DEPLETION  1 185 

While  perhaps  technically  no  information  not  available  March  i, 
1913,  is  supposed  to  be  used  in  such  estimates,  in  this  case,  as  in  the 
case  of  estimating  profits,  no  engineer  would  or  should  be  asked  to 
stultify  himself  by  using  estimates  based  on  what  he  may  try  to 
imagine  he  would  have  thought  on  March  i,  1913,  but  which  on  in- 
formation available  when  his  estimate  was  actually  made  he  knows 
to  be  incorrect.  The  Department  has  repeatedly  and  very  sensibly 
accepted  estimates  frankly  made  in  this  way. 

The  necessity  for  a  revision  of  original  estimates  is  shown 
in  the  following : 

Ruling During  the  year  1917  in  the  development  of  the 

mining  operations  of  the  taxpayer,  it  was  discovered  that  the  com- 
pany's coal  vein  was  lacking  in  approximately  ^  acres  and  that  there 
was  hard  black  rock  in  its  place.  This  so-called  "rock  fault"  was 
actually  determined  by  tests  and  statements  to  this  effect  are  sup- 
ported by  affidavit  of  engineers.  On  the  basis  of  original  cost  of  this 
vein  of  coal,  the  development  of  this  large  area  of  solid  rock  deter- 
mined a  loss  of  x  dollars.  With  respect  to  loss  of  this  character, 
section  234(a)  of  the  Revenue  Act  of  1918  does  not  materially  differ 
from  section   I2(a)2  of  the  Revenue  Act  of   191 7. 

The  examining  revenue  agent  reports  that  the  vein  of  coal  pur- 
chased had  an  estimated  recovery  of  y  tons  per  acre.  In  the  original 
acreage  purchased  there  were  42  acres.  The  acreage  loss  by  location 
of  the  rock  fault  was  z  acres,  leaving  actual  coal  acreage  purchased 
3^  acres.  The  en  bloc  tonnage  on  revised  estimate  was,  therefore,  6^y 
tons  which,  at  a  cost  of  3.1-  dollars,  gives  the  cost  per  unit  for  deple- 
tion charge  on  basis  of  3,:;  acres  actually  contained  in  this  tract. 

It  is  contended  by  taxpayer  that  a  loss  of  x  dollars  has  been  estab- 
lished during  the  year  1917  under  article  143  of  Regulations  45.  The 
amount  of  alleged  loss  is  based  on  cost  at  i/2-)X  dollars  per  acre  plus 
four  years'  interest  charges. 

The  Committee  can  not  reach  the  conclusion  that  location  of  this 
rock  fault  determines  a  loss  of  useful  value  as  contemplated  by  the 
regulations.  The  rock  fault  determined  that  a  bad  estimate  had  been 
made  in  fixing  the  consideration  of  purchase.  This  mistaken  value 
for  tax  purposes  affected  the  true  measure  of  capital  returnable  by 
way  of  depletion.  Article  208,  Regulations  45,  provides  for  the  deter- 
mination of  mineral  contents  of  a  mine.  The  last  sentence  of  the 
article  reads : 

If  subsequent  developments  show  a  material  error  in  the  original 
estimate,  a  new  estimate  may  be  made  and  the  capital  remaining  to 
be  recovered  distributed  accordingly. 

Hence,  if  this  mine  was  under  production  after  discovery  of  the 
rock  fault,  the  capital  remaining  to  be  recovered  through  depletion 


Ii86  DEDUCTIONS 

may  be  distributed  pro  rata  over  subsequent  years.  If  the  mining 
operation  of  this  property  was  discontinued  entirely  in  the  taxable 
year,  the  deduction  for  depletion  should  be  taken  in  that  year  so 
that  the  return  of  capital  may  be  complete.  No  interest  on  the  capi- 
tal sum  should  be  considered  in  this  computation. 

If  an  erroneous  estimate  is  made  and  a  large  amount  of 
tax  is  paid  in  the  years  of  high  rates  (1917  to  1921)  and  the 
error  is  discovered  in  1922,  it  would  be  equitable  to  permit  the 

filing-  of  amended  returns  on  the  basis  of  a  correct  estimate." 

Calculation  of  Value. — 

Regulation (c)  The  number  of  units  of  mineral  re- 
coverable in  marketable  form  multiplied  by  the  difference  between  the 
selling  price  and  the  operating  cost  per  unit  gives  the  total  expected 
operating  profit.  The  value  of  each  mineral  deposit  is  then  the  total 
expected  operating  profit  from  that  deposit  reduced  to  a  present  value 
as  of  the  basic  date  at  the  rate  of  interest  commensurate  with  the  risk 
for  the  operating  life,  and  further  reduced  by  the  value  at  the  basic 
date  of  the  depreciable  assets  and  of  the  capital  additions,  if  any, 
necessary  to  realize  the  profits.  The  degree  of  risk  is  generally  lowest 
in  cases  where  the  factors  of  valuation  are  fully  supported  by  the 
operating  record  of  the  mineral  property  prior  to  the  basic  date; 
relatively  higher  risks  attach  to  appraisals  upon  any  other  basis. 
(Art.  206.) 

If  the  mine  at  date  of  valuation  is  not  equipped,  it  is  cus- 
tomary to  discotmt  further  the  operating  profits,  on  a  straight 
compound  interest  basis,  for  the  number  of  years  necessary 
to  equip  the  mine.  For  example,  if  two  years  are  necessary 
to  equip  the  property,  the  value  of  the  ore  is  still  less, 
because  of  the   further  loss  of  interest  in  delay."*^ 

The  following  expression  of  opinion  as  to  the  best  method 
of  determining  fair  market  value  is  also  of  interest: 

The  valuation  engineers  of  the  Revenue  Bureau,  as  I  under- 
stand it,  are  to  answer  the  question  of  valuation  that  is  compre- 
hended in  the  imaginary  situation  of  a  prospective  buyer,  competent 
to  measure  mine  values  and  actuated  by  the  hope  of  profit  to  be  de- 
rived from  mine  operation,  making  an  offer  for  a  mine  to  the  owner 
who  is  likewise  competent  to  measure  mine  values  and  who  is  under 


""  See  page  601. 

™H.  C.  Hoover,  Frinciplcs  of  Mining,  page  48. 


FOR   DEPLETION  1 187 

no  obligation  to  sell  except  such  obligation  as  arises  from  his  belief 

that  the  offer  made  is  advantageous  to  him 

In  arriving  at  fair  market  value  as  of  March  i,  1913,  one  is  sup- 
posed to  take  into  consideration  only  the  facts  that  were  then  known 
or  that  could  have  been  then  known  had  one  endeavored  to  learn 
them  at  that  time.  The  question  may  therefore  arise  as  to  whether 
it  is  fair  to  arrive  at  a  1913  valuation  by  applying  to  the  standard 
present-value  method  of  mine  valuation  modifications  which  have  not 
been  proposed  until  1919.  In  my  opinion,  however,  there  is  suffi- 
cient justification  for  using  those  modifications  that  are  consequences 
of  taking  into  account  changing  grade  of  ore  and  changing  rate  of 
production.  The  justification  is  this:  In  1913  and  since  that  time 
there  was  no  actual  method  followed  for  valuing  mines  for  purpose 
of  sale,  for  the  reason  that  mines  of  the  size  to  which  these  newly 
proposed  factors  would  apply  are  rarely,  if  ever,  sold.  In  arriving 
at  a  market  value  as  of  1913,  therefore,  we  are  dealing  with  a 
wholly  hypothetical  question.  //  there  had  been  occasion  to  value 
such  mines  for  sale  in  1913,  it  is  unbelievable  that  factors  so  impor- 
tant as  the  change  in  grade  of  ore  and  the  likely  change  in  rate  of 
production  would  have  been  ignored.  In  other  words,  if  a  market 
value  had  been  required  at  that  time,  it  would  have  been  reached 
in  accordance  with  the  methods  now  proposed.-" 

What  is  fair  rate  of  interest? — There  seems  to  be 
considerable  difference  of  opinion  as  to  what  is  the  proper  rate 
of  interest  to  be  used  in  determining  the  present  value  of 
future  earnings,  when  arriving  at  the  value  of  mining  prop- 
erty as  at  a  specified  date. 

It  is  understood  that  the  Treasury  is  using  8  per  cent  for 
bituminous  and  6  per  cent  for  anthracite  coal  properties. 
An  eminent  authority"^  points  out  that  rates  vary  consider- 
ably with  the  risks  involved  and  summarizes  the  various 
rates  that  have  been  used  by  other  authorities,  as  follows : 

The  proper  rate  of  interest  on  mining  investments  has  been  and 
still  remains  the  subject  of  much  discussion  among  engineers.  A  rea- 
sonable solution  of  the  problem  has  not  been  advanced  and  it  is  the 
belief  of  the  author  that  it  is  not  possible  to  determine  a  rate  of  in- 
terest that  would  apply  equally  well  to  all  mining  investments.  The 
risk  incurred  by  investing  in  a  property  that  has  been  slightly  devel- 
oped is  much  greater  than  the  risk  in  the  case  of  a  well-prospected  ore 
body  even  when  the  mines  contain  similar  ores  and  will  be  operated 


"  L.  C.  Graton,  Federal  Taxation  of  Mines. 

"C.  E.  Grunsky,  Valuation,  Depreciation  and  the  Rate-Base,  page  241. 


1 188  DEDUCTIONS 

under  similar  conditions.     Then  again  the  average  risks  in  copper 
mining  differ  from  the  average  risks  in  gold  mining  and  so  on. 

Mr.  H.  C.  Hoover  has  tabulated  the  risks  of  mining  as  follows 
(Principles  of  Mining,   1909)  : 

"i.  The  risk  of  continuity  in  metal  contents  beyond  the  sample 
faces. 

2.  The  risk  of  continuity  in  volume  through  the  blocks  estimated. 

3.  The  risk  of  successful  metallurgical  treatment. 

4.  The  risk  of  metal  prices,  in  all  but  gold. 

5.  The  risk  of  properly  estimating  costs. 

6.  The  risk  of  extension  of  the  ore  beyond  exposures. 

7.  The  risk  of  management." 

Several  of  these  risks  are  found  in  industrial  enterprises  (risks 
4,  5  and  7).  The  risks  of  continuity  of  ore  body  and  of  ore  values 
are  peculiar  to  the  mining  industry.  The  limited  market  for  the 
mineral  products  and  the  effect  of  the  volume  of  the  output  on  the 
prices  that  can  be  obtained  increases  the  risk  that  capital  must  take. 
The  problem  of  obtaining  proper  metallurgical  treatment  is  an  im- 
portant one,  particularly  when  starting  operations  at  new  properties. 
The  fact  that  the  mineral  constituents  of  the  ore  may  change  as 
greater  depths  are  reached  and  that  the  previously  satisfactory  flow 
sheet  may  no  longer  realize  the  percentage  of  extraction  on  which 
the  profits  were  based  cannot  be  ignored  by  the  investor.  The  interest 
return  that  might  be  attractive  to  an  investor  in  a  proven  district 
might  not  be  sufficient  to  attract  capital  in  a  district  where  the  mines 
are  still  prospects  and  where  the  depth  of  the  mineralization  has  not 
been  tested. 

It  is  a  fact  that  industrial  enterprises  because  of  additional  risks 
demand  greater  interest  returns  than  government  bonds  and  it  seems 
reasonable  that  mining  investments  taken  as  a  class  should  call  for 
a  greater  rate  of  interest  than  industrial  enterprises. 

This  claim  for  a  higher  rate  of  interest  is  opposed  by  such  an 
authority  on  mine  valuation  as  Mr.  J.  R.  Finlay  {Valuation  of  Iron 
Mines,  Trans.  A.  I.  M.  E.,  Volume  45,  page  295),  who  can  be  quoted, 
as  follows: 

"I  have  generally  assumed  that  5  per  cent  was  a  normal  interest 
— or  discount  rate.  If  that  is  so,  it  is  a  fair  figure  to  use  in  a  mine 
valuation,  which  should  be  nothing  but  a  candid  inquiry  into  the  pres- 
ent value  of  expected  profits." 

If  Mr.  Finlay's  statement  is  correctly  understood,  he  is  willing  to 
ignore  the  risk  that  these  prospective  profits  may  be  diminished  or 
may  entirely  be  cut  off  before  the  estimated  life  of  the  property  has 
been  accomplished.  If  it  is  true  that  at  any  mining  property  risks 
exist  over  and  above  the  risks  existing  in  so-called  "safe"  investments, 
then  a  5  per  cent  discount  or  interest  rate  is  not  sufficient  to  induce 


FOR   DEPLETION  1 189 

sane  investment.  Mr.  Finlay's  5  per  cent  interest  rate,  as  applied  to 
the  iron  mines  of  Michigan  in  his  appraisal  made  for  the  State  Tax 
Commission  in  191 1,  was  changed  by  that  Commission  to  a  6  per  cent 
basis  in  1913. 

Other  authorities  have  gone  on  record  as  advocating  higher  in- 
terest rates  and  in  this  connection  the  following  will  be  found  of 
interest : 

Mr.  J.  H.  Curie  (The  Economist,  London,  September  15,  1903) 
states  that  a  suitable  mining  investment  must  fulfil  the  following  re- 
quirements : 

"i.  The  development  in  the  bottom  must  be  good. 

2.  The  mine  must  pay  10  per  cent  per  annum. 

3.  There  must  be  60  per  cent  of  the  price  of  the  shares  in  sight." 

Mr.  Hoover  in  his  admirable  work  on  mine  valuation  says  (Prin- 
ciples of  Mining,  1909)  : 

"What  rate  of  excess  return  the  mine  must  yield  is  a  matter  of 
the  risks  in  the  venture  and  the  demand  of  the  investor.  Mining  busi- 
ness is  one  where  7  per  cent  above  provision  for  capital  return  is  an 
absolute  minimum  demanded  by  the  risks  inherent  in  mines,  even 
where  the  profit  in  sight  gives  warranty  to  the  return  of  capital." 

Mr.  G.  A.  Denny  (Mexican  Mining  Journal,  July,  1910),  an 
English  engineer,  says : 

"A  normal  mining  risk  stated  in  terms  of  interest  may  be  taken 
at  ID  per  cent  per  annum  on  the  capital  expended  plus  a  rate  for 
the  redemption  of  capital." 

John  Hays  Hammond  (Engineering  and  Mining  Journal,  Jan- 
uary I,  1910)   expresses  his  views  on  this  question  as  follows: 

"In  many  mines  persistency  of  the  ore  deposits  and,  therefore, 
the  reliability  of  the  mines  as  dividend  payers,  justified  the  investment 
upon  a  basis  in  some  instances  as  low  as  8  per  cent,  dividends  to  which 
of  course,  must  be  added  a  certain  percentage  to  provide  for  the 
amortization  of  the  capital.  Generally  speaking,  however,  invest- 
ments in  mining  securities  are  not  to  be  regarded  as  attractive  unless 
they  return  from  10  per  cent  to  15  per  cent  in  dividends,  in  addition 
to  the  profits  to  be  set  aside  for  amortization." 

The  Treasury  has,  in  some  instances,  adopted  a  higher 
rate  of  interest  than  taxpayers  have  felt  to  be  warranted. 
It  is  noteworthy  that  an  eminent  authority  in  !iis  latest 
work  still  maintains  that  5  per  cent  is  sufficiently  high.^^ 

The  author  is  of  the  opinion  that  it  is  impossible  to  fix  a 


-*J.  R.  Finlay,  Cost  of  Mining  (1920  edition),  page  66. 


iicp 


DEDUCTIONS 


rate  of  discount  for  an  industry  which  should  be  appHed  to 
all  taxpayers  in  the  same  industry.  Each  case  should  be 
treated  separately,  and  the  rate  fixed  in  accordance  with  the 
risks  involved. 

In  the  case  of  a  lessor  the  contention  was  advanced  by  a 
certain  taxpayer  that  6  per  cent  is  an  equitable  rate  because 
the  risk  is  reduced  to  a  minimum  on  account  of  a  clause  in 
the  lease  which  provides  that  in  case  of  the  failure  of  the  lessee 
to  pay  the  royalties  all  rights  under  the  lease  will  be  forfeited 
together  with  all  improvements  made  by  the  lessee. 

Since  the  risk  to  the  lessor  is  never  as  great  as  that  to  the 
lessee,  the  rate  of  discount  should  be  somewhat  lower  than 
that  used  for  determining  the  value  to  the  lessee. 

It  must  be  remembered  that  the  Treasury,  in  discounting 
the  anticipated  profits,  uses  a  formula  which  provides  for  inter- 
est on  the  principal  sum  at  one  rate,  say  lo  per  cent,  and  also 
provides  for  an  annual  contribution  to  a  sinking  fund,  w'hich, 
accumulated  at  4  per  cent  interest  compounded  annually,  will 
equal  the  principal  sum  at  the  end  of  the  term.  The  actual 
return  on  the  capital  sum,  however,  is  greater  than  10  per  cent 
due  to  the  introduction  of  the  sinking  fund  provision.^"  The 
increase  in  interest  rate  has  been  w'orked  out  as  follows : 

On  the  assumption  that  money  in  an  ordinary,  good  investment 
is  entitled  to  6  per  cent,  it  is  found  that  in  the  case  of  a  property 
of  10  year  Hfe,  valued  to  give  10  per  cent  on  initial  sum  and 
amortized  at  4  per  cent  compounded  annually,  the  ratio  of  total  profit 
assignable  to  amount  remaining  at  risk  in  the  property,  divided  by  the 
total  of  the  amounts  at  risk  during  each  of  the  10  years,  works  out 
to  be  not  10  per  cent  but  13.25  per  cent.  Similarly,  for  a  10  year 
life,  an  apparent  8  per  cent  return  is  found  to  give  an  average  of 
9.71  per  cent;  and  a  12  per  cent  return  to  ayerage  in  reality  16.79 
per  cent  on  the  money  at  risk.  In  the  three  cases,  8  per  cent,  10 
per  cent,  and  12  per  cent,  these  actual  average  returns  are  re- 
spectively 21.4  per  cent,  32.5  per  cent,  and  40  per  cent  higher  than 
the  flat  rate  to  which  they  are  related. 

The  question  now  arises  whether  this  greater  interest  return, 
concealed  in  the  apparent  flat  rate  of  10  per  cent,  is  actually  required 

^"  Sec  page  11 77. 


FOR   DEPLETION 


II91 


to  offset  hazard,  or  whether  on  the  other  hand,  an  even  10  per  cent 
on  the  decreasing  sum  actually  at  risk  is  enough,  in  which  case  the 
present  value  of  the  mine  would  increase. '^^ 

Attention  has  already  been  called  (page  11 79)  to  the  fact 
stated  by  one  of  the  most  eminent  authorities,  Mr.  Herbert  C. 
Hoover,  that  sinking  funds  for  the  reinvestment  in  conserva- 
tive securities  of  the  annual  depletion  allowances  are  in  the 
practical  conduct  of  mines  and  mining  companies  never  es- 
tablished. The  Treasury  in  using  the  present  value  of  anti- 
cipated earnings  for  determining  the  value  of  oil  and  gas  wells^' 
does  not  use  the  4  per  cent  reinvestment  factor  which  it  insists 
shall  be  used  in  valuing  mines.  The  author  knows  of  no 
reason  why  mines  should  be  thus  discriminated  against. 

Since  the  depletion  deductions  return  to  the  mine  owner 
annually  a  part  of  his  capital,  leaving  a  decreasing  sum  at 
risk,  it  would  seem  to  be  sufficient  to  require  interest  i.e.,  a 
return  each  year,  only  on  the  decreasing  sum  and  not  on  the 
entire  capital  originally  invested. 

Illustration  of  present  value  method. — An  illustra- 
tion showing  the  computation  of  the  value  of  a  mine  as  of 
March  i,  191 3,  appears  on  pages  601. 

The  computations  will  be  varied  by  whatever  necessities 
arise  which  require  treatment  of  the  various  factors  employed 
in  a  manner  to  reflect  properly  normal  conditions  and  the 
elimination  of  abnormal  items. 

Evidence  required  to  support  depletion  charges. — The  law 

permits  a  reasonable  allowance  for  depletion  and  no  more. 
It  is  proper  and  necessary  that  taxpayers  should  comply  with 
all  reasonable  Treasury  requirements  and  furnish  detailed 
evidence  bearing  on  the  propriety  of  the  deductions  claimed. 
In  addition  to  the  regulations  reproduced  in  full  in  this 


"L.  C.  Graton,  I'edcnil  Taxation  of  M{)ics,  page  33. 

"The  Manual  for  the  Oil  and  Gas  Industry,  published  liy  the  Treasury 
Department,  contains  on  page  57,  a  disconnl  table  for  computing  present 
values.     This  tabic  includes  no  reinvestment   feature. 


1 192 


DEDUCTIONS 


book,  the  Treasury  has  prepared  comprehensive  "schedules 
of  depletion. ''^^  The  information  which  taxpayers  are  re- 
quired to  submit  in  these  schedules  or  questionnaires  includes 
maps  of  the  property ;  full  particulars  of  contents  and  produc- 
tion at  March  i,  19 13,  and  subsequently;  kinds  of  ore  or  min- 
eral produced;  manner  of  acquisition  and,  when  cash  was  not 
paid  for  property,  cash  value  of  securities  issued;  details  of 
appraisals,  if  any;  details  of  sales  of  similar  properties;  esti- 
mates of  deposits  made  by  engineers  or  others;  assessments 
for  local  taxation ;  sales  of  securities  on  exchanges  or  at  private 
sale ;  partnership  or  estate  accountings,  if  any,  about  March  i , 
1913  ;  various  other  details  are  required,  all  of  which  are  pertin- 
ent and  proper. 

It  should  be  noted,  however,  that  the  so-called  market  value 
of  the  securities  of  a  corporation  frequently  is  not  a  true  indi- 
cation of  the  fair  market  value  of  any  particular  asset.  The 
courts  have  so  decided  many  times. 

It  is  understood,  however,  that  the  Treasury  is  most  rea- 
sonable and  does  not  require  or  expect  special  research  to 
answer  these  questionnaires.  Information  not  affecting  the 
taxpayer's  claims  is  not  needed  and  blanks  for  this  may  be 
ignored. 

Revaluation  after  March  i,  1913,  not  permitted  except  in 
case  of  discoveries. — At  the  time  the  value  is  being  determined, 
it  is  important  to  present  all  the  pertinent  data  to  the  Treasury 
in  order  to  secure  the  maximum  valuation  to  which  the  tax- 
payer is  entitled,  because  after  the  value  is  once  determined, 
the  regulations  provide  that  a  revaluation  will  not  be  permitted. 
It  must  be  remembered  that  the  depletion  allowance  for  all  sub- 
sequent years  is  based  on  such  valuation. 

It  is  well  settled  practice  (although  disputed  by  many  per- 
sons) that  appreciation  since  March  i,  19 13,  cannot  be  con- 
sidered  in   increasing  depletion   allowances   or   reducing   the 


"Form   D    (minerals),   form   E    (coal),   form   F    (miscellaneous  non- 
metals),  form  O   (oil  and  gas),  form  T   (timber). 


FOR   DEPLETION 


1 193 


taxable  profit  arising  from  sales,  except  in  the  case  of  dis- 
coveries.^* 

Regulation.  No  revaluation  of  a  property  whose  value  as  of  the 
basic  date  has  been  determined  and  approved  will  be  allowed  during 
the  continuance  of  the  ownership  under  which  the  value  was  so  de- 
termined and  approved  except  in  the  case  of  discovery  as  defined  in 
articles  219  and  220  or  of  misrepresentation  or  fraud  or  gross  error  as 
to  any  facts  determinable  on  the  basic  date.  Revaluation  on  account 
of  misrepresentation  or  fraud  or  such  gross  error  will  only  be  made 
upon  written  application  to  the  Commissioner  and  approval  thereof 
by  him.  The  value  as  of  the  basic  date  may,  however,  be  corrected 
when  a  virtual  change  of  ownership  of  part  of  the  property  results 
as  the  outcome  of  litigation,  and  may  be  redistributed  (a)  when  a 
revision  of  the  number  of  imits  of  mineral  in  the  property  has  been 
made  in  accordance  with  articles  208,  209,  or  211,  and  (b)  in  case 
of  the  sale  of  a  part  of  the  property,  between  the  part  sold  and  part 
retained.     (Art.  207.) 

In  a  case  where  the  "probable  or  prospective"  ores  had  not 
been  included  in  the  original  valuation,  a  revaluation  was  per- 
mitted, as  shown  by  the  following: 

Ruling.  While  article  207  does  not  permit  of  a  revaluation  of 
property  whose  value  as  of  the  basic  date  has  been  determined,  it 
is  clear  that  only  a  valuation  based  upon  an  estimate  of  the  recover- 
able units  including  not  only  ores  and  minerals  in  sight,  blocked  out, 
developed  or  assured,  but  also  probable  or  prospective  ores,  is  con- 
templated by  this  article.  The  meaning  of  this  article  is  that  once 
the  property  has  been  valued  in  accordance  with  the  Regulations  as 
they  now  stand,  it  can  not  be  revalued  because  it  subsequently  de- 
velops that  the  taxpayer  has  in  his  mine  more  ore  than  could  rea- 
sonably have  been  included  in  the  original  estimate  of  recoverable 
units  when  the  estimate  was  properly  made. 

If,  as  is  now  contended  by  the  M  Company  the  original  valuations 
were  based  upon  estimates  of  recoverable  units  which  included  only 
ores  in  sight,  blocked  out,  developed  or  assured,  the  properties  should 
be  revalued  as  of  the  basic  date  in  accordance  with  the  present  regu- 
lations and  the  rate  of  depletion  determined  accordingly.  If  it  should 
subsequently  develop  that  a  material  error  in  the  original  estimate 
of  the  recoverable  units  was  made,  the  properties  may  not  be  re- 
valued but  a  redistribution  of  the  depletion  may  then  be  made  as 
provided  in  articles  207  and  208.^^  (Extract  from  memorandum  of 
the  Solicitor;  C.  B.  4,  page  190;  A.  R.  M.  124.) 


"*  See  page  1196. 
"  See  page  1184. 


110)^^  DEDUCTIONS 

The  Treasury  does  not  have  the  power  to  foreclose  a 
taxpayer's  right  to  review  in  case  of  error,  except  in  cases 
when  the  right  to  claim  a  refund  for  prior  years  is  barred 
by  statute. 

Discovery  of  mines. ^'^ — 

Fair  market  value  disproportionate  to  cost. — 

Regulation,  (a)  The  discovery  must  add  a  new  mine  to  those 
previously  known  to  exist  and  can  not  be  made  within  a  proven  tract 
or  lease  as  defined  in  paragraph  (g)  infra,  (b)  To  entitle  a  tax- 
payer to  a  vahiation  of  his  property,  for  the  purpose  of  depletion 
allowances,  by  reason  of  the  discovery  of  a  mine  on  or  after  March 
I,  1913,  the  discovery  must  be  made  by  the  taxpayer  after  that  date, 
and  must  resuh  in  the  fair  market  value  of  the  property  becoming 
disproportionate  to  the  cost.  The  fair  market  value  of  the  property 
will  be  deemed  to  have  become  disproportionate  to  the  cost  when  the 
newly  discovered  mine  contains  mineral  in  such  quantity  and  of  such 
quality  as  to  afford  a  reasonable  expectation  of  return  to  the  tax- 
payer of  an  amount  materially  in  excess  of  the  capital  expended 
in  making  such  discovery  plus  the  cost  of  future  development,  equip- 
ment, and  exploitation. 

Definition  of  discovery. — 

(c)  For  the  purpose  of  these  sections  of  the  Act  a  mine  may  be 
said  to  be  discovered  when  (i)  there  is  found  a  natural  deposit  of 
mineral,  or  (2)  there  is  disclosed  by  drilling  or  exploration,  con- 
ducted above  or  below  ground,  a  mineral  deposit  not  previously  known 
to  exist  and  so  improbable  that  it  had  not  been,  and  could  not  have 
been,  included  in  any  previous  valuation  for  the  purpose  of  depletion, 
and  which  in  either  case  exists  in  quantity  and  grade  sufficient  to 
justify  commercial  exploitation. 

(d)  In  determining  whether  a  discovery  entitling  the  taxpayer  to 
a  valuation  has  been  made,  the  Commissioner  will  take  into  account 
the  peculiar  conditions  of  each  case ;  but  no  discovery,  for  the  pur- 
poses of  valuation,  can  be  allowed,  as  to  ores  or  minerals,  such  as 
extensions  of  known  ore  bodies,  that  have  been  or  should  have  been 
included  in  ''probable"'  or  '"prospective"  ore  or  mineral,"'  or  in  any 
other  way  comprehended  in  a  prior  valuation,  nor  as  of  a  date  subse- 
quent to  that  when,  in  fact,  discovery  was  evident,  when  delay  by  the 
taxpayer  in  making  claim  therefor  has  resulted  or  will  result  in  ex- 
cessive allowances  for  depletion (Art.  219.) 


°°For  discovery  of  oil  and  gas  wells,  see  page  1205. 
"  See  page  1184. 


FOR   DErLETION 


"95 


"VVheii  iniprovcnicnts  in  pnKXSscs  of  treatment  make  valu- 
able certain  ores  previously  of  no  value  the  Treasury  recog- 
nizes that  exploration  for  such  ores  will  be  stimulated,  hence 
"discovery"  is  made;  but  it  is  unwilling  to  allow  a  discovery 
value  of  the  same  kind  of  ores  known  to  exist  in  the  mine 
before  the  improvement  in  process  made  the  ores  valuable. 

Ruling.  Advice  is  requested  as  to  whether  certain  known  bodies 
of  zinc  and  copper  ores  owned  by  the  M  Company  could  be  revalued 
on  account  of  improvements  in  certain  metallurgical  processes  which 
made  valuable  ores  which  theretofore  had  no  commercial  value. 

This  inquiry  raised  a  point  of  law  and  inasmuch  as  the  amendment 
of  the  regulations  with  respect  to  discovery  was  under  consideration 
the  matter  was  referred  to  the  Solicitor  for  consideration  and  an 
opinion.  The  Committee  is  in  receipt  of  a  memorandum  from  the 
Solicitor  dated  March  9,  1921,  which  reads,  in  part,  as  follows: 

As  the  question  is  presented  in  the  memorandum  the  claims  of  dis- 
coveries in  the  case  of  zinc  ore  were  based  upon  improvements  in 
metallurgical  processes,  making  valuable  ores  which  had  theretofore 
had  no  commercial  value.  It  now  appears  that,  while  these  processes 
first  made  commercially  valuable  zinc  ores  which  before  that  time 
were  valueless,  by  reason  of  this  very  fact  the  indications  of  zinc 
ore  which  had  originally  been  found  in  these  mines,  were  not  fol- 
lowed up,  and  the  presence  of  the  zinc  ores  which  were  commercially 
valuable  by  any  process  of  treatment  was  not  actually  discovered 
until  the  dates  claimed  for  discoveries.  The  claims  for  discoveries 
in  the  case  of  zinc  ores,  therefore,  have  no  different  basis  than  the 
claims  for  discovery  of  copper  ores. 

At  the  time  this  memorandum  was  received  in  this  office,  regu- 
lations dealing  with  the  question  of  discovery  were  in  process  of 
preparation,  and  it  was  not  deemed  advisable  to  anticipate  those 
regulations.  The  regulations  have  now  been  prepared  and  appear 
as  articles  under  the  appropriate  heading,  in  Regulations  45  (1920 
edition). 

Articles  219,  207,  and  208  of  those  Regulations  appear  to  answer 
the  question  presented. 

Under  this  article''^  a  discovery  for  the  purpose  of  a  new  valua- 
tion for  depletion  can  not  be  made  in  a  "known  mine,"  nor  can  a 
discovery  be  made  of  any  "probable"  or  "prospective"  ores  which 
had  been  or  could  have  been  included  in  the  previous  valuation.  This 
appears  to  exclude  most,  if  not  all,  of  the  alleged  discoveries  of  cop- 
per ores.  It  will  be  noted  that  this  article  does  not  recognize  a  dis- 
covery for  the  purpose  of  depletion  as  the  result  of  improved  processes 
of  treatment  of  ores,  making  commercially  valuable  ores  which  were 
theretofore  valueless.     This  omission  was  intentional  and  made  only 


'Referring  to  Art.  219  (b)  and   (f). 


1 196 


DEDUCTIONS 


after  mature  consideration.  If,  however,  bodies  of  zinc  ore,  not 
theretofore  known  to  exist,  were  discovered  within  the  meaning  of 
the  Regulations,  the  fact  that  the  explorations  were  stimulated  by 
recent  improvements  in  metallurgy  which   made  them  commercially 

valuable  for  the  first  time  would  not  bar  a  claim  for  discovery 

(C.  B.  4,  page  190;  A.  R.  M.  124.) 

The  foregoing  definition  of  the  word  "discovery"  may  not 
be  upheld  by  the  courts.  If  a  purchaser  of  low  grade  ore  finds 
a  body  of  high  grade  ore,  surely  it  is  a  discovery.  It  may  be, 
however,  that  the  term  will  be  strictly  interpreted  in  view  of 
the  intention  of  Congress  to  extend  what  may  be  characterized 
as  a  tax  privilege. 

Value  30  days  after  "discovery"  must  be  reasonably 

CERTAIN.^® 

Regulation (e)   The  value  of  the  property  claimed  as  a 

result  of  a  discovery  must  be  the  fair  market  value,  as  defined  in 
article  206,  based  on  what  is  evident  within  thirty  days  after  the  com- 
mercially valuable  character  and  extent  of  the  discovered  deposits  of 
ore  or  mineral  have  with  reasonable  certainty  been  established,  de- 
termined or  proved. 

Capital  account  to  be  adjusted. — 

(/)  After  a  bona  fide  discovery  the  taxpayer  shall  adjust  his  cap- 
ital and  depletion  accounts  in  accordance  with  article  206,  208,  and 
210,  and  shall  submit  such  evidence  as  to  establish  his  right  to  a  re- 
valuation, covering  the  conditions  and  circumstances  of  the  discovery 
and  the  size,  character,  and  location  of  the  discovered  deposit  of 
m.ineral,  the  value  of  the  property  at  the  prior  basic  date,  the  cost 
of  discovery,  and  its  development,  equipment,  and  exploitation,  its 
value  and  the  particular  method  used  in  the  determination. 

Proven  tract  or  lease. — 

(g)  In  the  case  of  a  mine,  a  "proven  tract  or  lease"  includes,  but 
is  not  necessarily  limited  to,  the  mineral  deposits  known  to  exist  in 
any  known  mine  at  the  date  as  of  which  such  mine  was  valued  for 
purposes  of  depletion,  and  all  extensions  thereof,  including  "probable" 
and  "prospective"  ores  considered  as  a  factor  in  the  determination  of 
the  value  or  cost.     (Art.  219.) 

""  See  page  1205. 


FOR   DEPLETION 


1 197 


Valuation  of  Oil  and  Gas  Wells" 

In  the  foregoing  pages  dealing  with  the  valuation  of  mines, 
the  general  principles  underlying  the  valuation  of  mineral 
properties  for  purposes  of  depletion  have  been  explained. 
The  following  discussion  refers  to  some  of  the  particular  prob- 
lems found  in  the  valuation  of  oil  and  gas  wells. 

In  view  of  the  highly  technical  regulations  relative  to  the 
gas  and  oil  industries  the  Treasury  has  prepared  an  exhaustive 
treatise  which  should  be  consulted  by  all  interested.*^  There- 
fore articles  209,  21 1-2 14,  220,  220  (a),  223  and  226  are 
omitted  from  this  chapter. 

Among  petroleum  engineers  the  recognized  method  of  ap- 
praising an  oil  or  gas  property  for  tax  purposes  is  on  the  basis 
of  past  production  of  similar  properties  in  the  same  sand  and 
pool  or  geographical  district.  The  authority  for  this  method 
is  the  law  of  equal  expectations,  which  is  as  follows :  "If  two 
wells  under  similar  conditions  produce  equal  amounts  during 
any  given  year,  the  amounts  they  will  produce  thereafter,  on 
the  average,  will  be  approximately  equal,  regardless  of  their 
relative  ages."" 

Production  decline  curves. — The  past  production  of  individ- 
ual wells  may  be  graphically  represented  by  production  decline 
curves  which  depict  the  decline  in  the  production  of  a  well 
over  the  period  of  its  existence.  Such  curves  are  constructed 
on  co-ordinate  paper  with  evenly  spaced  divisions,  the  vertical 
scale  indicating  units  of  production,  the  horizontal  scale  rep- 
resenting years.  The  curve  for  an  oil  well  is  symmetrical. 
The  decline  of  production  in  the  first  year  of  the  well's  exist- 
ence is  very  rapid  but  the  slope  gradually  subsides  until  it  ap- 
proaches the  horizontal.    All  oil  curves  are  of  this  type.    Wells 


*°  For  former  procedure  and  comments  thereon,  see  Income  Tax  Pro- 
cedure, 1919,  pages  602-609,  1156-1164  (Supp.). 

"  The  book  contains  245  pages  and  is  entitled  Manual  for  the  Oil  and 
Gas  Industry.  Copies  may  be  obtained  from  the  Superintendent  of  Docu- 
ments, Washington,  D.  C,  for  25  cents  each. 

*' Manual  for  the  Oil  and  Gas  Industry  (1921),  page  72)',  and  Bureau  of 
Mines  Bulletin  177,  by  Carl  H.  Beal  (1919),  page  36. 


ti98  ^EDUCTIONS 

with  a  large  first  year  production  decline  more  rapidly  than 
wells  with  a  small  initial  production.  The  curve  for  a  gas 
well  approximates  that  of  an  oil  curve,  but  it  is  less  likely 
to  be  symmetrical. 

The  unit  of  production  in  the  case  of  oil  is  the  barrel. 
There  is  little  difficulty  in  obtaining  the  records  of  the  produc- 
tion for  this  unit  as  the  production  of  a  lease  is  generally 
measured  on  the  lease  by  the  flow  of  oil  into  tanks.  Royalties, 
the  equivalent  of  rents,  on  oil  leases  are  almost  universally 
based  on  production,  the  lessor  usually  receiving  the  value  of 
one-eighth  of  the  production. 

There  is  a  different  situation  with  gas.  The  production 
unit  is  a  thousand  cubic  feet.  Royalties  consist  of  fixed  pay- 
ments each  year  or  payments  based  on  pressures  taken  at 
the  well.  There  are  numerous  instances  where  producers  do 
not  meter  their  gas  at  the  lease  and  it  is  not  metered  until  it 
reaches  the  consumer.  This  is  not  fatal  if  the  producer  has 
accurate  pressure  records  from  which  the  production  of  a 
well  for  the  year  may  be  calculated.  Where  there  are  not 
accurate  pressure  records  the  appraiser  should  check  his  esti- 
mate of  production  in  the  field  by  adding  to  the  total  volume 
of  metered  gas  the  line  losses,  or  leaks  from  the  pipe  fines  car- 
rying the  gas,  and  such  other  losses  between  the  wells  and  the 
meters,  as  free  gas  to  the  lessor  and  gas  used  by  the  lessee  for 
drilling  purposes. 

Line  losses  are  difficult  to  estimate  when  the  production  in 
the  field  is  not  known.  They  vary  according  to  the  weather, 
condition  of  the  pipe  line,  and  the  type  of  pipe  line.  Line 
losses  in  a  city  are  apt  to  be  large  because  of  the  frequent 
connections  made  for  each  house  or  factory.  Welded  lines 
show  less  loss  than  other  types.  Leaks  are  more  frequent 
in  the  winter  than  in  the  summer.  It  is  obvious  that  with 
such  difficulties  at  the  outset  the  estimation  of  the  gas  which 
a  well  will  produce  is  subject  to  a  large  percentage  of  error. 

Having  constructed  decline  curves  for  the  individual  wells, 
the  next  step  is  to  construct  a  composite  production  decline 


FOR    DEPLETION 


1199 


curve  for  a  given  sand  in  a  given  pool  or  district.  The 
Manual  for  the  Oil  and-  Gas  Indiistry^^  recommends  that  the 
family  curve  be  used.  The  family  curve  is  constructed  by  se- 
lecting the  largest  producing  well  in  the  pool,  and,  using  that 
as  a  basis,  putting  the  production  of  the  second  largest  well 
with  its  first  year's  production  on  the  curve  of  the  first  well, 
the  third  in  the  same  way,  and  so  on.  An  average  curve  is 
constructed  giving  due  weight  to  the  variations  of  each  well. 
There  is  a  considerable  personal  equation  with  the  consequent 
danger  of  error  involved  in  this  method.  It  is  laborious  and 
difficult  to  accomplish  neatly.  Some  engineers  have  found 
that  the  segmental  method  is  a  short  and  fairly  accurate  method 
of  constructing  a  composite  decline  curve.  Thisi  consists 
of  averaging  the  periods  of  time  for  declines  between  selected 
points  of  production.  The  months  or  years  required  by  all 
the  wells  to  decline  from  a  production  of,  let  us  say,  lOO  to  90, 
90  to  80,  80  to  70,  etc.,  are  read  from  the  individual  well 
curves  and  averaged  by  dividing  the  total  amount  of  time  by 
the  number  of  producing  wells. 

Great  care  must  be  exercised  in  selecting  the  wells  to  be 
used  in  the  composite  production  decline  curve.  All  aberrant 
or  erratic  wells  such  as  those  which  show  the  effects  of  water, 
which  are  aljandoned  after  short  periods,  and  which  are  drilled 
too  closely  to  one  another,  should  be  excluded.  In  making  in- 
dividual curves  for  gas  wells  the  appraiser  should  exercise 
caution  in  selecting  pressures  upon  which  to  calculate  yearly 
production.  The  majority  of  Appalachian  producers  .who  sup- 
ply domestic  consumers  shut  in  some  of  their  wells  during 
the  summer  months  as  the  demand  for  gas  is  low,  practically 
none  being  required  for  heating  purposes.  The  effect  of  shut- 
ting in  the  wells  is  to  increase  the  pressures.  In  the  winter 
pressures  are  low,  due  to  the  cold  weather  and  the  heavy  drain 
on  the  fields  made  necessary  to  supply  the  consumers  with  gas 
for  fuel.    In  general  the  pressures  at  the  end  of  September  are 


Manual  for  Oil  and  Gas  Induslry,  page  86. 


I200  DEDUCTIONS 

representative  pressures  upon  which  to  base  a  calculation  of 
the  year's  volume.  Abnormally  low  pressures  due  to  the  pres- 
ence of  water  in  a  well  or  sudden  high  pressures  due  to  the 
abandonment  of  nearby  wells  should  be  disregarded. 

The  composite  production  decline  curve  represents  the 
decline  in  production  of  the  average  well  in  a  given  sand,  or 
stratum,  and  geographical  district.  To  obtain  the  estimated 
future  production  of  a  well,  the  point  on  the  composite  decline 
curve  corresponding  to  the  yearly  rate  of  production  as  of 
the  date  of  valuation  of  the  well  is  located  and  the  future 
production  is  read  off,  year  by  year,  to  the  economic  limit. 
The  economic  limit  is  that  point  where  the  production  is  so 
small  that  the  producer  makes  no  profit  by  operating  the  well. 
The  economic  limit  varies  according  to  the  profit  on  the  com- 
modity. The  sum  of  the  future  production,  year  by  year, 
equals  the  estimated  recoverable  reserves,  or  the  amount  of  oil 
or  gas  which  the  taxpayer  expects  to  produce. 

Field  prices  and  costs. — Prices  are  estimated  for  the  oil 
or  gas  unit  of  production  on  the  lease.  The  taxpayer  places  a 
value  on  his  well  or  lease,  taking  into  consideration  the  trans- 
portation facilities  available.  It  is  essential  in  predicting  fu- 
ture prices,  especially  in  the  case  of  oil,  that  the  engineer  be 
acquainted  with  the  supply  of  and  demand  for  the  com- 
modity. In  recent  years  price  curves  depicting  the  rise  in 
price  of  oil  since  the  year  1900  extrapolated,  or  extended, 
into  the  future  with  the  same  percentage  of  increase,  have 
been  unsatisfactory  because  of  the  sudden  drop  in  the  price 
of  oil  at  the  beginning  of  192 1.  This  type  of  prediction  has 
been  successful  for  the  prices  of  gas  in  the  Appalachian  region. 
In  this  section  the  gas  reserves  seem  to  be  steadily  declining 
with  no  new  pools  being  discovered.  One  company  had  one- 
third  less  production  in  1920  than  in  1916,  although  it  had 
about  30  per  cent  more  wells  producing  in  1920.  The  pro- 
ducers are  educating  the  people  in  methods  of  conservation 
and  at  the  same  time  gradually  increasing  the  prices  against 


FOR   DEPLETION  I20I 

the  day  when  there  will  be  no  natural  gas  resources  and  the 
people  must  use  artificial  gas,  which  is  more  expensive.  Some 
of  the  cities  of  Pennsylvania  which  formerly  used  natural  gas 
for  fuel  have  had  to  turn  to  coal  within  the  last  year.  This 
situation  indicates  that  the  taxpayer  in  the  Appalachian  field 
is  safe  in  assuming  that  the  price  of  gas  will  rise  steadily  for 
the  next  few  years. 

Where  a  producer  does  not  sell  his  gas  in  the  field  to  a  pipe 
line  company,  and  has  only  a  consumer's  price,  there  is  the 
same  difficulty  in  estimating  a  field  price  as  there  is  in  estimat- 
ing field  production  when  there  are  no  pressure  records.  Field 
prices  must  then  be  estimated  by  deducting  from  consumers' 
prices  the  value  of  line  losses,  free  gas,  and  gas  used  for  drill- 
ing or  other  purposes. 

Production  costs  include  the  cost  of  drilling,  maintenance, 
and  transmission  of  the  product  to  the  lease  boundary.  The 
appraiser  should  be  cautious  about  estimating  his  future  costs 
on  the  basis  of  the  rise  in  the  past  because  of  the  inflation 
of  prices  of  materials  during  the  period  of  the  recent  war. 

The  field  price  per  unit  of  production  minus  the  production 
cost  in  any  year,  equals  the  future  net  revenue  for  the  unit  in 
that  year.  The  future  net  revenue  for  the  unit  for  a  year 
times  the  estimated  recoverable  units  of  production  for  the 
year,  equals  the  net  revenue  for  the  property  in  the  year. 

Present  value  method. — To  obtain  the  present  worth  of  the 
property  discount  factors  of  from  8  to  lo  per  cent  are  used. 

In  addition  to  the  discount  to  obtain  the  present  value,  a 
"discovery"  well  should  be  further  discounted  for  the  risk 
of  abandonment,  which  is  the  risk  that  natural  forces,  such  as 
water,  will  prevent  the  actual  production  equalling  the  anti- 
cipated production,  and  the  risk  of  olTset  wells,  that  is,  the 
risk  that  rival  producers  will  drill  so  close  as  to  drain  a  por- 
tion of  the  resources  of  the  well. 

The  discount  table  published  1)y  the  Treasury"**  is  based 


^Manual  for  lite  Oil  and  Gas  /mluslry,  page  57. 


1202  DEDUCTIONS 

on  the  present  value  of  $i  due  a  number  of  years  hence,  the 
present  value  being  worked  out  for  each  year  separately.  The 
sum  of  the  present  worths  for  each  year  is  the  total  value  to  be 
ascribed  to  the  property.  The  necessity  for  discounting  each 
year's  income  separately  is  that  production  in  an  oil  prop- 
erty progressively  declines,  whereas  in  a  mine  it  is  assumed 
to  be  fairly  constant  year  after  year.  The  discount  table 
contains  no  reinvestment  feature  as  is  the  case  in  the  tables 
used  for  mines ;  that  is,  no  provision  is  made  for  estab- 
lishing a  theoretical  sinking  fund  at  4  per  cent  compounded 
annually,  as  in  the  case  of  mines,  which  results,  of  course, 
in  a  greater  present  value  being  assigned  to  the  property.  As 
stated  by  the  Treasury,  "The  rate  of  discount  employed  de- 
pends upon  the  judgment  of  the  person  making  the  valuation. ''*° 

Risks  affecting  rate  of  return. — Some  of  the  ordinary 
risks  to  be  considered  in  valuing  oil  and  gas  properties  are : 

1.  For  wells  valued  as  of  March  i,  1913: 

(a)  Risk  of  offset  wells  or  the  risk  that  rival  pro- 

ducers will  drill  producing  wells  so  close  to 
the  property  as  to  drain  a  portion  of  the  re- 
sources. 

(b)  Risk  of  abandonment,  or  the  risk  that  natural 

forces  will  prevent  the  actual  production 
equalling  the  anticipated  production. 

2.  For  discovery  wells : 

(a)  Risk  of  dry  holes,  or  the  risk  that  there  will 

be  no  production. 

(b)  Risk  of  abandonment. 

(c)  Risk  of  offset  wells. 

3.  For  undrilled   locations : 

(a)  Risk  of  dry  holes. 

(b)  Risk  of  abandonment. 

(c)  Risk  of  offset  wells. 


''Manual  for  the  Oil  and  Gas  Indiislry,  page  58. 


FOR   DEPLETION 


1203 


(d)  Risk  of  deferment  in  drilling,  the  risk  that  the 
rate  of  production  in  the  field  may  be  smaller 
at  the  time  the  proposed  well  is  drilled. 

Perhaps  in  191 3  it  would  have  been  absurd  for  engineers 
to  attempt  to  estimate  the  present  value  of  oil  and  gas  wells 
by  appraisals.  During  the  last  six  years  many  improvements 
have  ]:)een  made  in  the  methods  of  valuation  so  that  at  the  pres- 
ent day  with  the  law  of  equal  expectations'*''  and  the  use  of  pro- 
duction decline  curves  as  a  basis  for  estimates,  very  fair  values 
may  be  placed  upon  oil  and  gas  properties. 

Valuation  of  undrilled  acreage. — A  fair  method  of  valuing 
undrilled  acreage  surrounding  a  well  is  on  the  basis  of  the 
drilling  program  which  any  experienced  producer  would  in- 
augurate. The  drainage  area  of  a  wxll  varies  as  to  its  locality 
and  the  porosity  of  the  sand.  In  the  Appalachian  field  an  oil 
well  drains  about  eight  acres  and  a  gas  well  approximately 
forty  acres.  Using  the  drainage  area  of  the  well  as  a  basis, 
the  appraiser  indicates  on  a  map  the  territory  which  he  expects 
to  be  drilled,  taking  into  account  the  geological  conditions, 
the  practical  difficulties,  and  the  neccbsity  of  placing  the  wells 
in  such  positions  that  they  will  drain  the  maximum  amount 
from  the  taxpayer's  territory  at  the  least  cost,  and  at  the  same 
time  be  as  near  the  lease  boundaries  as  possible  in  order  to 
drain  neighboring  leases  held  by  rival  producers.  The  value 
of  a  location  for  a  future  well  should  be  discounted  for  defer- 
ment, the  risk  of  a  dry  hole,  the  risk  of  abandonment,  and  the 
risk  of  offset  wells.  The  risk  of  deferment  is  the  risk  that 
the  rate  of  production  for  the  field  will  be  smaller  than  its 
present  rate  at  the  time  the  proposed  well  is  drilled.  The 
risk  of  a  dry  hole  is  the  risk  that  the  proposed  well  will  not 
produce  any  gas  or  oil  at  all. 

Gasoline. — In  recent  years  producers  have  found  that/ 
sometimes  they  can  absorb  gasoline  from  the  gas  as  it  comes 


'Manual  for  the  Oil  and  Gas  Industry  (iQJi),  paj'c  7Z- 


I204  DEDUCTIONS 

from  the  well.  Where  the  producer  has  indicated  by  the  pres- 
ence of  an  absorbing  plant  his  intention  to  take  out  the  gasoline 
at  the  date  of  valuation,  or  shortly  thereafter,  he  may  claim 
depletion  on  the  gasoline  contents  of  the  gas,  as  well  as  on 
the  gas  itself. 

A  refiner  may  have  a  large  number  of  contracts  for  the 
purchase  of  gasoline  at  the  wells.  It  is  understood  that  he  is 
allowed  to  deplete  the  value  of  these  contracts.  Apparently 
the  reason  for  this  is  that  the  refiner  has  a  legal  interest  in  the 
mineral  content  of  the  well  similar  to  that  of  the  lessee  who 
is  allowed  to  claim  depletion  for  the  value  of  his  rights.  De- 
pletion of  such  contracts,  however,  would  be  permissible  only 
if  they  were  held  at  March  i,  1913,  or  were  acquired  since 
for  a  valuable  consideration. 

Evidence  required  to  support  depletion  charges. — Although 
the  oil  and  gas  taxpayer  reaps  many  benefits  under  the  income 
tax  law  as  it  now  stands,  he  must  also  undergo  considerable 
expense  in  meeting  the  requirements  of  form  O  to  support  his 
claims  for  depletion  and  depreciation.  The  information  re- 
quired is  not  likely  to  be  kept  in  such  form  by  the  taxpayer 
that  he  can  readily  produce  it.  Some  companies  require  three 
years,  with  a  staff  of  twenty  men  and  girls  working  continu- 
ously, to  complete  amended  returns  from  191 3  to  date.  De- 
tailed information  as  to  each  lease  is  required.  When  a  tax- 
payer has  three  or  four  thousand  leases,  this  information  is  in 
itself  a  burden.  The  most  unreasonable  requirement  is  that 
a  taxpayer  show  development  in  the  neighborhood  of  his  dis- 
covery. This  is  in  effect  compelling  him  to  wrest  information 
from  his  rivals.  Probably  the  Treasury  Department  is  not 
particular  as  to  this  feature  today,  as  the  government  maps 
showing  development  are  understood  to  be  in  good  shape.  In 
the  case  of  discovery  wells  the  Treasury  Department  asks  for 
the  true  bearing  and  distance  of  all  wells  within  3,733.5  feet 
of  the  discovery.  In  thickly  drilled  fields  this  is  almost  impos- 
sible of  accomplishment.     Tlie  information  as  to  true  bearing 


FOR   DEPLETION     •  1205 

should  be  eliminated,  since  the  Treasury  holds  under  the  law 
that  ordinarily  a  discovery  proves  a  maximum  area  of  160 
acres. 

Revaluation  after  March  i,  1913,  not  permitted  except 
in  case  of  discoveries. — The  comments  on  page  1192  apply 
equally  to  oil  and  gas  wells.    Article  206a  is  therefore  omitted. 

Discovery  of  oil  and  gas  w^ells. — 

Fair  market  value  disproportionate  to  cost. — In  the 
case  of  oil  and  gas  properties  it  is  understood  that  the  Treasury 
Department  requires  that  the  fair  market  value  of  the  prop- 
erty must  exceed  the  cost  by  at  least  100  per  cent. 

The  law,*^  however,  does  not  fix  any  definite  percentage 
by  which  the  fair  market  value  must  exceed  the  cost.  It  reads 
''where  the  fair  market  value  is  materially  disproportionate 
to  the  cost." 

Proven  tracts  in  relation  to  discovery  claim. — The 
Treasury  interprets  the  law  allowing  revaluation  on  account 
of  discovery  as  meaning  that  a  discovery  well  ordinarily  proves 
an  area  of  160  acres  of  a  sand  regardless  of  private  boundaries, 
or  in  other  words,  a  producing  well  indicates  that  there 
is  a  reasonable  certainty  that  the  area  of  160  acres  around 
the  well  contains  oil  and  gas  in  sufficient  quantities  to  justify 
its  exploitation.^^ 

The  discovery  law  was  originally  enacted  to  protect  the  ad- 
venturous oil  men  who  drilled  wild-cat  wells,  or  who  drilled 
and  opened  up  undeveloped  territory.  As  such  producers  take 
large  risks  their  returns  should  be  large.  The  original  inter- 
pretation of  the  law  was  that  a  discovery  well  proved  a  pool 
or  geographical  district.  The  more  recent  rulings  of  the 
Treasury  indicate  that  a  proven  area  is  limited  to  160  acres. 
The  following  are  some  of  the  ordinary  cases   which  arise 


"Sections  214  (a-io)  and  234  (a-9). 
**  Manual,  page  44,  first  paragraph. 


i2o6  DEDUCTIONS 

under  the  first  three  paragraphs  on  page  44  of  the  Manual  for 
the  Oil  and  Gas  Industry  (1921). 

1.  The  Sniitli  lease  is  taken  in  1916.  The  Jones  Xo.  i  is  drilled 
in  191S  and  produces  from  the  Big  Injun  sand.  The  Smith  No.  i 
is  drilled  to  the  Big  Injun  in  1919  within  the  area  proved  by  the 
Jones  No.  i.  A  discovery  may  be  claimed  since  the  Smith  lease  was 
acquired  before  the  Jones  well  was  drilled. 

2.  The  Smith  lease  is  taken  in  1918  and  No.  i  well  is  drilled 
to  the  Big  Injun  sand  in  the  same  year.  Although  the  well  itself 
is  not  on  proven  territory  it  is  compactly  surrounded  by  the  proven 
areas  of  other  wells  drilled  to  the  Big  Injun  sand  in  previous  years. 
No  discovery  may  be  claimed.  This  is  a  case  where  the  present  in- 
terpretation of  the  Treasury  contains  the  spirit  of  the  old  interpreta- 
tion that  a  well  may  prove  more  than  160  acres. 

3.  The  Jones  No.  i  is  drilled  to  the  Big  Injun  sand  in  1917. 
The  Smith  lease  is  taken  in  1918  and  the  No.  i  well  is  drilled  to 
the  Speechly  sand  in  1918  within  the  160  acres  surrounding  Jones 
No.  I.  Smith  No.  i  may  be  claimed  as  a  discovery  since  its  production 
comes  from  a  different  sand.  The  Jones  No.  i  proves  160  acres  of 
Big  Injun  sand  but  does  not  prove  the  Speechly  sand. 

4.  Smith  No.  i  is  drilled  to  the  Big  Injun  sand  in  191 7  and 
valued  as  a  discovery.  In  1918  it  is  drilled  deeper  to  the  Speechly 
sand.  It  may  be  revalued  as  a  discovery  in  the  Speechly  sand,  since 
that  sand  was  not  proved  by  the  discovery  in  the  Big  Injun  sand. 

5.  Smith  No.  I  is  drilled  in  undeveloped  territory.  It  produces 
oil  from  the  Berea  sand  and  gas  from  the  Big  Injun.  It  should  be 
valued  as  an  oil  discovery  and  a  gas  discovery. 

6.  Where  the  Wildcat  Oil  Company  owns  the  Smith  lease  but  not 
the  Jones  lease  and  part  of  the  proven  area  of  Smith  No.  i  lies  on 
the  Jones  lease,  that  portion  of  the  acreage  may  not  be  valued  by  the 
company.  Nor  may  the  owner  of  the  Jones  lease  value  it,  since  he 
has  not  made  the  discovery. 

7.  The  Jones  lease  lies  east  of  the  Smith  lease.  The  Smith  No.  i 
is  a  discovery  in  the  Gantz  sand.  The  Smith  No.  2  is  drilled  to  the 
same  sand  easterly  and  within  the  proven  area  of  the  Smith  No.  i 
and  proves  a  small  strip  A-A  on  the  Jones  lease  beyond  the  area 
proven  by  Smith  No.  i  but  it  is  not  a  discovery.  Jones  No.  i  is 
drilled  outside  of  either  area  and  is  claimed  for  discovery  in  the 
Gantz  sand.  Query  whether  the  strip  A-A  may  be  revalued  by  the 
Jones  lessee.  It  is  understood  that  the  Treasury  Department  has 
ruled  in  such  a  case  that  the  strip  A-A  may  not  be  revalued  by  the 
Jones  lessee  since  the  Smith  No.  2  extended  the  proven  acreage  of 
the  discovery. 

Ruling.  Where  a  partnership  incorporated  in  1917  and  at  the 
date   of   incorporation    the   property   transferred   was    '"proven   terri- 


FOR   DEPLETION  1207 

tory,''  depletion  was  allowed  the  corporation  on  the  basis  of  the  cost 
to  the  corporation,  i.e.,  the  appreciated  "discovery"  value  at  which 
taken  over,  even  though  under  Section  331*''  the  corporation,  for  in- 
vested capital,  could  not  include  any  such  appreciation.  (I-i-io; 
A.  R.  R.  712.) 

Comment  on  the  regulations. — The  expressed  purpose  of 
the  law  is  to  permit  annual  allowances  for  depletion,  based 
on  output,  up  to  the  cost  of  the  wells,  and  the  intention  of  the 
numerous  rulings  and  regulations  has  been  to  carry  out  the 
provisions  of  the  law.  The  most  that  any  owner  can  desire 
to  charge  off  against  income  is  the  fair  value  of  the  property 
March  i,  19 13,  or  the  entire  cost  of  property  acquired  or  the 
fair  value  of  discoveries  since  that  date.  He  recognizes  that 
any  net  income  realized  in  excess  of  such  amount  is  profit  and 
should  be  taxable. 

In  some  cases  owners  desire  to  charge  off  too  much  annu- 
ally and  in  other  cases  they  do  not  charge  off  enough.  Those 
who  charged  off  too  much  prior  to  January  i,  191 7,  regret 
their  action  because  there  is  now  so  much  less  left  to  claim  as 
allowable  deductions  under  laws  levying  higher  taxes.  On 
the  other  hand,  conservative  financing  and  accounting  require 
liberal  reserves  for  depreciation  and  depletion,  and  the  con- 
cern which  has  followed  this  policy  should  continue  it  and 
make  such  adjustments  between  the  books  and  the  tax  returns 
as  will  reflect  the  true  state  of  affairs.  An  oil  company  with  a 
large  cash  investment  cannot  afford  to  ignore  depletion  or 
exhaustion.  Aside  from  new  purchases,  it  is  obvious  that  at 
the  end  of  any  period  the  product  remaining  in  the  ground  is 
less  than  at  the  beginning  of  the  period  by  exactly  the  amount 
which  has  been  extracted. 

New  wells  brought  in  may  increase  flow  and  there  may  be 
an  apparent  appreciation  in  values  rather  than  depreciation, 
but  when  such  hazardous  properties  as  oil  wells  are  under  con- 
sideration the  tendency  of  good  managers  is  to  be  pessimistic 
about  the  future  and  to  be  liljeral  in  setting  up  depletion  re- 

"  1918  law. 


T2o8  DEDUCTIONS 

serves.  This  policy  prevents  the  overstatement  of  assets  and 
the  payment  of  excessive  dividends.  It  may  save  a  company 
from  bankruptcy.  The  government  will  not  lose  anything  in 
taxes  in  the  long  run  by  permitting  liberal  depletion  deductions. 
It  will  probably  gain,  because  the  instant  the  entire  investment 
is  written  off  the  books  no  further  deductions  for  depletion 
can  be  claimed  and  under  graduated  income  and  excess  profits 
tax  laws  the  aggregate  tax  is  increased.  From,  the  taxpayer's 
point  of  view,  it  is  better  to  pay  too  much  tax  in  the  long  run 
and  have  a  conservative  balance  sheet,  than  to  ignore  deple- 
tion or  provide  insufficient  reserves  and  publish  misleading 
balance  sheets. 

Determination  of  the  Depletion  Allowance 

Having  determined  the  value  of  the  property  as  at  the  date 
of  valuation  (the  ''basic  date"),  the  next  step  is  to  determine 
the  depletion  unit,  which  is  ascertained  by  dividing  the  value  of 
the  property  by  the  number  of  units  of  mineral  estimated  to  be 
in  the  property.  The  unit  value  multiplied  by  the  numbers 
of  units  sold  during  the  year  gives  the  depletion  allowance. 

Regulation,  (a)  Depletion  attaches  to  the  annual  production 
"according  to  the  peculiar  conditions  of  each  case"'  and  when  the 
depletion  actually  sustained,  whether  legally  allowable  or  not,  from 
the  basic  date,  equals  the  cost  or  value  on  the  basic  date  plus  subse- 
quent allowable  capital  additions,  no  further  deduction  for  depletion 
will  be  allowed  except  in  consequence  of  added  value  arising  through 
discovery  or  purchase 

(&)  When  the  value  of  the  property  at  the  basic  date  has  been 
determined,  depletion  sustained  for  the  taxable  year  shall  be  computed 
by  dividing  the  value  remaining  for  depletion  by  the  number  of  units 
of  mineral  to  which  this  value  is  applicable,  and  by  multiplying  the 
unit  value  for  depletion,  so  determined,  by  the  number  of  units  sold 
or  produced  within  the  taxable  year.  The  depletion  deduction  for  the 
taxable  year  is  subject,  however,  to  the  limitation  contained  in 
article  201  (h).^*^  In  the  selection  of  a  unit  for  depletion  preference 
shall  be  given  to  the  principal  or  customary  unit  or  units  paid  for  in 
the  product  sold.°^     (Art.  210.) 


™  See  page  121 i. 

°'  [Former  Procedure]      Before   the   revision   of   December  29,    1920, 


FOR   DEPLETION  1209 

In  (a)  "production"  is  mentioned,  but  in  (b)  reference  is 
made  to  the  "units  sold  or  produced."  It  is  obvious  that  the 
quantity  extracted  represents  actual  depletion,  because  coal  and 
other  natural  resources  are  frequently  consumed  by  the  tax- 
payer and  not  sold. 

Depletion  of  mines. — In  copper  mines  the  practice  is  to 
multiply  the  depletion  factor  by  the  number  of  net  tons  of  ore 
smelted  or  by  the  number  of  pounds  of  metal  recovered  or 
produced  from  ore  smelted. ^^ 

In  establishing  the  depletion  rate  care  must  be  taken  to 
use  a  rate  that  will  provide  for  the  proper  deduction  based  on 
the  grade  extracted.  If  high  grade  ore  is  extracted  during  the 
early  years,  and  low  grade  in  the  latter  years,  an  average  rate 
might  fail  to  recover  the  full  capital  because  in  the  later  years 
the  income  might  be  insufficient.  The  effect  of  improperly 
using  an  average  rate  may  be  seen  from  the  following : 

Assume  that  the  copper  in  this  mine  is  1,000,000,000  lb.  of  which 
the  high-grade  ore  averages  two-thirds,  or  666,000,000  lb.,  and  the 
low-grade  ore  amounts  to,  approximately,  333,000,000  lb.  The 
profit  on  the  high-grade  ore  is  10  cents,  or  $66,000,000  in  round 
figures,  and  the  profit  on  the  low-grade  is  5  cents,  or  $16,000,000. 
Adding  these  figures  together  gives  a  total  value  of  $82,000,000.  As- 
sume a  life  of  10  years;  this  gives  an  expected  annual  income  of 
$8,200,000.  The  present  value  of  that  income  would  be  in  round 
figures  $66,500,000.  Applying  the  Treasury  rufe  to  those  figures  for 
depletion,  you  must  divide  the  $66,500,000  by  the  total  number  of 
pounds  of  copper,  or  1,000,000,000,  and  be  allowed  a  depletion  of 
6.65  cents  per  pound.  In  the  first  years  when  we  get  a  10  cent  profit, 
all  is  well,  we  readily  obtain  the  depletion  of  6.65  cents,  but  in  the 
latter  years  of  that  mine's  life,  when  we  only  have  a  5  cent  profit 
on  that  ore,  how  can  we  take  7  cents  out?-""'^ 

The  point  is  that  the  extraction  of  100  pounds  of  copper 


Art.  210  provided  for  computing  the  depletion  allowance  based  on  the  num- 
ber of  units  extracted  during  the  year.  See  Income  Tax  Procedure,  1920, 
page  770. 

Reg.  45  (1920  edition),  Art.  210,  based  the  allowance  on  number  of 
units  sold.     See  Income  Tax  Procedure,  1921,  pages  936-937. 

"  T.  O.  McGrath,  Mine  Accounting,  page  72. 

"  L.  C.  Graton,  Federal  Taxation  of  Mines,  page  57. 


I2I0  DEDUCTIONS 

contained  in  rich  ore  results  in  a  greater  impairment  of  the 
mine,  because  of  the  greater  profit  in  the  high  grade  ore  than 
does  lOO  pounds  of  copper  in  low  grade  ore  in  which  there 
was  little  profit.  The  problem  may  be  solved  in  some  cases 
by  separate  valuations  of  the  various  blocks  of  ore,  where  it 
is  feasible  to  do  so,  as  provided  in  article  206,^*  and  the  es- 
tablishment of  separate  depletion  rates  applicable  to  each.^^ 
In  the  case  of  a  silver  mine,  this  situation  was  recognized  by 
basing  the  depletion,  not  on  the  tons  of  ore  contained  in  the 
mine,  but  on  the  metal  content  of  the  ore.  The  unit  of  deple- 
tion was,  therefore,  the  ounce  of  silver  instead  of  the  ton 
of  ore  containing  silver.  Each  year's  depletion  allowance  is 
based  on  the  silver  recovered  (allowance  having  been  made 
in  the  basic  valuation  for  expected  loss  in  extraction),  which 
naturally  varies  as  between  different  grades  of  ore.  Note 
particularly  the  last  sentence  of  article  210.  The  unit  paid 
for  in  the  product  sold  by  a  silver  mine  is  not  ore  but  silver, 
by  a  copper  mine,  copper  not  ore,  etc. 

Depletion  of  gas  wells. — When  gas  wells  have  been  valued 
on  the  basis  of  production,  it  is  more  practicable  to  use  the 
production  for  calculating  depletion  for  any  given  year  than 
the  pressure  units  suggested  by  the  Treasury  Department. ^^ 
Depletion  on  the  basis  of  production  is  the  depletable  capital 
sum  divided  by  the  estimated  recoverable  reserves  (which 
equals  the  unit  cost),  times  the  number  of  cubic  feet  of  gas 
produced  during  the  year. 

Depletion  of  oil  wells. — 

Each  barrel  of  oil  or  unit  extracted  and  marketed  must,  before 
a  profit  can  be  realized,  pay  not  only  its  proportionate  share  of  the 
operating  expense  and  deductions  for  depreciation  and  obsolescence 
of  physical  property,  but  also  must  pay  its  proportionate  share  of 
capital   sum   returnable  through   depletion '  allowances. 


"  See  page  11 76. 

"^  Recovery  of  the  cost  or  Alarch  i,  1913,  value  of  tlie  physical  property 
may  also  be  obtained  through  a  depreciation  deduction,  based  on  the  rate  of 
current  exhaustion  of  the  mineral.     See  page  1105. 

''"Manual  for  the  Oil  and  Gas  Industry  (1921),  page  32. 


FOR   DEPLETION  I2ll 

This  proportionate^  sliare  of  capital  sum  returnable  through 
depletion  allowances,  which  each  unit  of  oil  must  pay,  is  unit  cost. 

Unit  cost  is  obtained  by  dividing  the  capital  sum  returnable 
through  depletion  by  the  "estimated  recoverable  reserves"  at  the  be- 
ginning of  the  taxable  year.  *  *  *  * 

The  depletion  deduction  is  computed  by  multiplying  the  unit 
cost  by  the  number  of  units  produced  during  the  taxable  year."'" 

While  the  Treasury  refers  to  units  produced,  as  above,  it 
also  provides,  in  article  210,  that  depletion  shall  be  computed 
on  the  number  of  units  sold  or  produced  during  the  year.  In 
a  year  like  192 1  when,  with  falling  prices,  prodticers  were 
obliged  to  accumulate  storage  oil  instead  of  selling  all  of  their 
production  to  the  pipe  line  companies,  a  considerable  reduc- 
tion in  the  total  depletion  would  result  if  the  basis  of  sales 
were  adopted. 

Limitation  on  depletion  deduction  based  on  discovery 
value. — The  192 1  law^^  does  not  permit  any  part  of  the  deple- 
tion deduction  based  on  discovery  value  to  be  used  in  the  com- 
putation of  a  net  loss.  This  prevents  the  loss  from  being  de- 
ducted from  the  income  of  a  succeeding  year,  due  probably 
to  the  "discovery"  provision  (which  is  first  found  in  the  19 18 
law)  being  considered  to  be  in  the  nature  of  a  gift;  and  if  the 
net  income  in  any  one  year  is  not  sufficient  to  take  care  of  the 
full  depletion  charge  based  on  discovery,  there  is  no  good 
reason  for  extending  the  terms  of  the  gift  to  another  period. 

Regulation (/i)  Depletion  allowance  in  case  of  dis- 
covery :  The  deduction  for  depletion  in  case  of  a  discovery  can  not  ex- 
ceed the  net  income  computed  without  allowance  for  depletion,  from 
the  property  upon  which  the  discovery  is  made,  except  where  and  to 
the  extent  that  such  net  income  so  computed  is  less  than  the  depletion 
allowance  based  on  cost  or  fair  market  value  as  of  March  i,  1913.  Net 
income  is  the  gross  income  from  the  sale  of  all  mineral  products  and 
any  other  income  incidental  to  the  operation  of  the  property  for  the 
production  of  the  mineral  products,  less  operating  expenses,  includ- 
ing depreciation  on  equipment,  and  taxes,  but  excluding  any  allowance 
for  depletion.     If  the  mineral  products  are  not  sold  as  raw  material 


"  Ibid.,  page  30. 

■'''Section  204;  see  page  1023. 


I2I2  DEDUCTIONS 

but  are  manufactured  or  converted  into  a  refined  product,  then  the 
gross  income  shall  be  assumed  to  be  equivalent  to  the  market  or  field 
price  of  the  raw  material  before  conversion.  Operating  expenses, 
depreciation,  and  taxes  on  the  property  upon  which  the  discovery 
is  made,  should  be  applied  against  the  gross  income  from  the  same 
property  on  the  basis  of  actual  expenditures,  but  if  the  records  for 
the  year  1921  are  in  any  case  inadequate,  allocation  of  such  expendi- 
tures for  that  year  may  be  made  on  the  basis  of  the  ratio  of  (i) 
the  number  of  wells  operated  on  the  property  on  which  the  discov- 
ery is  made  to  (2)  the  total  number  of  wells  operated  in  the  operating 
division  in   which  the  discovery   is  included.      (Art.   201.) 

The  following  illustrations  show  how  the  limitation  oper- 
ates: 

I 

Net  income   from  investments $10,000 

Net  income  from  mineral  property  before  depletion 50,000 

Total    $60,000 

Depletion  charge  based  on  cost  or  March  i,  1913,  value..     $40,000 

Depletion  charge  based  on  discovery  value $80,000 

Depletion  allowable  (amount  of  depletion  charge  based  on  dis- 
covery value,  but  not  to  exceed  the  net  income  from  the 
property)    50,000 

Taxable  income   $10,000 

11 

Net  income  from  investments $10,000 

Net  income  from  mineral  property  before  depletion 50,000 

Total    $60,000 

Depletion  charge  based  on  cost  or  Alarcli  i,  1913,  value..     $60,000 

Depletion  charge  based  on  discovery  value $80,000 

Depletion  allowable  (amount  of  depletion  charge  based  on  discov- 
ery value,  which,  if  it  exceeds  net  income  from  the  property, 
is  allowed  up  to  the  amount  of  depletion  based  on  cost  or 
March  i,  1913,  value)   60,000 

Taxable  income    None 

III 

Net  income   from  mineral  property  before  depletion    (no  income 

from  other  sources)    $50,000 

Depletion  charge  based  on  cost  or  March  i,  1913,  value..     $60,000 

Depletion  charge  based  on  discovery  value $80,000 


FOR   DEPLETION  1213 

Depletion  allowable  (as  above)   60,000 

Net  loss    (which   may   be  applied   against  net   income   of 
succeeding  year — section  204)    $10,000 

IV 

Net  income  from  investments $  5,000 

Net  income  from  mineral  property  before  depletion 50,000 

Total   $55>ooo 

Depletion  charge  based  on  cost  or  March  i,  1913,  value..     $60,000 

Depletion  charge  based  on  discovery  value $80,000 

Depletion  allowable   (as  above)    60,000 


Net  loss  (which  may  be  carried  forward — section  204)  ...     $  5,000 


The  point  is  that  the  taxpayer  may  get  depletion  based  on 
discovery  value,  if  the  net  income  is  sufficient,  but  always  gets 
depletion  based  on  cost  or  March  i,  1913,  value  even  if  it  re- 
sults in  a  net  loss,  which  net  loss  may  be  applied  against  the 
net  income  of  a  succeeding  year  under  section  204. 

Inventory  to  be  market  even  though  higher  than  cost. — 
If  raw  products  are  inventoried  at  the  market  price,  as  per- 
mitted by  article  201,  the  latter  may  include  a  considerable 
element  of  profit.  In  so  far  as  this  may  be  a  method  recog- 
nized as  representing  the  best  accounting  practice  in  the  in- 
dustry, it  will  be  recognized  by  the  Treasury.  It  is  a  good  illus- 
tration of  one  of  the  five  departures  from  the  rule  of  cost  or 
market,  which  ever  is  lower.^° 

Depletion  accounts  on  books. — 

Regulation.  Every  taxpayer  claiming-  and  making  a  deduction 
for  depletion  and  depreciation""  of  mineral  property  shall  keep  accu- 
rate ledger  accounts  in  which  shall  be  charged  the  fair  market  value 
as  of  March  i,  1913,  or  within  thirty  days  after  the  date  of  discovery, 
or  the  cost,  as  the  case  may  be,  (a)  of  the  mineral  deposit,  and  (b) 
of  the  plant  and  equipment,  together  with  subsequent  allowable  capital 
additions  to  each  account.    These  accounts  shall  thereafter  be  credited 


""  See  Auditing,  Theory  and  Practice,  by  R.  R.  Monegomcry  (1921 
edition),  page  122. 

°"  See  pages  I104-T108  for  articles  222,  224  and  225  which  refer  to  depre- 
ciation as  well  as  depletion  in  connection  with  equipment. 


J2I4  DEDUCTIONS 

annually  with  the  amounts,  whether  legally  allowable  or  not,  of  the 
depletion  and  depreciation  sustained;  or  the  amounts  of  the  deple- 
tion and  depreciation  sustained  shall  be  credited  to  depletion  and  de- 
preciation reserve  accounts,  to  the  end  that  when  the  sum  of  the 
credits  for  depletion  and  depreciation  equals  the  value  or  cost  of  the 
property,  plus  subsequent  allowable  capital  additions,  no  further  de- 
duction for  depletion  and  depreciation  with  respect  to  the  property 
shall  be  allowed.      (Art.  216.)''^ 

Statement  to  be  attached  to  returns. — 

Regulation,  (a)  To  the  return  of  every  taxpayer  claiming  a 
deduction  for  depletion  or  depreciation  there  shall  be  attached  a  state- 
ment setting"  forth  with  respect  to  each  mineral  property:  (i)  Whether 
taxpayer  is  a  fee  owner,  lessor  or  lessee,  (2)  the  date  of  acquisition 
and  if  under  lease,  its  exact  terms  and  date  of  expiration,  (3)  the 
cost  of  the  property ;  stating  the  amount  paid  to  each  vendor,  with  his 
name  and  address,  (4)  the  basic  date  at  which  the  property  is  valued, 
(5)  the  value  of  the  property  on  the  basic  date  with  a  statement  of 
the  precise  method  by  which  it  was  determined,  (6)  the  value  of  the 
surface  of  the  land  for  purposes  other  than  mineral  production,  (7) 
the  estimated  number  of  units  of  mineral  at  the  basic  date  with  an 
explanation  of  the  method  used  in  the  estimation,  and  an  average 
analysis  which  will  indicate  the  quality  of  the  mineral  valued,  (8) 
the  number  of  units  sold  during  the  year  for  which  the  return  is  made, 
(9)  the  gross  and  net  income  derived  from  the  sale  of  mineral,  and 
in  case  of  discovery  the  net  income  from  the  property  upon  which  the 
discovery  was  made;  (10)  the  amounts  deducted  for  depletion,  (11) 
the  amounts  sustained  on  account  of  depletion  or  on  account  of  de- 
preciation stated  separately  from  the  basic  date  to  the  taxable  year, 
and  (12)  any  other  data  which  will  be  helpful  in  determining  the 
reasonableness  of  the  deductions  claimed  in  the  return. 

Additional  information  in  cases  of  fractional  in- 
terests AND  leaseholds. 

(b)  To  the  return  of  every  taxpayer  claiming  a  deduction  for 
depletion  in  respect  of  (i)  property  in  which  he  owns  a  fractional 
interest  only,  or  (2)  a  leasehold,  or  (3)  property  subject  to  lease, 
there  shall  also  be  attached  a  statement  setting  forth  the  name  and 
address  and  the  precise  nature  of  the  holding  of  each  person  inter- 
ested in  the  property,  and  every  lessor  shall  attach  to  his  return  an 
affidavit  stating,  as  of  the  date  of  filing  the  return,  whether  the  lease 
involved  is  still  in  effect  during  the  year  covered  by  the  return,  and, 
if  not  still  in  effect,  when  it  was  terminated  and  for  what  reason  and 
whether  the  lessor  has  repossessed  the  property. 


"  Sec  A.  R.  M.  124,  page  1195. 


FOR   DEPLETION 


1215 


(c)  All  statements  required  to  be  furnished  in  connection  with  the 
returns  of  taxpayers  claiming  depletion  or  depreciation  must  be 
under  oath  and  may  be  included  in  a  single  affidavit.     (Art.  217.) 

Depletion  may  be  deductible  even  if  not  on  books. — As 
with  depreciation,  depletion  charges  should  appear  on  the 
books  and  the  book  figures  should  conform  exactly  with  those 
given  in  the  returns.  If  it  has  not  been  the  practice  to  record 
depletion,  no  time  should  be  lost  in  making  the  proper  book 
entries.  However,  the  courts  thus  far  have  taken  the  posi- 
tion that  the  taxpayer  cannot  be  deprived  of  the  right  to  de- 
duct depletion  because  of  a  failure  properly  to  record  the 
charges. 

Decision.  The  United  States  District  Court  has  held  that  a  coal 
company  was  entitled  to  a  deduction  of  15  cents  for  each  ton  mined 
as  an  allowance  for  depletion.  The  fact  that  this  amount  was  in- 
correctly carried  on  the  books  of  the  company  in  surplus  account 
instead  of  as  depletion  reserve  did  not  justify  the  Government  in 
disallowing  the  deduction."" 

Under  the  192 1  law  the  Commissioner  is  authorized  to  re- 
quire taxpayers  to  adhere  to  good  accounting  practice."  The 
courts  may  and  should  interpret  this  to  mean  that  if  depletion 
is  not  set  up  on  the  books  the  claim  will  not  be  allowed  for 
income  tax  purposes.  Moreover,  the  deduction  claimed  in 
the  return  should  agree  exactly  with  the  books. 

Depletion  allowance  to  operating  owner. — 

Regulation.  In  the  case  of  an  operating  owner  in  fee,  the 
amount  remaining  in  any  year  returnable  through  depletion  and  de- 
preciation deductions  is  (o)  the  cost  or  value  of  the  property  at  the 
basic  date  plus  (b)  subsequent  allowable  capital  additions  and  minus 
(c)  depletion  and  depreciation  sustained,  whether  legally  allowable 
or  not,  from  the  basic  date  to  the  taxable  year,  and  minus  (d)  the 
value  of  the  land  at  the  basic  date  for  other  purposes  than  mineral 
production  and  the  residual  value  of  other  property  at  tlic  end  of 
operations.     The   amount   returnable   through   depletion    is   the   total 


'"Forty  Fori  Coal  Co.  z'.  Kirkcndall,  Collector,  233  Fed.  704. 
"  [Former  Procedure]    The  1918  law  had  a  similar  provision  [section 
212  (b)]. 


j2i6  DEDUCTIONS 

capital  remaining  less  the  sum  recoverable  through  depreciation. 
(Art.   202.) 

Stockholder  may  not  claim  depletion. — It  will  be  noted  that 
a  stockholder  in  a  mining  or  oil  or  gas  corporation  is  not  en- 
titled to  any  allowance  for  depletion,  because  the  depletion 
claimed  by  and  allowed  to  the  corporation  exhausts  the  allow- 
able deduction. 

Regulation Operating    owners,    lessors    and    lessees, 

whether  corporations  or  individuals  are  entitled  to  deduct  an  allow- 
ance for  depletion  and  depreciation,  but  a  stockholder  in  a  mining  or 
oil  or  gas  corporation  is  not  allowed  such  deductions (Art. 

201.) 

Depletion  allowance  to  lessor. — The  192 1  law**^  provides 
that  "in  the  case  of  leases  the  deductions  allowed  by  this  para- 
graph shall  be  equitably  apportioned  between  the  lessor  and 
lessee."  The  depletion  allowance  to  lessors  is  fully  discussed 
in  the  text  following. 

If  the  lessor  is  entitled  to  a  sliding  scale  of  royalties  or  if, 
as  in  the  case  of  oil  wells,  he  receives  in  addition  to  a  bonus 
a  specific  part  of  the  whole  product  (one-eighth  of  the  product 
being  a  widely  used  figure),  he  will  follow  the  same  proce- 
dure as  an  owner  who  is  also  an  operator.  Revaluations  as 
of  March  i,  191 3,  may  be  placed  on  the  books. 

When  leases  are  for  a  fixed  royalty  per  unit,  appreciation 
in  value  between  the  making  of  the  lease  and  March  i,  191 3, 
usually  accrues  solely  to  the  lessee.  Appreciation  which  ac- 
crued prior  to  the  making  of  the  lease  which  was  in  effect  at 
March  i,  1913,  inures  to  the  benefit  of  the  lessor  in  appor- 
tioning the  depletion  allowance  between  lessor  and  lessee. 

The  lessor  having  divested  himself  of  any  return  beyond 
the  royalties,  cannot  participate  in  appreciation  as  such.  If 
interest  rates  were  lower  at  March  i,  191 3,  than  when  the 
leases  were  made,  the  lessor  might  claim  an  increased  value  for 
the  property,  subject  to  the  lease. 


"Sections  214  (a-io)  and  234  (a-9).    The  igi8  law  included  the  same 
provision. 


FOR   DEPLETION  1217 

In  all  cases  the  lessor  merely  gets  back  through  depletion 
his  capital  investment  or  value  at  March  i,  19 13,  and  the 
lessee  through  depletion  charges  gets  back  his  investment  or 
value  at  March  i,  191 3;  and  in  no  case  must  the  aggregate 
depletion  charges  allowed  to  lessor  and  lessee  exceed  the 
aggregate  capital  investment. 

Regulation,  (a)  In  the  case  of  a  lessor,  the  amount  remaining 
in  any  year  returnable  through  depletion  and  depreciation  deduc- 
tions is  (i)  the  value  of  his  equity  in  the  property  at  the  basic  date 
minus  (2)  depletion  and  depreciation  sustained,  whether  legally  al- 
lowable or  not,  from  the  basic  date  to  the  taxable  year,  plus  (3) 
subsequent  allowable  capital  additions,  and  minus  (4)  the  value  of  the 
land  at  the  basic  date  for  other  purposes  than  mineral  production 
and  the  residual  value  of  other  property  at  the  end  of  operations.  The 
amount  returnable  through  depletion  is  the  total  capital  remaining 
less  the  sum  recoverable  through  depreciation. 

(b)  The  value  of  the  equities  of  lessor  and  lessee  shall  be  com- 
puted separately,  but,  when  determined  as  of  the  same  basic  date, 
shall  together  never  exceed  the  value  at  that  date  of  the  property  in 
fee  simple. 

(c)  The  value  of  the  lessor's  equity  in  the  case  of  a  mineral 
property  not  under  lease  on  March  i,  1913,  but  subsequently  leased, 
is  the  en  bloc  value  of  the  mineral  in  the  ground  on  March  i,  1913, 
and  will,  in  the  absence  of  satisfactory  evidence  to  the  contrary,  be 
presumed  not  to  exceed  the  value  as  of  March  i,  1913,  of  the  royal- 
ties to  be  expected  under  the  lease. 

(d)  The  value  of  a  lessor's  equity  in  a  mineral  property  under 
lease  March  i,  1913,  for  the  entire  operating  life  of  the  mineral  de- 
posits is  the  value  as  of  March  i,  1913,  of  the  royalties  and  other 
payments  to  be  expected  under  the  terms  of  the  lease  in  effect  on  that 
date. 

(e)  The  value  of  a  lessor's  equity  in  a  mineral  property  under 
lease  for  a  portion  of  its  operating  life  is  the  value  as  of  March  i, 
1913,  of  the  royalties  expected  from  the  mineral  to  be  extracted 
during  the  life  of  the  existing  lease  plus  the  estimated  en  bloc  value 
of  the  mineral  remaining  at  its  expiration,  which,  in  the  absence  of 
satisfactory  evidence  to  the  contrary,  will  be  presumed  not  to  exceed 
the  value  as  of  March  i,  1913,  of  royalties  which  could  have  been 
expected  as  at  that  date  from  the  remaining  mineral. 

(/)  The  value  of  a  lessor's  equity  in  a  mineral  property  when 
acquired  on  or  after  March  i,  1913.  is  its  cost. 

(g)  The  value  of  a  lessor's  equity  in  a  discovery  on  or  after 
March  i,  1913,  is  the  fair  market  value  at  the  date  of  discovery,  or 


I2i8  DEDUCTIONS 

within  thirty  days  thereafter,  of  his  equity  in  the  mineral  discovered.'* 
(Art.  204.) 

The  application  of  the  principle  laid  down  in  paragraph 
(e)  in  the  foregoing  regulation,  as  affected  by  the  1916  law, 
is  stated  in  the  following: 

Ruling.  The  question  is  raised  as  to  the  proper  construction  to 
be  placed  upon  Solicitor's  Memorandum  1365  in  so  far  as  it  relates  to 
the  computation  of  deductions  for  depletion  of  a  mine  allowed  to  a 
lessor. 

The  inquiry  is  made  in  connection  with  the  following  statement 
of  facts:  A  leases  a  property  to  B  in  1910  at  20  cents  a  ton  for  the 
period  of  10  years.  In  1913  it  is  determined  that  the  property  is  very 
valuable,  and  has  a  large  tonnage  of  ore  which  will  extend  its  life,  at 
the  probable  rate  of  extraction,  until  1940.  In  1920  A  renews  the 
lease  to  B  for  the  life  of  the  mine  at  a  royalty  of  $1.00  per  ton. 

In  Solicitor's  Memorandum  1365  it  is  held  that  the  allowable 
deduction  for  depletion  m  that  case  under  the  Act  of  September  8, 
1916,  i.e.,  the  maximum  amount  that  could  be  deducted,  was  to  be 
determined  by  dividing  the  fair  market  value  of  the  entire  body  of 
coal  in  place  on  March  i,  1913,  by  the  estimated  content  of  the  mine 
in  tons  and  multiplying  the  result  so  obtained  by  the  number  of  tons 
of  coal  taken  out  each  year,  in  accordance  with  article  172,  Regula- 
tion 33  (revised).  The  lease  there  considered  was  entered  into  June 
12,  1914.  There  was  no  evidence  in  the  case  that  the  value  of  the 
coal  in  place  had  increased  between  March  i,  1913,  and  the  date  of 
the  making  of  the  lease,  and  it  was  stated  that  the  lease,  which  was 
for  the  term  of  10  years,  was  coterminous  with  the  life  of  the  mine. 
The  decision  was  based  upon  these  facts  and  was  clearly  correct. 

Section  12(a)   Second  (b)   of  the  Revenue  Act  of  1916  provides 


'°  [Former  Procedure]  Article  202  before  amendment  in  1920  erro- 
neously provided  that  a  lessor  could  not  claim  any  part  of  discovery  value. 
See  Income  Tax  Procedure,  1920,  pages  771-772. 

In  an  opinion  of  the  Attorney  General,  dated  October  29,  1920,  it  was 
held: 

Ruling,  (i)  The  deduction  for  depletion  in  the  case  of  mines,  oil 
and  gas  wells,  as  the  result  of  discovery  on  or  after  March  i,  1913,  is 
allowed  only  to  the  party  or  parties  in  possession  at  the  time  of  the 
discovery,  and  not  to  subsequent  purchasers. 

(2)  The  value  which  may  be  set  up  in  the  case  of  the  discovery  of 
mines,  oil  and  gas  wells,  pursuant  to  the  second  proviso  of  section  234  (a) 
(9),  Revenue  Act  of  1918,  to  be  depleted  in  accordance  with  such  reason- 
able rules  and  regulations  as  the  Commissioner  of  Internal  Revenue  and 
the  Secretary  of  the  Treasury  may  prescribe  according  to  the  peculiar 
conditions  in  each  case,  is,  in  the  case  of  a  lease,  to  be  equitably  apportioned 
between  the  lessor  and  the  lessee.     (C.  B.  3,  page  175;  T.  D.  3089.) 


FOR  DEPLETION  I2ig 

for  a  deduction  in  the  case  of  mines  of  a  "reasonable  allozvance  for 
depletion  ....  not  to  exceed  the  market  value  in  the  mine."  It 
is  clear  from  this  language  that  it  was  not  the  intent  of  Congress 
that  an  owner  of  a  mine  who  had  leased  it  for  a  fixed  royalty,  thus 
putting  a  limit  upon  the  amount  which  he  could  receive  in  any  event, 
should  recover  all  the  value  of  the  ore  in  place  as  of  the  basic  date, 
but  only  that  he  should  be  allowed  a  deduction  for  depletion  to  the 
amount  of  his  interest  in  the  ore  extracted,  not  in  excess  of  the  cost 
of  the  mine  or  its  fair  market  value  as  of  March  i,  1913. 

In  the  case  now  presented  the  value  of  A's  interest  as  of  March 
I,  1913,  in  the  ore  in  the  mine  was  the  present  worth  as  of  that  date 
of  his  royalties  of  20  cents  per  ton,  obtained  by  multiplying  the  roy- 
alty per  ton  by  the  number  of  tons  probable  extraction  by  the  lessee 
and  discounting  the  product  for  the  remaining  life  of  the  lease,  plus 
the  value  of  the  ore  which  would  be  left  in  the  mine  at  the  termination 
of  the  lease.  T.he  fair  market  value  of  the  ore  in  the  mine  as  of 
March  l,  1913,  having  been  determined,  "a.  reasonable  allowance" 
to  the  lessor  for  depletion  under  such  lease  was  the  then  present 
worth  of  his  royalties,  provided  this  did  not  exceed  such  fair  market 
value.  Upon  the  renewal  of  the  lease  in  1920  for  the  remaining 
life  of  the  mine  the  lessor's  interest  in  the  capital  sum  will  again 
be  represented  by  the  royalties  stipulated  to  be  paid,  capitalized  and 
discounted  as  above,  and  this  present  worth  divided  by  the  estimated 
mineral  content  of  the  mine  at  the  date  of  the  lease  will  equal  the 
unit  of  depletion  which,  multiplied  by  the  number  of  tons  extracted 
in  any  year,  will  give  the  allowable  deduction  for  depletion  for  such 
year,  provided  always  that  such  deduction  does  not  exceed  the  value 
as  of  March  i,  1913,  of  the  ore  extracted  during  such  year. 

The  above  ruling  is  not  understood  to  modify  the  conclusion 
reached  in  Solicitor's  Memorandum  1365,  but  only  to  apply  the 
principle  therein  laid  down  to  the  different  facts  here  presented.  (C. 
B,  4,  page  195;  Sol.  Op.  80.) 

Assume  that  the  mine  leased  in  19 10  contained  at  March 
I,  1913,  2,700,000  tons,  annual  production  100,000  tons,  so 
that  when  the  lease  terminated  in  1920,  at  the  end  of  seven 
years,  2,000,000  tons  would  be  left.  The  lessor  then  renews 
the  lease  at  $1  royalty  per  ton.  The  Treasury  says,  in  effect, 
that,  since  under  the  1916  law  the  depletion  deduction  in  any 
one  year  is  limited  to  the  "market  value  in  the  mine"  of  the 
ore  removed,  such  market  value  was  the  present  worth  in  1913 
of  the  20-cent  royalty  fixed  in  19 10.  Permission  to  recover 
any  additional  part  of  the  value  of  the  mine  at  March  i,  1913, 


I220  DEDUCTIONS 

(under  the  191 6  law)  would  not  be  granted  until  the  termina- 
tion of  the  lease  in  1920,  under  which  stipulated  royalties  of 
20  cents  were  paid.  The  following  illustration  will  help  to 
make  this  clear.*'*^ 

Number  of  tons  in  mine  at  Alarch  i,  1913 2.700,000 

Number   of   tons   lessee   would   extract  between   March    i,    1913, 

and  termination  of  lease  in  1920  (say  7  years) 700.000 

Number  of  tons  remaining  in  mine  at  1920  (which  would  be  ex- 
tracted by  1940)    2,000,000 

Production  per  annum,  estimated  at 100.000  tons 

Value  of  A's  interest  at  1913 : 

Present  worth  of  royalties  to  be  received  from  191310  1920: 
100,000  tons  X  20  cents  ^=  an  annuity  of  $20,000,  dis- 
counted at  6%  for  7  years $    111,647.62 

Add:   Value  of  ore  remaining  at  end  of  lease 
in  1920: 
Estimated  profit  per  ton  of  ore  remaining 
at  1920  $  .25 

Operating  profit  from  1920  on,  of  ore  then 
remaining,  2,000,000  tons  at  25  cents . .  $    500,000.00 

$500,000    -^    20    ^    $25,000,    or    annual 

profits  1920  to  1940. 
Present  worth  of  an  annuity  of  $25,000 

for  20  years  at  6% $   286.748.03 

Since  the  realization  of  the  value  of  the  ore  in  1920 

($286,748.03)  is  deferred  for  another  7  years  (1913- 

1920),     such     value    must    be     further    discounted. 

Therefore,  present  worth  of  the  entire  $286,748.03 

at  6  %  is 190,703.78 

Total  value  of  A's  interest  at  March  i,  1913 $     302.351.40 

Depiction  allowed  A  from  March  i,  1913,  to  end 
of  lease  in  1920  is  the  present  value  of  his 
royalties  under  the  lease,  or,  as  stated  above,  $    111,647.62 


"''  In  a  case  with  which  the  author  is  familiar,  the  problem  was  to 
determine  the  value  as  at  March  i,  19 13,  of  the  royalties  to  be  received 
by  the  lessor.  At  that  date  it  was  estimated  that  the  mine  would  be  worked 
out  in  nineteen  years.  The  lessor  sold  its  interest  in  1917,  taking  in  pay- 
ment non-interest  bearing  notes  maturing  semi-annually,  running  to  1951, 
and  through  the  acceptance  of  those  notes  the  life  of  the  mine,  so  far  as 
the  lessor  was  concerned,  was  in  effect  extended  to  1951.  The  Treasury 
related  this  after-discovered  factor  of  longer  life  back  to  1913,  when  as  a 
matter  of  fact  it  had  no  bearing  on  the  estimate  of  nineteen  years'  life 
made  in  1913,  which  was  based  on  the  rate  at  which  the  mine  was  being 
exhausted. 


FOR   DEPLETION  I22I 

Upon  removal  of  the  lease  in  1920  the  capital 
value  at  that  date  °'  would  be  2,000,000 
tons  X  $1   (the  new  royalty  rate) $2,000,000.00 

Present  worth  of  an  annuity  of  $100,000  ($2,000,000  -^  20) 
for  20  years  at  6%  =^  vafue  of  A's  interest  in  1920, 
or    $1,146,992.10 

But,  for  purposes  of  depletion  deductions 
allowable  to  A  in  the  years  1920-1940  for 
the  2,000,000  tons,  the  value  would  be  re- 
stricted to  the  March  i,  1913,  value 
thereof,  determined  as  above  to  be $    190,703.78 


In  valuing  his  equity  at  March  i,  191 3,  the  lessor  is  justi- 
fied in  assuming  that  at  the  end  of  the  lease  not  then  terminated 
new  rates  will  be  effective  and  that  the  new  rates  will  be  as 
much  higher  relatively  as  the  March  i,  191 3,  rates  exceed  the 
rates  in  existing  leases. 

As  stated  by  an  authority : 

In  the  case  of  term  leases,  ....  the  value  of  the  property 
should  be  calculated,  taking  into  consideration  the  probable  going 
royalty  of  the  region  at  the  time  of  release  or  renewal,  rather  than 
calculating  for  the  entire  life  of  the  property,  at  the  royalty  of  the 
lease,  which  will  probably  be  far  lower  than  the  new  royalty  ob- 
tainable.®^ 

Bonus  in  addition  to  royalties. — 

Regulation,  (a)  Where  a  lessor  receives  a  bonus  or  other 
sum  in  addition  to  royalties,  such  bonus  or  other  sum  shall  be  re- 
garded as  a  return  of  capital  to  the  lessor,  but  only  to  the  extent  of  the 
amount  remaining  to  be  recovered  through  depletion  by  tlie  lessor 
at  the  date  of  lease.  If  the  bonus  exceeds  the  amount  remaining  to  be 
recovered,  the  excess  and  all  the  royalties  thereafter  received  will  be 
income  and  not  depletablc.  If  the  bonus  is  less  than  the  amount  re- 
maining to  be  recovered  by  the  lessor  through  depletion,  the  differ- 
ence may  be  recovered  through  depletion  deductions  based  on  the 
royalties  thereafter  received  to  the  extent  that  such  deductions  are 
legally  allowable.  The  bonus  or  other  sum  paid  by  the  lessee  for  a 
lease  made  on  or  after  March  i,  1913,  will  be  his  value  for  depletion 
as  of  date  of  acquisition (Art.  215.) 


"  Calculated  solely  for  the  purpose  of  corroborating  tlie  conservative 
estimate  of  25  cents  per  ton  as  of  March  i,  1913. 

"'R.  V.  Norris,  discussion  of  L.  C.  Graton  s  paper,  lu-deral  1  axaiion  of 
Mines,  page  43. 


1222  DEDUCTIONS 

In  a  recent  case  one  of  the  questions  as  to  bonuses  was : 
Where  annual  payments  of  large  amounts  in  addition  to 
stipulated  royalties  were  made,  could  the  receipt  of  such  pay- 
ments be  considered  by  the  lessor  as  bonuses? 

Ruling Upon  first  reading,  it  would  appear  that  the 

above-quoted  article^'-'  is  controlling  of  the  questions  presented  by  this 
case.  A  careful  examination  discloses,  however,  that  the  term  ''other 
sum"  means  a  sum  of  money  in  the  nature  of  a  bonus  which  is  paid 
for  the  delivery  or  assignment  of  a  lease  and  does  not  relate  to  rental 
payments  which  are  made  for  the  purpose  of  continuing  the  occupa- 
tion and  use  of  property.  The  annual  cash  payments  in  this  case  are 
not  bonuses,  or  in  the  nature  of  bonuses,  and  therefore  not  within  the 
meaning  and  spirit  of  said  article  215(a). 

It  is  to  be  observed  that  throughout  the  lease  instrument  the  an- 
nual cash  payments  are  described  and  referred  to  as  rentals  and  not 
as  bonuses.  It  is  to  be  further  observed  that  the  obligation  on  the 
part  of  the  lessee  to  make  these  payments  is  independent  of  any 
mineral  production.  If  no  development  work  is  done  or  operations 
performed,  the  obligation  to  pay  these  fixed  amounts  remains  as  long 
as  the  lease  continues  in  force.  Where  no  mineral  is  produced  upon 
the  premises  it  follows  that  the  interest  of  the  taxpayer  in  the  mineral 
reserves  is  not  affected  and  that  no  allowance  can  be  made  for  de- 
pletion. Under  such  conditions  to  treat  the  annual  payments  of  50;?; 
dollars  each  as  a  return  of  capital  would  be  the  equivalent  of  making 
an  allowance  for  depletion  when  no  depletion  has  been  sustained. 

In  the  same  ruling  the  other  cjuestion  involved  was  whether 
the  property  leased,  and  for  which  bonus  was  received  by  the 
lessor,  had  value  at  March  i,  1913,  against  which  to  apply 
the  bonus  payment. 

The  payments  under  the  aforesaid  leases  are  unquestionably  in  the 
nature  of  bonuses,  but  before  they  can  be  treated  as  returns  of  capi- 
tal under  article  215  it  must  be  shown  that  the  leased  lands  had  a 
value  for  mineral  purposes  on  March  i,  1913.  If  the  lands  had  no 
value  for  such  purposes  on  that  date,  then  there  would  be  no  capital 
remaining  to  be  recovered  through  allowances  for  depletion.  There 
would  be  nothing  against  which  a  depletion  deduction  could  be  taken. 
The  ascertainment  of  values  is  a  function  of  the  Natural  Resources 
subdivision  of  the  Income  Tax  Unit  and  it  has  already  determined 
that  this  property  had  no  value  for  mineral  purposes  on  that  date 
and  as  far  as  it  appears  it  has  no  such  value  today.     The  land  lies 

"Art.  215  (a). 


FOR   DEPLETION  1223 

outside  of  the  producing  area  and  no  evidence  has  been  submitted 
which  indicates  any  mineral  vakie.  It  is,  therefore,  the  opinion  of 
this  office  that  the  18  i/^-v  dollars  paid  by  the  aforesaid  lessees  upon 
the  execution  and  delivery  of  the  leases  should  be  treated  as  income 
....     (I-5-56;  A.  R.  M.  148.) 

The  ruling  states  that  the  property  "has  no  value  today." 
The  lessees  paid  a  considerable  sum,  apparently  for  the  oppor- 
tunity to  explore  the  property,  which  must  have  seemed  valu- 
able to  them.  Similarly,  at  March  i,  191 3,  other  persons  may 
have  considered  the  property  to  have  prospective  value.  One 
of  the  tests  is  what  a  prospective  lessee  would  pay. 

Restoration  of  bonus  written  off. — 

Regulation ((/)   Upon     the     expiration,     termination     or 

al'andonment  of  a  lease,  without  the  removal  of  any  or  all  of  the  min- 
eral contemplated  by  the  lease,  the  lessor  shall  be  required  to  restore  to 
capital  account  so  much  of  the  bonus  received  and  deducted  from  the 
amount  returnable  through  depletion  as  is  in  excess  of  the  actual  de- 
pletion or  loss  in  value  sustained  as  a  result  of  the  operations  under  the 
lease  and  the  corresponding  amount  will  be  income  for  the  year  in 
which  the  lease  expires,  terminates,  or  is  abandoned.     (Art.  215.) 

Apportionment  of  depletion  between  lessor  and 
LESSEE. — The  following  comment  on  the  allocation  of  deple- 
tion between  lessor  and  lessee  is  of  interest.^" 

The  clause  requiring  the  lessor  and  lessee  "to  equitably  appor- 
tion the  allowances  on  the  basis  of  their  respective  interests,"  is  per- 
fectly just,  but  quite  impracticable  in  application.  From  long  experi- 
ence in  the  relations  of  lessor  and  lessee  it  seems  most  improbable 
that  such  apportionment  could  be  made  except  through  the  action  of 
the  courts,  or  of  some  commission  having  the  necessary  authority. 

It  seems  wise  not  to  attempt  the  apportionment  required  but  to 
value  the  interests  of  lessor  and  lessee  separately,  using  recognized 
methods  of  valuation. 

The  two  estates  of  lessor  and  lessee  in  the  case  of  royalty  "leases" 
of  natural  resources  are  essentially  separate.  That  such  a  "lease"  is 
a  sale  of  mineral  in  place  has  been  repeatedly  decided  by  the  Supreme 
Court  of  Pennsylvania— 31  Pa.  475;  105  Pa.  469-472;  94  Pa.  15; 
109  Pa.  583;  123  Pa.  240;  144  Pa.  613;  143  Pa.  293;  240  Pa.  234;  etc. 


"R.  V.  Norris,  The  Taxdlion  of  Income  front  IVastinn  .Issels. 


1224 


DEDUCTIONS 


Depletion  allowance  to  lessee. — The  192 1  and  1918  laws 
fully  recognize  that  leases  are  property  and  may  be  revalued  as 
of  March  i,  19 13,  such  value  to  be  returned  to  the  lessee 
through  depletion  charges  without  any  tax  being  levied.  This 
point  is  settled  by  the  specific  provision  that  "the  taxpayer's  in- 
terest" in  *'the  fair  market  value  of  the  property"  acquired 
prior  to  March  i,  1913,  is  the  basis  of  the  deductions  per- 
mitted. In  the  opinion  of  the  author  lessees  have  always  had 
the  same  rights  and  privileges,  in  regard  to  depletion,  as  were 
accorded  to  owners  under  the  191 3  and  191 6  laws.^^ 

Regulation,  (a)  In  the  case  of  a  lessee,  the  amount  remaining 
in  any  year  returnable  through  depletion  and  depreciation  deductions 
is  (i)  the  value  as  of  the  basic  date  of  the  lessee's  equity  in  the 
property  plus  (2)  subsequent  allowable  capital  additions  but  minus 
(3)  depletion  and  depreciation  sustained,  whether  legally  allowable 
or  not,  from  the  basic  date  to  the  taxable  year  and  the  residual  value 
of  other  property  at  the  end  of  operations.  The  amount  returnable 
through  depletion  is  the  total  capital  remaining  less  the  sum  recov- 
erable through  depreciation. 

(b)  The  value  of  the  equities  of  lessor  and  lessee  shall  be  com- 
puted separately,  but,  when  determined  as  of  the  same  basic  date,  shall 
together  never  exceed  the  value  at  that  date  of  the  property  in  fee 
simple. 

(c)  The  value  of  a  lessee's  equity,  if  acquired  prior  to  March  i, 
1913,  is  the  value  of  his  interest  in  the  mineral  as  of  that  date. 

(d)  The  value  of  a  lessee's  equity  in  a  proven  mineral  property 
acquired  on  or  after  March  i,  19 13,  is  its  cost. 

(e)  The  value  of  a  lessee's  equity  in  a  discovery  on  or  after 


''For  former  procedure  and  criticism  of  regulations  and  rulings,  see  In- 
come Tax  Procedure,  1918,  pages  409-410,  and  Income  Tax  Procedure, 
1919,  pages  611-613. 

The  following  ruling  in  1920  is  based  upon  Regulations  33,  many  articles 
of  which  have  been  overruled: 

Ruling Article   171    of   Regulations  33,   revised,   provides  that : 

"The  deduction  in  the  case  of  a  lessee  [of  a  mine]  will  be  limited  to 
an  amount  equal  to  the  capital  actually  invested  in  the  lease,  without  regard 
to  value  as  of  March   i,   1913,  or  any  other  date." 

....  It  is  therefore  held  that  where  a  corporation,  organized  for  the 
purpose,  takes  over  a  mining  lease,  issuing  its  entire  capital  stock  to  the  indi- 
vidual owners  of  the  lease  in  the  proportion  of  their  respective  interests 
therein  the  "capital  actually  invested  in  the  lease,"  for  the  purpose  of  the 
deductions  allowed  by  section  12  (a)  of  the  Act  of  September  8,  1916,  is 
the  fair  market  value  of  the  stock  so  issued.     (C.  B.  2,  page  145;  O.  1033.) 


FOR   DEPLETION  1225 

March  i,  1913,  is  the  fair  market  value  at  date  of  discovery  or  within 
thirty  days  thereafter,  of  his  equity  in  the  mineral  discovered.  (Art. 
203.) 

In  a  recent  decision'-  the  court  held : 

Decision.  The  question  of  law  presented  for  decision  is  whether 
or  not  the  plaintiff  is  entitled  to  deduct  a  reasonable  allowance  for 
depletion  of  iron  ore  from  the  gross  amount  of  its  receipts  from  all 
sources  in  order  to  determine  the  net  income  subject  to  tax.  The 
answer  to  this  question  turns  on  the  true  meaning  of  section  12  of 
the  Revenue  Act  of  September  18,  1916.  The  government's  conten- 
tion is  that  the  deduction  authorized  by  the  second  subdivision  of 
this  section  is  allowable  only  to  an  operating  owner  of  an  ore  mine 
and  not  to  an  operating  lessee  under  a  lease  of  the  character 
stated 

I  have  carefully  examined  all  of  the  cases  decided  under  the 
corporation  tax  act  of  1909  and  under  the  several  income  tax  acts 
and  have  also  carefully  studied  the  several  provisions  of  these  sev- 
eral acts  so  far  as  they  relate  to  this  question.  My  conclusion  is 
that  the  operating  lessee  is  entitled  to  the  deduction  as  claimed. 

Upon  appeal  to  the  Circuit  Court  of  Appeals,  Sixth  Cir- 
cuit, the  district  court  was  reversed.  A  careful  reading  of  the 
opinions  of  the  two  courts  indicates  that  the  district  court 
decided  the  case  on  its  merits,  while  the  circuit  court  depended 
almost  entirely  on  the  decision  in  the  Bi\val)ik  case.'"'  Not  only 
did  that  case  arise  under  the  1909  law  (which  did  not  provide 
specifically  for  depletion)  but  in  referring  to  it  the  court  said: 

Decision the  nature   of  the   interest  held   by   the   lessee 

was  not  such  as  to  permit  it  to  claim  the  allowance,  but  ...  .  the 
contingencies  which  attended  the  character  of  the  lessee's  interest 
barred  it  from  claiming  that  its  capital  assets  had  been  diminished. 

The  circuit  court  also  said : 

Decision In  the  Biwabik  case,  the  lessee  was  not  heard 

to  say  that  his  capital  assets  had  been  consumed  by  his  mining  opera- 
tions, and  we  interpret  that  decision  as  resting  in  an  essential  degree 
on  the  idea  that  the  nature  of  the  lessee's  title  forbade  him  to  make 
this  claim.     We  cannot  read  the  decisions  of  the  Supreme  Court  as 


"Mohazvk  Mining  Co.  v.  IVciss,  Collector.  U.  S.  Dist.  Court,  Nortlicrn 
District  of  Ohio,  Eastern  Division  (November  3,  1919)  ;  rt.'vcrscd  June  15, 
1920  (264  Fed.  502).  Writ  of  certiorari  denied  by  Supreme  Court,  October 
18,  1920  (254  U.  S.  637)-.      ,.,    ,,.   .       ^.  „    „        , 

"United  Stales  v.  Bmahik  Mnnng  Co.,  247  U.  b.  iiO. 


1226  DEDUCTIONS 

having  determined  that  the  exhaustion  of  ore  reserves  is  so  inherently 
a  business  loss,  rather  than  an  impairment  of  capital,  that  a  statutory 
grant  of  the  right  to  deduct  for  depletion  on  that  account  will  reach 
a  case  which  has  been  adjudged  not  to  involve  the  diminution  of 
capital  assets.  We  think  the  substantial  principles  established  by  the 
decisions  are  that  both  the  royalty  received  by  the  fee  owner  and  the 
sums  received  by  the  operating  lessee  above  the  cost  of  operation  are 
income;  that  the  statutory  reduction  for  "depletion"  cannot  be  twice 
credited,  once  to  the  fee  owner,  and  once  to  the  lessee ;  and  that  the 
exemption  belongs  of  right  to  the  fee  owner. 

It  is  difficult  to  infer  from  the  foregoing  that  a  lessee  is 
not  entitled  under  the  1916  law  to  depletion  of  the  March  i, 
19 1 3,  value.  The  special  circumstances  of  the  case  seem  to 
have  been  a  factor  in  the  decision.  The  conclusion  that  an 
allowance  for  diminution  of  capital  value  after  March  i,  191 3, 
accrues  solely  to  the  owner  or  lessor,  even  though  the  royalties 
or  rentals  thereafter  are  fixed,  is  not  logical.  It  would  mean 
in  many  cases  that  the  lessor  could  claim  depletion  equal  to  the 
gross  royalties  or  rent  collected. 

The  synopsis  of  the  decision  appearing  on  page  208  of 
the  report  of  the  Commissioner  of  Internal  Revenue  for  1920 
is  not  as  complete  as  it  should  be. 

]-50NU.S  DEDUCTIBLE  BY  LESSEE  THROUGH   DEPLETION. 

Ruling.  Under  an  option  to  purchase  or  so-called  "bond  and 
lease"  agreement,  providing  for  the  payment  of  royalties  on  ore 
mined  and  for  the  payment  at  stated  times  of  the  amounts  necessary 
to  bring  the  total  amounts  paid  to  certain  specified  sums,  and  giving 
an  option  to  the  purchaser  to  take  title  to  the  property  upon  the  pay- 
ment of  a  specified  amount  upon  which  the  royalties  and  deficiency 
payments  are  credited  as  part  of  the  purchase  price,  the  amounts  paid 
as  royalties  constitute  operating  expenses  and  are  deductible  as  such 
in  determining  net  income. 

The  additional  sums  paid  to  make  up  the  amounts  of  the  several 
installments  when  due  are  capital  investments  in  the  nature  of  bonuses 
recoverable  through  deduction  for  depletion,  computed  upon  the  total 
sum  of  such  additional  payments  to  the  end  of  the  tax  year. 

Where,  as  in  this  case,  the  option  is  forfeited,  the  capital  sum  re- 
maining to  be  recovered  is  deductible  as  depletion  in  the  return  for 

the  vear  in  which  the  forfeiture  occurs (C.  B.  4,  page  138; 

Sol.' Op.  86.) 


FOR   DEPLETION 


1227 


Lease  as  distinguished  from  sale. — Mining  "leases"  some- 
times partake  of  the  nature  of  a  sale  of  the  ore  in  place,  and 
before  a  determination  of  the  depletion  deduction  it  may  be 
necessary  to  ascertain  whether  or  not  the  contract  constitutes 
one  a  lessee.  In  the  foregoing  ruling  (Sohcitor's  Opinion  86) 
the  Solicitor,  referring  to  the  option  to  purchase  or  so-called 
"bond  and  lease,"  quotes  :^* 

It  is  often  difficult  in  a  given  instance  to  find  a  technically  correct 
legal  name  for  the  contract  employed,  for  it  may  possess  some  of  the 
characteristics  of  two  or  more  well-defined  classes.  What  is  more 
important,  however,  from  a  practical  standpoint  is  to  ascertain  from 
the  contract  what  are  the  respective  rights  of  the  contracting  parties. 

In  another  case  involving  the  construction  of  timber  con- 
tracts, the  Treasury  ruled  that  the  contracts  conveying  title 
to  timber  cut  and  removed  from  the  property  constituted  leases 
and  not  sales  of  the  standing  timber."'^ 

Depletion  sustained  but  not  allowed  under  previous  laws. 
— As  heretofore  stated,'"  the  income  tax  laws  of  1913  and  1916 
imposed  limitations  upon  the  deduction  for  depletion. 

Ruling.  The  amount  recoverable  by  a  taxpayer  without  liability 
to  tax  under  the  War  Revenue  Act  of  1918,  either  by  way  of  deduction 
for  depletion  or  of  the  return  of  capital  upon  the  sale  of  the  property, 
is  the  cost  of  the  property,  its  fair  market  value  at  March  i,  1913, 
or  within  30  days  after  discovery,  as  the^case  may  be,  minus  the 
amount  of  depletion  (based  upon  the  same  cost  or  value)  actually 
sustained  prior  to  January  i,  1918,  whether  or  not  all  of  such  amount 
has  been  allowed  for  the  purpose  of  computing  net  income  under 
earlier  income  tax  laws.     (C.  B.  i,  page  141;  T.  B.  R.  4.) 

The  foregoing  ruling  has  not  been  sustained  by  the  courts 
and  good  authorities  doubt  if  it  will  be  sustained.  It  is  argued 
that  the  19 18  law  requires  that  the  capital  to  be  returned  free 
of  tax  is  cost  or  value  March  i,  19 13,  and  that  the  depletion 
which  was  not  deductible  cannot  be  considered,  otherwise  part 


""Lindlay  on  Mines,  sections  859   fa)  and  861. 
'"C.  B.  4,  page  201;  A.  R.  M.  iil. 
''See  page  1169. 


1228  DEDUCTIONS 

of  the  cost  or  value  March  i,  191 3,  will  be  taxed.  The  fol- 
lowing ruling  is  cited  as  a  precedent : 

Ruling.  Inasmuch  as  no  deduction  for  depreciation  of  the  per- 
sonal residence  of  a  taxpayer  is  allowable  in  his  income  tax  returns, 
a  taxpayer  in  determining  the  gain  or  loss  arising  from  the  sale  of 
his  personal  residence,  continuously  occupied  by  him  as  such,  is  not 
required  to  reduce  the  cost  of  the  property  or  its  fair  market  value 
as  at  March  i,  1913,  by  the  depreciation  sustained.     (C.  B.  3,  page  46; 

0.  D.  600.) 

Development  costs. — Development  costs,  as  heretofore, 
may  be  added  to  capital  investment  and  charged  off  there- 
after as  a  part  of  depreciation  or  depletion,  or  if  the  items  can 
be  held  to  be  proper  operating  costs  they  may  be  omitted 
from  the  annual  deduction  and  charged  direct  to  maintenance. 

To  the  cost  of  the  fee  or  the  lease  for  the  purposes  of 
depletion  there  may  be  added  in  the  case  of  both  owner  and 
lessee,  "the  cost  of  subsequent  improvements  and  develop- 
ment not  charged  to  current  operating  expenses." 

Oil  and  gas  operators  (as  distinguished  from  mines)  have 
the  option  of  charging  as  expense  or  of  capitalizing  major 
items,  such  as  cost  of  drilling  wells." 

Depletion  basis  for  discoverers. — The  192 1  law  continues 
the  provision  first  found  in  the  19 18  law  which,  in  effect,  per- 
mits the  original  discoverer  of  a  mine  or  an  oil  well  to  set  up 
the  market  value  of  a  new  discovery  as  a  basis  for  depletion 
charges,  when  the  discovery  is  after  March  i,  19 13,  and  irre- 
spective of  cost,  provided  the  cost  is  materially  disproportion- 
ate to  the  value.^® 

It  has  been  assumed  by  some  that  the  statement  in  the 
law,  to  the  effect  that  as  to  all  discoveries  on  and  after  March 

1,  191 3,  the  discoverer  shall  get  back  the  market  value  through 
depletion,  justifies  amended  returns  for  prior  years  so  that  the 
depletion  charge  shall  commence   in  the  year  of  discovery. 


"  See  page  11 07. 

"Sections  214  (a-io)  and  234  (a-9).    For  mines,  see  page  1194.    For  oil 
and  gas  wells,  see  page  1205. 


FOR   DEPLETION  1 229 

The  author  does  not  so  interpret  the  law.  There  is  no  doubt 
about  the  right  of  a  discoverer  to  charge  depletion  on  the  basis 
of  value  instead  of  on  cost,  but  it  was  hardly  the  intention  of 
Congress  to  permit  the  increased  depletion  charge  before 
January  i,  19 18. 

There  is  no  doubt,  however,  of  the  right  to  revalue  at  any 
time  after  March  i,  1913.  If  a  discoverer  paid  $1,000  for 
unproven  acreage  in  191 5,  and  discovered  oil  thereon  worth 
$1,000,000,  he  would  be  entitled  to  charge  depletion  up  to 
January  i,  19 18,  on  only  the  $1,000.  Commencing  January  i, 
19 18,  he  may  charge  depletion  on  the  $1,000,000  revaluation. 

While  depletion  deductions  from  income  for  the  years 
prior  to  19.18  would  be  based  on  cost  ($1,000),  the  depletion 
sustained  from  date  of  discovery  (1915)  would  be  computed 
on  the  basis  of  the  discovery  value  ($1,000,000).  The  deple- 
tion not  allowed  as  a  deduction  prior  to  19 18  would  represent 
realized  appreciation.  Not  having  been  charged  against  in- 
come, it  would  be  reflected  in  surplus.  After  January  i,  19 18, 
the  depletion  based  on  the  excess  of  discovery  value  over  cost, 
representing  appreciation  realized,  would  be  included  in  in- 
vested capital.'^® 

Discovery  value   under   lea.se   from   government. — 

Ruling.  Where  a  taxpayer  made  claim  under  the  placer  mining 
laws  to  public  land,  which  was  withdrawn  by  Executive  order  prior 
to  completion  of  valid  location  (and  prior  to  A'lar.  i,  1913),  and 
later  (subsequent  to  Mar.  i,  1913)  operated  the  land  under  agreement 
with  the  Secretary  of  the  Interior,  or  lease  from  the  Government,  he 
is  not  entitled  to  a  depletion  deduction  based  upon  the  value  of  his 
claim  as  of  March  i,  1913,  but,  under  the  provisions  of  the  Revenue 
Act  of  1918,  he  is  entitled  to  a  depletion  deduction  based  upon  the 
discovery  value  as  to  discoveries  made  subsequent  to  the  acquisition 
of  the  lease  or  leases  from  the  Government.  (B.  36-21-1801 ;  Sol. 
Op.  118.) 

Advance  royalties — depletion  basis. — Leases  of  mineral 
lands  frequently  provide  that  minimum  royalties  must  be  paid 


'"  See  Appendix  A,  Chapter  X. 


1230  DEDUCTIONS 

in  advance,  irrespective  of  mining  operations.  The  question 
arises  as  to  whether  a  lessor  should  be  entitled  to  claim  an 
allowance  for  depletion  as  directly  chargeable  against  the 
royalty  receipts,  or  whether  he  should  be  entitled  to  the  de- 
duction only  if  and  when  it  can  be  shown  that  the  number  of 
units  for  which  a  deduction  is  claimed  have  been  removed 
from  the  ground.  If  the  lessee  fails  to  remove  the  stipulated 
quantity  within  the  period  mentioned  in  the  lease  or  for  other 
causes,  the  lessor  may  repossess  the  property.  In  such  case 
he  will  find  himself  in  the  embarrassing  position  of  having 
claimed  a  deduction  covering  the  removal  of  a  given  number 
of  units,  whereas  his  property  is  intact  or  a  less  quantity  has 
been  extracted  than  has  been  claimed.  So  much  for  the  gov- 
ernment's side. 

If  the  lessor  receives  advance  royalty  payments  during  one 
period,  and  cannot  claim  an  allowance  for  depletion  until  some 
subsequent  period  when  proof  can  be  offered  to  support  the 
claim,  it  may  be  that  the  tax  on  the  royalties  reported  as  gross 
income  will  be  at  a  higher  rate  than  when  the  deduction  is 
permitted.  Or  it  may  be  that  in  the  subsequent  period  the  re- 
ceipts will  be  small  and  the  allowable  deductions  larger  than 
the  gross  receipts.  The  matter  is  important  if  graduated  tax 
rates  are  involved.    So  much  for  the  taxpayer's  side. 

In  the  regulations  the  Treasury  takes  a  liberal  attitude. 
Owners  in  receipt  of  royalties  must  report  royalties  as  tax- 
able income  but  are  permitted  to  deduct  depletion  even  though 
there  has  been  no  extraction  during  the  taxable  year.  It  is, 
however,  provided  that  if  the  deductions  are  found  to  be  un- 
warranted because  the  minerals  were  not  really  taken  out, 
upon  repossession  the  amount  theretofore  claimed  for  de- 
pletion must  be  returned  as  income  for  the  year  when  the 
property  is  repossessed.  The  actual  effect  of  this  might  be  the 
imposition  of  an  extremely  large  tax  for  one  year.  It  would 
be  more  equitable  if  amended  returns  were  permitted. 


FOR   DEPLETION  1231 

Dividends  declared  out  of  depletion  reserves. — Certain 
mining  companies  have  paid  dividends  which  have  been  de- 
clared to  be  out  of  depletion  reserves  instead  of  earned  surplus. 
For  a  discussion  of  this  practice,  see  page  743.^° 

Depletion  basis  when  resources  are  unworkable  within 
reasonable  period. — The  usual  rule  is  that  depletion  charges 
represent  the  book  value  of  the  quantity  mined  at  the  per  unit 
value,  established  by  dividing  the  cost  or  the  March  i,  191 3, 
value,  by  the  entire  estimated  contents  of  the  mine.  This  rule 
works  well  in  all  cases  when  the  life  of  a  mine  is  short.  In 
practice  it  works  well  also  when  the  life  of  a  mine  is  not 
short  because  it  is  not  customary  to  include  in  the  aggregate 
contents  of  a  mine  the  ore  or  coal  which  cannot  be  mined  with- 
in a  reasonable  time.  Otherwise  the  owner  of  a  mine  would 
receive  credit  for  an  insufficient  depletion  charge  during  the 
early  years  of  operation. 

The  reason  is  that,  in  effect,  nothing  is  paid  for  the  ore 
or  coal  in  the  ground  which  cannot  be  reached  by  ordinary 
mining  methods  within  a  reasonable  number  of  years.  If  the 
regulations  were  litPrally  followed  it  Vvould  result  inequitably 
and  would  not  return  the  capital  of  the  owner  or  lessor  as  the 
law  provides. 

A  copper  or  anthracite  mine  might  have  an  estimated  life 
of  100  years,  but  no  sane  purchaser  would  tie  up  any  of  his 
capital  for  100  years.  The  fair  market  value  of  mining  prop- 
erty is  based  on  the  possible  (or  probable)  extraction  of  the 
mineral  content  during,  say,  20  or  30  years  or  more,  depend- 
ing on  the  circumstances  of  each  case;  and  this  aggregate 
quantity  if  determined  by  careful  estimates  is  the  proper 
amount  by  which  the  cost  or  value  of  the  mine  should  be 
divided  to  ascertain  the  per  unit  cost  for  depletion  purposes. 


'"  [Former  Procedure] 

Regulation If  dividends  arc  paid  out  of  a  depletion  or  depre- 
ciation reserve,  the  stockholders  must  be  expressly  notified  that  the  dividend 

is  a  return  of  capital  and  not  an  ordinary  dividend  out  of  profits 

(Art.  216,  prior  to  amendment  by  T.  D.  3107,  flattd  December  29,  ujM.) 


1232  DEDUCTIONS 

Engineers  who  have  given  much  thought  to  this  subject  sug- 
gest that  the  maximum  be  45  years. 

Appraisals  of  oil  and  gas  wells  in  the  United  States  at  the 
present  time  rarely  show  a  maximum  life  of  more  than  twenty 
years. 

If  all  future  and  prospective  extraction  were  to  be  con- 
sidered as  an  element  of  the  calculation  it  would  be  necessary 
to  include  as  a  factor  the  question  of  interest  on  capital.  In 
other  words,  if  the  entire  possible  contents  of  a  mine  were 
to  be  used  as  a  divisor  it  would  be  necessary  to  compute  the 
depletion  charge  on  a  sliding  scale.  It  might  be  that  the  total 
contents  of  a  mine  would  be  estimated  at  1,000,000  tons.  If 
the  cost  or  value  at  March  i,  191 3,  were  $100,000,  the  theo- 
retical depletion  charge  would  be  10  cents  a  ton,  but  if  part 
of  the  contents  could  not  be  extracted  for  50  years  it  would 
be  evident  that  the  purchaser  did  not  pay  10  cents  a  ton  for 
that  part  of  the  contents  which  w'ould  not  be  mined  for  40 
or  50  years.  The  capital  invested  was  intended  to  cover  only 
the  extraction  during  a  period  which  warranted  an  investment. 

If  the  capital  were  spread  over  a  period  longer  than  twenty 
or  thirty  years,  the  owner  would  expect  in  some  way  to  be 
recompensed  for  the  use  of  long  time  capital  investment 
through  the  equivalent  of  an  interest  return. 

The  simplest  method  of  handling  a  case  of  this  sort  would 
be  to  segregate  any  part  of  the  estimated  contents  not  re- 
movable within  a  profitable  period,  and,  if  it  represented  any 
capital  investment,  such  part  of  the  asset  should  be  carried  to 
a  separate  account  designated  as  investment  not  subject  to 
depletion.  If  that  part  of  the  property  were  opened  subse- 
quently, depletion  charges  would  commence  as  if  it  were  a 
new  property.  The  investment  in  the  mine  which  the  owner 
knows  will  be  operated  and  expects  to  have  repaid  through 
depletion  charges  would  then  appear  at  cost  or  March  i,  1913, 
value;  and  the  resulting  book  value  of  .the  investment  divided 
by  the  quantity  removable  within  a  reasonable  time  would 
give  the  unit  value  for  depletion  purposes. 


FOR   DEPLETION 


1233 


It  may  be  urged  that  at  the  end  of  each  year  a  certain 
quantity  of  mineral  has  been  extracted,  but  its  place  is  taken, 
in  effect,  by  an  equal  quantity  which  at  the  end  of  the  year 
has  in  point  of  time  been  moved  forward  from  just  outside 
the  period  to  just  inside  the  period.  So  year  by  year  the  de- 
pletion is  made  good  by  other  mineral  covered  by  the  original 
purchase.  If  this  line  of  reasoning  were  sound  no  depletion 
should  be  allowed.    But  the  reasoning  is  not  sound. 

In  most  cases  in  which  the  extent  of  the  deposits  is 
known  at  the  time  of  purchase  there  is  a  definite  distinction 
drawn  as  to  the  value  after  a  certain  number  of  years,  and 
there  is  the  expectation  that  the  cost  of  mining  after  a  certain 
period  will  be  too  great  to  meet  the  competition  of  more  fa- 
vorably situated  deposits.  Irl  such  cases  the  postponement  of 
the  depletion  charge  would  be  unfair.  If  the  later  costs  of 
mining,  due  to  the  depth  of  the  deposit,  for  instance,  were 
far  greater  than  the  earlier  costs,  it  is  conceivable  that  there 
would  be  no  margin  to  cover  high  enough  depletion  in  the 
aggregate  to  return  the  entire  capital  invested. 

The  court  decisions  establish  the  principle  that  the  capital 
invested  in  specific  property  represents  the  amount  which  must 
be  returned  to  the  taxpayer  free  from  the  tax.  Therefore, 
if  it  were  shown  that  at  the  time  of  purchase  there  was  a 
specific  amount  of  capital  invested  in  a  specific  tonnage,  the 
purchaser  would  be  entitled  to  a  return  of  such  investment  in 
the  way  of  depletion  charges,  irrespective  of  additional  tonnage 
which  at  the  beginning  may  have  been  undeveloped  and  in  ef- 
fect is  not  reflected  in  any  capital  investment  whatever. 

Furthermore  the  quantity  of  mineral  to  be  extracted  after, 
say,  thirty  to  forty  years  is  always  uncertain.  If  additional 
quantity  becomes  valuable  or  realizable  while  the  quantity 
workable  within  a  reasonable  period  is  being  extracted  it  is  in 
effect  appreciation  and  is  not  taxable  until  actually  realized. 
Then,  too,  when  it  is  realized  the  entire  net  recovery  will  be 
taxable  as  the  book  investment  will  have  been  written  off. 

Appreciation  in  land  values  is  not  allowed  to  offset  depre- 
ciation in  the  value  of  Imildings.     (Sec  page  1050.) 


1234 


DEDUCTIONS 


Timber-Forest  Industries 

While  the  principles  underlying  the  valuation  of  the  natural 
resource  and  the  computation  of  the  depletion  allowance  are  in 
general  the  same  for  timber  as  for  mines  and  for  oil  and  gas 
wells,  there  is  a  very  important  difference  in  that  the  "dis- 
covery value"  provision^^  of  sections  214  (a-io)  and  234 
(a-9)  does  not  apply  to  timber.  There  are,  of  course,  other 
differences  in  the  details  of  the  computations  because  of  the 
different  physical  characteristics  of  timber  as  compared  with 
minerals. 

Regulations  in  regard  to  forest  industries  are  comprehen- 
sive and  are  reproduced  in  full  except  when  the  provisions 
are  the  same  as  for  mines,  etc. 

The  Treasury  has  issued  a  questionnaire  (form  T)  con- 
sisting of  36  pages  which  should  be  in  the  hands  of  all  who 
are  interested  in  the  valuation  or  taxation  of  forest  industries." 

Depletion  of  timber. — 

Regulation.  A  reasonable  deduction  from  gross  income  for  the 
depletion  of  timber  and  for  the  depreciation  of  improvements  is  per- 
mitted, based  (a)  upon  cost  if  acquired  after  February  28,  1913,  or 
(b)  upon  the  fair  market  value  as  of  March  i,  1913,  if  acquired  prior 
thereto.  The  essence  of  this  provision  is  that  the  owner  of  timber 
property,  whether  it  be  a  leasehold  or  a  freehold,  shall  secure  through 
an  aggregate  of  annual  depletion  and  depreciation  deductions  a  re- 
turn of  the  amount  of  capital  invested  by  him  in  the  property,  or  in 
lieu  thereof  an  amount  equal  to  its  fair  market  value  as  of  March  i, 
1913,  plus  in  any  case  the  subsequent  cost  of  plant,  equipment,  and 
development  which  is  not  chargeable  to  current  operating  expenses, 
but  not  including  cut-over  land  values.     (Art.  227.) 

Computation  of  allowance  for  depletion  of  tim- 
ber.— 

Regulation.  The  allowance  for  depletion  of  timber  in  any 
taxable  year  shall  be  based  upon  the  number  of  units  of  timber  felled 
during  the  year  and  the  unit  value  of  the  timber  in  the  timber  account 
or  accounts,  pertaining  to  the  timber  cut.     The  unit  value  of  the 

"  See  pages  1228-1229. 

'■  Form  T  (Timber),  7  pages,  is  another  schedule  which  must  be  filed 
with  the  return. 


FOR  DEPLETION  I235 

timber  for  a  given  timber  account  in  a  given  year  shall  be  the  quotient 
obtained  by  dividing  (a)  the  total  number  of  units  of  timber  on  hand 
in  the  given  account  at  the  beginning  of  the  year  plus  the  number  of 
units  acquired  during  the  year  plus  (or  minus)  the  number  of  units 
required  to  be  added  (or  deducted)  by  way  of  correcting  the  estimate 
of  the  number  of  units  remaining  available  in  the  account  into  (b) 
the  total  fair  market  value  as  of  March  i,  1913,  and  (or)  cost  of  the 
timber  on  hand  at  the  beginning  of  the  year,  plus  the  cost  of  the 
number  of  units  acquired  during  the  year,  plus  proper  additions  to 
capital.  (See  art.  231.)  The  amount  of  the  deduction  for  depletion 
in  any  taxable  year  with  respect  to  a  given  timber  account  shall  be 
the  product  of  (a)  the  number  of  units  of  timber  cut  from  the  given 
account  during  the  year  multiplied  by  (b)  the  unit  value  of  the  timber 
for  the  given  account  for  the  year.  Those  taxpayers  who  keep  their 
accounts  on  a  monthly  basis  may,  at  their  option,  keep  their  depletion 
accounts  on  a  monthly  basis,  in  which  case  the  amount  deductible  on 
account  of  depletion  for  a  given  month  will  be  determined  in  the 
manner  outlined  above  for  a  given  year.  The  total  amount  of  the 
deduction  for  depletion  in  any  taxable  year  shall  be  the  sum  of  the 
amounts  deductible  for  the  several  timber  accounts.  For  description 
of  timber  accounts  see  articles  235  and  236. 

The  depletion  of  timber  takes  place  at  the  time  the  timber  is 
felled.*^  Since,  however,  it  is  not  ordinarily  practicable  to  determine 
the  quantity  of  timber  immediately  after  felling,  depletion  for  pur- 
poses of  accounting  will  be  treated  as  taking  place  at  the  time  when, 
in  the  process  of  exploitation,  the  quantity  of  timber  is  first  definitely 
determined.     (Art.  229.) 

Revaluation  of  stumpage,  after  March  i,  1913,  not  al- 
lowed.— 

Regulation.  In  the  case  of  timber  acquired  prior  to  March  i, 
1913,  the  fair  market  value  as  of  that  date  shall,  when  determined 
and  approved  by  the  Commissioner,  be  the  basis  for  determining  the 
depletion  deduction  for  each  year  during  the  continuance  of  the 
ownership  under  which  the  fair  market  value  of  the  timber  was  fixed, 
and  during  such  ownership  there  shall  be  no  redetermination  of  the 
fair  market  value  of  the  timber  for  such  purpose.  However,  the  unit 
market  (or  cost)  value  of  the  timber  will  subsequently  be  changed 
if  from  any  cause  such  unit  market  (or  cost)  value,  if  continued  as 
a  basis  of  depletion,  shall  upon  evidence  satisfactory  to  the  Commis- 
sioner be  found  inadequate  or  excessive  for  the  extinguishment  of 


^^  Computing  depiction  on  the  basis  of  timber  felled  may  be  compared 
with  the  requirement  of  Art.  210,  in  the  case  of  mines,  that  it  be  calculated 
on  the  number  of  units  sold  or  produced. 


1236 


DEDUCTIONS 


the  cost,  or  fair  market  value  as  of  March  i,  1913,  of  the  timber. 
(Art.  230.) 

Revaluations  based  on  discoveries  after  March  i,  19 13,  are 
not  permitted  as  in  the  case  of  mines  and  oil  wells. 

Charges  to  capital  and  expense  of  timber  proper- 
ties.— The  subject  of  the  proper  division  of  expenditures  as 
between  capital  and  expense  items  is  treated  in  the  chapter  on 
Depreciation,  pages  1119-1121. 

Evidence  required  to  support  depletion  charges. — 

Regulation.  To  the  income  tax  return  of  the  taxpayer  claiming 
a  deduction  for  depletion  or  depreciation  or  both  there  shall  be 
attached  a  map  and  statement  (Form  T-Timber)  for  the  taxable 
year  covered  by  the  income  tax  return.  Form  T-Timber  requires 
the  following:  (a)  Map  showing  timber  and  land  acquired,  timber 
cut,  and  timber  and  land  sold;  (b)  description  of,  cost  of,  and  terms 
of  purchase  or  lease  of,  timber  and  land  acquired;  (c)  proof  of  profit 
or  loss  from  sale  of  capital  assets;  (d)  description  of  timber  with 
respect  to  which  claim  for  loss,  if  any,  is  made;  (e)  record  of  timber 
cut;  (f)  changes  in  each  timber  account  as  the  result  of  purchase, 
sale,  cutting,  reestimate,  or  loss;  (g)  changes  in  physical  property 
accounts  as  the  result  of  additions  to  or  deductions  from  capital  and 
depreciation;  (h)  operation  data  with  respect  to  raw  and  finished 
material  handled  and  inventoried;  (i)  unit  production  costs,  and  (j) 
any  other  data  which  will  be  helpful  in  determining  the  reasonable- 
ness of  the  depletion  and  (or)  depreciation  deductions  claimed  in  the 
return.  Similar  information  is  required  for  certain  years  prior  to  the 
1919  taxable  year  from  those  taxpayers  who  have  not  already  fur- 
nished it.  The  specific  nature  of  the  information  required  for  the 
earlier  years  is  given  in  detail  in  Form  T — General  forest  industries 
questionnaire  for  the  years  prior  to  1919.     (Art.  233.) 

Determination  of  interest  of  taxpayer. — The  law^* 
provides  that  the  depletion  is  to  be  based  on  the  taxpayer's 
interest  in  the  property.  Therefore,  it  is  necessary  to  deter- 
mine first  what  that  interest  is,  as  appears  from  the  following : 

Ruling.  Where  a  lumber  company  in  good  faith  purchased  lands 
from  a  railroad  company  in  violation  of  the  grant  of  the  lands  to  the 
railroad  under  an  Act  of  Congress  and  subsequently,  under  a  subse- 


Sections  214  (a-io)  and  234  (a-9). 


FOR   DEPLETION  1237 

quent  Act  of  Congress,  compromised  the  litigation  wliich  had  been 
instituted  by  the  United  States  to  declare  a  forfeiture  of  said  lands 
by  reason  of  the  violation  of  the  provisos  of  the  grant,  it  did  not 
thereby  purchase  complete  title  from  the  Government  but  only  such 
title  or  interest  as  remained  in  the  United  States,  nor  did  it  relinquish 
whatever  right,  title,  or  interest  it  had  acquired  from  the  railroad 
company.  By  proceeding  under  the  Act  of  Congress  the  parties 
compromised  and  adjusted  their  differences  and  the  title  of  the 
lumber  company  to  the  lands  was  perfected  and  confirmed. 

On  March  i,  1913,  after  proceedings  had  been  instituted  under 
the  Act  of  Congress  to  compromise  the  litigation  between  the  United 
States  and  the  so-called  innocent  purchasers,  but  prior  to  the  issuance 
of  patents  for  the  land  involved  and  tlie  making  of  final  payments 
therefor,  the  said  purchasers  had  such  an  interest  in  the  lands  as 
would  entitle  them  to  an  allowance  for  depletion.  The  value  of  that 
interest  on  the  basic  date  was  the  value  of  the  land  less  the  amount 
paid  to  the  United  States  as  provided  by  the  Act.  (B.  46-21-1921 ; 
Sol.  Op.  124.) 

Determination  of  fair  market  value  of  timber. — 

Regulation.  Where  the  fair  market  value  of  the  property  at  a 
specified  date,  in  lieu  of  the  cost  thereof,  is  the  basis  for  depletion 
and  depreciation  deductions,  such  value  shall  be  determined,  subject 
to  approval  or  revision  by  the  Commissioner  upon  audit,  by  the  owner 
of  the  property  in  the  light  of  the  most  reliable  and  accurate  informa- 
tion available  with  reference  to  the  condition  of  the  property  as  it 
existed  at  that  date,  regardless  of  all  subsequent  changes,  such  as 
changes  in  surrounding  circumstances,  in  methods  of  exploitation,  in 
degree  of  utilization,  etc.  The  value  sought  will  be  the  selling  price, 
assuming  a  transfer  between  a  willing  seller  and  a  willing  buyer  as 
of  the  particular  date.  Such  factors  as  the  following  will  be  given 
due  consideration:  (a)  Character  and  quality  of  the  timber  as  deter- 
mined by  species,  age,  size,  condition,  etc.;  (b)  the  quantity  of  timber 
per  acre,  the  total  quantity  under  consideration,  and  the  location  of 
the  timber  in  question  with  reference  to  other  timber;  (c)  accessi- 
bility of  the  timber  (location  with  reference  to  distance  from  a  com- 
mon carrier,  the  topography  and  other  features  of  the  ground  upon 
which  the  timber  stands  and  over  which  it  must  be  transported  in 
process  of  exploitation,  the  probable  cost  of  exploitation,  and  the  cli- 
mate and  the  state  of  industrial  development  of  the  locality)  ;  and  (d) 
the  freight  rates  by  common  carrier  to  important  markets.  The  timber 
in  question  will  be  valued  on  its  own  merits,  and  not  on  the  basis  of 
general  averages  for  regions ;  however,  the  value  placed  upon  it, 
taking  into  consideration  such  factors  as  those  mentioned  above,  will 
be  consistent  with  that  of  the  other  timber  in  the  region.    The  Com-' 


1238 


DEDUCTIONS 


missioner  will  give  due  weight  and  consideration  to  any  and  all  facts 
and  evidences,  having  a  bearing  on  the  market  value,  such  as  cost, 
actual  sales  and  transfers  of  similar  properties,  the  margin  between 
the  cost  of  production  and  the  price  realized  for  timber  products, 
market  value  of  stock  or  shares,  royalties  and  rentals,  value  fixed  by 
the  owner  for  the  purpose  of  the  capital  stock  tax,  valuation  for  local 
or  State  taxation,  partnership  accountings,  records  of  litigation  in 
which  the  value  of  the  property  has  been  involved,  the  amount  at 
which  the  property  may  have  been  inventoried  and  (or)  appraised  in 
probate  or  similar  proceedings,  disinterested  appraisals  by  approved 
methods,  and  other  factors.  For  depletion  purposes  the  fair  market 
value  at  a  specified  date  shall  not  include  any  part  of  the  value  of 
the  land.     (Art.  234.) 

The  regulation  states  that  the  timber  will  be  "valued  on 
its  own  merits,  and  not  on  the  basis  of  general  averages  for 
regions."  In  the  case  of  some  companies  owning  many  tracts 
containing  a  variety  of  grades  and  species,  and  where  it  has 
been  the  well-settled  practice  for  sales  and  purchases  to  be 
made  on  the  basis  of  a  general  average  for  a  particular  section, 
the  courts  would  probably  sustain  valuations  made  on  such  basis 
by  those  having  experience  enough  to  qualify  as  experts. 

Revaluation  affecting  lessee. — 

Ruling.  A  licensee  of  Crown  Land  Limits  in  the  Province  of 
Quebec,  Canada,  is  to  be  regarded  as  a  lessee  for  tax  purposes  and 
is  not  entitled  to  deduct  depletion  based  upon  the  value  of  the  timber 
as  of  March  i,  1913 (C.  B.  3,  page  178;  L.  O.  1055.) 

The  leases  in  question,  however,  were  terminable  in  one 
year. 

For  the  distinction  between  a  lease  and  a  sale  of  timber, 
see  Chapter  XV. 

Determination  of  quantity  of  timber. — 

Regulation.  Each  taxpayer  claiming  or  expecting  to  claim  a 
deduction  for  depletion  is  required  to  estimate  with  respect  to  each 
separate  timber  account  the  total  units  (feet  board-measure  log  scale, 
cords,  or  other  units)  of  timber  reasonably  known  or  on  good  evi- 
dence believed  to  have  existed  on  the  ground  on  March  i,  1913,  or 
on  the  date  of  acquisition  of  the  property,  as  the  case  may  be.  This 
estimate  shall  state  as  nearly  as  possible  the  number  of  units  which 
would  have  been  found  present  by  a  careful  estimate  made  on  the 


FOR   DEPLETION 


1239 


specified  date  with  the  object  of  determining  100  per  cent  of  the 
quantity  of  timber  which  the  area  would  have  produced  on  that  date 
if  all  of  the  merchantable  timber  had  been  cut  and  utilized  in  accord- 
ance with  the  standards  of  utilization  prevailing  in  that  region  at 
that  time.  If  subsequently  during  the  ownership  of  the  taxpayer 
making  the  return,  as  the  net  result  of  the  growth  of  the  timber,  of 
changes  in  standards  of  utilization,  of  losses  not  otherwise  accounted 
for,  of  abandonment  of  timber,  and/or  of  errors  in  the  original  esti- 
mates, there  are  found  to  remain  on  the  ground,  available  for  utiliza- 
tion, more  or  less  units  of  timber  than  remain  in  the  timber  account 
or  accounts,  a  new  estimate  of  the  recoverable  units  of  timber  (but 
not  of  the  cost  or  the  fair  market  value  at  a  specified  date)  shall  be 
made,  and,  when  made,  shall  thereafter  constitute  a  basis  for  deple- 
tion.    (Art.  235.) 

Timber  accounts. — 

Regulation.  With  a  view  to  logical  and  reasonable  valuation  of 
timber,  the  taxpayer  shall  include  his  timber  in  one  or  more  accounts. 
In  general,  each  such  account  shall  include  all  of  the  taxpayer's  timber 
which  is  located  in  one  '"block,"  a  block  being  an  operation  unit 
which  includes  all  of  the  taxpayer's  timber  which  would  logically  go 
to  a  single  given  point  of  manufacture.  In  those  cases  in  which  the 
point  of  manufacture  is  at  a  considerable  distance,  or  in  which  the  logs 
or  other  products  will  probably  be  sold  in  a  log  or  other  market,  the 
block  may  be  a  logging  unit  which  includes  all  of  the  taxpayer's 
timber  which  would  logically  be  removed  by  a  single  logging  devel- 
opment. In  exceptional  cases,  provided  there  are  good  and  substan- 
tial reasons,  and  subject  to  approval  or  revision  by  the  Commissioner 
on  audit,  the  taxpayer  may  divide  the  timber  in  a  given  block  into 
two  or  more  accounts,  e.  g.,  timber  owned  on  February  28,  1913,  and 
that  purchased  subsequently  may  be  kept  in  separate  accounts,  or 
timber  owned  on  February  28,  1913,  and  the  timber  purchased  since 
that  date  in  several  distinct  transactions  may  be  kept  in  several  distinct 
accounts,  or  individual  tree  species  or  groups  of  tree  species  may  be 
carried  in  distinct  accounts,  or  special  timber  products  may  be  carried 
in  distinct  accounts,  or  blocks  may  be  divided  into  two  or  more 
accounts  based  on  the  character  of  the  timber  and  (or)  its  accessi- 
bility, or  scattered  tracts  may  be  included  in  separate  accounts.  When 
such  a  division  is  made,  a  proper  portion  of  the  total  value,  or  cost, 
as  the  case  may  be,  shall  be  allocated  to  each  account. 

The  timber  accounts  mentioned  in  the  preceding  paragraph  shall 
not  include  any  part  of  the  value  or  cost,  as  the  case  may  be,  of 
the  land.  In  a  manner  similar  to  that  prescribed  in  the  foregoing 
part  of  this  article  the  land  in  a  given  "block"  may  be  carried  in  a 
single  land  account  or  may  be  divided  into  two  or  more  accounts 


1240 


DEDUCTIONS 


on  the  basis  of  its  character  and  (or)  accessibility.  When  such  a 
division  is  made,  a  proper  portion  of  the  total  value  or  cost,  as  the 
case  may  be,  will  be  allocated  to  each  account. 

The  total  value  or  total  cost,  as  the  case  may  be,  of  land  and 
timber  shall  be  equitably  allocated  to  the  timber  and  land  accounts, 
respectively. 

Each  of  the  several  land  and  timber  accounts  carried  on  the  books 
of  the  taxpayer  shall  be  definitely  described  as  to  their  location  on 
the  ground  either  by  maps  or  by  legal  descriptions. 

For  good  and  substantial  reasons  to  be  approved  by  the  Com- 
missioner, or  as  required  by  the  Commissioner,  the  timber  or  the 
land  accounts  may  be  readjusted  by  dividing  individual  accounts,  by 
combining  two  or  more  accounts,  or  by  dividing  and  recombining 
accounts.     (Art.  236.) 

Depletion  and  depreciation  accounts  on  books. — Since  the 
requirements  are  practically  the  same  as  for  mineral  prop- 
erty,^^  the  regulation  for  timber  is  omitted. ^"^ 


"Art.  216;  see  page  214. 
*'Art.  237. 


CHAPTER  XXXIV 

DEDUCTIONS  FOR  CONTRIBUTIONS,  DONATIONS, 
GIFTS  AND  SUBSCRIPTIONS 

The  1 92 1  law  substantially  re-enacts  the  provisions  of 
the  1918  law  regarding  gifts  and  contributions. 

Individuals  are  permitted  to  deduct  contributions  made  to 
certain  classes  of  organizations  up  to  15  per  cent  of  their  net 
income.  The  scope  of  the  new  law  has  been  widened  to  in- 
clude organizations  not  included  in  the  19 18  law. 

Partnerships  may  deduct  from  gross  income  such  dona- 
tions as  are  in  the  nature  of  business  expenses,  any  others  being 
prorated  among  the  members  and  deducted  in  their  indi- 
vidual returns. 

Corporations  have  never  been  permitted  to  include  gifts, 
as  such,  among  their  deductible  expenses.  There  may  be 
some  merit  in  the  argument  which  has  been  advanced  that 
Congress  did  not  give  corporations  the  same  status  in  respect 
to  gifts  which  it  has  given  to  individuals  because  it  felt  it 
could  not  impliedly  condone  the  wholesale  giving  away  of 
stockholders'  property  by  boards  of  directors;  but  the  with- 
holding from  corporations  of  the  privilege  of  deducting  gifts 
does  not  prevent  the  making  of  so-called  gifts  which  are 
deemed  to  be  for  the  benefit  of  the  business  and  which  con- 
stitute ordinary  and  necessary  expenses. 

Gifts  by  individuals  deductible  within  limitations. — 

Law.  Section  214.  (a)  That  in  computing  net  income  there  shall 
be  allowed  as  deductions:  .... 

(11)  Contributions  or  gifts  made  within  the  taxable  year  to  or 
for  the  use  of:  (A)  The  United  States,  any  State,  Territory,  or  any 
political  subdivision  thereof,  or  the  District  of  Columbia,  for  ex- 
clusively public  purposes;  (B)  any  corporation,  or  community  chest, 
fund,  or  foundation,  organized  and  operated  exclusively  for  religious, 
charitable,  scientific,  literary,  or  educational  purposes,  including  posts 

1241 


1242 


DEDUCTIONS 


of  the  American  Legion  or  the  Women's  Auxiliary  units  thereof,  or 
for  the  prevention  of  cruelty  to  children  or  animals,  no  part  of  the 
net  earnings  of  which  inures  to  the  benefit  of  any  private  stockholder 
or  individual;  or  (C)  the  special  fund  for  vocational  rehabilitation 
authorized  by  section  7  of  the  Vocational  Rehabilitation  Act;  to  an 
amount  which  in  all  the  above  cases  combined  does  not  exceed  15  per 
centum  of  the  taxpayer's  net  income  as  computed  without  the  benefit 
of  this  paragraph.  In  case  of  a  nonresident  alien  individual  this  de- 
duction shall  be  allowed  only  as  to  contributions  or  gifts  made  to  do- 
mestic corporations,  or  to  community  chests,  funds,  or  foundations, 
created  in  the  United  States,  or  to  such  vocational  rehabilitation  fund. 
Such  contributions  or  gifts  shall  be  allowable  as  deductions  only  if 
verified  under  rules  and  regulations  prescribed  by  the  Commissioner, 
with  the  approval  of  the   Secretary  ;i    .... 

Gifts  to  United  States,  states,  municipalities,  etc.,  deduc- 
tible.— The  deduction  of  this  type  of  gift  is  new.  The  pro- 
vision of  the  law  is  restrictive  in  the  sense  that  contributions 
of  such  nature  must  be  for  exclusively  public  purposes.  A 
taxpayer  who  makes  a  donation  to  the  United  States  or  a  poli- 
tical subdivision  thereof,  which  meets  the  test  of  being  for 
the  general  good  of  the  public,  may  deduct  in  his  tax  return 
such  expenditures  up  to  the  15  per  cent  limit. 

The  policy  of  permitting  deductions  for  gifts  is  sound  and 
will  be  of  benefit  to  the  United  States  and  political  subdivi- 
sions thereof.  Ordinarily  when  public  improvements  are  made 
under  the  direction  of  public  officials,,  the  cost  thereof  is  as- 
sessed to  taxpayers  in  the  form  of  municipal  taxes.     Such 


'^  [Former  Procedure].  The  1917  law  included  the  words  "associa- 
tions" and  "societies"  as  recipients.  No  mention  of  the  rehabilitation 
act  nor  of  non-resident  aliens  was  made. 

No  deductions  for  gifts  were  permitted  before  the  passage  of  the 
1917  law. 

Form  1040  (revised,  1918)  erroneously  limited  the  base  upon 
which  the  allowance  could  be  computed  by  eliminating  the  amount 
of  dividends  received  in  1917,  applicable  to  earnings  of  prior  years. 
Subsequently  the  error  was  discovered  and  corrected.  (Telegram  to  A. 
Iselin  &  Co.,  from  Commissioner  Roper,  February  27,  1918.)  The  author's 
attention  has  been  called  to  the  fact  that  many  taxpayers  followed  the 
original  form  and  failed  to  obtain  the  credit  to  which  they  were  en- 
titled. If  the  correction  of  the  error  has  not  been  called  to  the  atten- 
tion of  taxpayers  who  erroneously  failed  to  add  to  the  total  income 
shown  on  line  M  of  the  return  the  dividends  applicable  to  prior  years, 
claim  can  be  made  for  the  amount  of  tax  overpaid  and  refund  se- 
cured. 


FOR   GIFTS   AND    DONATIONS 


1243 


taxes  are  deductible  in  an  individual's  return.  If  public  im- 
provements are  the  gift  of  an  individual  citizen  they  are 
similar  in  some  respects  to  taxes,  in  that  the  public  receives 
benefit  therefrom,  and  it  is  only  reasonable  that  a  limited  de- 
duction should  be  permitted,  as  is  now  provided  in  the  present 
tax  law. 

The  rules  for  valuing  and  reporting  such  gifts  as  pre- 
scribed by  the  Treasury  must  be  adhered  to." 

Gift  to  city  for  park  purposes. — 

Regulation A  gift  of  real  estate  to  a  city  to  be  main- 
tained perpetually  as  a  public  park  is  an  allowable  deduction  under 
the  present  statute,  but  was  not  an  allowable  deduction  under  tlie 
Revenue  Act  of  1918 (Art.  251.) 

Gifts  to  be  deductible  must  be  made  to  public  association. 
— The  law  is  not  designed  to  cover  private  charity,  such  as 
assistance  afforded  to  a  needy  relative  or  dependent;  but  the 
wording  of  the  law  is  broad  enough  to  include  all  contribu- 
tions to  churches  and  other  recognized  agencies,  which  in  turn 
dispense  aid  to  the  needy. 

Ruling.  Contributions  which  may  be  deducted  in  computing  the 
net  income  of  an  individual  taxpayer  include  not  only  donations  to 
incorporated  institutions,  but  those  given  to  similar  associations  which 
are  not  incorporated.  Contributions  to  war  chest  funds,  war  camp 
community  funds,  and  similar  funds  which  were  raised  solely  for 
organizations  supporting  and  furthering  war  rehef,  are  likewise  de- 
ductible items  on  personal  returns,  within  the  limit  named  in  tlie 
law. 

All  gifts  and  donations  to  churches  are  deductible,  it  being  held 
by  the  Bureau  that  every  church  constitutes  a  religious  corporation 
or  association  for  the  purpose  of  this  deduction.  Donations  to  mis- 
sionary funds,  church  building  funds,  or  for  church  activities,  which 
are  intended  for  the  furtherance  of  church  work,  constitute  deductible 

items (Statement  by  Bureau  of  Internal  Revenue,  February 

28,  1919.) 

The  192 1  law  specifically  includes  the  terms  "fund,  or 
foundation,"  which  broadens  the  class  of  organizations  em- 

'"  See  page  1247. 


1244  .  DEDUCTIONS 

braced  under  this  section  of  the  law.  Posts  of  the  American 
Legion  or  Women's  Auxiliary  units  thereof  are  now  speci- 
fically included  within  this  section. 

The  deductibility  of  such  gifts  will  depend  largely  on  the 
taxable  status  of  the  recipient  organization.  If  no  part  of 
the  contributed  receipts  inures  to  the  benefit  of  any  particular 
individual  or  individuals  and  it  can  be  shown  that  the  organi- 
zation comes  within  the  contemplation  of  the  law,  the  amounts 
donated  are  deductible  up  to  the  limit  specified. 

Many  such  organizations  have  realized  that  the  tax  laws 
have  operated  in  a  peculiar  manner  to  their  benefit.  They  are 
in  a  position  to  receive  relatively  larger  amounts  as  gifts  than 
the  expenditure  represents  to  the  donor,  the  difference  being 
the  amount  "saved"  under  this  section  of  the  law.  In  other 
words,  the  organization  receives  the  tax  which  the  govern- 
ment would  have  received  had  the  donation  not  been  made. 
This  condition  will  continue  as  long  as  the  high  surtax  rates 
are  in  force. 

Treasury's  rulings  holding  gifts  deductible. — The  Treas- 
ury has  passed  upon  a  large  number  of  cases  involving 
gifts.  Donations  to  the  following  organizations  have  been 
held  to  be  gifts  within  the  15  per  cent  limitation  provided  by 
section  214  (a;-ii)  :  a  memorial  association  which  is  organized 
for  the  purpose  of  erecting  by  public  contributions  a  monu- 
ment and  building  within  which  will  be  established  and  main- 
tained a  museum  as  a  depository  of  the  records,  flags,  litera- 
ture and  trophies  of  the  late  war,  as  well  as  a  forum  to  be 
utilized  for  educational  lectures  and  meetings,  and  educational 
in  its  nature  and  purpose;^  an  association  incorporated  under 
the  laws  of  Porto  Rico  for  the  purpose  of  soliciting  and 
obtaining  donations  to  be  used  in  reconstruction  work  and  for 
charitable  purposes  in  portions  of  Porto  Rico  devastated  by 


'  C.  B.  3,  page  188;  A.  R.  R.  301  ;  overruling  B.  35-20-1170;  O.  D.  649. 
While  this  ruling  appears  to  conflict  with  an  earlier  opinion  of  the  Solicitor 
appearing  in  C.  B.  2,  page  149;  S.  1246,  no  specific  reference  is  made  to  this 
opinion. 


FOR   GIFTS   AND    DONATIONS 


1245 


earthquake  and  tidal  wave;*  a  committee  constituted  by  law 
which  has  control  of  funds  to  be  used  for  the  pensioning  of 
members  of  a  municipal  police  force  ;^  an  association  organ- 
ized and  operated  exclusively  for  the  purpose  of  giving  musical 
concerts,  the  programs  being  of  an  educational  character,  and 
no  part  of  the  net  earnings  under  its  charter  inuring  to  the 
benefit  of  any  private  stockholder  or  individual;*^  a  board  of 
education  of  a  school  district  which  has  been  incorporated  by 
the  laws  of  a  state  ;^  and  the  Council  of  National  Defense 
which  was  established  by  the  Army  Appropriation  Act  of 
August  29,  1916.^ 

The  Treasury  has  also  held  that  pew  rents  and  so-called 
assessments  and  dues  paid  to  churches''  and  a  contribution  of 
money  toward  the  cost  of  an  article  presented  by  the  con- 
tributors to  a  corporation  organized  exclusively  for  educa- 
tional purposes,  are  deductible.^" 

Treasury's  rulings  holding  gifts  not  deductible. — Dona- 
tions, however,  to  the  following!  organizations  have  been 
held  not  to  be  deductible  within  the  15  per  cent  limitation 
provided  by  section  214  (a-il)  :  a  family  cemetery  corpora- 
tion organized  under  the  laws  of  the  state  of  New  York;^^ 
a  public  high  school,  if  the  funds  were  to  be  used  for  athletic 
purposes  ;^^  a  memorial  fund  established,  not  to  engage  in  a 
charitable  undertaking  itself,  but  which  distributes  its  income 
to  charitable  institutions  and  to  worthy  individuals];^^  and 
contributions  to  make  good  the  deficit  of  a  club  engaged  in 
recreational  as  well  as  educational  activities  ;^'*  the  National  Dry 


'  C.  B.  I,  page  151 
'C.  B.  I,  page  148 
'C.  B.  I,  page  147 
'  C.  B.  I,  page  146 
*C.  B.  I,  page  145 
°  C.  B.  I,  page  150 
'"  C.  B.  2,  page  152 
"  C.  B.  I,  page  151 
'-'C.  B.  I,  page  151 
"  C.  B.  4,  page  264 
"C.  B.  4,  page  203 


O.  D.  345. 
S.  1202. 
S.  I 176. 
S.  1052. 
S.  992. 
A.  R.  M.  2. 
O.  D.  46s. 
O.  D.  217. 
O.  D.  126. 
O.  D.  872. 
A.  R.  R.  ZT). 


1246  DEDUCTIONS 

Federation  ;^''  an  association  engaged  in  disseminating  propa- 
ganda to  encourage  the  passage  of  labor  legislation.^^ 

The  Treasury  has  also  held  that  contributions  by  citizens 
of  a  city  to  a  fund  raised  for  the  purpose  of  inducing  an 
industrial  plant  to  establish  itself  in  their  city/'  and  contribu- 
tions to  a  trust  company  (a  corporation)  in  trust  to  invest 
and  disburse  them  for  a  charitable  purpose  are  not  allowable 
deductions  under  section  214   (a-i  i ) ." 

Premiums  on  life  insurance  policy  deductible  as  a  gift — 

when? — 

Ruling.  Premiums  paid  on  a  life  insurance  policy  are  allowable 
deductions  from  gross  income  when  the  beneficiary  is  a  charitable 
corporation  exempt  from  tax,  provided  the  beneficiary  named  can 
not  be  changed  at  the  option  of  the  insured  and  the  sum  of  the  annual 
premium  plus  other  allowable  charitable  contributions  does  not 
exceed  15  per  cent  of  the  taxpayer's  net  income.  (C.  B.  i,  page  151 ; 
O.  D.  299.) 

Pledges — when  deductible. — The  deduction  evidently  is 
limited  to  contributions  "made"  and  does  not  include  sub- 
scriptions or  promises  to  pay  in  the  future.  A  subscription  may 
constitute  a  legal  liability  and  properly  so  appear  among  other 
accrued  and  unpaid  liabilities;  but  a  reasonable  interpretation 
of  the  law  seems  to  be  that  contributions  which  are  "made" 
are  strictly  limited  to  those  which  have  been  paid  in  property, 
cash  or  notes,  or  other  evidences  of  debt  which  the  beneficiaries 
can  reasonably  convert  into  cash  or  hold  as  a  suitable  invest- 
ment. 

Procedure  in  reporting  gifts. — 

Regulation In  connection  with  claims  for  this  deduc- 
tion there  shall  be  stated  on  returns  of  income  the  name  and  address 
of  each  organization  to  which  a  gift  was  made  and  the  approximate 
date  and  the  amount  of  the  gift  in  each  case (Art.  251.) 


"C.  B.  I,  page  150;  O.  D.  44. 
"C.  B.  2,  page  162;  S.  1362. 
"  C.  B.  I,  page  150;  O.  D.  39. 
"C.  B,  I,  page  187;  O.  D.  669. 


FOR   GIFTS   AND   DONATIONS 


1247 


Under  the  law  much  is  left  to  the  good  faith  of  the  tax- 
payer. It  is  not  enough,  however,  to  make  a  wild  guess  at 
one's  total  contributions  for  the  year.  An  accurate  record 
must  be  kept  to  form  a  basis  for  the  report  required  by  the 
regulations.  If  this  is  done,  such  gifts  as  plate  collections  will 
be  permitted. 

Rule  for  valuing  gifts. — 

Regulation Where  the   gift   is   other   than   money   the 

basis  for  calculation  of  the  amount  of  the  gift  shall  be  the  cost  of 
the  property,  if  acquired  after  February  28,  1913,  or  its  fair  market 
value  as  of  March  i,  1913,  if  acquired  prior  thereto,  after  deducting 
from  such  cost  or  value  the  amount  of  depreciation   sustained   and 

allowable  as  a   deduction  in  computing  net   income ^^      (Art. 

251-) 

The  foregoing  regulation  places  the  valuation  of  gifts  on 
a  proper  basis.  The  provision  regarding  depreciation  would 
seem  to  mean  that  if  a  taxpayer  donates  an  office  building 
which  cost  $100,000  in  19 16  and  no  depreciation  has  subse- 
quently been  claimed  (as  it  could  have  been)  and  the  depre- 
ciated value  at  date  of  gift  is  $80,000,  the  latter  amount  is 
to  be  used  as  a  deduction.  If  a  residence  which  cost  $100,000 
in  1916  is  donated,  credit  may  be  taken  for  $100,000,  because 
depreciation  since  19 16  could  not  have  been  deducted. 

If  the  foregoing  is  a  correct  inference  the  author  doubts 
the  validity  of  permitting  deductions  exceeding  in  amount 
the  value  of  the  property  donated  at  the  date  of  gift. 

Individual  credits  for  partnership  gifts. — Gifts,  such  as 
contributions  to  the  Red  Cross,  are  not  deductible  by  corpora- 


"•  [Former  Procedure]  In  an  early  edition  of  Regulations  45,  this 
sentence  of  the  article  read  as  follows : 

"Where  the  gift  is  other  than  money,  the  basis  for  calculation  of  the 
amount  of  the  gift  shall  be  the  fair  market  value  of  the  property  at  the 
time  given." 

As  was  pointed  out  in  the  1920  edition  of  this  book,  the  foregoing 
ruling  permitted  allowable  deductions  in  excess  of  an  equitable  allowance. 
Ff)r  a  detailed  criticism  of  this  article  as  it  originally  appeared,  see  Income 
Tax  Procedure,  1920,  pages  560-562. 


1248 


DEDUCTIONS 


tions  for  either  income  or  excess  profits  tax  purposes.^"  In 
the  case  of  the  partnership,  however,  donations  not  deductible 
as  business  expenses  "may  be  prorated  among  the  individual 
members  of  the  partnership  for  the  purpose  of  their  individual 
income  tax  returns,  as  contributions  or  gifts,"  subject  to  the  15 
per  cent  limitation. ^^ 

Article  251  specifically  provides  for  deduction  by  partners: 

Regulation The  proportionate  share  of  contributions 

made  by  a  partnership  may  be  claimed  as  deductions  in  the  personal 
returns  of  the  partners  to  an  amount  which,  added  to  the  amount  of 
such  contributions  made  by  the  partner  individually,  is  not  in  excess 
of  i'5  per  cent  of  the  partner's  net  income  computed  without  the  benefit 
of  the  deduction  for  such  contributions;  but  the  contributions  made 
by  the  partnership  shall  not  be  deducted  from  its  gross  income  in 
ascertaining  the  amount  of  its  net  income  to  be  reported  on  Form 
1065 (Art.  251.) 

The   distinction   between  gifts  and   business   expenses. — 

So-called  gifts  often  business  expenses. — It  has  been 
pointed  out  that  for  the  most  part  expenditures  termed  "Christ- 
mas gifts"  are,  as  a  matter  of  fact,  merely  remuneration  to  the 
employee  and  properly  deductible  as  a  business  expense  to  the 
employer.  The  same  thing  may  be  said  of  many  payments 
variously  characterized  as  gifts,  donations,  gratuities,'^  sub- 


"  [Former  Procedure]  The  author  has  always  contended  that  part- 
nerships were  permitted  under  the  1917  law  to  deduct  contributions,  since 
section  206  of  the  1917  law  provided  that  "there  shall  be  allowed  (a)  in 
the  case  of  a  domestic  partnership  the  same  deductions  as  allowed  to  indi- 
viduals in  subdivision  (a)  of  section  5."  The  deduction  resulted  in  a  con- 
siderable saving  in  excess  profits  tax.  The  Treasury  formerly  disallowed 
1917  contributions  by  partnerships,  but  the  author's  contention  has  been 
upheld  by  the  Committee  on  Appeals  and  Review  in  B.  45-21-1914. 

"  Letter  to  The  Corporation  Trust  Company,  signed  by  Commissioner 
Daniel  C.  Roper,  and  dated  May  23,  1918. 

"A  gratuity  is  a  free  gift,  voluntarily  given,  for  which  the  giver  re- 
ceives no  valuable  or  legal  consideration It  is  not  a  charge  against 

profits  or  surplus  because  it  is  not  an  expense  or  loss  incurred  in  the  opera- 
tions, transactions,  management  or  administration  of  a  business.  The  giver 
acquires  absolutely  nothing;  he  does  not  liquidate  a  liability.  The  giving 
of  it  merely  causes  a  depletion  of  assets  resulting  from  a  withdrawal  of 
undivided  profits  or  surplus. 

"Possibly  under  peculiar  conditions  the  giver  receives  consideration  in 
the  nature  of  advertising.  In  such  a  case  it  is  correct  to  consider  the 
disbursement  a  charge  against  advertising,  but  it  should  not  be  called 
a  gratuity."     (Joseph  Robinson,  Journal  of  Accountancy,  November,  1918.) 


FOR   GIFTS    AND    DONATIONS 


1249 


scriptions,  contributions,  etc.  In  the  past  little  attempt  has 
been  made  to  distinguish  one  class  of  payment  from  another. 
Certainly  most  payments  so  designated  have  not  been  dis- 
tributions of  profit  in  the  usual  and  accepted  meaning  of  that 
term.  Almost  without  exception  such  itehis  are  charged 
to  some  expense  account  and  are  treated  as  ordinary  and  nec- 
essary expenses  of  doing  business. 

The  Treasury's  attitude  toward  the  question  of  the  de- 
ductibility of  such  items  is  shown  in  the  following  regulation : 

Regulation.  Corporations  are  not  entitled  to  deduct  from  gross 
income  charitable  or  other  contributions  which  individuals  may  de- 
duct under  paragraph  (11)  of  section  214  (a).  Donations  made  by 
a  corporation  for  purposes  connected  with  the  operation  of  its  busi- 
ness, however,  when  limited  to  charitable  institutions,  hospitals,  or 
educational  institutions  conducted  for  the  benefit  of  its  employees  or 
their  dependents,  are  a  proper  deduction  as  ordinary  and  necessary 
expenses.  Donations  which  legitimately  represent  a  consideration 
for  a  benefit  flowing  directly  to  the  corporation  as  an  incident  of  its 
business  are  allowable  deductions  from  gross  income.  For  example, 
a  street  railway  corporatio;i  may  donate  a  sum  of  money  to  an  or- 
ganization intending  to  hold  a  convention  in  the  city  in  which  it 
operates,  with  the  reasonable  expectation  that  the  holding  of  such 
convention  will  augment  its  income  through  a  greater  number  of  people 
using  the  cars.  Sums  of  money  expended  for  lobbying  pur- 
poses, the  promotion  or  defeat  of  legislation,  the  exploitation  of 
propaganda,  including  advertising  other  than  trade  advertising,  and 
contributions  for  campaign  expenses,  are  not  deductible  from  gross 
income.     (Art.  562.) 

_3     The  first  sentence  of  the  foregoing  article  is  new. 

This  regulation  is  in  one  particular  even  more  rigid  than 
those  which  were  in  force  some  time  ago.  Under  it,  donations 
to  be  deductible  must  legitimately  represent  expenditure  for  a 
benefit  "flowing  directly  to  the  corporation."  T.  D.  2090,  in 
force  until  19 18,  used  the  language  "flowing  directly  or  indirec- 
ly  to  the  corporation."  The  example  of  the  street  railway  dona- 
tion, however,  indicates  that  the  Treasury  may  be  willing  to 
allow  deductions  for  expenditures  made  in  the  hope  or  ex- 
pectation that  they  will  cause  some  benefit  to  flow  "directly 
to  the  corporation."    The  attitude  of  the  Treasury  in  the  past 


1250 


DEDUCTIONS 


has  seemed  to  exclude  all  expenditures  which  did  not  actually 
result  in  a  "consideration  moving  in  some  form"  to  the  cor- 
poration.~^  The  distinction  between  an  expenditure  which  was 
allowable  and  one  which  was  not  turned  apparently  on  the 
result  of  such  payment  rather  than  on  the  intention  of  the 
payer.  Business,  of  course,  could  not  be  conducted  on  these 
principles,  because  vast  expenditures  must  often  be  made 
in  the  expectation  that  due  consideration  will  "move"  to 
those  who  pay  the  money — but  it  does  not  always  move. 

A  "bank"  donated  a  certain  amount  through  a  chamber  of 
commerce  for  the  purpose  of  inducing  a  railroad  company  to 
extend  its  tracks  into  the  town  in  which  it  is  located.  It  was 
held  that  the  donation  does  not  constitute  an  allowable  deduc- 
tion because  "donations  of  the  character  stated  are  not  ordin- 
ary and  necessary  expenses  incident  to  carrying  on  a  banking 
business"  and  that  there  is  no  "consideration  for  a  benefit  flow- 
ing directly  to  the  contributing  banks.'"-* 

It  is  to  be  hoped  that  the  courts  will  at  an  early  date  pass 
upon  the  distinction  between  expenses  which  taxpayers  think 
are  proper  and  those  which  are  held  by  the  Treasury  to  be 
gifts  without  consideration,  llie  Treasury  in  its  attitude  at- 
tacks the  good  faith  and  judgment  of  corporate  directors.  It 
is  not  likely  that  the  courts  will  take  a  similar  attitude. 

Let  the  taxpayer  ask  himself  this  question:  "Was  the  ex- 
penditure made  to  further  my  business  interests?"  If  it  can 
be  answered  in  the  affirmative,  it  is  an  allowable  deduction 
as  intended  by  the  law. 

This  whole  question  is  relatively  unimportant,  but  the 
author  has  seen  personally,  and  has  heard  of,  so  many  cases 
where  the  only  criticisms  which  have  been  made  by  income  tax 
inspectors  have  concerned  items  of  this  nature  that  it  seems 
desirable  to  dwell  upon  it  at  some  length.  Business  men  who 
are  trying  to  be  honest  with  the  government  do  not  like  to  be 
told  that  they  erroneously  included  donations  among  their  ex- 


T.  D.  2090,  December  14,  1914. 
'  1-3-35  ;   I-  T.   1 169. 


FOR   GIFTS   AND    DONATIONS  1251 

penses,  and  that  these  donations  were  distributions  of  profit. 
The  taxpayer  knows  that  they  were  not.  They  are,  he  con- 
siders, properly  to  be  classified  as  necessary  expenses,  and  he 
is  justly  annoyed. 

The  author  suggests  the  abandonment  of  all  these  terms 
(gifts,  donations,  subscriptions,  contributions,  etc.)  in  books 
of  account.  Instead,  open  a  new  account,  "Payments  out  of 
profits  not  deductible  in  income  tax  return."  Charge  to  this 
account  all  items  which  are  actually  gifts,  distributions  of  profit 
— that  is,  where  there  is  no  consideration  moving  in  some 
form  to  the  payer.  Then  in  the  regular  expense  accounts  in- 
clude all  payments  which  are  made  in  the  regular  order  of 
the  business  for  the  good  of  business,  and  do  not  call  them 
gifts,  but  describe  them  properly.  If  this  is  done,  it  is  not 
likely  that  any  inspector  will  criticize  the  distribution  so  long 
as  it  is  made  in  good  faith  and  without  intent  to  evade  the  just 
tax." 

Donations  by  corporations."*' — 

Article  562,  which  is  largely  a  repetition  of  former  regu- 
lations,   states   that    "donations   which   legitimately   represent 


"  [British  Practice]  In  Great  Britain  "donations,"  technically 
speaking,  are  not  deductible.  But  payments  in  the  nature  of  dona- 
tions are  sometimes  deductible.  For  instance,  "where  ....  sub- 
scriptions are  paid  by  a  manufacturer  to  an  infirmary — where  any  of 
his  work  people  might  be  sent  if  injured — such  subscriptions  are  allow- 
able as  a  deduction,  the  payment  being  looked  upon  as  a  trade  expense." 
(Murray  and  Carter,  A  Guide  to  Income  Tax  Practice  (8th  edition),  page 
155)-  When  no  direct  benefit  can  be  read  into  the  subscriptions,  they  arc 
regarded  as  disposals  of  profit  and  are  not  deductible. 

""  [Former  Procedure] 

Regulation Expenses    incurred    in   advertising   and    promoting 

the  sale  of  Liberty  bonds  and  war  savings  stamps  over  the  corporation's 
name  are  deductible (Reg.  45,  Art.  562.) 

Ruling.  Where  a  corporation  in  order  to  promote  the  sale  of  war  sav- 
ings stamps  to  its  employees  donates  a  thrift  stamp  with  each  war  savings 
stamp  purchased,  the  amount  expended  by  the  corporation  in  purchasing  the 
stamps  so  donated  is  an  expense  incurred  in  advertising  and  promoting  the 
sale  of  war  savings  stamps  over  the  name  of  the  corporation  and  hence 
deductible  from  gross  income  under  the  provisions  of  article  562  of  Regula- 
tions 45.     (C.  B.  3,  page  266;  O.  D.  682.) 

The  provision  that  the  expenses  for  jiromoting  the  sale  of  Liberty 
bonds  are  deductible  exix;nscs  was  hardly  in  line  with  the  Treasury's  atti- 
tude in  the  past. 


1252 


DEDUCTIONS 


a  consideration  for  a  benefit  flowing  directly  to  the  corpora- 
tion as  an  incident  of  its  business  are  allowable  deductions 
from  gross  income."  It  must  be  assumed,  therefore,  that 
expenses  incurred  in  advertising  the  sale  of  Liberty  bonds 
heretofore  permitted  as  a  deduction  entail  some  measure  of 
benefit  flowing  to  the  corporation.  At  the  same  time  the 
regulations  do  not  permit  as  deductions  gifts  to  the  Red  Cross, 
Y.  M.  C.  A.,  or  other  similar  purposes. 

Ruling.  Donations  made  by  a  corporation  to  a  Young  Men's 
Christian  Association  located  on  its  property  and  operated  for  the 
benefit  of  the  employees  of  such  corporation  are  not  deductible  as  or- 
dinary and  necessary  business  expenses.  (B.  Digest  31-21-1757; 
O.  D.  986.) 

If  benefits  running  to  the  corporation  can  be  identified 
with  gifts  such  as  those  mentioned  in  the  foregoing  ruling, 
the  deductions  should  be  allowed  as  "necessary"  expenses. 

Ruling.  Even  though  the  entire  stock  of  a  corporation  is  owned 
within  a  single  family,  such  corporation  is  not  entitled  under  the 
provisions  of  the  Revenue  Act  of  1918  to  deduct  from  gross  income 
donations  made  to  the  American  Red  Cross,  United  War  Workers, 
Liberty  loan  drives,  or  the  Salvation  Army.  (C.  B.  4,  page  291;  A. 
R.  R-  373-) 

It  would  seem  that  a  corporation  would  reap  quite  as  much 
benefit  by  making  a  contribution  to  the  Red  Cross  as  if  it  spent 
a  large  amount  of  money  in  advertising  Liberty  bonds.  In 
the  opinion  of  the  author,  Congress  did  not  intend  that  a  cor- 
poration should  be  permitted  to  deduct  donations  such  as 
are  mentioned  above,  and  it  cannot  be  expected  that  the  law 
will  be  so  administered.  The  allowance  for  Liberty  bond 
expenses  is  probably  a  matter  of  expediency  rather  than  a 
change  in  policy. 

It  has  been  stated  that  when  a  taxpayer  sent  a  cheque  to 
federal  reserve  banks  or  elsewhere  to  pay  part  or  all  of  a 
charge  for  advertising  Liberty  bonds  and  the  advertisement 
failed  to  mention  the  donor's  name,  the  amount  expended  has 
been  disallowed.  The  author  is  of  the  opinion  that,  if  there 
is  any  warrant  at  all  in  the  law  for  the  expense,  the  advertiser 


FOR   GIFTS    AND    DONATIONS 


1253 


whose  name  did  not  appear  can  claim  the  deduction  as  a  neces- 
sary business  expense  to  the  same  extent  as  if  the  name  ap- 
peared. 

Donations  to  Red  Cross  and  other  war  activities. — 
The  question  as  to  the  deductibiHty,  by  corporations,  of  dona- 
tions to  the  Red  Cross  has  arisen  so  often  that  the  Treasury 
in  a  lengthy  decision  reiterated  its  position  that  such  con- 
tributions are  not  deductible." 

During  1921,  reference  has  again  been  made  to  this  sub- 
ject in  the  following: 

Ruling.  In  order  to  obviate  the  necessity  of  filing  amended  re- 
turns on  the  prescribed  forms  for  the  year  1918,  corporations  which, 
prior  to  the  issuance  of  Treasury  Decision  2847,  filed  their  completed 
returns  and  erroneously  claimed  therein  deductions  on  account  of 
contributions  to  the  Red  Cross  and  other  recognized  war  organizations, 
are  required  to  file  with  the  Collector  of  Internal  Revenue  within  30 
days  from  the  date  of  this  decision  a  supplemental  return  in  the  form 
of  a  statement  under  oath  showing  the  amount  of  such  deductions 
claimed,  the  amount  of  net  income  as  reported  and  as  corrected,  and 
the  amount  of  additional  tax  due.  Payment  of  the  total  amount  of 
additional  tax  shown  to  be  due  by  such  supplemental  return  must 
also  be  made  within  30  days. 

In  cases  where  this  procedure  is  followed,  formal  amended  returns 
will  not  be  required  and  the  supplemental  returns  referred  to  when 
received  by  this  office  through  the  collector's  office  will  be  filed  with 
the  original  returns. 

Where  in  connection  with  any  return  for  the  year  1918  an  audit 
of  the  books  of  the  corporation  has  been  made  by  the  Department 
and  the  amount  of  such  contributions  disclosed,  the  statement  herein 
provided  for  need  not  be  made. 

Failure  by  a  corporation  to  file  a  supplemental  return  as  required 
will  subject  it  to  the  penalties  provided  by  section  3176,  United  States 
Revised  Statutes.     (B.  36-21-1807;  T.  D.  3215.) 

Donations  by  agricultural   corporations   to   fairs, 

ETC. 

Ruling.  A  corporation  engaged  in  agricultural  business  cannot 
be  allowed  to  make  a  deduction  from  gross  income  on  account  of 
donations  to  fairs,  churches  and  associations,  such  donations  being 


For  te.xt  of  regulation,  sec  Income  Tax  Procedure,  1920,  pages  566-567. 


1254 


DEDUCTIONS 


made  for  the  purpose  of  obtaining  and  preserving  the  goodwill  of  the 
farmers  who  raise  crops  for  it,  since  the  amounts  so  expended  are 
clearly  in  the  nature  of  gratuities  and  are  not  necessary  expenses  of 
operation  and  maintenance,  as  there  is  no  such  consideration  in  this 
case  as  is  contemplated  in  T.  D.  2090.  (Letter  from  Acting  Commis- 
sioner of  Internal  Revenue,  June  25,  1914.) 

If  followed  literally,  this  decision  would  deprive  some 
corporations  of  the  right  to  claim  advertising  as  an  allowable 
deduction.  Many  public  service  corporations  advertise  to  re- 
tain customers'  goodwill  rather  than  to  seek  new  business. 

Fortunately  for  corporations,  questions  as  to  what  are  and 
are  not  expenses  necessary  to  obtain  and  retain  the  goodwill 
of  customers  will  not  be  ultimately  decided  by  the  Commis- 
sioner of  Internal  Revenue  but  by  the  courts.  Until  such  de- 
cision, corporations  should  continue  to  deduct  all  those  ex- 
penses necessary  properly  to  maintain  their  businesses.  This, 
in  the  opinion  of  the  author,  is  in  accordance  with  the  law  and 
with  common  sense. 

"Treating  money"  an  expense^  not  a  gift. — 

Regulation.  So-called  "spending  or  treating  money"  actually 
advanced  by  corporations  to  their  traveling  salesmen,  to  be  used  by 
them  as  a  part  of  the  expense  incident  to  selling  the  product  of  such 
corporations,  is  an  allowable  deduction  in  a  return  of  income  by  such 
corporation.  The  deduction  of  such  expenditures  is  conditioned  upon 
a  satisfactory  showing  that  all  the  allowance  claimed  as  a  deduction 
was  actually  expended  for  and  was  an  ordinary  and  usual  expense 
incurred  in  selling  the  product  or  merchandise  of  the  corporation. 
(Reg.  33,  1918,  Art.  133. )'« 

Gifts  of  merchandise. — Probably  every  retailer  is  re- 
quested to  make  gifts  to  charitable  and  religious  organizations. 
Usually  the  solicitor  is  a  good  customer  and  the  donation  is 
made.  The  author  has  never  heard  it  seriously  contended 
that  gifts  of  this  nature  w^ere  other  than  expenses  of  doing 
business,  as,  of  course,  they  are;  and  they  should  be  so  treated 
in  preparing  income  tax  returns.     The  Treasury  in  a  certain 


T.  D.  2090,  December  14,  1914. 


FOR   GIFTS   AND    DONATIONS  1255 

case  ruled  that  they  are  not  allowable  deductions.  Corpora- 
tions, as  a  rule,  do  not  make  payments  representing  "mere 
gratuities,"  but  expect  and  receive  some  consideration  for 
expenditures  of  a  quasi-charitable  nature.  As  soon  as  the 
courts  pass  on  the  word  "expenses"  as  used  in  the  law,  all 
items  of  this  nature  will  no  doubt  loe  found  to  be  deductible. 


PART  IV 
SPECIAL  CLASSES  OF  TAXPAYERS 


CHAPTER    XXXV 

TAX  ON  UNDISTRIBUTED  PROFITS  OF 
CORPORATIONS 

Congress  has  adopted  two  methods  in  the  course  of  its 
attempts  to  prevent  corporations  from  defeating  the  purpose 
of  the  income  tax  laws  by  the  simple  device  of  refraining  from 
distributing  their  earnings.  Until  the  earnings  have  been  dis- 
tributed as  dividends  and,  consequently,  have  become  subject 
to  the  surtax  rates  in  the  hands  of  the  individual  stockholders 
the  demands  of  the  tax  have  not  been  fully  met.  The  first 
method  of  forcing  distributions  in  cases  in  which  they  are  de- 
liberately withheld  makes  the  entire  profits  "taxable  to  indi- 
vidual stockholders"  and  is  directed  at  holding  companies 
or  "close"  corporations  which  may  refrain  from  distributing 
earnings  because  corporations  are  not  subject  to  the  surtax 
imposed  upon  individuals.  An  attempt  is  made  to  tax  the  indi- 
vidual stockholder  as  if  the  earnings  were  actually  distributed, 
thus  collecting  the  surtax.  This  method  under  the  1913, 
1 9 16  and  191 8  laws  failed  in  its  object.  It  is  rumored  that 
the  tax  has  been  imposed  in  a  few  cases.  The  author  has  been 
unable  to  learn  the  details  of  a  single  case. 

The  second  method  levies  an  additional  tax  on  undistrib- 
uted earnings.  It  does  not  attempt  to  collect  a  surtax  from 
stockholders,  but  imposes  an  additional  flat  rate  tax  on  the 
corporation  itself.  The  191 7  law  which  imposed  this  tax  may 
be  said  to  have  been  a  failure.^  The  1921  law  may  be  more 
successful. 


'  [Former  Procedure]  Every  time  the  question  of  a  new  tax  on  undis- 
tributed profits  arises,  apprehension  is  felt  that  prior  or  accumulated  surplus 
is  to  be  taxed.  In  the  opinion  of  the  author  there  is  and  has  been  no  justi- 
fication for  such  apprehension. 

In  1917,  when  the  1916  law  was  being  amended.  Senator  Jones  proposed 

1259 


i26o  SPECIAL   CLASSES    OF   TAXPAYERS 

Evasion  of  surtaxes  by  incorporation. — 

Law.  Section  220.  That  if  any  corporation,  however  created  or 
organized,  is  formed  or  availed  of  for  the  purpose  of  preventing  the  im- 
position of  the  surtax  upon  its  stockholders  or  members  through  the 
medium  of  permitting  its  gains  and  profits  to  accumulate  instead  of 
being  divided  or  distributed,  there  shall  be  levied,  collected,  and  paid 
for  each  taxable  year  upon  the  net  income  of  such  corporation  a  tax 
equal  to  25  per  centum  of  the  amount  thereof,  which  shall  be  in  addi- 
tion to  the  tax  imposed  by  section  230  of  this  title  and  shall  be  com- 
puted, collected,  and  paid  upon  the  same  basis  and  in  the  same  manner 
and  subject  to  the  same  provisions  of  law,  including  penalities,  as  that 
tax:  Provided,  That  if  all  the  stockholders  or  members  of  such  corpora- 
tion agree  thereto,  the  Commissioner  may,  in  lieu  of  all  income,  war- 
profits  and  excess-profits  taxes  imposed  upon  the  corporation  for  the 
taxable  year,  tax  the  stockholders  or  members  of  such  corporation 
upon  their  distributive  shares  in  the  net  income  of  the  corporation  for 

an  amendment  imposing  an  additional  tax  of  15  per  cent  on  all  surplus 
of  the  taxable  year  undistributed  sixty  days  after  the  end  of  the  taxable 
year.  There  was  no  thought  of  retroactively  taxing  accumulated  surplus 
of  prior  years.  When  the  amendment  was  proposed  every  member  of  the 
Finance  Committee,  but  one,  voted  for  it.  (Congressional  Record,  Septem- 
ber 10,  1917,  page  7469.)  Subsequently  they  voted  against  it  and  the  amend- 
ment was  not  adopted. 

For  text  of  previous  laws  and  full  discussion  thereof,  see  Income  Tax 
Procedure,  1919,  pages  617-624;  and  1920,  pages  963-974.  What  has  occurred 
in  tlie  past  is  only  of  academic  interest. 

The  Treasury  admitted  that  section  220  of  the  1918  law  was  difficult 
to  administer.  In  Notes  on  the  Revenue  Act  of  191S,  the  Secretary  of  the 
Treasury  said : 

"The  corporate  form  of  organization  is  now  used  or  abused  by  wealthy 
individuals  who  incorporate  their  personal  business  and  investments  and 
thus  escape  surtaxes  upon  that  amount  of  their  income  which  is  reinvested 
or  saved.  Section  220  provides  a  remedy  for  this  abuse,  but  it  can  be  applied 
only  by  a  troublesome  special  procedure  which  will  necessarily  restrict  its 
use  to  a  comparatively  small  proportion  of  cases." 

In  the  stock  dividend  case  (Eisner  v.  Macombcr,  252  U.  S.  189),  the 
Supreme  Court  decided  in  effect  that  under  an  income  tax  law,  stockholders 
could  not  be  taxed  unless  they  received  or  realized  actual  income.  The  1918 
law  attempted  to  impose  a  tax  upon  individual  stockholders,  not  upon 
corporations.  The  tax  would  be  levied  against  stockholders  on  earnings 
not  distributed  and  would  therefore  appear  to  be  unconstitutional.  The 
author  does  not  know  of  any  case  in  which  such  an  assessment  has  been 
made,  and  as  the  Treasury  since  the  stock  dividend  decision  is  in  doubt 
about  the  legality  of  the  section,  the  practical  effect  of  the  1918  law  docs 
not  seem  to  be  serious. 


UNDISTRIBUTED    CORPORATE   PROFITS  1261 

the  taxable  year  in  the  same  manner  as  provided  in  subdivision  (a)  of 
section  218  in  the  case  of  members  of  a  partnership.  The  fact  that  any 
corporation  is  a  mere  holding  company,  or  that  the  gains  and  profits 
are  permitted  to  accumulate  beyond  the  reasonable  needs  of  the  busi- 
ness, shall  be  prima  facie  evidence  of  a  purpose  to  escape  the  surtax; 
but  the  fact  that  the  gains  and  profits  are  in  any  case  permitted  to  ac- 
cumulate and  become  surplus  shall  not  be  construed  as  evidence  of  a 
purpose  to  escape  the  tax  in  such  case  unless  the  Commissioner  cer- 
tifies that  in  his  opinion  such  accumulation  is  unreasonable  for  the  pur- 
poses of  the  business.  When  requested  by  the  Commissioner,  or  any 
collector,  every  corporation  shall  forvirard  to  him  a  correct  statement 
of  such  gains  and  profits  and  the  names  and  addresses  of  the  indi- 
viduals or  shareholders  who  would  be  entitled  to  the  same  if  divided  or 
distributed,  and  of  the  amounts  that  would  be  payable  to  each. 

Regulation.  Where  a  domestic  or  foreign  corporation  permits 
its  gains  and  profits  to  accumulate  for  the  purpose  of  preventing  the 
imposition  of  the  surtax  upon  such  income  if  distributed  to  its  stock- 
holders, it  shall  be  subject  to  an  income  tax  at  25  per  cent  in  addition 
to  the  taxes  imposed  by  section  230  of  the  statute.  If,  however,  all 
the  stockholders  agree  thereto,  the  Commissioner  may,  in  lieu  of  all 
income,  war-profits  and  excess-profits  taxes  imposed  upon  the  cor- 
poration for  the  taxable  year,  tax  them  upon  their  distributive  shares 
in  the  net  income  of  the  corporation  for  the  taxable  year  as  provided 
in  subdivision  (a)  of  section  218,  in  the  case  of  members  of  a  part- 
nership. In  any  case  the  Commissioner  or  a  collector  may  require  a 
corporation  to  furnish  a  statement  of  its  gains  and  profits  and  of  the 
names,  addresses,  and  shareholding  of  the  stockholders,  and  of  the 
amounts  that  would  be  payable  to  each.     (Art.  351.) 

Accumulation  of  earnings  to  be  taxable  must  be  with  pur- 
pose of  evasion. — 

Regulation.  Section  220  of  the  statute  applies  where  a  cor- 
poration is  formed  or  availed  of  for  the  purpose  of  preventing  the  im- 
position of  the  surtax  upon  its  stockholders  or  members  by  permitting 
its  gains  and  profits  to  accumulate  instead  of  being  divided  or  distri- 
buted. Prima  facie  evidence  of  a  purpose  to  escape  the  surtax 
exists  where  a  corporation  has  practically  no  business  except 
holding  stocks,  securities  or  other  property  and  collecting  the 
income  therefrom,  or  where  a  corporation  other  than  a  mere  hold- 
ing company  permits  its  gains  and  profits  to  accumulate  beyond  the 
reasonable  needs  of  the  business.  The  business  of  a  corporation  is 
not  limited  to  that  which  it  has  previously  carried  on,  but  in  general 
includes  any  line  of  business  which  it  may  legitimately  undertake. 
However,  a  radical  change  of  business  when  a  considerable  surplus 
has  been  accumulated  may  afford  evidence  of  a  purpose  to  escape 


1262  SPECIAL   CLASSES    OF   TAXPAYERS 

the  surtax.  When  one  corporation  ovns  the  stock  of  another  cor- 
poration in  the  same  or  a  related  line  of  business  and  in  effect  operates 
the  other  corporation,  the  business  of  the  latter  may  be  considered  in 
substance  the  business  of  the  first  corporation.  Gains  and  profits 
of  the  first  corporation  put  into  the  second  through  the  purchase  of 
stock  or  otherwise  may  therefore,  if  a  subsidiary  relationship  is  es- 
tablished, constitute  employment  of  the  income  in  its  own  business. 
To  establish  that  the  business  of  one  corporation  can  be  regarded  as 
including  the  business  of  another  it  is  ordinarily  essential  that  the 
first  corporation  own  substantially  all  of  the  stock  of  the  second.  In- 
vestment by  a  corporation  of  its  income  in  stock  and  securities  of 
another  corporation  is  not  without  anything  further  to  be  regarded 
as  employment  of  the  income  in  its  business.     (Art  352.) 

A  corporation  could  pay  ofif  all  its  debts,  add  to  its  plant 
and  inventories,  expand  in  similar  ways  and  retain  substantial 
cash  working  capital  without  being  subject  to  tax  upon  its 
undistributed  earnings. 

Accumulation  of  earnings  to  be  taxable  must  be  unreason- 
able in  amount. — 

Regulation.  An  accumulation  of  gains  and  profits  is  unreason- 
able if  it  is  not  required  for  the  purposes  of  the  business,  considering 
all  the  circumstances  of  the  case.  No  attempt  can  be  made  to  enum- 
erate all  the  ways  in  which  gains  and  profits  of  a  corporation  may  be 
■  accumulated  for  the  reasonable  needs  of  the  business.  Undistributed 
income  is  properly  accumulated  if  invested  in  increased  inventor- 
ies or  additions  to  plant  reasonably  needed  by  the  business.  It  is 
properly  accumulated  if  retained  for  working  capital  required  by  the 
business  or  in  accordance  with  contract  obligations  placed  to  the 
credit  of  a  sinking  fund  for  the  purpose  of  retiring  bonds  issued  by 
the  corporation.  In  the  case  of  a  banking  institution  the  business  of 
which  is  to  receive  and  loan  money,  using  capital,  surplus  and  de- 
posits for  that  purpose,  undistributed  income  actually  represented  by 
loans  or  reasonably  retained  for  future  loans  is  not  accumulated  be- 
yond the  reasonable  needs  of  the  business.  The  nature  of  the  invest- 
ment of  gains  and  profits  is  immaterial  if  they  are  not  in  fact  needed 
in  the  business.     (Art.  353.) 

When  investment  companies,  such  as  those  formed  by  in- 
dividuals and  estates,  invest  their  surplus  funds  in  market- 
able securities,  such  as  Liberty  bonds,  and  do  not  pay  reason- 
able cash  dividends,  an  intention  to  relieve  stockholders  from 
surtax  may  be  inferred.     When  the  investments  are  in  the 


UNDISTRIBUTED    CORPORATE    PROFITS  1263 

securities  of  closely  held  corporations,  in  real  estate  or  other 
property  which  is  not  readily  marketable,  and  when  it  is  nec- 
essary similarly  to  reinvest  the  accruing  surplus  in  the  same 
properties,  the  element  of  evasion  is  palpably  absent.  The 
section  became  effective  November  23,  192 1,  and  does  not 
affect  surplus  or  earnings  accumulated  prior  to  that  date.  Pen- 
alty sections,  unlike  others,  never  take  effect  retroactively. 

If  prior  to  November  23,  1921,  surplus  was  available  and 
was  not  distributed,  the  penalties  for  failure  to  distribute  are 
found  in  the  abortive  provision  of  the  19 18  law.  It  can  hardly 
be  held  that  the  1921  law  has  any  retroactive  effect.  Penalty 
sections  cannot  be  enforced  until  after  due  notice  has  been 
given. 

In  all  cases  where  no  good  reason  exists  for  the  accumula- 
tion of  earnings  subsequent  to  November  23,  1921,  dividends 
corresponding  closely  to  the  realized  earnings  should  be  de- 
clared. 

It  is  fortunate  for  corporations  that  the  word  "reason- 
able" is  in  the  law.  A  corporation  may  refrain  from  distribut- 
ing its  profits,  even  if  it  has  no  debts,  if  there  is  a  reasonable 
present  need  for  the  profits  in  the  business  or  a  prospective 
need  within  the  reasonably  near  future.  Conservative  cor- 
porations accumulate  large  cash  surplus  whenever  a  profit- 
able year  enables  them  to  do  so.  The  courts  will  not  hold 
that  distributions  should  be  made  to  stockholders,  if  the  di- 
rectors in  good  faith  and  after  due  consideration  decide  that 
the  present  or  prospective  needs  of  the  business  itself  (which 
must  be  paramount)  do  not  justify  larger  cash  dividends  than 
are  being  paid. 

Stockholders  of  properly  conducted  corporations  need  not 
be  any  more  disturbed  over  the  new  law  than  over  the  old. 
However,  if  accumulated  earnings  remain  undistributed  solely 
to  permit  stockholders  to  escape  the  surtax,  that  purpose  should 
be  frustrated.  The  continued  attempts  of  Congress  and  of 
the  Treasury  to  formulate  means  of  forcing  distributions 
indicate  that  an  attempt  will  be  made  to  enforce  the  present 
law. 


1264  SPECIAL   CLASSES    OF   TAXPAYERS 

Ruling.  The  question  as  to  the  unreasonable  accumulation  of 
undivided  profits  is  one  of  fact  to  be  decided  upon  a  consideration 
of  the  volume  of  business  done  and  the  principles  of  sound  business 
management.  The  fact  that  a  corporation  having  capital  stock  of 
lox  dollars  and  doing  an  annual  business  in  excess  of  150X  dollars 
has  an  accumulation  of  55X  dollars  in  undivided  profits  is  not  suffi- 
cient basis  for  finding  that  there  has  been  an  unreasonable  accu- 
mulation of  profits.     (C.  B.  I,  page  182;  S.  1117.) 

Investment  of  accumulation  in  obligations  of  the  United 
States  no  bar  to  action. — The  test  of  ability  to  distribute  Hes 
in  the  form  of  tlie  assets.  Investments  in  Liberty  bonds, 
when  no  habilities  present  or  prospective  exist,  constitute 
prima  facie  evidence  of  ability  to  distribute. 

Retirement  of  preferred  stock. — The  retirement  or  pur- 
chase of  preferred  stock  would  be  a  proper  use  of  surpkis 
earnings  and  would  not  be  deemed  to  be  a  method  of  prevent- 
ing the  imposition  of  the  surtax.' 

Reduction  of  common  stock. — The  purchase  of  common 
stock  for  the  treasury  or  the  retirement  of  common  stock,  with 
a  consequent  reduction  of  the  aggregate  stock  outstanding  or  a 
reduction  of  the  par  value  of  each  share,  cannot  in  itself  be 
deemed  to  be  a  method  of  preventing  the  imposition  of  the 
surtax.  But  if  the  common  stock  were  purchased  pro  rata 
from  stockholders  at  a  large  premium,  it  might  be  held  that 
such  purchase  is  in  effect  a  distribution  of  surplus.  If  the 
surplus  earned  since  March  i,  191 3,  had  not  been  distributed,  it 
could  hardly  be  claimed  that  the  premiinn  paid  on  the  com- 
mon stock  is  a  distribution  of  capital  surplus  or  surplus  ac- 
cumulated prior  to  March  i,  19 13. 

There  may  be  exceptional  cases  in  which  the  retirement 


"  [Former  Procedure]  A  ruling  which  directly  related  to  this  point 
was  rendered  under  the  1916  law : 

Regulation (a)  The  earnings  of  a  corporation  used  to  pur- 
chase preferred  stock  for  cancellation  are  retained  for  employment  in  the 
reasonable  requirements  of  the  business,  and  are  therefore  not  taxable. 
(T.  D.  2570,  November  6,  1917.) 


UNDISTRIBUTED    CORPORATE   PROFITS  1265 

of  common  stock  would  be  deemed  to  be  prima  facie  evidence 
that  earnings  were  unlawfully  accumulating. 

Ruling Inasmuch  as  a  retirement  of  capital  stock  would 

indicate  that  additional  capital  was  not  required,  any  retirement  of 
common  stock,  leaving  the  surplus  stand,  would  be  regarded  by  this 
office  as  making  the  corporation  one  coming  within   the  provisions 
of  Section  220  of  the  Revenue  Act  of  1918.     (C.  B.  2,  page  25;  O. 
D.  360.) 

Can  proceeds  of  sale  of  capital  assets  be  reinvested  with- 
out subjecting  stockholders  to  surtax? — Article  352  states 
that  "a  radical  change  of  business  when  a  considerable  surplus 
has  been  accumulated  may  afford  evidence  of  a  purpose  to 
escape  the  surtax." 

Many  corporations  sell  all  or  part  of  their  capital  assets 
and  receive  in  payment  cash  or  marketable  securities.  The 
question  arises,  whether  or  not  a  corporation  may  invest 
or  reinvest  the  proceeds  of  sale  without  subjecting  the  cor- 
poration to  the  25  per  cent  tax.  If  a  corporation  is  in  the  auto- 
mobile manufacturing  business  or  holds  stocks  in  other  corpor- 
ations which  are  in  that  i)usiness  and  sells  its  manufacturing 
business  or  capital  stocks  for  cash,  and  soon  thereafter  reinvests 
the  proceeds  in  other  automobile  stocks  or  resumes  the  manu- 
facture of  automobiles,  such  transactions  do  not  constitute 
a  radical  change  of  business  and  its  stockholders  could  not  be 
taxed.  If  the  corporation  sells  its  assets  and  purchases  gen- 
eral investment  securities  with  the  proceeds,  such  procedure 
involves  a  radical  change  in  the  business  and  it  could  hardly 
be  maintained  that  the  accumulated  surplus  is  held  for  the 
"reasonable  needs  of  the  business."  On  the  contrary  it  would 
be  difficult  to  argue  that  a  former  manufacturing  corporation 
with  a  large  surplus,  no  assets  except  marketable  securities 
and  no  debts,  requires  any  surplus  whatever. 

It  is  contrary  to  ordinary  commercial  methods  for  a  busi- 
ness corporation  to  transform  itself  into  an  investment  corpora- 
tion. When  stockholders  invest  in  manufacturing  or  trading 
corporations  they  hazard  their  money  and  expect  returns  com- 


1266  SPECIAL   CLASSES    OF   TAXPAYERS 

mensurate  with  the  risks  of  the  business.  Stock  in  a  bank  or 
trust  company  usually  is  looked  upon  as  less  of  a  risk.  Pur- 
chases of  one  or  the  other  are  made,  but  the  author  has  never 
heard  of  an  original  purchase  of  one  class  of  stock  by  a  pur- 
chaser who  expected  that  the  corporation  would  transform 
itself  into  a  concern  of  an  entirely  different  kind.  When  a 
corporation  does  transform  itself,  a  prima  facie  case  is  made 
out  for  the  imposition  of  the  25  per  cent  tax. 

If  corporation  sells  capital  assets  or  accumulates  funds  in 
excess  of  its  needs,  how  much  of  surplus  must  be  divided? — 

If  it  is  obvious  or  if  it  is  admitted  by  a  corporation  that 
cash  or  marketable  securities  in  hand  are  in  excess  of  the 
needs  of  the  business,  the  question  arises  as  to  what  part  of 
the  accumulated  surplus  must  be  distributed.  Ordinarily  it 
cannot  be  assumed  that  the  earnings  of  a  current  fiscal  period 
can  be  segregated  to  any  part  of  the  period.  Surplus  earnings 
accumulated  during  the  taxable  year  1922,  which  are  known 
to  be  available  as  soon  as  realization  takes  place,  fall  within 
the  purview  of  the  law.  But  the  192 1  law  can  reach  only 
unlawful  accumulations.  Surplus  which  originated  prior  to 
November  23,  1921,  if  lawfully  accumulated,  cannot  be  taxed 
at  the  25  per  cent  penalty  rate.  If  unlawfully  accumulated  it 
must  be  taxed;  if  at  all,  under  the  penalty  clauses  contained  in 
the  1913-1918  laws. 

The  Treasury  held  that  the  19 18  law  did  not  apply  to  sur- 
plus accumulated  prior  to  January  1,1918;  that  if  any  sur- 
plus was  improperly  accumulated  prior  to  that  date,  the  laws 
in  force  during  the  prior  period  are  applicable  thereto. 

Prior  to  November  2^),  192 1,  unlawful  accumulations  could 
be  taxed  only  as  if  the  stockholders  were  partners. 

The  attitude  of  the  Treasury  in  enforcing  the  penalty 
clauses  in  former  laws  is  fully  set  forth  in  one  case^  in  which 
the  Secretary  of  the  Treasury  had  certified  that  the  undis- 


•C  B.  4,  page  227;  A.  R.  R.  475. 


UNDISTRIBUTED    CORPORATE   PROFITS  1267 

tribtited  accumulations  of  profits  were  unreasonable.     Upon 
appeal  the  following  opinion  was  handed  down : 

Ruling.  The  taxpayer  contends  that  this  is  not  a  case  where 
section  2.  (A)  2  of  the  1913  Act,  section  (3)  of  the  1916  Act  and  sec- 
tion (3)  of  the  1916  Act  as  amended,  and  section  220  of  the  1918  Act 
should  be  appHed,  for  the  reason  that  the  M  Company  was  not  a 
mere  holding  company  and  did  not  permit  its  gains  and  profits  to  ac- 
cumulate beyond  the  reasonable  needs  of  the  business. 

In  the  ordinary  and  accepted  sense,  the  term  "holding  company" 
means  one  which  is  not  actively  engaged  in  business  and  which  does 
nothing  but  hold  stock  of  other  corporations.  The  M  Company  has 
been  actively  engaged  in  business  since  its  organization  and  has  con- 
sistently paid  capital  stock  taxes.  It  is  noted  that  the  1913  Act, 
quoted  above,  requires  that  the  corporation  must  be  formed  for  the 
purpose  of  preventing  the  imposition  of  the  tax  through  the  medium 
of  permitting  its  gains  and  profits  to  accumulate  instead  of  being  di- 
vided or  distributed,  or  must  have  been  fraudulently  availed  of  for 
that  purpose  before  the  Secretary  of  the  Treasury  is  authorized  to 
make  the  certification  which  has  been  made  in  this  case. 

An  examination  of  the  facts  leading  up  to  the  organization  of  this 
corporation,  the  consideration  of  the  rate  of  dividends  paid,  and  the 
amounts  carried  to  surplus  from  year  to  year  do  not  indicate  to  the 
Committee  that  the  corporation  was  frandidently  availed  of  for  the 
purpose  of  preventing  the  imposition  of  the  tax  through  the  medium 
of  permitting  the  gains  and  profits  to  accumulate  instead  of  dividing 
or  distributing  such  gains  and  profits. 

Therefore  the  Committee  recommends  that  the  action  of  the  In- 
come Tax  Unit  in  assessing  additional  taxes  for  the  years  1913  to 
1917,  inclusive,  was  in  error  and  that  such  action  be  reversed  and  that 
the  claim  filed  for  the  refunding  of  taxes  paid  on  account  of  such 
assessment  receive  favorable  consideration. 

The  Committee  has  accepted  the  Bureau's  position  with  respect  to 
the  reasonable  requirements  of  a  business  as  outlined  in  Treasury 
Decision  2736.  Applying  the  principle  therein  laid  down  to  the  facts 
in  the  instant  case,  it  would  appear  that  all  the  capital  of  the  M 
Company  which  is  invested  in  the  capital  stock  of  the  N  Company 
or  which  is  used  in  making  loans  and  otherwise  financing  such  sub- 
sidiary is  needed  in  the  business  of  such  company.  The  facts  now 
submitted  are  materially  different  from  those  submitted  to  the  Secre- 
tary of  the  Treasury  at  the  time  the  certification  in  question  was 
made.  Upon  the  basis  of  this  additional  evidence  the  present  Secre- 
tary of  the  Treasury  signed  a  resolution  recalling  the  former  certi- 
fication in  this  case.  The  Committee  is  in  full  accord  with  this  action. 
The  effect  of  this  resolution  is  to  remove  the  presumption  of  fraud 
heretofore  existing  against  the  corporation. 


1268  SPECIAL   CLASSES    OF   TAXPAYERS 

It  is  strongly  urged  that  any  taxes  assessable  under  the  provisions 
of  the  revenue  Acts  quoted  above  are  in  the  nature  of  a  penalty,  and 
in  order  that  such  assessment  may  properly  be  made  fraud  or  fraudu- 
lent intent  must  be  established.  It  is  submitted  in  the  instant  case 
that  the  corporation  in  carrying  to  surplus  a  considerable  part  of  its 
earnings  yearly  is  doing  nothing  more  than  was  contemplated  under 
the  provisions  of  its  charter.  It  is  also  submitted  that  this  corporation 
could  not  have  been  created  for  the  purpose  of  permitting  its  earn- 
ings to  accumulate,  thereby  preventing  the  imposition  of  tax  on 
such  earnings,  for  the  reason  that  the  corporation  was  organized  in 
1898.  The  mere  fact  that  the  corporation  carried  to  surplus  these 
earnings  is  not  to  be  considered  as  a  fraud  upon  the  Government, 
bearing  in  mind  always  that  the  corporation  is  not  a  mere  holding 
company,  that  it  has  considerable  income  from  operations,  rents, 
royalties,  and  from  interest  on  money  loaned  and  investments  in 
bonds.  The  corporation  has  been  conservative  in  carrying  a  con- 
siderable portion  of  its  earnings  to  surplus,  and  the  mere  fact  that 
such  earnings  were  carried  to  surplus  and  that  the  corporation  now 
has  a  large  accumulated  surplus  does  not  of  itself  authorize  the 
Income  Tax  Unit  to  assess  a  tax  against  the  stockholders  on  their 
pro  rata  share  of  such  earnings.  The  fact  that  the  corporation  in- 
creased its  dividends  and,  having  increased  the  dividends,  continued 
to  pay  same  even  though  the  earnings  of  the  corporation  fluctuated 
from  year  to  year,  substantiates  the  view  of  the  Committee  that  the 
corporation  was  not  fraudulently  availed  of  for  the  purpose  of  pre- 
venting the  imposition  of  the  tax  through  the  medium  of  permitting 
the  gains  and  profits  to  accumulate  instead  of  distributing  such  gains 
and  profits 

Election  to  be  taxed  as  individuals. — The  1921  law  pro- 
vides that  if  all  stockholders  agree,  the  corporation  may  be 
relieved  of  "all  income,  war-profits  and  excess-profits  taxes" 
and  the  stockholders  as  individuals  shall  be  taxed  upon  their 
distributive  shares.  The  only  apparent  excuse  for  such  an 
agreement  would  be  the  definite  knowledge  that  the  25  per  cent 
penalty  tax  is  to  be  enforced.  In  such  cases  stockholders 
should  agree.  But  the  contingency  can  hardly  arise  in  a  busi- 
ness corporation,  and  if  it  appears  to  arise  in  other  cases  the 
proper  procedure  is  to  distribute  current  earnings  as  they  ac- 
cumulate. 


CHAPTER  XXXVI 

NQN-RESIDENT  ALIENS 

The  192 1  law^  deals  at  greater  length  than  prior  laws  with 
the  determination  of  the  gross  income  of  non-resident  aliens 
which  is  to  be  considered  as  income  from  sources  within  the 
United  States."  What  is  so  considered  may  be  summarized 
as  follows : 

1.  Interest  on  bonds,  notes  or  other  interest-bearing  ob- 

ligations of  residents,  corporate  or  otherwise.""' 

2.  Dividends  from  certain  domestic  and  foreign  corpora- 

tions.* 
.    3.  Compensation  for  labor  or  personal  services  performed 
in  the  United  States. 

4.  Rentals  and  royalties  from  United  States  sources. 

5.  Gains  from  sale  of  real  property  located  in  the  United 

States. 

While  the  foregoing  represents  what  is  generally  taxable 
income  to  a  non-resident  alien,  there  are  various  items  not 
subject  to  tax  which  are  specifically  dealt  with  hereafter  in 
this  chapter.^  Of  these  exempt  items,  interest  on  deposits  in 
banks  located  in  the  United  States  paid  to  persons  not  engaged 
in  business  within  the  United  States  is  for  the  first  time  in- 
cluded in  the  192 1  law.  Considerable  objection  has  been  raised 
heretofore  concerning  the  taxation  of  this  interest  and  its  ex- 
emption now  will  be  as  popular  as  it  is  equitable.     Another 


*  Section  217  for  individuals.  Section  233  (b)  makes  the  classification 
in  section  217  also  applicable  to  the  gross  income  of  foreign  corporations, 
except  foreign  insurance  companies  subject  to  the  tax  imposed  by  sec- 
tions 243  and  246. 

^  For  former  procedure,  sec  Income  Tax  Procedure,  1921,  page  975 
et  seq. 

^  For  exception  relative  to  interest,   sec  page   1278. 

'  See  page  1279. 

^  See  page  1284. 

1269 


1270  SPECIAL   CLASSES    OF    TAXPAYERS 

new  feature  of  the  present  statute  is  the  exemption  from  tax- 
ation of  interest  received  from  a  resident  ahen  individual 
or  foreign  corporations  where  less  than  20  per  cent  of  the 
gross  income  of  the  payor  has,  for  the  preceding  three  years, 
been  derived  from  sources  within  the  United  States. 

From  the  taxable  items  constituting  the  gross  income  there 
may  be  deducted  items  of  expense  properly  allocated  to  such 
income.  Where  the  segregation  of  expenses  against  particular 
gains  cannot  be  made,  a  proportionate  part  of  the  total  ex- 
penses must  be  so  allocated. 

In  drafting  the  new-  law,  it  was  proposed  to  tax  citizens  or 
residents  of  the  United  States,  domestic  partnerships  or  do- 
mestic corporations,  80  per  cent  of  whose  gross  income  for  the 
past  three  years  w^as  from  sources  without  the  United  States, 
and  50  per  cent  of  whose  gross  income  for  the  past  three  years 
was  from  the  active  conduct  of  a  business  outside  the  United 
States,  only  on  the  income  arising  from  sources  within  the 
United  States  as  defined  in  section  217. 

In  place  of  this  proposal,  the  new^  law  limits  the  privilege 
to  citizens  of  the  United  States  and  to  domestic  corpora- 
tions.*^ 

Method  of  collecting  the  tax. — The  collection  of  the  tax 
may  be  made  through  two  channels : 

1.  Withholding  of  normal  tax  at  source. 

2.  Requirement  of  returns  direct  from  taxpayer. 

Only  in  case  (2)  is  a  non-resident  alien  able  to  get  the 
benefit  of  such  deductions  and  credits  as  are  allowed  him  by 
law,  except  that  benefit  of  the  $1,000  credit  allowed  by  section 


^  [Former  Procedure]  Ruling.  "A  corporation  organized  in  the 
United  States  is  subject  to  the  4  per  cent  war  income  tax  imposed  by  section 
4  of  Title  I  of  the  Revenue  Act  of  1917,  even  though  it  has 'its  principal 
office,  keeps  its  accounts,  and  does  all  of  its  business  in  Porto  Rico  and 
derives  all  of  its  income  from  sources  therein.  Such  a  corporation  should 
file  its  return  in  the  internal  revenue  district  where  its  principal  office  in  the 
United  States  is  located. 

"Law  Opinion  303  (not  in  bulletin  service)  revoked."  (C.  B.  4,  page  272; 
L.  O.  1066.) 


NON-RESIDENT    ALIENS 


1271 


216  (e)  may  be  obtained  by  filing  claim  with  the  withholding 
agent. 

Definitions. — It  is  very  important  that  taxpayers  and  those 
responsible  for  withholding  appreciate  the  real  significance  of 
the  following  definitions. 

Law.     Section  2 (4)  The  term  "foreign"  when  applied  to  a 

corporation  or  partnership  means  created  or  organized  outside  the 
United  States; 

(5)  The  term  "United  States"  when  used  in  a  geographical  sense 
includes  only  the  States,  the  Territories  of  Alaska  and  Hawaii,  and  the 
District  of  Columbia;   .... 

Foreign  partnerships  and  resident  foreign  corpora- 
tions.— 

Regulation The  nationality  or  residence  of  members 

of  a  partnership  does  not  affect  its  status.  A  partnership  created  by 
articles  entered  into  in  San  Francisco  between  residents  of  the  United 
States  and  residents  of  China  is  a  domestic  partnership.  A  foreign 
corporation  engaged  in  trade  or  business  within  the  United  States  or 
having  an  office  or  place  of  business  therein  is  sometimes  referred  to 
in  the  regulations  as  a  resident  foreign  corporation  and  a  foreign 
corporation  not  engaged  in  trade  or  business  within  the  United 
States  and  not  having  any  office  or  place  of  business  therein  as  a 
nonresident  foreign  corporation (Art.  1509.) 

Non-resident  alien  individual. — 

Regulation.  A  "nonresident  alien  individual"  means  an  indi- 
vidual (a)  whose  residence  is  not  within  the  United  States  and  (b) 
who  is  not  a  citizen  of  the  United  States.  An  alien  actually  present 
in  the  United  States  who  is  not  a  mere  transient  or  sojourner  is  a 
resident  of  the  United  States  for  purposes  of  the  income  tax. 
Whether  he  is  a  transient  or  not  is  determined  by  his  intentions  with 
regard  to  the  length  and  nature  of  his  stay.  A  mere  floating 
intention,  indefinite  as  to  time,  to  return  to  another  country 
is  not  sufficient  to  constitute  him  a  transient.  If  he  lives  in  the 
United  States  and  has  no  definite  intention  as  to  his  stay,  he  is  a 
resident.  One  who  comes  to  the  United  States  for  a  definite  purpose 
which  in  its  nature  may  be  promptly  accomplished  is  a  transient; 
but  if  his  purpose  is  of  such  a  nature  that  an  extended  stay  may  be 
necessary  for  its  accomplishment,  and  to  that  end  the  alien  makes  his 
home  temporarily  in  the  United  States,  he  becomes  a  resident,  though 
it  may  be  his  intention  at  all  times  to  return  to  his  domicile  abroad 


1272  SPECIAL   CLASSES    OF   TAXPAYERS 

when   the   purpose    for   which    he    came    has   been    consummated    or 
abandoned (Art.  311.) 

Proof  of  residence  of  alien. — 

Regulation.  The  following  rules  of  evidence  shall  govern  in 
determining  whether  or  not  an  alien  within  the  United  States  has 
acquired  residence  therein  within  the  meaning  of  the  Revenue  Act. 
An  alien,  by  reason  of  his  alienage,  is  presumed  to  be  a  nonresident 
alien.  Such  presumption  may  be  overthrown  (i)  in  the  case  of  an 
alien  who  presents  himself  for  determination  of  tax  Hability  prior  to 
departure  for  his  native  country,  by  (a)  proof  that  the  alien,  at 
least  six  months  prior  to  the  date  he  so  presents  himself,  has  filed  a 
declaration  of  his  intention  to  become  a  citizen  of  the  United  States 
under  the  Naturalization  Laws,  (b)  proof  that  the  alien,  at  least 
six  months  prior  to  the  date  he  so  presents  himself,  has  filed  Form 
1078  or  its  equivalent,  or  (c)  proof  of  acts  and  statements  of  the 
alien  showing  a  definite  intention  to  acquire  residence  in  the  United 
States  or  showing  that  his  stay  in  the  United  States  had  been  of  such 
an  extended  nature  as  to  constitute  him  a  resident;  (2)  in  other 
cases  by  (a)  proof  that  the  alien  has  filed  a  declaration  of  his  in- 
tention to  become  a  citizen  of  the  United  States  under  the  naturaliza- 
tion laws,  (b)  proof  that  the  alien  has  filed  Form  1078  or 
its  equivalent,  or  (c)  proof  of  acts  and  statements  of  an  alien  show- 
ing a  definite  intention  to  acquire  residence  in  the  United  States  or 
showing  that  his  stay  in  the  United  States  has  been  of  such  an  ex- 
tended nature  as  to  constitute  him  a  resident.  In  any  case  in  which 
an  alien  seeks  to  overcome  the  presumption  of  nonresidence  under 
(i)  (c)  or  (2)  (c)  above,  if  the  officer  who  examines  the  alien  is  in 
doubt  as  to  the  facts,  such  officer  may,  to  assist  him  in  determining 
the  facts,  require  an  affidavit  or  affidavits  setting  forth  the  facts  relied 
upon,  executed  by  some  credible  person  or  persons,  other  than  the 
alien  and  members  of  his  family,  who  have  known  the  alien  at  least 
six  months  prior  to  the  date  of  execution  of  the  affidavit  or  affidavits. 
(Art.  312;  Reg.  45,  Art.  313.) 

Loss  of  residence  by  alien. — 

Regulation.  An  alien  who  has  acquired  residence  in  the  United 
States  retains  his  status  as  a  resident  until  he  abandons  the  same 
and  actually  departs  from  the  United  States.  An  intention  to  change 
his  residence  does  not  change  his  status  as  a  resident  alien  to  that  of 
a  nonresident  alien.  Thus  an  alien  who  has  acquired  a  residence 
in  the  United  States  is  taxable  as  a  resident  for  the  remainder  of 
his  stay  in  the  United  States.  The  status  of  an  alien  on  the  last  day 
of  his  taxable  year  or  period  determines  his  liability  to  tax  for  such 


NON  RESIDENT    ALIENS  1273 

year   or   period   as    a    resident    or    nonresident (Art.    313; 

Reg.  45,  Art.  314.) 

Determination  of  status  of  alien  leaving  the  United  States. 

— The  status  of  an  alien  leaving  the  United  States  during  the 

taxable  year  is  determined  by  his  status  on  the  last  day  of  his 

taxable  period. 

Ruling The    taxable    period    is   the    interval   between 

January  i  and  the  last  day  of  the  month  preceding  his  departure. 
If  the  alien  had  formed  no  intention  of  leaving  the  United  States 
by  such  date  he  will  be  taxed  as  a  resident  alien.  If,  however,  his 
intention  to  depart  was  formed  prior  to  the  last  day  of  the  month 
preceding  departure,  he  will  be  taxed  as  a  nonresident  alien  for  such 
period.  In  either  case  the  alien  is  entitled  to  the  full  exemption  and 
credit  for  dependents  that  he  would  have  been  entitled  to  had  his  re- 
turn been  filed  for  the  full  taxable  year.  If  the  absence  of  a  resident 
alien  is  to  be  only  temporary,  he  will  not  lose  his  status  as  resident  by 
reason  of  such  absence.     (C.  B.  2,  page  243 ;  O.  D.  468.) 

Alien  seaman — when  to  be  regarded  as  resident. — 
Regulation.  In  order  to  determine  whether  an  alien  seaman  is  a 
resident  within  the  meaning  of  the  income-tax  law,  it  is  necessary  to 
decide  whether  the  presumption  of  nonresidence  is  overcome  by 
facts  showing  that  he  has  established  a  residence  in  the  territorial 
United  States,  which  consists  of  the  States,  the  District  of  Columbia, 
and  the  Territories  of  Hawaii  and  Alaska,  and  excludes  other  places. 
Residence  may  be  established  on  a  vessel  regularly  engaged  in  coast- 
wise trade,  but  the  mere  fact  that  a  sailor  makes  his  home  on  a 
vessel  flying  the  United  States  flag  and  engaged  in  foreign  trade  is 
not  sufficient  to  establish  residence  in  the  United  States,  even  though 
the  vessel,  while  carrying  on  foreign  trade,  touches  at  American 
ports.  An  alien  seaman  may  acquire  an  actual  residence  in  the  ter- 
ritorial United  States  within  the  rules  laid  down  in  article  312,  al- 
though the  nature  of  his  calling  requires  him  to  be  absent  from  the 
place  where  his  residence  is  established  for  a  long  period.  An  alien 
seaman  may  acquire  such  a  residence  at  a  sailor's  boarding  house  or 
hotel,  but  such  a  claim  should  be  carefully  scrutinized  in  order  to 
make  sure  that  such  residence  is  bona  fide.  The  filing  of  Form  1078 
or  taking  out  first-citizenship  papers,  is  proof  of  residence  in  the 
United  States  from  the  time  the  form  is  filed  or  the  papers 
taken  out,  unless  rebutted  by  other  evidence  showing  an  intention  to 
be  a  transient.  The  fact  tliat  a  head  tax  has  been  paid  on  behalf  of 
an  alien  seaman  entering  the  United  States  is  no  evidence  that  he  has 
acquired  residence  because  the  head  tax  is  payable  unless  the  alien 
who  is  entering  the  country  is  merely  in  transit  through  the  country. 


12/4  SPECIAL   CLASSES    OF   TAXPAYERS 

An   alien   may   remain   a   nonresident  although   he   is   not   in   transit 
through  the  country [Art.  311  (a).] 

It  is  apparent  from  the  foregoing  regulations  that  resi- 
dence for  income  tax  purposes  is  a  question  both  of  intent 
and  of  fact.  If  an  ahen  Hves  as  long  as  one  year  within  the 
United  States,  such  fact  is  presumptive  but  not  conclusive  evi- 
dence as  to  residence.'^  Nevertheless,  the  pay-rolls  of  an  em- 
ployer may  be  accepted  as  written  evidence  of  an  employee's 
continuous  residence  in  the  United  States,  thereby  establish- 
ing his  status  as  a  resident  alien,  unless  the  employer  knows 
that  the  employee  does  not  intend  to  remain  here  permanently.* 
A  member  of  a  foreign  partnership  who  is  within  the  territorial 
limits  of  the  United  States  seven  or  eight  months  of  the  year 
does  not  become  a  resident  if  his  presence  here  is  to  complete 
business  for  his  firm  and  if  when  that  is  accomplished  he  returns 
abroad.^  A  non-resident  alien  who  has  served  at  least  one 
year  in  the  United  States  Army  has  been  considered  a  resident 
for  income  tax  purposes.^"  It  is  necessary  for  a  widow  who 
was  a  citizen  before  her  marriage  to  a  non-resident  alien  to 
register  as  an  American  citizen  with  a  United  States  consul 
within  one  year  after  the  death  of  her  husband  if  she  would 
become  a  citizen  instead  of  a  non-resident  alien  for  tax  pur- 
poses.^^  Members  of  the  families  of  foreign  ambassadors  and 
attaches,  secretaries  and  servants  included  in  their  suites, 
are  held  to  have  the  status  of  non-resident  aliens  for  tax  pur- 
poses and  are  subject  to  taxation  only  as  income  from  any 
business  conducted  by  them  in  the  United  States. ^^  Non-resi- 
dent naturalized  citizens  who  expatriate  themselves  but  sub- 
sequently apply  to  an  American  consul  for  registration  as 
American  citizens,  do  not  thereby  become  repatriated  though 
their  registration  is  accepted  by  the  Department  of  State.^' 


'  C.  B.  I,  page  164;  O.  D.  197. 
"Treasury  Bulletin  "B,"  page  13. 
°  C.  B.  3,  page  128;  O.  D.  S92. 
'"C.  B.  I,  page  163;  O.  D.'  117. 
"C.  B.  2,  page  59;  O.  D.  533. 
"  I-1-5  ;  T.  D.  3266. 
"C.  B.  4,  page  59;  O.  D.  861. 


NON-RESIDENT   ALIENS  1275 

Duty  of  employer  to  determine  status  of  alien  employee. — 

.Regulation.  If  wages  are  paid  to  aliens  without  withholding  the 
tax,  except  as  permitted  in  article  315,  the  employer  should  be  pre- 
pared to  prove  the  status  of  the  alien  as  provided  in  the  foregoing 
articles.  An  employer  may  rely  upon  the  evidence  of  residence  af- 
forded by  the  fact  that  an  alien  has  filed  Form  1078  or  an  equivalent 
certificate  of  the  alien  establishing  residence.  An  employer  need  not 
secure  Form  1078  from  the  alien  if  he  is  satisfied  that  the  alien  is  a 
resident  alien.  An  employer  who  seeks  to  account  for  failure  to 
withhold  in  the  past,  if  he  had  not  at  the  time  secured  Form  1078  or 
its  equivalent,  is  permitted  to  prove  the  former  status  of  the  alien 
by  any  competent  evidence.  The  written  statement  of  the  alien 
employee  jnay  ordinarily  be  relied  upon  by  the  employer  as  proof 
that  the  alien  is  a  resident  of  the  United  States.      (Art.  314.) 

Form  1078 — "Certificate  of  alien  claiming  residence  in  the 
United  States." — The  presumption  of  non-residence  is  over- 
come by  obtaining  from  the  ahen  form  1078  (revised)  or  an 
equivalent  certificate  of  alien  claiming  residence.  Ordinarily 
this  form  should  be  executed  before  any  officer  duly  authorized 
to  administer  oaths. 

Ruling However,    if   such   an    officer    is   not   reasonably 

accessible,  it  will  be  accepted  if  signed  in  the  presence  of  an  officer 
of  the  employer  company  under  whose  supervision  the  employee's 
duties  are  performed,  and  one  other  credible  witness.  If  the  with- 
holding agent  did  not  procure  this  form  or  its  equivalent,  at  the  time 
of  payment,  he  may  prove  the  former  status  of  the  alien  by  any 
material  evidence.  Execution  of  this  form  does  not  bind  the  alien 
to  become  a  citizen  or  to  reside  here  permanently.  Furthermore,  it 
will  not  be  necessary  to  procure  this  certificate  every  taxable  year. 
It  is  applicable  to  the  year  during  which  filed  and  subsequent  years. 
The  employer  should  keep  a  record  of  each  Form  1078  filed.  The 
forms  should  be  sent  to  the  Commissioner  of  Internal  Revenue,  Sort- 
ing Division,  Washington,  D.  C,  not  later  than  the  20th  of  the  month 
succeeding  that  during  which  the  certificate  was  received.  (Treasury 
Bulletin  "B,"  page  14.)^* 

If  form  1078  (revised)  was  not  secured  from  an  alien 
and  the  employer  is  required  to  account  for  failure  to  with- 
hold tax  in  the  past,  the  employer  is  permitted  to  submit  pay- 


"  Pending  further  revision  of  form  1078  (revised  January,  1920)  in- 
formation regarding  length  of  employment  and  amnnnt  paid  need  not  he 
supplied  on  tliis  form.     (B.  37-20-1194;  O.  D.  660.) 


1276  SPECIAL   CLASSES    OF   TAXPAYERS 

roll  records  as  written  evidence  or  proof  of  the  status  of  the 
alien/^ 

Gross  income  defined. — The  gross  income  of  non-resident 
alien  individuals"  and  foreign  corporations^'  is  covered  by 
the  following  statutory  provisions  and  regulations : 

Law.     Section  213 (c)  In  the  case  of  a  nonresident  alien 

individual,  gross  income  means  only  the  gross  income  from  sources 
within  the  United  States,  determined  under  the  provisions  of  section  217. 

Regulation.  In  the  case  of  nonresident  alien  individuals  ''gross 
income"  means  only  the  gross  income  from  sources  within  the  United 

States,  determined  under  the  provisions  of  section  217 As 

to  the  gross  income  of  foreign  corporations  see  section  233  (b)  of  the 

statute  and  article  550;  also  section  217 The  items  of  gross 

income  from  sources  without  the  United  States  and  therefore  not 
taxable  to  nonresident  aliens  or  foreign  corporations  are  described 
in  section  217  (c)    ....      (Art.  92.) 

The  essential  differences  between  the  192 1  law  and  the 
statute  of  1918^^  are  contained  in  section  217  of  the  former, 
which  is  referred  to  in  the  foregoing  regulation.  In  so  far  as 
income  is  concerned  the  material  changes  are  the  e.vchision 
under  specific  conditions,  of 


"Treasury  Bulletin  "B,"  page  13;  see  also  Income  Tax  Procedure,  1920, 
page  818. 

'*  Members  of  foreign  partnerships  are  taxed  in  their  individual  capacity 
upon  their  respective  shares  of  income  of  the  partnership  from  sources 
within  the  United  States.  However,  withholding  is  now  required.  See  page 
1306. 

"  Under  the  Revenue  Act  of  1916  the  Treasury  ruled  that  foreign 
corporations,  of  the  nature  specified  as  being  exempt  from  taxation,  are  in 
the  tax-exempt  class.  There  has  been  no  subsequent  ruling  on  this  point, 
but  the  wording  of  the  law  would  imply  that  such  organizations  are  exempt 
from  tax. 

'*  [Former  Procedure]  The  following  definition  of  "gross  income" 
obtained  under  the  1918  law : 

Regulation.  "In  the  case  of  nonresident  alien  individuals  'gross  in- 
come' means  only  the  gross  income  from  sources  within  the  United  States. 
This  includes  interest  on  bonds,  notes  or  other  interest-bearing  obligations 
of  residents,  corporate  or  otherwise,  dividends  from  resident  corporations, 
amounts  received  representing  profits  on  the  manufacture  or  disposition  of 
goods  within  the  United  States,  rentals  and  royalties  from  property  and 
income  from  business  carried  on  in  the  United  States,  interest  on  deposits 
in  banks  located  within  the  United  States,  income  from  capital  otherwise 
invested  in  the  United  States,  and  income  from  services  rendered  or  labor 
performed  within  the  United   States "    (Reg.  45,   1918,  Art.  91.) 


NON-RESIDENT   ALIENS 


1277 


1.  Interest   on    deposits    with   persons    carrying   on    the 

banking  business. 

2.  Interest   received   from   resident  alien   individuals   or 

resident  foreign  corporations  when  less  than  20  per 
cent  of  the  gross  income  of  the  payor,  for  the  three 
preceding  years,  has  been  derived  from  sources 
within  the  United  States. 

3.  Dividends   from  corporations  entitled  to  the  benefits 

of  section  262. 

4.  Earnings  derived  from  the  operation  of  ships  under 

circumstances  defined  in  section  213    (b-8). 

The  changes  in  the  nature  of  additional  inclusions  are: 

1.  Dividends  from  foreign  corporations  50  per  cent  or 

more  of  whose  gross  income  for  the  three  years 
preceding  the  declaration  of  such  dividend  was  de- 
rived from  sources  within  the  United  States. 

2.  Gains,  profits  and  income  from  the  sale^®  of  real  prop- 

erty located  in  the  United  States. 

3.  Rentals   and   royalties   are   extended  to   embrace   the 

use  of,  or  privilege  of  using,  in  the  United  States, 
patents,  copyrights,  formulas,  trademarks  and  other 
like  property. 

Ruling.  The  profit  derived  by  a  nonresident  alien  author  from 
the  sale  of  all  rights  of  serial  publication  in  the  United  States  in 
certain  stories  is  not  considered  as  income  from  a  source  within  the 
United  States  and  accordingly  is  not  subject  to  withholding.  (B. 
32-21-1759;  O.  D.  988.) 

Law.  Section  233 (b)  In  the  case  of  a  foreign  corpo- 
ration, gross  income  means  only  gross  income  from  sources  within 
the  United  States,  determined  (except  in  the  case  of  insurance  com- 
panies subject  to  the  tax  imposed  by  section  243  or  246)  in  the  manner 
provided  in  section  217. 

There  is  no  difference  in  the  computation  of  the  gross  in- 


"' Law.  Section  217.  "...  (f)  As  used  in  this  section  the  words  'sale' 
or  'sold'  include  'exchange'  or  'exchanged' ;  and  the  word  'produced'  includes 
'created,'  'fabricated,'  'manufactured,'  'extracted,'  'processed,'  'cured,'  or 
aged,'  .  .  .  .  " 


1278  SPECIAL   CLASSES    OF   TAXPAYERS 

come  of  foreign  corporations  and  non-resident  alien  individ- 
uals.    Both  are  governed  by  section  217  of  the  statute. 

Regulation.  The  gross  income  of  a  foreign  corporation,  includ- 
ing a  mutual  insurance  company,  means  its  gross  income  from 
sources  within  the  United  States,  as  defined  and  described  in  section 
217  and  articles  316-328  relating  to  nonresident  alien  individuals. 
....      (Art.  550.) 

Income  of  Non-resident  Alien  Individuals  or  of  Citizens 
Entitled  to  Benefit  of  Section  262 

Section  213  (c)"°  defines  gross  income  as  that  determin- 
able under  section  217,  which  has  two  main  divisions: 

1.  Income  from  sources  within  the  United  States,  covered 

by  subdivision   (a). 

2.  Income  from  sources  without  the  United  States,  cov- 

ered by  subdivision   (c). 

Income  from  sources  within  the  United  States. — 

Law.  Section  217.  (a)  That  in  the  case  of  a  nonresident  alien 
individual  or  of  a  citizen  entitled  to  the  benefits  of  section  262  the 
following  items  of  gross  income  shall  be  treated  as  income  from  sources 
within  the  United  States:   .... 

Interest. — 

Law.  Section  217.  (a)  ....  (i)  Interest  on  bonds,  notes, 
or  other  interest-bearing  obligations  of  residents,  corporate  or  other- 
wise, not  including  (A)  interest  on  deposits  with  persons  carrying  on 
the  banking  business  paid  to  persons  not  engaged  in  business  within 
the  United  States  and  not  having  an  office  or  place  of  business  therein, 
or  (B)  interest  received  from  a  resident  alien  individual  or  a  resident 
foreign  corporation  v/hen  it  is  shown  to  the  satisfaction  of  the  Com- 
missioner that  less  than  20  per  centum  of  the  gross  income  of  such 
resident  payor  has  been  derived  from  sources  within  the  United  States, 
as  determined  under  the  provisions  of  this  section,  for  the  three-year 
period  ending  with  the  close  of  the  taxable  year  of  such  payor,  or 
for  such  part  of  such  period  immediately  preceding  the  close  of  such 
taxable  year  as  may  be  applicable;   .... 

^  See  page  1276. 


NON-RESIDENT    ALIENS 


1279 


Dividends. — 


Law.  Section  217.  (a)  ....  (2)  The  amount  received  as  divi- 
dends (A)  from  a  domestic  corporation  other  than  a  corporation  en- 
titled to  the  benefits  of  section  262,  or  (B)  from  a  foreign  corporation 
unless  less  than  50  per  centum  of  the  gross  income  of  such  foreign  cor- 
poration for  the  three-year  period  ending  with  the  close  of  its  taxable 
year  preceding  the  declaration  of  such  dividends  (or  for  such  part  of 
such  period  as  the  corporation  has  been  in  existence)  was  derived  from 
sources  within  the  United  States  as  determined  under  the  provisions 
of  this  section;   .... 

Dividends  paid  by  resident  corporations  are  included  in 
gross  income,  but  as  they  are  allowed  as  a  deduction  under 
section  234  (a-6),  no  tax  is  payable  thereon. 

The  following  excerpt  from  the  regulations  covering  the 
foregoing  subsection  of  the  law,  calls  attention  to  the  necessity 
of  the  taxpayer  proving  that  the  income  he  reports  hereunder 
falls  within  the  meaning  of  the  law'. 

Regulation.  There  shall  be  included  in  the  gross  income  from 
sources  within  the  United  States,  of  nonresident  alien  individuals, 
foreign  corporations  and  citizens  of  the  United  States  or  domestic 
corporations  which  are  entitled  to  the  benefits  of  section  262,  all  in- 
terest received  or  accrued,  as  the  case  may  be,  on  bonds,  notes,  or 
other  interest-bearing  obligations  of  residents  of  the  United  States, 
whether  corporate  or  otherwise,  except : 

(a)  Interest  paid  on  deposits  with  persons,  including  individuals, 
partnerships,  or  corporations  carrying  on  the  banking  business,  to 
persons  (nonresident  alien  individuals,  foreign  corporations  and  citi- 
zens of  the  United  States,  or  domestic  corporations  entitled  to  tlie 
benefits  of  sec.  262)  not  engaged  in  business  within  the  United 
States,  and  not  having  an  oiifice  or  place  of  business  therein;  and 

(b)  Interest  received  from  a  resident  alien  individual  or  a  resi- 
dent foreign  corporation  when  it  is  shown  to  the  satisfaction  of  the 
Commissioner  that  less  than  20  per  cent  of  the  gross  income  of  such 
resident  payor  has  been  derived  from  sources  within  the  United  States 
for  the  three-year  period  ending  with  the  close  of  the  taxable  year  of 
such  payor,  or  for  such  part  of  such  period  immediately  preceding 
the  close  of  such  taxable  year  as  may  be  applicable. 

Any  taxpayer  who  excludes  from  gross  income  from  sources  with- 
in the  United  States  income  of  the  type  specified  in  (a)  or  (b)  above 
shall  file  with  his  return  a  statement  setting  forth  the  amount  of  such 
income  and  .such  information  as  may  be  necessary  to  show  that  the 
income  is  of  the  type  specified  in  those  paragraphs.     (Art.  317.) 


I28o  SPECIAL   CLASSES    OF   TAXPAYERS 

Compensation. — 

Law.  Section  217.  (a)  .  .  .  .  (3)  Compensation  for  labor  or 
personal  services  performed  in  the  United  States;   .... 

Regulation.  Gross  income  from  sources  within  the  United  States 
includes  compensation  for  labor  or  personal  services  performed  within 
the  United  States  regardless  of  the  residence  of  the  payor,  of  the  place 
in  which  the  contract  for  services  was  made,  or  of  the  place  of  pay- 
ment. When  a  specific  amount  is  paid  for  labor  or  personal  services 
performed  in  the  United  States,  such  amount  shall  be  included  in  the 
gross  income.  When  'no  accurate  allocation  or  segregation  of  com- 
pensation for  labor  or  personal  services  performed  in  the  United 
States  can  be  made,  or  when  such  labor  or  service  is  performed  partly 
within  and  partly  without  the  United  States,  the  amount  to  be  in- 
cluded in  the  gross  income  shall  be  determined  by  an  apportionment 
on  the  time  basis,  i.  e.,  there  shall  be  included  in  the  gross  income 
an  amount  which  bears  the  same  relation  to  the  total  compensation 
as  the  number  of  days  of  performance  of  the  labor  or  services  within 
the  United  States  bears  to  the  total  number  of  days  of  performance 
of  labor  or  services  for  which  the  payment  is  made.     (Art.  319.) 

Rentals  and  royalties. — 

Law.  Section  217.  (a)  .  .  .  .  (4)  Rentals  or  royalties  from 
property  located  in  the  United  States  or  from  any  interest  in  such 
property,  including  rentals  or  royalties  for  the  use  of  or  for  the 
privilege  of  using  in  the  United  States,  patents,  copyrights,  secret  pro- 
cesses and  formulas,  good  will,  trade-marks,  trade  brands,  franchises, 
and  other  like  property;   .... 

Sale  of  real  property. — 

Law,  Section  217.  (a)  .  .  .  .  (5)  Gains,  profits,  and  income 
from  the  sale  of  real  property  located  in  the  United  States 

Regulation (c)   A  nonresident   alien  individual,   or  a 

citizen  entitled  to  the  benefits  of  section  262  may  elect  to  be  taxed 
under  section  206  with  respect  to  sales  or  exchanges  of  property 
located  within  the  United  States,  subject  to  the  limitation  that  his 
total  tax  may  not  be  less  than  I2j^^  per  cent  of  his  total  net  income 
from  sources  within  the  United  States.     (Art.  165 1.) 

For  the  treatment  of  capital  net  gain,  see  full  discussion 
of  the  subject  in  Chapter  XVII. 

Only  non-resident  alien  individuals  are  interested  in 
whether  or  not  profits  from  sale  of  property  are  to  be  taxed 
as  a  "capital  gain,"  as  the  rate  of  tax  on  the  income  of  cor- 


NON-RESIDENT   ALIENS  1281 

porations  (both  foreign  and  domestic)  and  the  rate  of  tax 
on  capital  gains  are  identical,  viz.,  12J/I  per  cent. 

Other  income  from  sources  within  the  United 
States. — 

Regulation.  Items  of  gross  income  other  than  those  specified  in 
section  217  (a)  and  (c)  and  articles  317-323  shall  be  allocated  or  ap- 
portioned to  sources  within  or  without  the  United  States,  as  pro- 
vided in  subdivision  (e)  of  section  217. 

The  income  derived  from  the  ownership  or  operation  of  any  farm, 
mine,  oil  or  gas  well,  other  natural  deposit,  or  timber,  located  within 
the  United  States,  and  from  the  sale  by  the  producer  of  the  products 
thereof  within  or  without  the  United  States,  shall  ordinarily  be  in- 
cluded in  gross  income  from  sources  within  the  United  States.  If, 
however,  it  is  shown  to  the  satisfaction  of  the  Commissioner  that  due 
to  the  peculiar  conditions  of  production  and  sale  in  a  specific  case  or 
for  other  reasons  all  of  such  gross  income  should  not  be  allocated  to 
sources  within  the  United  States,  an  apportionment  thereof  to  sources 
within  the  United  States  and  to  sources  without  the  United  States 
shall  be  made  as  provided  in  article  327. 

Where  items  of  gross  income  are  separately  allocated  to  sources 
within  the  United  States,  there  shall  be  deducted  therefrom,  in  com- 
puting net  income,  the  expenses,  losses,  and  other  deductions  properly 
apportioned  or  allocated  thereto  and  a  ratal:)le  part  of  other  expenses, 
losses,  or  other  deductions  which  can  not  definitely  be  allocated  to 
some  item  or  class  of  gross  income.     (Art.  326.) 

C 

Income    from    sources   without    the    United    States. — The 

law  merely  defines  in  section  217  (c)  (1-5),  income  from 
sources  without  the  United  States  as  being  income  which  is 
other  than  that  provided  for  in  the  subsections  (i)  to  (5) 
of  section  217  (a)  ([uoted  above. 

Income  from  sources  both  within  and  without  the  United 

States. — 

Law.     Section   217 (e)   Items  of  gross  income,  expenses, 

losses  and  deductions,  other  than  those  specified  in  subdivisions  (a) 
and  (c),  shall  be  allocated  or  apportioned  to  sources  within  or  without 
the  United  States  under  rules  and  regulations  prescribed  by  the  Com- 
missioner with  the  approval  of  the  Secretary.  Where  items  of  gross 
income  are  separately  allocated  to  sources  within  the  United  States, 
there  shall  be  deducted  (for  the  purpose  of  computing  the  net  income 


1282  SPECIAL   CLASSES    OF   TAXPAYERS 

therefrom)  the  expenses,  losses  and  other  deductions  properly  appor- 
tioned or  allocated  thereto  and  a  ratable  part  of  other  expenses,  losses 
or  other  deductions  which  can  not  definitely  be  allocated  to  some  item 
or  class  of  gross  income.  The  remainder,  if  any,  shall  be  included  in 
full  as  net  income  from  sources  within  the  United  States.  In  the  case 
of  gross  income  derived  from  sources  partly  within  and  partly  without 
the  United  States,  the  net  income  may  first  be  computed  by  deducting 
the  expenses,  losses  or  other  deductions  apportioned  or  allocated 
thereto  and  a  ratable  part  of  any  expenses,  losses  or  other  deductions 
which  can  not  definitely  be  allocated  to  some  item  or  class  of  gross 
income;  and  the  portion  of  such  net  income  attributable  to  sources 
within  the  United  States  may  be  determined  by  processes  or  formulas 
of  general  apportionment  prescribed  by  the  Commissioner  with  the 
approval  of  the  Secretary.  Gains,  profits  and  income  from  (i)  trans- 
portation or  other  services  rendered  partly  within  and  partly  without 
the  United  States,  or  (2)  from  the  sale  of  personal  property  produced 
(in  whole  or  in  part)  by  the  taxpayer  within  and  sold  without  the 
United  States,  or  produced  (in  whole  or  in  part)  by  the  taxpayer 
without  and  sold  within  the  United  States,  shall  be  treated  as  derived 
partly  from  sources  within  and  partly  from  sources  without  the 
United  States.  Gains,  profits  and  income  derived  from  the  purchase 
of  personal  property  within  and  its  sale  without  the  United  States  or 
from  the  purchase  of  personal  property  without  and  its  sale  within 
the  United  States,  shall  be  treated  as  derived  entirely  from  the  coun- 
try in  which  sold 

Regulation.  Income  derived  from  the  purchase  and  sale  of 
personal  property  shall  be  treated  as  derived  entirely  from  the  country 
in  which  sold.  The  word  "sold"  includes  "exchanged"  and  ordinarily 
means  the  place  where  marketed.  This  article  does  not  apply  to  in- 
come from  the  sale  of  personal  property  produced  (in  whole  or  in 
part)  by  the  taxpayer  within  and  sold  without  the  United  States  or 
produced  (in  whole  or  in  part)  by  the  taxpayer  without  and  sold 
within  the  United  States (Art.  323.) 

The  following  article  of  the  new  regulations  gives  certain 
rules  for  the  allocation  of  income  derived  from  sources  partly 
within  and  partly  without  the  United  States  by  manufacturers 
and  producers. 

Regulation Manufacturers  and  producers. — Gross  income 

derived  from  the  sale  of  personal  property  produced  (in  whole  or  in 
part)  by  the  taxpayer  within  and  sold  without  the  United  States,  or 
produced  in  whole  or  in  part  by  the  taxpayer  without  and  sold  within 
the  United  States  shall  be  treated  as  derived  partly  from  sources  within 
and  partly  from  sources  without  the  United  States,  under  one  of  the 
cases  named  below.     As  used  herein,  the  word  "produced"  includes 


NON-RESIDENT   ALIENS  1283 

created,  fabricated,  manufactured,  extracted,  processed,  cured,  or 
aged. 

Case  I :  Where  the  manufacturer  or  producer  regularly  sells  part 
of  his  output  to  wholly  independent  distributors  or  other  selling  con- 
cerns in  such  a  way  as  to  establish  fairly  an  independent  factory  or 
production  price — or  shows  to  the  satisfaction  of  the  Commissioner 
that  such  an  independent  factory  or  production  price  has  been  other- 
wise established — unaffected  by  considerations  of  tax  liability,  and 
the  selling  or  distributing  branch  or  department  of  the  business  is 
located  in  a  different  country  than  that  in  which  the  factory  is 
located  or  the  production  carried  on,  the  net  income  attributable 
to  sources  within  the  United  States  shall  be  computed  by  an  accounting 
which  treats  the  products  as  sold  by  the  factory  or  productive  de- 
partment of  the  business  to  the  distributing  or  selling  department  at 
the  independent  factory  price  so  established.  In  all  such  cases  the 
basis  of  the  accounting  shall  be  fully  explained  in  a  statement  at- 
tached to  the  return. 

Case  2 :  Where  an  independent  factory  or  production  price  has 
not  been  established  as  provided  under  case  i,  the  net  income  shall 
first  be  computed  by  deducting  from  the  gross  income  derived  from 
sources  partly  within  and  partly  without  the  United  States  the 
expenses,  losses,  or  other  deductions  properly  apportioned  or  allo- 
cated thereto  and  a  ratable  part  of  any  expenses,  losses,  or  other 
deductions  which  can  not  definitely  be  allocated  to  some  item  or  class 
of  gross  income.  Of  the  amount  of  net  income  so  determined,  one- 
half  shall  be  apportioned  in  accordance  with  the  value  of  the  tax- 
payer's property  within  and  without  the  United  States,  the  por- 
tion attributable  to  sources  within  the  United  States  being  deter- 
mined by  multiplying  such  one-half  by  a  fraction  the  numerator  of 
which  consists  of  the  value  of  the  taxpayer's  property  within  the 
United  States  and  the  denominator  of  which  consists  of  the  value 
of  the  taxpayer's  property  both  within  and  without  the  United 
States.  The  remaining  one-half  of  such  net  income  shall  be  appor- 
tioned in  accordance  with  the  gross  sales  of  the  taxpayer  within  and 
without  the  United  States,  the  portion  attributable  to  sources  within 
the  United  States  being  determined  by  multiplying  such  one-half  by 
a  fraction  the  numerator  of  which  consists  of  the  taxpayer's  gross 
sales  for  the  taxable  year  or  period  within  the  United  States,  and 
the  denominator  of  which  consists  of  the  taxpayer's  gross  sales  for 
the  taxable  year  or  period  both  within  and  without  the  United 
States.  "Gross  sales  within  the  United  States"  means  the  aggregate 
arrtount  of  all  sales  made  during  the  taxable  year  which  were  prin- 
cipally secured,  negotiated  or  effected  by  employees,  agents,  offices, 
or  branches  of  tlic  taxpayer's  business  resident  or  located  in  the 
United  States. 

The   term    "property''   as   used   in   this   article   includes   only   the 


1284  SPECIAL   CLASSES    OF    TAXPAYERS 

property  held  or  used  to  produce  income  which  is  derived  from 
sources  partly  within  and  partly  without  the  United  States  ^( exclud- 
ing all  property  held  or  used  to  produce  income  which  is  allocated 
or  apportioned  under  other  articles  or  paragraphs  of  these  regula- 
tions). Such  property  should  be  taken  at  its  actual  value^  which  in 
the  case  of  property  valued  or  appraised  for  purposes  of  inventory, 
depreciation,  depletion,  or  other  purposes  of  the  Revenue  Act  of  1921 
shall  be  the  highest  amount  at  which  so  valued  or  appraised,  and 
which  in  other  cases  shall  be  deemed  to  be  its  book  value  in  the 
absence  of  affirmative  evidence  showing  such  value  to  be  greater  or 
less  than  the  actual  value.  The  average  value  during  the  taxable 
year  or  period  shall  be  employed.  The  average  value  of  property  as 
above  prescribed  at  the  beginning  and  end  of  the  taxable  year  or  period 
ordinarily  may  be  used,  unless  by  reason  of  material  changes  during 
the  taxable  year  or  period,  such  average  does  not  fairly  represent  the 
average  for  such  year  or  period,  in  which  event  the  average  shall  be 
determined  upon  a  monthly  or  daily  basis.  Bills  and  accounts  receivable 
shall  (unless  satisfactory  reason  for  a  different  treatment  is  shown) 
be  assigned  or  allocated  to  the  United  States  when  the  debtor  resides 
in  the  United  States,  unless  the  taxpayer  has  no  office,  branch  or 
agent  in  the  LTnited  States. 

Case  3  :  Application  for  permission  to  base  the  return  upon  the 
taxpayer's  books  of  account  will  be  considered  by  the  Commissioner 
in  the  case  of  any  taxpayer  who,  in  good  faith  and  unaffected  by  con- 
siderations of  tax  liability,  regularly  employs  in  his  books  of  account 
a  detailed  allocation  of  receipts  and  expenditures  which  reflects  more 
clearly  than  the  processes  or  formulas  prescribed  under  cases  I  and  2, 
the   income   derived   from   sources   within   the   United    States.     (Art. 

Computation  of  tax  where  income  is  from  sources  within 
and  without  the  United  States. — 

Regulation.  Where  a  taxpayer  has  gross  income  from  sources 
within  or  without  the  LTnited  .States  as  defined  by  section  217  (a)  or 
(c)  together  with  gross  income  derived  partly  from  sources  within 
and  partly  from  sources  without  the  United  States,  the  amounts 
thereof,  together  with  the  expenses  and  investment  applicable  thereto 
shall  be  segregated,  and  the  net  income  from  sources  within  the 
L'nited  States  shall  be  separately  computed  therefrom.      (Art.  328.) 

What  is  excluded  from  gross  income? — The  general  priji- 
ci])le  underlying  section  217  uf  the  1921  law  is  that  income 
which  non-resident  aliens  (whether  individuals  or  corpora- 
tions) derive  from  sources  within  the  United  States  shall  be 


NON-RESIDENT    ALIENS  1285 

subjected  to  the  same  income  taxes  which  have  to  be  paid  on 
similar  income  received  by  residents  or  domestic  corporations 
in  the  United  States.  There  is,  however,  certain  income  which 
is  exempt  wdien  received  by  non-resident  ahens,  some  of  it 
because  it  is  exempt  regardless  of  by  whom  received  and  some 
of  it  because  of  specific  provisions  of  law  applicable  only  to 
non-resident  aliens  or  foreign  governments. 

Income  generally  exempt. — Interest  from  state  and 
municipal  bonds,  farm  loan  bonds,  property  acquired  by  gift,"^ 
devise,  bequest  or  descent,  proceeds  of  life  insurance  paid  to  an 
individual  upon  death  of  the  insured,  and  similar  items  ex- 
pressly stated  by  law  to  be  exempt  from  tax  when  received 
by  a  resident,  are  also  exempt  when  paid  to  a  non-resident 
alien. 

Income  from  United  States  bonds  tax  exempt"  after 

March  3,  19 19. — - 

Regulation.  By  virtue  of  section  4  of  the  Victory  Liberty 
Loan  Act  of  March  3,  1919,  amending  section  3  of  the  Fourth  Lib- 
erty Bond  Act  of  July  9,  1918,  the  interest  received  on  and  after 
March  3,  1919,  on  bonds,  notes  and  certificates  of  indebtedness  of 
the  United  States  and  bonds  of  the  War  P'inance  Corporation,  while 
beneficially  owned  by  a  nonresident  alien  individual,  or  a  foreign 
corporation,  partnership,  or  association,  not  engaged  in  business  in 
the  United  States,  is ,  exempt  from  all  income  and  war-profits  and 
excess-profits  taxes.     (Art.  94.) 

This  regulation  was  numbered  93  in  the  1918  regulations. 

Income  of  foreign  governments. — 

Regulation.  The  exemption  of  income  of  foreign  Govern- 
ments applies  also  to  their  political  subdivisions.  Any  income  col- 
lected by  foreign  Governments  from  investments  in  the  United  States 
in  stocks,  bonds,  or  other  domestic  securities,  which  are  not  actually 
owned  by  but  are  loaned  to  such  foreign  Governments,  is  subject  to 
tax.  The  income  from  investments  in  the  United  States  in  bonds  and 
stocks  and  from  interest  on  bank  lialances  received  by  ambassadors 
and  ministers  accredited  to  the  United  States  and  the  fees  of  foreipn 


"  Subject  to  limitation  of  section  202   (a-2).     See  page  6iy. 
~  See  Chapter  XX. 


1286  SPECIAL   CLASSES    OF   TAXPAYERS 

consuls  are  exempt  from  tax,  but  income  of  such  foreign  officials 
from  any  business  carried  on  by  them  in  the  United  States  would  be 
taxable.-'   ....      (Art.  86.) 

Operation  of  ships^  when  earnings  are  not  included 
IN  GROSS  income. — Under  section  213  (b-8)  non-resident 
alien  or  foreign  corporations  are  not  called  upon  to  include  in 
their  gross  income  earnings  derived  from  the  operation  of 
ships  under  conditions  specified  in  the  following  regulation. 

Regulation.  The  following  additional  exclusions  from  gross  in- 
come not  provided  by  the  Revenue  Act  of  1918  are  allowed  by  the 
Revenue  Act  of  1921  : 

(i)  Income  of  a  nonresident  alien  or  foreign  corporation  consist- 
ing exclusively  of  earnings  derived  from  the  operation  of  a  ship  or 
ships  documented  under  the  laws  of  a  foreign  country  which  grants 
an  equivalent  exemption  to  citizens  of  the  United  States  and  corpo- 
rations organized  in  the  United  States.  Any  taxpayer  claiming  this 
exemption  must  file,  under  oath,  a  statement  citing  the  foreign 
statute  which  grants  the  equivalent  exemption  and  stating  fully  the 
facts  upon  which  he  relies  to  establish  his  claim;   ....      (Art.  89.) 

Rulings  regarding  income  from  sources  within  the  United 
States. — While  it  is  difficult  to  determine  from  the  law  and 
regulations  exactly  what  constitutes  income  from  sources 
within  the  United  States,  certain  items  of  income  have  been 
expressly  construed  by  the  Treasury  as  taxable  or  non-taxable. 

Ruling.  Where  bonds,  notes,  or  other  obligations  of  a  foreign 
Government  are  underwritten  by  a  United  States  banking  establish- 
ment and  are  by  their  terms  payable  at  an  office  of  such  banking 
establishment  in  the  United  States,  interest  paid  from  the  United 
States  office  to  nonresident  alien  individuals  or  foreign  corporations 
who  are  holders  of  such  securities  is  not  to  be  regarded  as  income 
received  from  a  source  within  the  United  States.  (C.  B.  i,  page  99; 
O.  786.) 

Profits'  on  exchange  realized  on  such  payments  are  held  to 
be  non-taxable  because  not  realized  from  sources  within  the 


^  "Income  from  sources  within  the  United  States  received  by  a  foreign 
ruler  in  his  individual  capacity  is  subject  to  income  tax.  Income  received 
by  him  from  property  belonging  to  the  Crown  is  not."  C.  B.  2,  page  96; 
O.  D.  483.) 


NON-RESIDENT   ALIENS  1287 

United  States.^*  The  identity  of  interest  on  such  securities  is 
lost  if  the  amount  collected  is  credited  to  an  account  in  a 
domestic  bank  and  interest  is  allowed  on  such  balances.  Under 
this  condition  the  interest  becomes  subject  to  tax.^^  The  fol- 
lowing ruling  regarding  discount  on  British  treasury  bills  is 
of  interest : 

Ruling.  Where  foreign  corporations  or  nonresident  alien  in- 
dividuals purchase  British  Government  treasury  bills  at  a  discount  in 
United  States  markets  and  collect  the  same  at  maturity  either  in  the 
foreign  country  or  from  the  paying  agent  of  that  Government  in  the 
United  States,  such  discount  is  not  income  from  sources  within  the 
United  States  and  is  not  subject  to  tax. 

Where  foreign  corporations  or  nonresident  alien  individuals  pur- 
chase British  Government  treasury  bills  at  a  discount  in  United  States 
markets  and  sell  the  same  at  a  profit  in  the  United  States,  such  profit 
is  income  from  sources  within  the  United  States  and  as  such  is  sub- 
ject to  tax.     (C.  B.  2,  page  103;  O.  D.  534.)^*' 

It  has  been  held  that  income  derived  by  a  foreign  partner- 
ship from  goods  purchased  in  the  United  States  through  a 
purchasing  agent  in  this  country  and  sold  in  foreign  coun- 
tries is  not  income  from  sources  within  the  United  States  and 
hence  is  non-taxable.^^  Salary  paid  to  a  non-resident  alien 
employee  during  a  temporary  visit  to  this  country  on  business 
has  been  held  not  to  be  income  from  sources  within  the  United 
States.^®  If  an  alien  comes  to  this  country  with  merchandise 
and  sells  it  at  a  profit,  he  receives  taxable  income,  irrespective 
of  the  time  necessary  to  complete  his  sales. ^^  Interest  on  tax- 
free  covenant  bonds  of  corporations  organized  in  the  United 
States  doing  no  business  and  owning  no  property  therein  is 


■' C.  B.  I,  page  loi ;  O.  D.  35. 

"C.  B.  I,  page  183;  O.  D.  269. 

'°  A  similar  ruling,  making  a  distinction  between  profit  on  resale  in  the 
United  States  of  foreign  government  or  corporation  bonds,  which  would  be 
taxable,  and  profit  realized  at  maturity  of  the  bonds,  which  would  not  be 
taxable  even  though  the  bonds  were  paid  off  in  the  United  States,  was 
contained  in  a  letter  from  Commissioner  Wm.  M.  Williams  to  Morris  F. 
Frey.  dated  March  21.  1921. 

"C.  B.  3,  page  128;  O.  D.  ^92. 

■"C.  B.  3,  page  128;  O.  D.  578. 

-"C.  B.  I,  page  98;  O.  D.  291. 


1288  SPECIAL    CLASSES    OF    TAXPAYERS 

non-taxable  when  paid  to  non-resident  aliens. ^°  A  non-resident 
alien  corporation  deriving  profit  from  purchase  or  sale  in  this 
country  of  bank  acceptances  is  taxable  on  such  income,  even 
though  the  corporation  has  no  office  or  place  of  business  in 
the  United  States.^^  Further  information  regarding  "trans- 
acting business  within  the  United  States"  and  income  from 
such  sources  is  afforded  by  the  following  rulings : 

Rulings.  In  construing  the  provision  of  article  66  of  Regulations 
^T,,  revised,  that  a  foreign  corporation  is  liable  to  tax  with  respect  to 
income,  the  source  of  which  is  in  the  United  States,  and  that  the 
"source"  as  used  therein  means  the  place  of  origin,  it  is  held  that 
the  place  of  origin  thus  referred  to,  is  not  restricted  to  the  place 
where  payment  is  made,  since  the  place  of  payment  may  be  ar- 
bitrarily selected  without  relation  to  the  nature  of  the  transaction 
and  is  not  indicative  of  the  source.  Where  the  income  grows  out  of 
a  business  activity  in  the  United  States  it  is  immaterial  where  actual 
payment  is  made. 

The  provision  of  article  92  of  Regulations  45,  exempting  from  tax 
the  charter  money  on  freight  shipments  received  by  a  foreign  owner 
in  regard  to  a  vessel  operated  between  the  United  States  and  a  foreign 
port,  is  limited  to  foreign  steamship  companies  having  no  office,  con- 
nections or  agency  in  the  United  States,  whose  vessels  only  occasion- 
ally touch  at  ports  in  the  United  States  and  who  can  not  otherwise  be 
regarded  as  doing  business  therein.      (  C.  B.  3,  page  265;  O.  D.  651.) 

Amounts  paid  to  a  nonresident  alien  corporation  not  having  an 
office  or  place  of  business  in  the  United  States  as  compensation  for 
orders  secured  by  it  from  foreign  customers  for  export  booked 
through  such  nonresident  alien  corporation  are  held  not  to  be  income 
from  sources  within  the  United  States  and  not  subject  to  with- 
holding.    (C.  B.  I,  page  232;  O.  D.  112.) 

Profits  derived  by  a  foreign  corporation  having  no  office 
or  place  of  business  in  the  United  States  from  a  sale  of  goods 
to  the  United  States  Government  are  not  subject  to  any  income  or 
profits  taxes  provided  for  by  the  Revenue  Act  of  1918,  where  the 
contract  for  sale  was  executed,  the  goods  manufactured  and  delivered, 
and  payment  therefor  received  by  the  foreign  corporation  outside  the 
United  States (C.  B.  4,  page  114;  A.  R.  M.  113.) 

Certain  foreign  corporations  were  organized  for  the  purpose  of 
manufacturing  certain  products.  The  entire  capital  stock  of  these 
companies  is  owned  by  a  domestic  corporation.     The  companies  have 


^^  C.  B.  I.  page  100;  O.  908. 
"  C.  B.  I,  page  232;  O.  D.  221. 


NON-RESIDENT    ALIENS  1289 

executive  and  administrative  offices  in  the  United  States,  maintained 
merely  for  the  convenience  of  the  domestic  company  which  owns 
their  stock,  the  offices  which  they  maintain  for  business  activities 
being  located  in  the  foreign  country. 

The  companies'  products  are  sold  in  the  open  market  by  the 
foreign  organization.  Any  products  sold  to  citizens  of  the  United 
States  or  to  domestic  corporations  are  sold  f.  o.  b.  shipping  point  in 
the  foreign  country.  The  merchandise  thus  sold  is  invoiced  by  the 
United  States  office,  but  this  is  merely  a  part  of  the  clerical  detail. 
The  sales  are  made  by  mail  or  through  United  States  representatives 
visiting  the  plants  in  the  foreign  country,  payments  on  the  con- 
tracts being  made  through  the  office  of  the  domestic  corporation. 

Held,  that  the  sales  are  consummated  and  the  title  to  the  property 
passes  in  the  foreign  country.  Any  profit  derived  by  the  foreign 
corporations  from  such  sales  is  not  subject  to  tax  under  the  provi- 
sions of  the  Revenue  Act  of  1918  as  income  from  sources  within  the 
United  States.     (B.  46-20-1920;  O.  D.  iioo.) 

Regulation.  While  resident  alien  seamen  are  taxable  like  citi- 
zens on  their  entire  income  from  whatever  sources  derived,  non- 
resident alien  seamen  are  taxable  only  on  income  from  sources  within 
the  United  States.  Wages  received  for  services  rendered  inside  the 
territorial  United  States  are  to  be  regarded  as  from  sources  within 
the  United  States.  The  wages  of  an  alien  seaman  earned  on  a  coast- 
wise vessel  are  from  sources  within  the  United  States There 

is  no  withholding  from  the  wages  of  alien  seamen  unless  they  are 
nonresidents  within  the  rules  laid  down  in  articles  311  to  315.  Even 
in  the  case  of  a  nonresident  alien  seaman,  the  employer  is  not  obliged 
to  withhold  from  wages  unless  those  wages  are  from  sources  within 
the  United  States  as  defined  above (Art.  93.) 

Ruling.  The  wages  of  nonresident  alien  seamen  received  for 
services  rendered  on  vessels  sailing  from  a  United  States  port  on  the 
Pacific  coast  to  a  United  States  port  on  the  Atlantic  coast,  or  vice 
versa,  via  the  Panama  Canal,  are  subject  to  withholding.  (C.  B.  4. 
page  116;  O.  D.  784.) 

Wages  earned  1))-  non-resident  aliens  on  vessels  plying  be- 
tween continental  United  States  and  Porto  Rico  do  not  con- 
stitute income  from  sources  within  the  United  States.  (C.  B., 
2,  page  162;  O.  D.  536.)  Wages  earned  by  a  non-resident 
alien  on  occasional  coastwise  voyages  on  a  vessel  regularly 
making  foreign  voyages  have  a  taxable  status. ^- 


C.  B.  I,  page  183;  O.  D.  245. 


1290 


SPECIAL   CLASSES    OF   TAXPAYERS 


Ruling.  An  annuity  paid  by  a  domestic  corporation  to  a  non- 
resident alien  individual  is  not  subject  to  withholding  except  to  the 
extent  that  the  aggregate  amount  of  the  payments  to  the  annuitant 
exceeds  the  amount  paid  to  purchase  the  annuity.  (B.  44-21-1898; 
O.  D.  1086.) 

Ruling.  A  foreign  corporation  derives  income  from  sources 
within  the  United  States  in  the  form  of  dividends,  received  from 
stock  owned  by  it  in  taxable  subsidiary  corporations  organized  and 
doing  business  in  the  United  States.  A  portion  of  the  stock  of  the 
foreign  corporation  is  deposited  with  an  American  agent,  who  issues 
certificates  of  participation  in  such  stock  and  the  dividends  thereon. 

Held,  that  since  the  foreign  corporation  derives  income  from 
sources  within  the  United  States,  any  dividends  received  by  indi- 
vidual holders  of  such  certificates  of  participation  may  be  claimed 
as  a  credit  for  the  purpose  of  the  normal  tax  as  a  deduction  from 
gross  income  in  the  case  of  corporate  holders  of  such  certificates 
subject  in  the.  case  of  foreign  corporation  holders  to  the  provisions 
of  section  234  (b)  of  the  statute.     (I-2-22;  L  T.  1160.) 

The  fact  that  foreign  steamship  companies  having  agents 
in  the  United  States,  receive  income  from  sources  within  the 
United  States  to  the  extent  of  freight  charges  paid  by  domestic 
corporations,  does  not  thereby  make  them  receive  income 
"from  sources  within  the  United  States"  under  section  217  of 
the  law.^^  Such  instances  are  purely  cases  of  domicile.  To 
have  taxable  income,  foreign  corporations  must  be  domiciled 
within  the  jurisdiction  imposing  the  tax,  or  their  property  or 
business  must  be  situated  within  such  jurisdiction  so  that  the 
income  may  be  said  to  have  a  situs  therein.^* 

Ruling,  (i)  There  is  no  income  from  sources  within  the  United 
States  from  goods  manufactured  there  unless  there  is,  in  the  language 
of  section  233  (b),^^  both  "manufacture  and  disposition  of  goods 
within  the  United  States."  The  Act  taxes  only  income  that  accrues 
within  the  United  States. 

(2)  The  mere  buying  of  goods  within  the  United  States,  with  capi- 
tal furnished  from  abroad,  to  be  sold  abroad,  is  not  a  trade  or  busi- 
ness exercised  in  the  United  States  so  as  to  subject  the  purchaser  of 


"Bulletin  36-21-1806;  O.  D.  1024. 

^*  C.  B.  3,  page  21 ;  T.  D.  311 1. 

"  [Former  Procedure]  According  to  section  233  (b)  of  the  1918  law, 
gross  income  included  "all  amounts  received  (although  paid  under  a  con- 
tract for  sale  of  goods  or  otherwise)  representing  profits  on  the  manufac- 
ture and  disposition  of  goods  within  the  United  States." 


NON-RESIDENT   ALIENS  1291 

the  goods  to  income  tax.  A  merchant  exercises  his  trade  where  he 
has  his  principal  place  of  business,  viz.,  where  his  profits  come  home 
to  him. 

If  income  be  taxed  the  recipient  thereof  must  have  a  domicile 
within  the  jurisdiction  imposing  the  tax,  or  the  property  or  business 
out  of  which  the  income  issues  must  be  situate  within  such  jurisdic- 
tion so  that  the  income  may  be  said  to  have  a  situs  therein. 

(4)  Where  a  corporation  purchases  goods  abroad  and  sells  them 
within  the  United  States,  the  profits  accruing  from  such  transactions 
are  profits  derived  from  business  carried  on  within  the  United  States 
and  the  gross  income  from  such  business  is  income  from  sources 
within  the  United  States. 

(5)  In  the  case  of  a  partnership  organized  abroad,  one  of  whose 
members  is  a  resident  citizen  of  the  United  States,  and  whose  busi- 
ness consists  in  selling  abroad  goods  consigned  to  it  from  various 
parts  of  the  world,  including  the  United  States,  upon  commission, 
title  to  the  goods  never  vesting  in  the  firm,  but  passing  directly  from 
the  consignors  to  the  purchasers,  the  business  of  the  United  States 
member  consisting  of  soliciting  consignments  of  goods,  disbursing 
proceeds  of  sales  made  abroad  in  payment  to  consignors  in  the  United 
States,  attending  to  the  shipment  of  goods,  and  making  advances  to 
consignors  on  security  of  bills  of  lading  and  express  receipts;  the 
funds  for  the  use  of  the  branch  office  in  the  United  States  being 
obtained  by  selling  drafts  on  a  foreign  city,  only  the  income  of  the 
partner  resident  within  the  United  States  is  income  from  sources 
within  the  United  States  and  subject  to  income  tax. 

(6)  A  foreign  corporation,  having  its  home  ofiice  abroad,  which 
operates  a  line  of  steamships  between  the  United  States  and  foreign 
ports,  consigns  its  steamships  to  an  American  firm,  which  handles 
them  as  agents  and  brokers,  seeing  to  the  entry  and  clearance  of  each 
steamer,  the  discharge  and  loading  of  cargo  and  supplies,  collecting 
such  part  of  the  freight  as  is  prepayable  in  this  country,  deducting 
the  amount  of  its  disbursements  and  charges  and  remitting  the  bal- 
ance to  the  foreign  corporation,  derives  income  from  sources  within 
the  United  States  to  the  extent  that  it  derives  income  from  traffic 
originating  within  the  United  States  and  is  taxable  upon  such  income. 
(C.  B.  4,  page  280;  T.  D.  3111.) 

The  place  where  property  may  he  purchased  does  not  affect 
the  determination  of  the  source  from  which  any  profit  arising 
from  its  disposition  within  the  United  States  is  derived.^" 
Income  from  property  purchased  within  the  United  States  but 
sold  without  is  not  taxable ;  income  from  property  purchased 


C.  B.  4,  page  114;  O.  D. 


1292 


SPECIAL   CLASSES    OF    TAXPAYERS 


without  the  United  States  but  sold  within  is  taxable.  The 
deciding  factor  is  where  the  property  may  be  sold.^'' 

In  connection  with  the  foregoing  rulings  concerning  steam- 
ship companies  and  foreign  merchants,  it  is  to  be  borne  in  mind 
that  the  1921  law  contains  in  section  217  (e)  specific  pro- 
visions providing  for  the  allocation  to  United  States  sources 
of  a  portion  of  transportation  or  other  services  rendered  partly 
within  and  partly  without  the  United  States  and  of  a  portion 
of  the  income  derived  from  manufacture  and  sale  when  cither 
of  these  operations  occurred  in  the  United  States.  Under  the 
19 18  law  profits  from  manufacturing  operations  w^ere  deemed 
to  have  been  earned  within  the  United  States  only  when  the 
goods  were  sold  in  this  country. 

W'here  foreign  merchants  merely  purchase  goods  in  the 
United  States,  as  distinguished  from  producing  them  (in 
whole  or  in  part)  here,  and  sell  them  abroad,  neither  the  192 1 
nor  the  191 8  law  deems  any  part  of  the  profit  to  have  arisen 
within  the  United  States. 

Allowable  deductions. — The  deductions  of  non-resident 
alien  individuals  are  restricted  by  statute  as  follows : 

Law.  Section  214.  [Xon-resident  alien  individuals]  .... 
(b)  In  the  case  of  a  nonresident  alien  individual,  the  deductions  al- 
lowed in  subdivision  (a),  except  those  allowed  in  paragraphs  (5),  (6), 
and  (11),  shall  be  allowed  only  if  and  to  the  extent  that  they  are 
connected  with  income  from  sources  within  the  United  States;  and  the 
proper  apportionment  and  allocation  of  the  deductions  with  respect  to 
sources  of  income  within  and  without  the  United  States  shall  be  de- 
termined as  provided  in  section  217  under  rules  and  regulations  pre- 
scribed by  the  Commissioner  with  the  approval  of  the  Secretary.  In 
the  case  of  a  citizen  entitled  to  the  benefits  of  section  262  the  de- 
ductions shall  be  the  same  and  shall  be  determined  in  the  same  manner 
as  in  the  case  of  a  nonresident  alien  individual. 

L.wv.  Section  234.  [Foreign  corporations]  ....  (b)  In  the 
case  of  a  foreign  corporation  or  of  a  corporation  entitled  to  the  benefits 
of  section  262  the  deductions  allowed  in  subdivision  (a)  shall  be  al- 
lowed only  if  and  to  the  extent  that  they  are  connected  with  income 
from  sources  within  the  United  States;  and  the  proper  apportionment 


The  law,  section  217   (e-2). 


NON-RESIDENT   ALIENS 


1293 


and  allocation  of  the  deductions  with  respect  to  sources  within  and 

without  the  United  States  shall  be  determined  as  provided  in  section 

217  under  rules  and  regulations  prescribed  by  the  Commissioner  with 
the  approval  of  the  Secretary. 

Regulations.  Foreign  corporations  are  allowed  the  same  de- 
ductions from  their  gross  income  arising  from  sources  within  the 
United  States  as  are  allowed  to  domestic  corporations,^^  to  the  extent 
that  such  deductions  are  connected  with  such  gross  income.  The 
proper  apportionment  and  allocation  of  the  deductions  with  respect  to 
sources  within  and  without  the  United  States  shall  be  determined  as 
provided   in  Section  217 (Art.  573.) 

The  deductions  provided  for  in  section  214  shall  be  allowed  to 
nonresident  alien  individuals  and  to  citizens  of  the  United  States  en- 
titled to  the  benefits  of  section  262,  and  the  deductions  provided  for 
in  section  234  shall  be  allowed  to  foreign  corporations  and  to  domestic 
corporations  entitled  to  the  benefits  of  section  262,  only  if  and  to 
the  extent  that  they  are  connected  with  income  from  sources  within 
the  United  States.  In  the  case  of  nonresident  alien  individuals, 
however,  (i)  losses  sustained  during  the  taxable  year  and  not  com- 
pensated for  by  insurance  or  otherwise,  if  incurred  in  any  transaction 
entered  into  for  profit,  though  not  connected  with  the  trade  or  busi- 
ness, are  deductible  only  if  and  to  the  extent  that  the  profit,  if  such 
transaction  had  resulted  in  a  profit,  would  have  been  taxable  as  in- 
come from  sources  within  the  United  States;  (2)  losses  sustained 
during  the  taxable  year  of  property  not  connected  with  the  trade  or 
business  if  arising  from  fires,  storms,  shipwreck,  or  other  casualty, 
or  from  theft,  and  if  not  compensated  for  by  insurance  or  otherwise 
are  deductible  only  if  the  property  was  located  within  the  United 
States;  and  (3)  contributions  or  gifts  made  within  the  taxable  year 
are  deductible  only  if  made  to  domestic  corporations  or  to  com- 
munity chests,  funds,  or  foundations  created  in  the  United  States  of 
the  type  specified  in  section  214  (a)  (11)  and  article  251,  or  to  the  vo- 
cational rehabilitation  fund. 

Losses  embraced  under  clauses  (2)  and  (3)  above  are  deductible 
in  full  from  items  of  gross  income  specified  as  being  derived  in  full 
from  sources  within  the  United  States,  but  if  greater  than  the  sum 
of  such  items,  the  excess  of  unabsorbed  loss  may  be  deducted  from  the 
income  apportioned  to  sources  within  the  United  States  under  the 
provisions  of  article  327.  Losses  embraced  under  clause  (i)  are  de- 
ductible in  full  ("as  provided  in  article  325  or  article  326)  when  the 
profit  from  the  transaction,  if  it  had  resulted  in  a  profit,  would  have 
been  taxable  in  full  as  income  from  sources  within  the  United  States, 
but  should  be  deducted  under  the  provisions  of  article  327  when  the 
profit   from  the  transaction,   if   it   Iiad   resulted   in  profit,   would   have 


See  Chapters  XXV-XXXIV. 


1294 


SPECIAL   CLASSES    OF   TAXPAYERS 


been  taxable  only  in  part.  The  amount  of  dividends  included  in  the 
gross  income  may  be  deducted  or  credited,  but  in  the  case  of  a  non- 
resident alien  individual,  for  the  purpose  of  the  normal  tax  only. 
(Art.  324.) 

Apportionment  of  deductions. — 

Regulation.  Froni  the  items  specified  in  articles  317-323  as 
being  derived  specifically  from  sources  within  and  vi^ithout  the 
United  States  there  shall  be  deducted  the  expenses,  losses,  and  other 
deductions  properly  apportioned  or  allocated  thereto  and  a  ratable 
part  of  any  other  expenses,  losses,  or  deductions  which  can  not 
definitely  be  allocated  to  some  item  or  class  of  gross  income.  The 
remainder  shall  be  included  in  full  as  income  from  sources  within 
the  United  States.  The  ratable  part  is  based  upon  the  ratio  of  gross 
income  from  sources  within  the  United  States  to  the  total  gross 
income. 

Example. — A  nonresident  alien  individual  derived  gross  income 
from  all  sources  for  1921  of  $180,000.     There  was  included  therein: 

$9,000  interest  on  bonds  of  a  domestic  corporation. 
4,000  dividends  on  stock  of  a  domestic  corporation. 
12,000  royalty  for  the  use  of  patents  within  the  United  States. 
11,000  gain  from  the  sale  of  real  property  located  within  the  United  States. 

$36,000  total. 

That  is,  one-fifth  of  the  total  gross  income  was  from  sources  within 
the  United  States.  The  remainder  of  the  gross  income  was  from 
sources  without  the  United  States,  determined  under  article  322 
above. 

The  expenses  of  the  taxpayer  for  the  year  amounted  to  $78,000. 
Of  these  expenses  the  amount  of  $8,000,  including  such  items  as  com- 
mission paid  for  the  sale  of  the  real  property  located  within  the 
United  States  and  interest  on  indebtedness  incurred  to  purchase  the 
stock  of  a  domestic  corporation,  is  properly  allocated  to  income  from 
sources  within  the  United  States  and  the  amount  of  $40,000  is  prop- 
erly allocated  to  income  from  sources  without  the  United  States. 

The  remainder  of  the  expenses,  $30,000,  can  not  be  definitely 
allocated  to  any  class  of  income.  A  ratable  part  thereof,  based 
upon  the  relation  of  gross  income  from  sources  within  the  United 
States  to  the  total  gross  income,  shall  be  deducted  in  computing  net 
income  from  sources  within  the  United  States.  Thus,  there  is  de- 
ducted from  the  $36,000  of  gross  income  from  sources  within  the 
United  States,  expenses  amounting  to  $14,000  (representing  $8,000 
properly  apportioned  to  the  income  from  sources  within  the  United 
States  and  $6,000,  a  ratable  part  (one-fifth)  of  the  expenses  which 
could  not  be  allocated  to  any  item  or  class  of  gross  income).     The 


NON-RESIDENT   ALIENS  1295 

remainder,  $22,000,  is  the  net  income  from  sources  within  the  United 
States.     (Art.  325.) 

Filing  of  returns  necessary  to  secure  deductions 

AND  credits. 

Regulation.  Unless  a  nonresident  alien  individual,  a  foreign 
corporation,  or  a  citizen  of  the  United  States  or  domestic  corporation 
entitled  to  the  benefits  of  section  262,  shall  file,  or  cause  to  be  filed  with 
the  collector,  a  true  and  accurate  return  of  income  from  sources  within 
the  United  States,  regardless  of  amount,  the  tax  shall  be  collected 
on  the  basis  of  the  gross  income  (not  the  net  income)  from  sources 
within  the  United  States.  Where  a  nonresident  alien  has  various 
sources  of  income  within  the  United  States,  so  that  from  any  one 
source  or  from  all  sources  combined  the  amount  of  income  shall  call 
for  the  assessment  of  a  surtax,  and  a  return  of  income  shall  not  be 
filed  by  him  or  on  his  behalf,  the  Commissioner  will  cause  a  return 
of  income  to  be  made  and  include  therein  the  income  of  such  non- 
resident alien  from  all  sources  concerning  which  he  has  information, 
and  he  will  assess  the  tax  and  collect  it  from  one  or  more  of  the 
sources  of  income  within  the  United  States  of  such  nonresident  alien, 
without  allowance  for  deductions  or  credits.'  ....      (Art.  329.) 

Credits  allowed  to  individuals.^^ — Non-resident  alien  indi- 
viduals are  allowed  a  specific  exemption  of  $1,000  whatever 
their  status  and  without  regard  to  the  reciprocal  provisions 
extended  by  the  country  of  which  they  are  nationals.  No 
additional  allowances  are  permitted  for  dependents. 

Law.     Section  216 (e)   In  the  case  of  a  nonresident  alien 

individual  or  of  a  citizen  entitled  to  the  benefits  of  section  262,  the  per- 


^'  [Former  Procedure]  Under  the  1918  law  credits  allowed  non- 
resident alien  individuals  were  the  same  as  in  the  case  of  citizens  or  resi- 
dents, conditional  upon  the  country  of  which  they  were  citizens  allowing 
similar  credits  to  citizens  of  the  United  States.  See'  1918  law,  section 
216  (e),  and  Income  Tax  Procedure,  1921,  pages  992  and  993.  To  the 
countries  named  in  Income  Tax  Procedure,  1921.  must  be  added  the  fol- 
lowing: 

Under  class  (a)  :  Malta,  Albania,  Basutoland,  Ceylon.  Gambia,  Grenada, 
Alauritius,  N.  Rhodesia,  Sierra  Leone,  "Virgin  Islands  (British),  Zanzibar, 
Bechuanaland,  Cyprus,  Gibraltar,  Hongkong,  Montscrrat,  Nyasaland  Pro- 
tectorate, Somaliland,  Wcihaiwci,  British  Guiana,  Falkland  Islands,  Gold 
Coast,  Malay  States,  Nigeria,  St.  Helena,  Swaziland,  Uganda,  Palestine, 
Armenia,  Syria,  Jamaica,  Barbados,  (jcrmany,  Hungary,  Fiji  Islands,  West- 
ern Pacific  Islands,  Kenya  and  St.  Kitts-Ncvis,  British  Honduras. 

Under  class  (b)  :  Poland  (formerly  Prussian  Poland).  Not  satisfying 
section  216  (e).    Trinidad,  Dutch  Guiana,  Straits  Settlements. 


1296  SPECIAL   CLASSES    OF    TAXPAYERS 

sonal  exemption  shall  be  only  $1,000,  and  he  shall  not  be  entitled  to 
the  credit  provided  in  subdivision  (d)    .... 

Regulations.  A  citizen  entitled  to  benefits  of  section  262  and 
a  nonresident  alien  individual,  similarly  to  a  citizen  or  resident,  are 
entitled  for  the  purpose  of  the  normal  tax  to  the  dividend  credit 
described  in  article  301.  They  are  also  entitled  in  every  case  to  a 
personal  exemption  of  $1,000.  but  under  no  circumstances  to  any 
credit  for  dependents.  Under  the  Revenue  Act  of  1921,  the  provisions 
of  tax  laws  of  the  foreign  country  of  which  a  nonresident  is  a 
citizen  or  subject  are  immaterial,  the  right  to  a  personal  exemption 
of  $1,000  being"  absolute.     (Art.  306.) 

....  The  benefit  of  the  credits  allowed  against  net  income  for 
the  purpose  of  the  normal  tax  may  not  be  received  by  a  nonresident 
alien  by  filing  a  claim  with  the  withholding  agent,  but  only  by 
claiming  it  upon  filing  a  return  of  income,  except  as  permitted  in 
articles  315  and  364 (Art.  329.) 

The  specific  exemption  is  dependent  upon  the  status  of  the 
taxpayer  on  the  last  da}'  of  the  period  covered  by  his  return. 

Credits  allowed  a  foreign  corporation. — A  foreign  corpora- 
tion is  allowed  the  same  credits  as  a  dottiestic  corporation,  ex- 
cepting the  specific  exemption  of  $2,000  to  corporations  with 
income  not  exceeding  $25,000,  which  is  not  allowed. *°  A 
foreign  corporation,  like  a  non-resident  alien  individual,  can 
ol^tain  the  full  benefit  of  credits  only  by  filing  a  complete  re- 
turn of  income  from  sources  within  the  United  States. 

Income  of  foreign  corporations  received  on  and  after 
March  3.  19 19.  from  bonds,  notes  and  certificates  of  indebted- 
ness of  the  United  States  and  bonds  of  the  War  Finance  Cor- 
poration, is  exempt  from  income  and  profits  taxes.  Such  in- 
come is  not  inchtded  in  gross  income,  and,  of  course,  a  credit 
cannot  be  taken  therefor  except  for  such  income  received  prior 
to  March  3,  19 19. 

As  is  the  case  of  non-resident  alien  individuals,  a  for- 
eign corporatioit  is  permitted  a  credit  against  its  taxes'*^  for 
any  amounts  withheld  at  the  source.     The  gross  income,  in- 

'"  Sec  Art.  591. 

"  This  should  not  be  confused  with  credits  against  income. 


NON-RESIDENT   ALIENS 


1297 


eluding-  income  upon  which  any  tax  is  withheld  at  source,  must 
be  inchided  in  the  return. 

Rates  of  tax  for  non-resident  alien  individuals/^ — 

Law.     Section  210 there  shall  be  levied,  collected,  and  for 

each  taxable  year  upon  the  net  income  of  every  individual  a  normal 
tax  of  8  per  centum  of  the  amount  of  the  net  income  in  excess  of  the 
credits  provided  in  section  216:   .... 

Rates  of  surtax. — Rates  of  surtax  on  the  income  of  non- 
resident ahens  are  the  same  as  in  the  case  of  citizens  or  resi- 
dents of  the  United  States  as  given  in  section  211.  (See 
Chapter  VII,  page  156.) 

Rates  of  tax  for  foreign  corporations. — 

Law.  Section  230.  ....  (a)  For  the  calendar  year  1921,  10 
per  centum  of  the  amount  of  the  net  income  in  excess  of  the  credits 
provided  in  section  236 ;^''  and 

(b)  For  each  calendar  year  thereafter,  12^  per  centum  of  such  ex- 
cess amount. 

Returns  of  non-resident  alien  individuals. — 

Regulation,  A  nonresident  alien  individual  shall  make  or  have 
made  a  full  and  accurate  return  on  form  1040B  of  his  income  received 
from  sources  within  the  United  States,  regardless  of  amount,  unless 

the  tax  on  such  income  has  been  fully  paid  at  the  source The 

responsible  representatives  of  nonresident  aliens  in  connection  with 
any  sources  of  income  which  such  nonresident  aliens  may  have  within 
the  United  States  shall  make  a  return  of  such  income,  and  shall  pay 
any  and  all  tax,  normal  and  additional,  assessed  upon  the  income  re- 
ceived by  them  in  behalf  of  their  nonresident  alien  principals,  in  all 
cases  where  the  tax  on  income  so  in  their  receipt,  custody  or  control 
shall  not  have  been  withheld  at  the  source (Art.  404.) 

Returns  required  of  aliens  to  secure  sailing  permits. — Sec- 
tion 250  (g)  of  the  1918  law  has  been  amplified  to  include 
specific  reference  to  the  cases  of  departing  aliens  and  imposing 
a  penalty  for  any  attempt  to  violate  this  section  of  the  law. 


''Normal  tax  on  tlic  first  $4,000  of  net  income  at  the  rate  of  4  per  cent 
applies  only  to  citizens  and  residents. 

"See  Chapter  XII  for  credits  enumerated  under  section  236. 


1298  SPECIAL   CLASSES    OF   TAXPAYERS 

Law.     Section  250 (g)  If  the  Commissioner  finds  that 

a  taxpayer  designs  quickly  to  depart  from  the  United  States  or  to  re- 
move his  property  therefrom  or  to  conceal  himself  or  his  property  there- 
in, or  to  do  any  other  act  tending  to  prejudice  or  to  render  wholly  or 
partly  ineffectual  proceedings  to  collect  the  tax  for  the  taxable  year 
then  last  past  or  the  taxable  year  then  current  unless  such  proceedings 
be  brought  without  delay,  the  Commissioner  shall  declare  the  tax- 
able period  for  such  taxpayer  immediately  terminated  and  shall  cause 
notice  of  such  finding  and  declaration  to  be  given  the  taxpayer,  to- 
gether with  a  demand  for  immediate  payment  of  the  tax  for  the  tax- 
able period  so  declared  terminated  and  of  the  tax  for  the  pre- 
ceding taxable  year  or  so  much  of  said  tax  as  is  unpaid,  whether  or 
not  the  time  otherwise  allowed  by  law  for  filing  return  and  paying  the 
tax  has  expired;  and  such  taxes  shall  thereupon  become  immediately 
due  and  payable.^*  In  any  action  or  suit  brought  to  enforce  payment 
of  taxes  made  due  and  payable  by  virtue  of  the  provisions  of  this 
subdivision  the  finding  of  the  Commissioner,  made  as  herein  pro- 
vided, whether  made  after  notice  to  the  taxpayer  or  not,  shall  be  for  all 
purposes  presumptive  evidence  of  the  taxpayer's  design.  A  taxpayer 
who  is  not  in  default  in  making  any  return  or  paying  income,  war- 
profits,  or  excess-profits  tax  under  any  act  of  Congress  may  furnish 
to  the  United  States,  under  regulations  to  be  prescribed  by  the  Com- 
missioner with  the  approval  of  the  Secretary,  security  approved  by 
the  Commissioner  that  he  will  duly  make  the  return  next  thereafter 
required  to  be  filed  and  pay  the  tax  next  thereafter  required  to  be 
paid.  The  Commissioner  m.ay  approve  and  accept  in  like  manner 
security  for  return  and  payment  of  taxes  made  due  and  payable  by 
virtue  of  the  provisions  of  this  subdivision,  provided  the  taxpayer  has 
paid  in  full  all  other  income,  war-profits,  or  excess-profits  taxes  due 
from  him  under  any  act  of  Congress.  If  security  is  approved  and  ac- 
cepted pursuant  to  the  provisions  of  this  subdivision  and  such  further 
or  other  security  with  respect  to  the  tax  or  taxes  covered  thereby  is 
given  as  the  Commissioner  shall  from  time  to  time  find  necessary  and 
require,  payment  of  such  taxes  shall  not  be  enforced  by  any  proceed- 
ings under  the  provisions  of  this  subdivision  prior  to  the  expiration 
of  the  time  otherwise  allowed;  or  paying  such  respective  taxes.  In  the 
case  of  a  citizen  of  the  United  States  about  to  depart  from  the  United 
States  the  Commissioner  may,  at  his  discretion,  waive  any  or  all  of 
the  requirements  placed  on  the  taxpayer  by  this  subdivision.  No  alien 
shall  depart  from  the  United  States  unless  he  first  secures  from  the  col- 
lector or  agent  in  charge  a  certificate  that  he  has  complied  with  all  the 
obligations  imposed  upon  him  by  the  income,  war-profits,  and  excess- 
profits  tax  laws.    If  a  taxpayer  violates  or  attempts  to  violate  this  subdi- 


"  The  same  personal  exemption  is  allowed  as  if  return  were  for  a  full 
taxable  period.  (Reg.  45,  Art.  1013.)  Credit  should  be  taken  for  any  taxes 
withheld  at  source.     (C.  B.  i,  page  253;  Mim.  2195.) 


NON-RESIDENT    ALIENS 


1299 


vision  there  shall,  in  addition  to  all  other  penalties,  be  added  as  part 
of  the  tax  25  per  centum  of  the  total  amount  of  the  tax  or  deficiency 
in  the  tax,  together  with  interest  at  the  rate  of  i  per  centum  per  month 
from  the  time  the  tax  became  due. 

(h)  The  provisions  of  subdivisions  (e),  (f)  and  (g)  of  this  section 
shall  apply  to  the  assessment  and  collection  of  taxes  vi^hich  have 
accrued  or  may  accrue  under  the  Revenue  Act  of  1917,  the  Revenue 
Act  of  1918  or  this  Act. 

The  fact  that  a  non-resident  alien  has  executed  a  power 
of  attorney  authorizing  a  domestic  bank  to  act  as  its  agent  in 
all  income  tax  matters,  does  not  relieve  a  domestic  corporation 
paying  royalties  to  such  non-resident  alien  from  the  with- 
holding requirements  of  the  law. 

The  various  instructions  issued  with  respect  to  departing 
aliens  are  not  applicable  to  representatives  of  foreign  coun- 
tries bearing  diplomatic  passports. ^'^ 

Responsibility  of  agent  for  making  return. — 

Regulation The  agent  of  a  nonresident  alien  is  respon- 
sible for  a  correct  return  of  all  income  accruing  to  his  principal  within 
the  purview  of  the  agency.  The  agency  appointment  will  determine 
how  completely  the  agent  is  substituted  for  the  principal  for  tax  pur- 
poses. Where  upon  filing  a  return  of  income  it  appears  that  a  non- 
resident alien  is  not  liable  for  tax,  but  nevertheless  a  tax  shall  have 
been  withheld  at  the  source,  in  order  to  obtain  a  refund  on  the  basis 
of  the  showing  made  by  the  return  there  should  be  attached  to  it  a 
statement  showing  accurately  the  amounts  of  tax  withheld,  with  the 
names  and  post-office  addresses  of  all  withholding  agents.  .  .  . 
(Art.  404.) 

Domestic  corporations  handling  specific  transactions  for 
foreign  customers  but  not  as  agents  are  not  required  to  file 
returns  or  withhold  taxes  for  such  customers. 

In  the  case  of  a  commission  house  in  the  United  States 
which  bought  and  sold  cotton  for  English  mills,  the  Commis- 
sioner ruled  as  follows  on  the  question  of  whether  either  the 
making  of  a  return  or  the  withholding  of  tax  was  required  of 
the  commission  house. 


Bulletin  44-21-1899;  O.  D.  1087. 


I300 


SPECIAL   CLASSES    OF   TAXPAYERS 


Ruling Inasmuch  as  you  state  that  you  have  not  been 

designated  to  act  as  agent  for  the  foreign  corporations  in  question,  to 
prepare  their  tax  returns,  or  to  otherwise  assume  general  agency  ob- 
ligations, and  since  you  were  instructed  merely  to  handle  specific 
transactions  for  such  corporations,  the  same  way  that  any  customer 
might  instruct  a  stock  broker  to  buy  or  sell  securities  for  his  account, 
it  is  held  that  you  were  not  agent  for  the  foreign  corporations  in 
transactions  of  the  character  stated,  within  the  meaning  of  the  statute 
and  regulations  before  mentioned,  and,  therefore,  are  not  required  to 
file  a  return  for  the  foreign  corporations  for  whom  such  purchases 

and    sales    were    made You    are    not    required    to    withhold 

the  tax  from  the  income  accrued  to  foreign  corporations  in  trans- 
actions such  as  those  described,  as  the  income  arising  therefrom  is 
not  deemed  to  be  fixed  or  determinable  annual  or  periodical  income 
within  the  meaning  of  Section  221  of  the  Revenue  Act  of  1918  re- 
quiring withholding.  (Letter  of  Commissioner  D.  H.  Blair,  dated 
June  8,  1921.) 

Return  for  non-resident  alien  beneficiary/'' — 

Regulation.  Where  a  citizen  or  resident  fiduciary  has  the  dis- 
tribution of  the  income  of  a  trust  any  beneficiary  of  which  is  a  non- 
resident alien,  the  fiduciary  shall  make  a  return  on  Form  1040  B  for 
such  nonresident  alien  and  pay  any  tax  shown  thereon  to  be  due. 
Unless  such  return  is  a  true  and  accurate  return  of  the  nonresident 
alien  beneficiary's  income  from  all  sources  within  the  United  States 
the  benefits  of  the  credits  and  deductions  to  which  the  beneficiary 
is  entitled  can  not  be  obtained  in  the  return  filed  by  the  fiduciary. 
....  If  the  beneficiary  appoints  a  person  in  the  United  States 
to  act  as  his  agent  for  the  purpose  of  rendering  income  tax  returns 
the  fiduciary  shall  be  relieved  from  the  necessity  of  filing  Form  1040 
B  in  behalf  of  the  beneficiary  and  from  paying  the  tax.  In  such  a 
case  the  fiduciary  shall  make  a  return  on  Form  1041  and  attach 
thereto  a  copy  of  the  notice  of  appointment.  If  there  are  two  or 
more  nonresident  alien  beneficiaries  the  fiduciary  shall  render  a  re- 
'turn  on  Form  1041*'  and  also  a  return  on  Form  1040  B  for  each  non- 
resident alien  beneficiary (Art.  425.) 

Ruling.  Where  two  separate  trusts  are  created  for  the  same 
nonresident  alien  beneficiary,  each  trustee  is  required  to  render  a 
personal  return  on  Form  1040  or  1040-A  on  behalf  of  the  nonresident 
alien,  and  pay  any  and  all  normal  tax  found  by  such  return  to  be  due 
and  any  and  all  surtax,  provided  the  income  is  not  returned  for  the 
purpose  of  the  tax  by  the  beneficiary. 


*"  See  Chapter  XXXVII  for  general  discussion  of  fiduciaries. 
^'  See  Appendix  B. 


NON-RESIDENT   ALIENS 


1 301 


If  one  of  the  trustees  is  the  representative  or  authorized  agent  of 
the  nonresident  alien,  he  may  render  a  complete  return  on  Form  1040 
or  1040-A,  combining  the  entire  net  income  from  both  trusts  and 
take  credit  on  the  return  for  any  tax  paid  by  the  other  fiduciary  in 
behalf  of  the  nonresident  alien. 

If  the  nonresident  alien  beneficiary  of  the  two  trusts  should 
appoint  a  resident  agent  for  the  purpose  of  filing  his  return  and  pay- 
ing the  tax  in  his  behalf,  it  would  not  be  necessary  for  the  two  trustees 
to  file  returns  on  Form  1040  or  1040-A,  provided  they  have  received 
notice  of  such  appointment.  The  fiduciaries,  however,  would  not 
be  relieved  from  liability  for  rendering  returns  as  such  on  Form  1041, 
as  required  by  law.      (C.  B.  3,  page  229;  O.  D.  572.) 

Returns  on  form  1040  are  required  even  though  the  aHen's 
income  consists  entirely  of  dividends  and  is  less  than  $5,000.** 

Record  owner  of  stock  is  responsible  for  making  return  and 

payifig  surtax  due.*'' — 

Regulation.  Dividends  on  stock  of  domestic  corporations  or 
resident  foreign  corporations  are  prima  facie  income  of  the  record 
owner  of  the  stock,  and  such  record  owner  will  be  liable  for  any 
additional  tax  based  thereon,  unless  a  disclosure  of  the  actual  owner- 
ship is  made  to  the  Commissioner  on  Form  1087  which  shall  show 
that  the  record  owner  is  not  the  actual  owner  and  who  the 
owner  is  and  his  address.  In  all  cases  where  the  actual  owner 
is  a  nonresident  alien  individual  and  the  record  owner  is  a  person 
in  the  United  States,  the  record  owner  will  be  considered  for  tax 
purposes  to  have  the  receipt,  custody,  control  and  disposal  of  the 
dividend  income  and  will  be  required  to  make  return  for  the  actual 
owner,  regardless  of  the  amount  of  the  income,  and  to  pay  any 
surtax  found  by  such  return  to  be  due.     (Art.  405.) 

Forms  for  making  individual  returns. — 

Regulation.  Nonresident  alien  individuals  or  their  authorized 
agents  should  use  form  1040  (revised)  or  1040A  (revised)  in  mak- 
ing returns  of  income  derived  from  sources  within  the  United 
States,  regardless  of  amount,  unless  the  tax  on  such  income  has 
been  fully  paid  at  the  source.  If  a  nonresident  alien  individual 
is  not  liable  for  any  tax  which  has  been  withheld  at  the  source,  no 
refund  of  such  tax  will  be  permitted  unless  such  a  return  is  filed 
and  a  statement  is  attached  thereto  indicating  the  amounts  of  the 
tax  withheld   and  the  names  and  post  office  addresses  of  all   with- 


Bulletin  1-19-79;  O.  D.  58. 

See  also  Chapter  X,  page  318,  for  use  of  form  1087. 


1302  SPECIAL   CLASSES    OF   TAXPAYERS 

holding  agents.  Unless  a  nonresident  alien  individual  shall  render 
a  return  of  income,  the  tax  will  be  collected  on  the  basis  of  his 
gross  income  (not  his  net  income)  from  sources  within  the  United 
States.     (Extract  from  T.  D.  2815;  dated  April  2,  1919.) 

Form  1040C  has  been  issued  for  the  use  of  non-resident 
ahen  individuals  having  net  incomes  of  not  more  than  $5,000 
for  the  taxable  period  1921.  This  form  is  largely  used  with 
sailing  permits  for  aliens.  In  accounting  for  net  incomes  of 
over  $5,000,  form  1040  must  be  used,  as  stated  above. 

Returns  for  foreign  partnerships. — While  foreign  partner- 
ships as  well  as  domestic  partnerships  are  not  taxed  as  busi- 
ness entities,  returns  on  form  1065,  regardless  of  the  amount 
of  income,  are  required  to  show  the  distributive  shares  of  the 
partners,  whether  or  not  distributed. ^°  Foreign  partnerships 
account  only  for  taxable  income  from  sources  within  the 
United  States  on  form  1065,  and  are  required  to  file  returns  if 
they  transact  business  within  the  United  States. 

Law.  ■  Section  224.  That  every  partnership  shall  make  a  return 
for  each  taxable  year,  stating  specifically  the  items  of  its  gross  income 
and  the  deductions  allowed  by  this  title,  and  chail  include  in  the  return 
the  names  and  addresses  of  the  individuals  v/ho  would  be  entitled  to 
share  in  the  net  income  if  distributed  and  the  amount  of  the  distribu- 
tive share  of  each  individual.  The  return  shall  be  sworn  to  by  any 
one  of  the  partners. 

Regulation.  Every  partnership  must  make  a  return  of  income, 
regardless  of  the  amount  of  its  net  income.  The  return  shall  be  on 
Form  1065  and  shall  be  sworn  to  by  one  of  the  partners.  Such 
return  shall  be  made  for  the  taxable  3'ear  of  the  partnership,  that 
is,  for  its  annual  accounting  period  (fiscal  year  or  calendar 
year  as  the  case  may  be),  irrespective  of  the  taxable  years  of  the 
partners (Art.  411.) 

Returns  for  foreign  corporations. — 

Regulation.  Every  foreign  corporation  and  corporation  satis- 
fying the  conditions  set  forth  under  section  262,  having  income  from 
sources  within  the  United  States  must  make  a  return  of  income  on 
Form  1 120.     If  such  a  corporation  has  no  office  or  place  of  business 

""See  page  1308  for  discussion  of  partnership  income. 


NON-RESIDENT    ALIENS  1303 

here,  but  has  a  resident  agent,  he  shall  make  the  return.  It  is  not 
necessary,  however,  for  it  to  be  required  to  make  a  return  that  the 
foreign  corporation  shall  be  engaged  in  business  in  this  country  or 

that  it  have  any  office,  branch,  or  agency  in  the  United  States 

(Art.  625.) 


Consolidated  returns." — Power  is  given  to  the  Commis- 
sioner to  consolidate  the  returns  of  foreign  corporations  when- 
ever he  deems  it  proper  to  do  so.  Given  this  discretion,  he 
should  be  asked  to  exercise  it  where  circumstances  justify  the 
reqtiest  and  where  it  would  prevent  what  would  otherwise  be 
an  evident  hardship  on  the  corporations  involved. 

Law.  Section  240.  ....  (d)  For  the  purposes  of  this  section  a 
corporation  entitled  to  the  benefits  of  section  262  shall  be  treated  as  a 
foreign  corporation:  Provided,  That  in  any  case  of  two  or  more  related 
trades  or  businesses  (whether  unincorporated  or  incorporated  and 
whether  organized  in  the  United  States  or  not)  owned  or  controlled 
directly  or  indirectly  by  the  same  interests,  the  Commissioner  may 
consolidate  the  accounts  of  such  related  trades  and  businesses,  in  any 
proper  case,  for  the  purpose  of  making  an  accurate  distribution  or 
apportionment  of  gains,  profits,  income,  deductions,  or  capital  between 
or  among  such  related  trades  or  businesses 

Return  by  agent.^'-' — Section  239  provides  that  "if  any  for- 
eign corporation  has  no  office  or  place  of  business  in  the  United 
States,  but  has  an  agent  in  the  United  States,  the  return  shall  be 
made  by  the  agent."     (See  article  625,  page  1302.) 


"'  [Former  Procedure]  LTnder  the  1918  law  no  provision  was  made 
for  the  consolidation  of  returns  for  foreign  corporations.  It  was  provided, 
however,  that  in  case  a  domestic  corporation  controlled  a  foreign  corpora- 
tion, a  credit  should  be  given  for  taxes  paid  by  the  foreign  corporation. 
This  provision  [section  240  (c)]  has  been  materially  modified  [it  is  section 
238   (c)   of  the  1921]   law.     See  Chapter  XX VIII. 

°"  Ruling.  "An  insurance  broker  in  the  United  States  who  solicits  and 
procures  insurance  for  nonresident  foreign  corporations,  collects  the  pre- 
miums thereon  and  credits  the  accounts  of  the  respective  corporations  with 
the  net  proceeds  after  deductions  are  made,  is  considered  the  resident  agent 
of  such  foreign  corporations  with  respect  to  the  business  obtained  through 
his  efforts  and  is  required  to  file  returns  for  each  nonresident  foreign  cor- 
poration covering  the  gross  income  received  from  sources  within  the  United 
States  within  the  purview  of  bis  agency,  claiming  therein  any  deductions 
to  which  the  corporations  are  entitled  and  to  pay  the  total  tax  due  thereon." 
(C.  B.  3,  page  284;  O.  D.  586.) 


1304  SPECIAL    CLASSES    OF    TAXPAYERS 

Time  and  place  for  filing  non-resident  individual  re- 
turns.^^ — 

Law.  Section  22-.  (a)  ....  In  the  case  of  a  nonresident  alien 
individual  returns  shall  be  made  on  or  before  the  fifteenth  day  of  the 
sixth  month  following  the  close  of  the  fiscal  year,  or,  if  the  return  is 
made  on  the  basis  of  the  calendar  year,  then  the  return  shall  be  made 
on  or  before  the  15th  day  of  June.  The  Commissioner  may  grant  a 
reasonable  extension  of  time  for  filing  returns  whenever  in  his  judg- 
ment good  cause  exists  and  shall  keep  a  record  of  every  such  exten- 
sion and  the  reason  therefor.  Except  in  the  case  of  taxpayers  who 
are  abroad,  no  such  extension  shall  be  for  more  than  six  months. 

(b)  Returns  shall  be  made  to  the  collector  for  the  district  in 
which  is  located  the  legal  residence  or  principal  place  of  business  ot 
the  person  making  the  return,  or,  if  he  has  no  legal  residence  or  prin- 
cipal place  of  business  in  the  United  States,  then  to  the  collector  at 
Baltimore,  Maryland. 

Time  and  place  for  filing  corporation  returns. — 

Law.  Section  241.  (a)  That  returns  of  corporations  shall  be 
made  at  the  same  time  as  is  provided  in  subdivision  (a)  of  section  227, 
except  that  in  the  case  of  foreign  corporations  not  having  any  office 
or  place  of  bvsiness  in  the  United  States  returns  shall  be  made  at  the 
same  time  as  provided  in  section  227  in  the  case  of  a  nonresident  alien 
individual. 

(b)  Returns  shall  be  made  to  the  collector  of  the  district  in 
which  is  located  the  principal  place  of  business  or  principal  office  or 
agency  of  the  corporation,  or,  if  it  has  no  principal  place  of  busi- 
ness or  principal  office  or  agency  in  the  United  States,  then  to  the 
collector  at  Baltimore,  Maryland. 

Returns  in  respect  of  money  and  other  property  sur- 
rendered to  the  Alien  Property  Custodian. — 

Ruling.  Receipt  is  acknowledged  of  your  letter  dated  October 
30,  1919,  stating  that  the  ....  Trust  Company  is  attorney-in- 
fact  for  a  non-resident  alien  client  who  is  held  to  be  an  enemy  by  the 
Alien  Property  Custodian.  On  August  22,  1918^  the  Trust  Company 
surrendered  to  the  Alien  Property  Custodian  all  money  and  securities 
in  its  possession  belonging  to  its  client.  Your  statement  is  noted, 
referring  to  article  446  of  I'iegulations  45,  that  apparently  the  Trust 
Company  was  required  to  render  a  return  at  the  time  the  money  and 
securities  were  relinquished,  .... 

In    reply,    you    are    advised    that    at    the    time    the  ....  Trust 


"Form  1065  for  foreign  partnerships  is  filed  under  the  same  conditions 
as  for  individuals. 


NON-RESIDENT    ALIENS 


1305 


Company  turned  over  the  money  and  securities  of  its  enemy  client  to 
the  AHen  Property  Custodian,  the  provisions  of  T.  D.  2673,  dated 
March  18,  1918,  were  in  force.  Under  that  decision  it  was  required 
that  "All  persons  who  on  October  6,  1917,  had,  or  since  have  had,  or 
may  hereafter  have,  control  of  any  money  or  other  property  for  any 
enemy  or  ally  of  enemy,  or  who  on  October  6,  1917,  were,  or  since 
have  been,  or  may  hereafter  be,  indebted  to  any  enemy  or  ally  of 
enemy,  shall  hold  and  deliver  all  said  money  and  property  in  all 
respects  subject  to  the  provisions  of  the  Trading  with  the  Enemy  Act 
and  to  the  order  of  the  President  of  the  United  States  and  of  the  Alien 
Property  Custodian  thereunder,  and  shall  in  due  course  file  returns  of 
income  in  respect  of  all  said  money  and  property  for  such  periods  as 
may  elapse  or  have  elapsed  prior  to  the  actual  delivery  of  said  money 
and  property  to  the  Alien  Property  Custodian." 

This  decision  was  substantially  repeated  in  article  446.  Neither 
the  language  of  the  original  ruling  nor  that  of  article  446  can  be  so 
construed  as  to  require  the  filing  of  returns  at  the  time  of  surrender- 
ing the  money  and  property  of  enemies  to  the  Alien  Property  Cus- 
todian. But  as  indicated  in  the  last  sentence  of  the  decision  given 
above,  returns  of  income  are  to  be  filed  in  due  course,  which  is  held 
to  mean  by  the  next  regular  due  date  for  the  filing  of  returns  of 
income.  The  following  ruling  of  the  Alien  Property  Custodian  under 
T.  D.  2673  is  approved  and  quoted  for  your  information,  to  wit : 
"Return  of  income  is  required  to  be  filed  in  due  course  in  respect  of 
all  money  or  other  property  for  such  part  of  the  year  1918,  or  any 
subsequent  year  as  may  elapse  prior  to  the  actual  delivery  of  the 
money  or  other  property  to  the  Alien  Property  Custodian,  but  no 
withholding  or  the  payment  of  any  taxes  is  required."  (Letter  to 
The  Corporation  Trust  Company,  signed  by  Commissioner  Daniel  C. 
Roper,  and  dated  January  19,  1920.) 

When  tax  shown  to  be  due  by  return  is  payable. — Pay- 
ment of  tax  shown  to  be  due  by  returns  as  previously  described 
shall  be  made  when  returns  are  filed  or  in  instalments  in  ac- 
cordance with  the  provisions  of  section  250.  (See  Chapter 
VIII,  page  217.) 

Extension  of  time  for  filing  returns. — The  1921  law  gives 
non-resident  alien  individuals  and  foreign  corporations  having 
no  ]jlace  of  business  in  the  United  States  three  months  longer 
for  filing  returns  than  is  allowed  residents  of  the  United 
States.^*     Consequently  it  should  be  possible  for  most  foreign 


'^'  See  section  227  on  page  1304. 


1306  SPECIAL   CLASSES    OF   TAXPAYERS 

taxpayers  to  file  their  returns  within  the  required  time  without 
securing  an  extension.  The  Commissioner  is  authorized, 
however,  to  grant  a  reasonable  extension  of  time  when  good 
cause  therefore  exists. 

Withholding  from  Non-Resident  Aliens 

The  tax  is  collected  from  non-resident  aliens  in  two  ways : 
(i)  Payment  by  the  aliens  of  the  tax  shown  to  be  due  by  re- 
turns filed;  (2)  withholding  of  normal  tax  at  the  source  in  the 
case  of  all  payments  of  fixed  and  determinable  annual  or  other 
periodical  income.  In  the  case  of  income  from  w^hich  tax  is 
deducted  at  the  source,  non-resident  aliens  are  required  to 
include  the  gross  payments  in  their  returns,  but  a  credit  is 
allowed  against  tax  for  the  amount  which  has  been  deducted 
at  the  source.  There  is  withholding  at  the  source  only  in  the 
case  of  income  described  as  "fixed  and  determinable,  annual  or 
periodical,"  and  the  withholding  provisions  of  the  law  do  not 
apply  to  foreign  partnerships,  except  in  the  case  of  payment  of 
interest  on  tax-free  covenant  bonds.  Chapter  X  discusses  in 
detail  the  use  of  various  forms  of  ownership  certificates  and 
the  use  of  withholding  returns  in  lieu  of  information  returns. 
Chapter  XI  explains  the  legal  theory  underlying  tax-free 
covenants  in  bonds  and  withholding  from  citizens  or  resi- 
dents. 

Withholding  of  tax  at  the  source. — 

Law.  Section  221.  (a)  That  all  individuals,  corporations,  and 
partnerships,  in  whatever  capacity  acting,  including  lessees  or  mort- 
gagors of  real  or  personal  property,  fiduciaries,  employers,  and  all 
officers  and  employees  of  the  United  States  having  the  control,  re- 
ceipt, custody,  disposal,  or  payment  of  interest  (except  interest  on 
deposits  with  persons  carrying  on  the  banking  business  paid  to  persons 
not  engaged  in  business  in  the  United  States,  and  not  having  an  office 
or  place  of  business  therein),  rent,  salaries,  wages,  premiums,  an- 
nuities, compensations,  remunerations,  emoluments,  or  other  fixed  or 
determinable  annual  or  periodical  gains,  profits,  and  income,  of  any 
nonresident  alien  individual  or  partnership  composed  in  whole  or  in 
part  of   nonresident  aliens    (other  than  income   received  as   dividends 


NON-RESIDENT   ALIENS  1307 

of  the  class  allowed  as  a  credit  by  subdivision  (a)  of  section  216) 
shall  (except  in  the  cases  provided  for  in  subdivision  (b)  and  except 
as  otherwise  provided  in  regulations  prescribed  by  the  Commissioner 
under  section  217)  deduct  and  withhold  from  such  annual  or  periodical 
gains,  profits,  and  income  a  tax  equal  to  8  per  centum  thereof:  Provided, 
That  the  Commissioner  may  authorize  such  tax  to  be  deducted  and 
withheld  from  the  interest  upon  any  securities  the  owners  of  which 
are  not  known  to  the  withholding  agent. 

(b)  In  any  case  where  bonds,  mortgages,  or  deeds  of  trust,  or 
other  similar  obligations  of  a  corporation  contain  a  contract  or  pro- 
vision by  which  the  obligor  agrees  to  pay  any  portion  of  the  tax  im- 
posed by  this  title  upon  the  obligee,  or  to  reimburse  the  obligee  for 
any  portion  of  the  tax,  or  to  pay  the  interest  without  deduction  for 
any  tax  which  the  obhgcr  may  be  required  or  permitted  to  pay  thereon, 
or  to  retain  therefrom  under  any  law  of  the  United  States,  the  obligor 
shall  deduct  and  withhold  a  tax  equal  to  2  per  centum  of  the  interest 
upon  such  bonds,  mortgages,  deeds  of  trust,  or  other  obligations, 
whether  such  interest  is  payable  annually  or  at  shorter  or  longer 
periods  and  whether  payable  to  a  nonresident  alien  individual  or  to  an 
individual  citizen  or  resident  of  the  United  States  or  to  a  partnership: 
Provided,  That  the  Commissioner  may  authorize  such  tax  to  be  de- 
ducted and  withheld  in  the  case  of  interest  upon  any  such  bonds,  mort- 
gages, deeds  of  trust,  or  other  obligations,  the  owners  of  which  are 
not  known  to  the  withholding  agent.  Such  deduction  and  withholding 
shall  not  be  required  in  the  case  of  a  citizen  or  resident  entitled  to  re- 
ceive such  interest,  if  he  files  with  the  withholding  agent  on  or  before 
February  i,  a  signed  notice  in  writing  claiming  the  benefit  of  the 
credits  provided  in  subdivisions  (c)  and  (d)  of  section  216;  nor  in  the 
case  of  a  nonresident  alien  individual  if  so  provided  for  in  regulations 
prescribed  by  the  Comm.issioner  under  subdivision  (g)  of  section 
217. '^s   .... 

Law.  Section  237.  That  in  the  case  of  foreign  corporations  sub- 
ject to  taxation  under  this  title  not  engaged  in  trade  or  business  within 
the  United  States  and  not  having  any  office  or  place  of  business  therein, 
there  shall  be  deducted  and  withheld  at  the  source  in  the  same  man- 
ner and  upon  the  same  items  of  income  as  is  provided  in  section  221 
a  tax  equal  to  12^/2  per  centum  thereof  (but  during  the  calendar  year 
1921  only  10  per  centum),  and  such  tax  shall  be  returned  and  paid  in 
the  same  manner  and  subject  to  the  same  conditions  as  provided  in 
that  section:  Provided,  That  in  the  case  of  interest  described  in  sub- 


"^  Withholding  in  the  case  of  payments  described  in  section  221  (a) 
(rent,  salaries,  etc.)  is  at  the  rate  of  8  per  cent,  that  being  the  normal 
tax  rate  prescribed  by  law  for  1919  and  subsequent  years.  Withholding 
of  tax  on  interest  on  so-called  tax-free  bonds,  however,  is  only  at  the  rate 
of  2  per  cent. 


1308  SPECIAL   CLASSES    OF   TAXPAYERS 

division  (b)  of  that  section  the  deduction  and  withholding  shall  be 
at  the  rate  of  2  per  centum. 

Regulation.  With  respect  to, payments  to  foreign  corporations 
not  engaged  in  trade  or  business  within  the  United  States  and  not 
having  any  office  or  place  of  business  therein,  withholding  is  re- 
quired of  a  tax  of  2  per  cent  in  the  case  of  interest  payable  upon 
corporate  bonds  or  other  obligations  containing  a  tax-free  covenant 
clause,  and  of  a  tax  of  12J/'  per  cent  (10  per  cent  during  the  calen- 
dar year  1921)   in  the  case  of  other  fixed  or  determinable  annual  or 

periodical  income,  other  than  corporate  dividends To  enable 

debtors  in  the  L^nited  States  to  distinguish  between  foreign  corpora- 
tions which  have  and  those  which  have  not  any  office  or  place  of  busi- 
ness in  the  United  States,  and  also  to  enable  such  corporations  as  have 
an  office  or  place  of  business  in  the  United  States  to  claim  exemption 
from  withholding  the  tax  on  bond  interest  or  other  income,  a  certifi- 
cate, Form  108^,  stating  that  any  such  corporation  has  an  office  or 
place  of  business  in  the  L^nited  States  should  be  filed  by  it  with  the 
debtor.     (Art.  6or.) 

Ruling.  The  obHgation  of  a  person  in  the  United  States  to  pay 
to  a  foreign  bank  amounts  representing  drafts  and  interest  thereon, 
drawn  by  him  and  accepted  by  the  foreign  bank,  is  such  an  "interest- 
bearing  obligation"  as  is  contemplated  by  section  233  (b),  regard- 
less of  the  fact  that  tlie  debt  was  incurred  outside  the  United  States 
and  the    interest   was   paid    in    a    foreign    country   in    foreign   money. 

The  interest  is  subject  to  withholding (B.  41-21-1863;   O. 

D.  1062.) 

Withholding  in  case  of  partnerships. — A  partnership 
composed  in  whole  or  in  part  of  non-resident  ahens,  is  subject 
to  the  withholding  provisions  of  the  statute. 

Ruling Withholding   required    from    payments   of    in- 
come specified  in  Section  221   (a)  Revenue  Act  of  1921  made  to  part- 
nerships composed  in  whole  or  in  part  of  nonresident  aliens.     (Tele-, 
gram  signed  by  Commissioner  D.  H.   Blair,  and  dated  December  8, 
1921.) 

Nevertheless,  the  foregoing  does  not  apply  in  the  case  of 
a  partnership  having  an  office  or  place  of  business  in  the  United 
States. 

Ruling.  Section  221  of  the  Revenue  Act  of  1921  provides  for 
withholding  of  a  tax  equal  to  8  per  cent  from  the  annual  or  periodi- 
cal gains,  profits,  or  income  of  a  partnership  composed  in  whole  or 
in   part   of   nonresident   aliens.      (See   sec.    221.)      However,    in   the 


NON-RESIDENT    ALIENS  1309 

case  of  a  partnership  having  an  office  or  place  of  business  in  the 
United  States,  withholding  will  not  be  required,  even  though  one  or 
more  of  the  members  thereof  is  a  nonresident  alien;  the  partnership, 
however,  as  agent  of  the  nonresident  alien  member  or  members,  shall 
file  a  return  of  the  income  of  such  nonresident  alien  member  or 
members  in  accordance  with  the  provision  of  article  404  of  Regula- 
tions 45,  and  the  corresponding  article  of  Regulations  62,  to  be 
promulgated  under  the  Revenue  Act  of  1921. 

Approved  January  5,  1922.      (I-3-34;  T.  D.  3268.) 

Filing  of  return  by  foreign  corporation  does  not  relieve 

withholding.^*' — 

Ruling.  A  domestic  corporation  making  payments  of  fixed  or  de- 
terminable annual  or  periodical  income  to  a  nonresident  foreign 
corporation  is  not  relieved  from  compliance  with  the  withholding  re- 
quirements of  the  income  tax  law  on  account  of  the  fact  that  the 
nonresident  foreign  corporation  has  filed  Federal  income  tax  returns 
and  claims  for  refund  of  excess  taxes  paid  during  prior  years.  (C. 
B.  4,  page  302;  O.  D.  853.) 

Definition  of  withholding  agent.  — 

Regulation A  withholding  agent  may  be  a  corporation 

with  bonds  outstanding,  a  trustee  under  a  corporate  mortgage,  or  any 
corporation,  partnership  or  private  individual (Art.  1533.) 

Assignee  must  withhold. — 

Regulation Where  in  connection  with  the  sale  of  its 

property  payment  of  the  bonds  or  other  obligations  of  a  corporation  is 
assumed  by  the  assignee,  such  assignee,  whether  an  individual,  part- 
nership, corporation,  or  a  State  or  political  subdivision  thereof,  must 
deduct  and  withhold  such  taxes  as  would  have  been  required  to  be 
withheld  by  the  assignor  had  no  such  sale  and  transfer  been  made. 
....     (Art.  365.     Reg.  45,  Art.  364.) 


'"  [Former  Procedure] 

Ruling.  "A  tax  of  10  per  cent  is  required  to  be  withheld  from  the 
interest  credited  by  a  domestic  bank  to  the  account  of  a  foreign  corporation 
not  having  any  office  or  place  of  business  in  the  United  States  regardless 
of  the  fact  that  the  foreign  corporation  intends  to  file  an  income  tax  return 
covering  its  income  from  all  sources  within  the  United  States."  (C.  B.  4, 
page  302;  O.  D.  910.) 

As  interest  on  deposits  with  domestic  banks  is  no  longer  taxable  to 
foreign  corporations  not  doing  business  in  the  United  States,  the  foregoing 
ruling  is  to  that  extent  obsolete. 


I3I0 


SPECIAL   CLASSES    OF   TAXPAYERS 


What  is  fixed  and  determinable  annual  or  periodical  in- 
come ? — 

Regulation.  Only  (a)  fixed  or  determinable  (b)  annual  or 
periodical  income  is  subject  to  withholding.  Among  such  income, 
giving  an  idea  of  the  general  character  of  income  intended,  the  statute 
specifies  interest,  rent,  salaries,  wages,  premiums,  annuities,  com- 
pensations, remunerations,  and  emoluments.  But  other  kinds  of  in- 
come may  be  included,  (a)  Income  is  fixed  when  it  is  to  be  paid  in 
amounts  definitely  predetermined.  On  the  other  hand,  it  is  deter- 
minable whenever  there  is  a  basis  of  calculation  by  which  the  amount 
to  be  paid  may  be  ascertained,  (b)  The  income  need  not  be  paid 
annually  if  it  is  paid  periodically,  that  is  to  say,  from  time  to  time, 
whether  or  not  at  regular  intervals.  That  the  length  of  time  during 
which  the  payments  are  to  be  made  may  be  increased  or  diminished 
in  accordance  with  someone's  will  or  with  the  happening  of  an  event 
does  not  make  the  payments  any  the  less  determinable  or  periodical. 
A  salesman  working  by  the  month  for  a  commission  on  sales  which 
is  paid  or  credited  monthly  receives  determinable  periodical  income. 
(Art.  362.) 

Rulings.  The  excess  of  the  face  value  of  a  so-called  bank  accept- 
ance as  collected  at  its  maturity,  over  the  amount  paid  therefor  by  a 
person  collecting  the  acceptance  at  maturity,  is  not  interest  within 
the  meaning  of  sections  221  (a)  and  237  of  the  Revenue  Act  of  1918. 

Gains  and  profits  derived  from  the  purchase  and  sale  of  so-called 
bank  acceptances  are  not  fixed  and  determinable  annual  or  periodical 
income  within  the  meaning  of  sections  221  (a)  and  237,  and  are  not 
subject  to  the  withholding  provisions  of  the  act.  (C.  B.  2,  page  189; 
O.  1024.) 

The  tax  should  be  withheld  on  payments  by  an  American  cor- 
poration to  a  nonresident  foreign  corporation  having  no  office  or 
place  of  business  within  the  United  States,  representing  royalties  for 
the  use  of  a  patent,  regardless  of  whether  the  amount  paid  is  an 
agreed  sum  or  is  contingent  on  profits  earned.  The  entire  royalty, 
if  not  unreasonable,  may  be  taken  as  a  deduction  by  the  American 
corporation.     (C.  B.  i,  page  230;  T.  B.  R.  29.) 

Winnings  of  horses  at  a  race  track  credited  by  the  racing  associa- 
tion to  a  nonresident  alien  owner  and  trainer  of  the  horses  winning 
such  amounts  are  not  fixed  nor  determinable  annual  or  periodical 
gains,  profits,  and  income  within  the  meaning  of  section  221  (a), 
Revenue  Act  of  1918,  and  no  withholding  by  the  racing  association 
is  necessary.     (B.  2-19-157;  S.  975.) 

A  firm  of  ship  chandlers  bills  its  sales  to  ships'  captains  at  the  list 
price  of  the  goods  but  accepts  a  lesser  sum  in  full  settlement  in 
order  to  secure  their  trade.     No  payments  whatever  were  made  by 


NON-RESIDENT   ALIENS  1311 

the  firm  to  the  ships'  captains,  who  in  this  case  were  nonresident 
aliens.  It  is  presumed  that  the  captain  of  the  ship  in  each  case 
collected  the  face  of  the  bill  from  the  owner  of  the  ship  or  his  em- 
ployer. The  mere  fact  that  the  firm  billed  the  goods  to  the  ships' 
captains  at  list  price,  entered  such  amounts  on  its  books,  but  accepted 
in  payment  amounts  less  than  list  price,  can  not  in  the  judgment  of 
the  Committee  make  the  firm  the  payer  of  discount  or  commission  to 
the  ships'  captains.  Since  the  firm  made  no  payments  of  fixed  or 
determinable  annual  or  periodical  income  to  the  nonresident  alien 
ships'  captains,  there  would  be  no  amounts  from  which  withholding 
is  required.     (C.  B.  i,  page  184;  A.  R.  R.  265.) 

While  certain  income  payments  do  not  require  withhold- 
ing, such  payments,  nevertheless,  have  a  taxable  status.  In 
other  words,  relief  from  withholding  does  not  make  income 
non-taxable.^^ 


No  withholding  from  interest  on  bank  balances  in  certain 
cases. — Under  the  1921  law  interest  paid  to  non-resident  aliens 
not  having  a  place  of  business  in  the  United  States,  on  deposits 
in  domestic  banks,  is  specifically  exempt  from  taxation.^* 

Regulation.  Under  the  Revenue  Act  of  1921  persons  carrying 
on  the  banking  business  within  the  United  States  are  not  required  to 
withhold  any  tax  from  interest  on  bank  deposits  which  is  paid  to 
(or  credited  to  the  accounts  of)  persons  not  engaged  in  business  within 
the  United  States  and  not  having  an  office  or  place  of  business  therein. 
Any  tax  which,  subsequent  to  December  31,  1920,  and  pursuant  to 
the  Revenue  Act  of  1918,  had  been  withheld  by  persons  carrying  on 
the  banking  business  within  the  United  States  from  interest  on  bank 
deposits  paid  to  (or  credited  to  the  accounts  of)  non-resident  alien 
individuals  not  engaged  in  business  within  the  United  States  and  not 
having  an  office  or  place  of  business  therein,  or  foreign  corporations 
not  engaged  in  business  within  the  United  States  and  not  having  an 
office  or  place  of  business  therein,  shall  be  released  and  paid  over  to 
such  nonresident  alien  individual  or  foreign  corporation,  or  his  or  its 
representative.     (Art.  372.) 


"  Section  217   (a). 

°'  [Former  Procedure]  Under  the  1918  law  interest  on  bank  balances 
paid  or  credited  to  non-resident  ab'cn  individuals  or  foreign  corporations 
was  subject  to  withholding.  See  Income  Tax  Procedure,  1921,  pages  lOio 
and  ion. 


I3I2  SPECIAL    CLASSES    OF    TAXPAYERS 

Withholding  from  bond  interest  and  ownership  certificates 
required. — 

I.  Form  iooo  (revised). — This  form  must  be  used  in  col- 
lecting interest  on  bonds  in  all  cases  in  which  there  is  with- 
holding at  the  source.  A  tax  of  2  per  cent  must  be  withheld  on 
bonds  of  domestic  or  resident  corporations  containing  a  tax- 
free  covenant  clause  if  the  owner  is  (a)  a  non-resident  alien 
individual  or  fiduciary,  (b)  a  foreign  partnership,  (c)  a  for- 
eign corporation  not  having  an  office  or  place  of  business 
within  the  United  States. 

If  such  bonds  do  not  contain  a  tax-free  covenant  clause, 
a  tax  of  8  per  cent  must  be  withheld  in  the  case  of  non-resi- 
dent alien  individuals  or  fiduciaries,  and  10  per  cent^^  in  the 
case  of  corporations  not  having  an  office  or  place  of  business 
within  the  United  States. 

A  foreign  corporation  not  engaged  in  trade  or  business 
within  the  United  States  but  having  a  fiscal  agent  in  this 
country  is  not  a  resident  corporation''*'  and  should  use  form 
IOOO  in  collecting  interest  on  tax-free  covenant  bonds  of  do- 
mestic or  resident  corporations.  It  is  held,*'^  however,  that  a 
resident  fiscal  agent  or  a  resident  paying  agent  of  a  foreign 
corporation  or  country  which  has  issued  bonds  containing  a 
tax-free  covenant  clause  is  required  to  withhold  a  tax  of  2 
per  cent  from  interest  on  such  bonds,  when  form  1000  (re- 
vised) is  used  by  (a)  citizens  or  residents  not  claiming  ex- 
emption, (b)  domestic  or  resident  partnerships  or  (c)  ap- 
proved personal  service  corporations."-  It  will  be  noted  that 
such  a  foreign  debtor  is  not  required  to  withhold  against 
domestic  or  resident  corporations  owning  its  bonds.  Citizens 
or  residents  may  claim  personal  exemption  on  such  interest 
payments  by  filing  form  looiA  (revised). 


'°  Increased  to  12' j  per  cent  from  January  i,  1922,  by  section  237  of 
the  1921  law. 

"'Bulletin  4-19-225;  O.  D.   144. 

"'  Letter  to  The  Equitable  Trust  Company  of  New  York,  N.  Y..  signed 
by  Paul  F.  Myers,  Acting  Commissioner  and  dated  July  7,   1920. 

""No  corporations  are  classed  as  personal  service  corporations  after 
December  31,  1921. 


NON-RESIDENT   ALIENS  1313 

2.  Form  iooi  (revised). — This  form  should  be  used  by 
foreign  partnerships  in  collecting  interest  on  bonds  of  domestic 
or  resident  corporations  which  do  not  contain  a  tax-free 
covenant  clause  and  by  foreign  corporations  having  an  office 
or  place  of  business  within  the  United  States,  foreign  govern-: 
ments  and  exempt  foreign  corporations,  regardless  of  whether 
the  bonds  contain  a  tax-free  covenant  clause  or  not.  There 
is  no  withholding  if  this  form  is  used. 

3.  Form  iooi  A  (revised). — This  form  is  used  for  inter- 
est payments  on  foreign  bonds  when  no  withholding  is  re- 
quired and  for  foreign  dividend  payments.  Such  income  is 
not  taxable  in  the  case  of  non-resident  aliens,  although  the 
funds  pass  through  domestic  banking  channels  for  payment. ^^ 
The  form  may  be  executed  on  behalf  of  a  non-resident  alien 
individual,  fiduciary,  partnership  or  corporation  by  any  re- 
sponsible foreign  or  domestic  banker  having  knowledge  of 
the  ownership  of  such  securities.  The  name  of  the  foreign 
owner  need  not  be  supplied,  but  the  due  date  and  date  paid 
must  be  given.  The  paying  agent,  if  within  the  United  States, 
is  treated  as  the  source  of  information;  otherwise  the  last 
bank  or  collecting  agent  is  so  regarded. 

4.  Form  iooiB. — This  form  is  used  by  non-resident 
aliens  when  a  personal  exemption  is  claimed  in  collecting  in- 
terest on  tax-free  covenant  bonds."'* 

The  use  of  substitute  certificates  is  not  permitted  in  case 
of  foreign  payments.*'^ 

Exemption  claim  of  alien  in  collecting  tax-free  covenant 
bond  interest — form  looiB.'" — 

Exemption  certificates  of  non-resident  aliens. — 

Regulation,  (a)  When  the  g-ross  income  (inchiding  bond  in- 
terest)  of  a  nonresident  alien,  which  is  derived  from  sonrces  within 


*^  See  page  309. 
'"  See  page  309. 
""^Art.  368;  see  page  311. 

""See  page  331  for  discussion  of  when  citizens  or  residents  should  claim 
exemption  on  tax-free  covenant  bonds. 


I3I4 


SPECIAL   CLASSES    OF   TAXPAYERS 


the  United  States,  does  not  exceed  the  personal  exemption  of  $1,000, 
allowed  by  section  216  (e),  an  exemption  certificate.  Form  looi  B, 
should  be  executed  and  filed  with  the  withholding  agent,  if  any  part 
of  the  gross  income  is  derived  from  interest  upon  bonds  or  similar 
obligations  of  a  domestic  corporation  which  contain  a  tax-free 
covenant  clause.  The  amount  of  tax  due  from  the  withholding 
agent,  as  shown  by  Form  1013,  may  be  reduced  by  2  per  cent  of  the 
aggregate  amount  of  interest  payments  made  to  such  nonresident 
alien  upon  tax-free  covenant  bonds  during  the  calendar  year. 

(b)  When  the  gross  income  of  a  nonresident  alien,  derived  from 
sources  within  the  United  States,  does  not  exceed  $1,000,  such  per- 
son may  file  with  the  withholding  agent  an  exemption  certificate  on 
Form  lOOi  C  with  respect  to  interest  upon  bonds  or  similar  obligations 
of  a  domestic  corporation  not  containing  a  tax-free  covenant  clause. 
The  debtor  organization  or  withholding  agent,  upon  receipt  of  a 
properly  excuted  certificate  showing  that  the  individual's  income  does 
not  exceed  $1,000,  shall  release  and  pay  over  to  such  individual  upon 
demand  any  tax  withheld  during  the  preceding  calendar  year.  The 
tax  assessed  against  the  withholding  agent  and  which  has  not  been 
paid  may  be  made  the  subject  of  a  claim  for  abatement  to  the  extent 
of  the  amount  of  excess  tax  withheld,  and  refunded  to  the  alien  on 
the  basis  of  this  certificate.  In  case  the  tax  so  withheld  has  been 
paid  to  the  Government,  refund  of  the  tax  withheld  in  the  case  of 
non  tax-free  bonds  and  similar  obligations  can  only  be  made  to  the 
bond  owner  or  his  duly  authorized  representative. 

The  exemption  certificates,  Forms  lOOi  B  and  looi  C,  properly 
executed,  may  be  filed  with  the  debtor  organization  or  its  duly  au- 
thorized withholding  agent  at  any  time  after  the  close  of  the  calen- 
dar year,  but  not  later  than  j\Iay  i  of  the  succeeding  year.  Owner- 
ship certificates,  however,  must  be  filed  in  connection  with  all  in- 
terest payments  upon  bonds  and  similar  obligations  of  domestic  cor- 
porations in  accordance  with  the  regulations,  notwithstanding  the  fact 
that  Form  lOOi  B  or  Form  looi  C  is  filed.     (Art.  364.) 

Ruling While   form    looiB   was  intended,   primarily,    for 

reporting  1919  income,  it  may  be  adopted  for  reporting  any  interest 
received  in  respect  of  the  years  1916  and  1918,  in  which  case  a  sepa- 
rate form  should  be  filed  for  each  of  those  years,  in  respect  of  which 
the  nonresident  alien  has  received  interest  during  the  calendar  year. 
(Extract  from  letter  to  The  Corporation  Trust  Company,  signed  by 
Commissioner  Daniel  C.  Roper,  and  dated  February  3,  1920.) 

Procedure  when  foreign  item  is  presented  without  owner- 
ship certificate  and  owner  is  unknown. — 

Ruling.  In  case  foreign  item  is  unaccompanied  by  certificate  and 
owner  is  unknown,  affidavit  and  form  looiA,  revised,  showing  name 


NON-RESIDENT   ALIENS  1315 

and  address  of  payee  should  be  executed  by  first  bank  unless  item 
represents  interest  on  bonds  containing  tax  free  covenant  issued  by 
foreign  country  or  corporation  having  paying  agent  in  U.  S.  in 
which  case  affidavit  and  form  1000,  revised,  should  be  executed  by 
first  bank  in  accordance  with  article  368.'''^  For  audit  purposes  payee 
will  be  considered  actual  owner.  (Telegram  to  the  Equitable  Trust 
Company,  New  York,  signed  by  Commissioner  Daniel  C.  Roper,  and 
dated  January  20,  1920.) 

No  withholding  on  bond  interest  due  prior  to  March  i, 
1913.— 

Ruling.  Coupons  which  became  due  June  i,  1910,  presented  on 
behalf  of  non-resident  alien  individual  owner.  Should  the  federal 
income  tax  be  withheld  therefrom?  Please  wire  reply.  (Answer.) 
Bond  interest  represents  income  to  taxpayer  when  due  and  payable 
in  accordance  with  article  54,  Regulations  45.  No  tax  required  to 
be  withheld  from  interest  upon  bonds  due  prior  to  March  i,  1913,  but 
paid  subsequent  to  that  date.  (Telegram  from  Chicago  &  Northwest- 
ern Railway  Company  and  the  answer  thereto,  signed  by  Acting 
Commissioner  Callan  and  dated  August  26,  1919.) 

Withholding  is  required  at  the  rates  for  the  year  in  which 
coupons  are  paid,  but  if  they  became  due  and  payable  in  prior 
years,  a  claim  for  refund  of  excess  tax  withheld  may  be 
made. — 

Ruling.  Income  tax  should  be  withheld  from  interest  payments 
to  nonresident  aliens  upon  bonds  at  rates  in  force  during  year  in  which 
payments  were  actually  made,  although  bond  interest  is  held  to  repre- 
sent income  for  year  during  which  coupons  became  due  and  payable. 
Any  tax  withheld  and  paid  to  Government  in  excess  of  taxpayer's 
liability  may  be  adjusted  through  claim  for  refund.  (C.  B.  i,  page 
182;  O.  D.  167.) 

Duties  and  obligations  of  employers,  in  connection  with 
withholding,  in  the  case  of  non-resident  aliens  employed  in  the 
United  States. — Employers  are  held  liable  for  deduction  of 
income  tax  from  salaries,  wages,  or  other  fixed  and  deter- 
minable annual  or  other  periodical  income  paid  to  non-resident 
alien  employees  since  September  17,  1915,  the  date  of  issuance 

"  See  page  310, 


1316  SPECIAL   CLASSES    OF   TAXPAYERS 

of  T.  D.  2242,  which  defined  a  non-resident  ahen  and  pre- 
scribed the  certificate  of  residence,  form  loyS.^^  If  it  can  be 
estabHshed,  as  provided  in  articles  312  to  316  that  the  ahen 
employee  had  in  fact  acquired  residence,  the  employer  will  not 
be  liable  for  tax,  because  no  withholding  is  required  in  case  of 
resident  aliens. *^° 

Allowance  of  personal  exemption'"  to  non-resident 

alien  employee. 

Regulation.  A  nonresident  alien  employee  may  claim  the  bene- 
fit of  the  credit  for  personal  exemption  by  filing  with  his  employer 
Form  1 1 15,  duly  filled  out  and  executed  under  oath.  On  the 
filing  of  such  a  claim  the  employer  shall  examine  it.  If  on  such 
examination  it  appears  that  the  claim  is  in  due  form,  that  it  contains 
no  statement  which  to  the  knowledge  of  the  employer  is  untrue,  that 
such  employee  on  the  face  of  the  claim  is  entitled  to  credit,  and  that 
such  credit  has  not  yet  been  exhausted,  such  employer  need  not  until 
such  credit  be  in  fact  exhausted  withhold  any  tax  from  payments  of 
salary  or  wages  made  to  such  employee.  Every  employer  with  whom 
affidavits  of  claim  on  Form  1115  are  filed  by  employees  shall 
preserve  such  affidavits  until  the  following  calendar  year,  and 
shall  then  file  them,  attached  to  his  annual  withholding  return 
on  Form  1042,  with  the  collector  on  or  before  March  i.  In 
case,  however,  when  the  following  calendar  year  arrives  such  em- 
ployer has  no  withholding  to  return,  he  shall  forward  all  such  affi- 
davits of  claim  directly  to  the  Commissioner,  with  a  letter  of  trans- 
mittal, on  or  before  March  15.  Where  any  tax  is  withheld  the  em- 
ployer in  every  instance  shall  show  on  the  pay  envelope  or  shall  fur- 
nish some  other  memorandum  showing  the  name  of  the  employee,  the 
date  and  the  amount  withheld.     This  article  applies  only  to  payments 

of  compensation  by  an  employer  to  an  employee (Art.  315; 

Reg.  45,  Art.  316.) 

Form  1 1 15,  used  to  secure  relief  from  withholding  by  a 
non-resident  alien  employee,  may  also  be  used  by  aliens  other 
than  employees  to  establish  credit  for  personal  exemption  when 
a  complete  return  of  income  from  sources  within  the  United 
States  is  filed. '^ 


'*  See  Income  Tax  Procedure.  1920,  page  8:; 
"'  See  pages   1273-1276. 
'"See  page  1295. 
"  See  page  1296. 


NON-RESIDENT   ALIENS 


1317 


Refund  of  taxes  erroneously  withheld  if  alien 
cannot  be  found. 

Ruling.  Tax  erroneously  withheld  from  the  wages  of  a  non- 
resident alien  seaman,  who  can  not  now  be  located  for  the  purpose 
of  making  refund,  should  be  reported  on  the  annual  list  return.  Form 
1042,  and  paid  to  the  Government,  and  when  the  seaman  is  located  he 
should  be  advised  of  his  right  to  file  claim  for  refund.  (B.  16-19- 
463;  O.  D.  258.) 

Refund  of  tax  on  establishment  of  residence. — 

Rulings.  In  cases  where  tax  was  withheld  from  wages  of  em- 
ployees who  refused  to  sign  the  old  Form  1078,  but  who  have  now 
signed  the  new  Form  1078,  the  amount  of  tax  should  not  be  refunded 
by  the  employer  upon  execution  of  the  new  Form  1078.  The  amount 
of  tax  withheld  should  be  reported  on  Form  1042  and  paid  to  the  col- 
lector of  internal  revenue  for  the  district  m  which  the  withholding 
agent  is  located,  subject  to  claim  £or  personal  exemption  provided 
in  section  216  of  the  Revenue  Act  of  1918. 

If  the  personal  exemption  is  not  available  to  the  nonresident 
alien,  the  amount  of  tax  can  be  refunded  only  upon  execution  of 
Form  46,  accompanied  by  a  complete  return  of  the  individual's  income 
from  sources  within  the  United  States,  and  evidence  establishing  the 
fact  that  tax  has  been  withheld  in  excess  of  the  actual  liability.  (C. 
B.  I,  page  184;  O.  D.  107.) 

Any  income  tax  withheld  during  the  calendar  year  from  the  wages 
paid  to  an  alien  employee,  which  has  not  been  paid  over  to  the  Gov- 
ernment, should  be  refunded  to  such  alien  employee  upon  the  estab- 
lishment of  residence  by  the  execution  and  filing  of  Form  1078  with 
his  employer.  As  a  condition  precedent  the  employer  should  require 
the  employee  to  return  the  receipts  showing  the  amount  of  tax  pre- 
viously withheld  before  making  the  refund.  (C.  B.  i,  page  165; 
O.  D.  302.) 

The  fact  that  an  alien  has  been  employed  by  a  resident  corpora- 
tion for  at  least  three  months  is  not  ipso  facto  sufficient  to  permit  the 
employer  to  refund  the  amount  of  any  tax  withheld.  Forms  1 115 
and  1078  should  be  filed  by  resident  or  nonresident  aliens  in  order 
to  secure  refund.     (C.  B.  i,  page  165;  O.  D.  254.) 

Alien  employees — resident  and  non-rp:sident — with- 
holding upon  change  of  .status. 

RuLiNG.s Where  the  status  of  an  alien  changes  during  the 

year  from  that  of  a  resident  to  that  of  a  non-resident,  or  from  that 
of  a  non-resident  to  that  of  a  resident,  the  s^^tus  which  exists  at  the 


1318  SPECIAL   CLASSES    OF   TAXPAYERS 

end  of  the  taxable  year  is  the  one  which  determines  his  right  to  ex- 
emption as  to  the  whole  year.  Where  an  employer  has  withheld 
wages  from  a  non-resident  during  part  of  the  year  and  thereafter 
the  employee  became  a  resident  (before  the  employer  has  paid  over 
to  the  United  States  the  amount  withheld),  the  employer  is  authorized 
on  receiving  proof  of  the  change  to  refund  to  the  employee  the 
amounts  which  had  been  withheld  from  him  during  the  earlier  part 

of  the  taxable  year,  while  his  status  was  that  of  a  non-resident 

(Extract  from  letter  to  W.  B.  Reed,  Accounting  Secretary,  National 
Coal  Association,  Washington,  D.  C,  signed  by  Commissioner 
Daniel  C.  Roper,  and  dated  June  12,  1919.) 

....  If  the  status  of  a  resident  employee  changes  to  that  of  a 
non-resident  alien,  the  employer  should  withhold  income  tax  at  the  rate 
of  eight  per  cent  from  all  wages  paid  to  the  non-resident  employee 
on  and  after  the  date  on  which  the  employer  had  knowledge  of  the 
change.  Although  the  employee,  in  such  case,  will  be  taxable  as  a 
non-resident  alien  for  the  entire  taxable  year  during  which  his  status 
is  changed  from  that  of  a  resident  to  that  of  a  non-resident  alien,  the 
employer  will  not  be  held  liable  for  the  deduction  of  income  tax  with 
respect  to  wages  paid  preceding  the  knowledge  of  the  employer  as 
to  the  change  in  status.  (Extract  from  letter  to  W.  B.  Reed,  Account- 
ing Secretary,  National  Coal  Association,  Washington,  D.  C,  signed 
by  Commissioner  Daniel  C.  Roper,  and  dated  August  6,  1919.) 

Return  of  tax  withheld."- — 

Regulation,  (a)  Every  withholding  agent  shall  make  an  annual 
return  to  the  collector  of  the  tax  withheld  from  interest  on  corporate 


''  [Former  Procedure  ]  Withholding  from  non-resident  aliens  at 
1917  rates  prior  to  February  25,  1919. — 

Regulation.  "In  the  case  of  payments  made  prior  to  February  25, 
1919,  where  a  withholding  agent  pursuant  to  the  Revenue  Acts  of  1916  and 
1917  withheld  only  2  per  cent  from  the  income  of  nonresident  alien  indi- 
viduals, he  need  return  only  such  sum.  In  all  such  cases  where  a  withhold- 
ing agent  withheld  the  tax  pursuant  to  the  Revenue  Acts  of  1916  and  1917 
from  the  income  of  foreign  corporations  not  engaged  in  trade  or  business 
within  the  United  States  and  not  having  any  office  or  place  of  business 
therein,  he  need  return  only  the  sum  withheld,  to  an  amount  not  in  excess 
of  the  aggregate  sum  required  to  be  withheld  by  the  terms  of  the  Revenue 
Act  of  1918  from  the  income  paid  over  by  the  withholding  agent.  In  the 
case  of  every  payment  made  after  February  24,  1919,  the  withholding  agent 
must  withhold  at  the  rates  prescribed  by  the  present  statute  from  the  whole 
payment,  not  merely  from  that  part  which  applies  to  the  period  after  Febru- 
ary 24,  1919."     (Reg.  45,  Art.  371.) 

Withholding  in  1918. — 

Regul.\tion.  "Any  sum  withheld  for  tax  since  December  31,  1917, 
in    excess    of    the    aggregate    amount    required    under    the    terms    of    the 


NON-RESIDENT    ALIENS 


1319 


bonds  or  other  obligations  on  or  before  March  I  on  Form  1013. 
He  shall  also  make  a  monthly  return  on  Form  1012  on  or  be- 
fore the  2oth  day  of  the  month  following  that  for  which  the 
return  is  made.  The  original  ownership  certificates,  or  the  substitute 
certificates  where  authorized,  must  be  forwarded  to  the  Commissioner 
with  the  monthly  return,  (b)  Every  person  required  to  deduct  and 
withhold  any  tax  from  income  other  than  such  bond  interest  shall 
make  an  annual  return  thereof  to  the  collector  on  or  before  March  i 
on  Form  1042  showing  the  amount  of  tax  required  to  be  withheld 
for  each  nonresident  alien  individual,  partnership  composed  in 
whole  or  in  part  of  nonresident  aliens  and  not  having  an  office  or  place 
of  business  within  the  United  States,  or  foreign  corporation 
not  engaged  in  trade  or  business  within  the  United  States  and  not 
having  any  office  or  place  of  business  therein,  to  whom  income  other 
than  bond  interest  was  paid  during  the  previous  taxable  year.  In 
every  case  of  both  classes  the  tax  withheld  must  be  paid  on  or  be- 
fore June  15  of  each  year  to  the  collector (Art.  371 ;  Reg. 

45,  Art.  370.) 

Return  of  income  from  which  tax  withheld. — 

Regulation.  The  entire  amount  of  the  income  from  which 
the  tax  was  withheld  shall  be  included  in  gross  income  without  de- 
duction for  such  payment  of  the  tax.  But  any  tax  actually  so  with- 
held shall  be  credited  against  the  total  tax  as  computed  in  the  tax- 
payer's return If  the  tax  is  paid  by  the  recipient  of  the  income 

or  by  the  withholding  agent  it  shall  not  be  re-collected  from  the  other, 
regardless  of  the  original  liability  therefor,  and  in  such  event  no 
penalty  will  be  asserted  against  either  person  for  failure  to  return 
or  pay  the  tax  where  no  fraud  or  purpose  to  evade  payment  is  in- 
volved.    (Art.  375;  Reg.  45,  Art.  376.) 


Revenue  Act  of  1918,  shall  be  released  by  the  withholding  agent  and  paid 
over  to  the  person  from  whom  it  was  withheld  or  his  proper  representative. 
With  reference  to  how  a  debtor  corporation  may  release  and  pay  over  the 
amount  of  tax  so  withheld  in  a  case  where  a  bank  or  other  collection  agency 
detached  the  ownership  certificate  which  accompanied  an  interest  coupon 
and  substituted  its  own  certificate  (form  1059),  which  does  not  disclose 
the  name  and  address  of  the  bond  owner,  in  such  cases  the  withholding 
agent  shall  request  the  bank  or  collection  agency  to  disclose  the  name  and 
address  of  the  owner  of  the  bonds,  as  shown  by  the  original  certificate,  and 
it  shall  be  the  duty  of  the  bank  or  collection  agency  to  make  such  disclosure 
to  the  withholding  agent.  Where  withholding  agents  have  so  released  any 
excess  of  tax,  an  itemized  statement  showing  the  names,  addresses  and 
amounts  refunded  should  be  attached  to  the  annual  list  return  (form  1013), 
in  order  to  reconcile  any  discrepancy  between  the  aggregate  amount  of  taxes 
returned  as  shown  by  the  monthly  list  returns  (form  1012)  and  the  aggre- 
gate amount  as  shown  b}'  the  annual  list  return."  (Reg.  45,  Art.  372.) 


1320 


SPECIAL   CLASSES    OF   TAXPAYERS 


Foreign  corporations  doing  business  in  the  United  States 

must  file  certificate. — 

Regulation To  enable   debtors   in  the  United   States  to 

distinguish  between  foreign  corporations  which  have  and  those  which 
have  not  any  office  or  place  of  business  in  the  United  States,  and  also 
to  enable  such  corporations  as  have  an  office  or  place  of  business 
in  the  United  States  to  claim  exemption  from  withholding  the  tax 
on  bond  interest  or  other  income,  a  certificate,  Form  1086,  stating 
that  any  such  corporation  has  an  office  or  place  of  business  in  the 
United  States  should  be  filed  by  it  with  the  debtor.     (Art.  601.) 

Return    of   information    as    to    payments    to   non-resident 

aliens. '■'■ — 

Regulation.  In  the  case  of  payments  of  annual  or  periodical 
income  to  nonresident  alien  individuals,  partnerships  composed  in 
whole  or  in  part  of  nonresident  aliens  and  not  having  an  office  or 
place  of  business  within  the  United  States,  or  to  foreign  corporations 
not  engaged  in  trade  or  business  within  the  United  States  and  not 
having  any  office  or  place  of  business  therein,  the  returns  filed  by 
withholding  agents  on  Form  1042  shall  constitute  and  be  treated  as 
returns  of  information (Art.  1075;  Reg.  45,  Art.  1076.) 

Withholding  in  the  case  of  Alien  Property  Custodian. — 

Regulation.  Payments  made  after  October  6,  1917,  to  the  Alien 
Property  Custodian  are  in  the  same  category  as  payments  made  to  or 
for  citizens  or  residents  of  the  United  States.  Withholding  at  the 
source  is  accordingly  unnecessary  except  in  the  case  of  interest  pay- 
ments on  corporate  bonds  or  other  obligations  containing  a  tax-free 
covenant  where  no  exemption  is  claimed.  The  Alien  Property  Cus- 
todian should  use  Form  1000  (revised)  in  collecting  interest  on  bonds 
containing  a  tax-free  covenant  and  in  all  other  cases  should  use  Form 
looi  (revised),  except  that  in  cases  in  which  the  Alien  Property  Cus- 
todian shall,  under  the  trading-with-the-enemy  act,  demand  payment 
to  himself  of  interest  accrued  upon  bonds  or  other  securities  not  yet 
reduced  to  his  custody  (even  though  they  be  registered  in  the  name 
of  an  enemy,  ally  of  an  enemy,  or  his  agent  or  trustee),  the  corpora- 
tion paying  such  income  to  the  Alien  Property  Custodian  is  authorized 
to  accept  from  the  Alien  Property  Custodian  ownership  certificates, 
Forms  1000  (revised)  and  lOOi  (revised),  altered  by  the  substitution 
(in  lieu  of  the  certificate  required  thereon)  of  a  certificate  that  the 
Alien  Property  Custodian  is  entitled  to  the  interest  entered  therein 
with  or  without  deduction  of  tax,  as  the  case  may  be.     No  distinction 


"  See  Chapter  X. 


NON-RESIDENT   ALIENS 


1321 


is  to  be  made  between  payments  directly  to  the  Alien  Property  Cus- 
todian and  to  his  depositaries  and  between  interest  on  registered 
bonds  and  interest  on  coupon  bonds.  In  the  case  of  enemies  or  allies 
of  enemies  holding  a  license  granted  under  the  provisions  of  the 
trading-with-the-enemy  act,  .withholding  is  required  as  in  the  case  of 
any  nonresident  alien  not  an  enemy  or  ally  of  enemy.  (Reg.  45, 
Art.  375.) 

Ruling.  A  nonresident  alien  enemy  is  not  liable  for  tax  on  prop- 
erty taken  over  by  the  Alien  Property  Custodian  until  it  is  returned 
to  him.  However,  he  is  liable  to  tax  on  such  other  income  as  was  not 
taken  over  by  the  Alien  Property  Custodian  and  should  pay  the  same. 
If  the  property  ultimately  is  returned  to  the  enemy,  any  income  de- 
rived from  the  property  in  the  hands  of  the  Alien  Property  Custodian 
as  income,  would  be  subject  to  tax  in  the  hands  of  the  alien  enemy. 
Such  alien  should  make  a  return  on  the  proper  form,  showing  all 
sources  of  income  in  the  United  States  and  the  amount  thereof, 
v/hether  or  not  it  was  taken  over  by  the  Alien  Property  Custodian. 

Any  tax  withheld  after  October  6,  1917,  which,  under  Treasury 
Decision  2673,  was  erroneously  withheld,  will  be  deemed  to  have  been 
erroneously  withheld  up  to  the  time  of  restoration  of  the  property  to 
the  original  owners  by  the  Alien  Property  Custodian,  but,  after  the 
restoration  of  the  property,  the  tax  so  withheld  if  otherwise  prop- 
erly withheld  in  accordance  with  the  Revenue  Act  of  1916,  as  amended, 
if  not  in  excess  of  the  tax  liability  of  such  alien,  will  be  deemed  to 
have  been  properly  withheld  and,  if  returned  and  paid  to  the  Govern- 
ment as  income  tax,  may  be  taken  as  a  credit  against  the  tax  shown 
to  be  due  by  the  return  required  for  the  respective  year  to  be  sub- 
mitted at  or  after  the  restoration  of  the  property  by  the  Alien  Prop- 
erty Custodian.     (C.  B.  3,  page  219;  O.  D.  657.) 

Penalties  for  failure  to  withhold. — In  case  of  failure  to 
make  returns  and  payments  of  tax  severe  penalties  are  im- 
posed.    (See  Chapter  V^I.) 

License  for  collection  of  foreign  items. — 

L.\w.  Section  259.  That  all  individuals,  corporations,  or  partner- 
ships undertaking  as  a  matter  of  business  or  for  profit  the  collection 
of  foreign  payments  of  interest  or  dividends  by  means  of  coupons, 
checks,  or  bills  of  exchange  shall  obtain  a  license  from  the  Commis- 
sioner and  shall  be  subject  to  such  regulations  enabling  the  Govern- 
ment to  obtain  the  information  required  under  this  title  as  the  Com- 
missioner, with  the  approval  of  the  Secretary,  shall  prescribe;  and 
whoever  knowingly  undertakes  to  collect  such  payments  without 
having  obtained  a  license  therefor,  or  without   complying  with  such 


1322  SPECIAL   CLASSES    OF   TAXPAYERS 

regulations,  shall  be  guilty  of  a  misdemeanor  and  shall  be  fined  not 
more  than  $5,000,  or  imprisoned  for  not  more  than  one  year,  or  both. 

Regulation.  Banks  or  agents  collecting  foreign  items,  as  defined 
in  article  1076,  and  required  by  article  1079  to  make  returns  of  in- 
formation with  respect  thereto,  must  obtain  a  license  from  the  Com- 
missioner to  engage  in  such  business.  Application  Form  1017 
for  such  license  may  Ijc  procured  from  collectors.  The  license 
is  issued  without  cost  on  Form  loio.  Foreign  items  shall  not  be  ac- 
cepted for  collection  by  any  bank  or  collecting  agent  so  licensed  un- 
less properly  indorsed  or  accompanied  by  proper  ownership  certifi- 
cates giving  all  the  information  called  for  by  such  certificate 

(Art.    nil.) 


Taxation  of  Citizens  or  Residents  of  United  States 

Possessions   and   Persons   Deriving   Income 

Therefrom 

Citizens  of  United  States  possessions  taxed  as  non-resident 

aliens. — 

Law.  Section  260.  That  any  individual  w^ho  is  a  citizen  of  any 
possession  of  the  United  States  (but  not  otherwise  a  citizen  of  the 
United  States)  and  who  is  not  a  resident  of  the  United  States,  shall 
be  subject  to  taxation  under  this  title  only  as  to  income  derived  from 
sources  within  the  United  States,  and  in  such  case  the  tax  shall  be 
computed  and  paid  in  the  same  manner  and  subject  to  the  same 
conditions  as  in  the  case  of  other  persons  who  are  taxable  only  as 
to  income  derived  from  such  sources 

Regulation.  A  citizen  of  a  possession  of  the  United  States 
(except  the  Virgin  Islands),  who  is  not  otherwise  a  citizen  or  a  resi- 
dent of  the  United  States,  including  only  the  States,  the  Territories 
of  Alaska  and  Hawaii,  and  the  District  of  Columbia,  is  treated  for 
the  purpose  of  the  tax  as  if  he  were  a  nonresident  alien  individual. 
....  His  income  from  sources  within  the  United  States  is  subject 
to  withholding (Art.  1121.) 

Citizens  of  Virgin  Islands. — 

Law.  Section  260.  ....  Nothing  in  this  section  shall  be  con- 
strued to  alter  or  amend  the  provisions  of  the  Act  entitled  "An  Act 
making  appropriations  for  the  naval  service  for  the  fiscal  year  ending 
June  30,  1922,  and  for  other  purposes,"  approved  July  12,  1921,  relat- 
ing to  the  imposition  of  income  taxes  in  the  Virgin  Islands  of  the 
United  States. 


NON-RESIDENT   ALIENS  1323 

Regulation The  Act  referred  to  in  section  260  of  the 

statute  provided  that  income  tax  laws  then  or  thereafter  in  force 
in  the  United  States  should  apply  to  the  Virgin  Islands,  but  that  the 
taxes  should  be  paid  into  the  treasury  of  the  Virgin  Islands.  Ac- 
cordingly, a  citizen  or  resident  of  the  Virgin  Islands  is  taxed  there 
under  the  provisions  of  the  Revenue  Act  of  1921.     (Art.  1121.) 

Non-residents  of  Porto  Rico  or  the  Philippine  Islands. — 

Law.  Section  261.  That  in  Porto  Rico  and  the  Philippine 
Islands  the  income  tax  shall  be  levied,  assessed,  collected,  and  paid 
as  provided  by  law  prior  to  the  passage  of  this  Act.'* 

The  Porto  Rican  or  Philippine  Legislature  shall  have  power  by 
due  enactment  to  amend,  alter,  modify,  or  repeal  the  income  tax  laws 
in  force  in  Porto  Rico  or  the  Philippine  Islands,  respectively. 

Regulation,  (a)  A  citizen  of  the  United  States  who  resides 
in  Porto  Rico,  and  a  citizen  of  Porto  Rico  who  resides  in  the  United 
States,  are  taxable  in  both  places,  but  the  income  tax  in  the  United 
States  is  credited  with  the  amount  of  any  income,  war  profits,  and 

excess  profits  taxes  paid  in  Porto  Rico (^)   A  resident  of 

the  United  States,  who  is  not  a  citizen  of  Porto  Rico,  is  taxable  in 
Porto  Rico  as  a  nonresident  alien  individual  on  any  income  derived 
from  sources  within  Porto  Rico,  but  the  income  tax  in  the  United 
States  is  credited  with  the  tax  paid  in  Porto  Rico,  (c)  A  resident 
of  Porto  Rico,  who  is  not  a  citizen  of  the  United  States,  is  taxable 
in  the  United  States  as  a  nonresident  alien  individual  on  any  income 
derived  from  sources  vvithin  the  United  States,  and  receives  no  such 
credit The  same  principles  apply  in  the  case  of  the  Philip- 
pine Islands.     (Art.  1132.) 

It  has  been  held  that  a  foreign  corporation  transacting 
business  and  having  a  place  of  business  in  both  continental 
United  States  and  in  Porto  Rico,  is  not  subject  to  income  tax 
in  continental  United  States  upon  income  derived  from  Porto 
Rico  under  the  Act  of  September  8,  19 16,  as  amended  by  the 
Act  of  October  3,  1917.''^  This  avoidance  of  double  taxation 
is  further  supported  by  the  following  regulation. 

Regulation,  (a)  A  United  States  corporation  which  derives 
income  from  sources  within  Porto  Rico,  (b)  a  Porto  Rico  corpora- 
tion which  derives  income  from  sources  within  the  United  States, 
and    (c)   a  corporation  of   a   foreign  country  which   derives   income 


"  For  the  provision  of  prior  laws  alluded  to  in  tins  section,  see  Income 
Tax  Procedure,  1921,  page  1022. 
"C.  B.  2,  page  ^60,;  Q,  976. 


1324 


SPECIAL   CLASSES    OF   TAXPAYERS 


both  from  sources  within  Porto  Rico  and  from  sources  within 
the  United  States,  are  all  taxable  in  both  places.  In  the  case  of 
the  United  States  corporation  the  income,  war  profits,  and  excess 
profits  taxes  in  the  United  States  are  credited  with  the  amount  of 
any  income,  war  profits,  and  excess  profits  taxes  paid  in  Porto  Rico. 
In  the  case  of  the  Porto  Rico  corporation  there  is  no  such  credit. 
....  The  corporation  of  the  foreign  country  deriving  income 
from  both  places  is  subject  to  no  double  taxation  so  far  as  the  United 

States   and   Porto   Rico   are   concerned For  the   purpose   of 

withholding,  a  Porto  Rico  corporation  is  a  foreign  corporation. 
....  The  same  principles  apply  in  the  case  of  the  Philippine 
Islands.     (Art.  1133.) 

Income  from  sources  within  the  possessions'®  of  the  United 
States. — In  order  to  avoid  the  repetition  of  hardships  that 
have  resulted  to  taxpayers  through  double  taxation  such  as 
existed  under  the  law  of  19 18,  whereby  United  States  citizens 
resident  in  the  Philippines  could  be  taxed  twice  upon  the  same 
income,'"  a  new  section  (262)  has  been  incorporated  in  the 
192 1  law,  effective  from  January  i,  192 1.  This  section  de- 
termines the  status  of  citizens  resident  in  possessions  of  the 
United  States  as  to  whether,  for  purposes  of  taxation,  they 
could  be  considered  non-resident  aliens  or  residents. 

Law.  Section  262.  (a)  That  in  the  case  of  citizens  of  the  United 
States  or  domestic  corporations,  satisfying  the  following  conditions, 
gross  income  means  onlj'  gross  income  from  sources  within  the  United 
States— 

(i)  If  80  per  centum  or  more  of  the  gross  income  of  such  citizen 
or  domestic  corporation  (com.puted  without  the  benefit  of  this 
section)  for  the  three-year  period  immediately  preceding  the  close 
of  the  taxable  year  (or  for  such  part  of  such  period  immediately  pre- 
ceding the  close  of  such  taxable  year  as  may  be  applicable)  was  de- 
rived from  sources  within  a  possession  of  the  United  States;  and 

(2)  If,  in  the  case  of  such  corporation,  50  per  centum  or  more  of 
its  gross  income  (computed  without  the  benefit  of  this  section)  for  such 


'"Law.  Section  262.  "  .  .  .  .  (c)  As  used  in  this  section  the  term  'pos- 
session of  the  United  States'  docs  not  include  the  Virgin  Islands  of  the 
United  States." 

Regulation.  "  .  .  .  .  The  term  'possession  of  the  United  States'  .... 
includes  Porto  Rico,  the  Philippine  Islands,  the  Panama  Canal  Zone,  Guam, 
Tutuila,  Wake,  and  Palmyra;  it  does  not  include  the  Virgin  Islands."  (Art. 
1137.) 

"C.  B.  4.  Page55;  T.  D.  3178. 


NON-RESIDENT   ALIENS  1325 

period  or  such  part  thereof  was  derived  from  the  active  conduct  of  a 
trade  or  business  within  a  possession  of  the  United  States;  or 

(3)  If,  in  the  case  of  such  citizen,  50  per  centum  or  more  of  his 
gross  income  (computed  without  the  benefit  of  this  section)  for  such 
period  or  such  part  thereof  was  derived  from  the  active  conduct  of  a 
trade  or  business  within  a  possession  of  the  United  States  either  on  his 
own  account  or  as  an  employee  or  agent  of  another 

The  foregoing  subsections  (i)  and  (2)  make  citizens  or 
domestic  corporations  having  such  income  derived  from 
sources  within  United  States  possessions,  subject  to  taxation 
on  net  income  computed  under  section  217  of  the  192 1  law. 

In  computing  gross  income  under  section  217,  taxpayers, 
in  arriving  at  the  percentage  necessary  to  secure  the  benefit 
of  taxation  under  section  262,  must  furnish  all  the  data  con- 
cerning gross  income  from  sources  both  within  and  without 
the  United  States.  In  other  words,  to  satisfy  the  Commissioner 
as  to  the  correctness  of  this  assumption  that  they  are  entitled 
to  the  benefits  extended  by  section  262,  they  must  make  a 
return  showing  their  computation  to  be  correct. 

Law.     Section  262 (b)   Notwithstanding  the  provisions  of 

subdivision  (a)  there  shall  be  included  in  gross  income  all  amounts 
received  by  such  citizens  or  corporations  within  the  United  States, 
whether  derived  from  sources  within  or  without  the  United 
States 

Section  262  (b)  means  that  if  United  States  citizens  and 
domestic  corporations  remit  amounts  received  in  United  States 
possessions  to  the  United  States,  such  amounts  must  be  in- 
cluded in  gross  income.  If  taxpayers  have  qualified  under  sec- 
tion 262  (a)  and  wish  to  omit  from  gross  income  amounts 
received  from  without  the  United  States,  it  is  important  that 
such  amounts  also  Ije  disljursed   without  the  United  States. 


CHAPTER    XXXVII 

FIDUCIARIES 

The  sections  of  the  192 1  law  relating  to  fiduciaries,  which 
differ  in  no  essential  features  from  that  of  1918,  have  clarified 
rather  than  changed  the  provisions  of  the  1916,  1917,  and  1918 
laws. 

Fiduciary  defined. — A  fiduciary  is  one  who  occupies  a  posi- 
tion of  peculiar  confidence  toward  others.  As  a  general  rule,  a 
fiduciary  has  legal  title  to  the  property  and  those  for  whom  he 
acts  enjoy  the  beneficial  title.  The  law  defines  a  fiduciary  as 
follows : 

Law.  Section  200 (2)  The  term  "fiduciary"  means  a  guar- 
dian, trustee,  executor,  administrator,  receiver,  conservator,  or  any  per- 
son acting  in  any  fiduciary  capacity  for  any  person,  trust  or  es- 
tate;^   .... 

Regulation.  "Fiduciary"'  is  a  term  which  applies  to  all  persons 
that  occupy  positions  of  peculiar  confidence  toward  others,  such  as 
trustees,  executors,  and  administrators,  and  a  fiduciary  for  income  tax 
purposes  is  a  person  who  holds  in  trust  an  estate  to  which  another 
has  the  beneficial  title  or  in  which  another  has  a  beneficial  interest, 
or  receives  and  controls  income  of  another  as  in  the  case  of  receivers. 
A  committee  or  guardian  of  the  property  of  an  incompetent  person  is 
a  fiduciary (Art.  1521.) 

It  has  been  held  that  property  of  enemy  aliens  which  w^as 
seized  and  is  held  by  the  Alien  Property  Custodian,  cannot  be 
said  to  be  held  in  trust  within  the  meaning-  of  the  Revenue  Act 


^  [Former  Procedure]  The  act  of  1913  included  agents  in  the  defini- 
tion of  fiduciaries,  but  as  this  clearly  did  not  mean  the  ordinary  agent  or 
attorney,  and  the  Treasury  so  held,  the  word  was  omitted  from  the  1916  law. 

Prior  to  1918,  fiduciaries  were  considered  the  agents  having  the  receipt, 
custody,  control  and  disposal  of  non-resident  alien  beneficiaries'  income, 
and  as  such  were  required  to  make  return  for  such  beneficiaries,  and  to  pay 
any  and  all  tax  found  by  such  return  to  be  due,  provided  return  was  not 
made  by  the  beneficiary.  Since  1918  a  fiduciary  for  a  non-resident  alien 
is  required  to  account  for  any  and  all  normal  and  surtax  upon  income  paid 
to  such  a  beneficiary.  If  this  results  in  payment  of  excessive  taxes,  relief 
must  be  sought  by  filing  a  return  and  claiming  refund. 

1326 


FIDUCIARIES  1327 

of  1918.^  The  Alien  Property  Custodian  is  construed  to  be 
merely  an  agent  or  officer  of  the  government  and  not  a  trustee 
or  fiduciary  such  as  is  required  to  make  returns  and  pay  in- 
come tax.  While  it  is  held  that  the  custodian  is  not  required 
to  make  returns  and  pay  tax,  the  Treasury,  before  paying  out 
any  funds  representing  accrual  of  income  during  retention  of 
the  alien's  property  by  the  government,  may  ascertain  the 
taxes  due  on  such  income  and  require  that  they  be  paid. 

Fiduciary  distinguished  from  agent. — 

Regulation.  There  may  be  a  fiduciary  relationship  between  an 
agent  and  a  principal,  but  the  word  "agent"  does  not  denote  a  fidu- 
ciary. A  fiduciary  relationship  can  not  be  created  by  a  power  of 
attorney.  An  agent  having  entire  charge  of  property,  with  authority 
to  effect  and  execute  leases  with  tenants  entirely  on  his  own  responsi- 
bility and  without  consulting  his  principal,  merely  turning  over  the 
net  profits  from  the  property  periodically  to  his  principal  by  virtue 
of  authority  conferred  upon  him  by  a  power  of  attorney,  is  not  a 
fiduciary  within  the  meaning  of  the  statute.  In  cases  where  no  legal 
trust  has  been  created  in  the  estate  controlled  by  the  agent  and  attor- 
ney the  liability  to  make  a  return  rests  with  the  principal.  (Art. 
1522.) 

Rulings.  A.n  oral  agreement  wheieby  one  of  a  number  of 
brothers  and  sisters  acts  as  agent  for  all  of  them  in  managing  prop- 
erty held  by  them  as  tenants  in  common  under  the  father's  will,  and 
in  distributing  the  income  therefrom,  is  not  a  legal  trust  for  income- 
tax  purposes,  nor  is  the  agent  a  fiduciary.  Each  principal  should  file 
a  separate  return  including  therein  his  share  of  the  income  from  the 
property  and  claiming  a  proportionate  share  of  any  allowable  deduc- 
tions.    (C.  B.  2,  page  198;  O.  D.  425.) 

By  an  agreement  among  owners  of  unequal  portions  of  a  royalty 
interest  in  oil  and  gas  wells,  A  was  appointed  to  receive  from  the 
purchaser  of  the  oil  and  gas,  moneys  arising  from  the  sale  and  run- 
ning of  the  oil  and  gas  and  to  account  therefor  to  the  signers  of  the 
agreement.  A  also  had  authority  under  the  agreement  to  sign  di- 
vision orders  respecting  the  sale  and  running  of  the  oil  and  gas  from 
the  land.    The  agreement  conveyed  no  property  to  A. 

Held,  that  A  is  an  agent  of  the  signers  and  not  a  trustee  within 
the  meaning  of  the  Revenue  Act  of  1918  and  is  not  required  to  file 
a  return  on  l-'ornis  1040  or  1041  to  account  for  the  income  received 
by  him.      Since  the  amounts  paid  over  by  him  to  his  principals  are 


'C.  B.  3,  page  199;  Op.  A.  G.  2. 


1328  SPECIAL   CLASSES    OF   TAXPAYERS 

not  fixed  and  determinable  gains,  he  is  not  liable  for  the  filing  of  re- 
turns of  information  under  section  256  of  the  aforesaid  Act 

(C.  B.  4,  page  14;  O.  D.  875.) 

Receivers  are  all  classed  as  fiduciaries.^ — 

Law.      Section    239 (a)  ....  In    cases    where   receivers, 

trustees  in  bankruptcy,  or  assignees  are  operating  the  property  or  busi- 
ness of  corporations,  such  receivers,  trustees,  or  assignees  shall  make 
returns  for  such  corporations  in  the  same  manner  and  form  as  corpora- 
tions are  required  to  make  returns.  Any  tax  due  on  the  basis  of  such 
returns  made  by  receivers,  trustees,  or  assignees  shall  be  collected  in 
the  same  manner  as  if  collected  from  the  corporations  of  whose  busi- 
ness or  property  they  have  custody  and  control.*   .... 

Responsibility  of  fiduciary. — A  fiduciary  cannot  be 
held  personally  responsible  for  erroneous  or  fraudulent  re- 
turns by  the  decedent,  but  an}'  additional  tax  arising  from 
such  returns  would  ht  a  charge  against  the  estate.  It  might 
properly  be  held  that  such  a  fiduciary  should  not  make  a  final 
distribution  until  all  past  returns  had  been  audited. 

Association"  distinguished  from  trust. — 

Regulation.  Where  trustees  hold  real  estate  subject  to  a  lease 
and  collect  the  rents,  doing  no  business  other  than  distributing  the 
income  less  taxes  and  similar  expenses  to  the  holders  of  their  receipt 
certificates,  who  have  no  control  except  the  right  of  filling  a  vacancy 
among  the  trustees  and  of  consenting  to  a  modification  of  the  terms 
of  the  trust,  no  association  exists  and  the  cestuis  que  trust  are  liable 
to  tax  as  beneficiaries  of  a  trust  the  income  of  which  is  to  be  dis- 
tributed periodically,  whether  or  not  at  regular  intervals.  But  in 
such  a  trust  if  the  trustees  pursuant  to  the  terms  thereof  have  the 
right  to  hold  the  income  for  future  distribution,  the  net  income  is 
taxed  to  the  trustees  instead  of  to  the  beneficiaries If,  how- 
ever, the  cestuis  que  trust  have  a  voice  in  the  conduct  of  the  business 
of  the  trust,  whether  through  the  right  periodically  to  elect  trustees  or 
otherwise,  the  trust  is  an  association  within  the  meaning  of  the 
statute.®     (Art.  1504.) 


^  See  footnote  22,  page  1341. 

*  See  page  1341  where  this  point  is  elaborated. 

"An  organization  the  membership  interests  in  which  are  transferable 
without  the  consent  of  all  the  members,  however  the  transfer  may  be  other- 
wise restricted,  and  the  business  of  which  is  conducted  by  trustees  or  direc- 
tors and  officers  without  the  active  participation  of  all  the  members  as 
such,  is  an  association  and  not  a  partnership.     (Art.  1503.) 

*As  to  Massachusetts  trusts,  see  page  93. 


FIDUCIARIES  1329 

It  has  been  ruled  that,  under  the  191 6  law  as  amended  by 
the  19 17  law,  the  test  as  to  whether  or  not  a  reorganization 
committee  of  bondholders  constituted  an  association,  depended 
upon  the  degree  of  control  which  the  latter  exercised  over  the 
former. 

While  the  power  to  terminate  a  trust  is  not  alone  enough 
to  render  a  trust  taxable  as  an  association,  retention  of  sub- 
stantial control  over  the  management  of  the  trust  does  operate 
to  make  the  trust  an  association  within  the  meaning  of  the  law/ 

The  quesion  of  substantial  control  over  the  management 
of  a  trust  is  one  of  fact  and  there  must  be  a  clear  showing  in 
each  case  in  order  that  it  may  be  determined  whether  the  trust 
is  to  be  taxed  as  an  association'^  or  not.  It  was  held  in  Crocker 
V.  Malley^  that : 

....  The  trustees  by  themselves  cannot  be  a  joint  stock  associa- 
tion within  the  meaning  of  the  act  unless  all  trustees  with  discretion- 
ary powers  are  such,  and  the  special  provision  for  trustees  in  D  is  to 
be  made  meaningless. 

How  Estates  and  Trusts  Are  Taxed 

Rates  of  tax. — 

Law.  Section  219.  (a)  That  the  tax^o  imposed  by  sections  210 
and  211  shall  apply  to  the  income  of  estates  or  of  any  kind  of  prop- 
erty held  in  trust,  including — 

Income  subject  to  tax. — 

(i)  Income  received  by  estates  of  deceased  persons  during  the 
period  of  administration  or  settlement  of  the  estate; 


'C.  B.  3,  page  13;  Sol.  Op.  49. 

» Cf.  Bulletins : 
C.  B.  I,  page    5;  S.  1068  C.  B.  3,  page  13;  Sol.  Op.  49 

"       I,      "       7;   S.  1205  "      3,      "      13;  O.  D.  6S4 

"      I,      "       9;  O.  D.  620  "      4,       "      10;  O.  D.  790  and 

"      2,      "       9;  S.  1337  O.  D.  868 

"      2,      "      11;  O.  D.  407  "      4,       "      11;  O.  D.  886 

"      3,      "       9;  O.  D.  598  B.  30-21-1741;  T.  D.  3193 

"      3,      "      10;  Sol.  Op.  56  B.  38-21-1830;  O.  D.  1040 

°249  U.  S.  223,  63  L.  Ed.  573,  39  Sup  Ct.  270,  2  A.  L.  R.  looi. 

"  The  tax  referred  to  is  the  normal  and  surtax  imposed  in  the  case  of 
individuals.     (See  Chapter  VII.) 


I330 


SPECIAL    CLASSES    OF    TAXPAYERS 


(2)  Income  accumulated  in  trust  for  the  benefit  of  unborn  or 
unascertained  persons  or  persons  with  contingent  interests; 

(3)  Income  held  for  future  distribution  under  the  terms  of  the 
will  or  trust;  and 

(4)  Income  which  is  to  be  distributed  to  the  beneficiaries  period- 
ically, whether  or  not  at  regular  intervals,  and  the  income  collected 
by  a  guardian  of  an  infant  to  be  held  or  distributed  as  the  court  may 
direct 


Returns  by  Fiduciaries 

Law.  Section  225.  (a)  That  every  fiduciary  (except  a  receiver 
appointed  by  authority  of  law  in  possession  cf  part  only  of  the  property 
of  an  individual)  shall  make  under  oath  a  return  for  any  of  the  follow- 
ing individuals,  estates,  or  trusts  for  which  he  acts,  stating  specifically 
the  items  of  gross  income  thereof  and  the  deductions  and  credits 
allowed  under  this  title — 

When  returns  are  required. — 

(i)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$1,000  or  over,  if  single,  or  if  married  and  not  living  with  husband  or 
wife; 

(2)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$2,000  or  over,  if  married  and  living  with  husband  or  wife; 

(3)  Every  individual  having  a  gross  income  for  the  taxable  year 
of  $5,000  or  over,  regardless  of  the  amount  of  his  net  income; 

(4)  Every  estate  or  trust  the  net  income  of  which  for  the  taxable 
year  is  $1,000  or  over;  and 

(5)  Every  estate  or  trust  of  which  any  beneficiary  is  a  nonresident 
alien 

Attention  is  directed  to  subdivision  (3)  in  tlie  foregoing. 
The  statute  now  directs  that  every  individual  taxpayer  having 
a  </ross  income  of  $5,000  or  more  must  file  a  return. 

Regulation.  Every  fiduciary,  or  at  least  one  of  joint  fiduciaries, 
must  make  a  return  of  income  (a)  for  the  individual  whose  income 
is  in  his  charge,  if  the  gross  income  of  such  individual  is  $5,000  or 
over,  or  if  the  net  income  of  such  individual  is  $2,000  or  over  if  mar- 
ried and  living  with  husband  or  wife,  or  is  $1,000  or  over  in  other 
cases,  or  (b)  for  the  estate  or  trust  for  which  he  acts,  if  the  net 
income  of  such  estate  or  trust  is  $1,000  or  over,  or  if  any  beneficiary 
of  such  estate  or  trust  is  a  nonresident  alien.  The  return  in  case  (a) 
and  also  in  case  (b),  if  the  tax  is  payable  by  the  fiduciary,  shall  be 
on  Form  1040,  or  on  Form  1040  A  if  the  net  income  does  not  exceed 


FIDUCIARIES  1 33 1 

$5,000.  In  cases  under  (b)  where  the  tax  is  payable  by  the  bene- 
ficiaries the  returns  shall  be  made  on  Form  1041.  In  such 
a  case  the  fiduciary  shall  include  in  the  return  a  statement  of  each 
beneficiary's  distributive  share  of  the  net  income,  whether  or  not 
distributed  before  the  close  of  the  taxable  year  for  which  the  re- 
turn  is  made If  the  net  income  of  a   decedent   from  the 

beginning  of  the  taxable  year  to  the  date  of  his  death  was  at  the  rate 
of  $1,000  or  more  a  year  if  unmarried,  or  $2,000  or  more  a  year  if 
married,  or  if  his  gross  income  for  the  same  period  was  at  the  rate 
of  $5,000  or  over  a  year,  the  executor  or  administrator  shall  make 
a  return  for  such  decedent (Art.  421.) 

When  returns  are  due. — 

Law.  Section  227.  (a)  That  returns  (except  in  the  case  of  non- 
resident aliens)  shall  be  made  on  or  before  the  fifteenth  day  of  the 
third  month  following  the  close  of  the  fiscal  year,  or,  if  the  return  is 
made  on  the  basis  of  the  calendar  year,  then  the  return  shall  be  made 
on  or  before  the  15th  day  of  March.  In  the  case  of  a  nonresident  alien 
individual  returns  shall  be  made  on  or  before  the  fifteenth  day  of  the 
sixth  month  following  the  close  of  the  fiscal  year,  or,  if  the  return  is 
made  on  the  basis  of  the  calendar  year,  then  the  return  shall  be  made 
on  or  before  the  15th  day  of  June.  The  Commissioner  may  grant  a 
reasonable  extension  of  time  for  filing  returns  whenever  in  his  judg- 
ment good  cause  exists  and  shall  keep  a  record  of  every  such  extension 
and  the  reason  therefor.  Except  in  the  case  of  taxpayers  who  are 
abroad,  no  such  extension  shall  be  for  more  than  six  months 

Exercising  the  authority  vested  in  him  by  the  foregoing 
section  of  the  law,  the  Commissioner  has  granted  a  general 
extension  of  time  up  to  and  inchiding  May  15,  1922,  in  which 
to  file  fiduciary  returns.  This  extension  appHes  to  income 
returns  (form  1041)  and  information  returns  (forms  1099 
and  1096),  and  is  granted  with  ragpect  to  returns  covering 
the  calendar  or  any  fiscal  year  ending  in  1921.^' 

Place  for  filing  return. — 

Ruling.  In  the  case  where  a  decedent,  a  resident  of  New  York, 
but  at  the  time  of  her  decease  living  in  California,  left  property  in 
both  States,  an  executor  being  appointed  in  each  State,  it  is  held  that 
since  the  entire  will  was  probated  in  New  York  and  only  that  part 
pertaining  to  the  property  located  in  California  was  probated  in  that 

"I-S-59;  T.  D.  3272,  dated  January  19,  1922. 


1332 


SPECIAL   CLASSES    OF   TAXPAYERS 


State  in  conformity  with  its  laws,  the  executor  in  California  is  in  fact 
an  ancillary  executor  and  is  not  required  to  file  a  return  for  the  estate, 
if  the  domiciliary  executor  includes  in  his  return  the  entire  income 
of  the  estate.     (C.  B.  3,  page  231;  O.  D.  584.) 

See  also  section  227   (b)   on  page  63. 

Income  may  be   computed   on  basis   other  than   calendar 

year/- — 

Law.  Section  212.  [Individuals.]  .  .  .  .  (b)  The  net  income  shall 
be  computed  upon  the  basis  of  the  taxpayer's  annual  accounting  period 
(fiscal  year  or  calendar  year,  as  the  case  may  be)  in  accordance  with 
the  method  of  accounting  regularly  employed  in  keeping  the  books 
of  such  taxpayer;  .... 

The  section  is  applicable  to  fiduciaries,  because  of  the  defi- 
nition of  taxpayer  given  in  the  law,  viz.,  "The  term  'taxpayer' 
includes  any  person,  trust  or  estate  subject  to  a  tax  imposed 
by  this  Act"  (section  i). 

Return  for  deceased  person  to  date  of  death. — As  soon  as 
possible  after  an  executor  or  administrator  enters  upon  his 
duties,  he  is  required  to  make  a  return  for  the  decedent  up  to 
the  date  of  decedent's  death.  This  is  tisttally  for  the  period 
from  January  i  of  the  year  in  which  the  death  occurred,  but 
may  be  also  for  the  preceding  year,  as  in  the  case  of  a  man 
dying  in  January  or  February  before  he  had  filed  his  annual 
return  then  due.  The  income  tax  due  from  the  decedent  is  a 
debt  against  the  estate  in  the  hands  of  the  executor  or  admin- 
istrator, and  the  executor  or  administrator  is  required  to  file  the 
return  for  the  decedent  iy  order  that  the  amount  dtte  to  the 
government  from  the  decedent's  estate  may  be  determined  and 
paid.^^ 

In  filing  a  return  the  executor  or  administrator  reports  all 
items  in  the  manner  w'hich  the  decedent  himself  would  have 
followed.     He  may  claim,  on  behalf  of  the  decedent,  an  ex- 


'"  [Former  Procedure]  Under  the  laws  prior  to  the  1918  act.  all 
fiduciary  returns  had  to  be  made  on  the  basis  of  a  calendar  year,  except 
that  returns  could  be  made  immediately  upon  the  settlement  of  an  estate. 

"  See  T.  D.  2494,  June  2,  1917;  also  Income  Tax  Procedure,  1920,  pages 
869-870. 


FIDUCIARIES 


1333 


emption  of  $1,000,  $2,000  or  $2,500,  as  the  case  may  be,  no 
matter  how  small  a  portion  of  the  year  is  covered  by  the 
return.  And  he  may  again  claim  the  full  exemption  of  $1,000 
when  he  later  reports  the  income  of  the  estate  for  the  remain- 
ing portion  of  a  year.  If  the  net  income  of  the  decedent  for 
the  part  of  the  year  in  which  he  lived  was  less  than  $1,000, 
if  unmarried,  or  less  than  $2,000  if  married  (provided  also 
that  his  gross  income  was  less  than  $5,000^"*),  the  executor 
or  administrator  need  not  make  any  return  for  him,  nor  is  he 
required  to  account  for  such  luireported  income  when  he 
reports  for  the  estate  and  its  beneficiaries.  Such  income  is 
entirely  ignored  so  far  as  the  income  tax  is  concerned. 

Regulations.  As  soon  as  possible  after  his  appointment  and 
qualification,  without  waiting  for  the  close  of  the  taxable  year,  an 
executor  or  administrator  shall  file  a  return  of  income  for  the  de- 
cedent. Upon  the  completion  of  the  administration  of  an  estate 
and  final  accounting  an  executor  or  administrator  shall  file  a  return 
of  income  of  the  estate  for  the  portion  of  the  taxable  year  in  which 
the  administration  was  closed,  attaching  to  the  return  a  certified  copy 
of  the  order  for  his  discharge.  An  ancillary  administrator  need 
make  no  separate  return  if  the  domiciliary  administrator  includes 
in  his  return  the  entire  income  of  the  estate.  Similarly,  upon  the 
termination  of  any  other  trust  the  trustee  shall  make  a  return  with- 
out waiting  for  the  close  of  the  taxable  year.  In  any  such  case  the 
requirements  with  respect  to  the  payment  of  the  tax  are  the  same 
as  if  the  return  were  for  a  full  taxable  year  closing  at  the  end  of 
the  month  during  which  the  decedent  dies  or  the  estate  is  settled 
or  the  trust  is  terminated,  as  the  case  may  be.  The  payment  of  the 
tax  before  the  end  of  the  taxable  year  in  such  circumstances  does 
not  relieve  the  taxpayer  from  liability  for  any  additional  tax  which 
might  subsequently  be  imposed  upon  income  of  the  taxable  year. 
.    .    .    .      (Art.  442.) 

....  If  an  individual  dies  during  the  taxable  year,  his  executor 
or  administrator  in  making  a  return  for  him  is  entitled  to  claim  his 
full  personal  exemption  according  to  his  status  at  the  time  of  his 

death If  a  husband  or  wife  so  dies  and  the  joint  personal 

exemption  is  used  by  the  executor  or  administrator  in  making  a 
return  for  the  decedent,  an  undiminished  personal  exemption  ac- 
cording to  the  status  of  the  survivor  at  the  end  of  the  taxable  year 


'*  [Former  Procedure]     The  (lualification  as  to  gross  income  was  not 
in  prior  laws. 


1334  SPECIAL   CLASSES    OF   TAXPAYERS 

may  be  claimed  in  the  survivor's  return.  If  a  taxpayer  makes  a 
return  for  a  period  other  than  a  taxable  year,  the  last  day  of  such 
period  shall  be  treated  as  the  last  day  of  the  taxable  year  for  the 
purpose  of  this  article (Art.  305.) 

If  the  deceased  person  kept  books  on  an  accrual  basis,  all 
income  accrued  to  date  of  death  must  be  reported  in  the  return 
made  by  the  executor  or  administrator  covering  the  period 
from  the  beginning  of  the  taxable  year  to  date  of  death.  If, 
however,  the  deceased  kept  books  on  a  receipt  basis,  only  in- 
come actually  received  to  date  of  his  death  is  to  be  reported  on 
the  return."  In  the  case  of  a  deceased  stockholder  of  a  per- 
sonal service  corporation,^®  the  distributive  share  of  the  de- 
cedent in  the  profits  from  the  beginning  of  his  taxable  year 
to  date  of  death  is  to  be  included. ^^  The  same  rule  applies  to 
partnership  profits,  and  in  both  cases  such  shares  would  pre- 
sumably be  determined  by  prorating,  if  no  other  determination 
were  possible.  It  has  been  held  that  in  case  a  decedent  had 
been  granted  an  extension  of  time  in  which  to  file  a  return 
for  a  previous  taxable  period  and  later  died  without  filing  such 
return,  the  executor  or  administrator  should  file,  immediately 
after  his  appointment  or  qualification,  the  return  of  the  ae- 
cedent  and  pay  tax  plus  the  amount  of  interest  due  on  the 
deferred  instalments.^^ 

Rulings.  A  taxpayer  in  October,  1919,  converted  all  of  his  prop- 
erty into  cash  and  distributed  it  to  his  wife  and  sister,  so  that  at  the 
time  of  his  death  in  January,  1920,  nothing  remained  to  be  adminis- 
tered or  to  satisfy  his  income  tax  liability.  It  is  stated  that  the  net 
income  from  the  operation  of  his  farm  in  1919,  together  with  the 
profit  derived  from  the  sale  of  his  property,  was  sufficient  to  require 
a  return. 

Held,  that  the  gift  tended  to  defeat  the  intent  and  purpose  of  the 
income  tax  law  and  that  liability  for  tax  upon  the  income  accruing 
from  the  sale  attaches  to  and  follows  the  property  distributed  into 
the  hands  of  the  recipients;  also  that  a  return  for  1919  should  be  filed 


'"C.  B.  2.  page  170;  O.  D.  454. 

"After  December  31,  1921,  personal  service  corporations  are  treated 
the  same  as  other  corporations,  stockholders  including  in  their  individual 
returns  onlv  dividends  actually  received. 

"C.  B.'i,  page  180;  O.  D.  S2. 

"C.  B.  3,  page  230;  O.  D.  681. 


FIDUCIARIES  1335 

on  behalf  of  the  decedent  and  that  the  tax  found  to  be  due  should  he 
assessed  against  the  estate  of  the  decedent,  but  that  demand  for  pay- 
ment should  be  made  upon  the  recipients  of  the  gift.  (C.  B.  3,  page 
211;  O.  D.  582.) 

In  case  no  necessity  exists  for  the  appointment  of  an  admin- 
istrator, the  beneficiaries  may  act  jointly,  or  may  duly  appoint  one 
of  their  number  as  the  agent  of  the  estate  for  the  purpose  of  filing 
the  income-tax  return  of  the  decedent.  In  doing  so,  however,  the 
agent  assumes  the  responsibility  for  making  the  return  and  incurs 
the  liability  to  the  specific  penalties  provided  for  in  the  case  of  the 
filing  of  erroneous,  false,  and  fraudulent  returns.  (C.  B.  3,  page 
229;  O.  D.  702.) 

Returns  of  income  to  be  made  by  fiduciaries. — 

Law.  Section  219.  ....  (b)  The  fiduciary  shall  be  responsible 
for  making  the  return  of  income  for  the  estate  or  trust  for  which  he 
acts.  The  net  income  of  the  estate  or  trust  shall  be  computed  in  the 
same  manner  and  on  the  same  basis  as  provided  in  section  212,1-^  .... 

Regulation.  The  "period  of  administration  or  settlement  of  the 
estate"  is  the  period  required  by  the  executor  or  administrator  to  per- 
form the  ordinary  duties  pertaining  to  administration,  in  particular 
the  collection  of  assets  and  the  payment  of  debts  and  legacies.  It  is 
the  time  actually  required  for  this  purpose,  whether  longer  or  shorter 
than  the  period  specified  in  the  local  statute  for  the  settlement  of 
estates.  Where  an  executor,  who  is  also  named  as  trustee,  fails  to 
obtain  his  discharge  as  executor,  the  period  of  administration  con- 
tinues up  to  the  time  when  the  duties  of  administration  are  complete 
and  he  actually  assumes  his  duties  as  trustee,  whether  pursuant  to  an 
order  of  the  court  or  not (Art.  343.) 

An  administrator  or  executor  may,  immediately  after  his 
discharge  upon  final  accounting,  file  with  the  proper  coUector 
of  internal  revenue  a  return  covering  the  income  and  deduc- 
tions of  the  estate  for  the  period  from  the  end  of  the  last  tax- 
able year  to  the  date  of  his  discharge.  To  such  a  return  there 
should  be  attached  a  certificate,  under  seal,  settino-  forth  the 
fact  of  the  final  accounting  and  discharge  of  the  administrator 
or  executor.  The  tax  assessed  against  that  return  may  be  paid 
immediately  after  receipt  from  the  collector  of  a  notice  of  the 
amount  assessed  and  a  demand  therefor.     It  should  be  under- 


Section  212  relates  to  net  incomes  of  individuals. 


1336  SPECIAL   CLASSES    OF   TAXPAYERS     • 

Stood,  however,  that  if,  upon  an  audit  of  that  return,  a 
further  assessment  of  tax  is  made,  the  administrator  or  execu- 
tor will  be  held  liable  for  its  proper  payment. 

One  of  two  or  more  joint  fiduciaries  required  to  file  re- 
turn.— 

Law.  Section  225 (b)  Under  such  regulations  as  the  Com- 
missioner with  the  approval  of  the  Secretary  may  prescribe,  a  return 
made  by  one  of  two  or  more  joint  fiduciaries  and  filed  in  the  office 
of  the  collector  of  the  district  where  such  fiduciary  resides  shall  be 
sufficient  compliance  with  the  above  requirement.  Such  fiduciary  shall 
make  oath  (i)  that  he  has  sufficient  knowledge  of  the  affairs  of  the  in- 
dividual, estate  or  trust  for  which  the  return  is  made,  to  enable  him 
to  make  the  return,  and  (2)  that  the  return  is,  to  the  best  of  his 
knowledge  and  belief,  true  and  correct.  Any  fiduciary  required  to  make 
a  return  under  this  Act  shall  be  subject  to  all  the  provisions  of  this 
Act  which  apply  to  individuals. 

Returns  for  estates  or  trusts  which  cannot  be  treated  as 
units. — 

Ruling.  Under  section  219  of  the  Revenue  Act  of  1918-"  where 
an  estate  or  trust  represents  different  interests  and  is  not  susceptible  of 
treatment  as  a  unit,  the  fiduciary,  in  determining  the  distributive  shares 
of  the  beneficiaries,  shall  analyze  the  items  of  gross  income  and  de- 
duction and  shall  (a)  account  as  fiduciary  for  income  held  for  future 
distribution  or  added  to  the  corpus;  (b)  assign  to  the  beneficiaries 
income  which  is  distributable  periodically;  (c)  report  on  form  1041 
the  net  income  of  the  estate  or  trust  computed  as  a  unit,  but  show  as 
the  distributive  shares  of  the  beneficiaries  the  amounts  of  income 
which  should  be  periodically  distributed  to  them  (whether  distributed 
or  not)  ;  (d)  report  on  form  1041  any  excess  of  the  net  income  of  the 
estate  or  trust  over  the  aggregate  distributive  shares  of  the  individual 
beneficiaries  as  the  distributive  share  of  the  fiduciary;  (e)  if  such 
amount  exceeds  $1,000,  make  a  separate  return  on  form  1040  or 
1040-A  including  such  income. 

The  result  of  this  will  be  that  each  beneficiary  must  include  in 
computing  his  net  income  the  entire  sum  which  should  be  periodi- 
cally distributed  to  him  (whether  distributed  or  not)  from  the  estate 
or  trust  as  income  (other  than  exempt  income)  and  no  more  than 
such  sum.     (C.  B.  2,  page  181 ;  O.  1013.) 


'"As  the  provisions  of  the  1918  law  on  which  this  ruling  is  based  were 
re-enacted  without  change  in  the  1921  law,  the  ruling  is  fully  applicable 
under  the  new  law. 


FIDUCIARIES  1337 

The  application  of  the  above  principle  is  shown  in  the  fol- 
lowing : 

Rulings.  Under  the  terms  of  the  will  of  a  decedent  a  trust  was 
created  part  of  the  income  of  which  is  distributable  periodically  to 
the  beneficiaries  and  a  portion  of  which  is  to  be  accumulated  and 
added  to  the  principal  of  the  trust  or  held  for  future  distribution. 
During  the  taxable  year  1920  real  estate  owned  by  the  trust  was  sold 
at  a  loss  and  the  return  for  the  trust  for  that  year  showed  a  net  loss 
as  a  result  of  the  sale. 

It  is  held  that  the  amount  of  the  loss  may  be  deducted  from  the 
gross  income  of  the  trust  for  the  taxable  year  in  computing  the  net 
income  of  the  trust  as  a  unit;  but  since  the  loss  on  the  sale  of  the 
capital  assets  of  the  trust  affected  the  corpus  of  the  trust  only,  each 
beneficiary  is  required  to  include  in  computing  his  net  income  the 
amount  of  the  income  of  the  trust,  if  any,  distributable  to  him,  even 
though  the  aggregate  of  the  distributive  shares  of  the  beneficiaries  is 
larger  than  the  net  income  of  the  trust  computed  as  a  unit.  Inasmuch 
as  there  is  no  provision  in  the  statute  allowing  one  taxpayer  to  de- 
duct from  his  gross  income  the  losses  sustained  by  another  taxpayer 
and  as  under  the  statute  the  trust  and  the  beneficiaries  must  be  con- 
sidered as  separate  taxpayers,  the  beneficiaries  may  not  deduct  from 
gross  income  in  their  individual  returns  for  1920  any  part  of  the  loss 
which  was  sustained  by  the  trust  through  the  sale  of  the  real  estate 
or  through  the  sale  of  any  other  property  owned  by  the  trust.  (B. 
38-21-1831;   O.   D.   1041.) 

Under  a  will  a  trust  was  created  for  the  period  of  A's  life,  a  part 
of  the  income  of  which  is  payable  to  a  charitable  and  an  educational 
institution  and  the  remainder  of  the  income  to  A.  Upon  the  termina- 
tion of  the  trust  the  property  is  bequeathed  to  the  charitable  and 
educational  institutions.  The  estate  received  the  right  to  subscribe 
for  shares  of  stock  in  a  corporation  in  which  it  was  a  shareholder  and 
the  trustee  sold  this  right. 

Held,  that  the  trust  can  not  be  treated  as  a  unit  for  income  tax 
purposes,  there  being  income  distributable  periodically  and  also  in- 
come (according  to  Federal  income  tax  statutes  and  regulations) 
which  is  not  distributable  periodically  under  the  law  of  the  State  in 
which  the  testator  resided.  The  trustee  should  file  Form  1040,  re- 
turning as  income  the  amount  received  from  the  sale  of  the  right,- ^ 
and  also   Form    1041,   showing  the   distributive   shares   of   the   bcne- 


"'  Regarding  the  income  realized  from  sale  of  rights  reference  shoulfl 
be  had  to  the  opinion  of  the  court  in  the  case  of  ,9^/^'  Deposit  &  Trust  Co. 
of  Baltimore  v.  Joshua  IV.  Miles,  Collector  of  Internal  Revenue  (273  Fed. 
822),  which  appears  on  page  550. 


1338  SPECIAL   CLASSES    OF   TAXPAYERS 

ficiaries  in  that  portion  of  the  trust  income  which  is  distributable 
periodically.     (C  B.  4,  page  226;  O.  D.  808.) 

Return  must  show  beneficiary's  distributive  share. — 

Law.      Section  219 (b)  ....  In  cases  in  which  there  is 

any  income  of  the  class  described  in  paragraph  (4)  of  subdivision  (a) 
of  this  section  the  fiduciary  shall  include  in  the  return  a  statement  of 
the  income  of  the  estate  or  trust  which,  pursuant  to  the  instrument 
or  order  governing  the  distribution,  is  distributable  to  each  bene- 
ficiary, whether  or  not  distributed  before  the  close  of  the  taxable  year 
for  which  the  return  is  made. 

Ruling.  An  executor  or  administrator  of  an  estate  in  process  of 
administration  may  not,  at  his  option,  in  rendering  the  return  Form 
1040,  for  the  estate,  either  claim  as  a  deduction  the  amount  of  income 
properly  paid  or  credited  during  the  year  to  any  heir,  legatee,  or 
other  beneficiary,  or  compute  the  net  income  without  the  benefit  of 
such  deduction  and  pay  the  entire  tax  himself. 

Held,  in  accordance  with  the  provisions  of  Section  219,  subdi- 
vision (c)  and  (d)  of  the  Revenue  Act  of  1918,  that  the  adminis- 
trator or  executor  shall  claim  in  his  return,  Form  1040,  for  the  es- 
tate a  deduction  for  any  amount  of  income  properly  paid  or  credited 
within  the  year  to  any  legatee,  heir,  or  other  beneficiary  and  that 
recipient  must  include  such  amount  in  his  gross  income.  This  ap- 
plies to  cases  of  final  distribution  as  well  as  distribution  made  dur- 
ing the  period  of  administration.     (B.  27-21-1714;  O.  D.  967.) 

Regulations.  In  the  case  of  («)  estates  of  decedents  before 
final  settlement,  (b)  trusts,  whether  created  by  will  or  deed,  for  ac- 
cumulation of  income,  whether  for  unascertained  persons  or  persons 
with  contingent  interests  or  otherwise,  and  in  any  other  case  within 
section  219(a)  except  paragraph  4  thereof,  the  income  is  taxed  to  the 
fiduciary  as  to  any  single  individual,  except  that  from  the  income  of 
a  decedent's  estate  there  may  first  be  deducted  any  amount  of  income 

properly    paid    or    credited    to    a    beneficiary Where    under 

the  terms  of  the  will  or  deed  the  trustee  may  in  his  discretion  dis- 
tribute the  income  or  accumulate  it,  the  income  is  taxed  to  the  trustee 
irrespective  of  the  exercise  of  the  discretion.  The  imposition  of  the 
tax  is  not  affected  by  the  fact  that  an  ultimate  beneficiary  may  be  a 
person  exempt  from  tax.  An  allowance  paid  a  widow  out  of  the 
corpus  of  the  estate  is  not  deductible  from  gross  income.  As  an 
intestate's  real  estate  does  not  pass  to  his  administrator,  upon  a  sale 
by  the  heirs,  whether  before  or  after  settlement  of  the  estate,  each 
lieir  is  taxed  individually  on  any  profit  derived.     (Art.  342.) 

While  certain  estates  and  trusts  are  subject  to  tax  as  such  and 
others  are  not,  the  fiduciary  in  every  case  is  required  to  make  a  re- 
turn of  income (Art.  341.) 


FIDUCIARIES 


1339 


Returns  for  beneficiaries. — As  a  general  rule,  a  fiduciary 
completes  his  duty  as  to  reporting  when  he  files  form  1041. 
The  beneficiary  then  files  on  his  own  behalf  form  1040,  includ- 
ing therein,  among  other  items,  the  amount  he  has  received 
from  the  estate.  It  should  be  borne  in  mind  that,  although 
the  fiduciary  may  not  have  been  required  to  file  form  1041, 
because  the  payment  to  each  beneficiary  was  less  than  $1,000, 
the  beneficiary  must  nevertheless  include  the  amount  he  re- 
ceives from  the  estate,  no  matter  how  small,  in  his  own  return. 

The  fiduciary  may,  of  course,  file  form  1040,  for  his  bene- 
ficiary if  he  has  knowledge  of  all  the  income  of  the  beneficiary 
from  the  estate  and  other  sources,  provided  he  has  been  ap- 
pointed as  agent  or  attorney-in-fact  by  the  beneficiary  for  the 
purpose.  In  doing  so  he  acts  in  an  entirely  separate  capacity, 
performs  no  duty  as  a  fiduciary  and  is  not  thereby  relieved 
from  any  responsibility  as  a  fiduciary. 

Return  by  guardian  for  minor,  or  committee  for  incom- 
petent.— 

Regulation.  A  fiduciary  acting  as  the  guardian  of  a  minor 
having  a  net  income  of  $1,000  or  more,  or  $2,000  or  more,  accord- 
ing to  the  marital  status  of  such  person,  or  having  a  gross  income 
of  $5,000  or  over,  must  make  a  return  for  such  minor  on  Form  1040 
or  1040  A  and  pay  the  tax,  unless  such  minor  himself  makes  a  return 
or  causes  it  to  be  made.  A  fiduciary  acting  as  a  guardian  or  the 
committee  of  an  insane  person  having  an  income  of  $1,000  or  more  or 
$2,000  or  more,  according  to  the  marital  status  of  such  person,  or 
having  a  gross  income  of  $5,000  or  over,  must  make  a  return  for  such 
incompetent  on  Form   1040  or  1040  A  and  pay  the  tax.     (Art.  422.) 

When  there  has  been  a  change  of  guardian  during  the  year, 
the  fiduciary  in  charge  on  the  last  day  of  the  taxable  year  is 
responsible  for  filing  the  return  for  the  full  year.  (I-5-5H; 
I.  T.  1 185.) 

Return  v/here  trustees  turn  property  over  to  administrator 
for  beneficiaries. — 

Ruling.  Under  the  terms  of  the  will  of  A,  creating  a  trust  in 
favor  of  his  wife  which  was  terminated  in   1920,  and  in  accordance 


I340 


SPECIAL   CLASSES    OE   TAXPAYERS 


with  a  court  order,  the  trustees  paid  over  to  the  administrators  of 
A's  estate  all  of  the  cash  and  property  remaining  in  their  hands 
after  making  certain  payments  to  the  heirs  and  legal  representatives 
of  A's  wife,  and  the  administrators  in  turn  distributed  to  the  bene- 
ficiaries under  the  will  all  of  the  cash  and  property  which  they  held 
as  administrators,  including  that  received  from  the  trustees.  The 
question  raised  is  as  to  how  the  income  received  in  1920  should  be 
reported. 

Held,  that  the  trustees  should  file  a  return  on  Form  1041  showing 
the  gross  income  of  the  trust  and  deductions  claimed;  also  the  amount 
of  income  paid  over  to  the  administrators  of  A's  estate  and  any 
amount  of  such  income  distributed  to  the  heirs  or  personal  represen- 
tatives of  A's  wife. 

The  administrators  should  file  a  return  on  Form  1040  or  1040  A, 
as  the  case  may  be,  if  the  entire  net  income  of  the  estate,  including 
income  received  through  the  trustees,  was  $1,000  or  over.  In  such  re- 
turn may  be  claimed  a  deduction  for  the  entire  amount  of  income 
received  during  the  year  by  the  administrators,  either  directly  or 
through  the  trustees,  and  properly  paid  over  or  credited  to  the  bene- 
ficiaries under  the  will.  This  return  must  be  accompanied  by  a  state- 
ment showing  the  names  and  addresses  of  the  beneficiaries  to  whom 

income  was  paid  during  1920,  and  the  amount  paid  to  each 

(C.  B.  4,  page  223;  O.  D.  806.) 

Return  where  several  trusts  are  created  by  same  person. — 

Regulation.  In  the  case  of  two  or  more  trusts  the  income  of 
which  is  taxable  to  the  beneficiaries,  which  were  created  by  the 
same  person  and  are  in  charge  of  the  same  trustee,  the  trustee  shall 
make  a  single  return  on  form  1041  for  all  such  trusts,  not- 
withstanding that  they  may  arise  from  different  instruments. 
When,  however,  a  trustee  holds  trusts  created  by  different  persons 
for  the  benefit  of  the  same  beneficiary,  he  shall  make  a  return  on  form 
1 04 1    for  each  trust  separately.      (Art.  423.) 

Return  by  trustee  under  revocable  trust. — 

Ruling The  trustee  under  a  revocable  trust  is  required 

to  file  a  return  on  Form  1041,  revised,  in  accordance  with  section  225 
of  the  Revenue  Act  of  1918  and  article  421  of  Regulations  45,  showing 
the  grantor  as  the  beneficiary  under  the  trust.  The  trustee  must  also 
file  a  return  of  information  on  Form  1099,  revised,  as  provided  in 
section  256  of  the  Act  upon  w'hich  should  be  entered  the  name  and 
address  of  the  grantor  in  whose  return  the  income  should  be  in- 
cluded.    (C.  B.  3,  page  202;  O.  D.  621.) 

The  legality  of  this  ruling  has  been  questioned. 


■  '  FIDUCIARIES  1341 

Return  by  trustee  in  bankruptcy. — 

Ruling.  A  "trustee  in  bankruptcy"  is  required  to  file  a  return 
of  net  income  for  the  bankrupt's  estate  if  the  net  income  exceeds  the 
specific  exemption  of  $1,000. 

The  bankrupt  individual  is  required  to  file  a  return  accounting  for 
his  individual  earnings  but  is  entitled  to  the  exemptions  provided  in 
section  216  of  the  Revenue  x^ct  of  1918.  (C.  B.  i,  page  175;  O. 
D.   174.) 

Returns  by  receivers." — The  Treasury  has  held  that  re- 
ceivers in  certain  proceedings  are  required  to  make  returns. 
The  regulations  definitely  specify  that  receivers  in  partition 
and  similar  proceedings  are  not  required  to  render  returns  of 
income. 

Regulations.  A  receiver  who  stands  in  the  stead  of  an  indi- 
vidual or  corporation  must  render  a  return  of  income  and  pay  the 
tax  for  his  trust,  but  a  receiver  of  only  part  of  the  property  of  an 
individual  or  corporation  need  not.  If  the  receiver  acts  for  an  in- 
dividual the  return  shall  be  on  form  1040  or  1040A.  When  acting 
for  a  corporation  a  receiver  is  not  treated  as  a  fiduciary,  and  in  such 

a  case  the  return  shall  be  made  as  if  by  the  corporation  itself 

A  receiver  in  charge  of  the  business  of  a  partnership  shall  render  a 
return  on  form  1065.  A  receiver  of  the  rents  and  profits  ap- 
pointed to  hold  and  operate  a  mortgaged  parcel  of  real  estate,  but 
not  in  control  of  all  the  property  or  business  of  the  mortgagor,  and 
a  receiver  in  partition  proceedings,  are  not  required  to  render  returns 
of  income.  In  general,  statutory  receivers  and  common  law  receiv- 
ers of  all  the  property  or  business  of  an  individual  or  corporation 
must  make  returns (Art.  424.) 

Receivers,  trustees  in  dissolution,  trustees  in  bankruptcy,  and 
assignees,  operating  the  property  or  business  of  corporations,  must 
make  returns  of  income  for  such  corporations  on  form  1120,  covering 
each  year  or  part  of  a  year  during  which  they  are  in  control.  Not- 
withstanding that  the  powers  and  functions  of  a  corporation  are 
suspended  and  that  the  property  and  business  are  for  the  time  being 
in  the  custody  of  the  receiver,  trustee  or  assignee,  subject  to  the 
order  of  the  court,  such  receiver,  trustee  or  assignee  stands  in  the 


"  [Former  Procedure] 

RuMXG.  The  net  income  of  a  corporation  in  the  hands  of  a  receiver 
who  is  acting  solely  as  an  officer  of  the  court  which  appointed  him  and 
subject  to  its  orders  is  not  taxable  under  the  act  of  October  3,  1913.  This 
ruling  does  not  apply  to  the  net  income  of  a  corporation  in  the  hands  of 
trustees  or  voluntary  liquidators  not  so  acting.    (C.  B.  2,  page  222;  O.  1009.) 


1342 


SPECIAL   CLASSES    OF   TAXPAYERS 


place  of  the  corporate  officers  and  is  required  to  perform  all  the 
duties  and  assume  all  the  liabilities  which  would  devolve  upon  the 
officers  of  the  corporation  were  they  in  control.  A  receiver  in 
charge  of  only  part  of  the  property  of  a  corporation,  however,  as  a 
receiver  in  mortgage  foreclosure  proceedings  involving  merely  a 
small  portion  of  its  property,  need  not  make  a  return  of  income. 
....   (Art.  622.) 

Ruling.  Liquidating  agents  in  charge  of  the  affairs  of  a  national 
bank  should  make  returns  for  the  bank  for  each  year  during  which 
they  were  in  control.  If  the  bank  was  engaged  in  operating  its  busi- 
ness during  a  portion  of  a  year  in  which  the  liquidating  agents  were 
in  charge  of  its  affairs,  the  return  of  the  liquidating  agents  should  in- 
clude the  income  from  such  operations.  Provided  the  taxes  shown 
to  be  due  by  the  several  returns  filed  by  the  liquidating  agents  for 
the  years  during  which  they  were  in  control,  have  been  paid,  the 
liquidating  agents  may  distribute  the  assets  of  the  bank,  and  no  per- 
sonal liability  will  be  incurred  by  them  for  the  payment  of  any  addi- 
tional tax  that  subsequently  may  be  assessed  against  the  bank.  How- 
ever, liability  for  any  such  tax  follows  the  assets  into  the  hands  of 
the  stockholders  and  other  persons  not  creditors  or  purchasers  for  a 
valuable  consideration.     (C".  B.  4,  page  308;  O.  D.  883.) 

A  receiver,  being  relieved  of  his  trust  by  the  resumption 
of  the  corporation  as  a  going  concern  with  possession  of  its 
physical  property  restored  to  it,  is  also  reheved  of  making  a 
return  for  the  fiscal  period  during  which  such  action  took 
place. 

Ruling.  A  corporation  on  a  calendar  year  basis,  to  which  on 
December  i  is  restored  all  its  property  formerly  in  possession  of  re- 
ceivers, should  file  a  corporation  income  and  profits  tax  return  for 
the  calendar  year,  including  therein  the  gross  income  received  while 
the  corporation  was  in  the  control  of  receivers  and  also  the  gross  in- 
come received  after  December  i.     (C.  R.  4,  page  308;  O.  D.  873.) 

The  Treasury  has  ruled  that  when  trustees  in  liquidation 
are  appointed  for  a  corporation  during  a  fiscal  period,  the 
trustees  should  file  a  return  for  the  whole  of  such  fiscal  period. 

Ruling If  the  affairs  of  the  company  are  not  finally 

settled  during  the  taxable  year  for  which  the  return  is  rendered,  the 
return  of  the  company  should  be  filed  by  the  trustees  in  liquidation 
for  the  entire  taxable  year  and  should  include  the  gross  income  re- 
ceived by  the  company  prior  to  the  time  of  the  trustees'  appointment 
and  also  the   gross   income   received   under  the   supervision   of   the 


FIDUCIARIES  1343 

trustees.  If,  however,  the  affairs  of  the  company  are  finally  adjusted 
within  the  taxable  year  for  which  the  return  is  rendered,  the  return 
of  the  company  should  be  filed  by  the  trustees  in  liquidation  for  the 
period  from  the  beginning  of  the  taxable  year  to  the  date  within  that 
year  on  which  its  transactions  were  finally  closed.  (C.  B.  4,  page 
309;   O.  D.  884.) 

The  responsibility  of  filing  a  return  rests  with  the  receiver 
only  when  he  is  in  fact  operating  the  business  as  a  business  and 
not  merely  winding  up  its  affairs. 

Ruling.  Article  622,  Regulations  45,  which  provides  that  "re- 
ceivers, trustees  in  dissolution,  trustees  in  bankruptcy,  and  assignees, 
operating  the  property  or  business  of  corporations,  must  make  re- 
turns of  income  for  such  corporations  on  Form  1120,  covering  such 
year  or  part  of  a  year  during  which  they  are  in  control  .  .  .  .  " 
refers  specifically  to  receivers,  trustees  or  assignees  who  are  operat- 
ing the  property  or  business  of  corporations,  and  it  has  been  held 
that  where  trustees  in  liquidation  are  merely  engaged  in  marshalling, 
selling  and  distributing  the  assets  of  a  corporation  they  are  not  operat- 
ing the  property  or  business  of  the  corporation  within  the  contem- 
plation of  the  article  mentioned.  It  is  held  further,  however,  that 
where  the  trustees  in  dissolution,  under  the  statutes  of  the  State,  as 
in  Ohio,  wholly  supersede  the  officers  of  the  corporation  and  become 
vested  with  its  entire  assets  and  control,  the  trustees  in  liquidation, 
and  not  the  officers  of  the  corporation,  are  the  proper  persons  to  make 

a  return  of  income  for  the  company (C.  B.  4,  page  309; 

O.   D.  884.) 

Depositors  who  are  unfortunate  enough  to  have  funds  in 
a  bank  that  has  become  insolvent,  are  made  preferred  creditors 
over  the  Commissioner  of  Internal  Revenue : 

Ruling.  The  question  is  presented  as  to  what  action  is  to  be 
taken  with  reference  to  the  collection  of  taxes  where  banks  which 
are  in  the  hands  of  receivers  owe  income  taxes  either  by  way  of 
assessments  or  deferred  payments. 

Section  22  of  the  Act  of  March  i,  1879,  provides  as  follows: 

That  whenever  and  after  any  bank  has  ceased  to  do  business  by 
reason  of  insolvency  or  bankruptcy,  no  tax  shall  be  assessed  or  col- 
lected, or  paid  into  the  Treasury  of  the  United  States,  on  account  of 
such  bank,  which  shall  diminish  the  assets  thereof  necessary  for  the 
full  payment  of  all  its  depositors;  and  such  tax  shall  be  abated  from 
such  national  banks  as  are  found  by  the  Comptroller  of  Currency  to 
be  insolvent;  and  the  Commissioner  of  Internal  Revenue,  when  the 
facts  shall  so  appear  to  him,  is  authorized  to  remit  so  much  of  said 


1344  SPECIAL   CLASSES    OF   TAXPAYERS 

tax  against  insolvent  State  and  savings  banks  as  shall  be  found  to 
affect  claims  of  their  depositors. 

In  view  of  the  above  statute,  no  action  should  be  taken  against 
receivers  of  banks  which  have  ceased  to  do  business  by  reason  of 
insolvency  or  bankruptcy  until  the  depositors'  claims  have  been  fully 
satisfied.  In  the  event  that  any  bank  has  ceased  to  do  business  or 
is  in  the  hands  of  a  receiver  for  other  reasons  than  insolvency  or 
bankruptcy,  the  statute  does  not  apply,  and  in  such  case  proceedings 
may  be  instituted  for  the  recovery  of  taxes  due,  notwithstanding  the 
fact  that  the  bank  is  in  the  hands  of  a  receiver.  (B.  32-21-1763; 
O.  D.  990.) 

Return  for  non-resident  alien  beneficiary. — 

Regulation.  Where  a  citizen  or  resident  fiduciary  has  the  dis- 
tribution of  the  income  of  a  trust  any  beneficiary  of  which  is  a  non- 
resident alien,  the  fiduciary  shall  make  a  return  on  form  1040  B  for 
such  nonresident  alien  and  pay  any  tax  shown  thereon  to  be  due. 
.    .    .    .      (Art.  425.) 

The  authority  for  the  requirement  that  the  fiduciary  must 
pay  the  tax  in  those  cases  in  which  the  income  has  been  dis- 
tributed to  the  beneficiary  is  not  clear.  Section  225  of  the 
law  requires  a  fiduciary  to  make  a  return  for  the  individual 
estate  or  trust  for  which  he  acts.  If  the  income  is  being  dis- 
tributed, he  is  acting  for  the  estate  but  not  for  the  beneficiary."^ 
When  the  fiduciary  files  a  return  and  pays  both  normal  and 
surtax,  and  such  tax  is  in  excess  of  the  tax  assessed  on  the 
alien's  return  of  all  income  from  sources  within  the  United 
States,  then  relief  must  be  sought  through  a  claim  for  a  re- 
fund. 

Information  at  the  source. — 

Ownership  certificates. — 

Regulation.  When  fiduciaries  have  the  control  and  custody  of 
more  than  one  estate  or  trust,  and  such  estates  and  trusts  have  as 
assets  bonds  of  corporations  and  other  securities,  a  certificate  of 
ownership  shall  be  executed  for  each  estate  or  trust,  regardless  of 
the   fact  that  the  bonds   are  of  the   same   issue.     When  bonds  are 


"'  [Former  Procedure]  Under  the  Act  of  September  8,  1916.  as 
amended  by  the  Act  of  October  3,  1917,  the  fiduciary  was  required  to  pay 
normal  and  surtax  only  if  tlie  non-resident  alien  failed  to  file  a  return. 


FIDUCIARIES  1345 

owned  jointly  by  two  or  more  persons,  a  separate  ownership  certifi- 
cate must  be  executed  in  behalf  of  each  of  the  owners.     (Art.  374.) 

However,  the  several  beneficiaries  of  a  trust-estate  are 
not  considered  joint  owners  of  bonds  in  the  custody  of  the 
fiduciary,  and  separate  ownership  certificates  are  not  required. 

Ruling.  Receipt  is  acknowledged  of  your  letter  dated  Novem- 
ber I,  1921,  in  which  it  is  stated  that  in  a  number  of  instances  with- 
holding agents  have  returned  ownership  certificates,  forms  1000  and 
1001,  filed  by  you  in  connection  with  the  coupons  on  bonds  held  in 
your  various  trust  estates,  with  the  request  that  you  file  separate 
ownership  certificates  for  the  pro  rata  amount  of  income  appor- 
tionable  to  each  beneficiary  of  the  estate,  and  in  other  cases  that 
you  furnish  a.Hst  of  thfe  various  beneficiaries  with  their  respective 
interests.  You  state  that  you  have  always  complied  with  the  provisions 
of  Article  374  of  Regulations  45  and  have  executed  separate  certificates 
for  each  estate  and  trust.  You  are  of  the  opinion  that  the  last  sen- 
tence of  that  article  has  no  reference  to  trust  estates  and  that  to 
comply  with  the  construction  placed  upon  this  article  by  withholding 
agents  would  be  impossible  in  many  estates  and  would  impose  an 
enormous  burden  on  the  fiduciary  for  which  there  is  apparently  no 
necessity.  You  inquire  whether  this  office  has  made  a  ruling  requir- 
ing the  interests  of  the  various  beneficiaries  to  be  separately  reported 
or  has  so  construed  Article  374. 

There  is  no  connection  between  the  first  and  second  sentences  of 
this  article.  The  various  beneficiaries  of  a  trust  or  estate  are  not  con- 
sidered joint  owners  of  the  bonds  which  are  in  the  possession  of  the 
fiduciary  acting  for  the  estate  or  trust  and  to  whom  the  income  arising 
from  such  bonds  is  paid. 

The  fiduciary  is  required  to  file  an  ownership  certificate,  Form 
1000  Revised  or  Form  looi  Revised,  disclosing  the  identity  of  the 
estate  or  trust  for  which  he  acts.  In  connection  with  the  collection 
of  the  income  accruing  to  the  estate  from  bonds  issued  by  domestic 
or  resident  corporations,  as  a  fiduciary  acts  for  his  principal,  the 
estate  or  trust,  and  not  for  the  beneficiaries  of  such  estate  or  trust, 
this  office  has  not  ruled  that  a  fiduciary  is  required  to  file  separate 
ownership  certificates  in  behalf  of  the  beneficiaries,  showing  their 
pro  rata  share  in  the  income  of  the  estate  represented  by  corporate 
bond  interest. 

There  appears  to  be  no  reason  for  income  tax  purposes,  why  a 
withholding  agent  or  a  debtor  corporation  should  be  furnished  a  list 
of  the  various  beneficiaries  of  an  estate  or  trust,  as  the  withholding 
agent  or  the  debtor  corporation  is  not  required  to  pay  any  tax  at  the 
source  in  behalf  of  such  beneficiaries,  with  respect  to  the  income  ac- 
cruing to  the  estate  or  trust,   or  to   furnish  this  office  with  any  in- 


134^ 


SPECIAL   CLASSES    OF    TAXPAYERS 


formation  relative  to  the  beneficiaries.  (Letter  to  the  Mercantile 
Trust  and  Deposit  Company  of  Baltimore.  Baltimore,  Md.,  signed  by 
Deputy  Commissioner  E.  H.  Batson,  and  dated  November  17,  1921.) 

Fiduciaries  must  make  full  returns  of  informa- 
tion.— 

Ruling.  Is  any  other  than  a  return  of  income  required  of  a 
fiduciary  ? 

Yes.  Fiduciaries  come  within  the  provisions  of  section  256,  of 
the  revenue  act  of  1918,  and  will  be  required  to  render  to  tlie  Com- 
missioner of  Internal  Revenue  a  return  of  information,  if,  during 
the  taxable  year,  any  income  has  been  paid  to  an  individual,  partner- 
ship, corporation,  joint-stock  company,  etc.,  equal  to,  or  in  excess  of 
$1,000.     (Income  Tax  Primer,  1919,  question  106.) 

In  accordance  with  the  provisions  of  the  above-mentioned 
section,  fiduciaries  are  required  to  make  returns  of  information 
regarding  all  payments  of  interest,  rent,  salaries,  wages,  premi- 
ums, annuities,  compensation,  remunerations,  emoluments  or 
other  fixed  or  determinable  gains,  profits  and  income  (other 
than  ])ayments  described  in  sections  254  and  255)  of  $1,000 
or  more  in  any  taxable  ye;ir.'"* 

This  oljligation  is  reasonable  and  can  be  readily  fulfilled 
by  fiduciaries.  It  is  vastly  simpler  than  the  cumbersome  and 
annoying  system  of  deduction  at  the  source. 

It  is  incumbent  upon  liduciaries  not  only  to  furnish  the  in- 
formation rccpiired  but  also  to  assist  as  far  as  possible  in  the 
securing  of  returns  from  beneficiaries,  so  that  no  tax  shall  be 
lost  thrcAigh  the  abolition  of  deduction  at  the  source. 

Return  forms. — The  forms  used  at  present  are  as  follows : 

Fiduciary   return   for  estate No.  104T 

Return    for    minor,    etc "  1040 

or  1 040 A 

Report  of   information "  1099 

Annual  information  return "  1096 

Tax  withheld    "  1098 

Annual  return  of  tax  withheld "  1042 


"■*  See  Chapter  XI  for  full  text  of  this  section. 


FIDUCIARIES  1347 

Payment  of  Tax 

When  tax  is  payable  by  the  fiduciary. — 

Law.  Section  219.  .  .  .  .  (c)  In  cases  under  paragraphs  (i), 
(2),  or  (3)  of  subdivision  (a)  or  in  any  other  case  within  subdivision 
(a)  of  this  section  except  paragraph  (4)  thereof  the  tax  shall  be  im- 
posed upon  the  net  income  of  the  estate  or  trust  and  shall  be  paid  by 
the  fiduciary,'-'^   .... 

Tlie  Treasur}'  has  tmifornil}-  held  that  income  accunittlated 
for  the  benefit  of  unborn  or  unascertained  persons  or  persons 
with  contingent  interests  is  to  be  taxed  to  the  fiduciary,  not- 
withstanchng  the  fact  that  specific  provision  to  this  effect  was 
not  included  in  the  1913  law.  However,  the  1916  law  (as 
amended  by  the  191 7  law)  and  the  subsequent  laws  do  make 
such  .specific  provision. 

Prior  to  July  26,  191 5,  the  Treasury  held  that  under  the 
19 1 3  law  this  class  of  income  was  not  taxable,  but  on  that  date 
issued  the  following  ruling: 

Regulation Any  part  of  the  annual  income  of  trust  estates 

not  distributed  becomes  an  entity  and  as  such  is  liable  for  the  normal 
and  additional  tax,  which  must  be  paid  by  the  fiduciary.  When  the  ben- 
eficiary is  not  in  esse  and  the  income  of  the  estate  is  retained  by  the 
fiduciary,  such  income  will  be  taxable  to  the  estate  as  for  an  individual 

and  the  fiduciary  will  pay  the  tax  both  normal  and  additional 

(T.  D.  2231,  dated  July  26,  1915.) 

In  the  case  of  First  Trust  and  Savings  Bank  z'.  Sniictanka,'^ 
the  court  held  that  this  ruling  was  in  error. 

Decision This  ruling  was  the  cause  of  the  present  and 

other  similar  suits.  It  illustrates  the  not  unnatural  tendency  of  tax 
officers  to  increase  the  revenues  by  implications  and  strained  construc- 
tions. The  department's  first  rulings  were  in  harmony  with  the  nat- 
ural import  of  the  language  used  by  Congress ;  its  later  ruling  does 
more  than  violate  the  canon  that  doubts  and  ambiguities  are  to  go 
against  the  government,  for  it  is  based,  not  upon  any  uncertainty  in 
the  terms  of  the  act,  but  upon  a  metamorphosis  of  a  body  of  property 
into  a  person,  and  upon  exactions  contrary  to  the  exemptions  in  the 
Act  of   1913.     If  the  unascertained  residuary  legatees  were  now  at 


"'"  Fiduciaries  are  classed  as  individuals,   so  that  payments   of   the  tax 
must  be  made  as  provided  in  the  case  of  individuals.     (See  Chapter  VIII.) 
='268  Fed.  230. 


1348  SPECIAL   CLASSES    OE    TAXPAYERS 

hand  to  receive  from  the  trustee  the  accumulations  of  the  preceding 
calendar  year,  they  might  be  such  in  number  as  that  nothing  but  the 
normal  tax  on  the  share  of  each  in  excess  of  his  personal  exemption 
could  be  assessed ;  but  the  department,  by  converting  an  estate  into 
a  personal  entity,  cuts  off  all  personal  exemptions  and  by 
adding  the  shares  together  subjects  each  share  to  the  rates  of 
surtaxes  that  are  calculable  on  the  sum  total.  If  the  residuary 
legatee  were  a  charitable  or  e(lucati(jna]  institution,  the  department's 
method  would  add  to  the  detriment  due  to  the  testator's  postponement 
of  the  benefit  of  the  taxes  and  surtaxes  throughout  the  period  of 
postponement.  Congress  recognized  that  such  alterations  and  amend- 
ments were  legislative  and  passed  the  amendatory  act  of  September 
8,  1916,  levying  a  tax  upon  undistributed  income  added  to  the  prin- 
cipal  of  trust  estates.-^ 

Liability  for  tax  on  estate  or  trust. — 

Regulation.  Liability  for  payment  of  the  tax  attaches  to  the 
person  of  an  executor  or  administrator  up  to  and  after  his  discharge, 
where  prior  to  distribution  and  discharge  he  had  notice  of  his  tax 
obligations  or  failed  to  exercise  due  diligence  in  determining  whether 
or  not  such  obligations  existed.  Liability  for  the  tax  also  follows 
the  estate  itself,  and  when  by  reason  of  the  distribution  of  the 
estate  and  the  discharge  of  the  executor  or  administrator  it  appears 
that  collection  of  the  tax  can  not  be  made  from  the  executor  or 
administrator,  the  legatees  or  distributees  must  account  for  their 
proportionate  share  of  the  tax  due  and  unpaid.  The  same  consid- 
erations apply  to  other  trusts.  Where  the  tax  has  been  paid  on 
the  net  income  of  an  estate  or  trust  by  the  fiduciary,  such  income 
is  free  from  tax  when  distributed  to  the  beneficiaries.      (Art.  344.) 

Income  of  minors  taxable  to  fiduciary. — Where  minors  are 
concerned  the  procedure  required  of  the  fidticiary  is  outlined 
in  the  following: 

Ruling If  the  minor  children  are  nonresident  aliens, 

the  fiduciary  is  required  to  make  return  and  to  pay  the  tax  thereon, 
for  each  of  the  beneficiaries.  If  such  minors  are  citizens  of  the 
L^nited  States,  the  fiduciary  is  required  to  make  return  for  them  and 


"'  [Former  Procedure] 

Ruling.  Where  the  income  of  a  trust  fund  is  payable  only  in  the  dis- 
cretion of  the  trustees,  such  income  as  the  trustees  in  their  discretion  dis- 
tribute to  the  beneficiary  during  the  years  1916  or  1917,  is  taxable  to  the 
recipient  personally  (Act  of  Sept.  8,  1916,  sec.  2  (b).)  .  .  .  (C.  B.  i, 
page  176;  S.  1088.) 

The  tax  on  the  undistributed  income  was  paid  by  the  trustee. 


FIDUCIARIES 


1349 


to  pay  the  tax,  unless  such  minors  themselves  make  a  return  or  cause 
it  to  be  made,  provided  in  either  instance  such  minors  have  a  net 
income  of  $1,000  or  $2,000  according  to  their  marital  status.  In 
either  event,  the  return  to  he  made  by  the  fiduciary  for  each  minor 
child  should  be  on  Form  1040  (revised)  or  1040- A  (revised).  (B. 
44-21-1897;  O.  D.   1085.) 

Payments  to  beneficiaries  during  period  of  administration 
not  taxable  to  fiduciary."'' — 

Law.  Section  2iy.  ....  (c)  ....  in  determining  the  net  in- 
come of  the  estate  of  any  deceased  person  during  the  period  of  admin- 
istration or  settlement  there  may  be  deducted  the  amount  of  any  in- 
come properly  paid  or  credited  to  any  legatee,  heir  or  other  bene- 
ficiary  

Ruling.  Income  of  an  estate  during  the  period  of  administration 
which  is  not  paid  or  credited  to  the  beneficiary  is  taxable  to  the  estate 
even  though  such  beneficiary  was,  as  a  matter  of  law,  entitled  to  be 
paid  or  credited  with  such  income  durino-  that  year.  (C.  B.  i,  page 
178;  T.  B.  R.  47.) 

Allowances  paid  to  a  uidow  under  an  order  of  court  are 
amotints  "properly  paid."-'^ 

When  income  is  taxed  to  beneficiary. — 

Law.     Section   219 (d)   In  cases   under  paragraph   (4)    of 

subdivision  (a),  and  in  the  case  of  any  income  of  an  estate  during  the 


■""  [Former  Procedure] 

"The  rule  in  New  York  that  one  who  receives  a  bequest  of  the 
income  of  a  specified  sum,  the  property  of  the  decedent  being  income  pro- 
ducing at  the  time  of  his  death,  is  entitled  to  such  income  from  the  date 
of  death  {Re  Stanficld's  Estate,  135  N.  V.  292;  31  N.  E.  1013)  has  no 
application  to  interests  arising  under  a  will  creating  a  trust  of  the  residuary 
estate,  and  directing  the  payment  of  the  income  of  certain  portions  thereof 
to  specified  individuals.  The  trust  being  created  only  at  the  expiration  of 
administration,  the  right  to  the  income  of  the  trust  fund  accrues  only  at 
that  time;  and  consequently,  under  the  Revenue  Act  of  1916,  no  part  of 
it  is  taxable  to  the  individual  beneficiary  during  the  period  of  administra- 
tion, but  the  whole  of  it  is  taxable  to  the  estate  as  an  entity.  (Revenue  Act 
of  1916,  sec.  2  (b)]  The  result  is  the  same  where  the  will  creates  a  right 
in  the  legatee  to  income  from  the  date  of  the  death,  since  such  income  is 
not  payable  until  the  comjiletion  of  administration,  and  until  that  time  the 
property  producing  the  income  is  ])art  of  the  estate  in  i)rocess  of  administra- 
tion.    Solicitor's  Memorandum  783  revoked. 

"Under  the  Revenue  Act  of  1918,  however,  the  estate  is  entitled  to 
deduct  income  properly  paid  or  credited  to  legatees  during  the  period  of 
adirrinistration,  and  such  income  is  taxable  to  the  beneficiary.  (Revenue 
Act  of  1918,  sec.  219  (c).)"     (B.  Digest  38-20-1206;  L.  O.  1051.) 

=■■•0.  B.  4,  page  224;  O.  D.  829. 


I350 


SPECIAL   CLASSES    OF   TAXPAYERS 


period  of  administration  or  settlement  permitted  by  subdivision  (c) 
to  be  deducted  from  the  net  income  upon  which  tax  is  to  be  paid  by 
the  fiduciary,  the  tax  shall  not  be  paid  by  the  fiduciary,  but  there  shall 
be  included  in  computing  the  net  income  of  each  beneficiary  that  part 
of  the  income  of  the  estate  or  trust  for  its  taxable  year  which,  pursuant 
to  the  instrument  or  order  governing  the  distribution,  is  distributable 
to  such  beneficiary,  whether  distributed  or  not,  or,  if  his  taxable  year 
is  different  from  that  of  the  estate  or  trust,  then  there  shall  be  included 
in  computing  his  net  income  his  distributive  share  of  the  income  of 
the  estate  or  trust  for  its  taxable  year  ending  within  the  taxable  year 
of  the  beneficiary 

Regulation.  In  the  case  of  (a)  a  trust  the  income  of  which  is 
distributable  periodically,  (b)  an  ordinary  guardianship  of  a  minor, 
and  (c)  an  estate  of  a  decedent  before  final  settlement  as  to  any  in- 
come properly  paid  or  credited  as  such  to  a  beneficiary,  the  income  is 
taxable  directly  to  the  l^eneficiary  or  beneficiaries.  Each  such  bene- 
ficiary must  include  in  his  return  his  distributive  share  of  the  net  in- 
come, even  though  not  yet  paid  him,  but  if  his  taxable  year  is  different 
from  that  of  the  estate  or  trust,  then  he  need  only  include  in  comput- 
ing his  net  income  his  distributive  share  of  the  income  of  the  estate 
or  trust  for  its  taxable  year  ending  within  his  taxable  year.  The 
regulations  governing  partnerships  are  generally  applicable  to  such  an 
estate  or  trust (Art.  345.) 

Ruling.  When  a  trust  provides  for  the  distribution  of  income 
"when  received,*'  the  beneficiary  should  accoimt  for  it  personally 
whether  distributed  to  liini  or  not.  The  creator  of  the  trust  is  not 
liable  for  income  tax  witli  respect  thereto.  (C.  B.  i.  page  t8o;  S. 
961.) 

If  a  trust  is  irrevocable  there  can  be  no  question  but  that 
the  income  is  taxable  to  the  beneficiary.  1  f  the  trust  is  revo- 
cable the  Treasury  holds  that  the  income  is  to  be  taxed  to  the 
grantor.  For  further  discussion  of  this  question  see  page  1353. 
As  to  what  may,  or  ma\-  not.  be  an  irrevocable  trust  imder  these 
circumstances  is  determined  by  circumstantial  evidence  as  to 
the  intent  of  the  creator  of  the  trust,  llie  follou'ing  is  a  defi- 
nition given  by  the  Solicitor  to  the  Treasury  Department  as 
to  what  constituted  an  irrevocable  trust  imder  the  laws  of  the 
state  of  Kentucky  : 

While  it  is  essential  to  the  creation  of  a  trust  that  there  be  an  ex- 
plicit declaration  of  trust,  or  circumstances  which  show  beyond  'rea- 
sonable doubt  tliat  a  trust  was  intended  to  be  created,  no  formal  or 


FIDUCIARIES  1351 

particular  words  are  necessary,  but  it  is  sufficient  if  an  intention  to 
create  a  trust  and  the  subject  matter,  purpose,  and  beneficiary  are 
stated  with  reasonable  certainty.  Neither  is  it  necessary  in  all  cases 
that  the  creator  of  a  trust  constitute  a  third  person  trustee  and  trans- 
fer the  legal  title  to  him,  for  it  is  well  settled  that  one  may  create  a 
trust  in  his  own  property  by  constituting  himself  trustee,  provided 
his  words  and  acts  clearly  and  unequivocally  denote  an  intention  to 
hold  henceforth  as  trustee  for  the  benefit  of  another.^" 

Income  of  discretionary  trust  taxable  to  trustee.^  ^ — 

Ruling.  Where  the  income  of  a  trust  fund  is  payable  only  in 
the  discretion  of  the  trustees,  such  income  ....  as  is  received  in 
1918  or  later  years  by  the  trust  estate  is  taxed  to  the  trustees  irre- 
spective of  the  exercise  of  their  discretion.  (C.  B.  i,  page  176; 
S.  1088.) 

As  ill  the  application  of  the  estate  tax  law  (q.  v.),  so  with 
the  income  tax  law,  consideration  must  be  given  to  the  laws 
dealing  with  the  subject  of  trustees  which  obtain  in  the  state 
wherein  the  estate  is  situated  and  which  may  govern  the  situ- 
ation. 

It  should  be  noted  that  the  income  on  which  the  trustees 
had  paid  the  tax  is  tax-free  when  received  by  the  beneficiaries. 

The  constructive  creation  of  a  trust  whereby  a  beneficiary 
becomes  a  fiduciary  is  shown  in  the  following: 

Ruling.  A  father  and  son,  having  acquired  from  an  intestate 
a  life  estate  and  vested  remainder  respectively  in  real  property  in 
New  York,  made  a  joint  conveyance  of  the  property  for  an  amount 
in  excess  of  its  value  when  acquired  by  them.  The  proceeds  of  the 
sale  were  placed  in  a  bank  in  the  father's  name  and  they  agreed  that 
the  father  should  have  the  income  from  the  fund  for  life  and  upon 
his  death  that  the  principal  should  go  to  the  son. 

Under  the  laws  of  the  State  of  New  York  and  by  the  weight  of 
authority  generally,  the  father  is  a  trustee  for  the  remainderman,  his 
son.     The  profit  derived  from  the  sale  represents  the  undistributal)le 


""C.  B.  4,  page  108;  A.  R.  R.  492. 

■'  [Former  Procedure] 

Ruling.  Wlicre  llic  income  of  a  trust  fund  is  payable  only  in  tbe  dis- 
cretion of  the  trustees,  such  income  as  the  trustees  in  their  discretion  dis- 
tribute to  the  beneficiary  during  the  years  1916  or  1917,  is  taxable  to  the 
recipient  personally  (Act  of  Sept.  8,  1916,  sec.  2  (b).)  ....  (C.  B.  i, 
page  176;  S.  1088.) 

Tlic  tax  on  the  undistributed  income  was  paid  by  the  trustee. 


1352 


SPECIAL   CLASSES    OF    TAXPAYERS 


income  of  a  trust  entity,  and  the  trustee  sliould  file  a  return  on  Form 

1040  showing  the  profit   from  the   sale (B.   Digest  38-21- 

1830;  O.  D.  1040.) 


Residuary  legatee  pays  tax — when? — 


Ruling.  Inasmuch  as  a  residuary  estate  is  the  gross  estate  of  the 
decedent  less  proper  expenses  and  bequests  of  specific  amounts  or 
specific  property,  and  the  specific  bequests  must  be  paid  in  full  after 
all  debts  and  expenses  are  paid,  even  though  nothing  remains  to  con- 
stitute a  residue,  it  follows  that  if  an  estate  is  distributed  and  no 
provision  made  for  any  part  of  such  expenses  or  specific  bequests,  a 
proper  residue  is  not  obtained  and  the  residuary  legatee  has  received 
an  amount  in  excess  of  that  to  which  he  is  entitled.  Therefore, 
where  the  estate  of  a  deceased  person  has  been  settled,  no  provision 
being  made  for  the  payment  of  income  tax,  the  tax  assessable  is 
properly  cn]Iectil)le  from  the  rcsiduarv  legatee.  (C  B.  3,  page  211; 
O.  D.  722.) 

Income  of  each  trust  separately  taxed. — 

Ruling.  Where  the  same  trustee  is  designated  in  a  will  to  ad- 
minister several  trusts,  the  accumulated  income  of  each  separate 
trust  will  be  taxable  as  an  entity,  not  the  income  of  the  trusts  com- 
bined.    (C.  B.  I,  page  175;  O.  D.  316.) 

Grantor  taxable  on  income  of  revocable  trust. — 

Regulation The  income  of  a  revocable  trust  must  be  in- 
cluded in  the  gross  income  of  the  grantor.     (Reg.  45,  Art.  341.) 

The  foregoing  regulation  is  of  interest  to  taxpayers  who 
have  created  revocable  trusts  on  the  assumption  that  the  tax 
on  the  income  from  the  trust  will  be  imposed  upon  the  benefi- 
ciary. 

Rulings.  Where  a  declaration  of  trust  provides  that  during  the 
life  of  the  donor  he  may  indicate  the  manner  in  which  the  trustee  shall 
exercise  the  powers  conferred  by  the  trust  agreement;  that  the  donor 
shall  have  a  voice  in  determining  the  amount  of  net  income  to  be 
distributed  to  the  beneficiaries;  and  that  the  estate  created  and  the 
interests  vested  thereunder  shall  be  subject  to  revocation  by  the 
donor  at  any  time,  in  whole  or  in  part,  it  is  held  that  the  amount  of 
income  received  by  the  beneficiaries  is  in  the  nature  of  a  gift,  and 
that  the  trustee  merely  acts  as  agent  for  the  donor.  The  income  of 
the  trust   should  therefore  be   included   in  the   gross   income   of  the 

donor  in  accordance  with  article  341  of  Regulations  45 (C. 

•B.  3,  page  202;  O.  D.  676.) 


FIDUCIARIES  1353 

Where  a  person  transfers  funds  or  property  to  trustees  to  pay  to 
him  during  his  lifetime  so  much  of  the  income  as  he  may  demand,  and 
from  time  to  time  as  much  of  the  principal  as  such  trustees  might 
deem  advisable,  all  unwithdrawn  income  at  the  date  of  the  death  of 
the  settlor  to  become  a  part  of  the  trust  fund,  the  settlor  should  return 
in  any  one  year  all  the  income  accruing  from  such  trust  fund,  whether 
actually  withdrawn  by  him  or  not. 

The  trustees  under  such  deed  must  make  return  of  all  income 

from  the  trust,  but  are  relieved  from  paying  a  tax  thereon ^- 

(C  B.  2,  page  176;  S.  1344.) 

A  devised  to  B  a  life  estate  in  property  coupled  with  a  power  of 
disposition.  B  exercised  the  power  by  an  indenture  creating  an 
irrevocable  trust  in  her  right  and  interest  in  A's  estate.  The  trust 
instrument  by  reference  incorporated  and  made  a  part  thereof  B's 
will  for  the  purpose  of  providing  for  the  distribution  of  the  trust 
fund  after  her  death  and  the  designation  of  the  beneficiaries,  corpo- 
rations exempt  from  taxation. 

The  Committee  is  of  the  opinion  that  the  title  of  the  beneficiaries 
vested  upon  the  delivery  of  the  trust  property  to  the  trustees,  and 
that  the  income  accruing  to  the  trust  fund  from  the  date  of  the  death 
of  the  creator  of  the  trust  to  the  date  of  the  distribution  of  the  trust 
fund  is  not  taxable  in  the  hands  of  the  trustees.  The  Committee  rec- 
ommends that  a  return  should  be  made  by  the  trustees  on  Form  1041, 
taking  as  a  deduction  all  amounts  paid  to  or  permanently  set  aside 

during  the  taxable  year   iov  the  exempt  corporations (C. 

B.  4,  page  221 ;  A.  R.  R.  521.) 

The  theory  of  the  regulation  is  that  it  is  a  gift.  If  the 
grantor  in  such  cases  were  permitted  to  exclude  such  income 
from  his  gross  income,  it  would  result  in  "wholesale"  evasions 
of  taxes,  especially  where  taxpayers  are  subject  to  high  sur- 
tax. 

A  reasonable  doubt  exists  in  the  case  of  some  revocable 
trusts  as  to  the  taxable  status  of  grantor  and  grantee  when  the 
grantor  conveys  and  delivers  property  to  a  trustee  and  the 
latter  has  sole  control  over  principal  and  income  and  no  revoca- 
tion is  made  prior  to  the  end  of  the  taxable  year.  It  is  true 
that  the  trustee  is  an  agent,  but  he  is  an  agent  for  the  grantee 
as  well  as  for  the  grantor.     Upon  the  collection  of  income, 


""This  ruling  apjjlied  to  a  case  arising  under  the  1916  law  as  amended 
by  the  1917  law,  but  the  same  principle  doubtless  governs  under  the  present 
law. 


1354 


SPECIAL   CLASSES    OF   TAXPAYERS 


title  thereto  vests  in  the  trustee  in  trust  for  the  grantee.  The 
question  is:  "What  did  the  trustee  collect?"  It  would  seem 
that  in  the  absence  of  revocation  up  to  the  date  of  collection 
the  sole  beneficial  interest  rests  in  the  grantee  and  the  income 
collected  can  hardly  be  said  to  have  been  income  of  the  grantor, 
even  constructively  or  in  the  hands  of  his  agent.  Any  act  of 
the  grantor  must  be  performed  before  income  arises;  therefore 
failure  to  act  would  seem  to  destroy  the  agency  theory.  Cer- 
tainly if  income  such  as  interest  and  rents  which  accrue  from 
day  to  day  vests  in  the  trustee  in  trust  for  the  grantee  and  be- 
comes the  sole  property  of  the  grantee,  even  though  the  trust 
is  revoked  and  the  principal  is  withdrawn  there  is  room  for 
argument  that  such  income  as  accrues  to  the  grantee  is  taxable 
income  and  should  not  be  included  in  the  return  of  the 
grantor. 

No  specific  ruling  is  available  as  to  the  status  of  revocable 
trusts  when  there  are  several  creators.  Presumably  the  same 
general  principle  would  govern. 

Tax  payable  by  estates  of  non-resident  aliens.^^ — 

Rulings i.  The  undistributed  net  income  of  a  trust  estate 

under  the  control  of  a  resident  fiduciary  and  subject  to  the  jurisdiction 
of  a  state  or  territory  of  the  United  States,  or  of  the  District  of  Co- 
lumbia, is  taxable  in  the  same  manner  as  income  accruing  to  an 
unmarried  resident  individual,  irrespective  of  the  fact  that  the  creator 
of  the  trust  may  be  a  nonresident  alien  and  irrespective  of  the  fact 
that  the  ultimate  beneficiaries  may  be  nonresident  aliens.  The  ex- 
emption to  which  a  single  person  is  entitled  may  properly  be  claimed 
regardless  of  the  citizenship  or  residence  of  the  creator  or  of  the 
trust  of  the  beneficiaries  for  whom  the  income  is  retained, 

2.  The  income  of  an  estate  in  process  of  administration  in  the 
courts  of  a  state  or  territory  of  the  United  States  or  of  the  District 
of  Columbia  by  resident  fiduciaries  is  taxable  as  an  entity,  irrespective 
of  the  fact  that  the  decedent  may  have  been  a  nonresident  individual 
and  the  beneficiaries  or  distributees  may  be  nonresident  aliens  and 
the  income  may  be,  in  part  or  in  whole,  derived  from  foreign  sources. 
The  same  specific  exemption  may  properly  be  claimed  as  provided 
for  under  (i)  above.  The  income  taxable  to  the  estate  is  determined 
after  applying  the  provisions  of  section  219  (c). 


•"  See  Chapter  XXXVI  for  discussion. 


FIDUCIARIES  1355 

3.  Nonresident  alien  fiduciaries  of  trusts  subject  to  the  jurisdiction 
of  a  foreign  country  are  taxable  on  undistributed  net  income  from 
sources  within  the  United  States,  irrespective  of  the  fact  that  the 
creator  of  the  trust  or  estate  may  be  either  a  citizen  or  resident  of  the 
United  States  or  a  nonresident  alien  and  the  beneficiaries  may  be 
cither  citizens  or  residents  of  the  United  States  or  nonresident  aliens. 
An  exemption  allowed  a  single  person  may  properly  be  claimed, 
provided  the  fiduciary  is  a  citizen  or  subject  of  a  country  which 
imposes  an  income  tax  and  allows  a  similar  credit  to  citizens  of  the 
United  States  not  residing  in  such  country. 

4.  The  income  of  estates  in  process  of  administration  in  the  courts 
of  a  foreign  country  by  nonresident  alien  fiduciaries  is  taxable  as  an 
entity  in  so  far  as  the  income  received  is  from  sources  within  the 
United  States,  irrespective  of  the  fact  that  the  decedent  may  have  been 
either  a  nonresident  alien  or  citizen  of  tlie  United  States  and  the  bene- 
ficiaries in  the  distribution  may  be  either  nonresident  aliens  or  citizens 
or  residents  of  the  United  States.  The  same  specific  exemption  as 
provided  for  in  (3)  above  may  be  claimed  under  the  same  conditions 
and  limitations.     (C.  B.  2,  page  172;  A.  R.  M.  37.) 

The  net  income  of  a  discretionary  trust  which  was  created  by  a 
nonresident  alien  for  the  benefit  of  another  nonresident  alien  is 
taxable  in  the  hands  of  a  resident  fiduciary  who  is  subject  to  the 
jurisdiction  of  a  State  or  Territory  of  the  United  States,  or  the  Dis- 
trict of  Columbia,  notwithstanding  such  income  is  derived  from 
interest  on  the  bonds  of  foreign  governments  and  foreign  corpora- 
tions, where  the  incom.e  is  not  otherwise  exempt  under  the  provisions 
of  section  213  (b)  of  the  Revenue  Act  of  1918.  (C.  B.  3,  page 
203;  O.  D.  743.) 

Estate  of  an  enemy  alien, — 

Ruling.  During  the  period  of  administration  it  is  the  duty  of  the 
administrator  or  executor  to  make  return  and  pay  whatever  may  be 
due  on  income  received  by  the  estate  of  a  deceased  person.  The  de- 
mand of  the  Alien  Property  Custodian  for  the  interest  of  the  benefici- 
ary, who  is  an  alien  enemy,  entitles  the  Alien  Property  Custodian  to  re- 
ceive from  the  administrator  or  executor  the  net  amount  found  to  be 
due  by  the  court  administering  the  estate  to  the  alien  enemy.  After 
the  distribution  and  receipt  by  the  Alien  Property  Custodian  of  the 
enemy's  share  in  the  estate  no  further  tax  can  be  required  to  be  re- 
ported or  paid  by  the  Alien  Property  Custodian.  However,  up  to  the 
date  of  the  distribution  of  the  estate  it  is  incumbent  upon  the  admin- 
istrator or  executor  to  report  and  pay  the  income  tax  due  on  the 
estate,  the  Alien  Property  Custodian  being  concerned  only  with  the 
net  amount  found  to  be  due  the  enemy  on  distribution.  In  case  the 
property   of    the   enemy    is   ultimately    returned   to   the    enemy   such 


1356  SPECIAL   CLASSES    OF   TAXPAYERS 

part  of  the  property  as  represents  income  of  the  property  taken 
over  by  the  Alien  Property  Custodian  would  be  subject  to  a  tax  in 
the  hands  of  the  enemy.  The  question  how  this  shall  be  collected 
is  a  matter  of  procedure  between  the  Alien  Property  Custodian's 
Office  and  the  Internal  Revenue  Bureau."*  ( C.  F>.  3,  page  203;  O. 
D.  598.) 

Withholding  the  tax."  ~  fhe  duties  of  a  fiduciary  as  with- 
holding agent  are  twofold.  On  payments  to  non-resident 
aliens  of  rent,  salary,  interest  on  debts  of  the  estate  and  of 
other  fixed  or  determinable  annual  or  periodical  income,  he 
acts  in  the  capacity  of  a  withholding  agent  and,  like  any  other 
payer  of  similar  income,  he  is  authorized  to  accept  the  same 
ownership  certificates  and  is  required  to  file  the  same  annual 
list  returns.  For  a  description  of  his  duties  in  this  capacity, 
see  pages  297  and  314,  dealing  with  the  collection  of  the  tax 
at  the  source  on  miscellaneous  income  payable  to  non-resident 
aliens. 

In  his  capacity  as  a  fiduciary,  when  he  pays  the  net  income 
or  profits  of  the  estate  to  the  non-resident  alien  beneficiaries  he 
proceeds  as  indicated  on  page  1300  of  Chapter  XXXVI,  "Non- 
Resident  Aliens."  It  is  not  his  duty  to  deduct  the  tax  on 
payments  to  citizens  or  resident  beneficiaries.  When  the  fidu- 
ciary pays  over  any  part  of  the  principal  or  corpus  of  the  estate 
no  tax  is  due.  The  tax  is  deducted  only  on  income  payments. 
Property  coming  to  the  estate  by  gift,  bequest,  devise  or  de- 
scent may  be  distributed  among  the  beneficiaries  without  re- 
gard to  the  tax,  since  such  income  is  expressly  declared  to  be 
exempt  from  the  law.  Gains  or  income  from  such  property, 
however,  are  taxable. 

On  payments  to  non-resident  aliens  the  tax  should  be  de- 
ducted regardless  of  the  amount  paid.  A  non-resident  alien 
by  filing  a  complete  return  of  income  from  sources  within  the 
United  States  may  secure  the  benefit  of  the  personal  exemp- 
tion, if  entitled  thereto.     (See  page  1295.) 


^  See  Chapter  XXXVT. 

''  [Former  Procedure]  The  previous  provisions  of  law,  requiring 
fiduciaries  to  withhold  the  tax  at  the  source,  were  reoealed  on  October 
3,  1917,  except  as  they  applied  to  non-resident  aliens. 


FIDUCIARIES  1357 

No  penalty  for  delay  in  payment  in  certain  cases. — 

Law.  Section  250.  ....  (e)  If  any  tax  remains  unpaid  after 
the  date  when  it  is  due,  and  for  ten  days  after  notice  and  demand  by 
the  collector,  then,  except  in  the  case  of  estates  of  insane,  deceased, 
or  insolvent  persons,  there  shall  be  added  as  part  of  the  tax  the  sum 
of  5  per  centum  on  the  amount  due  but  unpaid,  plus  interest  at  the 
rate  of  i  per  centum  per  month  upon  such  amount  from  the  time  it 
became  due:   .... 


Determination  of  Income  Taxable  to  Fiduciaries  and  to 

Beneficiaries 

There  has  been  included  in  the  1921  law  an  additional  sub- 
division to  section  219.  This  addition  summarizes  the  appor- 
tionment of  the  income  of  an  estate  or  trust  when  such  income 
arises  from  various  sources. 

Law.     Section  219 (e)  In  the  case  of  an  estate  or  trust 

the  income  of  which  consists  both  of  income  of  the  class  described  in 
paragraph  (4)  of  subdivision  (a)  of  this  section  and  other  income,  the 
net  income  of  the  estate  or  trust  shall  be  computed  and  a  return  thereof 
made  by  the  fiduciary  in  accordance  with  subdivision  (b)  and  the  tax 
shall  be  imposed,  and  shall  be  paid  by  the  fiduciary  in  accordance  with 
subdivision  (c),  except  that  there  shall  be  allowed  as  an  additional 
deduction  in  computing  the  net  income  of  the  estate  or  trust  that 
part  of  its  income  of  the  class  described  in  paragraph  (4)  of  sub- 
division (a)  which,  pursuant  to  the  instrument  or  order  governing  the 
distribution,  is  distributable  during  its  taxable  year  to  the  bene- 
ficiaries. In  cases  under  this  subdivision  there  shall  be  included,  as 
provided  in  subdivision  (d)  of  this  section,  in  computing  the  net  in- 
come of  each  beneficiary,  that  part  of  the  income  of  the  estate  or  trust 
which,  pursuant  to  the  instrument  or  order  governing  the  distribution, 
is  distributable   during    the   taxable   year   to   such   beneficiary 

The  foregoing  covers  the  procedure  when  income  includes 
items  taxable  to  both  fiduciary  and  beneficiarN'.  The  method 
prescribed  may  be  summarized  as  follows: 

I.  The  fiduciary  computes  net  income  in  same  manner  as 
for  an  individual,  except  that  deductions  may  be 
made, 

(a)   For  gifts  directed  by  the  will  or  trust  instru- 
ment   without   limitation. 


1358  SPECIAL   CLASSES    OF   TAXPAYERS 

(b)   For  amounts  properly  paid  or  credited  to  heirs, 
legatees,  or  beneficiaries. 
2.  The  beneficiary  computes  net  income  as  to  such  items 
in   (a)   and   (b)   above  as  apply  to  heirs. 

For  convenience  it  will  be  desirable  to  discuss  the  deter- 
mination of  net  taxable  income  in  the  following  cases: 

1.  Income  of  a  deceased  person  to  date  of  death. 

2.  Income  of  an  estate  in  the  process  of  administration. 

3.  Income  when  definite  trusts  have  been  created. 

4.  Income  paid  to  non-resident  aliens  from  resident  and 

non-resident  estates  and  trusts. 

Determination  of  net  taxable  income  during  administra- 
tion of  an  estate. — 

Regulation No  taxable   income   is   realized   from  the 

passage  of  property  to  the  executor  or  administrator  on  the  death  of 
the  decedent,  even  though  it  may  have  appreciated  in  value  since  the 
decedent  acquired  it.  In  the  event  of  the  delivery  of  property  in  kind 
to  a  legatee  or  distributee,  no  income  is  realized.  Where,  however,  the 
executor  sells  property  of  the  estate  for  more  than  its  value  at  the 
death  of  the  decedent,  the  excess  is  income  or  may  be  capital  gain 
taxable  to  the  estate (Art.  343.)^® 

Ruling.  A  died  testate  in  1917  and  his  widow  qualified  as  ad- 
ministratrix with  the  will  annexed  in  1918.  The  entire  estate  was 
left  to  the  widow  with  the  exception  of  lox  dollars  which  was  be- 
queathed to  B.  The  legacy  given  to  B  was  paid  in  1918  and  during 
that  year  all  debts,  taxes  and  costs  of  administration  were  paid  in  full 
and  the  widow,  as  sole  beneficiary,  reduced  whatever  remained  to  her 
possession  as  her  personal  estate.  All  the  income  of  the  estate  since 
the  decedent's  death  has  been  reported  by  the  widow  in  her  individual 
returns.  Upon  making  final  report  and  settlement  in  1921  a  court 
order  was  issued  discharging  the  widow  from  liability  as  administra- 
trix. 

Held,  that  inasmuch  as  the  estate  of  A  was  in  the  process  of  ad- 
ministration until  1921,  the  widow  as  administratrix,  is  required  to 
file  a  return  for  the  estate  for  each  of  the  periods  from  the  date  of 
the  decedent's  death  to  December  31,  1917,  January  i,  1918,  to  De- 
cember 31,   1918,  January  i,  1919,  to  December  31,   1919,  January  i, 


"°For  definition  of  "period  of  administration,"  see  balance  of  Art.  343. 
quoted  on  page  1335. 


FIDUCIARIES  1359 

1920,  to  December  31,  1920,  and  January  i,  1921,  to  the  date  of  her 
discharge,  during  which  the  net  income  of  the  estate  equaled  or  ex- 
ceeded $1,000.  The  return  for  the  period  from  the  date  of  the  de- 
cedent's death  to  December  31,  1917,  should  be  on  Form  1040  or 
1040A,  and  the  administratrix  will  be  required  to  pay  the  tax  which 
may  be  assessed  on  the  basis  of  such  return.  In  the  event  the  income 
of  the  estate  for  any  of  the  other  periods  in  question  was  $1,000  or 
more  as  computed  without  deducting  the  amount  paid  or  credited 
to  the  beneficiary,  returns  covering  such  periods  should  also  be  made 
on  Form  1040  or  1040A,  as  the  case  may  be.  The  returns  should  be 
accompanied  by  a  statement  showing  that  during  each  period  the  en- 
tire net  income  was  paid  or  credited  to  the  widow  as  sole  beneficiary. 
....      (C.  B.  4,  page  225;  O.  D.  926.) 

The  net  income  of  an  estate  in  the  process  of  administra- 
tion is  ordinarily  determined  on  the  same  basis  and  in  the  same 
manner  as  in  the  case  of  a  single  individual,"  except  that 
a, credit  is  allowed  for  any  payments  made  to  a  Ijeneficiary  and 
the  deduction  for  charitable  contributions  (paid  or  set  aside 
"pursuant  to  the  terms  of  the  will  or  deed  creating  the  trust"'^'') 
is  not  limited  to  15  per  cent,  as  in  the  case  of  individuals.  In- 
come ordinarily  exempt  when  received  by  individuals,  such 
as  proceeds  of  life  insurance,^''  municipal  and  other  exempt 
bond  interest,  etc.,  is  also  exempt  when  received  by  an  estate. 

A  decedent  contracts  for  the  sale  of  certain  property 
and  receives,  during  his  lifetime,  earnest  money  binding  the 
contract.  After  his  death  and  during  the  period  of  adminis- 
tration the  sale  is  consummated,  title  passes  and  possession 
is  taken  by  the  purchaser.  Held  that  no  income  accrues  from 
the  transaction  to  either  the  decedent  or  the  estate. *°  The 
reason  is  obvious.  No  completed  transaction  occurred  dur- 
ing decedent's  lifetime;  he  merely  received  the  cash  deposit 
and  retained  title  to  the  ])ropcrty.    'l"he  property,  with  the  con- 


"  Estates  taxed  as  entities  arc  allowed  an  exemption  of  $1,000  only. 

'"  Section  2ig   (b). 

"  [Former  Procedure]  Under  the  1916  and  IQ17  laws  all  proceeds 
of  life  insurance  policies  payable  to  others  than  the  individnal  beneficiaries 
were  taxable  (section  4).  The  1913  law  (section  B)  stated  that  net  income 
should  not  include  "the  proceeds  of  life  insurance  policies  paid  upon  the 
death  of  the  person  insured." 

*"  C.  B.  4,  page  224;  O.  D.  807. 


1360  SPECIAL   CLASSES    OF    TAXPAYERS 

tract,  passes  to  the  estate  of  the  decedent  at  his  death  and  is 
vakted  for  inclusion  in  the  corpus  of  that  estate  at  the  sale 
price  agreed  upon  by  the  decedent.  When  the  balance  of 
the  purchase  money  is  paid  there  is  no  difference  between 
the  value  of  the  property  on  the  books  of  the  estate  and  the 
amount  received  therefor.  Consequently  no  gain  or  loss  is 
realized. 

Current  expenses  incurred  in  the  management  of  an  estate 
may  be  deducted,  but  the  initial  expenses  may  not.  The 
Treasury  makes  a  distinction  between  such  first  expenses  of 
the  estate  as  are  properly  chargeable  against  the  corpus  or 
principal  of  the  estate  and  to  that  extent  reduce  the  size  of  the 
estate,  and  other  management  expenses  arising  from  the  nature 
of  the  properties  and  details  of  the  business,  which  arc  prop- 
erly deductible  from  the  year's  gross  income. 

Ruling.  Executors  who  continue  the  trade  or  husiness  of  the 
decedent  may  deduct  from  the  gross  income  of  the  estate,  in  computing 
its  net  income,  all  ordinary  and  necessary  expenses  paid  or  incurred 
during  the  taxable  year  in  continuing  such  trade  or  business,  but  may 
not  deduct  expenses  of  administration. 

The  amounts  which  may  be  deducted  as  salaries  or  other  compen- 
sation for  personal  services  are  limited  to  a  reasonable  compensation 
for  personal  services  actually  rendered  in  continuing  the  trade  or 
business  of  the  decedent (C.  B.  4,  page  119;  Sol.  Op.  88.) 

Regulation Expenses  of  the  administration  of  an  estate 

such  as  court  costs,  attorney's  fees  and  executor's  commissions,  are 
chargeable  against  tlie  corpus  of  the  estate  and  are  not  allowable 
deductions (Art.  293.) 

An  assessment  levied  f)n  Ijank  stock  owned  by  decedent 
is  held  by  the  Treasury  to  be  additional  cost  of  such  stock  and 
not  a  deductiljle  loss. 

Ruling.  An  assessment  of  100  per  cent  on  the  par  value  of  bank 
stock  paid  by  the  executor  of  the  estate  of  a  deceased  stockholder  in 
fulfillment  of  a  statutory  liability  is  not  deductible  from  the  gross  in- 
come of  the  estate.  The  amount  so  paid  should  be  added  to  the  fair 
market  value  of  the  shares  as  at  the  date  of  the  testator's  death  and 
the  resultant  sum  used  as  a  basis  in  determining  gain  or  loss  realized 
upon  final  disposition  of  the  shares  of  bank  stock  by  the  executor. 
,    .    .    .      (C.  B.  4,  page  213;  O.  D.  918.) 


FIDUCIARIES  1361 

Gain  or  loss  from  sale  of  stock  received  as  stock  dividend. 
— The  manner  of  determining  gain  or  loss  from  the  sale  of 
stock  acquired  as  stock  dividend  is  fully  discussed  and  exempli- 
fied in  Chapter  XXXIII. 

The  taxability  of  the  income  of  a  trust  estate  arising  from 
such  a  source  is  dealt  with  in  the  following  ruling: 

Ruling If  the  income  of  the  trust  estate  is  distributable 

periodically,  including  any  profit  realized  on  the  sale  of  such  capital 
assets  belonging  to  the  estate,  any  gain  realized  from  the  sale  of  such 
capital  assets  is  taxable  income  to  the  beneficiaries  regardless  of 
whether  distributed  or  not.  If  the  income  of  the  trust  estate  is  not 
distributable  or  is  distributable  in  the  discretion  of  the  trustee,  any 
profit  realized  from  the  sale  of  capital  assets  is  taxable  in  the  hands 
gf  the  trustee  regardless  of  whether  distributed  or  not.  As  will  be 
noted  from  Article  1547  of  Regulations  45,  any  loss  sustained  on  the 
sale  of  capital  assets  is  available  as  a  deduction  only  to  the  fiduciary 
of  the  estate  or  trust  in  determining  the  income  of  the  estate  or  trust 
taxable  to  the  fiduciary  and  such  loss  is  not  available  to  the  benefici- 
aries who  are  taxed  on  their  actual  distributable  income.  In  the  case 
of  stock  received  as  a  stock  dividend  being  distributed  to  the  benefici- 
aries by  the  fiduciary,  this  would  constitute  a  distribution  in  kind 
of  the  property  of  the  estate  and  no  taxable  gain  or  deductible  loss 
results  to  the  beneficiaries  until  such  stock  is  sold  or  otherwise  dis- 
posed of  by  them.  (Letter  to  the  Safe  Deposit  and  Trust  Company, 
Baltimore,  Maryland,  signed  by  E.  H.  Batson,  Deputy  Commissioner, 
dated  December  8,  192 1.) 

Federal  estate  tax  deductible. — Contrary  to  former  pro- 
cedure" and  in  keeping  with  the  following  decision  of  the 
United  States  Supreme  Court,^^  federal  estate  tax  is  now  de- 
ductible from  the  income  of  the  estate  in  the  year  when  such 
tax  becomes  due. 

Ruling.  Federal  estate  tax  paid  by  executors  of  an  estate  is  an 
allowable  deduction,  under  section  214,  in  ascertaining  the  net  taxable 
income  of  the  estate  for  the  year  in  which  said  estate  tax  "accrued," 
which  means  became  due.     (C  B.  4,  page  153;  T.  D.  3195.) 

The  decision  is  based  entirely  on  the  fact  that  when  the 


"[Former  Procedure]  Reg.  45  (1918),  Art.  134:  "  .  .  .  .  Federal 
estate  taxes  arc  not  deductible." 

"  U.  S.  V.  Woodward.  Supreme  Court,  June  6,  1921,  advance  opinions, 
65  L.  Ed.  728. 


1362  SPECIAL   CLASSES    OF   TAXPAYERS 

1918  income  tax  law  was  promulgated  it  provided  for  the 
deduction  of  '"taxes  paid  or  accrued  within  the  taxable  year 
imposed  (a)  by  the  authority  of  the  United  States  except 
income,  war  profits,  and  excess  profits  taxes. "*^  At  the  time 
of  such  promulgation  an  estate  tax  was  in  existence  and, 
further,  was  reimposed  in  Title  IV  of  the  1918  law  itself. 
No  steps  were  taken  to  make  the  estate  tax  a  non-deductible 
item  from  gross  income;  therefore  it  is  logical  to  assume  that 
Congress  did  not  intend  to  exclude  it. 

In  view  of  this  decision,  executors  and  administrators  \yho 
have  filed  returns  since  September  9,  1916,  (the  effective  date 
of  the  1916  law)  without  claiming  the  federal  estate  tax 
as  a  deduction  for  the  year  in  which  it  became  due,  should 
file  a  claim  for  refund  or  credit.  In  this  connection,  however, 
due  notice  must  be  taken  of  the  limitations  imposed  by  the 
various  laws  on  claims  for  refund. 

Other  taxes. — Taxes  or  assessments  for  local  benefits  are 
not  ordinarily  deductible.*^  It  has  been  held  that  where  such 
taxes  are  paid  by  a  tenant  on  behalf  of,  and  under  agreement 
with,  his  landlord,  they  may  be  considered  as  additional  rent 
paid  by  the  tenant.*'^  When  such  rent  is  a  business  expense 
the  item  would,  therefore,  be  deductible  in  determining  net 
taxable  income. 


Unrealized  losses  not  deductible  by  the  estate. — 

Ruling.  A  loss  can  not  be  claimed  in  a  return  rendered  for  a 
decedent  covering  the  taxable  period  to  the  date  of  his  death  where 
the  cost  of  securities,  or  their  fair  market  value  as  at  March  i,  1913, 
if  acquired  prior  thereto,  is  in  excess  of  the  value  established  by 
appraisal  for  the  purposes  of  administering  the  estate,  except  in  the 
case  of  a  decedent  who  was  a  dealer  in  securities  and  regularly  in- 
ventoried his  securities  and  made  his  return  accordingly.  The  exec- 
utor should  not  make  returns  of  book  gains  or  losses,  either  up  to 
the  date  of  death  or  on  transfer  of  the  property  to  tlie  legatee  or  to 


*^  1918  law,  section  214  (a-3). 
"Law.  section  214  (a-3)  and  (c). 
"Digest  II,  page  116;  O.  D.  373. 


FIDUCIARIES  1363 

a  trustee  under  the  will,  or  from  one  trustee  to  a  succeeding  trustee, 
the  appraised  value  remaining  as  the  basis  for  computing  all  subse- 
quent realizations  of  losses  or  gains  in  cash.  (C.  B.  1,  page  180; 
O.  D.  219.) 

In  Chapter  XXVI,  "Deductions  for  Expenses,"  deductions 
for  exhaustion  of  the  principal  of  life  or  other  terminable 
interest  acquired  by  gift,  bequest,  or  inheritance  are  discussed, 
particularly  having  regard  to  section  215  (b)  of  the  192 1 
law,  which  specifically  forbids  such  deductions  by  beneficiaries 
of  such  interest. 

Expenses  connected  with  sale  of  property  deductible — 
when  ? — 

Ruling.  An  executor  who  pays  to  another,  as  agent,  a  commis- 
sion upon  the  sale  of  property  belonging  to  the  estate  may  deduct  from 
the  selling  price  the  amount  so  paid  in  determining  the  gain  or  loss 
arising  from  the  sale. 

An  executor  who  retains  as  his  commission  a  portion  of  the  amount 
received  by  him  from  the  sale  of  property  belonging  to  the  estate 
may  not  deduct  the  amount  in  preparing  a  return  for  the  estate 
since  any  service  performed  by  him  in  that  connection  is  deemed  to  be 
a  part  of  his  duties  as  executor.  Such  a  commission,  however,  should 
be  included  in  the  gross  income  reported  in  the  executor's  personal 
return  for  the  year  in  which  received. 

Where  property  owned  by  an  estate  is  sold,  the  amount  of  the 
stamp  tax  upon  the  deed  conveying  title  to  the  property  constitutes 
an  allowable  deduction  in  the  return  of  the  estate.  (C.  B.  3,  page  204; 
O.  D.  632.) 

Deduction  for  depreciation. — In  the  illustration  in  arti- 
cle 347  neither  the  estate  as  a  unit  nor  the  beneficiary  receives 
credit  for  the  actual  depreciation.  The  following  quotation 
from  Bulletin  "F"  indicates  a  more  logical  solution,  viz.,  that 
whether  or  not  the  estate  is  treated  as  a  unit,  depreciation  will 
be  allowed. 

Ruling.  An  individual  who  receives  income  from  a  trust  estate 
may  not  deduct  from  gross  income  in  his  individual  income  tax 
return  any  amount  representing  depreciation  of  property  belonging 
to  the  estate.  However,  under  the  Revenue  Act  of  1918  it  is  permis- 
sible for  the  fiduciary  in   ascertaining  the  net  income  of  the  estate 


1364  SPECIAL   CLASSES    OF   TAXPAYERS 

or  trust  for  which  he  acts  to  deduct  a  reasonable  allowance  to  cover 
the  depreciation  sustained  during  the  taxable  year,  whether  or  not 
the  terms  of  the  will  or  agreement  creating  the  estate  or  trust  or  a 
decree  of  court  provide  for  taking  care  of  the  depreciation  which  may 
be  sustained  on  the  property  held  in  trust. 

Estates  and  trusts  in  certain  circumstances  are  treated  as  units 
and  in  other  cases  may  represent  aggregates  of  distinct  interests, 
to  all  of  which  the  fiduciaries  are  responsible.  Irrespective  of  whether 
the  estate  or  trust  is  or  is  not  treated  as  a  unit,  the  fiduciary  in  com- 
puting the  net  income  upon  which  he  is  required  to  pay  the  tax  may 
claim  a  deduction  for  depreciation  in  accordance  with  section  214  (a) 
8  Revenue  Act  of  1918  and  articles  161-171  Reg.  45.  See  also  T.  D. 
2987.     (Bulletin  "F,"  page  32.) 

Deductions  for  net  losses. — The  provisions  in  section  204 
of  the  191 8  law  for  the  deduction  of  net  losses  sttstained  dur- 
ing any  taxable  year  ended  October  31,  November  30,  or 
December  31,  191 9,  has,  with  some  modification,  been  revived 
in  the  new  law  and  made  effective  from  January  i,  1921. 
Under  the  1918  law  the  net  loss  arrived  at  in  accord  with 
the  requirements  of  this  section  was  deducted  from  the  prior 
year's  income,  so  far  as  such  income  permitted,  and  the  bal- 
ance, if  any,  was  deductible  from  the  following  year's  income. 
The  192 1  law,  however,  assigns  all  deductions  in  this  respect 
to  future  years  only.'*" 

Law.  .Section  _'04.  ....  (c)  The  benefit  of  this  section  shall 
be  allowed  to  the  members  of  a  partnership  and  the  beneficiaries  of  an 
estate  or  trust 

(d)  If  it  appears,  upon  the  production  of  evidence  satisfactory  to 
the  Commissioner,  that  a  taxpayer  having  a  fiscal  year  beginning  in 
1920  and  ending  in  1921  has  sustained  a  net  loss  during  such  fiscal 
year,  such  taxpayer  shall  be  entitled  to  the  benefits  of  this  section  in 
respect  to  the  same  proportion  of  such  net  loss  which  the  portion  of 
such  fiscal  year  falling  within  the  calendar  year  1921  is  of  the  entire 
fiscal  year. 

The  benefit  is  extended  to  beneficiaries,  as  such.  Assume 
a  year's  income  from  an  estate  during  the  period  of  admin- 
istration to  be  made  up  as  follows : 

"  .See  page  1021. 


FIDUCIARIES  1365 

Net  income  from  investments   $60,000 

Loss  on  operation  of  decedent's  business 20,000 

Net  income  of  estate   $40,000 


Under  the  terms  of  the  will  the  income  from  the  invest- 
ments was  to  be  distributed  among  two  beneficiaries  in  equal 
shares.  The  earnings  of  decedent's  business  went  to  a  third 
beneficiary  and  formed  his  only  source  of  income.  The  first 
two  beneficiaries  receive  their  $30,000  each ;  the  latter  receives 
nothing,  since  there  were  no  earnings  from  the  business,  but  a 
loss  instead.  Under  section  204  of  the  law,  however,  the 
$20,000  loss  will  be  deductible  in  the  two  succeeding  taxable 
years  to  the  extent  that  the  income  during  those  years  shall 
be  sufficient  to  equal  the  loss. 

The  inclusion  of  beneficiaries  specifically  in  this  provision 
is  intended  to  remove  any  question  that  might  otherwise  arise 
as  to  their  status  in  relation  thereto.  A  fiduciary  who  carries 
on  the  regular  business  of  the  decedent  and  distributes  the 
income  therefrom  to  beneficiaries  as  and  when  received,  would 
not  be  subject  to  tax.  The  beneficiaries  pay  the  tax  under 
such  circumstances.*^  Without  the  provision  under  discussion 
it  might  technically  be  held,  under  these  conditions,  that  the 
law  did  not  permit  of  the  deduction  by  a  beneficiary  of  net 
losses. 

Deduction  for  contributions. — 

Law.     Section  219 (b)    ....   except  that  (in  lieu  of  the 

deduction  authorized  by  paragraph  (11)  of  subdivision  (a)  of  section 
214)  there  shall  also  be  allowed  as  a  deduction,  without  limitation,  any 
part  of  the  gross  income  which,  pursuant  to  the  terms  of  the  will  or  deed 
creating  the  trust,  is  during  the  taxable  year  paid  or  permanently  set 
aside  for  the  purposes  and  in  the  manner  specified  in  paragraph  (11) 
of  subdivision  (a)  of  section  214 '** 

Ruling.  The  amount  of  undistributed  net  income  which  is  re- 
tained and  permanently  set  aside  for  certain  charitable  and  educa- 


"  Law,  section  219  (d). 

"Section  214   (a-ii)   refers  to  deduction  for  contributions. 


1366  SPECIAL   CLASSES    OF   TAXPAYERS 

tional  organizations  designated  by  the  will  of  a  decedent,  which 
were  in  existence  at  the  time  such  income  was  permanently  set  aside, 
and  was  then  reinvested  for  the  estate,  falls  within  the  meaning  and 
intent  of  part  of  section  219  (b)  of  the  Revenue  Act  of  1918.^^    .... 

Therefore  the  income  so  permanently  set  aside,  retained,  and 
invested  by  the  executors  and  trustees  is  not  subject  to  tax.  This 
does  not,  however,  apply  to  income  set  aside  for  the  benefit  of  an 
organization  not  fully  in  existence,  as  to  which  no  deduction  is  au- 
thorized.'''''    (C.  B.  3.  page  203;  A.  R.  R.  280.) 

The  foregoing  ruling,  which  appHes  to  the  19 18  law,  was 
evidently  based  upon  a  recent  case'^'^  decided  by  a  Circuit  Court 
of  Appeals  under  the  laws  prior  to  the  1918  act.  The  facts 
in  this  case  were  as  follows : 

Decision.  By  his  will  Alexander  J.  Derbyshire,  who  died  in 
1879,  devised  his  residuary  estate  to  "the  contributors  to  the  Penn- 
sylvania Hospital,"  a  corporation  of  Pennsylvania  created  for  char- 
itable uses  and  purposes,  and  no  part  of  the  net  income  thereof  is 
for  the  benefit  of  any  private  stockholder  or  individual.  The  devise 
was  subject  to  the  payment  to  certain  annuitants,  all  of  whom,  save 
one,  have  died.  The  residuary  estate  amounts  to  several  hundred 
thousand  dollars,  its  annual  income  is  substantially  $15,000  and  up- 
wards, and  the  remaining  annuity  is  for  a  few  hundred  dollars  per 
year.  The  construction  of  the  will  came  before  the  Supreme  Court 
of  Pennsylvania  in  Biddle's  Appeal,  99  Pa.  525,  wherein  the  title  to 
the  residuary  estate  was  adjudged  vested  in  the  hospital 

It  will  thus  be  seen  that,  while  the  residuary  estate  remains  theo- 
retically and  for  purposes  of  accounting  in  the  hands  of  the  trustee, 
it  is  already  in  the  possession  of  the  hospital  in  the  shape  of  money 
loaned  on  mortgage,  and  upon  such  loan  the  hospital  is  paying  to  the 
trustee  only  such  interest  as  takes  care  of  administrative  charges  and 
the  surviving  annuity.  Under  such  circumstances,  the  collector  as- 
sessed and  collected,  under  protest,  from  the  trustee  on  June  26,  1917, 
the  sum  of  $4,273.42,  being  on  the  income  of  the  residuary  estate 
for  the  years  1913,  1914,  191 5,  and  1916,  and  on  June  11,  1918,  an 
income  and  excess  profit  tax  of  $6,842.02  upon  the  income  of  the 
residuary  estate  of  1917.  It  is,  of  course,  apparent  the  trustee  has 
no  financial  interest  in  the  residuary  payment,  and  while  this  large 


"  Section  219  (b)  of  the  1921  law  is  similar  to  the  like  numbered  section 
of  the  1918  law. 

="C.  B.  I,  page  175;  O.  D.  278. 

"  Lederer  v.  Stockton,  266  Fed.  676 ;  certiorari  granted  October  25,  1920, 

TT     Q     ^or 


254  U.  S.  625. 


FIDUCIARIES  1367 

sum  is  in  theory  assesssed  as  a  tax  on  income  received  by  the  trustee 
or  the  testator's  estate,  the  whole  sum  is  paid  at  the  expense,  and 
from  the  property,  of  the  hospital.  The  question,  then,  in  substance 
and  practice,  resolves  itself  into  this :  Is  this  hospital  liable  for  income 
tax?  .... 

The  court,  in  deciding  that  no  tax  was  due,  said : 

Decision From  the  above,  it  is  clear  to  us,  first,  that  the 

United  States,  the  taxing  power  and  real  defendant  in  this  case, 
speaking  by  its  legislative  branch  in  plain  language  enacted  its  purpose 
and  will  to  exempt  from  taxation  the  income  of  "any  corporation 
or  association  organized  and  operated  exclusively  for  religious,  char- 
itable, scientific,  or  educational  purposes,  no  part  of  the  net  income 
of  which  inures  to  the  benefit  of  any  private  stockholder  or  individ- 
ual ;"  second,  that  the  action  of  the  United  States  by  its  executive 
officer,  in  this  case  the  collector  of  internal  revenue,  in  assessing  and 
collecting  this  income  tax  from  the  hospital,  was  not  warranted  by  the 
taxing  statutes;  and,  third,  that  it  is  the  duty  of  the  United  States, 
acting  by  its  third  agency,  the  federal  courts,  to  prevent  its  executive 
branch  from  illegally  defeating  its  expressed  will  in  the  law  enacted 
by  its  legislative  branch. 

The  sentence  in  article  342  of  Regulations  62  which  pro- 
vides that  "the  imposition  of  the  tax  is  not  affected  by  the 
fact  that  an  ultimate  beneficiary  may  be  a  person  exempt  from 
tax"  appears  to  be  in  conflict  with  the  decision  in  the  foregoing 
case  and  with  the  following  ruling : 

Ruling.  A  testator  bequeathed  and  devised  property  to  trustees 
to  pay  a  part  of  the  income  therefrom  to  A  during  his  life.  The  will 
provided  that  upon  A's  death  the  rest  and  residue  of  the  estate,  to- 
gether with  any  accumulated  income,  should  go  to  a  numicipality  in 
perpetual  trust  to  hold  the  same  as  a  permanent  trust  estate  and  fund, 
the  income  from  which  was  directed  to  he  used  exclusively  in  the 
exercise  of  a  normal  governmental  function. 

Held,  that  the  income  received  by  the  trustees  under  the  will  other 
than  that  distributed  to  the  annuitants  named  in  the  will  is  not  tax- 
able in  the  hands  of  the  trustees  under  the  Act  of  October  3,  1913, 
the  Revenue  Act  of  1916,  as  amended,  the  Revenue  Act  of  1917,  or 
the  Revenue  Act  of  1918 (B.  28-21-1724;  O.  D.  972.) 

When  executor  is  obligated  to  estate. — 

Ruling.  Amounts  paid  ])y  an  executor  of  an  estate,  out  of  his 
personal  funds  in  discharge  of  obligations  of  the  estate,  such  amounts 


1368  SPECIAL   CLASSES    OF   TAXPAYERS 

being  credited  against  the  executor's  liability  for  interest  to  the  estate, 
are  nevertheless  income  to  the  estate  to  the  extent  that  they  represent 
interest  accrued  since  the  death  of  the  testator  on  obligations  of  the 
executor  to  the  estate.     (C.  B.  i,  page  175;  O.  D.  51.) 

Credits  allowed  when  tax  is  payable  by  the  fiduciary. — 

Law.  Section  219.  ....  (c)  ....  In  such  cases  [paragraph(i), 
(2)  or  (3)  of  subdivision  (a)]  the  estate  or  trust  shall,  for  the  purpose 
of  the  normal  tax,  be  allowed  the  same  credits  as  are  allowed  to  single 
persons  under  section  216.''"  .... 

Regulation,  (a)  An  estate  or  trust  taxed  to  the  fiduciary  is 
allowed  the  same  credits  against  net  income  as  a  single  person,  in- 
cluding a  personal  exemption  of  $1,000,  but  no  credit  for  depend- 
ents, (b)  In  the  case  of  an  estate  or  trust  taxed  to  the  beneficiaries 
each  beneficiary  is  allowed  for  the  purpose  of  the  normal  tax,  in  addi- 
tion to  his  individual  credits,  his  proportionate  share  of  such  dividends 
as  described  in  Article  301  and  of  such  interest  not  entirely  exempt 
from  tax  upon  obligations  of  the  United  States  and  bonds  of  the  War 
Finance  Corporation  as  are  received  by  the  estate  or  trust.  Each 
beneficiary  is  entitled  to  but  one  personal  exemption,  no  matter  from 
how  many  trusts  he  may  receive  income (Art.  346.) 

Credit  for  taxes. — 

Law.  Section  222.  (a)  That  the  tax  computed  under  Part  II 
of  this  title  [Income  Tax]  shall  be  credited  with:   .... 

(4)  In  the  case  of  any  such  individual  who  is  a  member  of  a  partner- 
ship or  a  beneficiary  of  an  estate  or  trust,  his  proportionate  share  of 
such  taxes  of  the  partnership  or  the  estate  or  trust  paid  during  the 
taxable  year  to  a  foreign  country  or  to  any  possession  of  the  United 
States,  as  the  case  may  be.^  ■   .... 

Taxable  income  when  trusts  have  been   established.— I  f 

the  income  from  an  estate  or  trust  is  held  for  distribution  to 
unborn  or  unascertained  persons  or  persons  with  contingent 


°' The  credits  so  specified  in  section  216  are:  (i)  dividends,  (2)  in- 
terest on  United  States  government  bonds  and  bonds  of  the  War  Finance 
Corporation,  (3)  an  exemption  of  $1,000.  See  Chapter  XX  for  deter- 
mination of  taxable  Liberty  bond  interest. 

[Former  Procedure]  The  specific  exemption  allowed  to  estates 
under  the  acts  of  1913  and  1916  was  $3,000.  In  1917,  two  specific  exemp- 
tions, one  of  $3,000  and  one  of  $1,000,  were  permitted.  Under  all  acts,  if 
the  income  of  the  estate  or  the  amount  payable  to  any  beneficiary  was  less 
than  the  exemption,  no  return  was  required  from  the  fiduciary. 

"  See  Chapter  XXVIII  for  discussion  of  this  credit. 


FIDUCIARIES  1369 

interests  and  there  is  no  periodic  distribution  of  income,  the 
net  taxable  income  is  determined  in  substantially  the  same 
manner  as  is  prescribed  for  estates  in  the  process  of  admin- 
istration. If,  however,  income  is  distributed  periodically  to 
beneficiaries  or  part  is  distributed  and  part  held  in  trust,  the 
determination  of  the  taxable  income  of  the  estate  or  trust  and 
of  the  beneficiaries  becomes  a  more  difficult  problem.  Follow- 
ing is  the  latest  Treasury  regulation  on  this  subject : 

Estates  or  trusts  which  cannot  be  treated  as  units.''' — 

Rk(;ulation.  In  the  case  of  an  estate  or  trust,  the  income  of 
which  consists  both  of  income  to  be  distributed  to  beneficiaries  period- 
ically and  other  income,  the  net  income  of  the  estate  or  trust  shall 
be  computed  and  a  return  thereof  made  by  the  fiduciary  in  accordance 
with  section  219  (b)'"'"  and  the  tax  shall  be  imposed  and  paid  by  the 
fiduciary  in  accordance  with  section  219  (c)/'"  except  that  there 
shall  be  allowed  as  an  additional  deduction  in  computing  tlie  net 
income  of  the  estate  or  trust  that  part  of  its  income  of  the  class 
described  in  section  219  (a)  (4)''^  which,  pursuant  to  the  will  or 
trust  deed,  is  distributable  during  its  taxable  year  to  the  beneficiaries. 
Each  of  such  beneficiaries  shall  include,  in  computing  his  net  income, 
that  part  of  the  income  of  the  estate  or  trust  wdiich,  pursuant  to  the 
instrument  or  order  governing  the  distribution,  is  distributable  to  him 
during  the  taxable  year.     (Art.  347.) 


"  [Former  Procedure] 

Regulation.  In  the  case  of  a  trust  estate  where  the  terms  of  the 
will  or  trust  or  the  decree  of  a  court  of  competent  jurisdiction  provides 
for  keeping  the  corpus  of  the  estate  intact,  and  where  physical  property 
forming  a  part  of  the  corpus  of  such  estate  has  sufifered  depreciation 
through  its  employment  in  business,  a  deduction  from  gross  income  for 
the  purpose  of  caring  for  this  depreciation,  where  the  deduction  is  applied 
or  held  by  the  fiduciary  for  making  good  such  depreciation,  may  be 
claimed  by  the  fiduciary  in  his  return  of  income.  Fiduciaries  should  set 
forth  in  connection  with  their  returns  the  provision  of  law,  trust,  or  decree 
requiring  such  depreciation  deduction  where  any  exists  or  when  actual 
depreciation  occurs,  the  amount  thereof,  and  that  the  same  has  been  or 
will  be  preserved  and  applied  as  such.  All  amounts  paid  by  fiduciaries  to 
beneficiaries  of  trust  estates  from  the  income  of  such  trust  estates,  whether 
from  reserves  or  otherwise,  are  held  to  be  distributions  of  income  and 
will  be  treated  for  income-tax  purposes  in  accordance  with  the  provisions 
of  law  and  regulations  applicable  to  income  of  such  beneficiaries.  (Par. 
199,  Reg.  33;  the  1916  and  1917  laws.) 

•■"See  page  1335. 

""Sec  page  i347- 

°'  See  page  1329, 


13/0 


SPECIAL   CLASSES    OE   TAXPAYERS 


An  example  of  the  application  of  the  provisions  of  the  fore- 
going regulation  was  contained  in  an  amendment  to  the  ar- 
ticle of  the  19 18  regulations  dealing  with  the  same  subject. 

Ruling For  example,  a  trust  is  created  the  income  of  which 

is  distributable  periodically  for  the  life  of  the  beneficiary,  the  remainder 
over  to  others.  The  trust  has  the  following  items  of  income.  Rent, 
$3,000;  interest,  $2,000;  gain  on  sale  of  capital  assets,  $1,500;  cash  div- 
idend, $1,000;  and  deductions,  general  expenses  (all  deductible  from 
distributable  income),  $700;  depreciation,  $300;  loss  on  sale  of  capital 
assets,  $3,000.  Under  the  terms  of  the  trust  $5,300  will  be  distributed 
to  the  beneficiary,  viz.,  rent,  $3,000;  plus  interest,  $2,000;  plus  dividend, 
$1,000;  less  general  expenses,  $700.  The  gain  and  loss  on  the  sale 
of  capital  assets  will  be  considered  capital  items  affecting  the  corpus 
only,  and  the  items  of  depreciation  will  not  affect  the  amount  to  be  dis- 
tributed, there  being  no  rule  of  State  law  or  provision  of  the  trust 
requiring  this  deduction  from  distributable  income.  In  such  a  case 
the  fiduciary  must  report  on  form  1041  showing  a  net  income  for  the 
trust  of  $3,500,  and  nmst  show  as  the  distributive  share  of  the  bene- 
ficiary the  $5,300  to  which  he  is  entitled.  The  beneficiary  must 
account  for  the  amount  actually  distributable  to  him  as  income,  viz., 
$5,300,  as  provided  in  section  219  (d)  and  will  be  entitled  to  a  credit 
of  $1,000  on  account  of  the  dividends  in  computing  the  normal  tax, 
but  not  to  any  deduction  on  account  of  depreciation  or  capital  losses. 

If  there  had  been  no  loss  on  the  sale  of  capital  assets  so  that 
the  net  income  of  the  estate  or  trust  was  $6,500,  Form  1041  should 
show  the  distributive  share  of  the  beneficiary  as  $5,300,  and  the  dis- 
tributive share  of  the  fiduciary  as  $1,200;  and  the  fiduciary  should  file 
a  separate  return  on  Form  1040  A,  reporting  $1,200  for  taxation. 
(Art.  347,  amended,  C.  B.  2,  page  180;  T.  D.  2987.) 

Treasury  Decision  2987  (dated  March  i,  1920)  was  made 
retroacti^■e  to  January  i,  1918,  and  all  former  rtilings  incon- 
sistent tlierewith  were  revoked. 

The  significant  feature  of  the  amended  article  347  of 
Jvegulations  45,  which  was  issued  for  the  administration  of 
the  19 1 8  law,  was  the  refusal  to  allow  as  a  deduction  by  a 
beneficiary  of  an  estate  or  trust,  any  loss,  depreciation  or  de- 
pletion sustained  by  the  estate  or  trust  but  not  deducted  from 
income  distribtited  or  distributable  to  the  beneficiary.  This 
regulation  by  the  Treasury  Department  was  not  based  on  any 
section  of  the  1918  law  which  specifically  so  provided.     The 


FIDUCIARIES  1371 

192 1   law  embodies  such  a  provision,   however,   which  reads 
as  follows: 

Law.  Section  215.  [Items  not  deductible]  .  .  .  .  (b)  Amounts 
paid  under  the  laws  of  any  State,  Territory,  District  of  Columbia,  pos- 
session of  the  United  States,  or  foreign  country  as  income  to  the 
holder  of  a  life  or  terminable  interest  acquired  by  gift,  bequest,  or  in- 
heritance shall  not  be  reduced  or  diminshed  by  any  deduction  for  shrink- 
age (by  whatever  name  called)  in  the  value  of  such  interest  due  to  the 
lapse  of  time,  nor  by  any  deduction  allowed  by  this  act  for  the  purpose 
of  computing  the  net  income  of  an  estate  or  trust  but  not  allowed 
under  the  laws  of  such  State,  Territory,  District  of  Columbia,  pos- 
session of  the  United  States,  or  foreign  country  for  the  purpose  of 
computing  the  income  to  which  such  holder  is  entitled. 

The  Treasury  regulation  pertaining  to  this  section  of  the 
192 1  law  gives  an  example  of  its  effect. 

Regulation.  Amounts  paid  to  the  holder  of  a  life  or  terminable 
interest  acquired  by  gift,  bequest,  or  inheritance  shall  not  be  subject 
to  any  deduction  for  shrinkage  (whether  called  depreciation  or  any 
other  name)  in  the  value  of  such  interest  due  to  the  lapse  of  time. 
In  other  words,  the  holder  of  such  an  interest  so  acquired  may  not 
set  up  the  value  of  the  expected  future  payments  as  corpus  or  princi- 
pal and  claim  deductions  for  shrinkage  or  exhaustion  thereof  due  to 
the  passage  of  time. 

No  deductions  shall  be  allowed  in  the  case  of  a  life  or  a  terminable 
interest  acquired  by  gift,  bequest,  or  inheritance,  where  the  estate 
or  trust  is  entitled  to  a  deduction  under  the  statute  but  there  is  no 
reduction  of  the  income  of  the  life  or  terminable  interest.  For  ex- 
ample, an  estate  or  a  trust  in  a  certain  State  sells  securities  at  a 
loss;  if,  under  the  laws  of  that  State,  the  beneficiary  suffers  no  actual 
loss,  then  even  though  the  estate  or  trust  is  permitted  to  deduct  such 
loss  in  making  its  return,  the  beneficiary  whose  income  has  not  been 
diminished  thereby  is  not  entitled  to  a  deduction  on  account  of  such 
loss  but  nuist  include  in  his  return  the  full  amount  distributed  or 
distributable (Art.  295.) 

Inasmuch  as  section  215  (b)  gives  the  sanction  of  law 
from  January  i,  1921,  on,  to  the  position  previously  taken  in 
administering  the  1918  law,  the  following  opinion  of  the  So- 
licitor of  the  lUireau  of  Internal  Revenue  is  in  part  repro- 
duced. 

RuLiNc The  present  statute  specifies  class   (3)    "Income 

held  for  future  distribution  under  the  terms  of  the  will  or  trust"  and 


1372  SPECIAL   CLASSES    OE   TAXPAYERS 

class  (4)  "Income  which  is  to  be  distributed  to  the  beneficiaries  period- 
ically, whether  or  not  at  regular  intervals "     It  seems  clear 

that  the  part  of  the  income  which  is  distributable  falls  within 
class  (4)  and  that  the  part  which  is  accumulated  falls  within  class  (3). 
It  is  clear  that  the  total  amount  in  question  is  income  for  which  some 
one  should  account,  and  that  it  would  be  highly  inequitable  and  unjust 
to  tax  the  present  beneficiary  upon  income  which  is  not  distributable 
to  him  and  to  which  he  is  not  beneficially  entitled.  It  is  equitable 
and  just,  however,  that  the  fiduciary  should  pay  the  tax  upon  income 
accumulated  for  the  benefit  of  the  remainder-men,  thereby  deducting 
the  tax  from  the  amount  to  be  distributed  to  the  remainder-men  in 
the  future.  It  is  therefore  evident  that  in  this  case  the  two  classes 
of  income  must  be  treated  diiTerently  in  spite  of  the  general  treatment 

of   estates   and  trusts   as   a   unit   by   the   statute (C.    B.   2, 

page  181;  O.  1013;  Sec.  I.) 

Regarding  the  allocation  of  capital  losses  to  distributable 
income,  it  is  argued  that  such  losses  are  not  ordinarily  allow- 
able deductions  to  the  life  tenant,  because  such  deductions 
belong  to  the  remainderman  and,  regardless  of  whether  or 
not  there  are  capital  gains  to  offset  such  losses,  the  life  tenant 
is  not  equitably  entitled  to  take  the  losses.  Denial  of  such 
deductions  to  the  life  tenant  is  deemed  to  be  necessary  to 
protect  the  interests  of  the  remainderman. 

Ruling Trustees  may  be  induced  to  make  such  sales  in 

order  to  register  a  loss  for  the  benefit  of  the  life  tenant.  The  remain- 
derman is  thus  prevented  from  registering  the  loss  at  a  later  date  when 
his  remainder  becomes  vested  in  possession,  and  [he]  may  be  compelled 

to  account  for  an  unduly  large  gain  at  some  time  in  the  future 

(C.  B.  2,  page  181 ;  O.  1013;  .Sec.  III.) 

The  reasoning  relative  to  allowance  and  depreciation  to 
lite  tenants  is  stated  concisely  as  follows: 

Ruling.  Items  of  deduction  (according  to  income  tax  statute) 
which  are  disregarded  by  the  State  courts  in  making  distributions, 
there  being  no  term  of  the  will  or  trust  or  rule  of  law  requiring  their 
deduction  from  distributable  income,  e.  g.,  depreciation  and  depletion. 
In  Law  Opinion  456  it  was  held,  under  the  Revenue  Act  of  1916 
as  amended,  that  the  beneficiaries  should  compute  their  distributive 
shares  after  deduction  of  depletion.  That  statute,  however,  differed 
from  the  present  one.  In  Advisory  Tax  Board  recommendation  No. 
56  a  similar  ruling  was  made  with  reference  to  depreciation  under 
the  Revenue  Act  of  1918. 


FIDUCIARIES 


^?>73 


These  rulings  were  based  upon  the  literal  interpretation  of  the 
statute  previously  discussed  and  upon  the  theory  that  where  a  will 
provided  for  the  distribution  of  income  without  deduction  for  de- 
preciation or  depletion  the  beneficiary  really  received  partly  income 
and  partly  capital.  The  line  of  reasoning  developed  in  solving  case 
(III),  however,  indicates  that  this  result  is  erroneous.  Deductions 
for  depletion  and  depreciation  are  deductions  designed  to  restore 
capital  and  as  such  affect  the  interest  of  the  remainderman  and  do 
not  affect  the  distributive  share  of  the  life  tenant.  Probate  courts 
in  general  disregard  depreciation  (other  than  amounts  actually  ex- 
pended for  repairs)  and  depletion  unless  the  trust  specifically  pro- 
vides that  deduction  shall  be  made  on  that  account.  The  sums 
received  by  the  beneficiaries  in  such  cases  are  clearly  part  of  the  gross 
income  of  the  estate  or  trust  and  should  not  be  reduced  by  deduc- 
tions made  to  restore  capital  to  which  they  are  not  entitled.  The 
answer  is  the  same  as  the  answer  to  case  (IH)."*  (C.  B.  2,  page  18 r ; 
O.  1013;  Sec.  IV.) 

The  Treasury  seemed  to  realize  tliat  serious  objection 
would  be  made  to  the  principles  stated  in  article  347  of  Regu- 
lations 45. 

Ruling The  principal  objection  to  the  answers  given  to 

questions  (III)  and  (IV)  will  be  that  the  construction  there  adopted 
may  deprive  both  life  tenant  and  remainderman  of  the  benefit  of 
these  deductions  for  the  reason  that  there  will  be  no  income  subject 
to  the  same  treatment  in  some  years  from  which  to  deduct  them. 
It  is  obvious,  however,  that  in  many  cases  a  part  of  the  income  will 
be  accumulated  for  future  distribution  or  part  of  the  income  will 
consist  of  gains  from  sale  of  capital  assets  so  that  such  deduction 
may  be  taken.  In  such  cases  the  equity  of  the  classification  of  items 
of  gross  income  and  deductions  adopted  above  is  emphasized.  Such 
cases  will  be  readily  solved  by  an  application  of  the  principles  pre- 
viously stated.  The  fact  that  a  theoretically  correct  deduction  is  not 
beneficially  deducted  by  anyone  is  a  common  occurrence  and  in  no 
way  decisive.  The  deduction  is  beneficially  allowed  if  the  same 
interest  has  a  large  enough  gross  income.  An  individual  who  has  no 
income  loses  the  benefit  of  depreciation  deductions  to  which  he  is 
entitled.     (C.  B.  2,  page  181;  O.  1013;  Sec.  W) 

Replying  to  the  objection  that  denial  of  deduction  of 
capital  losses  by  life  tenants  is  contrary  to  the  express  provi- 
sion of  the  statute   (section  219),   which  stipulates  that  the 


°*  Section  III  of  this  ruling  deals  with  capital  losses. 


1374  SPECIAL   CLASSES    OF   TAXPAYERS 

aggregate  distributable  shares  shall  not  exceed  the  income  of 
the  trust  or  estate  computed  as  a  unit,  the  Treasury  says : 

Ruling.  This  applies  a  literal  interpretation  of  the  statute,  but 
reaches  a  result  which  should  be  avoided  if  possible  since  it  is  con- 
trary to  the  fundamental  rights  of  the  parties  and  to  the  spirit  and 
purpose  of  income  taxation  in  j^eneral.  ( C.  B.  2.  page  iSi  ;  O.  1013; 
Sec.  III.) 

How  closeh'  the  procedure  outlined  in  article  347  of  Regu- 
lations 45  is  to  be  considered  as  indicating  the  intent  of  the 
1 9 18  law  as  regards  estates,  rights  and  their  beneficiaries,  re- 
mains to  be  determined,  as  the  courts  have  not  yet  passed  on 
the  question.  The  enactment  of  section  215  (b)  of  the  1921 
law  is  not  necessarily  to  be  deemed  to  express  the  intent  of 
the  1918  law.  For  a  discussion  of  this  question,  particularly 
as  to  the  legality  of  article  347,  the  reader  is  referred  to 
pages  1045  to  1046  of  Income  Tax  Procedure,  192 1. 

Tax  on  capital  gains. — The  "capital  gains''  provision  of  the 
192 1  law  is  of  importance  to  estates  and  trusts  because  of  the 
amelioration  of  surtax  burdens  when  considerable  gains  are 
realized  on  sales  of  investments.  This  subject  is  discussed 
at  length  in  Chapter  XVTI,  and  the  principal  question  which 
needs  to  be  specially  considered  when  applying  section  206 
to  estates  and  trusts  is,  as  to  the  starting  point  for  the  pre- 
scribed two-year  period  during  which  investments  must  l3e 
held  to  obtain  the  benefits  of  the  "capital  gains"  provision. 

As  to  securities  purchased  by  the  fiduciany\  the  two-year 
period  obviously  runs  from  the  date  of  purchase.  As  to  secur- 
ities which  form  a  portion  of  the  corpus  of  the  estate  or  trust 
at  its  inception,  the  author's  opinion  is  that  the  two-year  period 
runs  from  the  time  the  estate  comes  into  the  hands  of  the 
fiduciary  or  the  trust  is  created.  The  time  during  which  a 
testator  or  the  creator  of  a  trust  had  held  securities  afterward 
sold  by  a  fiduciary  cannot  be  considered  as  being  equivalent 
to  ownership  by  estate  or  trtist.  A  decedent's  estate  or  a  trust 
created  by  an  irrevocable  deed  of  trust  are  separate  entities. 


FIDUCIARIES  1375 

Profits  or  losses  on  subsequnt  sales  of  securities  are  based,  not 
on  the  cost  thereof  to  the  decedent  in  his  lifetime  or  to  the 
maker  of  the  trust,  but  on  their  values  at  the  time  they  came 
ino  the  hands  of  the  fiduciary.  Similarly,  the  two-year  period 
under  the  "capital  gains"  section  starts  from  the  time  the  secur- 
ities came  into  the  hands  of  the  fiduciary. 

Taxable  income  under  profit-sharing  plans. — With  the 
growth  of  various  profit-sharing  plans,  instituted  by  employ- 
ers for  the  benefit  of  employees,  the  law  now  includes  a  new 
provision  which  defines  what  is  taxable  income  to  the  dis- 
tributees under  such  a  plan. 

Law.  Section  219.  ....  (f)  A  trust  created  by  an  employer  as 
a  part  of  a  stock  bonus  or  profit-sharing  plan  for  the  exclusive  bene- 
fit of  some  or  all  of  his  employees,  to  which  contributions  are  made 
by  such  employer,  or  employees,  or  both,  for  the  purpose  of  distribut- 
ing to  such  employees  the  earnings  and  principal  of  the  fund  accumu- 
lated by  the  trust  in  accordance  with  such  plan,  shall  not  be  taxable 
under  this  section,  but  the  amount  actually  distributed  or  made  avail- 
able to  any  distributee  shall  be  taxable  to  him  in  the  year  in  which 
so  distributed  or  made  available  to  the  extent  that  it  exceeds  the 
amounts  paid  in  by  him.  Such  distributees  shall  for  the  purpose  of  the 
normal  tax  be  allowed  as  credits  that  part  of  the  amount  so  dis- 
tributed or  made  available  as  represents  the  items  specified  in  sub- 
divisions  (a)   and   (b)   of  section  216. 

Rfx.uuation.  .Subdivision  (f)  of  section  219  provides  that  a  trust 
created  h)'  an  enipliwer  as  a  part  of  a  stock  bonus  or  profit-sharing 
plan  for  the  exclusive  I)enefit  of  some  or  all  of  his  employees,  to  which 
contributions  are  made  by  such  employer,  or  employees,  or  both,  for 
the  purpose  of  distributing  to  such  employees  the  earnings  and  prin- 
cipal of  the  fund  accunudated  by  tiie  trust  in  accordance  with  such 
plan,  shall  not  be  taxable  under  this  section,  but  the  amount  actually 
distributed  or  made  available  to  any  distributee  shall  be  taxable  to 
him  in  the  year  in  which  so  distributed  or  made  available  to  the  extent 
that  it  exceeds  the  amounts  paid  in  by  him.  Such  distributees  shall 
for  the  purpose  of  the  normal  tax  be  allowed  as  credits  that  part  of 
the  amount  so  distributed  or  made  available  as  represents  the  divi- 
dend and  interest  items  specified  in  subdivisions  (a)  and  (b)  of  sec- 
tion 216.     (Art.  348.) 

The  question  of  profit-sharing  funds  and  of  the  treatment 


1376  SPECIAL   CLASSES    OF   TAXPAYERS 

of  income  derived  therefrom  is  dealt  with  fully  in  the  chapter 
on  "Income  from  Personal  Services."'^ 

The  last  sentence  of  section  219  (f)  refers  to  the  allow- 
ance as  credits  of  the  proportionate  share  of  such  exempt 
dividends  and  interest  referred  to  in  section  216  (a)  and  (b) 
as  may  form  a  part  of  the  earnings  received  by,  or  credited  to, 
the  distributee. 

"Chapter  XIV. 


CHAPTER    XXXVIII 

INSURANCE  COMPANIES 

The  problem  of  taxing  insurance  companies  in  an  equitable 
manner  under  the  income  and  excess  profits  tax  provisions 
which  govern  corporations  was  considered  at  length  when  the 
19 1 8  law  was  being  formulated.  The  Senate  Committee  pro- 
posed and  the  Senate  adopted  an  entirely  new  plan  for  taxing 
these  companies,  but  the  proposal  was  lost  because  the  House 
conferees  refused  to  concur/ 

termining  the  taxable  income  of  insurance  companies  (other 
than  mutual  insurance  companies)  which  had  been  proposed 
and  rejected  in  1918.     A  number  of  sections  of  the  192 1  law 

The  192 1   law,"  however,  embodies  the  principle  for  de- 


'  "A  new  basis  is  recommended  for  the  taxation  of  life  insurance  com- 
panies (Part  IV,  sections  245,  246,  247).  The  tax  is  in  form  an  income 
tax,  but  is  imposed  upon  a  net  income  defined  with  special  reference  to  the 
peculiar  conditions  of  the  business  of  life  insurance.  Roughly,  it  consists 
of  the  gross  income  from  interest,  dividends  and  rents,  less  tax-free  interest, 
investment  expenses  and  taxes  and  other  expenses  paid  exclusively  in  con- 
nection with  real  estate  owned  by  the  compan}'.  In  the  case  of  a  domestic 
life  insurance  company  there  is  also  a  specific  deduction  of  $2,000.  Thus 
the  tax  falls  upon  the  true  income  of  the  company;  that  is,  its  income 
from  investments;  and  tlie  rate  is  so  fixed  that  this  tax  takes  the  place  of  the 
income  tax,  war  excess  profits  tax,  capital  stock  tax  and  the  tax  on  the 
issuance  of  policies.  It  will  yield  considerably  more  revenue  than  the  taxes 
which  it  is  designed  to  replace,  and  has  the  great  merit  of  simplicity  and 
certainty.  Above  all,  it  avoids  the  almost  insuperable  difficulty  of  defining 
the  invested  capital  of  a  life  insurance  company  for  purposes  of  the  war 
excess  profits  tax."     (lu'port  to  Senate,  by  Senator  Simmons,  December  6, 

191 8,  page  9.) 

"Your  conferees  did  not  think  that  its  scheme  would  be  equitable  or 
satisfactory  if  the  deductions  were  eliminated,  and,  after  much  controversy 
and  much  discussion,  reflection  and  investigation — for  wc  did  investigate  a 
good  deal  to  see  if  we  could  not  reach  a  basis  of  compromise — finding  our- 
selves unable  to  come  to  any  satisfactory  adjustment  with  reference  to  the 
Senate    scheme,    the    Senate    receded."      (Senator    Simmons,    February    11, 

1919,  Congressional  Record,  page  Z777.) 

"  [Former  Procedure]  In  view  of  the  radical  changes  effected  by  the 
1921  law  in  the  determination  of  taxable  income,  no  attempt  will  be  made  in 
this  chapter  to  give  in  detail  the  former  procedure  with  respect  to  the  vari- 
ous items  of  gross  income  and  deductions.  Those  who  desire  to  a.scertain 
former  procedure  are  referred  to  Chapter  XXXV  of  Income  Tax  Proced- 
ure, 1 921. 

f377 


1378  SPECIAL   CLASSES    OF   TAXPAYERS 

are  devoted  specifically  to  insurance  companies.  Sections  243- 
245  define  the  taxable  income  of  life  insurance  companies, 
and  sections  246-247^  define  the  taxable  income  of  insurance 
companies  other  than  life  or  mutual  insurance  companies. 
W'ith  the  exception  of  those  companies  which  are  entirely  ex- 
empt under  section  231  (10),  mutual  insurance  companies  are 
taxable  under  sections  232-236  which  define  the  taxable  in- 
come of  ordinary  corporations.  The  last  named  sections, 
however,  contain  certain  provisions  applicable  specifically  to 
mutual  insurance  companies. 

Regulation.  Insurance  companies  include  both  stock  and  mutual 
companies,  as  well  as  mutual  benefit  insurance  companies.  A  volun- 
tary unincorporated  association  of  employees  formed  for  the  pur- 
pose of  relieving  sick  and  aged  members  and  the  dependents  of 
deceased  members  is  an  insurance  company,  whether  the  fund  for 
such  purpose  is  created  wholly  by  membership  dues  or  partly  by  con- 
tributions from  the  employer.  But  a  corporation  which  merely  sets 
aside  a  fund  for  the  insurance  of  its  employees  is  not  required  to  file 
a  separate  return  for  such  fund  if  the  income  and  disbursements 
therefrom  are  included  in  tlie  corporation's  own  return.  (Art. 
1508.) 

To  facilitate  consideration  of  the  law  and  regulations  per- 
taining to  the  dift'erent  classes  of  insurance  companies,  this 
chapter  is  divided  into  the  following  sections : 

1.  i.ife  Insurance  Companies 

2.  Insurance    Companies    Other   than    Life   and    Mutual 

Companies 

3.  Mutual  Insurance  Companies 

4.  Exempt  Insurance  Companies 

Life  Insurance  Companies 

Definition  of  life  insurance  company. — 

Law.  Section  242.  That  when  used  in  this  title  the  term  "life 
insurance  company"  means  an  insurance  company  engaged  in  the  busi- 


^  Sections  246-247  are  effective  from  January  i,  1922,  while  sections 
243-245  are  effective  from  January  i,  1921.  Insurance  companies  which 
after  1921  are  taxable  under  sections  246-247,  are  taxed  for  1921  under  sec- 
tions 232-236  which  define  the  taxable   income  of  ordinary  corporations. 


INSURANCE    COMPANIES  1379 

ness  of  issuing  life  insurance  and  annuity  contracts  (including  con- 
tracts of  combined  life,  health,  and  accident  insurance),  the  reserve 
funds  of  which  held  for  the  fulfillment  of  such  contracts  comprise  more 
than  50  per  centum  of  its  total  reserve  funds 

Rates  of  tax, — 

Law.  Section  243.  That  in  lieu  of  the  taxes  imposed  by  sections 
230  and  1000  and  by  Title  III,  there  shall  be  levied,  collected,  and  paid 
for  the  calendar  year  192 1  and  for  each  taxable  year  thereafter  upon 
the  net  income  of  every  life  insurance  company  a  tax  as  follov/s: 

(i)  In  the  case  of  a  domestic  life  insurance  company,  the  same 
percentage  of  its  net  income  as  is  imposed  upon  other  corporations 
by  section  230;^ 

(2)  In  the  case  of  a  foreign  life  insurance  company,  the  same 
percentage  of  its  net  income  from  sources  within  the  United  States 
as  is  imposed  upon  the  net  income  of  other  corporations  by  section 
230. 

Regulation.  For  the  calendar  year  1921  and  thereafter,  life 
insurance  companies,  as  defined  in  section  242,  shall  pay  the  tax  im- 
posed by  section  243,  in  lieu  of  the  taxes  imposed  by  sections  230 
and  1000  and  by  Title  III  of  the  statute.  The  rate  for  1921  is  10 
per  cent  and  for  subsequent  years  12^  per  cent,  as  in  the  case 
of  other  corporations,  but  the  net  income  upon  which  the  tax  is 
imposed  differs  from  the  net  income  of  other  corporations.  In- 
surance companies  are  entitled  to  the  benefit  of  section  204 
(net  losses)  but  not  of  section  206  (capital  net  gain).  All  pro- 
visions of  the  statute  and  of  these  regulations  not  inconsistent  with  the 
.specific  provisions  of  sections  242  to  245,  inclusive,  are  applicable  to 
the  assessment  and  collection  of  this  tax,  and  life  insurance  com- 
panies are  subject  to  the  same  penalties  as  provided  in  the  case  of 
returns  and  payment  of  income  tax  by  other  corporations.  In  de- 
termining whether  an  insurance  company  is  a  "life  insurance  com- 
pany" as  defined  in  section  242,  no  reserve  shall  be  regarded  as  held 
for  the  fulfillment  of  life  insurance  and  annuity  contracts  unless  the 
company  is  entitled  to  a  deduction  from  gross  income  on  account 
thereof  under  the  provisions  of  section  245  (a)  (2)  and  article  6S1. 
As  to  foreign  companies  see  section  24S(c)  and  article  C87. 
(Art.  661.) 

Life   insurance    companies    not    subject    to    excess 

profits  tax. 

Regulation Life  insurance  companies  are  not  subject 

to  the  tax (Art.  75,1.) 


*  Section  230  imposes  a  tax  of  10  per  cent  on  the  net  income  of  cor- 
porations for  the  calendar  year  1921,  and  12^  per  cent  for  succeeding 
years. 


1380  SPECIAL   CLASSES    OF   TAXPAYERS 

Gross  income  defined. — Life  insurance  companies  include 
in  gross  income  only  the  amounts  received  as  interest,  divi- 
dends and  rents.  No  part  of  premiums  received  from  the  as- 
sured is  now  to  be  included  in  the  return. 

Law.  Sectidii  244.  (a)  That  in  the  case  of  a  life  insurance  com- 
pany the  term  "gross  income"  means  the  gross  amount  of  income  re- 
ceived during  the  taxable  year  from  interest,  dividends,  and 
rents 

Net  income  defined. — 

Regulation.  Net  income  in  the  case  of  life  insurance  compan- 
ies is  gross  income  from  interest,  dividends  and  rents  less  the  de- 
ductions allowed  by  section  245.  Gross  income  comprises  items 
25-34,  inclusive,  of  the  income  page  of  the  annual  statement  for  life 
companies  (edition  of  1920)  adopted  by  the  National  Convention  of 
Insurance  Commissioners  and  items  23-30,  inclusive,  of  the  income 
page  of  the  annual  statement  for  miscellaneous  stock  companies  if 
any  other  branches  of  the  insurance  business  are  conducted  by  the 
company;  except  that  the  rental  value  of  the  space  occupied  by  the 
company  in  its  own  building  or  buildings  if  included  in  gross  income 
shall  be  determined  according  to  the  provisions  of  section  245(b)  and 
article  686.  As  to  "reserve  funds  required  by  law,"  see  article  681. 
(Art.  671.) 

Deductions. — Deductions  are  allowed  to  take  into  consid- 
eration conditions  peculiar  to  insurance  companies,  particularly 
conditions  imposed  by  state  laws.  The  deductions  allowed  by 
the  192 1  law  are  materially  different  from  those  permitted  by 
the  1918  law.  It  will  be  noted  among  other  things  that  no 
deduction  is  provided  by  the  192 1  law  for  losses  on  invest- 
ments, thotigh  on  the  other  hand  gains  realized  from  sale  of 
securities  are  not  required  to  be  reported  as  gross  income. 

Exempt  interest. — 

Law.  Section  245.  (a)  (i)  The  amount  of  interest  received  dur- 
ing the  taxable  year  which  under  paragraph  (4)  of  subdivision  (b)  of 
section   213   is  exempt  from  taxation  under  this  title;  .... 

The  interest  referred  to  includes  that  on  United  States 
obligations  and  those  of  states,  municipalities,  etc.  For  full 
treatment  of  this  subject,  see  Chapters  XIX  and  XX. 


INSURANCE    COMPANIES  1381 

Reserve  eund  earning  allowance. — 

Law.  Section  245.  (a)  ....  (2)  An  amount  equal  to  the  ex- 
cess, if  any,  over  the  deduction  specified  in  paragraph  (i)  of  this  sub- 
division, of  4  per  centum  of  the  mean  of  the  reserve  funds  required  by 
law  and  held  at  the  beginning  and  end  of  the  taxable  year,  plus  (in 
case  of  life  insurance  companies  issuing  policies  covering  life,  health, 
and  accident  insurance  combined  in  one  policy  issued  on  the  weekly 
premium  payment  plan,  continuing  for  life  and  not  subject  to  can- 
cellation) 4  per  centum  of  the  mean  of  such  reserve  funds  (not  re- 
quired ijy  law)  held  at  the  beginning  and  end  of  the  taxable  year,  as 
the  Commissioner  finds  to  be  necessary  for  the  protection  of  the  hold- 
ers of  such  policies  only;  .... 

The  definition  of  '"reserve  funds  required  by  law"  is  'given 
below : 

Law.  Section  244.  ....  (b)  The  term  "reserve  funds  required 
by  law"  includes,  in  the  case  of  assessment  insurance,  sums  actually 
deposited  by  any  company  or  association  with  State  or  Territorial  of- 
ficers pursuant  to  law  as  guaranty  or  reserve  funds,  and  any  funds 
maintained  under  the  charter  or  articles  of  incorporation  of  the  com- 
pany or  association  exclusively  for  the  payment  of  claims  arising  under 
certificates  of  membership  or  policies  issued  upon  the  assessment  plan 
and  not  subject  to  any  other  use. 

The  effect  of  the  deductions  referred  to  in  subdivisions  ( i ) 
and  (2)  of  section  245  (a),  is  to  permit  a  deduction  of  4  per 
cent  of  the  year's  average  reserves  required  by  law,  together 
with  4  per  cent  of  the  mean  of  certain  other  reserves  not  re- 
quired by  law  at  the  discretion  of  the  ("ommissioner. 

Regulation.  Under  paragraphs  (r)  and  (2)  of  section  243(a). 
life  insurance  companies  are  entitled  to  deduct  from  gross  income: 
(1)  Interest  which  is  exempted  in  the  case  of  other  taxpayers  by 
section  213(b)  (4)  and  articles  74-H3 ;  and  (2)  the  excess,  if  any,  of 
the  reserve  deduction  specified  in  section  245  (a)  (2)  over  the  amount 
of  such  interest.  The  reserve  deduction  is  based  upon  the  re- 
serves required  by  express  statutory  provisions  or  by  the  rules  and 
regulations  of  the  State  insurance  departments  when  promulgated 
in  the  exercise  of  a  power  conferred  by  statute;  but  such  reserves 
do  not  include  assets  required  to  be  held  for  the  ordinary  running 
expenses  of  the  business  nor  do  they  include  the  reserve  or  net 
value  of  risks  reinsured  in  other  solvent  companies  lo  the  extent  of 
the  reinsurance.  In  the  case  of  life  insurance  companies  issuing  policies 
covering  life,  health,  and  accident  insurance  combined  in  one  policy 
issued  on  the  weekly  premium  payment  plan,  continuing  for  life  and  not 


1382  SPECIAL   CLASSES    OF   TAXPAYERS 

subject  to  cancellation,  it  is  required  that  reserves  thereon  be  based 
upon  recognized  tables  of  experience  covering-  disability  benefits  of 
the  kind  contained  in  policies  issued  by  this  particular  class  of 
companies.  Only  reserves  peculiar  to  insurance  companies  are  to 
be  taken  into  consideration.  Reserves  '"maintained  to  provide  for  the 
ordinary  running  expenses  of  a  business,  definite  in  amount,  and 
which  must  be  currently  paid  by  every  company  from  its  income 
if  its  business  is  to  continue,  such  as  taxes,  salaries,  reinsurance 
and  unpaid  brokerage"  (Maryland  Casualty  Co.  z'.  United  States, 
251  U.  S.,  342),  will  not  be  considered.  A  compan}'  is  permitted 
to  make  use  of  the  highest  aggregate  reserve  called  for  by  any  State 
in  which  it  transacts  business,  but  the  reserve  must  have  been  actually 
held  as  shown  by  the  annual  statement.  Generally  speaking,  the  fol- 
lowing will  be  considered  reserves  as  contemplated  by  the  law : 
Items  7,  8,  9,  10,  and  11  of  the  liability  page  of  the  annual  statement 
for  life  companies,"  and  items  16,  17,  18,  19,  and  26  of  the  liability 
page  of  the  annual  statement  for  miscellaneous  stock  companies,*'  if  a 
life  insurance  company  is  also  transacting  other  kinds  of  insurance 
business.  If  other  reserves  are  claimed,  sufficient  information  must 
be  filed  with  the  return  to  enable  the  commissioner  to  determine 
the  validity  of  the  claim.  Reference  should  be  made  to  the  item  in 
which  the  reserve  appears  in  the  annual  statement  and  to  the  State 
statute  or  insurance  department  ruling  requiring  that  such  reserves  be 
held.     (Art.  681.) 

Cert.\in  din'idend.s  deductible. — 

Law.  Section  245.  (a)  ....  (3)  The  amount  received  as  divi- 
dends (A)  from  a  domestic  corporation  other  than  a  corporation  en- 
titled to  the  benefits  of  section  262,  or  (B)  from  any  foreign  corporation 
when  it  is  shown  to  the  satisfaction  of  the  Commissioner  that  more 
than  50  per  centum  of  the  gross  income  of  such  foreign  corporation 
for  the  three-year  period  ending  with  the  close  of  its  taxable  year  pre- 
ceding the  declaration  of  such  dividends  (or  for  such  part  of  such 
period  as  the  foreign  corporation  has  been  in  existence)  was  derived 
from  sources  within  the  United  States  as  determined  under  section 
217;   .    ,    .    . 

The  (leditctioii  is  idfiUical  with  that  allowed  ordinary  cor- 
porations tinder  section  234  (a-6). 

Dividend  reserve  earning  allowance. — 

L.'\w.  Section  245.  (a)  .  .  .  .  (4)  An  amount  equal  to  2  per 
centum  of  any  sums  held  at  the  end  of  the  taxable  year  as  a  reserve 


Treasury  Bulletin  "H,"  page  27. 
'Treasury  Bulletin  "H,"  page  47. 


INSURANCE   COMPANIES  1383 

for  dividends  (other  than  dividends  payable  during  the  year  following 
the  taxable  year)  the  payment  of  which  is  deferred  for  a  period  of 
not  less   than  five  years  from  the  date  of  the  policy  contract;  .... 

Regulation.  The  deduction  for  deferred  dividends  under  section 
245  (a)  (4)  will  be  based  upon  item  37'  of  the  liability  page  of  the 
annual  statement  for  life  companies  but  shall  not  include  any  dividend 
payable  during  the  year  immediately  following  the  taxable  year. 
(Art.  682.) 

Investment  expenses. — 

Law.  Section  245.  (a)  .  .  .  .  (5)  Investment  expenses  paid 
during  the  taxable  year:  Proz'idrd.  That  if  any  general  expenses  are 
in  part  assigned  to  or  included  in  the  investment  expenses,  the  total 
deduction  under  this  paragraph  shall  not  exceed  one-fourth  of  i  per 
centum  of  the  book  value  of  the  mean  of  the  invested  assets  held  at  the 
beginning  and  end  of  the  taxable  year;   .... 

Regulation.  If  any  general  expenses  are  in  part  assigned  to 
or  included  in  the  investment  expenses,  the  total  investment  expenses 
(other  than  taxes  and  expenses  with  respect  to  real  estate)  allowable 
as  a  deduction  shall  not  exceed  one-quarter  of  i  per  cent  of  the 
mean  of  the  book  value  of  the  invested  assets  held  at  the  beginning 
and  end  of  the  taxable  year.  If  there  be  no  allocation  of  general 
expenses  to  investment  expenses'  the  deduction  may  consist  of  in- 
vestment expenses  actually  paid  during  the  taxable  year,  in  which 
case  an  itemized  schedule  of  such  expenses  must  be  appended  to  the 
return.  The  invested  assets  are  items  1-6,  inclusive,  item  9,  and 
items  10  and  11  (if  interest-bearing  assets)  of  the  asset  page  of  the 
annual  statement  for  life  companies,  and  items  1-4, .  inclusive,  item 
7,  and  items  27-30,  inclusive  (if  interest-bearing  assets),  of  the  asset 
page  of  the  annual  statement  for  miscellaneous  stock  companies.  If 
the  method  used  by  any  company  in  ascertaining  the  investment  ex- 
penses where  there  is  any  allocation  of  general  expenses  shall  be 
changed  so  that  a  greater  deduction  is  claimed,  the  company  shall  file 
with  its  return,  information  sufficient  to  enable  the  commissioner  to 
determine  the  validity  of  the  claim.  The  maximum  allowance  of  one- 
(juarter  of  i  per  cent  will  not  be  granted  unless  it  is  shown  lo  the 
satisfaction  of  the  Connnissioner  that  such  allowance  is  justified. 
(Art.  683.) 

Depreciation. — 

Law.  Section  245.  (a)  ....  (7)  A  reasonable  allowance  for 
the  exhaustion,  wear  and  tear  of  property,  including  a  reasonable  al- 


'  "Amounts  set  apart,  apportioned,  previously  ascertained,  calculated, 
declared,  or  held  awaiting  apportionment  upon  deferred  dividend 
policies " 


1384  SPECIAL    CLAS.SES    OF   TAXPAYERS 

lowance  for  obsolescence.  In  the  case  of  property  acquired  before 
March  i,  1913,  this  deduction  shall  be  computed  upon  the  basis  of  its 
fair  market  price  or  value  as  of  March  i,  1913;  .... 

For  the  limitation  in  regard  to  allowances  for  deprecia- 
tion, see  section  245  (b)  below. 

Taxes  and  expenses  with  respect  to  real  estate.— 

Law.  Section  245.  (a)  .  .  .  .  (6)  Taxes  and  other  expenses 
paid  during  the  taxable  year  exclusively  upon  or  with  respect  to  the 
real  estate  owned  by  the  company,  not  including  taxes  assessed  against 
local  benefits  of  a  kind  tending  to  increase  the  value  of  the  property 
assessed,  and  not  including  any  amount  paid  out  for  new  buildings, 
or  for  permanent  improvements  or  betterments  made  to  increase  the 
value  of  any  property.  The  deduction  allowed  by  this  paragraph  shall 
be  allowed  in  the  case  of  taxes  imposed  upon  a  shareholder  or  member 
of  a  company  upon  his  interest  as  shareholder  or  member,  which  are 
paid  by  the  company  without  reimbursement  from  the  shareholder  or 
member,  but  in  such  cases  no  deduction  shall  be  allowed  the  shareholder 
or  member  for  the  amount  of  such  taxes;  .... 

This  deduction  is  subject  to  the  proviso  contained  in  sec- 
tion 245   (  b)  lielow. 

Regulatiox.  This  deductiun  comprises  items  31  and  32  of  the 
disbursement  page  of  the  annual  statement  for  life  companies  and 
items  34  and  35  of  the  disbursement  page  of  the  annual  statement 
for  miscellaneous  stock  companies,  except  as  noted  below,  and  any 
sum  included  in  any  other  item  representing  taxes  imposed  upon  the 
individual  shareholders'  or  members'  interest  in  the  real  estate  of 
the  corporation  which  is  paid  by  the  corporation  without  reimburse- 
ment from  the  individual  shareholder  or  member.  In  the  latter  case 
the  amount  allowable  as  a  deduction  (subject  to  the  provisions  of 
Art.  686)  shall  be  that  proportion  of  the  total  tax  imposed  upon  the 
individual  shareholders'  or  members'  interest  in  the  corporation  which 
the  book  value  of  the  real  estate  owned  by  the  corporation  at  the  end 
of  the  taxable  year  is  of  the  book  value  of  all  the  corporation's  ledger 
assets,  and  so  much  thereof  as  represents  a  tax  upon  real  estate  oc- 
cupied in  whole  or  in  part  by  the  company  must  be  included  in  the 
calculation  referred  to  in  article  686.  The  amount  so  included  shall  be 
that  proportion  of  the  total  amount  allowable  as  a  deduction  which 
the  book  value  of  the  real  estate  owned  and  occupied  in  whole  or 
in  part  is  of  the  book  value  of  all  the  real  estate  owned.  Full  details 
must  accompany  the  return.  Any  other  taxes  and  expenses  (and  de- 
preciation) upon  any  real  estate  owned  and  occupied  in  whole  or  in 
part  by  the  company  must  also  be  included  in  the  calculation  referred 


INSURANCE   COMPANIES  1 385 

to  in  article  686.  Taxes  shall  not  include  assessments  against  local 
benefits  of  a  kind  tending  to  increase  the  value  of  the  property 
assessed  and  expenses  shall  not  include  any  amount  paid  out  for  build- 
ings or  for  permanent  improvements  and  betterments  made  to  in- 
crease the  value  of  any  property.     (Art.  684.) 

Limitation  on  deduction  for  taxes  and  deprecia- 
tion.— 

Law.     Section  245 (b)  No  deduction  shall  be  made  under 

paragraphs  (6)  and  (7)  of  subdivision  (a)  on  account  of  any  real  estate 
owned  and  occupied  in  whole  or  in  part  by  a  life  insurance  company 
unless  there  is  included  in  the  return  of  gross  income  the  rental  value 
of  the  space  so  occupied.  Such  rental  value  shall  be  not  less  than  a 
sum  which  in  addition  to  any  rents  received  from  other  tenants  shall 
provide  a  net  income  (after  deducting  taxes,  depreciation,  and  all  other 
expenses)  at  the  rate  of  4  per  centum  per  annum  of  the  book  value 
at  the  end  of  the  taxable  year  of  the  real  estate  so  owned  or  occu- 
pied  

Interest  paid  or  accrued. — 

Law.     Section  245.     (a) (8)  All  interest  paid  or  accrued 

within  the  taxable  year  on  its  indebtedness,  except  on  indebtedness  in- 
curred or  continued  to  purchase  or  carry  obligations  or  securities 
(other  than  obligations  of  the  United  States  issued  after  September  24, 
191 7,  and  originally  subscribed  for  by  the  taxpayer)  the  interest  upon 
which  is  wholly  exempt  from  taxation  under  this  title;   .... 

This  deduction  is  identical  with  that  allowed  other  cor- 
porations under  section  234  (a-2)  with  the  exception  that: 

Regulations this  deduction  includes  item  18  of  the  dis- 
bursement page  of  the  annual  statement  of  life  companies  to  the  ex- 
tent that  interest  on  dividends  held  on  deposit  and  surrendered  dur- 
ing the  taxable  year,  is  inchult'd  therein (Art.  685.) 

No  deduction  shall  be  made  for  any  taxes,  expenses,  or 
depreciation  on  account  of  any  real  estate  owned  and  occupied 
in  whole  or  in  part  by  a  life  insurance  company  unless  there 
is  included  in  the  return  of  gross  income  the  rental  value  of  the 
space  so  occupied.  Such  rental  value  shall  not  be  less  than  a  sum 
which  in  addition  to  any  rents  received  from  other  tenants  shall  pro- 
vide a  net  income  (after  deducting  taxes,  depreciation,  and  other  ex- 
penses) at  the  rate  of  4  per  cent  per  annum  of  the  book  value  at  the 
end  of  the  taxable  year  of  the  real  estate  so  owned  and  occupied. 
For  example,  if  the  book  value  of  a  parcel  of  real  estate  owned 
and  occupied  in   whole  or  in  part  by  the  company  is  $r,ooo,ooo,  the 


1386  SPECIAL   CLASSES    OF   TAXPAYERS 

rents  received  from  other  tenants  $30,000,  taxes  and  expenses  $40,000, 
and  depreciation  $20,000,  the  company  would  have  to  inchide  in  its 
gross  income  a  sum  not  less  than  $70,000  ($40,000  taxes  and  expenses, 
plus  $20,000  depreciation,  minus  $30,000  rents  from  tenants,  plus  4 
per  cent  of  $r, 000,000)  as  the  rental  value  of  the  space  occupied  by 
it  in  order  to  avail  itself  of  the  deductions  of  $40,000  and  $20,000. 
In  any  case  the  rents  received  from  other  tenants  must  be  included  in 
gross  income.     (Art.  686.) 

Specific  credit. — 

Law.  Section  245.  (a)  ....  (9)  In  the  case  of  a  domestic  life 
insurance  company,  the  net  income  of  which  (computed  without  the 
benefit  of  this  paragraph)  is  $25,000  or  less,  the  sum  of  $2,000;  but  if 
the  net  income  is  more  than  $25,000  the  tax  imposed  by  section  243 
shall  not  exceed  the  tax  which  would  be  payable  if  the  $2,000  credit 
were  allowed,  plus  the  amount  of  the  net  income  in  excess  of 
$25,000 

This  provision  is  identical  with  the  corresponding  allow- 
ance made  for  income  tax  purposes  to  other  corporations 
under  section  236  (b). 

Taxable  income  of  foreign  company. — The  net  income  of 
a  foreign  company  subject  to  United  States  income  tax  is  ascer- 
tained as  follows : 

Law.  Section  245.  ....  (c)  In  the  case  of  a  foreign  life  in- 
surance company  the  amount  of  its  net  income  for  any  taxable  year 
from  sources  within  the  United  States  shall  be  the  same  proportion  of 
its  net  income  for  the  taxable  year  from  sources  within  and  without 
the  United  States,  which  the  reserve  funds  required  by  law  and  held 
by  it  at  the  end  of  the  taxable  year  upon  business  transacted  within  the 
United  States  is  of  the  reserve  funds  held  by  it  at  the  end  of  the 
taxable  year  upon  all  business  transacted. 

Regulation.  Foreign  life  insurance  companies  holding  reserve 
funds  upon  business  transacted  within  the  United  States  are  taxed 
under  section  243  upon  their  net  income  from  sources  within  the 
United  States.  All  business  transacted  by  a  United  States  branch  or 
agency  of  a  foreign  insurance  company,  for  which  a  reserve  fund  is 
required  by  the  laws  of  any  State  or  Territory  of  the  United  States 
or  of  the  District  of  Columbia,  will  be  regarded  as  business  transacted 
within  the  United  States.  A  foreign  life  insurance  company  not  doing 
an  insurance  business  within  the  United  States  and  holding  no  re- 
serve funds  upon  business  transacted  within  the  United  States,  but 
which  derives  income   from  sources  within  the  United  States  as  de- 


INSURANCE   COMPANIES  1387 

fined  in  section  217*  ....  is  subject  to  the  tax  imposed  by  section 
230  upon  income  derived  from  sources  within  the  United  States. 
....  As  to  taxation  of  life  insurance  companies  between  United 
States  and  Porto  Rico  and  Philippine  Islands,  see  article  1133.  (Art. 
687.) 

Insurance  Companies  Other  than  Life 
and  Mutual  Companies 

Sections  246  and  J47  of  the  1921  law,  which  are  appHcable 
to  this  class  of  insurance  companies  are  effective  only  from 
January  i,  1922.  Therefore,  for  the  year  1921  these  com- 
panies are  taxed  under  sections  232  to  236  which,  in  their 
application  to  insurance  companies,  are  considered  later  in  this 
chapter."  Insurance  companies  in  this  class  are  also  subject  to 
excess  profits  tax  and  to  capital  stock  tax  for  the  year  1921. 

Following  are  the  law  provisions  effective  from  January 
I,  1922  : 

Rates  of  tax. — 

Law.  Section  246.  (a)  That,  in  lieu  of  the  taxes  imposed  by 
sections  230  and  1000,  there  shall  be  levied,  collected  and  paid  for  the 
calendar  year  1922,  and  for  each  taxable  year  thereafter,  upon  the  net 
income  of  every  insurance  company  (other  than  a  life  or  mutual  in- 
surance company)  a  tax  as  follows: 

(i)  In  the  case  of  such  a  domestic  insurance  company  the  same 
percentage  of  its  net  income  as  is  imposed  upon  other  corporations 
by  section  230; 

(2)  In  the  case  of  such  a  foreign  insurance  company  the  same 
percentage  of  its  net  income  from  sources  within  the  United  States 
as  is  imposed  upon  the  net  income  of  other  corporations  by  section 
230 

The  rate  provided  by  section  230  for  the  year  1922  and 
subsequent  years  is  123^  per  cent. 

Regulation.  For  the  calendar  year  1921  all  insurance  companies 
(other  than  life)  are  subject  to  taxes  imposed  by  sections  230  (cor- 
poration income  tax)  and  1,000  (capital  stock  tax)  and  Title  III  (war 
profits  and  excess  profits  tax).  For  the  calendar  year  1922 
and    thereafter,    however,    in    lieu    of    such    taxes,    insurance    com- 


'  See  pages  1272,  1278. 
"  See  pages  1394,  1401. 


1388  SPECIAL   CLASSES    OF   TAXPAYERS 

panics,  except  life  and  mutual  companies,  are  subject  to  the  tax 
imposed  by  section  246.  Mutual  insurance  companies  (other  than 
life)  remain  subject  to  the  taxes  imposed  by  sections  230  and 
1,000.  In  articles  691-693  the  term  "'insurance  companies"  means 
only  those  companies  subject  to  the  tax  imposed  by  sectiqn 
246.  The  rate  of  the  tax  imposed  by  section  246  is  the  same  as  the 
rate  imposed  by  section  230  (12^  per  cent),  but  the  net  income  upon 
which  the  tax  is  imposed,  as  defined  in  sections  246  and  247,  differs 
from  the  net  income  of  other  corporations.  Insurance  companies  are 
entitled  to  the  benefit  of  section  204  (net  losses)  but  not  of  section  206 
(capital  net  gain).  All  provisions  of  the  statute  and  of  these  regu- 
lations not  inconsistent  with  the  specific  provisions  of  sections  246 
and  247  are  applicable  to  the  assessment  and  collection  of  this  tax, 
and  insurance  companies  are  subject  to  the  same  penalties  as  provided 
in  the  case  of  returns  and  payment  of  income  tax  by  other  corpor- 
ations. Since  section  246  provides  that  the  underwriting  and  invest- 
ment exhibit  of  the  annual  statement  approved  by  the  National  Con- 
vention of  Insurance  Commissioners  shall  be  the  basis  for  computing 
gross  income  and  since  the  annual  statement  is  rendered  on  the  calen- 
dar year  basis,  the  first  returns  under  section  246  will  be  for  the  tax- 
able year  ending  December  31,  1922,  and  will  be  made  on  or  before 
March  15,   1923.     (Art.  691.) 

Gross  income  defined. — 

Law.  Section  246.  ....  (b)  In  the  case  of  an  insurance  com- 
pany subject  to  the  tax  imposed  by  this  section — 

(i)  The  term  "gross  income"  means  the  combined  gross  amount, 
earned  during  the  taxable  year,  from  investment  income  and  from 
underwriting  income  as  provided  in  this  subdivision,  computed  on  the 
basis  of  the  underwriting  and  investment  exhibit  of  the  annual  state- 
ment approved  by  the  National  Convention  of  Insurance  Commis- 
sioners; .... 

Investment  income. — 

Law.  Section  246.  ....  (b)  ....  (3)  The  term  "invest- 
ment income"  means  the  gross  amount  of  income  earned  during  the 
taxable  year  from  interest,  dividends  and  rents,  computed  as  follows: 

To  all  interest,  dividends  and  rents  received  during  the  taxable 
year,  add  interest,  dividends  and  rents  due  and  accrued  at  the  end  of 
the  taxable  year,  and  deduct  all  interest,  dividends  and  rents  due  and 
accrued  at  the  end  of  the  preceding  taxable  year;   .... 

Underwriting  income. — 

Law.  Section  246  ....  (b)  ....  (4)  The  term  "under- 
writing income"  means  the  premiums  earned  on  insurance  contracts 


INSURANCE   COMPANIES  1389 

during     the    taxable    year    less    losses     incurred    and     expenses     in- 
curred  


Premiums  earned. — 

Law.  Section  246 (b)  ....  (5)  The  term  "premi- 
ums earned  on  insurance  contracts  during  the  taxable  year"  means  an 
amount  computed  as  follows: 

From  the  amount  of  gross  premiums  written  on  insurance  con- 
tracts during  the  taxable  year,  deduct  return  premiums  and  premiums 
paid  for  reinsurance.  To  the  result  so  obtained  add  unearned  premiums 
on  outstanding  business  at  the  end  of  the  preceding  taxable  year  and 
deduct  unearned  premiums  on  outstanding  business  at  the  end  of  the 
taxable  year;   .... 

Net  income  defined. — 

Law.  Section  246.  ....  (b)  ....  (2)  The  term  "net  in- 
come" means  the  gross  income  as  defined  in  paragraph  (i)  of  this 
subdivision  less  the  deductions  allowed  by  section  247;   .... 

Regulation.  Net  income  is  gross  income  as  defined  in  section 
246  less  the  deductions  allowed  in  section  247.  Gross  income  is 
the  combined  gross  amount  earned  during  the  taxable  year  from 
interest,  dividends,  rents,  and  premium  income,  computed  on  the 
basis  of  the  underwriting  and  investment  exhibit  of  the  annual 
statement  approved  by  the  National  Convention  of  Insurance  Com- 
missioners. Gross  income  does  not  include  gain  derived  from  sale 
of  disposition  of  capital  assets,  nor  are  losses  sustained  from  such 
sale  or  disposition  allowable  deductions.  It  does  not  include  increase 
in  liabilities  during  the  year  on  account  of  reinsurance  treaties;  re- 
mittances from  home  office  of  a  foreign  insurance  company  to  United 
States  branch;  borrowed  money;  gross  profit  on  maturity  of  capital 
assets;  gross  increase  due  to  adjustments  in  book  value  of  capital 
assets  and  premium  on  capital  stock  sold.  11  ic  underwriting  and 
investment  exhibit  is  presumed  clearly  to  reflect  the  true  net  income 
of  the  company,  and  in  so  far  as  it  is  not  inconsistent  with  the 
provisions  of  the  statute  will  be  recognized  and  used  as  a  basis  for 
that  purpose.  All  items  of  the  exhibit,  however,  do  not  reflect  an 
insurance  company's  income  as  defined  in  the  statute.  l>y  reason  of 
the  definition  of  investment  income,  profit  or  loss  on  investment  items 
is  ignored,  as  well  as  those  miscellaneous  items  which  are  intended 
to  reflect  surplus  but  do  not  properly  enter  into  the  computation  of 
income,  such  as  dividends  declared,  home  ofiice  remittances  and 
receipts,  and  special  deposits.  Gain  or  loss  from  agency  balances 
and  bills  receivable  not  admitted  as  assets  on  the  underwriting  and 
investment  exhil)it   will  be  ignored,  excepting  only  such  agency  bal- 


I390  SPECIAL   CLASSES    OF   TAXPAYERS 

ances  and  bills  receivable  as  have  been  charged  off  the  books  of  the 
company  as  bad  debts,  or  having  been  previously  charged  off  are 
recovered  during  the  taxable  year.      (Art.  692.) 

Deductions.^" — The  statutory  deductions  allowed  insurance 
companies  other. than  life  and  mutual  companies  after  1921." 
are  as  follows : 

Ordinary  and  necessary  expenses. — 

Law.  Section  247.  (a)  .  .  .  .  (1)  All  ordinary  and  necessary 
expenses  incurred,  as  provided  in  paragraph  (i)  of  subdivision  (a) 
of  section  234;   .... 

The  deduction  is  the  same  as  that  allowed  to  other  cor- 
porations. 

Regulation.  For  the  calendar  year  1921  insurance  companies 
(other  than  life  insurance  companies)  are  entitled  to  the  same  de- 
ductions from  gross  income  as  other  corporations,  and  also  to  the 
deduction  of  the  net  addition  required  by  law  to  be  made  within  the 
taxable  year  to  reserve  funds  and  of  the  sums  other  than  dividends 
paid  within  the  taxable  year  on  policy  and  annuity  contracts.  After 
December  31,  1921,  such  insurance  companies,  except  mutual  com- 
panies, are  entitled  only  to  the  deductions  allowed  by  section  247. 
....  Mutual  insurance  companies  (other  than  life)  are  not  en- 
titled to  the  deductions  allowed  by  section  247,  but  are  entitled  to 
the  deductions  allowed  by  section  234 "Paid"  includes  "ac- 
crued" or  "incurred"  (construed  according  to  the  method  of  account- 
ing upon  the  basis  of  which  the  net  income  is  computed)  during  the 
taxable  year,  but  does  not  include  any  estimate  for  losses  incurred 
but  not  reported  during  the  taxable  year (Art.  568.) 

"Expenses  incurred"  defined. — 

Law.  Section  246.  ....  (b)  ....  (7)  The  term  "expenses 
incurred"  means  all  expenses  shown  on  the  annual  statement  approved 
by  the  National  Convention  of  Insurance  Commissioners,  and  shall 
be  computed  as  follows: 

To  all  expenses  paid  during  the  taxable  year  add  expenses  unpaid 
at  the  end  of  the  taxable  year  and  deduct  expenses  unpaid  at  the 
end  of  the  preceding  taxable  year.  For  the  purpose  of  computing 
the  net  income  subject  to  the  tax  imposed  by  this  section  there  shall 


'"Law.  Section  247.  "(c)  Notliing  in  this  section  or  in  section  246 
shall  be  construed  to  permit  the  same  item  to  be  twice  deducted." 

"  For  law  and  regulations  applicable  to  these  companies  during  1921, 
see  pages  1380  and  1395. 


INSURANCE   COMPANIES 


^391 


be  deducted  from  expenses  incurred  as  defined  in  this  paragraph  all 
expenses  incurred  which  are  not  allowed  as  deductions  by  sec- 
tion 247. 

Interest  paid  or  accrued. — 

Law.  Section  247.  (a)  .  .  .  .  (2)  All  interest  as  provided  in  para- 
graph (2)  of  subdivision  (a)  of  section  234; 

This  section  allows  the  deduction  of  all  interest  paid  or 
accrued,  except  that  arising  from  the  purchase  or  carrying  of 
tax-exem]:)t  securities  (other  than  original  subscriptions  to 
United  States  obligations  issued  after  September  24th,  191 7). 

For  full  treatment  see  Chapter  XXVII. 

Taxes  paid  ok  accrued. — 

Law.  Section  247.  (a)  ....  (3)  Taxes  as  provided  in  para- 
graph (3)  of  subdivision  (a)  of  section  234;   .... 

Regulation Among  the  items  which  may  not  be  de- 
ducted are  income  and  profits  taxes,  paid  or  accrued,  imposed  by  the 
United  States  and  so  much  of  the  income  and  profits  taxes  imposed 
by  any  foreign  country  or  possession  of  the  United  States  as  is 
allowed  as  a  credit  under  section  238;  taxes  assessed  against  local 
benefits;  donations;  decrease  during  the  year  due  to  adjustments  in 
book  value  of  capital  assets;  decrease  in  liabilities  during  the  year 
on  account  of  reinsurance  treaties;  dividends  paid  to  stockholders; 
remittances  to  home  office  of  a  foreign  insurance  company  by  United 
States  branch;  and  borrowed  money  repaid.     (Art.  693.) 

Credit  for  taxes. — 

Regulation A    domestic    insurance    company    is    also 

entitled  to  the  credit  for  income,  war  profits,  and  excess  profits  taxes 
paid  during  the  taxable  year  to  any  foreign  country  or  to  any  pos- 
session of  the  United  States  which  is  allowed  other  domestic  cor- 
porations by  section  238.^^   ....      (Art.  693.) 

For  full  treatment  of  the  subject  of  taxes,  see  Chapter 
XXVIII. 

Losses. — 

Law.     Section    247.     (a)    ....    (4)  Losses    incurred;  .... 

"Losses  incurred"  defined. — 

Law.     Section    246 (b)    ....    (6)  The    term    "losses 

"  See  page  947. 


1392 


SPECIAL   CLASSES    OF   TAXPAYERS 


incurred"  means  losses  incurred  during  the  taxable  year  on  insurance 
contracts,  computed  as  follows: 

To  losses  paid  during  the  taxable  year,  add  salvage  and  reinsurance 
recoverable  outstanding  at  the  end  of  the  preceding  taxable  year,  and 
deduct  salvage  and  reinsurance  recoverable  outstanding  at  the  end  of 
the  taxable  year.  To  the  results  so  obtained  add  all  unpaid  losses  out- 
standing at  the  end  of  the  taxable  year  and  deduct  unpaid  losses  out- 
standing at  the  end  of  the  preceding  taxable  year;   .... 

It  will  be  noted  that  the  term  "losses  incurred"  is  so  nar- 
rowly defined  that  it  cannot  include  losses  sustained  on  invest- 
ments. On  the  other  hand,  as  is  also  true  in  the  case  of  life 
insurance  companies,''*  the  gains  from  investments,  as  dis- 
tinguished from  investment  income'^  therefrom  ("interest 
dividends  and  rents")  are  not  required  to  be  included  in  tax- 
able gross  income. 

Bad  debts. — 

Law.  Section  247.  (a)  •  •  •  •  (5)  Bad  debts  in  the  nature  of 
agency  balances  and  bills  receivable  ascertained  to  be  worthless  and 
charged  off  within  the  taxable  year;   .... 

The  subject  of  bad  debts  is  treated  at  length  in  Chapter 
XXX. 

Certain  dividends  deductible. — 

Law.  Section  247.  (a)  ....  (6)  The  amount  received  as 
dividends  from  corporations  as  provided  in  paragraph  (6)  of  sub- 
division (a)  of  section  234;   .... 

The  dividends  in  question  are  those  received  from  domestic 
corporations  and  from  foreign  corporations  of  whose  gross  in- 
come for  the  preceding  three-year  period  more  than  50  per 
cent  was  derived  from  sources  within  the  United  States.  This 
subject  is  dealt  with  in  Chapter  XXII. 

Exempt  interest. — 

Law.  Section  247.  (a)  .  .  .  .  (7)  The  amount  of  interest 
earned  during  the  taxable  year  which  under  paragraph  (4)  of  subdivi- 
sion (b)   of  section  213  is  exempt  from  taxation  under  this  title,  and 


"  See  page  1380. 
"  Section  246  (b-3). 


INSURANCE   COMPANIES  1393 

the  amount  of  interest  allowed  as  a   credit  under  subdivision   (a)   of 
section  236;  .... 

The  interest  which  may  be  deducted  is  that  from  obHga- 
tions  of  the  United  States  or  its  possessions,  a  state,  territory 
or  any  poHtical  subdivision  thereof,  or  the  District  of  Colum- 
bia, also  from  Farm  Loan  bonds  and  bonds  issued  by  the  War 
Finance  Corporation.     See  Chapters  XIX  and  XX. 

Depreciation. — 

Law.  Section  247.  (a)  ....  (8)  A  reasonable  allowance,  for 
the  exhaustion,  wear  and  tear  of  property,  as  provided  in  paragraph 
(7)  of  subdivision  (a)  of  section  234;   .... 

For  a  full  treatment  of  depreciation,  see  Chapter  XXXI. 

Specific  credit. — 

Law.  Section  247.  (a)  ....  (9)  In  the  case  of  such  a  domes- 
tic insurance  company,  the  net  income  of  which  (computed  without  the 
benefit  of  this  paragraph)  is  $25,000  or  less,  the  sum  of  $2,000;  but  if 
the  net  income  is  more  than  $25,000  the  tax  imposed  by  section  246 
shall  not  exceed  the  tax  which  would  be  payable  if  the  $2,000  credit 
were  allowed,  plus  the  amount  of  the  net  income  in  excess  of 
$25,000 


Taxable  income  of  foreign  company. — The  law  contains 
in  the  case  of  "insurance  companies  other  than  life  and  mutual 
insurance  companies"  no  specific  direction  as  to  how  the  gross 
or  net  income  of  foreign  companies  is  to  be  determined.  It  is 
simply  stated  in  section  246  (a-2)^''  that  ''its  net  income  from 
sources  within  the  United  States"  is  to  be  subjected  to  tlie 
same  rate  of  tax  as  is  imposed  upon  the  income  of  ordinary 
corporations.  It  is  to  l)e  assumed  that  from  the  gross  income 
from  sources  within  the  United  States  [subject  to  the  defini- 
tions of  such  income  contained  in  section  246  (b)^"]  are  to  be 
subtracted  the  deductions  allowed  by  section  247."  These 
deductions  are  subject  to  the  following  limitation  : 


""'  See  page  1387. 
"See  pages  1388,  1389. 
"  See  page  1390. 


1394 


SPECIAL   CLASSES    OF   TAXPAYERS 


Law.  Section  247.  ....  (b)  In  the  case  of  a  foreign  cor- 
poration the  deduction  allowed  in  this  section  shall  be  allowed  to  the 
extent  provided  in  subdivision  (b)  of  section  234 

Section  234  (b)^®  limits  the  deductions  of  foreign  corpora- 
tions to  those  "connected  with  income  from  sources  within  the 
United  States." 


Mutual   Insurance  Companies 

Mutual  insurance  companies  other  than  those  which  are 
exempt'"  are  taxed  on  a  basis  similar  to  that  of  other  corpora- 
tions, with  certain  exceptions  noted  below.  For  the  year  192 1 
this  basis  also  applied  to  insurance  comj^anies  "other  than  life 
and  mutual  insurance  companies"  which  after  December  31, 
192 1,  are  taxed  under  special  sections  of  the  1921  law.""  In- 
surance companies  taxed  on  this  basis  are  sul)ject  to  excess 
profits  tax  for  1921  and  to  capital  stock  tax. 

Gross  income. — Section  233,  in  defining  gross  income  for 
corporations  generally,  makes  applicable  thereto  the  provisions 
of  section  213  (individuals)  and  section  217  (non-resident 
alien  individuals).  The  only  specific  reference  to  insurance 
companies  is  "that  mutual  marine  insurance  companies  shall 
include  in  gross  income  the  gross  premiums  collected  and  re- 
ceived by  them  less  amounts  paid  for  reinsurance." 

Law.  Section  2t,Ti.  (a)  That  in  the  case  of  a  corporation  sub- 
ject to  the  tax  imposed  by  section  230  the  term  "gross  income"  means 
the  gross  income  as  defined  in  sections  213  and  217,  except  that  mutual 
marine  insurance  companies  shall  include  in  gross  income  the  gross 
premiums  collected  and  received  by  them  less  amounts  paid  for  rein- 
surance  

Section  230  imposes  a  corporation  income  tax  of  10  per 
cent  for  1921,  and  1214  per  cent  for  each  year  thereafter. 

Regulation.  The  gross  income  of  mutual  insurance  companies 
(other  than  life)   consists  of  their  total  revenue  from  the  operation 


"  See  page  1292. 
'^  .See  page  1401. 
^  Sections  246-247 ;  see  pages  1387- 1389. 


Insurance  companies 


1395 


of  the  business  and  of  their  income  from  all  other  sources  within  the 
taxable  year,  except  as  otherwise  provided  by  the  statute.  Gross  in- 
come includes  net  premiums  (that  is,  gross  premiums  less  returned 
premiums  on  policies  cancelled  and  premiums  on  policies  not  taken), 
investment  income,  profits  from  the  sale  of  assets,  and  all  gains, 
profits,  and  income  reported  to  the  State  insurance  departments,  ex- 
cept income  specifically  exempt  from  tax.  Premiums  received  by 
mutual  marine  insurance  companies  which  are  paid  out  for  I'einsur- 
ance  should  be  eliminated  from  gross  income  and  the  payments  for 
reinsurance  from  disbursements.  Deposit  premiums  on  perpetual  risks 
received  and  returned  by  mutual  fire  insurance  companies  should  be 
treated  in  the  same  manner,  as  no  reserve  will  be  recognized  covering 
liability  for  such  deposits.  The  earnings  on  such  deposits,  including 
such  portion,  if  any,  of  the  deposits  as  are  not  returned  to  the  policy- 
holders upon  cancellation  of  the  policies,  must  be  included  in  the 
gross  income.  A  net  decrease  in  reserve  funds  required  by  law  within 
the  taxable  year  must  be  included  in  the  gross  income  to  the  extent 
that  it  is  released  to  the  general  uses  of  the  company  and  increases 
its  free  assets.  Any  net  decrease  in  reserves  shall  be  added  to  the 
gross  income,  unless  the  company  shall  show  that  such  decrease 
resulted  from  the  application  of  reserves  to  the  purposes  for  which 
they  were  established (Art.  549.) 

Shipowners'  mutual  protection  and  indemnity  asso- 
ciations.— If  such  associations  are  not  organized  for  profit 
and  no  part  of  the  earnings  inures  to  the  benefit  of  any  stock- 
holder, they  are  subject  to  tax  only  on  net  income  from  interest, 
dividends  and  rents. 

Regulation.  The  following  additional  exclusions  from  gross 
income   ....   are  allowed  by  the  Revenue  Act  of  1921. 

....  (4)  Receipts  of  shipowners'  mutual  protection  and 
indemnity  associations  not  organized  for  profit  and  no  part  of 
the  net  earnings  of  which  inures  to  the  benefit  of  any  private 
stockholder  or  member.  Such  associations,  however,  shall  be  sub- 
ject as  other  taxpayers  to  the  tax  upon  their  net  income  from  in- 
terest, dividends,  and  rents.  In  other  words,  they  are  subject  to  the 
taxes  imposed  by  section  230,  but  only  upon  net  income  from  in- 
terest, dividends,  and  rents;    ....      (Art.  89.) 

Deductions  allowed. — The  deductions  allowed  mutual  com- 
panies are  those  provided  in  .section  234'"'  (not  those  detailed  in 


"See  Chapters  on  Expenses  (XXVI),  Interest  (XXVII),  Taxes 
(XXVIII),  Losses  (XXIX),  Bad  Dcbt.s  (XXX),  and  Depreciation 
(XXXI). 


1396  SPECIAL   CLASSES   OF   TAXPAYERS 

section  247),  with  certain  additional  deductions  to  meet  the 
special  circumstances  obtaining  in  the  case  of  insurance  com- 
panies. 

Additions  to  reserve  funds. — 

Law.  Section  234.  (a)  .  .  .  .  (10)  In  the  case  of  insurance 
companies  (other  than  life  insurance  companies),  in  addition  to  the 
above  (unless  otherwise  allowed) :  (A)  The  net  addition  required  by 
law  to  be  made  within  the  taxable  year  to  reserve  funds  (including  in 
the  case  of  assessment  insurance  companies  the  actual  deposit  of  sums 
with  State  or  Territorial  officers  pursuant  to  law  as  additions  to 
guarantee  or  reserve  funds) ;  and  (B)  the  sums  other  than  dividends 
paid  within  the  taxable  year  on  policy  and  annuity  contracts.  After 
December  31,  1921,  this  subdivision  shall  apply  only  to  mutual  insur- 
ance companies  other  than  life  insurance  companies;   .... 

Regulation.  This  article  applies  to  all  insurance  companies 
(except  life)  for  the  calendar  year  1921 ;  thereafter  it  applies  only 
to  mutual  companies.  Insurance  companies  may  deduct  from  gross 
income  the  net  addition  required  by  law  to  be  made  within  the  tax- 
able year  to  reserve  funds,  including  in  the  case  of  assessment  insur- 
ance companies  the  actual  deposit  of  sums  with  State  or  Territorial 
officers  pursuant  to  law  as  additions  to  guaranty  or  reserve  funds. 
Reserve  funds  "required  by  law"  include  not  only  reserves  required 
by  express  statutory  provisions  but  also  reserves  required  by  the 
rules  and  regulations  of  State  insurance  departments  when  promul- 
gated in  the  exercise  of  an  appropriate  power  conferred  by  statute, 
but  do  not  include  assets  required  to  be  held  for  the  ordinary  running 
expenses  of  the  business,  such  as  taxes,  salaries,  reinsurance,  and 
unpaid  brokerage.  Only  reserves  commonly  recognized  as  reserve 
funds  in  insurance  accounting  are  to  be  taken  into  consideration  in 
computing  the  net  addition  to  reserve  funds  required  by  law.  In  the 
case  of  a  fire  insurance  company  the  only  reserve  fund  commonly 
recognized  is  the  "unearned-premium"  fund.  Casualty  companies 
may  deduct  losses  incurred  within  the  taxable  year ;  but  unless  the 
net  addition  to  the  unpaid  loss  reserve  required  by  law  exceeds  such 
losses  incurred,  no  deduction  for  the  net  addition  to  the  unpaid  loss 
reserve  may  be  taken.  In  any  event  only  the  excess  of  such  net  ad- 
dition over  such  losses  may  be  deducted.  Mutual  hail  and  mutual 
cyclone  insurance  companies  are  entitled  to  deduct  from  gross  in- 
come the  net  addition  which  they  are  required  to  make  to  the 
"guaranty  surplus"  fund  or  similar  fund (Art.  569.) 

Rulings.  The  decision  of  the  United  States  Supreme  Court  in 
Maryland  Casualty   Company   v.  United   States--  does  not  authorize 

"251  U.  S.  342. 


INSURANCE   COMPANIES 


1397 


any  insurance  company  to  deviate  from  the  present  method  of  com- 
puting the  "net  addition  to  reserve  funds"  deductible  from  gross  in- 
come. The  amount  deductible  is  the  excess  of  the  total  reserve 
funds  as  required  by  law  at  the  end  of  the  taxable  year  over  the 
total  of  such  reserve  funds  at  the  beginning  of  the  year  regardless 
of  the  fact  that  during  the  year  the  reserve  funds  are  increased  on 
account  of  new  business,  and  decreases  in  such  funds  are  inevitable 
when  policies  mature,  lapse,  or  arc  surrendered.  (C.  B.  2,  page  2 [6; 
O.  D.  427.) 

Reserve  funds  "required  by  law"  include  not  only  reserves  re- 
quired by  express  statutory  provisions,  but  also  reserves  required  by 
the  rules  and  regulations  of  State  insurance  departments  when  pro- 
mulgated in  the  exercise  of  an  appropriate  power  conferred  by 
statute,  but  do  not  include  assets  required  to  be  held  for  the  ordinary 
running  expenses  of  the  business,  such  as  taxes,  salaries,  reinsurance, 
and  unpaid  brokerage. 

Where  there  is  a  net  decrease  in  the  reserve  funds  required  to 
be  maintained  by  an  insurance  company,  so  much  of  the  decrease 
as  is  released  to  the  general  uses  of  the  company  and  increases  its 
free  assets  is  income  to  the  company. 

Any  net  decrease  in  reserve  shall  be  added  to  the  gross  income, 
unless  the  company  shall  show  that  such  decrease  resulted  from  the 
application  of  reserves  to  the  purposes  for  which  they  were  estab- 
lished.    (C.  B.  2,  page  216;  L.  O.  1032.) 

It  would  seem  that  outstanding  liabilities  for  expenses  such 

as  salaries  should  be  set  up  and  deducted  as  such  instead  of 

being  included  in  the  reserve  "required  by  law." 

Ruling.  A  reserve  for  the  expense  of  investigating  loss  claims 
of  an  insurance  company  is  not  a  "reserve"  within  the  meaning  of 
paragraph  G  (b)  of  the  Act  of  October  3,  1913,  and  therefore  any 
net  addition  thereto  may  not  be  deducted  in  determining  net  income 
subject  to  tax.     (C.  B.  3,  page  276;  Sol.  Op.  76.) 

As  stated  above,  accrued  expenses  sliouUl  be  deducted 
as  such  and  not  as  a  "reserve."  The  deduction,  however,  is 
permitted  only  when  taxpayers  keep  their  books  on  the  accrual 
system.  It  would  appear  from  the  foregoing  ruling  that  the 
deduction  was  denied  because  it  was  not  properly  accrued  on 
the  books  at  the  time. 

In  passing  on  the  question  of  "whether  the  reserve  set  up 
by  a  fire  insurance  company  against  unpaid  losses  is  a  reserve 
within  the  meaning  of   the  provision   ....   permitting  a 


1398  SPECIAL    CLASSES    OF   TAXPAYERS 

deduction  from  gross  income  in  the  case  of  insurance  com- 
panies, of  the  'net  addition  required  by  law  to  be  made  withm 
the  taxable  year  to  reserve  funds,'  "  the  SoHcitor  of  Internal 
Revenue  stated"'^  that : 

RuLiNC.  The  insurance  commissioners  of  the  several  States  re- 
quire fire  insurance  companies  to  return  each  year  as  an  item  of 
their  liabilities  the  net  amount  of  unpaid  losses  whether  actually  ad- 
justed or  in  process  of  adjustment  or  resisted,  and  it  is  contended 
on  behalf  of  such  insurance  companies  that,  under  the  decision  of  the 
Supreme  Court  of  the  United  States  in  the  case  of  the  Maryland 
Casualty  Company  v.  United  States,  251  U.  S.  342  (T.  D.  3013), 
the  amount  of  this  item  constitutes  a  "reserve"  within  the  meaning 
of  the  provision  of  the  Revenue  Act  of  igiS  above  cited.^' 

The  Sohcitor  further  stated,  however,  that : 

It  has  been  repeatedly  stated  on  behalf  of  the  fire  insurance 
companies,  and  never  denied,  that  their  books  are  kept  upon  an 
accrued  and  incurred  basis.  It  is  clear,  therefore,  that  under  the 
law  they  are  entitled  to  deduct  the  several  items  included  in  un- 
paid losses  as  "losses"  and  to  allow  them  also  to  include  these 
items  in  reserves  the  net  additions  to  which  may  be  deducted  from 
gross  income  in  determining  the  taxable  income  of  such  companies, 
would  be  in  effect  to  permit  them  a  double  deduction,  a  result  which 
can  not  be  presumed  to  have  been  intended  by  Congress,  and  which 
could  only  be  reached  under  the  compulsion  of  an  express  pro- 
vision of  the  statute. 

It  is  hardly  conceivable  that  insurance  companies  would 
intentionally  claim  a  double  deduction  for  losses.  It  would 
appear  from  the  Solicitor's  opinion  that,  while  he  holds  that 
unpaid  losses  are  not  deductible  as  ''reserves,''  they  are  de- 
ductible as  "losses"  if  a  company's  books  are  kept  on  an  ac- 
crual basis. 

Special  deductions  in  the  case  of  combined  life,  health  and 

accident  policies, — 

Law.  Section  234.  (a)  .  .  .  .  (11)  In  the  case  of  corpora- 
tions (except  those  taxed  under  section  243)'-"  issuing  policies  covering 


■^  C.  B.  4,  page  297 ;  L.  O.  1056. 

"'Section   234    (a-io-a),   re-enacted  without  substantial   change   in   1921 
law. 

"'Life  insurance  companies. 


INSURANCE   COMPANIES 


1399 


life,  health,  and  accident  insurance  combined  in  one  policy  issued  on 
the  weekly  premium  payment  plan  continuing  for  life  and  not  sub- 
ject to  cancellation,  in  addition  to  the  above,  such  portion  of  the  net 
addition  (not  required  by  law)  made  within  the  taxable  year  to  re- 
serve funds  as  the  Commissioner  finds  to  be  required  for  the  pro- 
tection of  the  holders  of  such  policies  only.  This  subdivision  shall 
not  be  in  effect  after  December  31,  1921;   .... 

Regulation,  Corporations  which  issue  combination  policies  of 
life,  health,  and  accident  insurance  on  the  weekly  premium  pay- 
ment plan,  continuing  for  life  and  not  subject  to  cancellation,  may 
deduct  from  gross  income  only  such  portion  of  the  net  addition  not 
required  by  law  made  within  the  taxal)le  year  to  reserve  funds  as  is 
needed  for  the  protection  of  the  holders  of  such  combination  policies. 
In  general  the  net  addition  to  any  fund  especially  maintained  for 
the  protection  of  such  policyholders  may  be  deducted.  The  deter- 
mination by  the  company  of  the  need  for  such  addition  is  subject  to 
review  by  the  commissioner,  and  the  return  of  income  should  be 
accompanied  by  a  full  explanation  of  the  basis  upon  which  such 
fund  and  the  additions  to  it  are  determined.  This  article  does  not 
apply  to  life  insurance  companies  taxed  under  section  243  nor  to  any 
taxable  period  after  December  31,  1921.     (Art.  570.) 

After  the  enactment  of  the  19 18  law,  some  insurance  com- 
panies writing  poHcies  described  in  section  234  (a-ii)  con- 
tended that,  since  no  reserve  for  the  purpose  was  recognized 
prior  to  the  19 18  law,  the  entire  reserve  might  now  be  de- 
ducted, including  the  portion  set  up  prior  to  1918.  The  Solici- 
tor of  Internal  Revenue,  replying  to  this  contention,  cited  a 
statement  made  in  a  Federal  Court  case"*^  that,  "there  is  no 
safer  or  better  settled  canon  of  interpretation  than  that  when 
language  is  clear  and  unambiguous  it  must  be  held  to  mean 
what  it  plainly  expresses,  and  no  room  is  left  for  construction," 
and  pointed  out  that  the  law  specifically  provided  that  the  de- 
duction to  be  allowed  is  only  for  "the  net  addition  .... 
made  within  the  taxable  year."  He  further  pointed  out  that 
the  portion  of  the  addition  to  be  allowed  as  a  deduction  is  by 
law  within  the  discretion  of  the  Commissioner  and  that  the 
latter  had  promulgated  a  regulation  (article  570,  Regulations 
45)  the  effect  of  which  was  that  the  maximum  deduction  is 


"^Szvarls  v.  Siecjcl,  117  Fed.   13,  18. 


I400  SPECIAL   CLASSES    OF   TAXPAYERS 

the  net  addition  (not  required  by  law)  within  the  taxable 
year  to  reserve  funds. 

Premium  repayments  by  mutual  marine  insurance 
companies. 

Law.  Section  234.  (a)  .  .  .  .  (12)  In  the  case  of  mutual  marine 
insurance  companies,  there  shall  be  allowed,  in  addition  to  the  deductions 
allowed  in  paragraphs  (i)  to  (10)  inclusive,  and  paragraph  (14),  unless 
otherwise  allowed,  amounts  repaid  to  policyholders  on  account  of 
premiums  previously  paid  by  them,  and  interest  paid  upon  such  amounts 
between  the  ascertainment  and  the  payment  thereof;   .... 

Regulation.  Mutual  marine  insurance  companies  should  include 
in  gross  income  the  gross  premiums  collected  and  received  by  them 

less  amounts  paid  for  reinsurance They  may  deduct  from 

gross  income  amounts  repaid  to  policyholders  on  account  of  premiums 
previously  paid  by  them,  together  with  the  interest  actually  paid  upon 
such  amounts  between  the  date  of  ascertainment  and  the  date  of 
payment  thereof.  The  remainder  of  the  premiums  accordingly  form 
part  of  the  net  income  of  the  company,  except  to  the  extent  that 
they  are  subject  to  the  deductions  allowed  such  insurance  companies 
and  other  corporations.     (Art.  571.) 

Premium  deposits  returned  or  retained. — 

Law.  Section  234.  (a)  .  .  .  .  (13)  In  the  case  of  mutual  in- 
surance companies  (including  interinsurers  and  reciprocal  underwriters, 
but  not  including  mutual  life  or  mutual  marine  insurance  companies) 
requiring  their  members  to  make  premium  deposits  to  provide  for 
losses  and  expenses,  there  shall  be  allowed,  in  addition  to  the  deduc- 
tions allowed  in  paragraphs  (i)  to  (10),  inclusive,  and  paragraph  (14), 
unless  otherwise  allowed,  the  amount  of  premium  deposits  returned 
to  their  policyholders  and  the  amount  of  premium  deposits  retained 
for  the  payment  of  losses,  expenses,  and  reinsurance  reserves;   .... 

Regulation.  Mutual  insurance  companies  (other  than  mutual 
life  and  mutual  marine  insurance  companies),  which  require  their 
members  to  make  premium  deposits  to  provide  for  losses  and  ex- 
penses, are  allowed  to  deduct  from  gross  income  the  aggregate  amount 
of  premium  deposits  returned  to  their  policyholders  or  retained  for 
the  payment  of  losses,  expenses,  and  reinsurance  reserves.  In  de- 
termining the  amount  of  premium  deposits  retained  by  a  mutual  fire 
or  mutual  casualty  insurance  company  for  the  payment  of  losses,  ex- 
penses, and  reinsurance  reserves,  it  will  be  presumed  that  losses  and 
expenses  have  been  paid  out  of  earnings  and  profits  other  than  pre- 
miums to  the  extent  of  such  earnings  and  profits.  If,  however,  any 
portion  of  such  amount  is  applied  during  the  taxable  year  to  the  pay- 


INSURANCE   COMPANIES  1401 

ment  of  losses,  expenses,  or  reinsurance  reserves,  for  which  a  separate 
allowance  is  taken,  then  such  portion  is  not  deductible;  and  if  any 
portion  of  such  amount  for  which  an  allowance  is  taken  is  subse- 
quently applied  to  the  payment  of  expenses,  losses,  or  reinsurance  re- 
serves, then  such  payment  can  not  be  separately  deducted.  An  amount 
of  premium  deposits  retained  for  the  payment  of  expenses  and  losses, 
and  the  amount  of  such  expenses  and  losses,  may  not  both  be  deducted. 
A  company  which  invests  part  of  the  premium  deposits  so  retained 
by  it  in  interest-bearing  securities  may  nevertheless  deduct  such  part, 
but  not  the  interest  received  on  such  securities.  A  mutual  fire  in- 
surance company  which  has  a  guaranty  capital  is  taxed  like  other 
mutual  fire  insurance  companies.  A  stock  fire  insurance  company, 
operated  on  the  mutual  plan  to  tlie  extent  of  paying  dividends  to 
certain  classes  of  policyholders,  may  make  a  return  on  the  same 
basis  as  a  nmtual  fire  insurance  company  witli  respect  to  its  business 
conducted  on  the  mutual  plan.     (Art.  572.) 

Ruling.  In  determining  the  amount  of  premium  deposits  retained 
by  a  mutual  fire  or  mutual  casualty  insurance  company  for  the 
payment  of  losses,  expenses  and  reinsurance  reserves,  it  is  to  be 
presumed  that  losses  and  expenses  have  been  paid  out  of  earnings 
and  profits,  other  than  premium,  to  the  extent  of  such  earnings  and 
profits.  Office  Decision  403  (Bulletin  7-20)  overruled.  (C.  B.  3, 
page  279;  L.  O.  1050.) 

Insurance  Companies  Which  Are  Exempt 

Mutual  insurauce  companies  which  conform  to  certain 
specified  requirements  are  exempt  from  taxation. 

Fraternal  beneficiary  societies.-' — 

Law.     Section     231 (3)  Fraternal     beneficiary     societies, 

orders,  or  associations,  (a)  operating  under  the  lodge  system  or  for  the 
exclusive  benefit  of  the  members  of  a  fraternity  itself  operating  under 
the  lodge  system;  and  (b)  providing  for  the  payment  of  life,  sick,  ac- 
cident, or  other  benefits  to  the  members  of  such  society,  order,  or  as- 
sociation or  their  dependents;  .... 

Mutual  insurance  companies  and  like  organizations. — 

Law.     Section  231 (10)  Farmers'  or  other  mutual  hail, 

cyclone  or  fire  insurance  companies,  mutual  ditch  or  irrigation  com- 
panies, mutual  or  cooperative  telephone  companies,  or  like  organiza- 
tions of  a  purely  local  character,  the  income  of  which  consists  solely 


For  rulings  regarding  fraternal  beneficiary  societies,  see  Chapter  II. 


1402 


SPECIAL    CLASSES    OF   TAXPAYERS 


of  assessments,   dues,   and  fees  collected  from   members   for  the   sole 
purpose  of  meeting  expenses;   .... 

Regulation.  It  is  necessary  to  exemption  that  the  income  of  the 
company  be  derived  solely  from  assessments,  dues,  and  fees  col- 
lected from  members.  If  income  is  received  from  other  sources,  such 
as  cash  premiums  or  premium  deposits,  the  corporation  is  not  exempt, 
even  though  its  additional  income  is  tax  exempt.  Income,  however, 
from  sources  other  than  those  specified  does  not  prevent  exemption 
where  its  receipt  is  a  mere  incident  of  the  business  of  the  company. 
Thus  the  receipt  of  interest  upon  a  working  bank  balance,  or  of  the 
proceeds  of  the  sale  of  badges,  office  supplies  or  equipment,  will  not 
defeat  the  exemption.  The  same  is  true  of  the  receipt  of  interest 
upon  Liberty  bonds,  where  they  were  purchased  as  a  patriotic  duty 
and  were  afterwards  sold.  Where,  however,  such  bonds  are  bought 
as  a  permanent  investment,  the  receipt  of  the  interest  destroys  the 
exemption.  The  receipt  of  what  is  in  substance  an  entrance  fee, 
charged  by  a  mutual  fire  insurance  company  as  a  condition  of  mem- 
bership, does  not  render  the  company  taxable,  although  this  fee  is 
called  a  premium.  A  farmers'  mutual  fire  and  lightning  insurance 
company  does  not  become  taxable  because  it  makes  advance  assess- 
ments for  the  sole  purpose  of  meeting  future  losses  and  expenses, 
where  any  balance  of  such  assessments  remaining  at  the  end  of  the 
year  is  retained  to  meet  losses  and  expenses  in  the  ensuing  year.  But 
the  issuance  of  policies  for  stipulated  cash  premiums  prevents  exemp- 
tion. A  local  exchange  or  association  to  insure  the  owners  of  auto- 
mobiles against  fire,  theft,  collision,  public  liability,  and  property 
damage  is  exempt,  since  it  performs  functions  of  the  same  character 
as  a  mutual  fire  insurance  company,  and  is  a  like  organization 
within  the  meaning  of  the  statute.  A  local  reservoir  and  ditch  com- 
pany may  likewise  be  exempt  from  tax.  An  organization  doing 
business  on  the  "interindemnity"  or  "reciprocal  insurance'  plan 
through  an  attorney  in  fact  subject  to  direction  of  an  advisory  board 
of  policyholders,  which  requires  advance  deposits  to  cover  the  cost 
of  the  insurance  and  maintains  investments  or  deposits  from  which 
substantial  income  is  derived,  is  not  exempt.  The  exemption  does 
not  include  a  telephone  clearing  association,  whose  business  is  to 
apportion  toll  rates  between  independent  telephone  companies 
handling  the  same  calls  and  whose  income  consists  of  compensation 
paid  by  such  companies  and  receipts  from  the  sale  of  form  blanks. 
The  phrase  "of  a  purely  local  character"  qualifies  all  the  organizations 
enumerated  in  subdivision  (10)  of  section  231.  An  organization  of  a 
"purely  local  character'"  is  one  whose  business  activities  are  con- 
fined to  a  particular  community,  place,  or  district,  irrespective,  how- 
ever, of  political  subdivisions.  The  word  "purely"'  intensifies  and 
limits  "local,'"  and  indicates  a  clear  intention  on  the  part  of  Congress 


INSURANCE    COMPANIES 


1403 


to  exempt  from  taxation  only  such  organizations  as  are  entirely  and 
unqualifiedly  "local"  in  their  operations.     (Art.  521.) 

It  has  been  held  that  a  farmers'  mutual  fire  and  lightning 
insurance  company  does  not  lose  its  exempt  status  by  reason  of 
having  funds  on  hand  at  the  end  of  its  taxable  year  due  to 
additional  assessments  to  meet  expenses  for  the  ensuing  year. 
The  following  quotation  from  the  opinion  of  the  Solicitor  of 
Internal  Revenue  is  of  interest: 

Ruling.  Assessments  are  made  by  mutual  fire  insurance  com- 
panies either  after  losses  occur  or  in  anticipation  of  such  losses.  It 
is  thought  that  the  majority  of  such  companies  at  the  present  time 
make  assessments  to  meet  estimated  future  losses,  the  assessments  be- 
ing made  quarterly,  half-yearly,  or  yearly,  as  the  case  may  be.  The 
advantages  of  making  assessments  in  this  manner  are  obvious,  avoiding 
as  they  do  operating  expenses  incidental  to  the  making  of  a  large 
number  of  assessments  to  meet  particular  losses  as  they  occur.  Where 
assessments  are  made  in  this  manner,  the  resulting  fund  is  held  by 
the  company,  and  any  unexpended  balance  at  the  end  of  the  year  is 
retained  and  applied  to  expenses  and  losses  for  the  ensuing  year,  the 
assessment  or  assessments  for  that  year  being  reduced  accordingly. 
The  unconsumed  portion  of  the  assessments  is  not  returned  to  the 
policyholders  as  in  the  case  of  premium  deposits 

The  policyholder  is  in  precisely  the  same  position  as  where  the 
assessment  is  made  subsequent  to  the  loss,  except  that  he  is  called 
upon  to  make  his  payment  at  an  earlier  time  and  is  spared  the  an- 
noyance of  a  large  number  of  payments  to  meet  the  individual  losses 
as  they  occur.  In  either  case  the  amount  he  eventually  i)ays  should 
be  the  same.     (C.  B.  4,  page  270;  Sol.  Op.  99.) 

Static  created  mutual  liabieity  insurance  company 
NOT  EXEMPT. — The  exemption  of  a  mutual  liability  insurance 
company  created  by  the  act  of  a  state  depends  upon  the  nature 
of  the  controlling  management. 

Ruling.  The  funds  contemijlak-d  by  article  .S4  of  Regulations 
45^*  are  only  those  managed  and  controlled  directly  by  the  State 
through  State  officers,  that  is  to  say  those  funds  the  management  and 
control  of  which  constitute  an  activity  of  the  State.  A  mutual  liability 
insurance  company  created  by  an  act  of  the  State  legislature  to  pro- 
vide insurance  for  employers  to  cover  their  liability  under  the  State 
employers'   liability   act   and    workmen's   compensation    law,    which    is 


See  Art.  87  of  the  1021   regulations  vvliicli  is  identical. 


I404 


SPECIAL   CLASSES    OF   TAXPAYERS 


not  so  managed  and  controlled,  is  not  exempt  from  taxation  under 
section  213  (b)  7,  or  under  any  other  provision  of  the  Revenue  Act 
of  1918.     (B.  43-21-1883;  O.  D.  1074.) 

Reciprocal  indemnity  exchange  not  necessarily 
EXEMPT. — A  number  of  manufacturers  incorporated  as  a  re- 
ciprocal indemnity  exchange  to  insure  their  businesses  against 
fire  loss,  each  subscriber  depositing  a  fixed  amount  to  meet 
losses,  and  at  the  end  of  the  period  any  unexpended  balance 
being  returned  to  the  depositors. 

This  exchange  was  originally  held  to  be  exempt.-^  The 
earlier  decision  was,  however,  overruled  by  the  following: 

Ruling.  A  number  of  manufacturers  incorporated  as  a  recipro- 
cal indemnity  exchange  to  insure  their  business  against  fire  loss  on 
the  reciprocal  and  inter-insurance  plan  through  an  attorney  in  fact 
having  the  power  to  issue  policies,  collect  premiums  and  adjust  losses. 

While  the  subscriber's  contract  provides  that  there  shall  be  no 
joint  funds,  the  rules  of  the  association  show  that  the  provision  is  not 
carried  out  in  letter  or  spirit.  The  advance  payments  are  not  all 
made  directly  to  the  attorney  but  direct  to  the  exchange  and  are 
charged  in  the  nature  of  advance  premium  deposits. 

Provision  is  made  in  the  rules  of  the  association  for  cancellation 
of  the  policies  on  a  short  rate  basis.  In  view  of  the  above  facts  it  is 
held  that  the  association  does  not  come  within  the  exemption  provided 
in  paragraph  10,  section  231  of  the  Revenue  Act  of  1918,  and  will 
therefore  be  required  to  file  returns  of  annual  net  income.  (C.  B.  4, 
page  269;  O.  D.  866.) 

Automobile  owners  insurance  exchange  held  to  be 
exempt. — An  insurance  company  incorporated  for  the  pur- 
pose of  permitting  automobile  owners  to  exchange  contracts 
of  insurance  and  indemnity  without  becoming  jointly  liable 
as  subscribers  on  any  risks,  its  only  sotirce  of  income  being 
from  assessments  collected  from  members  for  the  sole  purpose 
of  meeting-  expenses,  was  held  to  be  exempt.^*' 

Rulings  holding  certain  corporations  not  exempt. — 
The  following  corporations  have  been  held  by  the  Treasury 
not  to  be  exempt  under  section  231    (3)   and    ( 10)  :  an  associa- 


'■*  C.  B.  2,  page  210;  O.  D.  538. 
'"  C.  B.  I,  page  207;  O.  D.  312. 


INSURANCE   COMPANIES  1405 

tion  operated  under  the  lodge  system,  its  charter  providing  for 
the  union  of  its  members  into  a  grand  fraternal  beneficiary 
educational  and  patriotic  society  which  assessed  its  members 
to  provide  for  sick  and  death  benefits,  but  derived  income  from 
subscriptions  to  a  paper  which  it  published  as  well  as  from 
job  printing  and  other  sources;"^  a  mutual  liability  insurance 
compan}^  which  derived  its  inc(jme  from  i)reiniums  and  assess- 
ments of  its  members  which  were  used  to  defray  operating 
expenses  and  indemnify  policyholders  against  payments  under 
a  workmen's  compensation  law  f'  a  travelers*  association  pro- 
viding for  fixed  death  benefits  to  the  beneficiaries  of  its  mem- 
l)ers  f^'  a  mutual  irrigating  ditch  company  which  derived  in- 
come from  rents  for  the  use  of  its  surplus  water;''*  a  casualty 
insurance  association  organized  for  the  purpose  of  insuring 
its  members  throughout  a  state  ^\•hich  issued  policies  for  stipu- 
lated cash  premiums."'' 

An  association  qualified  as  a  "like  organization  under  sec- 
tion 231  (10)  but  was  held  not  to  be  of  a  purely  local  char- 
acter'' when  its  business  activities  w'ere  not  confined  to  a  par- 
ticular community,  place  or  district,  but  covered  an  entire 
state.  ^^ 

Returns  of  Insurance  Companies 

Regulation.  Insurance  companies  transacting  business  in  the 
United  States  or  deriving  an  income  from  sources  tlierein  arc  re- 
quired to  file  returns  of  income.  'J'hc  return  shall  be  on  Form  1120, 
except  that  life  insurance  companies  shall  make  return  on  Form  1120  L. 
As  an  aid  in  auditing  the  returns,  wherever  possible  a  copy  of  the 
report  to  the  State  insurance  department  should  be  submitted  with  the 
return.  Otherwise  a  copy  of  schedule  D,  parts  i,  3  and  4,  of  tlie 
report  should  l)e  attached  to  the  return,  showing  the  Federal,  State, 
and  municipal  obligations  from  which  the  interest  omitted  from  gross 
income  was  derived,  and  a  copy  of  the  complete  report  should  be 
furnished  as  soon  as  ready  for  filing.     (Art.  623.) 


"  C.  B.  2.  page  207 ;  O.  D.  508. 
^'C.  B.  I,  page  206;  O.  D.  252. 
"C  B.  I,  page  206;  O.  D.  63. 
•'*C.  B.  I,  page  207;  O.  D.  318. 
^C.  B.  I,  page  203;  O.  790. 
"  C.  B.  I,  page  205;  O.  792. 


l4o6  SPECIAL   CLASSES    OF    TAXPAYERS 

Net  Losses 

The  provision  of  the  1921  law"  whereby  taxpayers  may 
deduct  net  losses  resulting  from  the  operation  of  their  regular 
trade  or  business  from  the  net  income  of  the  succeeding  tax- 
able year,  and  from  the  second  succeeding  taxable  year,  if  nec- 
essary, extends  to  all  insurance  companies. 


°' Section  204;  sec  pages  1022-1029. 


CHAPTER  XXXIX 
FARMERS 

The  lowering  of  the  specific  exemption  to  $i,ooo  and 
$2,000  in  191 7  had  the  efYect  of  bringing  many  thousands  of 
farmers  within  the  class  of  income  tax  payers.  There  are 
many  difficulties  involved  in  the  assessment  of  tax  upon  the 
true  net  income  of  a  farmer,  the  accounting  difficulty  being 
very  serious.  It  is  now  generally  recognized,  however,  that 
accurate  accounting  of  the  income  and  expenses  incident  to 
the  business  of  farming  is  practicable  and  is  very  beneficial 
to  the  farmer.  The  attempt  by  the  Commissioner  of  Internal 
Revenue  to  secure  returns  which  reflect  actual  operating  re- 
sults should  have  unanimous  support. 

It  has  been  charged  in  the  past  that  law  makers  legislate 
in  favor  of  the  farmer  whenever  possible.  It  is  questionable 
whether  the  farmer  ever  demanded  si)ecial  favors.  It  may 
rather  be  assumed  that  all  he  asked  was  a  square  deal,  that  is. 
the  right  to  insist  that  no  undue  burden  be  placed  upon  him. 
It  has  not  been  shown  that  farmers  as  a  class  have  knowingly 
evaded  income  tax  requirements.  Inability  to  understand  the 
laws  and  difficulty  in  determining  actual  net  income  have  prob- 
ably deterred  many  from  making  returns.  Under  saner  laws 
and  intelligent  administration  it  may  be  expected  that  many 
returns  and  substantial  taxes  will  be  received. 

To  the  extent  that  a  farmer  is  not  required  to  return  as 
income  that  part  of  his  crops  which  is  consumed  as  food  by 
himself  and  his  family  he  receives  an  allowance  for  living 
expenses.  This  is  an  allowance  which  is  not  permitted  to  any 
other  class  of  taxpayers.  As  soon  as  possible  the  allowance 
should  be  withdrawn. 

In  Great  Britain  a  method  was  devised  under  which  a 
farmer's  taxable  income  was  assumed  to  have  a  definite  rela- 

1407 


I4o8  SPECIAL   CLASSES    OF   TAXPAYERS 

tion  to  the  rental  value  of  the  farm.  Such  a  method  would 
liardly  meet  with  favor  in  the  United  States;  but  if  a  farmer 
is  not  willing  to  keep  books  and  ascertain,  even  roughly,  his 
net  income  some  plan  should  be  devised  whereby  to  impose  a 
reasonable  tax  in  all  cases  in  which  a  tax  obviously  is  due. 

T\\Q  introduction  of  the  inventory  system  will  do  more 
than  anything  else  to  prove  to  the  farmer  that  there  may  be  an 
increase  in  net  worth  even  though  his  bank  balance  has  not 
increased. 

Gross  income. — Farmers  of  course  are  taxable  on  any  gain 
derived  from  sale  of  all  or  part  of  their  farm  property.  In 
such  cases  the  rules  applicable  to  gains  arising  from  sales  are 
applicable.^ 

During  19 19  and  1920  many  thousands  of  farms  changed 
hands  and  it  is  said  that  enormous  profits  were  realized  by  the 
sellers.  The  return  of  such  profits  should  have  yielded  a  large 
tax. 

Under  the  1921  law  the  gain  arising  from  the  sale  of  farms, 
title  to  which  has  not  changed  within  two  years,  immediately 
prior  to  the  sale,  will  be  subject  to  the  maximum  rate  of  1234 
per  cent  imi)osed  u\h>u  capital  gains.  Such  crops  as  form  part 
of  the  sale  should  not  l)e  included  among  capital  assets. 

Rkgui.a  rrox.  A  fanner  reportiiii;-  on  the  basis  of  receipts  and 
disbursements  (  in  wliich  no  inventory  to  determine  profits  is  used) 
shall  include  in  his  gross  income  for  the  taxable  year  (  1 )  the  amount 
of  cash  or  tlie  value  of  merchandise  or  other  property  received  from 
the  sale  of  live  stock  and  produce  which  were  raised  during  the  taxable 
year  or  prior  years,  (2)  the  profits  from  the  sale  of  any  live  stock  or 
other  items  which  were  purchased,  and  (3)  gross  income  from  all 
other  sources.  The  profit  from  the  sale  of  live  stock  or  other 
items  which  were  purchased  is  to  be  ascertained  by  deducting  the 
cost  from  the  sales  price  in  the  year  in  which  the  sale  occurs,  except 
that  in  the  case  of  the  sale  of  animals  purchased  as  draft  or  work  ani- 
mals or  solely  for  breeding  or  dairy  purposes  and  not  for  resale,  the 
profit  shall  be  the  amount  of  any  excess  of  the  sales  price  over  the 
amount    representing   the    difference   between    the    cost    and   the    de- 

'  See  page  535. 


FARMERS 


1409 


preciation  theretofore  sustained  and  allowable  as  a  deduction  in 
computing  net  income. 

In  the  case  of  a  farmer  reporting  on  the  accrual  basis  (in  which 
an  inventory  to  determine  profits  is  used)  his  gross  profits  are  ascer- 
tained by  adding  to  the  inventory  value  of  live  stock  and  products 
on  hand  at  the  end  of  the  year  the  amount  recei.ved  from  the  sale 
of  live  stock  and  products,  and  miscellaneous  receipts  for  hire  of 
teams,  machinery,  and  the  like,  during  the  year,  and  deducting  from 
this  sum  the  inventory  value  of  live  stock  and  products  on  hand  at 
the  beginning  of  the  year  and  the  cost  of  live  stock  and  products 
purchased  during  the  year.  In  such  cases  all  live  stock  raised  or 
purchased  for  sale  shall  be  included  in  the  inventory  at  their  proper 
valuation  determined  in  accordance  with  the  method  authorized  and 
adopted  for  the  purpose.  Also  live  stock  acquired  for  draft,  breeding, 
or  dairy  purposes  and  not  for  sale  may  be  included  in  the  inventory, 
instead  of  being  treated  as  capital  assets  subject  to  depreciation, 
provided  such  practice  is  followed  consistently  by  the  taxpayer. 
In  case  of  the  sale  of  any  live  stock  included  in  an  inventory  their 
cost  must  not  be  taken  as  an  additional  deduction  in  the  return  of 
income,  as  such  deduction  will  be  reflected  in  the  inventory 

Sale  of  machinery  equipment,  etc. — 

In  every  case  of  the  sale  of  machinery,  farm  equipment,  or  other 
capital  assets  (which  are  not  to  be  included  in  an  inventory  if  one 
is  used  to  determine  profits)  any  excess  over  the  cost  thereof  less 
the  amount  of  depreciation  theretofore  sustained  and  allowable 
as  a  deduction  in  com.puting  net  income,  shall  be  included  as  gross* 
income. 

Exchange  of  produce  for  merchandise. — 

Where  farm  produce  is  exchanged  for  merchandise,  groceries, 
or  the  like,  the  market  value  of  the  article  received  in  exchange  is  to 
be  included  in  gross  income. 

Rents. — 
Rents  received  in  crop  shares  shall  be  returned  as  of  the  year  in  which 
the  crop  shares  are  reduced  to  money  or  a  money  equivalent. 

Proceeds  of  insurance. — 
Proceeds  of  insurance,  such  as  hail  and  fire  insurance,  on  growing 
crops  should  be  included  in  gross  income  to  the  amount  received  in 
cash  or  its  equivalent  for  the  crop  injured  or  destroyed. 

Computing  income  on  crop  basis. — 

If  a  farmer  is  engaged  in  producing  crops  which  take  more  than  a 
year  from  the  time  of  planting  to  the  time  of  gathering  and  disposing, 


I4IO 


SPECIAL   CLASSES    OF   TAXPAYERS 


the  income  therefrom  may  be  computed  upon  the  crop  basis;  but  in 
any  such  cases  the  entire  cost  of  producing  the  crop  must  be  taken  as  a 
deduction  in  the  year  in  which  the  gross  income  from  the  crop  is 
realized. 

Definition  of -"farm." — 

As  herein  used  the  term  "farm"  embraces  the  farm  in  the  ordi- 
narily accepted  sense,  and  includes  stock,  dairy,  poultry,  fruit,  and 
truck  farms,  also  plantations,  ranches,  and  all  land  used  for  farm- 
ing operations.  All  individuals,  partnerships,  or  corporations  that 
cultivate,  operate,  or  manage  farms  for  gain  or  profit,  either  as 
owners  or  tenants,  are  designated  farmers. 

"Gentlemen"  farmers. — 

A  person  cultivating  or  operating  a  farm  for  recreation  or  pleasure, 
the  result  of  which  is  a  continual  loss  from  year  to  year,  is  not  re- 
garded as  a  farmer (Art.  38.) 

Regulations If    an    individual   owns    and    operates    a 

farm,  in  addition  to  being  engaged  in  another  trade,  business,  or  call- 
ing, and  sustains  a  loss  from  such  operation  of  the  farm,  then  the 
amount  of  loss  sustained  may  be  deducted  from  gross  income  received 
from  all  sources,  provided  the  farm  is  not  operated  for  recreation  or 
pleasure (Art.  145.) 

....  If  a  farm  is  operated  for  recreation  or  pleasure  and 
not  on  a  commercial  basis,  and  if  the  expenses  incurred  in  connection 
with  the  farm  are  in  excess  of  the  receipts  therefrom,  the  entire 
receipts  from  the  sale  of  products  may  be  ignored  in  rendering  a 
return  of  income,  and  the  expenses  incurred,  being  regarded  as  per- 
sonal expenses,  will  not  constitute  allowable  deductions (Art. 

no.) 

It  may  be  inferred  from  the  foregoing  that  if  a  person 
makes  a  profit  out  of  operating  a  farm  he  is  a  farmer. 
The  Treasury's  position  is  as  follows: 

Ruling.  It  is  held  that  where  a  farm  is  operated  on  a  basis 
other  than  the  recognized  principles  of  commercial  farming,  such  a 
farm  is  not  to  be  classed  as  a  commercial  enterprise,  inasmuch  as  it 
does  not  form  a  part  of  the  owner's  business  or  trade,  and  until  it 
is  placed  upon  a  profit-paying  basis  the  gross  receipts  are  not  to  be 
reported  under  "gross  income"  and  the  expenses  are  not  to  be  claimed 
as  a  deduction.  (Extract  from  letter  to  a  taxpayer,  February  9, 
1920.) 


FARMERS 


1411 


,  The  regulations  are  quite  right  in  refusing  to  allow  losses 
unless  it  can  be  shown  that  a  farm  is  operated  as  if  it  were  a 
transaction  undertaken  for  profit. 

If  a  taxpayer  conducts  the  farm  or  estate  chiefly  for  rec- 
reation or  pleasure,  and  not  as  he  would  conduct  a  business 
for  profit,  the  loss,  if  any,  is  apparent  only.  The  deficit  is  a 
family,  personal  or  living  expense. 

But  if  a  taxpayer  in  good  faith  embarks  in  the  farming 
business  and  loses  money  during  one  or  more  years  the  loss  is 
an  allowable  deduction  under  the  law,  to  the  same  extent  that 
losses  are  allowable  in  other  businesses. 

The  question  to  be  decided  is  whether  the  farm  is  being 
operated  as  a  business  or  for  recreation  or  pleasure.  It  is  nec- 
essary to  judge  the  facts  of  each  case  before  the  point  can 
be  settled.  In  a  case  that  has  been  given  considerable  promin- 
ence in  the  press, ^  the  court  charged  the  jury  as  follows : 

Decision.  That,  if  the  plaintiff  was  a  person  cultivating  and 
operating  a  farm  for  recreation  or  pleasure,  other  than  on  the  recog- 
nized principles  of  commercial  farming,  then  he  was  not  a  farmer. 

That  if  the  jury  find  that  the  plaintiff  was  the  owner  of  a  body  of 
land  devoted  to  agriculture,  either  to  the  raising  of  crops  or  pasture, 
for  the  purpose  of  selling  the  products  as  a  business,  then  they  are 
entitled  to  find  a  verdict  in  favor  of  plaintiff  on  this  issue. 

Business  is  that  which  occupies  the  time,  attention  and  labor  of 
men  for  the  purpose  of  a  livelihood  or  profit.  It  is  that  which  is  his 
personal  concern,  interest  or  regular  occupation. 

In  deciding  the  foregoing  case  the  jury  found  (and  the 
court  sustained  the  finding)  that  the  following  constituted  a 
"business"  farm : 

The  Continental  Village  farm  was  located  in  Putnam  County,  and 
consisted  of  1,300  acres,  900  of  woodland  and  400  cultivated.  The 
place  was  equipped  with  cow  barns  and  there  were  40  cows  there, 
and  there  was  evidence  of  it  being  a  cattle  farm.  There  were  no 
profits  upon  the  farm,  although  there  was  reasonable  probability  of 
believing  that  some  day  there  would  be. 

It  was  also  decided  that  another  farm  was  maintained  for 
recreation  or  pleasure : 


' Stuyvesant  I'isli  v.  Roscoc  Jnviii,  U.  S.  Dist.  Ct.,  No.  Dist.  of  N.  Y., 
July  29,  1 92 1. 


I4I2 


SPECIAL   CLASSES    OF   TAXPAYERS 


The  Glenclyffe  farm  consisted  of  480  acres,  and  only  70  were 
cultivated  and  the  testimony  was  that  there  never  was  a  profit  or 
reasonable  expectancy  of  a  profit,  that  the  expenses  were  far  in 
excess  of  what  legitimately  would  be  a  farm  venture,  that  the  raising 
of  crops  was  more  of  a  hobby  than  a  business. 

Ruling.  When  an  executor  operated  a  decedent's  farm  prior 
to  disposition  thereof,  the  costs  of  operation  were  deductible  even 
though  the  decedent  was  not  entitled  to  such  deduction. 

It  could  not  be  held  that  the  executor  operated  the  farm  as  a 
hobby  or  for  pleasure.     (C.  B.  3,  page  145;  A.  R.  R.  249.) 

Farmers'  associations. — 

Regulation,  (a)  Cooperative  associations,  acting  as  sales 
agents  for  farmers,  fruit  growers,  dairymen,  etc.,  and  turning  back 
to  them  the  proceeds  of  the  sales,  less  the  necessary  selling  ex- 
penses, on  the  basis  of  the  produce  furnished  by  them,  are  exempt 
from  income  tax.  Thus  cooperative  dairy  companies,  which  are 
engaged  in  collecting  milk  and  disposing  of  it  or  the  products  thereof 
and  distributing  the  proceeds,  less  necessary  operating  expenses, 
among  their  members  upon  the  basis  of  the  quantity  of  milk  or 
of  butter  fat  in  the  milk  furnished  by  such  members,  are  exempt 
from  the  tax.  If  the  proceeds  of  the  business  are  distributed  in 
any  other  way  than  on  such  a  proportionate  basis,  or  if  the  associa- 
tion deducts  more  than  necessary  selling  expenses,  it  does  not  meet 
the  requirements  of  the  statute  and  is  not  exempt.  The  maintenance  of 
a  reasonable  reserve  for  depreciation  or  possible  losses  or  a  reserve  re- 
quired by  State  statute  will  not  necessarily  destroy  the  exemption.  A 
corporation  organized  to  act  as  a  sales  agent  for  farmers  and  having  a 
capital  stock  on  which  it  pays  a  fixed  dividend  amounting  to  the  legal 
rate  of  interest,  all  of  the  capital  stock  being  owned  by  such  farmers, 
will  not  for  that  reason  be  denied  exemption. 

(b)  Cooperative  associations  organized  and  operated  as  purchas- 
ing agents  for  farmers,  fruitgrowers,  dairymen,  etc.,  for  the  pur- 
pose of  buying  supplies  and  equipment  for  the  use  of  members  and 
turning  over  such  supplies  and  equipment  to  members  at  actual 
cost,  plus  necessary  expenses,  are  also  exempt.  In  order  to  be 
exempt  under  either  (a)  or  (b)  an  association  must  establish  that  it 
has  no  net  income  for  its  own  account.  An  association  acting  both  as 
a  sales  and  a  purchasing  agent  is  exempt  if  as  to  each  of  its  func- 
tions it  meets  the  requirements  of  the  statute.     (Art.  522.) 

Expenses  deductible. — 

Regulation.  A  farmer  who  operates  a  farm  for  profit  is  entitled 
to  deduct  from  gross  income  as  necessary  expenses  all  amounts 
actually  expended  in  the  carrying  on  of  the  business  of  farming. 


FARMERS 


T413 


Tools. — 

The  cost  of  ordinary  tools,  of  short  life  or  small  cost,  such  as  hand 
tools,  including  shovels,  rakes,  etc.,  may  be  included. 

Feeding  and  raising  live  stock. — 

The  cost  of  feeding  and  raising  live  stock  may  be  treated  as  an  ex- 
pense deduction,  in  so  far  as  such  cost  represents  actual  outlay,  but 
not  including  the  value  of  farm  produce  grown  upon  the  farm  or 
the  labor  of  the  taxpayer 

Farm  machinery  and  buildings. — 

The  cost  of  farm  machinery,  equipment,  and  farm  buildings  repre- 
sents a  capital  investment  and  is  not  an  allowable  deduction  as  an 
item  of  expense. 

Development  expenses. — 

Amounts  expended  in  the  development  of  farms,  orchards,  and 
ranches  prior  to  the  time  when  the  productive  state  is  reached  may 
be  regarded  as  investments  of  capital. 

Cost  of  draft  or  work  animals  or  live  stock. — 

Amounts  expended  in  purchasing  work,  breeding  or  dairy  animals 
are  regarded  as  investments  of  capital 

Cost  of  automobile  not  deductible. — 

The  purchase  price  of  an  automobile,  even  when  wholly  used  in 
carrying  on  farming  operations,  is  not  deductible,  bul  is  regarded 
as  an  investment  of  capital. 

Upkeep  of  automobile  may  be  deductible. — 

The  cost  of  gasoline,  repairs  and  upkeep  of  an  automobile  if  used 
wholly  in  the  business  of  farming  is  deductible  as  an  expense;  if  used 
partly  for  business  purposes  and  partly  for  the  pleasure  or  conven- 
ience of  the  taxpayer  or  his  family,  such  cost  may  be  apportioned 
according  to  the  extent  of  the  use  for  purposes  of  business  and  pleas- 
ure-or  convenience,  and  only  the  proportion  of  such  cost  justly 
attributable  to  business  purposes  is  deductible  as  a  necessary  expense. 
.  .  .  .   (Art.  no.) 

Depreciation. — 

Regulation.  A  reasonable  allowance  for  depreciation  may  be 
claimed  on  farm  buildings  (other  than  a  dwelling  occupied  by  the 
owner),  farm  machinery,  and  other  physical  property.  A  reason- 
able  allowance   for  depreciation   may   al'^o  be  claimed   on   live   stock 


I4I4 


SPECIAL   CLASSES    OF   TAXPAYERS 


acquired  for  work,  breeding,  or  dairy  purposes,  unless  they  are  in- 
cluded in  an  inventory  used  to  determine  profits  in  accordance  with 
article  38.  Such  depreciation  should  be  based  on  the  cost  and  the 
estimated  life  of  the  live  stock.  If  such  live  stock  be  included  in 
an  inventory  no  depreciation  thereof  will  be  allowed,  as  the  cor- 
responding reduction  in  their  value  will  be  reflected  in  the  in- 
ventory.  ....      (Art.  171.) 

Ruling.  An  owner  of  an  orchard  which  has  reached  an  income- 
producing  stage  is  entitled  to  deduct  from  gross  income  in  his  annual 
tax  returns  an  annual  allowance  for  depreciation,  based  upon  the 
capital  invested,  which  comprises  the  original  purchase  price  of  the 
trees  together  with  the  necessary  expenditures  incurred  in  bringing 
them  to  the  producing  age;  and  the  rate  of  depreciation  is  to  be  de- 
termined by  the  average  life  of  the  trees  under  normal  conditions. 
(C.  B.  2,  page  130;  O.  797.) 

Losses. — 

Regulation.  Losses  incurred  in  the  operation  of  farms  as  busi- 
ness enterprises  are  deductible  from  gross  income (Art.  145.) 

Depreciation  of  fruit  trees  and  the  computation  of 
deductible  loss  in  event  of  death. 

Rulings.  Receipt  is  acknowledged  of  your  letter  dated  Febru- 
ary 24,  1920,  quoted  here  as  follows:  "I  have  a  20-acre  prune  or- 
chard of  two  thousand  (2,000)  six-year-old  trees.  Last  year,  two 
hundred  and  fifty  (250)  of  them  died  from  some  unavoidable  cause. 
Am  I  allowed  any  depreciation  on  same  ?" 

In  reply,  you  are  advised  that  the  loss  sustained  by  the  killing 
of  the  trees  is  the  cost  of  the  trees  killed,  and  the  amount  of  such 
loss  is  deductible  from  your  income  for  the  taxable  year  1919.  If 
the  orchard  had  not  reached  an  income  producing  stage  at  the  time 
the  trees  were  killed,  the  cost  of  the  trees  would  be  the  initial  cost, 
or  fair  market  value  on  Alarch  i,  1913,  if  the  trees  were  acquired 
prior  to  that  date,  plus  the  capitalized  expenditures  incurred  in  bring- 
ing them  to  maturity.  In  the  event  the  orchard  had  reached  the 
income  producing  stage  at  the  time  the  trees  were  destroyed,  the 
cost  would  be  the  initial  cost  or  fair  market  value  as  of  March  i, 
1913,  plus  the  capitalized  expenditures  incurred  in  bringing  them  to 
maturity   less   depreciation   sustained. 

The  basis  of  computing  depreciation  is  the  cost  of  the  trees  at 
the  time  the  orchard  has  reached  an  income  producing  stage,  includ- 
ing initial  cost  and  capitalized  expenditures  incurred  in  bringing  them 
to  maturity,  and  the  rate  of  depreciation  is  to  be  determined  by  the 
average   life  of   the  trees    from  the   income   producing  stage   under 


FARMERS  1415 

normal  conditions.  (Letter  to  C.  M.  McKinney,  Walla  Walla,  Wash- 
ington, signed  by  G.  V.  Newton,  Acting  Assistant  to  the  Commis- 
sioner, by  S.  Alexander,  Head  of  Division,  dated  March,  1920,) 

In  the  case  of  orchards  and  vineyards  acquired  subsequent  to 
March  i,  1913,  and  later  destroyed,  any  deduction  for  loss  should 
be  confined  to  the  amounts  of  capital  originally  invested  in  the  grow- 
ing trees  and  in  the  new  nursery  stock  which  was  totally  destroyed 
and  the  amount  expended  from  date  of  acquirement  to  date  of  de- 
struction in  an  endeavor  to  bring  such  trees  and  stock  to  an  income- 
producing  stage,  eliminating  all  expenditures  on  account  of  perma- 
nent improvements  or  on  account  of  trees  and  vines  the  growth  of 
which  was  merely  retarded  and  not  entirely  destroyed.  (C.  B.  2, 
page  127;  O.  D.  374.) 

Attorney's  fees  deductible. — 

Ruling.  A  tenant  at  work  on  the  farm  of  a  taxpayer  was  in- 
jured. In  defending  suit  for  damages  on  account  of  negligence 
the  taxpayer   incurred  expenses   for   attorney's   fees. 

It  is  held  that  if  the  taxpayer  was  engaged  in  farming  he  was 
carrying  on  a  trade  or  business,  and  that  the  attorney's  fees  consti- 
tuted compensation  for  personal  services  actually  rendered  which  is 
deductible  as  an  ordinary  and  necessary  expense.  If  the  farm  was 
rented,  the  amount  so  paid  is  deductible  as  a  business  expense  inci- 
dent to  the  earning  of  the  rent.     (B.  48-21-1947;  O.  D.  11 17.) 

Deterioration  or  loss  by  casualty. — 

Regulation If   farm  products  are  held  for  favorable 

markets,  no  deduction  on  account  of  shrinkage  in  weight  or  physical 
value  or  by  reason  of  deterioration  in  storage  shall  be  allowed, 
except  as  such  shrinkage  may  be  reflected  in  an  inventory  if  used 
to  determine  profits.  The  total  loss  by  frost,  storm,  flood,  or  fire  of 
a  prospective  crop  is  not  a  deductible  loss  in  computing  net  in- 
come       (Art.  145.) 

However,  if  the  farmer's  accounts  are  kept  on  the  accrual 
basis,  he  receives  credit,  in  effect,  for  the  loss  of  the  destroyed 
crop  because  it  appears  in  neither  sales  nor  inventory  (which 
enter  into  the  determination  of  his  gross  income),  while  the 
cost  of  the  crop  is  included  among  the  deductions.  If  the  ac- 
counts are  kept  on  the  cash  basis,  the  destroyed  crop  would 
not  appear  among  the  gross  income  (sales  of  produce)  but  the 
cost  would  be  allowed  as  a  deduction. 


I4l6  SPECIAL   CLASSES    OF   TAXPAYERS 

Loss   FROM   DEATH   OF   STOCK   RAISED   ON    FARM. 

Regulation A  farmer  engaged  in  raising  and  selling 

stock,  cattle,  sheep,  horses,  etc.,  is  not  entitled  to  claim  as  a  loss 
the  value  of  animals  that  perish  from  among  those  animals  that 
were  raised  on  the  farm,  except  as  such  loss  is  reflected  in  an 
inventory  if  used. 

Loss   FROM   DEATH   OF   STOCK   PURCHASED. 

If  live  stock  has  been  purchased  for  any  purpose,  and  afterwards  dies 
from  disease,  exposure,  or  injury,  or  is  killed  by  order  of  the  authori- 
ties of  a  State  or  the  United  States,  the  actual  purchase  price  of  such 
stock,  less  any  depreciation  sustained  and  allowable  as  a  deduction 
in  computing  net  income,  with  respect  to  such  perished  live 
stock,  and  less  also  any  insurance  or  indemnity  recovered,  may  be 
deducted  as  a  loss.  The  actual  cost  of  other  property,  less  deprecia- 
tion sustained  and  allowable  as  a  deduction  in  computing  net  income, 
destroyed  by  order  of  the  authorities  of  a  State  or  of  the  United 
States,  may  in  like  manner  be  claimed  as  a  loss;  but  if  reimburse- 
ment is  made  by  a  State  or  the  United  States  in  whole  or  in  part  on 
account  of  stock  killed  or  property  destroyed,  the  amount  received 
shall  be  reported  as  income  for  the  year  in  which  reimbursement  is 
made.  The  cost  of  any  feed,  pasturage,  or  care  which  has  been  de- 
ducted as  an  expense  of  operation  shall  not  be  included  as  part  of  the 
cost  of  the  stock  for  the  purpose  of  ascertaining  the  amount  oi  a 
deductible  loss. 

Inventory  method  when  used  will  reflect  loss. — 

If  gross  income  is  ascertained  by  inventories,  no  deduction  can  be 
made  for  live  stock  or  products  lost  during  the  year,  whether  pur- 
chased for  resale  or  produced  on  the  farm,  as  such  losses  will  be 
reflected  in  the  inventory  by  reducing  the  amount  of  live  stock  or 
products  on  hand  at  the  close  of  the  year (Art.  145.) 

Inventories  of  livestock  raisers  and  other  farmers. — 

Regulation,  (i)  Farmers  may  change  the  basis  of  their  re- 
turns from  that  of  receipts  and  disbursements  to  that  of  an  inventory 
basis,  which  necessitates  the  use  of  opening  and  closing  inventories 
for  the  year  in  which  the  change  is  made.  There  should  be  included 
in  the  opening  inventory,  all  farm  products  (including  live  stock), 
purchased  or  raised,  which  were  on  hand  at  the  date  of  the  inventory, 
but  inventories  must  not  include  real  estate,  buildings,  permanent  im- 
provements, or  any  other  assets  subject  to  depreciation. 

(2)  Because  of  the  difficulty  of  ascertaining  actual  cost  of  live 
stock  and  other  farm  products,  farmers  who  render  their  retivrns 
upon  an  inventory  basis  may  at  their  option  value  their  inventoiies 


FARMERS  1417 

for  the  current  taxable  year  according  to  the  "farm-price  method" 
which  provides  for  the  valuation  of  inventories  at  market  price 
less  cost  of  marketing.  If  the  use  of  the  "farm-price  method"  of 
valuing  inventories  for  any  taxable  year  involves  a  change  in  method 
of  pricing  inventories  from  that  employed  in  prior  years,  the  ope  n- 
ing  inventory  for  the  taxable  year  in  which  the  change  is  made 
should  be  brought  in  at  the  same  value  as  the  closing  inventory  for 
the  preceding  taxable  year.  If  such  valuation  of  the  opening  inventory 
for  the  taxable  year  in  which  the  change  is  made  results  in  an 
abnormally  large  income  for  that  year,  there  may  be  submitted  with 
the  return  for  such  taxable  year  an  adjustment  statement  for  the 
preceding  year  based  on  the  "farm-price  method"  of  valuing  inven- 
tories; upon  the  amount  of  which  adjustments  the  tax,  if  any  be  due, 
shall  be  assessed  and  paid  at  the  rate  of  tax  in  effect  for  such  preced- 
ing year. 

(3)  Where  returns  have  been  made  in  which  the  taxable  net  in- 
come has  been  computed  upon  incomplete  inventories,  the  abnormal- 
ity should  be  corrected  by  submitting  with  the  return  for  the  cur- 
rent taxable  year  a  statement  for  the  preceding  year  in  which  such 
adjustments  shall  be  made  as  are  necessary  to  bring  the  closing  in- 
ventory for  the  preceding  year  into  agreement  with  the  opening 
complete  inventory  for  the  current  taxable  year.  If  necessary  to 
reflect  the  income,  similar  adjustments  may  be  made  as  at  the  be- 
ginning of  the  preceding  year,  and  the  tax,  if  any  be  due,  shall  be 
assessed  at  the  rate  of  tax  in  effect  for  such  year.     (Art.  1586.) 

Ruling.  Article  1586  of  Regulations  45  (1920  edition)  revokes 
all  previous  rulings  and  instructions  inconsistent  therewith.  It  is 
not  permissible  for  farmers,  in  changing  to  the  inventory  basis  of 
making  their  returns,  to  make  adjustments  by  calculating  their  net 
income  for  the  current  taxable  year  without  taking  as  a  credit  the 
inventory  of  live  stock,  crops,  and  other  products  at  the  beginning 
of  the  year  in  accordance  with  the  instructions  on  page  4  of  Form 
1040-F.     (C.  B.  4,  page  54;  O.  D.  939.) 

Treasury  Decision  3104  does  net  require  adjustment  of  taxes  for 
years  prior  to  191 7,  in  cases  in  which  farmers  change  to  the  inventory 
basis  in  rendering  their  income  tax  returns  for  the  current  taxable 
year  because  in  most  cases  records  for  such  prior  years  are  not  avail- 
able. If,  however,  adequate  records  for  the  years  1915  and  1916  arc 
available,  adjustments  may  be  made  for  those  years  also.  (C.  B.  4, 
page  53;  O.  D.  802.) 

It  is  not  contemplated  by  Treasury  Decision  3104  that  farmers 
must  obtain  formal  permission  in  order  to  change  the  basis  of  their 
returns  from  that  of  receipts  and  disbursements  to  that  of  an  inven- 
tory basis.  The  use  of  opening  and  closing  inventories  for  the  year 
in  which  the  change  is  made  is,  however,  necessary,  and  there  must 


1418  SPECIAL   CLASSES    OF   TAXPAYERS 

be  submitted  with  the  return  for  the  current  taxable  year  an  adjust- 
ment sheet  for  1917  and  each  year  thereafter  (prior  to  the  year  in 
which  the  change  is  made)  based  on  the  inventory  method,  upon  the 
amount  of  which  adjustments  the  tax  shall  be  assessed  and  paid  (if 
any  be  due)  at  the  rate  of  tax  in  effect  for  each  respective  year.  (C. 
B.  4,  page  53;  O-  D.  841.) 

The  Treasury  makes  it  as  easy  as  possible  for  a  farmer 
to  change  from  a  cash  receipts  to  an  accrual  basis.  If  tax- 
payers have  not  taken  inventories  heretofore,  the  information 
required  for  the  years  prior  to  the  current  year  may  be  sup- 
plied by  estimating  their  inventories  as  of  past  dates. 

Farm  price  method. — Article  1586^  permits  farmers  to 
use  market  as  the  basis  of  inventory  (in  contrast  with  cost  or 
market).  This  is  apparently  the  only  case  in  which  apprecia- 
tions would  be  taxed  before  realization,  excepting  when  dealers 
in  securities  use  the  "market  value"  basis  of  inventorying  per- 
mitted by  article  1585. 

Rulings.  The  purpose  of  the  adjustment  sheets  required  in 
article  1586,  Regulations  45,  is  properly  to  allocate  over  the  period 
from  191 7  to  date,  the  net  dift'erence  in  gain  or  loss  due  to  changing 
from  a  cash  basis  to  an  inventory  basis. 

Opening  and  closing  inventories  for  these  years  are  first  ascer- 
tained from  the  best  source  of  information  available,  and  the  gross 
income  of  each  year  is  adjusted  by  adding  or  subtracting,  as  the  case 
may  be,  the  additional  gain  or  loss  due  to  the  difference  between  the 
opening  and  closing  inventory  in  each  year.  A  separate  adjustment 
sheet  should  be  made  for  each  year  from  1917  to  date,  in  order  that 
the  sheet  for  each  year  may  be  attached  to  the  return  for  that  par- 
ticular year.  The  net  income  is  then  adjusted  conformably,  and 
from  this  information  the  tax  on  each  return  is  recomputed  in  this 
office  at  the  rate  at  which  the  tax  was  originally  computed.  (B, 
47-21-1928;  O.  D.  1 105.) 

Florists  are  not  required  to  use  inventories  of  growing  plants  for 
the  purpose  of  calculating  their  net  income  for  income  tax  purposes 
and  should  not  compute  the  cost  of  goods  sold  during  the  year  by 
using  an  inventory  value  of  growing  plants  on  hand  at  the  beginning 
and  end  of  the  taxable  year.     (B.  34-21-1774;  O.  D.  995.) 

It  should  be  noted  that  farmers  are  entitled  to  the  benefit 
°  See  page  1416. 


FARMERS 


1419 


of  section  204  of  the  192 1  law"*;  and  if  a  net  loss  is  sustained 
in  any  taxable  year,  beginning  after  December  31,  1920,  the 
loss  may  be  applied  against  the  profits  of  the  succeeding  year 
and  any  excess  of  such  loss  may  be  applied  against  the  profits 
of  the  next  succeeding  year. 

Farmers  who  keep  books. — The  regulations  provide  that 
farmers  who  keep  books  according  to  an  approved  system 
may  prepare  their  returns  therefrom. 

Several  accounting  systems  for  farmers  have  been  devised. 
It  is  claimed  that  with  little  effort  a  correct  record  of  the  finan- 
cial position  and  income  and  expenses  of  farmers  may  be 
kcpt.°     The  claims  sound  rather  optimistic  to  the  author. 

Operating  a  farm  is  conducting  a  business  for  profit.  Ac- 
curate results  cannot  be  ascertained  unless  inventories  are  taken. 
Otherwise  a  farmer  who  is  breeding  stock  and  accumulating 
a  large  herd  might  show  no  income  (or  a  loss)  for  several 
years  and  then,  if  he  were  to' dispose  of  all  his  stock  in  one 
year,  he  would  have  to  pay  an  excessive  tax,  although  the 
profit  would  be  properly  distributable  over  several  prior  years. 

The  accurate  and  fair  method  would  be  to  inventory  his 
stock  annually  and  pay  the  tax  on  the  profit  as  it  accrues  an- 
nually and  as  shown  by  his  books. 

Use  of  form  1040F  optional. — 

Ruling.  The  use  of  form  1040F  is  optional  since  it  is  designed 
merely  to  assist  farmers  in  computing  their  net  income.  Therefore, 
it  is  unnecessary  to  file  same  where  the  taxpayer  has  made  return 
and  paid  the  taxes  due.     ( C.   B.   r,  page  71;  O.   D.  266.) 


*  [Former  Procedure]  Under  section  204  of  the  1918  law,  if  a  net 
loss  was  sustained  in  any  taxable  year,  beginning  after  October  31,  1918, 
and  ending  prior  to  January  i,  1920,  such  net  loss  was  deductible  from  the 
profits  of  the  preceding  year  or  of  the  succeeding  taxable  year.  Farmers, 
of  course,  if  their  fiscal  year  ended  at  any  date  between  January  and  Oc- 
tober, were  not  entitled  to  the  benefit  of  section  204.  Presumably  most 
farmers  make  up  their  accounts  on  the  basis  of  the  calendar  year,  so  that 
there  was  no  discrimination  against  them,  as  was  the  case  with  many  cor- 
porations. 

'For  details  of  a  system  see  the  Magazine  of  Wall  Street  for  January 
24,  1920,  pages  392-3.  A  bibliography  on  farm  accounting  will  be  found  in 
Accountant's  Index,  1921,  pages  46-53.  7^7,  788. 


1420 


SPECIAL   CLASSES   OF   TAXPAYERS 


The  following  statement  appears  as  instruction  7  on  form 

1040: 

If  you  are  a  farmer  or  a  farm  owner  renting  your  farm  out  on 
shares  and  keep  no  books  of  account,  or  keep  books  on  a  cash  basis, 
obtain  from  the  Collector,  and  attach  to  this  return,  Form  1040F, 
Schedule  of  Farm  Income  and  Expenses.  Enter  the  net  farm  income 
as  Item  5,  page  i  of  the  return.  If  your  farm  books  of  account  are 
kept  on  an  accrual  basis,  the  filing  of  Form  1040F  is  optional.  Report 
income  from  salaries,  interest,  rents,  sales  of  property,  etc.,  in  Itcmi 
I  to  7  of  the  return. 


PART  V 
MISCELLANEOUS  TAXES 


CHAPTER  XL 

FEDERAL  ESTATE  TAX 

This  tax,  which  forms  Title  IV  of  the  Revenue  Act  of 
1 92 1,  bears  at  least  the  merit  of  antiquity  as  a  part  of  federal 
taxation,  although  some  authorities  think  that  this  source  of 
revenue  should  be  left  exclusively  to  the  states.  As  long 
ago  as  1797  there  was  imposed,  under  the  Stamp  Act  of  that 
year,  an  inheritance  tax.  This  latter  act  was  in  force  for  five 
years.  It  was  a  war  measure,  as  have  been  all  subsequent 
inheritance  tax  acts.  The  Civil  War  was  responsible  for 
the  next  law  of  this  nature,  imposed  in  1862,  with  a  life  of 
eight  years;  while  the  Spanish-American  War  produced  the 
Act  of  1898  which  remained  in  force  for  four  years.  Within 
the  last  decade  appeared  the  Revenue  Act  of  1916,  Title  II  of 
which  was  termed  an  "Estate  Tax,"  amended  twice  in  1917 
(March  3  and  October  3),  and  the  Act  of  February  24,  1919, 
(known  as  the  Revenue  Act  of  1918),  the  last  prior  to  the 
one  herein  discussed. 

It  will  be  noticed  that  the  Stamp  Act  of  1797  imposed  an 
"inheritance  tax."  This  term  cannot  be  used  in  relation  to 
the  existing  tax.  True,  it  is  a  tax  on  the  transfer  of  property 
which  passes  by  inheritance,  but  it  is  distinctly  a  tax  on  the 
transfer  and  not  on  the  manner  of  that  transfer.  The  law, 
section  401,  states  that  the  tax  "is  hereby  imposed  on  the 
transfer  of  the  net  estate  .  .  .  ."  It  further  imposes 
a  tax  on  the  transfer  of  property  by  will  or  trust  in  antici- 
pation of  death.  It  is  tentatively  assumed  that  all  property 
transferred  within  two  years  prior  to  death  has  been  trans- 
ferred to  avoid  the  tax,  and  the  amount  of  any  such  property 
must  be  included  in  the  return  of  the  gross  estate,  unless 
transferred  by  "a  bona  fide  sale  for  a  fair  consideration  in 

1423 


1424 


MISCELLANEOUS    TAXES 


money  or  money's  worth, "^  or  unless  any  such  transfer  being 
made  without  valuable  consideration  within  two  years  of 
decedent's  death,  can  be  established  not  to  have  been  made 
in  contemplation  of  death.  In  any  case,  the  property  must  be 
described  in  the  return  and  its  value  shown  therein.  The  bur- 
den of  proof  regarding  the  non-inclusion  of  the  value  of  such 
property  in  the  gross  estate  lies  with  the  legal  representatives 
of  the  decedent.  The  latter  are  likewise  responsible  for  the 
filing  of  the  notice,  the  return  itself,^  and  the  payment  of 
the  tax.^ 

The  tax  is  computed  on  the  value  of  the  net  estate  at 
varying  rates  and  in  graduated  blocks  or  brackets.  Herein 
it  differs  from  most  of  the  state  taxes  of  this  nature  which 
are  based  on  the  several  distributive  shares  of  the  net  estate, 
different  exemptions  being  allowed  according  to  the  status  of 
the  beneficiaries  in  relation  to  the  decedent.  In  the  federal  tax 
the  total  net  estate  is  taxed,  the  net  amount  having  been  ar- 
rived at  in  accordance  with  the  regulations  hereinafter  men- 
tioned, less,  in  the  case  of  resident  estates,  a  single  exemption 
of  $50,000.  It  is  obvious,  therefore,  that  resident  estates 
whose  net  transfer  values  do  not  amount  to  $50,000  are  not 
subject  to  the  estate  tax.* 

The  law  dealing  with  the  estate  tax  forms  sections  400-411 
of  the  Revenue  Act  of  192 1,  w^iich  is  eff'ective  from  November 
23,  1921.  Prior  to  this  date,  the  1918  law  was  in  effect.  The 
latest  regulations  are  known  as  Regulations  37  and  deal  with 
the  1918  law.  Regulations  for  the  192 1  law  have  not  yet 
been  issued. 


Summary  of  Law 

s. 

:ax. 
Section  402.     Determination  of  gross  estate. 


Section  400.     Definitions 
Section  401.     Rates  of  tax 


^1921  law,  section  402  (c). 

'  1921  law,  section  404. 

^  1921  law,  section  407. 

'  See  Reg.  37,  Art.  77.     Sec  page  1497. 


FEDERAL  ESTATE  TAX  1425 

Property  owned  by  decedent. 
Dower  and  curtesy. 
Transfers  in  contemplation  of  death. 
Interest  of  decedent  in  joint  estate. 

Property  passing  under  a  power  of  appointment  by  will  or  deed. 
Insurance   on   life   of   decedent   payable  to   his   estate   or  to   in- 
dividual beneficiaries  in  excess  of  $40,000. 

Section  403.     Determination   of   net   estate    (deductions   allowable). 

Funeral  and  administration  expenses;  claims,  etc. 
Decedent's  share  in  estate  of  prior  decedent  taxed  within  previous 

five  years. 
Charitable  bequests,  etc. 
Specific  exemption  of  $50,000  (for  residents  only). 

Sections  404,  405.     Returns,  by  whom  and  when  made. 
Sections  406,  411.    Tax,  when  due  and  by  whom  payable. 

Definitions. — The  following  definitions  appearing  in  section 
2,  Title  I,  of  the  Revenue  Act  of  192 1,  are  applicable  to  the 
estate  tax : 

"Person"  includes  partnerships  and  corporations  as  well 

as  individuals ; 
"Corporation"  means  associations,  joint-stock  companies, 

and  insurance  companies; 
"United  States"  means,  in  a  geographical  sense  only  the 

states,  the  Territories  of  Alaska  and  Hawaii,  and  the 

District  of  Columbia. 
"Taxpayer"   means  any  person,  trust,  or  estate  subject 

to  taxation  under  this  act. 

"Executor"  is  defined  as  "the  executor  or  administrator  of 
the  decedent,  or,  if  there  is  no  executor  or  administrator,  any 
person  in  actual  or  constructive  possession  of  any  property 
of  the  decedent"    (law,  section  400). 

Rates  of  Tax. — The  rates  of  tax  imposed  by  the  1921  law 
are  identical  with  those  under  the  19 18  law.  The  exemption 
of  $50,000  applies  only  to  residents. 

Law.  Section  461.  That,  in  lieu  of  the  tax  imposed  by  Title  IV 
of  the  Revenue  Act  of  1918,  a  tax  equal  to  the  sum  of  the  following 


1426  MISCELLANEOUS   TAXES 

percentages  of  the  value  of  the  net  estate  (determined  as  provided  in 
section  403)  is  hereby  imposed  upon  the  transfer  of  the  net  estate 
of  every  decedent  dying  after  the  passage  of  this  Act,  whether  a  resi- 
dent or  nonresident  of  the  United  States: 

1  per  centum  of  the  amount  of  the  net  estate  not  in  excess  of 
$50,000 ; 

2  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$50,000    and    does    not    exceed    $150,000; 

3  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$150,000  and   does  not  exceed  $250,000; 

4  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$250,000  and  does  not  exceed  $450,000; 

6  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$450,000  and  does  not  exceed  $750,000; 

8  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$750,000   and  does   not   exceed   $1,000,000; 

10  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$1,000,000  and  does  not  exceed  $1,500,000; 

12  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$1,500,000    and    does    not    exceed    $2,000,000; 

14  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$2,000,000  and  does  not  exceed  $3,000,000; 

16  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$3,000,000  and  does   not  exceed  $4,000,000; 

18  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$4,000,000  and  does  not  exceed  $5,000,000; 

20  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$5,000,000  and  does  not  exceed  $8,000,000; 

22  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$8,000,000  and  does  not  exceed  $10,000,000;  and 

25  per  centum  of  the  amount  by  which  the  net  estate  exceeds 
$10,000,000. 

Regulation.  For  the  purpose  of  computing  the  tax,  the  net 
estate  is  divisible  into  blocks,  each  block  being  taxed  at  a  different  and 
increasing  rate.  The  preceding  table  gives  the  amount  at  the  various 
blocks  and  the  applicable  rate  of  tax  under  each  of  the  taxing  acts. 
For  example,  the  tax  upon  the  net  estate  of  $1,240,000  of  a  decedent 
dying  on  or  after  February  25,  1919.  would  be  computed  as  follows: 

Amount  of   first  block $50,000  at  i  per  cent     $500 

Amount  of  second  block 100,000  at  2  per  cent    2,000 

Amount  of  third  block 100,000  at  3  per  cent    3,000 

Amount  of  fourth  block.  .  .• 200,000  at  4  per  cent    8,000 

Amount  of  iifth  block 300,000  at  6  per  cent  18,000 

Amount  of  sixth  block 250.000  at  8  per  cent  20,000 

Remainder    240,000  at  10  per  cent  24,000 

Total   net   estate    $1,240,000  Total  tax . .  .$75,500 


FEDERAL   ESTATE   TAX 


1427 


There  is  subjoined  a  table  for  ascertaining  the  tax  without  the 
detailed  computation  given  above.  An  illustration  of  its  use  is  as 
follows.  The  net  estate  of  a  decedent  dying  on  or  after  February  25, 
1919,  amounts  to  $1,240,000.  By  reference  to  the  table  it  will  be  seen 
that  the  last  complete  block  prior  to  this  amount  is  $1,000,000,  and 
that  the  total  tax  on  a  million  dollars  under  the  rates  in  force  amounts 
to  $51,500.  Upon  the  remainder  of  the  estate,  $240,000,  the  tax  is 
computed  at  the  rate  contained  in  the  following  line,  or  at  10  per  cent. 
The  tax  on  this  amount  is  consequently  $24,000.  The  following,  result 
is  thus  obtained : 

Total  tax  on $1,000,000        $51,500 

Tax  on  240,000  24,000 

Total    $1,240,000        $75,500 


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1428 


FEDERAL  ESTATE  TAX  1429 

Description  of  taxable  estates. — 

Regulation.  The  tax  is  imposed  in  the  case  of  the  estate  of 
"every  decedent,"  although,  by  reason  of  an  exemption,  the  net  es- 
tate of  a  resident  decedent,  in  order  to  be  taxable,  must  exceed 
$50,000.  (See  Sec.  403  (a)  4.)  The  estate  of  a  nonresident  decedent, 
however,  is  taxable  if  any  part  of  it  is  situated  in  the  United  States. 
The  statute  takes  no  account  of  the  citizenship  of  the  decedent,  but 
prescribes -different  rules  according  to  whether  the  decedent  was  a 
"resident"  or  a  "nonresident"  of  the  United  States A  "resi- 
dent" is  one  who  at  the  time  of  his  death  resided  in  the  States,  the 
Territories  of  Alaska  or  Hawaii,  or  the  District  of  Columbia.  All 
other  persons  are  "nonresidents."   ....      (Reg.  37,  Art.  4.) 

The  tax  is  imposed  on  the  estate  of  every  resident  domiciled 
in  the  United  States  at  the  time  of  death,  quite  apart  from 
the  question  of  nationality.  The  apphcation  of  the  law  to 
non-residents  is  shown  concisely  in  the  above  regulation. 
Special  regulations  such  as  those  concerning  deductions,  where 
non-resident  estates  are  involved,  are  dealt  with  under  their 
respective  headings. 

Definition  of  "resident." — 

Regulation.  A  person  is  a  "resident"  of  the  United  States,  for 
the  purposes  of  this  tax,  only  in  case  he  has  a  domicile  therein  at  the 
time  of  his  death.  A  person  acquires  a  domicile  in  a  place  by  livinj; 
there,  for  even  a  brief  period  of  time,  with  no  definite  present  inten- 
tion of  later  removing  therefrom.  Residence  without  the  requisite  in- 
tention to  remain  will  not  suffice  to  constitute  domicile,  nor  will  in- 
tention to  change  domicile  effect  such  a  change  unless  accompanied  by 
actual  removal.  A  decedent  who  died  while  abroad  will  be  presumed 
to  be  a  nonresident,  and  the  burden  of  proving  the  contrary  rests  upon 
the  executor.      (Reg.   37,   Art.   5.) 

In  the  192 1  act  the  definition  of  the  term  "resident"  is  also 
extended  to  citizens  regarding  whose  property  any  probate  or 
administration  proceedings  are  had  in  the  United  States  Court 
for  China.^ 

No  satisfactory  conclusive  or  general  definition  of  "resi- 
dent" can  be  given.  Intention  plays  a  large  part,  and  each 
case  must  be  decided  on  its  merits. 

°  See  page  1516, 


I430 


MISCELLANEOUS    TAXES 


Military  exemption. — 

Law.     Section  401 The  taxes  imposed  by  this  title  or  by 

Title  II  of  the  Revenue  Act  of  1916  (as  amended  by  the  Act  entitled 
"An  Act  to  provide  increased  revenue  to  defray  the  expenses  of  the 
increased  appropriations  for  the  Army  and  Navy  and  the  extensions 
of  fortifications,  and  for  other  purposes,"  approved  March  3,  1917)  or 
by  Title  IX  of  the  Revenue  Act  of  1917,  or  by  Title  IV  of  the  Revenue 
Act  of  1918,  shall  not  apply  to  the  transfer  of  the  net  estate  of  any 
decedent  virho  has  died  or  may  die  from  injuries  received  or  disease 
contracted  in  line  of  duty  while  serving  in  the  military  or  naval  forces 
of  the  United  States  in  the  war  against  the  German  Government,  or 
to  the  transfer  of  the  net  estate  of  any  citizen  of  the  United  States  who 
has  died  or  may  die  from  injuries  received  or  disease  contracted  in  line 
of  duty  while  serving  in  the  military  or  naval  forces  of  any  country 
while  associated  with  the  United  States  in  the  prosecution  of  such  v.'ar, 
or  prior  to  the  entrance  therein  of  the  United  States,  and  any  tax  col- 
lected upon  such  transfer  shall  be  refunded  to  the  estate  of  suchf 
decedent. 

The  intent  of  this  section  is  as  obvious  as  it  is  just. 

While  the  above  section  inchides  only  those  affected  by  the 
late  AA'orld  War,  it  might  be  well  made  applicable  to  any  per- 
son on  active  service  generally  in  the  military  or  naval  forces. 
This  attitude  has  been  taken  in  Title  II  (income  tax)  in  regard 
to  pensions. "^  Doubt  might  exist  as  to  just  what  is  comprised 
under  the  term  ''military  or  naval  forces  of  the  United  States." 
Help  in  this  direction  is  given  in  the  following  definition : 

Regulation The  term  '"military  or  naval  forces  of  the 

United  States"  includes,  among-  other  units,  the  Marine  Corps,  the 
Coast  Guard,  the  Army  Nurse  Corps,  Female,  and  the  Navy  Nurse 
Corps,  Female.  This  exemption  applies  to  any  estate  tax  imposed, 
whether  by  the  Revenue  Act  of  1916  or  subsequent  statutes.  If  the 
tax  has  been  collected,  the  executor  should  make  claim  for  refund. 
(Reg.   Z7,   Art.   9.) 

It  would  appear  that  relief  froin  taxation  under  the  statutes 
mentioned  is  intended  to  apply  merely  to  those  persons  em- 
ployed directly  by  the  government  in  the  prosecution  of  the 
war,  and  no  mention  is  made  of  the  large  army  of  non-com- 
batants who,  while  not  directly  in  government  pay,  were  sub- 
ject to  the  risks  of  death  and  disease  in  the  service.     Included 


Section  213   (b-9). 


FEDERAL   ESTATE   TAX 


143 1 


in  this  latter  category  might  be  the  Red  Cross  workers  whose 
duties  entailed  the  same  hardships  and'  sufferings  as  those 
performed  by  the  Army  Nurse  Corps,  a  body  specifically 
mentioned  in  the  regulation  quoted  'above.  The  distinction 
is  arbitrary  and,  in  practice,  might  obviously  work  an  injustice 
to  those  who  helped  in  the  World  War.  The  attitude  of  the 
Department  in  excluding  members  of  the  Public  Health  Ser- 
vice from  income  tax  exemption  would  indicate  that  the  let- 
ter, rather  than  the  spirit  of  the  law,  governs  these  exemptions. 
Any  collection  made  on  the  transfer  of  an  estate  exempt 
from  taxation  under  this  section,  is  subject  to  refund  but 
the  burden  of  proving  such  exemption  lies  with  the  executor. 
A  formal  claim  must  be  made  on  form  793  as  soon  as  the  nec- 
essary supporting  evidence  can  be  secui*ed.  This  evidence 
should  consist  of  the  following  data : 

Regulation Where  the  decedent  died  while  serving  in  the 

military  or  naval  forces,  but  after  the  termination  of  the  war  with 
Germany,  there  should  be  submitted : 

(i)  Certificate  of  The  Adjutant  General,  Surgeon  General  of 
the  Navy,  or  commanding  officer  as  above,  stating  the  occurrence  of 
death  while  in  the  service,  and  the  cause  of  death. 

(2)  Affidavits  or  other  evidence  to  show  that  the  death  resulted 
from  injuries  received,  or  disease  contracted,  while  serving  in  the 
military  or  naval  forces  during  the  war  with  Germany. 

Where  the  decedent  died  after  discharge  from  the  military  or 
naval  forces  there  should  be  submitted : 

(1)  Certificate  of  discharge  from  the  service,  or  copy  of  such 
certificate. 

(2)  Certified  copy  of  public  record  of  death,  showing  cause  of 
death. 

(3)  Affidavit  of  physician  who  attended  decedent  during  last  ill- 
ness, setting  forth  the  medical  history  of  the  decedent  while  under 
his  treatment. 

(4)  Affidavits  or  other  evidence  to  show  that  the  death  resulted 
from  injuries  received,  or  disease  contracted,  while  serving  in  tl'e 

military  or  naval  forces  during  the  war  with  Germany (Reg 

37,  Art.  10.) 

Claims  for  refund  arising  from  military  exemption. — In 
view  of  the  fact  that  the  granting  of  this  exemption  is  retro- 
active, attention  is  particularly  called  to  the   following: 


143^ 


MISCELLANEOUS   TAXES 


Regulation.  Prior  to  the  passage  of  the  Revenue  Act  of  1918 
there  was  no  military  exemption  from  estate  tax  except  with  respect 
to  the  increase  of  rates  imposed  by  the  Revenue  Act  of  1917.  The 
provision  in  the  Revenue  Act  of  1918  granting  the  exemption  is 
retroactive,  and  authorizes  the  refund  of  all  estate  taxes  collected 
under  the  provisions  of  former  acts  from  estates  now  entitled  to  the 
exemption.  Where  such  taxes  have  been  collected,  the  executor 
should  file  a  claim  for  refund  on  Form  46,  accompanied  by  the  same 
evidence  as  is  required  in  support  of  a  claim  for  military  exemption. 
(Reg.  37,  Art.  11.) 

Gross  Estate — Individual  Property 

The  intention  of  the  lawmakers  is  to  impose  the  tax  upon 
what  may  be  called  the  "realizable"  value  of  the  estate.  Since 
the  use  of  the  word  "realizable"  might  in  some  cases  lead  to 
abuses,  the  word  "value"  is  used;  but  it  is  intended  in  all  cases 
that  the  word  is  to  mean  the  fair  or  market  or  reasonable 
or  realizable  value  in  so  far  as  the  aggregate  net  value,  as 
determined,  shall  yield  a  tax  fair  to  the  government  and  fair 
to  those  upon  whom  it  is  imposed.  Tax  laws  must  be  con- 
strued most  strictly  against  the  government.^  This  just  prin- 
ciple is  not  of  great  importance  when  tax  rates  are  low;  but 
where  tax  rates  reach  25  per  cent  it  would  be  harsh,  inequi- 
table, and  would  lead  to  wholesale  evasions  if  all  doubtful 
questions  were  decided  against  taxpayers.  Property  for  which 
there  is  no  broad  and  active  market  must  not  be  overvalued  or 
the  tax  collected  would  be  in  excess  of  that  which  is  intended. 
If  an  item  of  property  were  valued  at  $4,000  when  the  readily 
realizable  value  is  $1,000,  the  actual  tax  rate  would  be  100 
per  cent  instead  of  25  per  cent.  These  questions  will  be  dis- 
cussed in  detail  hereafter.  At  this  point  only  the  general 
principle  is  to  be  noted. 

Law.  Section  402.  That  the  value  of  the  gross  estate  of  the  de- 
cedent shall  be  determined  by  including  the  value  at  the  time  of  his 
death  of  all  property,  real  or  personal,  tangible  or  intangible,  wherever 
situated — 

(a)  To  the  extent  of  the  interest  therein  of  the  decedent  at  the 


'  Gould  V.  Gould,  245  U.  S.  151.  38  Sup.  Ct.  53,  62  L.  Ed.  211. 


FEDERAL  ESTATE  TAX  1433 

time  of  his  death  which  after  his  death  is  subject  to  the  payment  of 
the  charges  against  his  estate  and  the  expenses  of  its  administration 
and  is  subject  to  distribution  as  part  of  his  estate;  .... 

.  The  two  regulations  following  are  very  complete  and  ex- 
plicit and  leave  little  room  for  doubt  as  to  the  items  of  property 
which  should,  or  should  not,  be  included  in  the  gross  estate 
of  the  decedent. 

Regulations.  This  provision  is  designed  to  include  all  property 
interests  of  the  decedent,  of  whatever  character.  It  is  the  common- 
est form  of  taxable  transfer.  As  a  basis  for  tax,  there  must  be  an 
actual,  beneficial  ownership  in  the  decedent,  not  a  bare  legal  ti^^le,  or 
one  held  in  trust.  Thus,  property  actually  devoted  to  religion^-  or 
charitable  purposes,  and  placed  in  the  name  of  an  individual  solely 
for  convenience  in  administration,  is  not  included  in  his  gross  estate. 
The  statute  also  includes  only  property  rights  existing  in  the  decedent 
in  his  lifetime  and  passing  to  his  estate.  It  consequently  does  not  in- 
clude a  right  which  came  into  existence  only  after  the  decedent's 
death,  such  as  a  cause  of  action  by  statute  for  causing  the  death.  The 
proceeds  of  such  a  cause  of  action  should  not  be  included  in  the 
gross  estate,  whether  payable  generally  to  the  estate  or  to  some  speci- 
fied class  of  persons,   such  as  the  widow  or  children. 

The  value  of  a  vested  remainder  should  be  included  in  the  gross 
estate.  Nothing  should  be  included,  however,  on  account  of  a  con- 
tingent remainder  where  the  contingency  does  not  happen  in  the  life- 
time of  the  decedent,  and  the  interest  consequently  lapses  at  his  death. 
Nor  should  anything  be  included  on  account  of  a  life  estate  in  the  de- 
cedent. There  should  be  included,  however,  the  value  of  an  annuity'^ 
payable  to  the  decedent  upon  the  life  of  a  third  person  who  survives 
him,  and  the  value  of  an  estate  for  the  life  of  a  person  other  than 
the  decedent (Reg.  37,  Art.  12.) 

Specific  property  to  be  included. — 

Regulation.  Real  property  owned  by  the  decedent,  when  situated 
in  the  United  States,  should  be  included  in  the  gross  estate,  whether 
the  decedent  was  a  resident  or  a  nonresident,  and  whether  the  prop- 
erty came  into  the  possession  and  control  of  the  executor  or  admin- 
istrator or  passed  directly  to  heirs  or  devisees.  Real  property  not 
situated  in  the  United  States  should  not  be  included,  whether  the 
decedent  was  a  resident  or  nonresident.  Where  the  decedent  was  a 
resident,  all  personal  property  owned  by  him  should  be  included, 
wherever  situated.     Where  decedent  was  a  nonresident,  so  much  ofi 


"For  rules  as  to  valuing  such  annuities  and  illustrations,  sec  Reg.  2i7, 
Art.  20. 


y^34  MISCELLANEOUS    TAXES 

his  personal  property  as  was  actually  situated  in  the  United  States 
at  the  time  of  his  death  should  be  included.  For  further  discussion 
of  the  rules  relating  to  the  estates  of  nonresidents,  see  Arti&le  60. 

A  cemetery  lot  owned  by  the  decedent  is  part  of  his  gross  estate, 
but  its  value  is  limited  to  the  salable  value  of  such  part  of  it  as  is. not 
designed  for  the  interment  of  the  decedent  or  members  of  his  family. 
Rent  which  had  accrued  upon  real  property  at  the  time  of  the  de- 
cedent's death,  whether  then  payable  or  not,  is  included  in  the  gross 
estate.  The  amount  of  interest  accrued  upon  bonds  on  the  day  of 
death,  whether  payable  then  or  subsequently,  should  be  included. 
All  matured  coupons,  whether  presented  for  payment  or  not,  should 
be  included.  The  value  of  notes  or  other  claims  held  by  the  decedent 
should  be  included,  though  they  are  canceled  by  his  will  or  appear  to 
be  barred  by  the  statute  of  limitations.  As  to  the  valuation  of  notes 
or  claims  apparently  barred,  see  Article  15,  paragraph  3.  All  bonds, 
wdiether  federal,  state,  or  municipal,  and  whether  or  not  containing  a 
tax-free  covenant,  should  be   included. 

Dividends,  whether  upon  preferred  or  common  stock,  should  not 
be  included  unless  actually  declared  prior  to  the  date  of  death.  The 
amount  of  dividends  upon  stock  which  have  been  declared,  but  not 
paid,  must  be  returned  where  the  value  of  the  stock  at  the  time  of  the 
decedent's  death  does  not  reflect  the  dividends ;  that  is,  where  the 
death  occurs  after  the  closing  of  the  books  of  the  corporation  and 
the  stock  consequently  sells  "ex  dividend."  Where  the  death  occurs 
before  the  closing  of  the  books,  the  value  of  the  stock  reflects  the 
dividend,  and  it  should  not  be  included. 

•  Example:  A  5  per  cent  dividend  upon  stock  is  declared  March  i, 
payable  on  April  i  to  stockholders  of  record  on  March  15.  If  the 
death  occurred  on  March  10  and  the  market  price  on  that  day  was  90, 
the  value  to  be  returned  for  both  stock  and  dividend  is  90,  the  divi- 
dend being  reflected  in  the  quoted  price.  If  the  death  occurred  on 
March  20,  the  books  have  been  closed  and  the  dividend  is  not  re- 
flected in  the  selling  price.  Under  these  circumstances  the  dividend 
must  be  returned  in  addition  to  the  quoted  price  of  the  stock ;  and  the 
proper  return  would  be  stock  90,  dividend  $5.     (Reg.  37,  Art.  13.) 

Determination  of  value  of  property  included  in 
GROSS  ESTATE. — From  the  point  of  view  of  those  responsible 
for  the  fiHng  of  estate  tax  returns,  the  question  of  the  deter- 
mination of  values  is,  naturally,  the  crux  of  the  whole  situa- 
tion. The  regulations,  full  as  they  are  in  substance,  cannot 
deal  with  every  contingency  that  arises  in  fact.  There  are 
appraisal  companies  which,  in  order  to  secure  business,  adver- 
tise their  ability  to   furnish  appraisals  which  they  guarantee 


FEDERAL  ESTATE  TAX 


1435 


will  be  accepted  by  the  Treasury  Department.  The  guarantee 
carries  the  danger  that  an  appraisal  sufficiently  high  would 
always  be  acceptable  to  the  Department.  In  other  words,  an 
appraisal  company  engaged  on  this  implied  basis  would  be 
working  against  the  interest  of  the  taxpayer  in  order  that  it 
might  make  good  its  initial  claim  as  to  acceptance  of  its 
appraisal.  Instead  of  being  an  inducement  to  make  an  engage- 
ment, such  an  assertion  should  be  a  warning  to  the  executor. 
Undeniably,  expert  advice  should  be  sought  where  an  estate 
is  large,  its  affairs  complicated,  and  its  assets  varied.  Any 
advice  tendered  on  a  "money  back  if  you're  not  satisfied" 
basis  should  be  avoided. 

Regulation.  The  value  at  which  property  included  in  the  gross 
estate  is  to  be  returned  for  tax  purposes  is  the  value  at  the  time  of 
the  decedent's  death.  Neither  depreciation  nor  appreciation  in  value 
subsequent  to  the  date  of  death  is  considered.  The  value  to  be  as- 
certained is  the  market,  or  sale,  value  of  the  property.  The  highest 
price  obtainable  for  the  property  within  a  reasonable  period  of  f.he 
decedent's  death  is  the  value  to  be  included.  A  sale  of  the  property, 
however,  in  order  to  be  accepted  as  the  criterion  of  value,  must  be 
made  in  such  manner  as  to  insure  the  best  price  obtainable  under  ex- 
isting circumstances.  This  requires  (a)  that  the  sale  be  made  as  a 
matter  of  business,  and  not  merely  in  order  to  establish  value;  (b) 
that  it  be  made  in  absolute  good  faith,  with  a  view  to  realizing  as  high 
a  price  as  possible;  and  (c)  that  reasonable  care  and  skill  be  exerci.sed 
to  obtain  such  price.  If  one  method  brings  better  results  than  another, 
the  better  method  must  be  employed. 

For  example,  if  individual  sales  of  property  are  better  adapted  to 
procure  a  good  price  than  auction  sales,  the  price  obtained  at  an  auction 
sale  will  be  accepted  only  after  reasonable  effort  to  find  individual 
purchasers  has  been  made.    See  further  on  this  point  Article  15. 

Great  care  must  be  exercised  by  the  executor  to  arrive  at  a  fair 
valuation  of  every  asset  of  the  gross  estate.     (Reg.  37,  Art.  14.) 

The  legal  definition  of  the  word  "vahie"  is  by  no  means 
settled.  The  word  is  held  to  mean  one  thing  in  one  law  and 
something  else  in  another  law.  Generally  speaking,  the  gov- 
ernment attempts  to  fix  too  high  a  value,  and  taxpayers  fix 
too  low  a  value,  upon  the  property  the  value  of  which  is  dif- 
ficult to  determine.  Some  value  in  between  the  two  is  fair. 
There  should  be  brought  into  the  determination  lawyers  and 


1436  MISCELLANEOUS    TAXES 

accountants  whose  wide  experience  and  familiarity  with  actual 
values  insure  an  equitable  adjustment. 

In  view  of  the  fact  that  many  months  may  elapse  between 
the  determination  of  values  for  inclusion  in  the  gross  estate 
and  their  inevitable  review  by  an  officer  of  the  Internal  Rev- 
enue Bureau®  it  is  necessary  that  all  calculations  and  methods 
of  computation  used  should  be  carefully  preserved  in  a  man- 
ner that  will  permit  of  easy  reference.  This  is,  indeed,  called 
for,^°  but  that  it  is  an  essential  will  be  readily  recognized  by 
an  executor  who  has  to  make  good  his  estimates  to  satisfy  the 
investigating  officer  at  any  length  of  time  after  they  have 
been  made.  It  would  be  well  for  all  parties  concerned  if 
this  lapse  of  time  could  be  shortened  so  that  administration 
of  the  decedent's  estate  could  be  speedily  concluded  and  a 
distribution  to  the  legatees  made.  Apparently,  unnecessary 
expense  and  hardship  is  involved  under  existing  conditions. 
A  suggestion  that  a  final  assessment  of  the  tax  be  made  within 
sixty  days  of  the  filing  of  the  return,  presented  to  the  Com- 
mittee on  Ways  and  Means  prior  to  the  passing  of  the  Revenue 
Act  of  1918,  produced  no  tangible  reform  in  this  direction. 
Consideration  of  the  following  shows  exactly  how  far  the 
suggestion  was  acted  on,  taking  the  expression  "as  soon  as 
practicable"  at  its  putative  worth  in  so  far  as  the  Department 
of  Internal  Revenue  is  concerned. 

Regulation It  is   the  purpose  of  the   Bureau  to  make 

these  investigations  as  soon  as  practicable  after  the  filing  of  tlie  re- 
turn. Whenever  there  are  special  and  urgent  reasons  for  an  early 
investigation,  the  collector  should  be  notified  in  order  that  the  case  may 
be  given  special  attention.  Upon  completion  of  the  investigation  the 
executor  will  be  apprised  by  the  examining  officer  of  his  findings, 
and  will  be  given  an  opportunity  to  discuss  the  case  and  present  such 
data  as  he  may  desire,  to  be  considered  by  the  Bureau  in  connection 
with  the  examining  officer's  report.  Upon  the  completion  of  the  review 
and  audit  by  the  Bureau  of  the  return  and  the  examining  officer's  re- 
port, the  executor  will  be  informed  by  letter  from  the  Commissioner 
of  the  result  of  the  audit.     If  the  letter  contains  notification  of  an 


Reg.  ^^7,  Art.  79- 
"  Section  410. 


FEDERAL   ESTATE   TAX 


1437 


unpaid  balance  of  tax,  the  executor  should  make  payment  to  the  col- 
lector. After  the  expiration  of  30  days  from  receipt  of  the  notification 
interest  will  accrue  upon  the  excess  tax  at  the  rate  of  ten  per  centum 
per  annum.  If  the  executor  wishes  to  file  claim  for  abatement  of  any 
part  of  the  excess  tax,  such  claim  must  be  filed  within  30  days  of  re- 
ceipt of  notification,  or  he  may  pay  the  tax  in  order  to  prevent 
the  running  of  interest,  and  submit  claim  for  refund.  (Reg.  2>7' 
Art.  79. 

Valuation  of  property. — Guidance  in  determining  values 
in  accord  with  what  is  called  for  in  section  402  (a)  of  the 
law,  quoted  above,  is  given  in  the  ensuing  regulations. 

Valuation  of  cash. — 

Regulation (4)    Bank  deposits  should  be  returned  at  the 

amount  for  which  the  bank  would  be  liable  if  the  deposit  were  with- 
drawn upon  the  date  of  the  decedent's  death.  Interest  which  the 
bank  agreed  to  pay  upon  condition  that  the  money  remain  on  de- 
posit after  the  death  should  not  be  included.     (Reg.  37,  Art.  15.) 

Real  estate. — 

Regulation,  (i)  Where  real  property  has  been  sold,  the  amount 
received  will  be  taken  as  its  value  provided  the  sale  was  made 
within  a  reasonable  period  of  the  decedent's  death,  and  in  such 
manner  as  to  insure  the  highest  possible  price.  Where  no  sale  has 
been  made,  the  criterion  of  value  is  the  best  price  which  could  have 
been  obtained  within  a  reasonable  period  of  the  decedent's  death. 
The  amount  brought  at  an  auction  sale  should  be  considered,  but 
will  be  accepted  only  if  it  appears  that  there  was  no  available  method 
of  obtaining  a  higher  price.  The  assessed  valuation  of  the  property 
should  be  considered,  but  is  not  conclusive.     All  relevant  facts  and 

all  elements  of  value  should  be  considered  in  every  case (Reg. 

37,  Art.  15.) 

The  one  consideration  in  determining  values  of  real  estate, 
and,  in  fact,  of  any  other  item  of  property  to  be  included  in 
the  gross  estate  of  the  decedent,  is  to  arrive  at  a  figure  accep- 
table to  the  examining  officer  and  at  the  same  time  to  act  fairly 
by  the  estate.  The  regulation  just  cited  is  full  of  indetermin- 
ate expressions,  any  one  of  which  might  form  a  basis  for  con- 
troversy and  possible  revision  of  the  value  submitted  by  the 
executor.     Definition  of  ^''a  reasonable  period,"  proof  as  to 


1438 


MISCELLANEOUS    TAXES 


what  will  be  considered  "a  proper  manner"  of  obtaining  the 
highest  price,  establishment  of  the  "best  price"  which  could 
have  been  obtained,  are  all  factors  w^hich,  if  utilized,  should 
be  supported  by  every  possible  shred  of  evidence  likely  to  en- 
sure their  acceptance.  It  should  be  borne  in  mind  that  any 
haphazard  estimate  of  value,  or  any  item  included  which 
could  .not  be  substantiated  by  adequate  evidence,  might,  if 
detected,  lead  to  the  discounting  of  other  facts  possibly  of  vital 
interest  to  the  taxpayer. 

The  regulations  are  not  the  law.  They  can  only  be  recog- 
nized as  indicative  of  the  interpretation  of  the  law  by  the 
Bureau  of  Internal  Revenue.  They  are  of  undeniable  assist- 
ance in  preparing  returns  which  must  satisfy  that  Bureau.  The 
regulations  should  be  followed  in  all  possible  respects.  Im- 
proper or  negligent  methods  of  determining  the  reported 
values  wall  be  summarily  dealt  with.  Slipshod  valuations 
result  in  the  Commissioner  fixing  values  with  an  eye,  always, 
to  "highest  price."  Unless  determined  by  bona  fide  sales,  the 
fair  value  of  real  estate  is,  at  best,  a  hypothetical  proposition. 
In  the  absence  of  sale  it  w'ould  appear  that  the  most  acceptable 
method  is  to  establish  a  value  by  appraisal  conducted  by 
reputable  appraisers,  and  to  submit  such  appraisals  (three  or 
more  in  number)  in  the  form  of  affidavits.  It  is  likely  that 
such  a  procedure  would  be  accepted  without  question.  Care 
should  be  taken  to  instruct  the  appraisers  as  to  the  basis  called 
for  in  the  following : 

Regulation.  Where  expert  appraisers  are  to  be  employed,  care 
should  be  taken  to  see  that  they  are  men  of  recognized  competence 
with  respect  to  the  particular  class  of  property  involved.  In  order 
to  facilitate  the  acceptance  of  the  appraisal,  appraisers  should  be 
employed  whose  competence  is  well  established. 

The  basis  to  be  employed  in  appraising  articles  of  this  character 
is  what  they  would  bring  at  a  bona  fide  sale  to  individual  purchasers, 
to  dealers,  or  upon  a  well-advertised  auction  sale.  If  there  has 
been  an  actual  bona  fide  sale,  the  amount  received  may  be  returned 
as  the  value  of  the  property.  Where  property  is  valued  by  legatees 
for  purposes  of  distribution,  such  value  will  not  necessarily  be  ac- 
cepted.    The  original  cost  of  the  articles  is  not  necessarily  a  proper 


FEDERAL   ESTATE   TAX 


1439 


basis,  on  account  of  depreciation  or  appreciation  in  value.  (Reg. 
Z7,  Art.  19.) 

Cases  have  arisen  where  appraisers  whose  competence 
was  unquestionable  have  been  employed  on  valuations;  yet 
the  Treasury  has  refused  to  accept  their  valuations,  although 
such  valuations  were  accepted  by  the  surrogate's  court  of 
the  state  in  question  and  by  the  state  tax  commission. 

The  Treasury  should  initiate  some  procedure  whereby 
co-operation  with  the  appraisers  appointed  by  the  surrogate's 
court  would  be  possible,  thereby  eliminating  duplications  which 
result  in  such  disagreements  as  those  referred  to  above. 

Stocks  and  bonds. — 

Regulation (2)  The  value  of  stocks  and  bonds  listed  upon 

a  stock  exchange  should  be  obtained  by  taking  the  mean  between  the 
highest  and  the  lowest  sale  price  upon  the  day  of  death,  provided 
the  sales  were  made  in  the  regular  course  of  business,  and  not  for 
the  special  purpose  of  establishing  value.  If  there  were  no  sales 
upon  the  date  of  death,  the  price  nearest  to  that  date,  and  within 
a  reasonable  period  thereof,  either  before  or  after  death,  should  be 
taken.  Such  sale  price  obtains  irrespective  of  the  number  of  shares 
held  by  the  estate.  If  the  security  was  listed  upon  more  than  one 
exchange,  the  records  of  the  exchange  where  the  security  is  princi- 
pally dealt  in  should  be  employed.  If  the  decedent  died  on  Sunday 
or  a  legal  holiday,  the  business  of  the  previous  day  will  govern. 

If  the  stock  is  not  listed  upon  an  exchange,  but  is  dealt  in  actively 
by  brokers  or  has  other  active  market,  the  latest  sale  price  prior  to 
the  day  of  death  will  govern.  If  there  is  no  active  market  for  the 
stock  and  no  sales  of  it  have  been  made  within  a  reasonable  period 
of  the  decedent's  death,  and  in  particular  where  it  is  closely  held 
(stock  of  a  "close  corporation"),  return  should  be  made  upon  the 
basis  of  the  value  of  the  stock,  as  evidenced  by  the  clear  value  of 
the  excess  of  the  assets  of  the  corporation  over  its  liabilities,  and  its 
earning  capacity  for  the  five  years  preceding  the  death  of  the  de- 
cedent. Where  the  earnings  of  the  corporation  have  been  greater 
than  a  fair  return  on  its  invested  capital,  computed  according  to  the 
nature  of  the  business,  and  where  the  business  is  a  going  business, 
there  should  be  added  to  the  net  value  of  the  other  assets  of  the 
business  the  value  of  the  good  will,  computed  in  accordance  with 
sound  accounting  principles.  Where  the  earnings  of  the  corporation 
have  been  less  than  a  fair  return  on  the  invested  capital,  if  the  dif- 
ference is  material  and  the  decreased  earnings  affect  value,  the  net 


I440 


MISCELLANEOUS    TAXES 


worth  of  the  corporation  as  disclosed  by  its  balance  sheet  may  be 
adjusted  on  a  reasonable  basis  to  allow  for  this  decreased  value. 
In  all  cases  where  stock  of  this  character  forms  a  principal  asset, 
there  should  be  submitted  with  the  return,  Form  706,  a  copy  of  the 
balance  sheets  for  the  five  preceding  years,  and  of  the  balance  sheet 
on  the  day  of  death  or  the  nearest  date  thereto,  together  with  a  state- 
ment of  the  net  earnings  of  the  invested  capital  for  the  preceding 
five  years. 

The  full  value  of  securities  pledged  to  secure  a  loan  should  be 
included  in  the  gross  estate.  If  the  decedent  had  a  trading  account 
with  a  broker,  all  securities  belonging  to  the  decedent  held  by  the 
broker  at  the  date  of  death  must  be  included  at  their  market  value 
on  that  date.  Securities  purchased  on  margin  for  the  decedent's  ac- 
count and  held  by  the  broker  should  also  be  returned  at  their  market 
value  on  the  day  of  death.  The  amount  of  the  decedent's  indebtedness 
to  the  broker  will  be  allowed  as  a  deduction  from  the  gross  estate. 
(Reg.  37,  Art.  15.) 

The  foregoing  formula  may  result  in  the  determination  of 
the  fair  value  of  stocks  or  bonds,  but  in  many  cases  it  is  un- 
sound and  will  not  be  sustained  by  the  courts.  In  the  case  of 
listed  stocks,  the  quotations  or  the  actual  transactions  for  one 
day  may  be  misleading.  The  trend  of  the  market  may  be  up 
or  down  and  the  number  of  shares  sold  may  be  insufficient 
to  fix  conclusively  the  value  of  any  considerable  number  of 
shares.  If  a  decedent  leaves  100  shares  of  United  States 
Steel  common  stock,  the  formula  in  the  regulation  is  fair;  if 
the  decedent  leaves  a  large  number  of  shares  of  an  inactive 
stock,  the  sale  of  a  few  hundred  shares  may  only  be  the  start- 
ing point  in  determining  the  value  of  the  greater  number  of 
shares.  In  the  case  of  a  ''close  corporation,"  the  earnings  for 
the  preceding  years  may  be  a  major  factor  in  arriving  at  a 
fair  price,  but  if  there  is  an  abnormal  period  during  those 
years,  or  if  there  is  a  decided  trend  towards  the  end  of  the 
period,  any  buyer  of  the  stock  would  give  more  weight  to  the 
probable  earnings  or  losses  following  the  date  of  death  than 
to  the  results  of  any  of  the  years  preceding  death." 

As  an  illustration,  consider  a  close  corporation  in  which 


'^  For  methods  of  arriving  at  fair  value,  see  Chapter  XLI,  "Capital  Stock 
Tax." 


FEDERAL   ESTATE   TAX 


1441 


the  estate  is  interested  to  the  extent  of  1,000  shares  of  7  per 
cent  non-cumulative  preferred  stock.  A  few  isolated  sales 
to  employees  or  officers  of  the  corporation  have  been  effected 
at  par.  According  to  the  book  figures,  the  excess  of  liquid 
assets  over  liabilities  shows  a  backing  behind  the  preferred 
stock  of  $130  per  share  issued.  The  dividend  has  been  regu- 
larly paid.  The  corporation  also  has  an  issue  of  common  stock 
which  is  cared  for  by  an  excess  of  all  assets  over  liabilities 
(exclusive  of  goodwill)  and  after  providing  for  the  preferred 
stock  at  par,  in  a  sum  representing  over  $83  per  share.  Earn- 
ings for  five  years  averaged  12^  per  cent  on  the  common 
stock  after  allowing  for  7  per  cent  on  the  preferred.  Accord- 
ing to  earnings  shown  by  these  book  figures,  the  preferred 
stock  of  this  corporation  would  be  worth  at  least  par.  By 
reason  of  the  fact  that  the  corporation  is  a  "close  corporation" 
and  its  ramifications  are  known  only  to  the  few  directly  inter- 
ested, it  would  be  a  matter  of  considerable  difficulty  to  find 
a  purchaser  for  the  1,000  shares  included  in  the  estate.  An 
intelligent  investor  would  say  "at  what  price  can  I  purchase 
7  per  cent  preferred  shares  in  any  well-known  and  quoted  stock 
in  a  similar  line  of  business?"  By  this  means  he  knows  he  can 
buy  an  issue  which  he  is  able  to  dispose  of  readily  and  the  price 
of  which  is  regulated  by  the  prevailing  supply,  demand,  and 
general  business  conditions.  He  finds  that  the  average  price 
of  such  securities  is  91.  Why  should  he  pay  $100  for  what 
he  knows  nothing  about  and  which  he  might  have  some  diffi- 
culty in  disposing  of,  if  need  be,  when  he  can  get  the  same 
thing  for  $91  in  a  form  more  easily  negotiable  and  the  price 
of  which  is  established  on  an  accepted  financial  basis.  The 
fundamental  principle  on  which  "fair  value"  is  based  demands 
the  possibility  of  a  willing  buyer  and  a  willing  seller.  In 
appraising  values  of  stocks  in  close  corporations  strictly  in 
accord  with  the  regulations,  it  would  seem  that  this  principle 
may  very  easily  be  lost  sight  of  and  that  an  arbitrary  figure 
may  be  cstal^lished  which,  on  consideration,  does  not  repre- 
sent a  fair  value. 


1442 


MISCELLANEOUS    TAXES 


Whatever  other  factors  may  obtain,  it  cannot  be  denied 
that  the  stock  of  a  close  corporation  should  never  be  valued 
in  excess  of  the  fair  market  price  of  shares  of  stock  of  cor- 
porations in  a  similar  line  of  business  according  to  quotations 
on  the  open  market.  Investigation  has  proven  that  the  applica- 
tion of  this  principle  shows  how  little  the  actual  book  value 
does  reflect  the  fair  market  value  of  corporation  stock  generally. 
A  comparison  of  the  market  price  of  stocks  of  sixty-one 
corporations  with  the  book  value  of  those  same  stocks  arrived 
at  by  reference  to  the  last  preceding  balance  sheets,  as  pub- 
lished by  the  best-known  authority,  revealed  that  the  average 
book  value  per  share  was  $137.80,  whereas  the  average  sell- 
ing price  per  share  was  v$75.84.  In  other  words,  the  selling 
price  represented  only  55  per  cent  of  the  book  value,  at  or 
about  the  date  selected. 

While  55  per  cent  cannot  be  a  constant  relative  factor 
as  between  the  selling  price  of  stock  and  its  book  value,  the 
fact  that  it  was  so  in  the  investigation  mentioned,  conclusively 
shows  how  far  from  being  a  "fair  market  value"  would  be  any 
figure  determined  solely  on  a  valuation  of  the  corporate  assets. 

The  principle,  however,  may  well  be  used  where  circum- 
stances allow  of  its  introduction.  The  book  value  of  corpora- 
tions which  issue  similar  stocks,  together  with  the  market  value 
thereof,  should  be  listed  and  the  percentage  of  the  latter 
to  the  former  should  be  determined.  This  percentage  should 
then  be  applied  to  the  book  value  of  the  assets  under  consid- 
eration, and  the  resultant  stock  value  per  share  should  be 
utilized  as  the  actual  value  or  in  support  of  a  value  computed 
under  some  alternative  method. 

Generally  speaking,  it  will  be  found  in  practice  that  the 
valuation  of  holdings  in  close  corporations  presents  a  problem 
to  be  solved  by  a  general  review  of  conditions  from  without 
as  well  as  from  within.  As  has  been  mentioned  before,  "a 
revenue  law  cannot  be  made  elastic  enough  to  deal  with  unusual 
problems."^"    Recognizing  this  fact,  the  authors  of  the  Revenue 


"Excess  Profits  Tax  Procedure,  1921,  page  338. 


FEDERAL   ESTATE   TAX 


1443 


Act  of  1 92 1,  of  which  the  estate  tax  is  Title  IV,  have,  in 
Title  III  (sections  327  and  328)  inserted  relief  clauses  to  cover 
cases  where  a  literal  interpretation  of  the  law  relating  to  the 
war-profits  and  excess-profits  tax  would  work  evident  hard- 
ships on  the  corporation  taxpayer.  The  spirit  of  compromise 
here  offered  might  well  be  used  in  principle  in  the  valuation 
of  stocks  and  bonds  for  estate  tax  purposes. 

While  balance  sheets  of  organizations  which  come  under 
the  category  of  close  corporations  are  called  for  in  substanti- 
ation of  determined  values  of  their  stock,  there  would  appear 
to  be  no  reason  why  the  component  parts  of  the  balance  sheets 
should  not  have  to  be  appraised  as  to  value.  In  this  event,  and 
in  submitting  balance  sheets  in  evident  support  of  values 
arrived  at,  it  would  be  necessary  to  show  comparative  figures 
depicting  "fair  value"  as  against  "book  value."  A  piece  of 
real  estate  held  for  a  number  of  years  will,  under  normal 
circumstances,  have  a  different  value  at  the  time  of  the  dece- 
dent's death  from  the  figure  at  which  it  vvas  purchased.  In 
fact,  the  whole  list  of  items  shown  in  a  balance  sheet,  where 
such  method  of  determining  the  value  of  stock  is  used,  should 
be  subjected  to  the  same  scrutiny  for  worth  at  the  date  re- 
quired as  are  the  items  which  are  comprised  in  the  gross 
estate  itself  and  upon  the  same  lines  as  are  suggested  for  them. 

Valuation  of  notes. — 

Regulation (3)   Notes,  whether  secured  or  unsecured, 

will  be  presumed  to  be  worth  their  full  face  value,  plus  accrued 
interest  to  the  date  of  decedent's  death,  unless  the  executor 
establishes  the  right  to  return  them  at  a  lower  valuation.  Interest 
should  be  computed  upon  the  basis  of  365  days  to  the  year.  In  the 
case  of  an  unsecured  note  it  must  be  shown  by  satisfactory  evidence, 
in  order  to  justify  failure  to  include  it,  that  the  note  is  uncollectible, 
either  in  whole  or  in  part,  from  the  maker  or  other  parties  to  the 
note,  an  account  of  the  insolvency  of  the  parties  thereto,  or  other 
cause.  Where  the  note  is  secured  it  must  also  be  shown  that  the 
security  is  insufficient  to  satisfy  it.  Where  a  note  appears  to  be 
barred  by  the  statute  of  limitations  its  value  must  be  included  in  the 
gross  estate  in  the  absence  of  proof  that  the  liability  has  not  re- 
vived by  promise  to  pay  or  part  payment,  and  also  that  the  parties 


1444 


MISCELLANEOUS   TAXES 


liable  refuse  to  pay  the  debt  and  intend  to  assert  the  defense.  (Reg. 
37,  Art.  15.) 

It  will  be  observed  that  the  above  regulation  demands 
the  valuation  of  notes  at  their  face  value  unless  a  right  to 
establish  a  lower  value  is  supported  by  satisfactory  and  suffi- 
cient evidence.  This  is  a  question  which  depends  entirely  on 
circumstances.  When  the  decedent  leaves  a  business  in  active 
running  order,  which  is  ultimately  to  be  carried  on  continu- 
ously by  his  successors,  the  face  value  of  the  assets  may  well 
be  maintained.  In  instances,  however,  when  a  liquidation 
of  all  or  part  of  the  assets  is  necessary,  unless  value  has 
already  been  determined  by  sales,  the  items  under  this  caption 
should  be  included  in  the  gross  estate  at  their  readily  realizable 
value  at  the  time  of  death.  Reference  to  the  law^^  demands 
the  inclusion  "of  all  property,  real  or  personal,  tangible  or 
intangible,"  at  the  "value"  at  the  time  of  death.  An  interpre- 
tation of  the  law  which  differentiates  as  to  the  meaning  of 
the  term  "value  at- time  of  death"  as  between  the  various  prop- 
erties involved,  is  an  erroneous  one.  The  value  of  bonds 
which  are  quoted  on  the  active  market  is  determined  primarily 
by  their  yield  and  due  date.  These  quotations  are  accepted  by 
the  Treasury  Department  in  connection  with  their  inclusion 
in  the  gross  estate.  The  principle  of  ready  realization  being 
thus  established,  the  same  principle  should  apply  to  all  assets. 

Valuation  of  interest  in  business. — 

Regulation (5)   Care  should  be  taken  to  arrive  at  an 

accurate  valuation  of  any  business  in  which  the  decedent  was  interested 
whether  as  partner  or  pi-oprietor.  A  fair  appraisal  as  of  the  date  of 
death  should  be  made  of  all  the  assets  of  the  business,  tangible  and 
intangible,  and  the  business  should  be  given  a  net  worth  equal  to  the 
amount  which  a  purchaser,  whether  an  individual  or  corporation, 
would  be  willing  to  pay  therefor  at  a  normal  sale  in  view  of  the 
net  value  of  the  assets  and  the  demonstrated  earning  capacity.  Special 
attention  should  be  given  to  fixing  an  adequate  figure  for  the 
value  of  the  good  will  of  the  business  in  all  cases  where  the  decedent 


"  Law,  section  402,  quoted  on  page  1432. 


FEDERAL  ESTATE  TAX  T445 

has  not,  for  a  fair  consideration  in  money  or  money's  worth,  agreed 
that  his  interest  therein  shall  pass  at  his  death  to  his  surviving  partner 
or  partners.     (Reg.  37,  Art.  15.) 

Comments  heretofore  made  regarding  the  valuation  of 
real  estate,  stocks,  and  bonds  apply  as  well  to  many  other  items 
of  property.  A  careful  audit  of  the  accounts  of  a  going  busi- 
ness should  be  made  and  a  detailed  financial  statement  pre- 
pared.   Each  item  in  the  balance  sheet  should  be  fairly  valued. 

Valuation  of  goodwill,  patents,  etc. — 

Regulation (6)  The  basis  for  valuation  of  intangible 

assets  of  this  character  is  the  present  worth  of  the  estimated  future 
earnings  of  the  exclusive  right  during  the  rest  of  its  existence.  The 
return  received  by  the  decedent  should  be  considered  in  estimating 
future  earnings.     (Reg.  37,  Art.  15.) 

The  formula  laid  down  in  the  foregoing  regulation  regard- 
ing the  value  of  goodwill  is  a  sound  one  in  all  cases  when 
goodwill  is  the  subject  of  sale.  When  an  active  partner  dies, 
the  value  of  goodwill  is  usually  overestimated.  The  greater 
the  personal  interest  of  a  decedent  in  a  going  business,  the 
less  the  goodwill  is  worth. 

The  latter  part  of  the  regulation  is  not  clear.  Frequently 
goodwill  under  partnership  agreements  passes  to  the  surviving 
partners  without  valuation.  In  such  cases  the  decedent  has 
divested  himself  of  any  interest  in  the  goodwill  and  it  is  dif- 
ficult to  see  the  importance  of  ascertaining  the  value  which 
he  might  have  obtained  for  it  if  the  partnership  agreement  had 
provided  otherwise.  The  profit  a  man  might,  but  does  not 
realize  is  hardly  taxable  as  property  at  his  death.  Of  course 
if,  in  contemplation  of  death,  a  transfer  of  valuable  good- 
will should  be  made  within  two  years  before  a  decedent's 
death,  the  transaction  would  be  open  to  question,  as  would  be 
any  other  transfer  similarly  made. 

The  following  digest  of  a  memorandum  issued  by  the  Com- 
mittee on   Appeals   and   Review^*   indicates   the   methods   of 


"Method  of   obtaining   value   of   intangible   assets,    C.   B.   2,   page   31; 
A.  R.  M.  34. 


1446  MISCELLANEOUS    TAXES 

computation  of  goodwill  values  acceptable  to  the  Bureau  of 
Internal  Revenue. 

Brands.  Take  price  at  which  article  under  specific  brand  sold 
as  against  similar  article  with  no  brand.  Difference  multiplied  by 
number  of  units  sold  during  given  period  equals  profits  attributable 
to  use  of  brand.  Do  this  for  a  sufficient  number  of  years  to  give 
a  constant  figure  and  capitalize  result  at  20  per  cent. 

Brands  or  Goodwill,  etc.  (i)  Take  known  cash  price  at  which 
goodwill,  or  brand,  etc.,  may  have  been  sold.  Compare  business 
done  by  vendor  with  business  done  by  concern  under  review.  A 
proportionate  value  can  thus  be  established. 

(2)  Take  average  earnings  for  five  years,  apply  10  per  cent  of  this 
to  tangible  assets  and  apply  residue,  at  five  years'  purchase,  to  good- 
will. 

In  case  of  a  business  not  subject  to  fluctuations  or  manufacturing 
article  of  daily  necessity,  reduce  return  on  tangibles  to  8  or  9  per 
cent  and  capitalize  residue  for  goodwill  at  15  per  cent  instead  of 
20  per  cent. 

Representative  periods  should  be  used  in  arriving  at  adjustments. 
Years  showing  extraordinary  factors  to  be  eliminated.  In  capitalizing 
earnings,  percentage  shown  by  the  return  on  actual  cost  of  the 
business  should  be  considered.  If  earnings  at  one  of  the  figures  sug- 
gested above  is  in  excess  of  such  percentage,  the  smaller  figure 
should  be  used. 

This  memorandum  was  further  supplemented^^  by  the  sug- 
gestion that  in  determining  net  earnings  under  the  third  para- 
graph above,  a  reasonable  amount  on  account  of  salaries  for 
owners  actively  engaged  in  the  business  be  deducted. 

The  formula  set  forth  in  article  15  above  is  sound  when 
applied  to  the  valuation  of  patents.  It  is  not  the  same  as 
the  formula  prescribed  by  the  income  tax  unit  of  the  Bureau 
of  Internal  Revenue  for  the  valuation  of  goodwill  (quoted 
above).  As  is  the  case  with  stocks  of  close  corporations  and 
goodwill,  prospective  buyers  always  attach  much  importance 
to  the  probable  future  earnings  of  the  properties  they  buy. 

Valuation  of  accounts  receivable.^ — 

Regulation (7)  A   fair  valuation   for   assets  of   this 

character  at  the  time  of  death  should  be  fixed  by  the  executor  ac- 
cording  to   the   best    information    available    to   him    at   the   time    of 


''C.  B.  4,  page  43;  O.  D.  937. 


FEDERAL  ESTATE  TAX  1447 

making  return.  A  right  of  action  which  died  with  the  decedent 
should  not  be  inckided  in  the  gross  estate.     (Reg.  37,  Art.  15.) 

Accounts  receivable  should  be  valued  either  on  the  basis 
of  a  going  business  or  of  a  business  in  liquidation.  If  the 
business  is  being  continued  and  periodical  audit  reports  are 
available,  there  is  little  need  to  go  behind  the  book  value. 
Should  the  contrary  be  the  case,  a  verification  of  the  accounts 
should  be  made  by  direct  correspondence  with  the  debtors 
where  necessary,  and  every  care  should  be  exercised  in  the 
determination  of  their  collectibility  or  otherwise.  Claims  or 
judgments  should  not  be  accepted  at  face  value  without  due 
scrutiny  as  to  age  and  possible  collectibility. 

Valuation  of  furniture,  jewels,  etc.,  and  growing 

CROPS. — 

Regulations (8)  For  the  method  of  valuation  to  be 

employed  in  the  case  of  household  furniture  and  personal  effects  see 
Articles  16  to  19.  With  respect  to  all  other  tangible  property  the 
executor  should  endeavor  to  arrive  at  the  sound  and  actual  value 
at  the  day  of  death.  Where  such  property  is  subsequently  sold  the 
sale  price  must  be  returned  if  the  sale  was  a  bona  fide  sale  and 
for  the  best  price  obtainable.  In  the  case  of  growing  crops  the 
executor  should  ascertain  from  expert  opinion  what  the  value  of  the 
growing  crop  was  on  the  day  of  death,  as  evidenced  by  subsequent 
yield  and  crop  prices.  Where  the  crop  is  matured  the  value  is  the 
value  of  the  crop  unit  on  the  day  of  death  for  the  entire  yield,  less 
the  cost  of  harvesting  and  marketing.  Where  the  crop  is  not  matured 
these  factors  should  be  considered;  and  the  opinion  of  those  expert 
in  such  matters  should  be  ascertained  as  to  what  the  crop  was 
reasonably  worth  as  a  growing  crop  on  the  day  of  death.  (Reg. 
37,  Art.  15.) 

When  the  value  of  the  personalty  involved  is  less  than  $2,000, 
the  detailed  lists  may  be  prepared  by  the  executor  personally.  A 
room  by  room  appraisal  is  desirable;  and  all  the  articles  should  be 
named  specifically,  except  those  of  small  value,  such  as  common 
bric-a-brac  or  cheap  books.  A  separate  value  should  be  given  for 
each  article  named,  except  that  the  values  of  a  number  of  articles 
contained  in  the  same  room  may  be  grouped.  The  value  of  an  article 
worth  more  than  $50  should  be  stated  separately.  Such  an  entry  as 
the  following  would  be  acceptable : 

Dining  room:  Table,  six  chairs,  three  pictures  (common  prints), 
value  $75;  sideboard.  $60;  total,  $135.     (Reg.  n,  Art.  17.) 


1448  MISCELLANEOUS    TAXES 

Particular  care  is  needed  in  arriving  at  the  value  of  grow- 
ing crops.  The  knowledge  of  subsequent  realization,  most 
probably  available  by  the  time  the  executor  is  making  up  the 
return,  may  unduly  influence  the  ultimate  determination  of 
the  value  of  the  growing  crop  at  the  time  of  decedent's  death. 
Particularly  is  this  the  case  should  the  market  fall  below  anti- 
cipated figures  and  so  make  the  valuation  appear  too  high. 
The  appraisal  must  be  made  and  based  entirely  on  conditions 
and  estimates  obtaining  at  the  date  of  death  and  values  fixed 
in  accord  therewith,  or,  if  possible,  on  the  basis  of  sales  of 
similar  standing  crops  efifected  at  that  time.  All  charges  nec- 
essary to  the  harvesting  and  marketing  may  be  deducted  from 
an  appraisal  based  on  an  estimated  worth.  When  the  appraisal 
is  made  on  comparative  figures  based  on  sales  of  similar  stand- 
ing crops,  these  costs  will  not  generally  be  deductible.  Such 
a  sale  is  usually  conditional  on  the  vendee  removing  and 
marketing  the  ultimate  crop. 

If  custom  supports  the  procedure — as,  for  instance,  in 
tobacco  farming,  where  the  aggregate  cost  of  sowing,  tending, 
harvesting,  and  depositing  under  cover  (but  not  including 
picking  and  sorting)  is  considered  the  inventory  figure  of  the 
year's  crop — the  value  of  the  standing  crop  could  very  easily 
be  estimated.  The  value  at  any  given  date  would  be  the  cost 
up  to  that  date.  In  any  case,  and  under  whatever  circum- 
stances the  valuation  of  a  ground  crop  is  determined,  such 
valuation  should  be  supported  by  affidavits  from  responsible 
people  in  the  same  line  of  business  testifying  that  the  method 
employed  is  in  accord  with  prevailing  customs  in  the  trade 
and  that  the  result  so  obtained  fairly  represents  the  value  of 
the  crop  included  in  the  gross  estate. 

Other  regulations  bearing  on  valuation  follow : 

Regulations.  Executors  and  administrators  are  required  to  have 
careful  appraisal  made  of  all  household  and  personal  effects  of  the 
decedent,  and  to  furnish  in  duplicate  detailed  lists  and  affidavits  in 
the  manner  directed  below.  No  distribution  of  such  effects  may  be 
made  until  the  lists  and  affidavits  have  been  filed  with  the  collector, 
and,  if  deemed  necessary,  sufficient  time  afforded  the  Bureau  to  have 


FEDERAL   ESTATE   TAX 


1449 


personal  inspection  made  by  an  official  appraiser.  Where  it  is  desired 
to  distribute  or  sell  all  the  property  in  advance  of  the  filing  of  the 
return,  the  lists  and  affidavits  should  be  filed  with  the  collector,  to- 
gether v^rith  a  letter  stating  when  it  is  desired  to  efifect  distribution. 
If  personal  inspection  by  an  internal-revenue  officer  is  not  deemed 
necessary,  a  waiver  of  such  examination  will  be  sent  to  the  executor, 
who  may  thereupon  proceed  with  distribution.     (Reg.  37,  Art.  16.) 

The  foregoing  regulation  is  not  unreasonable  if  executors 
are  not  unduly  hampered  in  making  distributions.  The  law 
is  silent  on  this  point  and  no  penalty  is  imposed.  In  practice 
distribution  should  be  supervised  in  such  a  way  as  to  satisfy 
the  Treasury  that  the  full  value  of  the  estate  is  reported  for 
taxation. 

Regulations If  there  should  be  included  in  the  lot,  how- 
ever, jewelry  or  silverware  of  more  than  ordinary  value,  or  articles 
having  a  marked  artistic  value,  the  executor  must  furnish  an  appraisal 
by  persons  thoroughly  qualified  by  training  and  experience  to  judge  of 
the  value  of  such  articles. 

In  the  case  of  effects  having  a  total  value  of  less  than  $2,000, 
the  executor  may  furnish  as  an  alternative  requirement  a  sworn 
estimate  in  duplicate  of  the  approximate  total  value  of  the  property 
by  a  professional  appraiser  of  recognized  standing  and  ability,  or  by  a 
dealer  in  the  class  of  personalty  involved. 

In  addition  to  the  lists  or  estimates  described  above,  the  executor 
must  furnish  in  duplicate  his  affidavit  as  to  the  completeness  of  the 
lists  and  the  qualification  of  the  appraiser.     (Reg.  37,  Art.  17.) 

When  the  value  of  the  effects  is  more  than  $2,000,  detailed  lists 
must  be  furnished,  prepared  by  professional  appraisers  of  recognized 
competence,  or  by  dealers  in  the  particular  classes  of  personalty  in- 
volved. The  lists  must  be  prepared  in  the  same  detail  as  that  indicated 
above  for  the  executor's  list.  Where  the  personalty  includes  jewelry, 
silverware,  or  like  articles,  except  in  cases  where  the  value  of  these 
items  is  insignificant,  the  appraisal  of  a  reputable  dealer  or  appraiser 
of  jewelry  must  be  furnished. 

In  the  case  of  articles  having  marked  artistic  value,  such  as 
paintings,  engravings,  etchings,  statuary,  vases,  oriental  rugs,  or 
antiques,  the  appraisals  of  experts  will  be  required.  The  description 
of  such  articles  should  be  fully  given.  Where  paintings  having 
artistic  value  are  listed,  the  size,  subject,  and  artist  should  be  named. 
In  the  case  of  oriental  rugs,  the  size,  make,  age,  etc.,  should  be 
given.  The  weight  in  ounces  of  each  article  of  silverware  should 
be  stated.  With  the  duplicate  lists  there  must  be  filed  the  executor's 
affidavit  as  to  the  completeness  of  the  list  and  the  qualifications  of  the 
appraisers.      (Reg.  37,  Art.  18.) 


I450  MISCELLANEOUS    TAXES 

(For  Regulation  ^yl,  article  13,  see  page  1433.) 
The  valuation  of  such  miscellaneous  property,  in  excess 
of  $2,000,  as  may  come  under  the  last  four  articles  quoted 
from  the  regulations  is  purely  a  matter  of  expert  appraisal. 

A  point  that  requires  particular  attention  in  the  valuation 
of  household  effects  is  to  differentiate  between  property  of  this 
description  owned  by  a  surviving  husband  or  wife  individually, 
and  that  owned  by  the  decedent. 

Ruling.  Household  effects  and  like  personalty  used  by  husband 
and  wife  in  the  marriage  relation  are  presumed  to  be  the  property 
of  the  husband,  and,  in  the  absence  of  sufiScient  evidence  to  rebut 
this  presumption,  must  be  returned  as  portion  of  his  gross  estate.^* 

It  is  pointed  out  by  the  Commissioner  that  a  bare  state- 
ment from  the  wife  claiming  the  property  is  not  sufficient;  the 
burden  of  establishing  the  claim  is  thrown  upon  her.  When 
the  wife  owned  articles  of  household  furniture  before  mar- 
riage, purchased  them  out  of  her  separate  funds  or  received 
them  as  gifts  from  others,  if  her  claim  is  supported  by  proven 
evidence,  such  effects  need  not  be  included  in  the  gross  estate 
of  the  husband.    The  Commissioner  further  says:" 

Ruling.  The  following  proposition  has  been  announced  by  the 
courts  and  is  believed  by  this  office  to  be  sound.  To  constitute  a  valid 
gift  there  must  be  an  absolute  transfer  of  the  property  from  donor 
to  donee,  taking  effect  immediately  and  fully  executed  by  a  delivery 
of  the  property  to  the  donee,  and  the  acceptance  thereof  by  the  donee. 
It  is  essential  that  the  transaction  should  be  fully  executed  by  the 
delivery  of  the  property  to  the  donee,  or  to  some  person  for  him. 
In  several  States,  statutes  have  been  enacted  providing  that  no  gift, 
except  by  deed  or  will,  shall  be  valid  unless  actual  possession  shall 
come  to  and  remain  with  the  donee,  or  his  agent,  and  if  the  donee 
or  donor  reside  together  at  the  time  of  the  gift,  possession  by  the 
donee  at  their  place  of  residence  is  not  a  sufficient  possession  within 
the  meaning  of  statute. 

Community  property  and  other  property  in  which 
THERE  ARE  JOINT  INTERESTS. — In  applying  the  tax  levied  under 
this  title,  consideration  must  be  given  to  decisions  of  state 


"  T.  D.  2529. 
"  T.  D.  2529. 


FEDERAL   ESTATE   TAX  145 1 

courts  construing  local  statutes.  Particularly  is  this  true  in 
connection  with  community  property. ^^  A  test  case,  in  so  far 
as  the  California  statutes  are  concerned,  is  found  in  the  United 
States  District  Court,  Northern  District,  Cahfornia.^'*  The 
question  before  the  court  was  as  to  there  being  a  transfer  of 
any  estate,  under  the  California  law,  when  one-half  of  the 
community  property  became  vested  in  the  widow  upon  death 
of  the  husband.  The  court,  in  overruling  a  demurrer,  in  effect, 
held  that  a  wife,  under  community  property  laws,  no  longer 
takes  her  interest  in  the  community  property  as  heir,  and  hence 
that  her  interest  is  not  subject  to  the  federal  inheritance  tax 
imposed  on  the  transfer  of  a  decedent's  estate.    The  court  said : 

The  community  property  act  of  1917  is  valid  as  to  community 
property  acquired  before  its  passage  (Arnett  v.  Reade,  220  U.  S.  311, 
320,  31  Sup.  Ct.  425,  426,  55  L.  Ed.  477,  36  L.  R.  A.  (N.  S.)  1040), 
and  if  that  act  does  not  recognize  in  the  wife  a  vaHd  subsisting,  vested 
interest  and  estate  in  the  community  property  during  the  Ufe  of  the 
husband,  language  is  without  meaning  and  legislation  without  avail. 
When  the  husband  had  the  management  and  control  of  the  com- 
munity property,  with  the  like  absolute  power  of  disposition  as  of  his 
own  separate  estate,  a  decision  that  the  wife  had  a  mere  expectancy 

was  plausible,   if  unsound In   all  the  community  property 

states,  from  the  necessity  of  the  case,  the  agency  of  the  husband  as 
head  of  the  family  is  much  broader,  and  his  control  and  dominion 
^over  personal  property  much  greater,  than  in  the  case  of  real  prop- 
erty; but  it  has  never  been  supposed  that  this  difference  lessens  the 
estate  of  the  wife  in  community  personal  property,  or  calls  for  a 
different  rule   of  succession. 

In  so  far  as  the  life  usufruct""  in  favor  of  a  widow  under 
the  Louisiana  Civil  Code  is  concerned,  it  has  been  decided 
that  such  value  is  not  deductible  from  the  gross  estate  in  com- 
puting the  federal  estate  tax.^^ 


"For  a  full  discussion  of  community  property  in  relation  to  the  Rev- 
enue Act  of  1921,  see  pages  395-400. 

"  Blum  V.  Wardell,  270  Fed.  309. 

^  "The  right  of  enjoying  things  belonging  to  another  and  of  drawing 
from  them  all  the  profit  and  advantage  they  will  produce  without  destroying 
or  wasting  their  substance."  (Funk  and  Wagnall's  N civ  Standard  Diction- 
ary.) 

"■  T.  D.  3222. 


1452  MISCELLANEOUS    TAXES 

The  matter  of  community  property  is  dealt  with  generally 
and  conclusively  in  the  following : 

Ruling.  In  Washington,  Arizona,  Idaho,  New  Mexico,  Louisiana 
and  Nevada  there  should  be  included  in  gross  estate,  in  computing 
the  estate  tax  of  a  deceased  spouse,  one-half  only  of  the  community 
property  of  husband  and  wife  domiciled  therein;  this  is  not  based  upon 
any  statute  enacted  subsequent  to  March  i,  1913  and  applies  under 
estate  tax  acts  prior  to  the  Revenue  Act  of  1918.  ^^ 

Texas  is  included  in  the  same  category  as  the  states  enum- 
erated above. ^^ 

Valuation  of  annuities. — 

Regulation.  Where  the  decedent  was  entitled  to  receive  an 
annuity  of  a  definite  amount  during  the  lifetime  of  another  person, 
and  the  right  constitutes  an  asset  of  his  estate,  the  present  worth  of 
the  annuity  at  the  time  of  the  decedent's  death  must  be  computed 
upon  the  basis  of  the  expectancy  of  life  of  the  other  person.  The 
table  marked  "A"  [following]  should  be  used  for  this  computation. 
The  amount  of  annual  income  should  be  multiplied  by  the  figure  in 
column  2  of  the  table  opposite  the  number  of  years  in  column  i 
nearest  to  the  actual  age  of  the  other  person. 

Example :  The  decedent  received  vmder  the  terms  of  his  father's 
will  an  annuity  of  $10,000  for  the  life  of  his  elder  brother.  The 
brother  at  the  decedent's  death  was  40  years  8  months  old.  By  refer- 
ence to  the  table  the  figure  in  column  2  opposite  41  years,  the  number 
nearest  to  the  brother's  age,  is  found  to  be  14.86102.  The  present  worth 
of  the  annuity  is  therefore  $148,610.20. 

Where  the  decedent  was  entitled  to  receive  the  annuity  during 
a  specified  number  of  years,  the  table  marked  "B"  [following]  should 
be  used. 

Example :  The  decedent  received  under  the  terms  of  his  father's 
will  an  annuity  of  $10,000  for  a  period  of  20  years,  15  of  which  had 
expired  at  the  decedent's  death.  By  reference  to  the  table  it  is  found 
that  the  figure  in  column  2  opposite  5  years,  the  unexpired  portion  of 
the  20-year  period,  is  4.45182.  The  present  worth  of  the  annuity  is, 
therefore,  $44,518.20  (4.45182  multiplied  by  10,000). 

Where  the  decedent  was  entitled  to  receive  the  entire  income  of 
certain  property  during  the  life  of  another  or  for  a  term  of  years, 
and  where  the  rate  of  income  is  fixed  by  the  instrument  creating  the 
trust  or  is  definitely  determinable  at  the  time  of  the  decedent's  death. 


"T.  D.  3138. 
"T.  D.  3071. 


FEDERAL  ESTATE  TAX  1453 

the  average  annual  income  which  the  property  actually  yields  should 
be  determined,  and  its  present  worth  computed,  as  explained  above 
in  the  case  of  annuities. 

Example:  The  decedent's  father  placed  $100,000  in  trust,  with 
directions  that  it  be  invested  in  state  and  municipal  bonds  and  the 
entire  income  paid  to  the  decedent  during  the  life  of  his  elder  brother, 
who  was  41  years  old  at  the  decedent's  death.  Before  the  decedent's 
death  the  money  was  invested  in  state  and  municipal  bonds,  and 
actually  yielded  a  net  return  of  $5,000  per  annum.  In  this  case  the 
rate  of  income  is  definitely  determinable.  By  reference  to  the  table 
it  is  found  that  the  present  worth  of  an  income  of  $5,000,  dependent 
upon  the  life  of  a  person  41  years  of  age,  is  $74,305.10  (14.86102  mul- 
tiplied by  5,000). 

Where  the  rate  of  annual -income  is  not  determinable,  or  where 
the  decedent  was  entitled  merely  to  the  personal  use  of  nonincome- 
bearing  property,  a  hypothetical  annuity  at  a  rate  of  4  per  cent  of 
the  value  of  the  property  should  be  made  the  basis  of  the  calculation. 

Example:  The  decedent  died  before  a  fund  of  $100,000,  of  which 
he  was  entitled  to  receive  the  income  during  the  life  of  a  person  41 
years  old,  had  been  invested  by  the  trustees.  The  value  of  a  hypothet- 
ical annuity  of  $4,000,  dependent  upon  the  life  of  such  a  person,  is 
indicated  by  the  table  to  be  $59,444.08. 

Where  the  decedent  possessed  a  remainder  interest  in  property 
subject  to  the  life  estate  of  another,  and  such  interest  constituted  an 
asset  of  his  estate,  the  present  worth  of  the  remainder  interest  at  the 
time  of  death  should  be  obtained  by  multiplying  the  value  of  the 
property  at  the  time  of  death  by  the  figure  in  column  3  of  Table  A 
opposite  the  number  of  years  nearest  to  the  age  of  the  life  tenant. 
Where  the  remainder  interest  is  subject  to  an  estate  for  a  term  of 
years  Table  B  should  be  used. 

Example:  The  decedent  was  entitled  to  receive  property  worth 
$50,000  upon  the  death  of  his  elder  brother,  to  whom  the  income 
for  life  had  been  bequeathed.  The  brother  at  the  time  of  the  de- 
cedent's death  was  31  years  old.  By  reference  to  the  table  it  is 
found  that  the  figure  in  column  3  opposite  31  years  is  0.31262.  The 
present  worth  of  the  remainder  interest  is,  therefore,  $15,631.  (Reg. 
37,  Art.  20.) 

Where  annual  income  is  not  determinable,  the  basis  of  4 
per  cent  to  be  used  in  calculating  the  annuity  is  too  low. 
Resort  to  it  should  not  be  made  until  every  other  evidence  as 
to  possible  income  from  the  source  in  question  has  been  re- 
viewed. For  the  last  two  years  any  "gilt  edge"  interest-bearing 
investment  has  yielded   considerably  more  than  4  per  cent. 


1454 


MISCELLANEOUS    TAXES 


Unless  proof  can  be  established  to  the  contrary,  the  benefit  is 
distinctly  to  the  government  and  not  to  the  taxpayer.  For 
instance,  the  present  worth  of  an  annuity  of  $i  for  twenty 
years  at  4  per  cent  (Table  B-2)  is  $13.59,  whereas  the  same 
annuity  at  8  per  cent  would  show  a  present  worth  of  $9,818. 
Granted  that  a  straight  annuity,  providing  as  it  does  for  the 
average  rate  of  interest  covering  a  period  of  years,  can  be 
estimated  on  a  4  per  cent  basis,  nevertheless,  in  the  hypo- 
thetical instance  illustrated  in  the  regulation,  w^here  $100,000 
was  at  the  disposal  of  the  trustees  for  investment,  it  might 
well  be  that  at  the  time  of  the-  decedent's  death  this  sum 
could  be  invested  in  bonds  yielding  5^  per  cent  to  6  per  cent. 
The  value  under  such  circumstances  should  be  based  on  actual 
market  conditions  rather  than  on  hypothetical  rates  which 
would  not  represent  the  actual  value  at  the  date  of  decedent's 
death,  which  is  the  value  called  for  in  the  law.  It  is  of  interest 
to  note  that  the  first  tables  showing  present  worth  of  life  inter- 
ests in  personal  property  based  on  the  same  rate  as  those 
now  in  existence,  4  per  cent,  were  promulgated  by  the  Com- 
missioner of  Internal  Revenue  as  long  ago  as  December  16, 
1898,  (Spanish  War  Revenue  Act,  1898).  The  Supreme 
Court  of  the  United  States  expressed  the  opinion  that  "at  the 
time  this  tax  was  collected  (1899)  4  per  cent  was  very  gen- 
erally assumed  to  be  the  fair  value  or  earning  power  of  money 
safely  invested."'* 

Dower  and  Curtesy. — 

Law.  Section  402.  That  the  value  of  the  gross  estate  of  the 
decedent  shall  be  determined  by  including  the  value  at  the  time  of 
his  death  of  all  property,  real  or  personal,  tangible  or  intangible, 
wherever  situated — 

(b)  To  the  extent  of  any  interest  therein  of  the  surviving  spouse, 
existing  at  the  time  of  the  decedent's  death  as  dower,  curtesy,  or  by 
virtue  of  a  statute  creating  an  estate  in  lieu  of  dower  or  cur- 
tesy  


-\Siiiipson  V.  United  States,  252  U.  S.  547,  40  S.  Ct.  367,  64  L.  Ed.  700. 


FEDERAL   ESTATE   TAX 


1455 


Table  "A." 

Table,  single  life,  4  per'  cent,  showing  the  present  worth  of  an  annuity, 
or  life  interest,  and  of  a  reversionary  interest. 


1 

2 

3 

1 

2 

3 

Annuity,  or 

Reversion,  or 

Annuity,  or 

Reversion,    or 

present  value 

present  value 

present  value 

present  value 

of  $1  due  at 

of  $1  due  at 

of  $1  due  at 

of  $1  due  at 

Age. 

the  end  of  each 

the  end  of  the 

Age. 

the  end  of  each 

the  end  of  the 

year  during  the 

year  of  death 

year  du'ring  the 

year  of  death 

life  of  a  person 

of  a  person   of 

life  of  a  person 

of  a  person   of 

of  specified  age. 

specified  age. 

of  specified  age. 
Annuity. 

specified  age. 

Annuity. 

Reversion,    or 

Reversion. 

0 

$14.72829 

$0.39507 

51 

$12.17919 

$0.49311 

1 

17.30771 

.29586 

52 

11.88408 

.50446 

2 

18.69578 

.24247 

53 

11.58531 

.51595 

3 

19.15901 

.22465 

54 

11.28323 

.52757 

4 

19.41226 

.21491 

55 

10.97789 

.53931 

5 

19.55301 

.20950 

56 

10.60982 

.55116 

6 

19.61731 

.20703 

57 

10.35931 

.56310 

7 

19.62502 

.20673 

58 

10.04630 

.57514 

8 

19.61097 

.20727 

59 

9.73131 

.58726 

9 

19.53413 

.21022 

60 

9.41474 

.59943 

10 

19.45359 

.21332 

61 

9.09765 

.61163 

11 

19.36943 

.21656 

62 

8.78052 

.62382 

12 

19.28184 

.21993 

63 

8.46412 

.63600 

13 

19.19065 

.22344 

64 

8.14888 

.64812        1 

14 

19.09590 

.22708 

65 

7.83552 

.66017 

15 

18.99764 

.23086 

66 

7.52476 

.67212 

16 

18.89569 

.23478 

67 

7.21699 

.68397 

17 

18.79010 

.23884 

68 

6.91298 

.69S6S 

18 

18.68070 

.24305 

69 

6.61301 

.70719 

ly 

18.56751 

.24740 

70 

6.31716 

.71857 

20 

18.45038 

.25191 

71 

6.02612 

.72976 

21 

18.32932 

.25656 

72 

5.74003 

.74077 

22 

18.20416 

.26138 

7i 

5.45928 

.75157 

23 

18.07471         1 

.26636 

74 

5.18402 

.76215 

24 

17.94097 

.27150 

75 

4.91463 

.77251 

25 

17.80274 

.27682 

76 

4.65125 

.78264 

26 

17.65984 

.28231 

77 

4.39383 

.79254 

27 

17.51224 

.28799 

78 

4.14286 

.80220 

28 

17.35968 

.29386 

79 

3.89858 

.81159 

29 

17.20225 

.29991 

80 

3.66071 

.82074 

30 

17.03961 

.30617 

81 

3.42900 

.82965 

31 

16.87176 

.31262 

82 

3.20258 

.83836 

32 

16.69846 

.31929 

83 

2.98024 

.84691 

a 

16.51964 

.32617 

84 

2.76106 

.85534 

34 

16.33503 

.33327 

85 

2.54366 

.86371 

35 

16.14437 

.34060 

86 

2.32795 

.87200 

36 

15.94755 

.34817 

87 

2.11384 

.88024 

37 

15.74427 

.35599 

88 

1.90115 

.88842 

38 

15.53421 

.36407 

89 

1.69107 

.89650 

39 

15.31722 

.37241 

90 

1.48540 

.90441 

40 

15.09295 

.38104 

91 

1.28432 

.91214 

41 

14.86102 

.38996 

92 

1.09024 

.91961 

42 

14.62122 

.39918 

93 

.90647 

.92667 

43 

14.37356 

.40871 

94 

.73687 

.93320 

44 

14.11860 

.41852 

95 

.58435 

.93906 

45 

13.85713 

.42857 

96 

.46182 

.94378 

46 

13.58958 

.43886 

97 

.36698 

.94742 

47 

13.31698 

.44935 

98 

.24038 

.95229 

48 

13.03942 

.46002 

99 

.00000 

.96154 

49 

12.75716 

.47088 

50 

12.47032 

.48191 

1456 


MISCELLANEOUS    TAXES 
Table  "B." 


1 

2 

Present   worth 

3 

1 

2 

Present  worth 

3 

of  an  annuity 

Present  worth 

of  an  annuity 

Present  worth 

Number 

of  $1,  payable 

of  $1,  payable 

Number 

of  $1,  payable 

of  $1,  payable 

of  years. 

at   the  end   of 
each  year,  for 

at  the  end  of 
a  certain  num- 

of years. 

at   the  end   of 
each  year,  for 

at  the  end  of 
a  certain  num- 

a certain  num- 

ber of  years. 

a  certain  num- 

ber of  years. 

ber  of  years,    i 

ber  of  years. 

Annuity. 

Reversion. 

Annuity. 

Reversion. 

1 

$0.96154         \ 

$0.961538 

16 

$11.65229 

$0.533908 

2 

1.88609 

.924556 

17 

12.16567 

.513373 

3 

2.77509         I 

.888996 

18 

12.65929 

.493628 

4 

3.62989 

.854804 

19 

13.13394 

.474642 

5 

4.45182 

.821927 

20 

13.59032 

.456387 

6 

5.24214 

.790314 

21 

14.02916 

.438834 

7 

6.00205         i 

.759918 

22 

14.45111 

.421955 

8 

6.73274 

.730690 

23 

14.85684 

.405726 

9 

7.43533 

.702587 

24 

15.24696 

.390121 

10 

8.11089 

.675564 

25 

15.62208 

.375117 

11 

8.76047 

.649581 

26 

15.98277 

.360689 

12 

9.38507 

.624597 

27 

16.32958 

.346816 

13 

9.98565 

.600574 

28 

16.66306 

.333477 

14 

10.56312 

.577475 

29 

16.98371 

.320651 

IS 

11.11839 

.555265 

30 

17.29203 

.308319 

Regulation.  The  provision  includes  dower  and  courtesy  and 
all  interests  created  by  statute  in  lieu  thereof,  although  the  estate 
or  interest  so  created  is  different  in  character.  The  effect  of  the 
provision  is  to  require  the  inclusion  of  the  full  value  of  the  property, 
without  deduction  of  the  value  of  the  interest  of  the  surviving  hus- 
band or  wife.  This  rule  does  not  apply  to  the  estate  of  any  decedent 
dying  after  September  8,  1916,  and  prior  to  6:55  p.  m.,  February 
24th,  1919  (the  effective  date  of  Title  IV  of  the  Revenue  Act  of  1918), 
unless  the  property  has  its  situs  in  a  jurisdiction  wherein  dower, 
courtesy,  or  the  statutory  interest  in  lieu  thereof,  is  subject  to  the 
payment  of  charges  against  the  estate,  and  the  expenses  of  its  admin- 
istration and  is  subject  to  distribution  as  part  of  the  estate,  or  unless 
there  has  been  an  election  to  take  property  devised  or  bequeathed  in 
lieu  of  dower,  courtesy,  or  such  statutory  interest,  and  the  property  so 
taken  has  its  situs  in  a  jurisdiction  by  the  laws  of  which  it  is  subject 
to  the  payment  of  such  charges  and  expenses,  and  to  distribution 
as  part  of  the  estate.  (Reg.  37,  Art  21,  as  revised  by  T.  D.  3165, 
May  18,  1921.) 

Transfers  by  decedent  in  his  lifetime. — Under  ordinary 
circumstances  it  is  somewhat  difficult  to  substantiate  the  fact 
that  a  transfer  of  property,  either  by  means  of  a  trust  or 
otherwise,  made  without  consideration  and  within  two  years  of 
death,  was  not  executed  in  contemplation  of  death.  This  dif- 
ficulty is  not  lessened  by  the  burden  of  proof  resting  on  the 
executor  to  show  the  contrary. 


FEDERAL  ESTATE  TAX  1457 

Law.  Section  402.  That  the  value  of  the  gross  estate  of  the 
decedent  shall  be  determined  by  including  the  value  at  the  time  of  his 
death  of  all  property,  real  or  personal,  tangible  or  intangible,  where- 
ever  situated 

(c)  To  the  extent  of  any  interest  therein  of  which  the  decedent 
has  at  any  time  made  a  transfer,  or  vsrith  respect  to  which  he  has  at 
any  time  created  a  trust,  in  contemplation  of  or  intended  to  take  effect 
in  possession  or  enjoyment  at  or  after  his  death  (whether  such  transfer 
or  trust  is  made  or  created  before  or  after  the  passage  of  this  Act),  ex- 
cept in  case  of  a  bona  fide  sale  for  a  fair  consideration  in  money  or 
money's  worth.  Any  transfer  of  a  material  part  of  his  property  in 
the  nature  of  a  final  disposition  or  distribution  thereof,  made  by  the 
decedent  within  two  years  prior  to  his  death  without  such  a  con- 
sideration, shall,  unless  shown  to  the  contrary,  be  deemed  to  have 
been  made  in  contemplation  of  death  within  the  meaning  of  this 
title;     .... 

Regulations.  A  transfer  made  by  the  decedent  in  his  lifetime, 
if  made  by  way  of  gift,  is  taxable  when  made  in  contemplation  of 
death,  or  intended  to  take  effect  in  possession  or  enjoyment  at  or 
after  the  death  of  the  transferor.  No  distinction  is  made  between 
ordinary  transfers  and  transfers  involving-  the  creation  of  a  trust. 
Where  a  transfer,  however,  constitutes  a  bona  fide  sale  for  a  fair 
consideration  in  money  or  money's  worth,  it  is  not  taxable.  In  order  to 
constitute  such  a  bona  fide  sale,  there  must  be  a  valuable  consider- 
ation, as  distinguished  from  love  and  affection.  A  sale  implies  the 
receipt  of  a  price,  in  money  or  thing  of  value.  The  release  of  an 
existing  claim,  by  way  of  accord  and  satisfaction,  is  not  sufficient. 
The  price  must  also  be  a  fair  equivalent  for  the  property  transferred. 
Where  the  price  is  not  a  fair  one,  the  sale  will  not  be  considered  to 
have  been  made  bona  fide.  Such  transfers  are  taxable  whether  made 
before  or  after  September  8,  1916.     (Reg.  37,  Art.  22.) 

The  words  "in  contemplation  of  death"  do  not  refer  to  the  gen- 
eral expectation  of  death  which  all  persons  entertain.  A  transfer, 
however,  is  made  in  contemplation  of  death  wherever  the  person 
making  it  is  influenced  to  do  so  by  such  an  expectation  of  death, 
arising  from  bodily  or  mental  conditions,  as  prompts  persons  to  dis- 
pose of  their  property  to  those  whom  they  deem  proper  objects  of 
their  bounty.  The  cause  which  induces  such  bodily  or  mental  condi- 
tions is  immaterial ;  and  it  is  not  necessary  that  the  decedent  be  in  the 
immediate  expectation  of  death.  Such  a  transfer  is  taxable,  although 
the  decedent  parts  absolutely  and  immediately  with  his  title  to  and 
possession  of  the  property.  Transfers  made  within  two  years  of  a 
decedent's  death  are  presumed  to  be  taxable  if  they  are  of  a  material 
part  of  his  property  and  are  in  the  nature  of  a  final  disposition  thereof. 
Where  a  transfer  is  of  this  character,  the  executor  must  disclose 
the   transfer   in  the   return;  but  he  may  submit  therewith   evidence 


1458  MISCELLANEOUS    TAXES 

that  it  was  not  made  in  contemplation  of  death.  The  executor  must 
also  return  transfers  by  the  decedent  of  a  material  part  of  his  property 
to  relatives,  though  made  more  than  two  years  before  his  death ;  but 
he  need  not  list  them  as  taxable  if  he  contends  otherwise.  All  facts 
relating  to  the  transfer  should  be  stated,  including  the  motive  therefor, 
the  decedent's  state  of  health,  and  his  anticipation  of  death.  The  pre- 
sumption of  taxability  may  be  rebutted  by  proof  that  the  transfer 
was  not  induced  by  bodily  or  mental  conditions  leading  the  grantor 
to  make  a  disposition  of  property  testamentary  in  its  nature.  The 
fact  that  a  gift  was  made  as  an  advancement,  to  be  taken  into  account 
upon  the  final  distribution  of  the  decedent's  estate,  is  not  enough, 
standing  alone,  to  establish  taxability:  but  it  is  a  circumstance  to  be 
considered  in  determining  whether  the  transfer  was  made  in  contem- 
plation of  death.     (Reg.  37,  Art.  23.) 

The  expression,  "in  contemplation  of  death,"  was  held  in 
the  United  States  Circuit  Court  of  Appeals^^  not  to  mean  "on 
the  one  hand  the  general  expectancy  of  death  which  is  enter- 
tained by  all  persons,  nor,  on  the  other,  is  the  meaning  of  the 
term  necessarily  limited  to  an  expectancy  of  immediate  death 
or  dying  conditions.  Nor  is  it  necessary,  in  order  to  constitute 
a  transfer  in  contemplation  of  death,  that  the  conveyance 
or  transfer  be  made  while  death  is  imminent,  or  immediately 
impending  by  reason  of  ill  health,  disease,  injury  or  like  physi- 
cal condition.  But  a  transfer  may  be  said  to  be  made  in 
contemplation  of  death  if  the  expectancy  or  anticipation  of 
death  in  either  the  immediate  or  reasonably  near  future 
is  the  moving  cause  of  the  transfer." 

Generally  speaking,  the  only  argument  in  support  of  the 
contention  that  transfers  within  two  years  were  not  in  con- 
templation of  death,  that  can  be  urged  with  a  measurable 
promise  of  success,  arises  where  a  sequence  of  events  shows 
that  the  decedent,  having  had  an  eminently  satisfactory  busi- 
ness career,  decides  gradually  to  relinquish  an  active  control 
of  his  interest  and  to  enjoy  the  remainder  of  his  life  in  w'ell- 
earned  ease.  In  such  a  case,  the  decedent  is  not  contemplating 
death  but  rather  a  new  lease  of  enjoyable  life.  The  material 
factor  then  is  the  ultimate  cause  of  death.     Should  it  be  that 


'  Shzvab  V.  Doyle,  269  Fed.  321. 


FEDERAL  ESTATE  TAX  1459 

the  state  of  decedent's  health  at  the  time  the  transfer  was 
effected  showed  symptoms  of  the  disease  or  aihnent  which  was 
the  uUimate  cause  of  death,  there  is  very  httle  hkeHhood  that 
any  proof,  however  strong  in  circumstantial  evidence,  would 
enable  the  executor  to  prove  that  the  property  transferred  was 
not  in  contemplation  of  death  within  the  meaning  of  the  law. 
The  last  hope  would  center  in  affidavits  from  reputable  doc- 
tors to  the  effect  that  although  such  symptoms  must  have  ex- 
isted, decedent  might  be  quite  ignorant  of  their  fatal  signifi- 
cance— could  such  conceivably  be  the  case.  A  widow,  one  year 
before  death,  conveyed  by  means  of  an  absolute  transfer  a 
considerable  amount  of  personal  property.  She  died  of  apo- 
plexy primarily  resulting  from  hardening  of  the  arteries. 
Held,  the  trust  was  created  in  contemplation  of  death. ^^ 

The  ultimate  disposition  of  a  transfer  effected  less  than 
two  years  before  death  depends  entirely  upon  the  available 
evidence  and  arguments  showing  the  intention  of  the  decedent. 
It  is  important  that  all  of  the  evidence  be  assembled  in  the 
brief,  which  should  be  filed  in  support  of  the  claim.  Due 
regard  should  be  given  to  the  contingencies  discussed  in  the 
following  regulations : 

Regulations.  A  transfer  is  taxable  where  the  grantor  reserves 
to  himself  during  life  the  income  of  the  property  transferred.  In 
such  a  case  the  transfer  of  the  principal  takes  effect  in  possession  and 
enjoyment  after  the  death  of  the  grantor,  and  the  value  of  the  entire 
property  should  be  included  in  the  gross  estate.  Where  the  grantor 
reserves  a  proportionate  part  of  the  income,  only  a  corresponding 
proportion  of  the  property  should  be  included  in  the  gross  estate, 
unless  the  transfer  was  made  in  contemplation  of  death.  If,  for 
example,  he  reserves  one-half  of  the  income,  the  value  of  one-half  of 
the  property  transferred  should  be  included  in  the  gross  estate.  If  he 
reserves  an  annuity,  so  much  of  the  property  as  is  necessary  to  produce 
the  annuity  should  be  included  in  the  gross  estate.  Where  the 
property  does  not  produce  income,  its  value  as  of  the  date  of 
the  decedent's  death  should  be  ascertained,  and  so  much  of  this  sum 
as  is  necessary  to  produce  the  annuity  should  be  included  in  the  gross 
estate.  A  transfer  is  taxable  in  accordance  with  these  principles 
whether  the  grantor  makes  a  reservation  of  the  annuity  out  of  the 


'"  Shzmb  V.  Doyle,  269  Fed.  321. 


1460  MISCELLANEOUS   TAXES 

property  conveyed,  or  exacts  from  the  grantee  an  agreement  to  pay 
the  annuity.  A  gift  of  the  principal  of  a  trust  fund  which  takes 
effect  at  or  after  the  decedent's  death  is  taxable,  although  the  income 
during  the  decedent's  life  is  payable  to  some  one  other  than  himself. 
Example :  The  decedent  transfers  property  to  his  son,  the  latter 
agreeing  to  pay  the  income  to  his  mother  during  the  decedent's  life. 
The  transfer  to  the  son  is  taxable.     (Reg.  37,  Art.  24.) 

Property  held  in  trust  under  any  instrument  in  which  the  grantor 
has  reserved  a  power  of  revocation,  or  any  power  which  has  that 
effect,  constitutes  a  part  of  the  gross  estate  of  such  grantor  for  the 
purposes  of  this  tax.  For  example,  where  a  father  places  property 
in  trust  for  the  present  benefit  of  his  son,  but  reserves  power  to  re- 
voke the  trust  at  any  time  during  his  life,  the  value  of  the  entire 
property  transferred  should  be  included  in  the  gross  estate.  (Reg. 
37,  Art.  25.) 

Valuation  of  property  transferred. — The  rules  of 
valuation  already  dealt  with  apply  to  property  inckided  under 
the  caption  of  transfers.  The  value  at  the  time  of  decedent's 
death  includes  only  the  original  property  transferred;  any 
additions  or  betterments  effected  by  the  transferee,  or  portions 
of  trust  not  originally  contributed  or  owned  by  the  decedent 
are  excluded  from  inclusion  in  the  gross  estate. 

Regulation.  The  property  to  be  valued  is  the  interest  owned 
and  transferred  by  the  decedent ;  but  the  value  of  such  property  must 
be  ascertained  as  of  the  date  of  the  decedent's  death.  Where  the 
transferee  makes  additions  to  the  property,  or  betterments,  the  value 
of  the  additions  or  betterments  at  the  time  of  death  are  not  to  be 
included.  For  example,  a  father  makes  a  transfer  to  a  son,  in 
contemplation  of  death,  of  unimproved  real  estate  valued  at  $20,000. 
The  son  erects  buildings  on  the  land  at  a  cost  of  $10,000.  The 
amount  to  be  included  in  the  gross  estate  of  the  father  is  the  value 
of  the  entire  property  at  the  time  of  his  death  less  the  value  of  the 
buildings  on  that  date.     (Reg.  ■^y,  Art.  26.) 

Property  held  jointly. — The  following  section  of  the  192 1 
law  is  considerably  enlarged  as  compared  with  the  same  section 
in  the  1918  law.  In  the  latter  any  property  which  at  any 
time  had  been  in  the  possession  of  the  decedent  was  to  be 
included  in  the  gross  estate.  The  new  provision  allowing  for 
the  inclusion  of  what  may  have  been  acquired  from  the  de- 


FEDERAL  ESTATE  TAX  1461 

cedent  for  a  fair  consideration,  or  in  any  case  up  to  the  amount 
of  such  consideration,  removes  an  obvious  hardship  to  the 
taxpayer  which  resulted  under  the  arbitrary  provision  of  the 
1918  law.  Gifts  or  bequests  common  to  both  spouses,  also 
now  for  the  first  time  included  in  this  section,  are  placed  on 
an  equitable  basis  by  law. 

Law.  Section  402.  That  the  value  of  the  gross  estate  of  the 
decedent  shall  be  determined  by  including  the  value  at  the  time  of 
his  death  of  all  property,  real  or  personal,  tangible  or  intangible, 
wherever  situated 

(d)  To  the  extent  of  the  interest  therein  held  jointly  or  as  tenants 
in  the  entirety  by  the  decedent  and  any  other  person,  or  deposited  in 
banks  or  other  institutions  in  their  joint  names  and  payable  to  either 
or  the  survivor,  except  such  part  thereof  as  may  be  shown  to  have 
originally  belonged  to  such  other  person  and  never  to  have  been 
received  or  acquired  by  the  latter  from  the  decedent  for  less  than  a 
fair  consideration  in  money  or  money's  worth:  Provided,  That  where 
such  property  or  any  part  thereof,  or  part  of  the  consideration  with 
which  such  property  was  acquired,  is  shown  to  have  been  at  any  time 
acquired  by  such  other  person  from  the  decedent  for  less  than  a  fair 
consideration  in  money  or  money's  worth,  there  shall  be  excepted  only 
such  part  of  the  value  of  such  property  as  is  proportionate  to  the  con- 
sideration furnished  by  such  other  person:  Provided  further,  That 
where  any  property  has  been  acquired  by  gift,  bequest,  devise,  or  in- 
heritance, as  a  tenancy  in  the  entirety  by  the  decedent  and  spouse,  or 
where  so  acquired  by  the  decedent  and  any  other  person  as  joint 
tenants  and  their  interests  are  not  otherwise  specified  or  fixed  by  law, 
than  to  the  extent  of  one-half  of  the  value  thereof;   .    .    .    .-^ 

Regulation.  The  statute  prorvides  for  the  taxation  of  interests 
held  jointly,  or  as  tenants  in  the  entirety,  by  the  decedent  and  any 
other  person  or  persons.  This  class  of  property  includes  all  interests, 
whether  in  real  or  personal  property,  in  which  the  survivor  takes  the 
entire  property  by  right  of  survivorship,  and  it  consequently  does  not 
form  part  of  the  decedent's  estate  for  purposes  of  administration. 
It  does  not  include  interests  held  as  tenants  in  common,  where  the 
interest  of  each  tenant  passes  to  his  estate,  free  from  any  right  of 
survivorship. 


'-''  [Former  Procedure]     1918  Law.     Section  402 (d)  To  the  » 

extent  of  the  interest  therein  held  jointly  or  as  tenants  in  the  entirety 
by  the  decedent  and  any  other  person,  or  deposited  in  banks  or  other  insti- 
tutions in  their  joint  names  and  payable  to  either  or  the  survivor,  except 
such  part  thereof  as  may  be  shown  to  have  originally  belonged  to  such  other 
person  and  never  to  have  belonged  to  the  decedent;  .... 


1462  MISCELLANEOUS    TAXES 

The  following  are  examples  of  this  class  of  property :  Real  estate 
held  jointly;  real  estate  held  by  husband  and  wife  (known  as  an 
estate  in  the  entirety)  ;  money  deposited  in  a  bank  or  trust  company 
in  the  joint  names  of  the  decedent  and  another  and  payable  to  either 
or  the  survivor ;  joint  trading  accounts  with  brokers ;  stocks  and 
bonds  held  in  the  joint  names  of  several  owners.     (Reg.  37,  Art.  27.) 

The  regulations  which  govern  the  corresponding  section 
of  the  1 9 18  law^*  interpreted  that  section  in  accord  with  what 
is  now  included  in  the  law  itself. 

The  expression  "originally  belonged"  has  been  interpreted 
(T.  D.  3225)  as  referring,  not  to  the  time  of  death,  but 
to  the  time  a  joint  interest  was  created.  The  act  does  not 
become  retroactive  because  it  measures  a  transfer  tax  on  pro- 
perty which  decedent  has  given  away  in  his  lifetime.  In 
other  words,  the  passing  of  property  has,  generally  speaking,  to 
be  taxed  under  the  estate  tax  law  sooner  or  later,  and  the 
establishment  of  trusts  or  joint  interests  does  not  automatic- 
ally release  property  of  the  decedent  therein  included  from 
the  application  of  the  law.  A  surviving  tenant's  original  half 
interest  in  a  joint  tenancy  created  prior  to  the  enactment  of 
the  statute  has  been  held  to  form  part  of  the  decedent's  gross 
estate.^® 

Property  passing  under  power  of  appointment. — The  in- 
tention of  the  law  is  to  reach  all  the  property  which  a  decedent 
had  enjoyed  during  his  lifetime.  This  includes  not  only  such 
as  he  owned  but  also  property  of  which  he  had  merely  the 
right  to  direct  the  disposition  b}'  his  will  or  by  a  deed. 

Law.  Section  402;.  That  the  value  of  the  gross  estate  of  the 
decedent  shall  be  determined  by  including  the  value  at  the  time  of 
his  death  of  all  property,  real  or  personal,  tangible  or  intangible,  where- 
ever  situated — 

(e)  To  the  extent  of  any  property  passing  under  a  general  power 
of  appointment  exercised  by  the  decedent  (i)  by  will,  or  (2)  by  deed 
executed  in  contemplation  of,  or  intended  to  take  effect  in  possession 


"'Reg.  37,  1918,  Arts.  28  and  2g. 

"  McElligott  V.  Kissam  et  al.,  U.  S.  Circuit  Court  of  Appeals,  Second 
Circuit,  June  30,  1921,  Advance  Opinions,  275  Fed.  545. 


FEDERAL  ESTATE  TAX  1463 

or  enjoyment  at  or  after,  his  death,  except  in  case  of  a  bona  fide  sale 
for  a  fair  consideration  in  money  or  money's  worth;  .... 

The  provision  made  in  this  section,  which  is  the  same  in 
the  19 18  law,  was  included  in  that  law  in  order  specifically 
to  embrace  property  transferred  by  a  power  of  appointment. 
Section  202  (c)  of  the  Revenue  Act  of  191 6  served  as  a 
general  provision  which  was  intended  to  include  such  property 
in  its  provisions.  This  intent  was  more  or  less  obscure.  The 
1916  law  relied  upon  the  rule  generally  followed,  that  equity 
will  regard  the  property  appointed  under  a  power  of  appoint- 
ment, either  by  deed  or  will,  as  part  of  the  assets  of  the  ap- 
pointor. Nevertheless,  it  was  held  that,  "The  Revenue  Act  of 
191 6  did  not  impose  an  estate  tax  upon  property  passing  under 
a  testamentary  execution  of  a  general  power  of  appointment."^" 
Hence  the  direct  provision  in  the  statutes  subsequent  to  1916. 

By  "a  general  power  of  appointment"  is  meant  the  power 
which  is  often  given  by  a  will  to  the  life  beneficiary  of  a  trust 
fund  to  name  or  appoint  the  persons  who  shall  receive  the  prin- 
cipal after  his  life  estate  shall  have  terminated.  Such  prin- 
cipal, under  the  estate  tax  law,  is  taxable  as  the  property 
of  the  life  beneficiary  at  his  death  if  he  exercises  the  power  of 
appointment  by  his  will  or  by  a  deed  made  in  contemplation 
of  death  or  intended  to  take  effect  at  or  after  his  death  (except 
in  the  case  of  a  bona  fide  sale  for  a  fair  consideration).  The 
principal  is  therefore  to  be  included  in  the  appointor's  gross 
estate. 

Regulation.  As  a  general  rule,  property  passing  under  a  gen- 
eral power  of  appointment  must  be  included  in  the  gross  estate  of 
the  person  exercising  the  power  (known  as  the  donee,  or  appointor) 
where  the  power  is  exercised  by  will,  or  by  deed  executed  in  contempla- 
tion of  death,  or  intended  to  take  effect  at  or  after  death.  This  gen- 
eral rule  applies  wherever  the  decedent  died  after  September  8,  1916, 
although  the  power  was  created  prior  to  that  date.  In  certain  cases, 
however,  the  transfer  is  taxable  under  the  Revenue  Act  of  1918  when 
it  would  not  be  taxable  under  the  Revenue  Act  of  1916  (See  Art.  31). 

Only  property  passing  under  a  general  power  should  be  included. 


'"'  U.  S.  V.  Field,  255  U.  S.  257,  65  L.  Ed.  355,  4i  Sup.  Ct.  256,  October 
Term,  1920. 


1464  MISCELLANEOUS    TAXES 

A  general  power  is  one  to  appoint  to  any  person  or  persons  in  the  dis- 
cretion of  the  donee.  Where  the  donee  is  required  to  appoint  to 
a  specified  person  or  class  of  persons,  the  property  should  not  be 
included  in  his  gross  estate.  Property  appointed  under  a  general 
power  should  be  included  in  the  estate  of  the  appointor,  although  the 
persons  to  whom  the  appointment  was  made  would  have  taken  the 
property  had  the  power  not  been  exercised.  A  copy  of  the  instru- 
ment granting  the  power  should  be  filed  with  Form  706  in  all  cases 
in  order  that  the  Bureau  may  determine  whether  the  power  is  general 
or  special. 

Example :  The  income  of  property  is  left  to  a  person  for  life, 
with  the  right  to  name  in  his  will  the  person  who  shall  receive  it 
upon  his  death.  He  exercises  this  pow-er  in  his  will.  Upon  his  death, 
if  occurring  after  September  8,  1916,  the  property  so  appointed  should 
be  included  in  his  gross  estate.     (Reg.  37,  Art.  30.) 

Regulation.  The  Revenue  Act  of  1918  taxes  all  transfers  ef- 
fected by  the  exercise  of  a  general  power  of  appointment,  provided 
the  exercise  was  by  will,  or  by  deed  made  in  contemplation  of  death, 
or  intended  to  take  effect  at  or  after  death.  It  follows  that  all  trans- 
fers of  this  character,  where  the  decedent  died  after  February  24, 
1919,  are  taxable,  and  the  property  must  be  included  in  the  gross 
estate. 

Where  the  decedent  died  between  September  8,  191 6,  and  Feb- 
ruary 25,  1919,  the  taxability  of  the  transfer  depends  upon  whether 
the  property  was  subject  to  the  claims  of  the  creditors  of  the  ap- 
pointor, in  preference  to  the  person  or  persons  in  whose  favor  the 
power  was  exercised.  The  general  rule  is,  that  the  property  is  so 
subject;  and  it  should  consequently  be  included  in  the  gross  estate 
unless  this  rule  has  been  abrogated  in  the  State  whose  laws  determine 
the  nature  and  effect  of  the  transfer.  All  such  transfers  should  be 
disclosed  to  the  Bureau  in  order  that  it  may  pass  upon  the  question 
of  taxability.     (Reg.  37,  Art.  31.) 

The  right  to  tax  property  passing  under  a  power  of  appoint- 
ment does  not  solely  depend  on  whether  or  not  the  property 
is  subject  to  the  claims  of  the  creditors  of  the  appointor. 
Such  property  to  be  subject  to  the  estate  tax  involved  must 
also  be  property  subject  to  distribution  as*  a  part  of  the  dece- 
dent's estate.  "It  is  the  general  rule  of  the  common  law  sub- 
ject to  certain  exceptions,  that  the  appointee  of  an  estate  takes 
from  the  original  donor  and  not  from  the  donee  of  the 
power."^^ 


Ebersok  v.  McGrath,  271  Fed.  995. 


FEDERAL  ESTATE  TAX  1465 

Insurance.— It  is  recognized  that  a  reasonable  amount  of 
life  insurance  should  pass  to  beneficiaries  free  from  tax.  The 
amount  exempted  in  the  1921  law  is  $40,000,  just  as  under  the 
1918  law. 

Law.  Section  402.  That  the  value  of  the  gross  estate  of  the 
decedent  shall  be  determined  by  including  the  value  at  the  time  of 
his  death  of  all  property,  real  or  personal,  tangible  or  intangible, 
wherever  situated —  .... 

(f)  To  the  extent  of  the  amount  receivable  by  the  executor  as  in- 
surance under  policies  taken  out  by  the  decedent  upon  his  ov^n  life; 
and  to  the  extent  of  the  excess  over  $40,000  of  the  amount  receivable 
by  all  other  beneficiaries  as  insurance  under  policies  taken  out  by  the 
decedent  upon  his  own  life. 

Regulation.  The  statute  provides  for  the  inclusion  in  the  gross 
estate  of  certain  forms  of  insurance  taken  out  by  the  decedent  upon 
his  own  life.  Two  kinds  of  insurance  are  taxable:  (a)  all  insurance 
payable  to  the  estate;  (b)  insurance  payable  to  individual  beneficiaries 
to  the  extent  that  it  exceeds  $40,000.  The  term  "insurance"  refers 
to  life  insurance  of  every  description,  including  death  benefits  paid 
by  fraternal  beneficial  societies,  operating  under  the  lodge  system. 
Insurance  is  deemed  to  be  taken  out  by  the  decedent  in  all  cases 
where  he  pays  the  premiums,  either  directly  or  indirectly,  whether  or 
not  he  inakes  the  application.  On  the  other  hand^  the  insurance 
should  not  be  included  in  the  gross  estate,  even  though  the  application 
is  made  by  the  decedent,  where  the  premiums  are  actually  paid  by 
some  other  person  or  corporation,  and  not  out  of  funds  belonging  to, 
or  advanced  by,  the  decedent.  Where  the  decedent  takes  out  insurance 
in  favor  of  another  person  or  corporation,  as  collateral  security  for 
a  loan  or  another  accommodation,  and  the  decedent,  either  directly  or 
indirectly,  pays  the  premiums  thereon,  the  insurance  must  be  con- 
sidered in  determining  whether  there  is  an  excess  over  $40,000. 
Where  the  decedent  assigns  a  policy,  and  retains  no  interest  therein, 
and  thereafter  pays  no  part  of  the  premiums,  the  insurance  will  not 
be  considered  in  determining  whether  there  is  such  a  taxable  excess. 
(Reg. ^7,  Art.  32.) 

When  premiums  are  paid  by  other  persons  and  the  executor 
is  not  required  to  include  the  proceeds  of  the  insurance  in  the 
gross  estate  of  the  decedent,  care  must  be  exercised  to  see  that 
such  payments  were  not  constructive  payments  by  the  deceased; 
as,  for  instance,  where  premiums  are  paid  by  a  corporation 
on  behalf  of  an  official  as  part  of  the  latter' s  compensation 
for  services,   the  benefit  of   such   insurance  accruing  to   the 


1466  MISCELLANEOUS   TAXES 

official's  heirs  or  assigns.  This  benefit  would  form  part  of 
the  gross  estate  in  so  far  as  it,  or  any  portion  of  it,  was  in 
excess  of  $40,000.  All  insurance  coming  under  the  provisions 
of  this  section  must  be  included  in  detail  in  schedule  C  of  form 
706.  The  amounts  of  insurance  payable  to  beneficiaries,  other 
than  the  executor,  not  in  excess  of  $40,000,  are  not  extended. 
The  balance,  if  any,  is  extended  and  so  comprised  in  the  total 
gross  estate  reported  in  this  schedule.  The  inclusion  of  insur- 
ance eftected  as  security  for  indebtedness  is  obviously  correct, 
the  indebtedness  itself  being  an  offset  for  inclusion  in  deduc- 
tions from  gross  estate  in  schedule  I. 

The  constitutionality  of  taxing  the  proceeds  from  life 
insurance  policies  payable  to  beneficiaries  other  than  the  es- 
tates of  decedents  is  open  to  question.  The  estate  tax  is 
"imposed  upon  the  transfer  of  the  net  estate  of  every  dece- 
dent."^^  The  estate  of  the  decedent  consists  of  all  property 
of  which  the  decedent  dies  seized  and  possessed,  and  which 
can  be  devised  by  him;  or,  if  he  dies  intestate,  is  distributed 
according  to  the  statutes  of  descent  and  distribution  as  pro- 
vided by  law.  The  property  is  of  such  a  nature  as  to  be  liable 
for  his  debts.  The  proceeds  of  life  insurance  which  do  not 
go  to  a  decedent's  estate  never  formed  any  part  of  the  dece- 
dent's estate,  nor  were  they  liable  for  his  debts.  Where  en- 
dorsed to  a  third  party,  no  reversionary  interest  or  equity 
entered  into  the  value  of  the  decedent's  estate  prior  to  his 
death. 

In  this  connection  the  following  dissenting  opinion  of  Mr. 
Justice  Holmes  is  pertinent : 

Decision If   the   succession    has    fully   vested,   or    has 

passed  beyond  dependence  upon  the  continuing  of  the  state's  permis- 
sion or  grant,  an  attempt  to  levy  a  tax  under  the  power  to  regulate 
succession  would  be  an  attempt  to  appropriate  property  in  a  way 
which  the  14th  Amendment  has  been  construed  to  forbid.  ^^ 

A  test  as  to  the  taxability  of  this  form  of  insurance  is 


'"^  Section  401. 

''  Chanler  v.  Kclscy,  205  U.  S.  466,  479,  51  L.  Ed.  882,  27  Sup.  Ct.  550. 


FEDERAL   ESTATE   TAX 


1467 


furnished  in  a  case  before  the  United  States  District  Court 
of  Maryland.^*  The  testator,  two  months  before  his  death,  had 
caused  three  insurance  poHcies  to  be  made  payable  to  his 
son  and  daughter.  He  reserved  no  interest  to  himself  nor 
to  his  personal  representatives.  The  transfers  were  made 
without  consideration  and  within  two  years  of  his  death.  The 
court  decided : 

Decision.  Under  the  circumstances,  I  do  not  feel  justified  in 
holding  that  the  three  policies,  which  were  absolutely  assigned,  were 
within  the  statutory  meaning  of  the  phrase  "transferred  in  contempla- 
tion of  death." 

These  three  policies,  therefore,  did  not  remain  a  part  of 
the  decedent's  estate,  so  as  to  be  subject  to  the  estate  tax. 

The  above  decision  is  conclusive  in  its  expression.  If, 
even  within  two  months  of  death,  these  insurance  policies  were 
not  considered  as  "made  in  contemplation  of  death"  within 
the  meaning  of  the  statute,  it  would  seem  that  any  absolute 
transfer  effected  in  such  a  manner  could  be  reasonably  held  to 
be  without  the  power  of  the  estate  tax  law. 

Regulations.  The  provision  requiring  the  inclusion  in  the  gross 
estate  of  all  insurance  receivable  by  the  executor,  without  any  de- 
duction, applies  to  policies  made  payable  to  the  decedent's  estate  or 
his  executor  or  administrator,  and  all  insurance,  regardless  of  the 
manner  of  execution,  which  is  in  fact  receivable  by  the  estate,  or 
which  must  be  used  to  pay  charges  against  the  estate  or  the  expenses 
of  administration.  This  provision  includes  insurance  taken  out  to 
provide  funds  to  meet  the  estate  tax,  state  inheritance  taxes,  or  any 
other  legal  charge  upon  the  estate.  The  manner  in  which  the  policy 
is  drawn  is  immaterial  so  long  as  there  is  an  obligation,  legally  bind- 
ing upon  the  beneficiary,  to  use  the  proceeds  in  payment  of  the  charge. 
(Reg.  37,  Art.  33.) 

The  estate  is  entitled  to  only  one  exemption  of  $40,000  upon 
insurance  payable  to  beneficiaries  other  than  the  executor.  For  ex- 
ample, if  the  decedent  left  life  insurance  payable  to  three  persons 
in  amounts  of  $10,000,  $40,000  and  $50,000  (total  $100,000),  the 
amount  of  $60,000  should  be  returned  for  taxation,  which  is  the  excess 
of  the  sum  of  the  three  policies  over  the  exempted  amount.    The  word 

"  Gaither  v.  Miles,  268  Fed.  692. 


1468  MISCELLANEOUS    TAXES 

"beneficiary,"  as  used  in  reference  to  the  $40,000  exemption,  means 
a  person  entitled  to  tiie  actual  enjoyment  of  the  insurance  money. 
(Reg.  37,  Art.  34.) 

Insurance  receivable  by  the  executor  must  be  included  in  the 
gross  estate  of  all  decedents  who  died  after  September  8,  1916.  In- 
surance payable  to  beneficiaries  other  than  the  executor,  however, 
need  not  be  included  in  the  gross  estate  of  decedents  who  died 
before  February  25,  19 19,  the  effective  date  of  the  Revenue  Act  of 
1918,  unless  the  insurance  was  originally  payable  to  the  estate,  and 
was  transferred  by  the  decedent  to  specific  beneficiaries  in  contempla- 
tion of  death."     (Reg.  37,  Art.  35.) 

The  amount  to  be  returned  in  the  case  of  any  policy  is  the  amount 
actually  receivable  by  the  executor  or  beneficiary.  In  cases  where  the 
proceeds  of  a  policy  are  made  payable  to  the  beneficiary  in  the  form 
of  an  annuity  for  life  or  for  a  term  of  years,  the  present  worth  of 
the  annuity  at  the  time  of  death  should  be  included  in  the  gross 
estate.  For  the  method  of  computing  the  value  of  such  an  annuity, 
see  Article  20."^  Where  the  insurance  contract  gives  an  option  to 
receive  a  fixed  sum  of  money  in  lieu  of  an  annuity,  this  sum,  if  ac- 
cepted, represents  the  value  of  the  insurance  for  the  purpose  of  the 
tax.  If  such  sum  is  not  accepted  the  value  of  the  annuity  is  to  be 
included  in  the  gross  estate.  Where  there  is  more  than  one  option, 
and  none  of  them  is  convertible,  the  value  of  the  insurance  should 
be  determined  in  accordance  with  the  option  actually  exercised.  (Reg. 
i7,  Art.  36.) 

The  foregoing  regulations  merely  explain  the  principle 
under  which  the  proceeds  of  life  insurance  are  included  in 
tlie  gross  estate. 

Deductions  from  Gross  Estate 

Deductions  allowed  resident  estates. — Having  computed 
the  amount  of  the  gross  estate,  the  next  step  is  to  ascertain 
the  allowable  deductions. 

Law.  Section  403.  That  for  the  purpose  of  the  tax  the  value  of 
the  net  estate  shall  be  determined — 

(a)  In  the  case  of  a  resident,  by  deducting  from  the  value  of  the 
gross  estate — 

(i)  Such  amounts  for  funeral  expenses,  administration  expenses, 
claims  against  the  estate,  unpaid  mortgages  upon,  or  any  indebtedness 
in  respect  to,  property    (except,   in   the   case   of   a   resident  decedent, 

■"■'  See  page  1453. 


FEDERAL  ESTATE  TAX  1469 

where  such  property  is  not  situated  in  the  United  States),  losses  in- 
curred during  the  settlement  of  the  estate  arising  from  fires,  storms, 
shipwreck,  or  other  casualty,  or  from  theft,  when  such  losses  are  not 
compensated  for  by  insurance  or  otherwise,  and  such  amounts  reason- 
ably required  and  actually  expended  for  the  support  during  the  set- 
tlement of  the  estate  of  those  dependent  upon  the  decedent,  as  are  al- 
lowed by  the  laws  of  the  jurisdiction,  whether  within  or  without  the 
United  States,  under  which  the  estate  is  being  administered,  but  not  in- 
cluding any  income  taxes  upon  income  received  after  the  death  of  the 
decedent,  or  any  estate,  succession,  legacy,  or  inheritance  taxes. 

Regulations.  In  the  case  of  the  estates  of  residents,  the  de- 
ductions are  made  from  the  value  of  the  entire  gross  estate,  wherever 
situated.  The  deductions  specified  in  the  above  provisions,  contained 
in  the  Revenue  Act  of  1918,  are  proper  in  all  cases  where  the  decedent 
died  on  or  after  February  25,  1919.  Where  the  decedent  died  prior 
to  February  25.  1919,  the  case  is  governed  by  the  provisions  of  the 
Revenue  Act  of  1916,  which  permits  the  following  deductions : 

(i)   Funeral  expenses. 

(2)  Administration  expenses. 

(3)  Claims  against  the  estate. 

(4)  Unpaid  mortgages. 

(5)  Losses  from  casualty  or  theft. 

(6)  Support  of  decedent's  dependents. 

(7)  Other  charges  against  the  estate. 

(8)  Specific   exemption   of   $50,000. 

(9)  In  the  case  of  decedents  dying  after  December  31,  1917, 
public,  religious,  charitable,  scientific,  literary,  and  educational  be- 
quests. 

The  provision  in  the  Revenue  Act  of  1916  for  the  deduction  of 
"such  other  charges"  than  those  previously  specified  as  may  be  al- 
lowed by  the  laws  of  the  jurisdiction  is  omitted  in  the  Revenue  Act 
of  1918.  Consequently,  in  the  case  of  estates  of  all  persons  dying 
after  February  24,  1919,  the  executor,  in  order  to  obtain  a  deduction, 
must  bring  the  item  within  one  of  the  classes  specifically  described. 
(Reg.  37,  Art.  37.) 

In  order  to  be  deductible,  the  item  must  be  of  the  character  de- 
scribed in  the  statute;  and  it  must  also  be  one  the  payment  of  which 
out  of  the  estate  is  allowed  by  the  law  of  the  jurisdiction  administer- 
ing it.  Where  the  item  is  not  one  of  those  described,  it  is  not  de- 
ductible merely  because  payment  is  allowed  by  the  local  law.  On  the 
other  hand,  no  item  is  deductible  unless  its  payment  is  so  allowed. 
It  must  appear  in  every  case  either  that  payment  of  the  item  has  been 
made,  or  that  such  payment  is  clearly  contemplated.  Where  the 
amount  which  may  be  expended  for  the  particular  purpose  is  limited 
by  the  local  law,  no  deduction  in  excess  of  such  limitation  is  per- 
missible.    Where  the  local  courts  have  approved  the  expenditure  it 


1 4/0 


MISCELLANEOUS    TAXES 


will  ordinarily  be  allowed  for  deduction.  (See  Art.  39.)  Where  the 
disbursement  has  not  been  made,  the  item  may  be  entered  for  de- 
duction where  the  amount  is  certain,  and  it  appears  satisfactorily 
that  it  will  be  paid.  No  deduction  may  be  taken  upon  the  basis  of  a 
vague  or  uncertain  estimate.  Where  an  uncertain  or  contingent  lia- 
bility, not  allowed  as  a  deduction,  becomes  fixed,  and  payment  is 
made,  the  remedy  is  a  claim  for  a  refund  of  the  excess  tax.  (Reg. 
37,  Art.  38.) 

Effect  of  court  decree  on  deductibility. — 

Regulation.  The  decision  of  a  local  court  as  to  the  amount  of  a 
claim  or  administration  expense  will  ordinarily  be  accepted  where 
the  court  passes  upon  the  fact  upon  which  deductibility  depends. 
Where  the  court  does  not  pass  upon  such  fact  its  decree  will,  of 
course,  not  be  followed.  For  example,  where  the  question  before 
the  court  is  whether  a  claim  should  be  allowed,  the  decree  allowing  it 
will  ordinarily  be  accepted  as  establishing  that  the  claim  is  valid  and 
the  amount  of  it.  Where,  however,  a  legacy  is  left  to  an  executor 
in  lieu  of  commissions,  the  allowance  of  the  legacy  does  not  estab- 
lish that  the  executor's  claim  for  commissions  is  equal  to  the  amount 
bequeathed,  and  that  this  amount  is  consequently  deductible.  (See 
Art.  42.)  Nor  will  the  decree  necessarily  be  accepted  even  where  it 
purports  to  decide  the  fact  upon  which  deductibility  depends.  It  must 
appear  that  the  court  actually  passed  upon  the  merits  of  the  case. 
This  will  be  presumed  in  all  cases  where  there  is  an  active  and  genuine 
contest.  Where  the  result  reached  appears  to  be  unreasonable,  this 
is  some  evidence  that  there  was  not  such  a  contest,  but  it  may  be 
rebutted  by  proof  to  the  contrary.  Where  the  decree  was  rendered 
by  consent,  it  will  be  accepted,  provided  the  consent  was  a  bona  fide 
recognition  of  the  validity  of  the  claim — not  a  mere  cloak  for  a  gift — 
and  was  accepted  by  the  court  as  satisfactory  evidence  upon  the 
merits.  It  will  be  presumed  that  the  consent  was  of  this  character, 
and  was  so  accepted,  where  it  is  made  by  all  parties  having  an  interest 
adverse  to  the  claim,  when  all  aspects  of  the  matter,  including  its 
effect  upon  taxation,  are  considered.  The  decree  will  not  be  accepted . 
where  it  appears  to  be  at  variance  with  the  law  of  the  State ;  as, 
for  example,  if  an  allowance  is  made  to  an  executor  in  excess  of  the 
rate  prescribed  by  statute.     (Reg.  37,  Art.  39.) 

Funeral  expenses. — 

Regulation.  An  executor  may  deduct  such  amounts  for  funeral 
expenses  as  are  actually  expended  by  him,  provided  expenditures 
of  this  nature  are  a  liability  of  the  estate  under  the  laws  of  the  local 
jurisdiction.  A  reasonable  expenditure  by  the  executor  for  a  tomb- 
stone, monument  or  mausoleum,  or  for  a  burial  lot,  either  for  the  de- 


FEDERAL   ESTATE   TAX 


1471 


cedent  or  his  family,  may  be  deducted  under  this  heading,  provided 
such  an  expenditure  is  made  a  charge  upon  the  estate  by  the  local  law. 
Included  in  funeral  expenses  is  the  transportation  of  the  person 
bringing  the  body  to  the  place  of  burial.     (Reg.  37,  Art.  40.) 

Administration  expenses. — 

Regulation.  The  amounts  deductible  from  the  gross  estate  as 
"administration  expenses"  are  such  expenses  as  are  actually  and 
necessarily  incurred  in  the  administration  of  the  estate;  that  is,  in 
the  collection  of  assets,  payment  of  debts,  and  distribution  among  the 
persons  entitled.  The  expenses  contemplated  in  the  law  are  such  only 
as  attend  the  settlement  of  an  estate  by  the  legal  representative  pre- 
liminary to  the  transfer  of  the  property  to  individual  beneficiaries  or  to 
a  trustee,  whether  such  trustee  is  the  executor  or  some  other  person. 
Expenditures  not  essential  to  the  proper  settlement  of  the  estate, 
but  incurred  for  the  individual  benefit  of  the  heirs,  legatees,  or  de- 
visees, may  not  be  taken  as  deductions.  Administration  expenses 
include  (i)  executor's  commissions;  (2)  attorney's  fees;  (3)  mis- 
cellaneous expenses.  Each  of  these  classes  is  considered  separately. 
(See  Arts  42  to  44.)      (Reg.  37,  Art.  41.) 

Executor's  commissions. — 

Regulation.  No  amount  may  be  deducted  as  executor's  com- 
missions in  excess  of  that  actually  paid  or  to  be  paid,  and  in  no  case 
in  excess  of  the  amount  allowable  by  the  law  of  the  jurisdiction 
wherein  the  estate  is  being  administered.  If  at  the  time  of  filing  the 
return  the  commissions  of  the  executor  have  not  been  allowed  or 
awarded  by  the  court  or  tribunal  having  jurisdiction  in  the  premises, 
the  commissions  may  nevertheless  be  entered  on  the  return  and 
claimed  as  a  deduction,  subject  to  future  allowance  or  disallowance 
by  the  Commissioner,  provided:  (i)  That  the  amount  entered  and 
claimed  is  within  the  amount  allowable  by  the  laws  of  the  jurisdiction 
wherein  the  estate  is  being  administered;  (2)  that  such  amount  is 
in  accordance  with  the  usually  accepted  practice  in  such  cases  within 
said  jurisdiction;  and  (3)  that  it  may  reasonably  be  expected  that 
the  said  amount  will  be  paid  within  one  year  and  180  days  after 
the  decedent's  death.  Except  in  those  cases  in  which  the  commis- 
sions have  been  both  awarded  and  paid,  the  Commissioner  may  at 
any  time  require  the  executor  to  furnish  satisfactory  evidence  of 
his  right  to  take  or  claim  the  deduction.  Whenever  it  shall  appear 
to  the  Commissioner  that  the  commissions  claimed  but  not  awarded, 
whether  paid  or  unpaid,  exceed  the  amount  allowed  by  law  or  exceed 
the  amount  usually  allowed  within  the  commonly  accepted  practice 
of  the  jurisdiction  wherein  the  estate  is  being  administered,  or  where 
in  any  case  the  Commissioner  finds  after  the  lapse  of  i  year  and  180 


T472 


MISCELLANEOUS   TAXES 


days  after  the  decedent's  death  that  the  commissions  have  not  been 
paid,  the  deduction  will  be  disallowed,  subject  to  the  right  of  the 
executor  thereafter  in  a  proper  case  to  file  a  claim  for  abatement 
or  refund  as  he  may  be  advised,  when  the  commissions  shall  have 
been  actually  awarded  and  paid.  Where  the  executor  does  not  intend 
to  make  any  charg-e  upon  the  estate  for  his  services,  no  deduction 
may  be  claimed. 

No  deduction  may  be  made  for  trustees'  commissions,  and  an 
executor  who  acts  as  trustee  is  not  entitled  to  deduct  the  commission 
he  receives  for  his  services  in  the  latter  capacity.  The  executor's 
duties  are  complete  when  he  has  turned  over  the  estate  or  the  proceeds 
to  the  persons  entitled  thereto.  Such  persons  may  be  beneficiaries 
entitled  to  receive  the  property  in  their  own  right,  or  trustees  entitled 
to  receive  it  in  the  right  of  their  cestuis  que  trustent.  The  services 
of  the  trustees  are  distinct  from,  and  additional  to,  the  ordinary  duties 
of  an  executor  in  the  settlement  of  estates;  and  commissions  for  such 
trustees'  services  do  not  constitute  an  expense  of  administration. 

Where  a  bequest  is  made  to  an  executor  in  lieu  of  commissions  it 
may  be  deducted  as  an  administration  expense  only  to  an  amount 
thereof  not  in  excess  of  the  amount  allowable  as  commissions  by  the 
law  of  the  jurisdiction  wherein  the  estate  is  being  administered.  If 
the  legacy  is  in  excess  of  such  allowable  commissions,  the  excess  may 
not  be  deducted.     (Reg.  37,  Art.  42.) 

Attorney's  fees. — 

Regulation.  No  amount  may  be  deducted  in  any  case  as  at- 
torney's fees  in  excess  of  that  actually  paid  or  to  be  paid.  If  at  the 
time  of  filing  the  return  the  attorney's  fees  have  not  been  allowed  or 
awarded  by  the  court  or  tribunal  having  jurisdiction  in  the  premises, 
they  may  nevertheless  be  entered  on  the  return  and  claimed  as  a 
deduction,  subject  to  future  allowance  or  disallowance  by  the  Com- 
missioner, provided:  (i)  That  the  amount  so  entered  and  claimed  is 
reasonable  in  consideration  of  the  services  performed  and  the  value 
of  the  estate;  and  (2)  that  it  may  reasonably  be  expected  that  such 
amount  will  be  paid  within  i  year  and  180  days  after  the  decedent's 
death.  Except  in  those  cases  in  which  the  attorney's  fees  have  been 
both  awarded  and  paid,  the  Commissioner  may  at  any  time  require  the 
executor  to  furnish  satisfactory  evidence  of  his  right  to  take  or  claim 
this  deduction.  Whenever  it  shall  appear  to  the  Commissioner  that 
the  fees  claimed  were  not  awarded,  and  whether  paid  or  unpaid,  ex- 
ceed a  reasonable  amount  in  the  discretion  of  the  Commissioner,  or 
where  in  any  case  the  Commissioner  finds  after  the  lapse  of  i  year  and 
180  days  after  the  decedent's  death  that  the  fees  have  not  been  paid, 
the  deduction  will  be  disallowed,  subject  to  the  right  of  the  executor 
thereafter,  in  a  proper  case  to  file  a  claim  for  abatement  or  refund 
as  he  may  be  advised,  when  the  fees  have  actually  been  awarded  and 


FEDERAL  ESTATE  TAX  1473 

paid.  The  cost  of  litigation  insLitutcd  by  the  beneficiaries  as  to  the 
amount  of  their  respective  interests  may  not  be  deducted,  since  ex- 
penses of  this  character  are  properly  charges  against  the  beneficiaries 
personally,  rather  than  against  the  general  estate.     (Reg.  37,  Art.  43.) 

Miscellaneous  administration  expenses. — 

Regulation.  This  item  includes  expenses  incident  to  court  pro- 
ceedings, or  the  administration  of  the  estate,  such  as  court  costs,  sur- 
rogates' fees,  accountants'  fees,  appraisers'  fees,  clerk  hire,  etc.  Ex- 
penses necessarily  incurred  in  distributing  the  estate  are  deductible. 
This  includes  the  cost  of  storing  or  maintaining  property  of  the  es- 
tate, where  it  is  impossible  to  effect  immediate  distribution  to  the 
beneficiaries.  Expenses  for  preserving  and  caring  for  the  property 
may  be  deducted,  but  do  not  include  additions  or  improvements;  nor 
will  such  expenses  be  allowed  for  a  longer  period  than  the  executor 
is  required  to  retain  the  property.  A  brokerage  fee  for  selling  prop- 
erty of  the  estate  is  deductible  where  the  sale  is  necessary  in  order  to 
pay  the  decedent's  debts,  or  the  expenses  of  administration,  or  to  ef- 
fect distribution.  Other  expenses  attending  the  sale  are  deductible, 
such  as  the  fees  of  an  auctioneer,  where  it  is  reasonably  necessary  to 
employ  one.     (Reg.  37,  Art.  44.) 

Claims  against  the  estate. — 

Regulation.  The  amounts  that  may  be  deducted  under  this  head- 
ing are  such  only  as  represent  personal  obligations  of  the  decedent 
existing  at  the  time  of  his  death,  whether  then  matured  or  not.  Obli- 
gations contracted  by  the  executor  are  not  deductible.  Only  such 
claims  as  are  actually  enforceable  against  the  estate  may  be  deducted. 
(Reg.  37,  Art.  45.) 

Taxes. — 

Regulation.  Taxes  upon  real  property  should  be  accrued  to  the 
date  of  death.  This  is  done  by  ascertaining  the  time  between  the  first 
day  of  the  taxable  period  wherein  the  death  occurs  and  the  date  of 
death,  and  computing  the  proportion  of  the  entire  tax  which  this 
period  bears  to  the  entire  taxable  period.  Such  proportion  of  the 
tax  has  accrued  upon  the  date  of  death,  and  is  deductible. 

Taxes  upon  personal  property  are  either  wholly  deductible,  or  are 
not  deductible  at  all,  depending  upon  whether  the  tax  did,  or  did  not, 
become  the  personal  obligation  of  the  taxpayer  in  his  lifetime.  If 
the  tax  became  his  personal  obligation  during  his  life,  the  whole 
amount  is  deductible  as  a  claim  against  his  estate.  If  it  did  not 
become  such  personal  obligation  in  his  lifetime,  no  part  of  it  is  de- 
ductible. The  question  when  the  tax  became  the  personal  obligation 
of  the  taxpayer  depends  upon  the  law  of  the  jurisdiction  where  the 


1474  MISCELLANEOUS    TAXES 

decedent  was  domiciled  at  the  time  of  his  death.  Prima  facie,  the 
date  when  the  tax  became  the  personal  obligation  of  the  taxpayer  is 
the  date  when  the  assessment  was  laid. 

In  the  case  of  federal  taxes  upon  income,  the  tax  upon  income  re- 
ceived or  accrued  during  the  decedent's  lifetime  constitutes  the  per- 
sonal obligation  of  the  decedent,  and  is  deductible.  Taxes  upon  in- 
come received  after  the  decedent's  death  are  not  deductible.  No  es- 
tate, succession,  legacy,  or  inheritance  tax  is  deductible.  (Reg.  37, 
Art.  46.) 

Unpaid  mortgages. — 

Regulation.  The  full  amount  of  unpaid  mortgages  on  property 
included  in  the  gross  estate  should  be  deducted  under  this  heading, 
including  interest  which  had  accrued  at  the  time  of  death,  whether 
payable  at  that  time  or  not.  Interest  should  be  computed  upon  the 
basis  of  365  days  to  the  year.  The  full  value  of  the  real  estate,  with- 
out any  deduction  for  mortgages,  must  be  returned  as  part  of  the 
gross  estate.  As  real  property  situated  outside  of  the  United  States  is 
not  part  of  the  gross  estate,  the  amount  of  mortgages  upon  such 
property  should  be  deducted  only  where  the  decedent  was  personally 
liable  for  the  mortgage  debt.     (Reg.  37,  Art.  47.) 

Losses  fro:m  casualty  or  theft. — 

Regulation.  There  may  be  deducted  under  this  heading  losses 
incurred  during  the  settlement  of  the  estate  arising  from  fires,  storms, 
shipwreck,  or  other  casualty,  or  from  theft,  when  such  losses  are  not 
compensated  by  insurance  or  otherwise.  If  the  loss  is  partly  com- 
pensated, the  excess  of  the  loss  over  such  compensation  may  be  de- 
ducted. Losses  not  of  the  nature  described  are  not  deductible.  Losses 
sustained  by  reason  of  depreciation  in  the  value  of  the  assets  of  the 
estate  subsequent  to  the  decedent's  death  are  not  deductible.  The 
term  "casualty"  includes  only  losses  of  a  fortuitous  and  unusual 
character,  such  as  result  from  violence,  or  from  a  disaster  which 
could  not  be  foreseen  or  prevented  by  the  e.xercise  of  reasonable 
care.  Losses  due  to  the  death  of  animals  from  disease  are  deductible. 
In  order  to  be  deductible  a  loss  must  occur  during  the  settlement  of 
the  estate.  Where  property  has  been  delivered  to  the  beneficiary, 
settlement  has.  been  effected,  and  no  deduction  may  be  had  for  loss 
of  the  property.     (Reg.  2i7^  -^^^-  A^-) 

Support  of  dependents. — 

Regulation.  The  support  during  the  settlement  of  the  estate 
of  dependents  of  the  decedent  should  be  deducted,  but  pursuant  to 
the  following  rules : 


FEDERAL   ESTATE   TAX 


1475 


(i)  In  order  to  be  deductible,  the  allowance  must  be  authorized 
by  the  laws  of  the  jurisdiction  in  which  the  etsate  is  being  adminis- 
tered, and  not  in  excess  of  what  is  reasonably  required. 

(2)  The  allowance  for  which  deduction  may  be  made  is  limited 
to  support  during  the  settlement  of  the  estate.  Any  allowance  for  a 
more  extended  period  is  not  deductible. 

(3)  There  must  be  an  actual  disbursement  from  the  estate  to 
the  dependents,  but  after  payment  has  been  made  the  right  of  deduc- 
tion is  not  affected  by  the  fact  that  the  dependents  do  not  expend  the 
entire  amount  for  their  support  during  the  settlement  of  the  estate. 
(Reg.  37,  Art.  49.) 

The  governing  factor  in  determining  the  deductibility  of 
expenses  is  their  allowance  as  such  under  local  statutes.  Care- 
ful study  of  such  statutes  is  therefore  necessary,  since  under 
some  jurisdictions  a  deduction  for  the  support  of  dependents 
is  not  permitted.  Nevertheless,  expenses,  to  be  deductible  from 
the  gross  estate,  must  come  distinctly  under  some  one  of  the 
descriptions  enumerated  in  section  403  (a)  of  the  act.  Par- 
ticular attention  is  drawn  to  the  treatment  of  the  executor's 
commission  where  a  specific  sum  has  been  willed  by  the  dece- 
dent for  this  remuneration.  Any  such  amount  in  excess  of 
the  total  commission  permitted  by  the  local  court  is  disallowed. 

The  exclusion  of  mortgages  on  property  of  a  resident  de- 
cedent which  is  situated  outside  the  United  States  is  a  new 
provision.  Under  the  1918  regulations,  mortgages  on  prop- 
erty owned  outside  the  United  States  were  deductible  when  the 
decedent  was  personally  liable  for  the  mortgage  debt.^*^  The 
latter  would  seem  to  be  the  more  equitable  treatment. 

Where  the  indebtedness  of  the  decedent  includes  notes  pay- 
able, care  should  be  taken  to  ascertain  whether  such  notes  are 
secured  by  collateral.  The  value  of  such  collateral  would,  of 
course,  have  to  be  included  in  the  gross  estate. 

In  connection  with  the  deductibility  of  estate,  succession, 
legacy  or  inheritance  taxes  from  the  gross  estate,  despite  the 
fact  that  estate  taxes  are  included  in  those  not  deductible 
under  the  law,"  the  government  contended,  in  a  court  case. 


"  Reg.  37,  1918,  Art.  47. 
"  Sec.  403  (a-i). 


1476  MISCELLANEOUS    TAXES 

that  estate  taxes  were  deductible  because  levied  against  the 
estate  itself,  but  that  "legacy"'  taxes  are  not  deductible,  because 
levied  against  the  legatee.^*  In  this  particular  case  the  deci- 
sion was  that  the  ^Massachusetts  tax  should  have  been  deducted 
before  the  estate  tax  was  computed.  The  court  also  stated  it 
to  be  "unjust  to  hold  that  under  this  Federal  Statute  (Reve- 
nue Act  of  1 91 6)  the  State  tax  was  deductible  in  one  state 
and  not  deductible  in  another,  upon  a  subtle  legalism  without 
.practical  value."  On  the  other  hand,  a  contrary  opinion  has 
been  handed  down  by  the  Supreme  Court  of  the  United 
States  f^  "  'Charges  against  the  estate'  as  pointed  out  by  the 
Court  below,  are  only  charges  that  affect  the  estate  as  a  whole, 
and  therefore  do  not  include  taxes  on  the  right  of  individual 
beneficiaries.  This  reasoning  excludes  not  only  the  New  York- 
succession  tax,  but  those  paid  to  other  states,  which  can  stand 
no  better  than  that  paid  in  New  York."  And  again,  in  the 
United  States  District  Court,  Northern  District,  New  York,*" 
it  was  held  that  the  New  York  transfer  tax  was  a  proper  de- 
duction to  be  made  in  the  tax  due  the  United  States.  As  to 
the  Pennsylvania  collateral  inheritance  tax,  the  court  decided  *^ 
that  it  is  an  estate  tax,  not  a  legacy  tax,  and  that  as  such  it  is 
levied  upon  and  made  a  charge  against  the  estate.  For  this 
reason  the  court  held  that  the  tax  was  deductible  from  the 
gross  estate  before  the  imposition  of  the  federal  estate  tax. 

With  these  conflicting  decisions  given,  it  can  only  be  said 
that  the  question  of  deductibility  of  state  estate  or  inheritance 
taxes  is  entirely  dependent  upon  the  exact  nature  of  the  tax 
imposed  by  a  particular  state. 

Deduction  for  property  previously   taxed. — 

Law.  Section  403.  That  for  the  purpose  of  the  tax  the  value  of 
the  net  estate  shall  be  determined — 


^  Thayer  et  al.  v.  Mallcy,  U.  S.  District  Court,  Mass.,  March  28,  1921 
(case  not  reported). 

""  N.  }'.  Trust  Co.  et  al.  v.  Eisner.  U.  S.  Sun.  Ct.,  October  term.  1920. 
Advance  Opinions  620. 

*"  Say  re  et  al.  7:  Breivsler,  268  Fed.  533. 

*^  Northern  Trust  Co.  v.  Lederer.  262  Fed.  52;  certiorari  denied,  252 
U.  S.  487,  64  L.  Ed.  1025,  40  Sup.  Ct.  483. 


FEDERAL    ESTATE    TAX- 


1477 


(a)  In  the  case  of  a  resident,  by  deducting  from  the  value  of  the 
gross  estate —  .... 

(2)  An  amount  equal  to  the  value  of  any  property  forming  a  part 
of  the  gross  estate  situated  in  the  United  States  of  any  person  who 
died  within  five  years  prior  to  the  death  of  the  decedent  where  such 
property  can  be  identified  as  having  been  received  by  the  decedent 
from  such  prior  decedent  by  gift,  bequest,  devise,  or  inheritance,  or 
which  can  be  identified  as  having  been  acquired  in  exchange  for  prop- 
erty so  received:  Provided,  That  this  deduction  shall  be  allowed  only 
where  an  estate  tax  under  this  or  any  prior  Act  of  Congress  was  paid 
by  or  on  behalf  of  the  estate  of  such  prior  decedent,  and  only  in  the 
amount  of  the  value  placed  by  the  Commissioner  on  such  property  in 
determining  the  value  of  the  gross  estate  of  such  prior  decedent,  and 
only  to  the  extent  that  the  value  of  such  property  is  included  in  the 
decedent's  gross  estate  and  not  deducted  under  paragraphs  (i)  or  (3) 
of  subdivision  (a)  of  this  section.  This  deduction  shall  be  made  in  case 
of  the  estates  of  all  decedents  who  have  died  since  September  8, 
1916;  .... 

While  in  general  accord  with  the  corresponding  section  of 
the  1918  law,*^  this  section  also  includes  some  provisions  pre- 
viously covered  merely  by  regulation.  The  intent  is  perfectly 
clear,  in  that  where  an  estate  tax  has  l)een  paid  on  the  transfer 
of  any  portion  of  the  decedent's  estate  within  five  years  prior 
to  the  date  of  death,  no  further  federal  tax  need  be  paid  in 
respect  of  that  particular  property.*^ 

Only  the  value  accepted  by  the  Commissioner  in  the  return 
of  the  prior  decedent  may  be  deducted  from  the  gross  estate 
under  this  section.  If  the  actual  value  at  date  of  decedent's 
death  exceeds  the  original  value  the  excess  must  be  included 
in  the  gross  estate. 

Property  owned  by  a  resident  or  non-resident  decedent 
which  formed  part  of  the  estate  of  anyone  dying  after  Sep- 
temljer  8,  19 16,  and  upon  which  an  estate  tax  had  been  paid, 
may  be  deducted  from  the  gross  estate.  The  rules  for  such 
deduction  may  be  summarized  as  follows : 

I.  The  two  deaths  must  have  occurred  within  five  years 
of  each  other. 


*-Reg.  37,  1918,  Art.  50. 

"As  to  the  effect  of  the  change  of  the  effective  dale  on  refunds  of  tax, 
see  page  15 13. 


T478  MISCELLANEOUS    TAXES 

2.  The  first  decedent  must  have  died  after  September  8, 

191 6,  and  the  second  after  November  23,  1921. 

3.  Tax  must  have  been  paid  on  the  first  decedent's  prop- 

erty. 

4.  The  value  exempt  from  taxation  in  the  case  of  the  last 

decedent  is  the  value  at  which  such  property  was 
included  in  the  gross  estate  of  the  prior  decedent. 

5.  The  property  shall  be  situated  in  the  United  States  at 

the  time  of  the  last  decedent's  death. 

The  third  condition  above  paves  the  way  for  possibility 
of  an  injustice  in  certain  cases.  It  is  specifically  stated  that 
the  filing  of  a  return  is  not  a  sufficient  cause  for  deduction  ** 
but  that  the  tax  itself  must  have  been  paid.  The  inevitable 
construction  to  be  placed  on  this  condition  is  that  the  net 
estate  of  the  first  decedent  must  have  exceeded  the  $50,(X)0 
specific  exemption;  otherwise  there  would  have  been  no  tax- 
able estate  and,  consequently,  no  tax  paid.  Any  benefit  accru- 
ing to  the  estate  of  the  last  decedent,  under  these  circumstances, 
is  entirely  dependent  on  the  fact  as  to  whether  or  not  the  gross 
estate  of  the  prior  decedent  exceeded  $50,000. 

If  the  gross  estate  of  the  prior  decedent  exceeded  $50,000, 
then  bequests  to  the  second  decedent  will  be  deductible  from 
the  latter's  gross  estate.  This  is  true,  in  spite  of  the  fact  that 
the  estate  of  the  prior  decedent  (if  a  resident)  was  only  sub- 
ject to  tax  on  the  amount  in  excess  of  $50,000. 

Where  the  gross  estate  of  the  prior  decedent  was  less  than 
$50,000,  no  tax  was  payable  (by  a  resident),  and  therefore 
the  estate  of  the  second  decedent  will  be  unable  to  deduct  any 
bequests  received  from  the  prior  decedent. 

To  illustrate : 

(i)  Assume  A  (a  resident)  had  a  gross  estate  of $100,000 

Deduct:    Specific  exemption    50,000 

Tax  paid  by  A's  estate  on $  50,000 


Reg.  37,  1918,  Art.  62. 


FEDERAL   ESTATE   TAX 


1479 


B   (a  resident)  has  a  personal  estate  excluding  payment  from 

A  of   $  40,000 

Bequest  from  A 100,000 

Gross  estate  of  B $140,000 

Deduct:  A's   bequest    $100,000 

Specific    exemption 50,000     150,000 

Excess  of  deductions   $  10,000 

No  tax  due  on  B's  estate. 
The  Treasury  receives  in  total    from  the  estates  of  A  and  B 

tax   on    $  50,000 

(2)   Assume  A   (a  resident)  had  a  gross  estate  of $  40,000 

No  tax  is  payable  by  the  estate  of  A. 

B    (a  resident)   has  a  personal  estate  excluding  bequest  from 

A  of  $100,000 

Bequest  from  A   40,000 

Gross  estate  of  B $140,000 

Only  the  specific  exemption  can  be  deducted 50,000 

Total  paid  by  A's  estate  on $  90,000 

The  Treasury  receives  in  total   from  the  estates  of  A  and  B 
tax  on $  90,000 


It  follows  that  the  discrimination  referred  to  above  results 
in  the  collection  by  the  Treasury  of  a  tax  on  $40,000  more  in 
the  second  case  than  in  the  first  although  the  total  personal 
estates  (excluding  the  transfer)  of  A  and  B  are  identical  in 
the  two  examples,  namely,  $140,000. 

The  discrimination  is  unfair.  The  Treasury  should  permit 
in  the  second  case  the  deduction  of  $40,000  from  the  estate 
of  B,  which  is  the  intention  of  Congress. 

Deduction  for  propekty  acquired  in  exchange. — ■ 

Regulations.  The  deduction  for  substituted  property  is  lim- 
ited to  property  acquired  in  exchange  for  the  identical  property  re- 
ceived from  the  estate  of  the  prior  decedent.  Where  there  is  a  sub- 
sequent exchange,  the  right  to  deduction  is  lost.  Where,  however, 
property  is  sold,  and  the  proceeds  immediately  invested  in  other  prop- 
erty, the  property  purchased  is  deemed  to  be  taken  in  exchange,  and 
its  value  is  deductible. 

In  the  case  of  an  exchange  the  executor  must  describe  and  identify 
fully  both  the  property  originally  received  from  the  prior  e.state  and 
the  property  acquired  in  exchange  therefor.     lie  must  also  state  the 


1480  MISCELLANEOUS   TAXES 

date  and  nature  of  the  transaction  by  which  the  exchange  was  effected, 
the  name  and  address  of  the  transferee,  and  the  consideration,  if 
any,  given  or  received  by  the  decedent  in  addition  to  the  property 
received  from  the  prior  estate.  If  the  exchange  was  made  by  written 
instrument  of  pubHc  record,  a  precise  reference  must  be  made  to  the 
record  containing  the  instrument,  and  if  by  instrument  not  of 
record  a  copy  of  the  instrument  must  be  supplied.  If  there  was  no 
written  instrument,  an  affidavit  as  to  the  facts  of  the  exchange  by 
one  or  more  persons  having  personal  knowledge  of  the  matter  must 
be  furnished. 

If  at  the  time  of  exchange  the  decedent  gave  a  consideration  in 
addition  to  the  property  received  from  the  prior  estate,  and  acquired 
property  of  greater  value  than  the  property  so  received,  there  may 
be  deducted  the  proportion  of  the  value  of  the  property  received  in 
exchange  which  the  value  of  the  original  property  bears  thereto. 
(Reg.  37,  Art.  52.) 

If  the  property  originally  received  from  the  prior  estate  is  in- 
cluded in  the  decedent's  gross  estate,  the  executor  must  describe  it 
fully,  and  prove  its  identity  with  the  property  received  from  the  prior 
estate.  The  value  to  be  deducted  is  the  value  at  the  time  of  the  second 
decedent's  death.     (Reg.  37,  Art.  51.) 

Since  the  amount  of  property  originally  received  under  the 
conditions  mentioned  will  have  been  included  (on  schedule  G 
of  form  706)  at  its  value  at  the  time  of  decedent's  death,  the 
deduction  made  (on  schedule  K  of  form  706)  will  be  at  the 
same  figure. 

Deduction  for  charitable  and  similar  bequests.*^ — 

Law.  Section  403.  That  for  the  purpose  of  the  tax  the  value  of 
the  net  estate  shall  be  determined — 

(a)  In  the  case  of  a  resident,  by  deducting  from  the  value  of  the 
gross  estate —  .... 

(3)  The  amount  of  all  bequests,  legacies,  devises,  or  transfers, 
except  bona  fide  sales  for  a  fair  consideration  in  money  or  money's 
worth,  in  contemplation  of  or  intended  to  take  effect  in  possession  or 
enjoyment  at  or  after  the  decedent's  death,  to  or  for  the  use  of  the 
United  States,  any  State,  Territory,  any  political  subdivision  thereof, 
or  the  District  of  Columbia,  for  exclusively  public  purposes,  or  to  or 
for   the   use    of   any   corporation    organized    and    operated    exclusively 


"  [Former  Procedure]  Frovisiun  for  the  deduction  of  charitable  and 
similar  bequests  was  first  instituted  in  the  1918  law.  That  law  provided  for 
deductions  similar  to  those  which  are  allowed  under  the  1921  law.  Prior 
laws  made  no  allusion  to  this  form  of  deduction  from  gross  estate. 


FEDERAL  ESTATE  TAX  1481 

for  religious,  charitable,  scientific,  literary,  or  educational  purposes,  in- 
cluding the  encouragement  of  art  and  the  prevention  of  cruelty  to 
children  or  animals,  no  part  of  the  net  earnings  of  which  inures  to  the 
benefit  of  any  private  stockholder  or  individual,  or  to  a  trustee  or 
trustees  exclusively  for  such  religious,  charitable,  scientific,  literary, 
or  educational  purposes.  This  deduction  shall  be  made  in  case  of 
the  estates  of  all  decedents  who  have  died  since  December  31, 
1917;  .... 

Regulations.  Bequests  to  religious,  charitable,  scientific,  literary, 
or  educational  corporations  are  deductible  only  if  the  corporation  is 
organized  or  operated  exclusively  for  one  of  the  purposes  specified 
(see  Art.  54).  Similarly,  in  the  case  of  a  trust,  the  trust  must  be 
exclusively  for  such  purposes.  It  does  not  prevent  deduction,  hovi'- 
ever,  that  the  property  placed  in  trust  is  also  subject  to  another  trust 
for  a  private  purpose.  Thus,  where  money  or  property  is  placed  in 
trust  to  pay  the  income  to  an  individual  during  life,  and  then  to  pay 
or  deliver  the  same  to  a  charitable  corporation,  or  apply  the  principal 
to  a  charitable  purpose,  the  charitable  bequest  or  devise  forms  the 
basis  for  a  deduction.  The  amount  of  the  deduction,  in  such  case, 
is  the  value,  at  the  date  of  the  decedent's  death,  of  the  remainder  in- 
terest in  the  money  or  property  which  is  devised  or  bequeathed  to 
charity.  For  the  manner  of  determining  the  value  of  such  remainder 
interest,  see  Article  20.  Gifts  made  in  the  decedent's  lifetime  are 
deductible  only  if  made  in  contemplation  of  death  ,or  intended  to  take 
effect  at  or  after  death,  and  the  property  is  consequently  included  in 
the  gross  estate.  Gifts  made  in  satisfaction  of  a  legacy  are  also  de- 
ductible. The  deduction  is  not  limited  in  the  case  of  the  estates  of 
residents  to  bequests  to  domestic  corporations  or  to  trustees  for  use 
within  the  United  States.     (Reg.  37,  Art.  53.) 

In  order  to  be  exempt  the  corporation  or  association  must  meet 
three  tests :  ( i )  it  must  be  organized  and  operated  for  one  or  more 
of  the  specified  purposes;  (2)  it  must  be  organized  and  operated 
exclusively  for  such  purposes;  and  (3)  no  part  of  its  income  must 
inure  to  the  benefit  of  private  stockholders  or  individuals. 

(i)  Charitable  corporations  include  an  association  for  the  relief 
of  the  families  of  clergymen,  even  though  the  latter  make  a  contribu- 
tion to  the  fund  established  for  this  purpose;  or  for  furnishing  the 
services  of  trained  nurses  to  persons  unable  to  pay  for  them ;  or  for 
aiding  the  general  body  of  litigants  by  improving  the  efficient  adminis- 
tration of  justice.  Educational  corporations  include  an  association 
whose  sole  purpose  is  the  instruction  of  the  public,  even  if  it  merely 
disseminates  propaganda  on  a  single  question.  Thus  an  association 
inculcating  prohibition  or  protectionist  principles  is  exempt.  The 
same  is  true  of  an  association  to  promote  acquaintance  with  the 
Spanish  language  and  literature,  although  it  has  incidental  amusement 


1482  MISCELLANEOUS    TAXES 

features;  of  an  association  to  increase  knowledge  of  the  civilization 
of  another  country ;  and  of  a  Chautauqua  association  whose  primary 
purpose  is  to  give  lectures  on  subjects  useful  to  the  individual  and 
beneficial  to  the  community,  and  whose  amusement  features  are  in- 
cidental to  this  purpose.  Societies  designed  to  encourage  the  per- 
formance of  first-class  orchestral  music  are  not  exempt,  the  purpose 
being  merely  to  provide  a  high  grade  of  entertainment.  Scientific 
corporations  include  an  association  for  the  scientific  study  of  law, 
to  the  end  of  improvement  in  its  administration. 

(2)  Where  a  religious  corporation  owns  a  large  quantity  of  farm 
land  and  works  it,  and  also  manufactures  and  sells  clothing  and 
other  articles  for  profit,  it  is  not  operated  exclusively  for  religious 
purposes  and  is  not  exempt,  even  though  its  property  is  held  in  com- 
mon and  its  profits  do  not  inure  to  the  benefit  of  individual  members  of 
the  society. 

(3)  It  does  not  prevent  exemption  that  private  individuals,  for 
whose  benefit  a  charity  is  organized,  received  the  income  of  the  cor- 
poration or  association.  The  statute  refers  to  individuals  having  a 
personal  and  private  interest  in  the  activities  of  the  corporation, 
such  as  stockholders.  If,  however,  a  corporation  issues  "voting 
shares,'"  which  entitle  the  holders  upon  the  dissolution  of  the  corpora- 
tion to  receive  the  proceeds  of  its  property,  including  accumulated 
income,  the  right  to  exemption  does  not  exist,  even  though  the  by- 
laws provide  that  the  shareholders  shall  not  receive  any  dividend  or 
other  return  upon  their  shares.     (Reg.  37,  Art.  54.) 

The  foregoing  regulations  in  most  respects  properly  inter- 
pret the  law.  When  the  intention  of  the  law  is  to  exempt 
certain  gifts  from  taxation,  gifts  falling  reasonably  within  the 
exempt  class  should  be  tax-free.  The  regulations  are  too  dras- 
tic in  such  cases  as  a  religious  corporation  which  operates  a 
farm,  a  factory,  a  hotel,  and  a  theatre,  the  profits,  if  any,  from 
these  varied  operations  being  entirely  devoted  to  the  religious 
objects  for  which  the  corporation  was  formed.  Surely  it  can- 
not be  maintained  that  such  bequests  were  other  than  for  the 
specific  furtherance  of  those  religious  objects.  The  test  in 
such  a  case  is  the  object  of  the  pursuits  followed,  not  the  fonn 
which  those  pursuits  may  take.  Should  any  of  the  profits 
inure  to  the  stockholders  (which  it  is  expressly  stated  that 
they  do  not),  then  the  exclusively  religious  purpose  of  the 
organization  would  cease  and  the  bequest  would  autoinatically 
be  deprived  of  any  claim  as  a  deductible  item. 


FEDERAL  ESTATE  TAX  1483 

A  decedent  may  bequeath  a  farm  to  a  religious  institution. 
The  gift  is  tax-free.  The  institution  is  unable  to  sell  the  farm 
and  operates  it  to  the  best  advantage.  Another  decedent  makes 
a  money  bequest  to  the  same  institution.  If  the  farm  has  been 
neglected  the  second  bequest  is  tax-free;  if  proper  care  has 
been  taken  of  the  farm  the  second  bec|uest  is  not  tax-free ! 
It  is  impossible  to  read  into  the  law  any  such  rediictio  ad  ab- 
surdnni.     Yet  the  regulations  appear  to  so  hold. 

It  is  difficult  to  see  for  what  reason  contributions  to  com- 
munity chests,  funds,  or  foundations  are  not  included  in  the 
deductions  under  this  title.  For  income  tax  purposes  ""^  they 
are  specifically  enumerated  among  the  deductions  allowed  to 
individuals.  This  is  an  invidious  distinction  as  between  the 
treatment  of  contributions  donated  by  an  individual  himself 
and  those  donated  by  his  executor  in  accord  with  his  expressed 
desires  before  his  death.  The  anomaly  is  further  instanced 
by  the  fact  that  contributions  by  a  living  individual  to  the 
National  Dry  Federation  are  not  allowable  deductions  from 
gross  income,  while  a  bequest  to  an  association  established  for 
the  purpose  of  inculcating  prohibition  principles  is  deductible 
from  the  gross  estate  under  this  section.^' 

In  claiming  the  deduction  for  charitable  and  similar  be- 
quests, the  executor  is  required  to  submit  certain  documentary 
evidence  as  indicated  in  the  following  article : 

Regulations.  In  order  to  prove  his  right  to  this  deduction  the 
executor  must  submit  : 

(i)  Certified  copy  of  the  will  of  the  decedent  or  the  instrument 
of  gift  in  the  case  of  a  transfer  of  property  in  contemplation  of  death. 

(2)  A  receipt,  statement,  or  other  documentary  evidence  to  show 
the  beneficiary's  receipt  of,  or  intention  to  accept,  the  legacy,  devise, 
or  gift. 

(3)  Affidavit  of  the  executor  stating  whether  any  action  has  been 
instituted  to  contest  the  will,  or  whether,  according  to  his  information 
and  belief,  any  such  action  is  contemplated. 

(4)  Such  other  document  or  evidence  as  may  be  specified  by  the 
I'ureau.     (Reg.  37,  Art.  55.) 


"Title  II,    section  214  (a-ii). 
"  Reg.  37,  1918,  Art.  54. 


1484  MISCELLANEOUS    TAXES 

Where  llie  bequest,  legacy,  devise,  or  gife  is  dependent  upon 
tlic  performance  of  some  act,  or  the  happening  of  some  event,  in 
order  to  become  effective,  it  is  necessary  that  the  performance  of  the 
act  or  the  occurrence  of  the  event  shall  have  taken  place  before  the 
deduction  can  be  allowed.  Where  the  legatee,  devisee,  donee,  or 
trustee  is  empowered  to  divert  the  property  or  fund,  in  whole  or  in 
part,  to  a  use  or  purpose  which  would  have  rendered  '\t,  to  the  extent 
that  it  is  subject  to  such  power,  not  deductible  had  it  been  directly 
so  bequeathed,  devised,  or  given  by  the  decedent,  deduction  will  be 
limited  to  that  portion,  if  any,  of  the  property  or  fund  which  is 
exempt  from  an  exercise  of  such  power.  (Reg.  37,  Art  56,  as  amended 
by  T.  D.  3241,  dated  November  i,  1921.) 

The  deduction  may  be  claimed  by  the  estates  of  all  decedents 
dying  after  December  31,  1917.  Where  the  tax  has  been  paid  without 
taking  the  deduction  a  claim  for  refund  may  be  made,  as  provided  by 
Article  no.     (Reg.  37,  Art.  57.) 

Specific  exemption. — The  1921  law  makes  no  change  in 
the  specific  exemption  of  $50,000  allowed  in  the  case  of  resi- 
dent estates.  This  exemption  has  been  allowed  in  all  laws 
from  191 6. 

Law.  Section  403.  That  for  the  purpose  of  the  tax  the  value  of 
the  net  estate  shall  be  determined — 

(a)  In  the  case  of  a  resident,  by  deducting  from  the  value  of  the 
gross  estate —  .... 

(4)  An    exemption    of   $50,000;  .... 

Regulation.  There  may  be  deducted  from  the  gross  estate  of 
all  resident  decedents  a  specific  exemption  of  $50,000.  No  part  of 
this  exemption  is  allowed  in  the  case  of  nonresident  decedents.  (See 
Art.  59.)  If  more  than  one  return  is  made  for  purposes  of  the  tax, 
the  exemption  may  be  taken  only  once.     (Reg.  37,  Art.  58.) 

Method  of  determination  of  net  estate  of  non-residents. — 

In  computing  the  net  estate  of  a  non-resident  which  is  subject 
to  tax,  there  are  two  important  differences  from  the  procedure 
in  the  case  of  resident  estates : 

1.  There  is  no  especific  exemption  of  $50,000. 

2.  Only  the  amount  of  the  gross  estate  which  is  deemed 

to  be  situated  in  the  United  States  is  considered,  and 
from  this  amount  the  statutory  deductions  (limited 
to  10  per  cent  of  the  gross  estate  ^^)  are  subtracted. 


Section  403   (b-i). 


FEDERAL  ESTATE  TAX  1485 

Status  of  certain  itujimcrty  of  non-resident  es- 
tates.— 

Law.     Section  403 (b)    ...   (3)  For  the  purpose  of 

this  title  stock  in  a  domestic  corporation  owned  and  held  by  a  nonresi- 
dent decedent  shall  be  deemed  property  within  the  United  States,  and 
any  property  of  which  the  decedent  has  made  a  transfer  or  with  respect 
to  which  he  has  created  a  trust,  within  the  meaning  of  subdivision  (c) 
of  section  402,^'-'  shall  be  deemed  to  be  situated  in  the  United  States, 
if  so  situated  either  at  the  time  of  the  transfer  or  the  creation  of  the 
trust,  or  at  the  time  of  the  decedent's  death. 

The  amount  receivable  as  insurance  upon  the  life  of  a  nonresident 
decedent,  and  any  moneys  deposited  with  any  person  carrying  on  the 
banking  business,  by  or  for  a  nonresident  decedent  who  was  not  en- 
gaged in  business  in  the  United  States  at  the  time  of  his  death,  shall 
not,  for  the  purpose  of  this  title,  be  deemed  property  within  the  United 
States. 

The  exclusion  of  the  proceeds  of  hfe  insurance,  or  bank 
deposits,  is  an  exemption  granted  to  non-residents  for  the  first 
time  in  this  law.  Heretofore,  when  the  insurer  was  a  domestic 
corporation,  insurance  receivable  from  such  a  source  was 
deemed  to  be  property  within  the  United  States,  and,  as  such, 
subject  to  inclusion  in  the  taxable  gross  estate.  Neither  of 
these  exemptions  apply  to  non-residents  engaged  in  business 
in  the  United  States. 

Missionaries  classed  as  residents. — 

Law.     Section     403 (b)   ....    (3)  Missionaries     duly 

commissioned  and  serving  under  boards  of  foreign  missions  of  the  vari- 
our  religious  denominations  in  the  United  States,  dying  while  in  a  foreign 
missionary  service  of  such  boards,  shall  not,  by  reason  merely  of  their 
intention  to  permanently  remain  in  such  foreign  service,  be  deemed 
nonresidents  of  the  United  States,  but  shall  be  presumed  to  be  resi- 
dents of  the  State,  the  District  of  Columbia,  or  the  Territories  of 
Alaska  or  Hawaii  wherein  they  respectively  resided  at  the  time  of 
their  commission  and  their  departure  for  such  foreign  service. 

The  foregoing  paragraph  applying  to  missionaries  and,  in 
effect,  placing  them  in  the  same  plane,  as  far  as  deductions  and 
exemptions  are  concerned,  as  residents,  is  a  new  and  equitable 
feature  of  the  192 1  law. 


'A  trust  created  in  contemplation  of  death. 


I486" 


MISCELLANEOUS    TAXES 


Deductions  allowed  non-resident  estates. — 

Law.  Section  403.  That  for  the  purpose  of  the  tax  the  value  of 
the  net  estate  shall  be  determined —  .... 

(b)  In  the  case  of  a  nonresident,  by  deducting  from  the  value  of 
that  part  of  his  gross  estate  which  at  the  time  of  his  death  is  situated 
in  the  United  States — 

(i)  That  proportion  of  the  deductions  specified  in  paragraph  (i) 
of  subdivision  (a)  of  this  section  •"  w^hich  the  value  of  such  part  bears 
to  the  value  of  his  entire  gross  estate,  wherever  situated,  but  in  no  case 
shall  the  amount  so  deducted  exceed  10  per  centum  of  the  value  of  that 
part  of  his  gross  estate  which  at  the  time  of  his  death  is  situated  in 
the  United  States;  .... 

(2)  An  amount  equal  to  the  value  of  any  property  forming  a  part 
of  the  gross  estate  situated  in  the  United  States  of  any  person  who 
died  within  five  years  prior  to  the  death  of  the  decedent  where  such 
property  can  be  identified  as  having  been  received  by  the  decedent 
from  such  prior  decedent  by  gift,  bequest,  devise,  or  inheritance,  or 
which  can  be  identified  as  having  been  acquired  in  exchange  for  prop- 
erty so  received:  Provided,  That  this  deduction  shall  be  allowed  only 
where  an  estate  tax  under  this  or  any  prior  Act  of  Congress  was  paid 
by  or  on  behalf  of  the  estate  of  such  prior  decedent,  and  only  in  the 
amount  of  the  value  placed  by  the  Commissioner  on  such  property 
in  determining  the  value  of  the  gross  estate  of  such  prior  decedent, 
and  only  to  the  extent  that  the  value  of  such  property  is  included  in 
that  part  of  the  decedent's  gross  estate  which  at  the  time  of  his  death 
is  situated  in  the  United  States  and  not  deducted  under  paragraphs 
(i)  or  (3)  of  subdivision  (b)  of  this  section.  This  deduction  shall  be 
made  in  case  of  the  estates  of  all  decedents  who  have  died  since  Sep- 
tember 8,  1916;°^  and 

(3)  The  amount  of  all  bequests,  legacies,  devises,  or  transfers, 
except  bona  fide  sales  for  a  fair  consideration,  in  money  or  money's 
worth,  in  contemplation  of  or  intended  to  take  effect  in  possession  or 
enjoyment  at  or  after  the  decedent's  death,  to  or  for  the  use  of  the 
United  States,  any  State,  Territory,  any  political  subdivision  thereof, 
or  the  District  of  Columbia,  for  exclusively  public  purposes,  or  to 
or  for  the  use  of  any  domestic  corporation  organized  and  operated 
exclusively  for  religious,  charitable,  scientific,  literary,  or  educational 
purposes,  including  the  encouragement  of  art  and  the  prevention  of 
cruelty  to  children  or  animals,  no  part  of  the  net  earnings  of  which 
inures  to  the  benefit  of  any  private  stockholder  or  individual,  or  to 
a  trustee  or  trustees  exclusively  for  such  religious,  charitable,  scientific, 
literary,  or  educational  purposes  within  the  United  States.     This  de- 


"  See  page  1468. 

"This  subsection  is   identical  with  section  403    (a-2). 
cussion,  see  page  1477. 


For  a  full  dis- 


FEDERAL  ESTATE  TAX  1487 

duction  shall  be  made  in  case  of  the  estates  of  all  decedents  who  have 
died  since  December  31,  1917. 

No  deduction  shall  be  allowed  in  the  case  of  a  nonresident  unless 
the  executor  includes  in  the  return  required  to  be  filed  under  section 
404  the  value  at  the  time  of  his  death  of  that  part  of  the  gross  estate  of 
the  nonresident  not  situated  in  the  United  States. 

Except  for  the  10  per  cent  limitation  included  in  paragraph 
( I )  above,  the  section  quoted  provides  the  same  general  de- 
ductions for  non-residents  as  in  the  case  of  resident  estates. 
The  specific  exemption  of  $50,000  does  not,  hoivever,  apply  as 
far  as  non-resident  estates  are  concerned. 

Regulation.  The  gross  estate  of  a  resident  and  of  a  nonresident 
are  made  up  in  the  same  way.  In  ascertaining  the  net  estate,  how- 
ever, which  is  subject  to  tax,  there  is  a  radical  difference  between  the 
two  cases.  Whereas  the  net  estate  in  the  case  of  a  resident  is  de- 
termined by  making  the  specified  deductions  from  the  entire  gross 
estate,  the  net  estate  in  the  case  of  a  nonresident  is  determined  by 
making  the  deductions  from  the  value  of  so  much  of  the  gross  estate 
as  is  situated  in  the  United  States.^-  Thus,  in  substance,  the  statute 
attempts  to  tax  only  the  transfer  of  so  much  of  the  estate  of  a  non- 
resident as  is  situated  in  the  United  States.  On  the  other  hand, 
nonresident  estates  are  not  entitled  to  the  specific  exemption  of 
$50,000.     (Reg.  37,  Art.  59.) 

Deduction  for  claims  and  expenses  of  non-resi- 
dents.— 

Regulation.  The  character  of  the  deduction  is  the  same  as  in 
the  case  of  resident  estates  (see  Arts  ^y  to  49).  It  is  immaterial 
whether  the  expenditures  are  incurred  or  paid  in  this  country  or  else- 
where. The  deduction,  however,  is  subject  to  limitations  which  do 
not  apply  in  the  case  of  a  resident  estate.  Only  that  proportion  of  the 
claims  and  expenses  is  deductible  which  the  value  of  the  property 
situated  in  the  United  States  bears  to  the  value  of  the  entire  gross 
estate,  wherever  situated;  and  in  no  event  may  a  sum  be  deducted 
in  excess  of  10  per  cent  of  the  value  of  the  property  situated  in  the 
United  States.  This  10  per  cent  limitation  does  not  apply  to  the  de- 
ductions subsequently  considered.  (See  Arts.  62,  63.)  (Reg.  37, 
Art.  61.) 

Deductions  for  public,  charitable,  or  similar  gifts 

BY    non-residents. 

Regulation.  Where  the  bequest  is  to  a  corporation,  it  is  limited 
to  a  domestic  corporation ;  tluit  is,   one  created  or  organized  in  the 


'But  not  in  excess  of  10  per  cent  thereof.    Act.  section  403   (i). 


1488  MI-SCELLANEOUS   TAXES 

United  States.  Where  the  bequest  is  to  a  trustee,  it  must  be  for 
use  exclusively  within  the  United  States.  The  requirements  are  dif- 
ferent and  should  not  be  confused.  The  first  relates  to  the  character 
of  the  donee ;  the  second  to  the  character  of  the  use  of  the  gift.  With 
these  exceptions  the  rules  for  deduction  are  the  same  as  in  the  case 
of  resident  estates   (see  Arts.  53,  54). 

This  deduction  applies  to  the  estates  of  all  decedents  dying  after 
December  31,  1917.  In  the  case  of  any  estate  entitled  to  the  deduc- 
tion which  paid  the  tax  without  receiving  the  benefit  of  the  right,  the 
excess  tax  will  be  refunded  upon  filing  of  claim  for  refund.  (Reg. 
37,  Art.  63.) 

Example  of  determination  of  net  estate  of  non-residents. — 

Regulation.  The  following  example  will  show  the  manner  of  de- 
termining the  net  estate,  subject  to  tax,  of  a  nonresident  decedent. 
The  gross  estate  of  the  decedent,  wherever  situated,  amounts  to  $1,- 
000,000,  of  which  the  property  in  the  United  States,  Hawaii,  and  Alaska 
amounts  to  $200,000.  The  total  legal  deduction  for  claims  and  ex- 
penses (see  Art.  61)  amounts  to  $75,000;  and  there  are  charitable 
bequests,  for  use  within  the  United  States,  amounting  to  $25,000.  In- 
asmuch as  the  property  in  the  United  States,  Hawaii,  and  Alaska  con- 
stitutes 20  per  cent  of  the  entire  gross  estate,  one-fifth  of  the  total 
deductions  for  claims  and  expenses  is  the  proportionate  share  corres- 
ponding to  this  property.  This  proportion  amounts  to  $15,000;  and 
as  this  amount  does  not  exceed  ten  per  cent  of  the  property  situated 
in  the  United  States.  Hawaii,  and  Alaska,  the  entire  amount  is  de- 
ductible.    The  following  result  is  accordingly  obtained : 

Gross  estate  within  the  United  States--- $200,000 

Proportion   of   deductions   for  claims  and   expenses  under 

subdivision   i      --- $15,000 

Charitable  bequests  in  United  States -- 25,000 

40,000 


Net  estate  subject  to  tax - 160, 


000 


The  tax  on  this  amount  should  be  computed  in  the  manner  previ- 
ously provided  for  estates  of  residents.      fSee  Art.  8.) 

In  the  example  given,  if  the  total  legal  deductions  for  claims  and 
expenses  had  amounted  to  $150,000,  the  proportionate  amount  of  de- 
ductions, $30,000,  would  not  have  been  deductible,  inasmuch  as  this 
would  have  exceeded  ten  per  cent  of  the  property  in  the  United  States, 
Hawaii  and  Alaska.  In  such  case  the  total  amount  of  the  deductions 
allowable  for  claims  and  expenses  would  have  been  ten  per  cent  of  the 
gross  estate  within  the  United  States,  or  $20,000,  making,  with  the 
charitable  bequests  of  $25,000,  a  total  deduction  of  $45,000.  The  net 
estate  subject  to  tax  would  accordingly  have  been  $155,000,  instead 
of  the  amount  given  in  the  example.      (Reg.  37,  Art.  64.) 


FEDERAL  ESTATE  TAX  1489 

It  is  presumed  that  insurance  payable  to  individuals  other 
than  the  executor  in  excess  of  $40,000  has  been  included  in  the 
gross  estate  in  arriving  at  the  $200,000.^^ 

Payment  of  tax — non-residents. — 

Regulation.  The  regulations  with  reference  to  rates  of  tax 
and  pa3^ment  are  the  same  in  the  case  of  estates  of  nonresidents  as 
of  residents.  The  statute  provides  that  the  executor  shall  pay  the 
tax.  If  no  executor  or  administrator  has  been  appointed  in  the 
United  States,  every  person  in  the  United  States  in  possession  of  any 
part  of  the  decedent's  gross  estate  is  constituted  an  executor  for  the 
purpose  of  tax  payment,  and  is  liable  for  the  tax  upon  the  trans- 
fer of  the  portion  of  the  gross  estate  in  his  possession.  All  checks, 
drafts,  or  money  orders  should  be  made  payable  to  the  order  of  Col- 
lector of  Internal  Revenue.  Payment  so  made  of  an  amount  indi- 
cated to  be  due  upon  the  return  discharges  the  tax  only  in  case  sub- 
sequent investigation  and  audit  disclose  that  the  correct  amount  has 
been  paid.     (See  Art.  90.)      (Reg.  2^^,  Art.  65.) 


Sixty-Day  Notice 

Resident  estates.^* — In  the  case  of  a  resident  decedent, 
action  is  required  on  the  part  of  the  executor  before  the  regu- 
lar return  is  filed.  It  is  necessary  that  he  give  written  notice 
to  the  collector  in  the  district  wherein  the  decedent  died  of 
such  death,  of  the  approximate  amount  of  the  gross  estate 
and  of  his  appointment  by  the  court  or  of  his  coming  into 
possession  of  the  property.  This  notice  must  be  filed  within 
two  months  (sixty  days)  after  the  executor  has  had  his  ap- 
pointment confirmed  by  the  courts. 

Law.  Section  404.  That  the  executor,  within  two  months"'"'  after 
the  decedent's  death,  or  within  a  like  period  after  qualifying  as  such, 
shall  give  written  notice  thereof  to  the  collector 

Regulations.  A  preliminary  notice,  called  the  60-day  notice,  is 
required  to  be  filed  in  the  case  of  every  resident  decedent  who  died 
on  or  after   February  25,    1919,   the   gross   amount  of  whose   estate 


"■'  See  Art.  60. 

'^  For  non-residents,  see  page  1493. 

'"The   term   "month"   means   calendar   month    (law,   section    400). 


I490 


MISCELLANEOUS    TAXES 


exceeds  $50,000.  This  notice  must  be  filed  in  duplicate  with  the  col- 
lector in  whose  district  the  decedent  had  his  domicile  at  the  time  of 
death.  Where  there  is  doubt  as  to  whether  the  gross  estate  exceeds 
$50,000,  the  notice  should  be  filed,  as  matter  of  precaution,  in  order  to 
avoid  penalties. 

Prior  to  February  25,  1919,  the  notice  was  required  if  the  gross 
estate  exceeded  $60,000,  or  if  there  was  any  net  estate  after  the 
deductions  allowed  by  law,  including  the  $50,000  exemption,  had  been 
taken.  These  provisions  are  not  now  in  effect  except  to  determine 
delinquency  under  previous  acts. 

In  the  case  of  the  estates  of  nonresident  decedents,  notice  is  re- 
quired if  there  is  any  property  situated  in  the  United  States,  without 
reference  to  its  value.     (Reg.  37,  Art.  66.) 

The  executor  or  administrator  of  an  estate  is  required  to  file 
notice  on  Form  704  within  60  days  of  his  appointment  by  the  court, 
or  of  coming  into  possession  of  any  property  of  the  estate,  whichever 
event  occurs  first.  The  primary  purpose  of  the  notice  is  to  advise  the 
Government  of  the  existence  of  taxable  estates,  and  filing  should  not 
be  delayed  beyond  the  60-day  period  because  of  uncertainty  as  to  the 
exact  value  of  the  assets.  Since  the  filing  of  the  notice  within  the 
prescribed  period  is  mandatory,  the  estimate  of  the  gross  estate  called 
for  by  the  notice  is  merely  the  best  approximation  of  value  which 
can  be  made  within  the  time  allowed.  The  instructions  upon  the 
back  of  the  form  should  be  read  carefully  before  executing  the  notice. 
The  signature  of  one  executor  or  administrator  upon  Form  704  is 
sufiEicient.  For  penalties  for  delinquency  in  filing  notice,  or  filing  of 
false  or  fraudulent  notice,  see  Articles  103  and  104.  (Reg.  37, 
Art.  ^y.) 

A  detailed  explanation  under  oath  must  accompany  form 
704  in  the  event  of  failure  to  file  same  within  the  time  set  by 
law. 

Notice  by  other.s  than  the  executor  or  adminis- 
trator.— 

Regulation.  The  notice  upon  Form  704  must  be  filed  by  others 
than  the  executor  or  administrator  if  either  of  the  following  situa- 
tions exists: 

(i)    No  executor   or   administrator   has   been   appointed. 

(2)  There  is  property  included  in  the  gross  estate,  as  defined  by 
-Statute,  which  has  not,  and  will  not,  come  into  the  custody  and  con- 
trol of  the  executor. 

In  these  cases,  the  persons  in  possession  of  the  property  included 
in  the  gross  estate  are  executors,  within  the  meaning  of  the  statute, 
for  the  purpose  of  filing  the  notice.     (Reg.  37,  Art.  68.) 


FEDERAL   ESTATE   TAX 


Notice  wken  no  executor  appointed. 


1491 


Regulation.  Where  no  executor  or  administratur  has  been  ap- 
pointed, the  person  taking  possession  of  property  at  the  time  of  death 
is  required  to  file  notice  within  60  days  of  the  date  of  death.  The 
notice  must  be  filed  whether  possession  of  the  property  was  held  at 
the  date  of  death,  or  was  acquired  thereafter.  The  notice  on  Form 
704  must  be  filed  by  such  persons  in  any  case  where  an  executor  or 
administrator  has  not  been  appointed  within  60  days  of  the  decedent's 
death,  although  one  is  appointed  subsequently.  Where  an  executor 
or  administrator  is  appointed  within  the  60-day  period,  the  duty  of 
filing  the  notice  devolves  upon  him;  and  all  other  persons  are  relieved 
from  liability  to  file  with  respect  to  property  coming  into  the  custody 
and  control  of  the  executor  or  administrator.      (Reg.  37,  Art.  69.) 

Notice  where  property  not  within  executor's  con- 
trol.— 

Regulation.  Where  there  is  property  that  will  not  come  into 
the  custody  and  control  of  the  executor,  but  which  is  included  in  the 
gross  estate  as  defined  by  the  statute,  the  notice  on  Form  704  must 
be  filed  within  60  days  of  the  date  of  death  by  the  person  in  possession 
or  control  of  the  property  at  the  time  of  death. 

The  persons  required  to  file  Form  704,  in  compliance  with  this 
requirement,   include  the   following: 

(i)  The  surviving  husband  or  wife  in  the  case  of  property  owned 
as  tenants  in  the  entirety. 

(2)  Donees  who  have  received  within  two  years  prior  to  the  de- 
cedent's death  any  gift  of  material  value  from  the  decedent,  or  who 
have  received  at  any  time  whatever  gifts  made  by  the  decedent  in 
contemplation  of  death  or  intended  to  take  effect  at  or  after  death. 

(3)  Trustees  holding  property  conveyed  during  lifetime  by  de- 
cedent in  contemplation  of  death,  or  with  intent  to  provide  for  others 
at  or  after  the  decedent's  death,  regardless  of  the  date  of  execution 
of  the  instrument  making  the  conveyance. 

(4)  Fiduciaries  holding  property  of  any  kind  jointly  for  the  de- 
cedent and  another  or  others.  Example :  A  savings  bank  holding  a 
joint  account  in  the  name  of  the  decedent  and  another,  payable  to 
either  or  to  the  survivor,  must  file  Form  704  for  the  full  amount  of 
the  account. 

(5)  Trustees  having  in  charge  property  over  which  the  decedent 
exercised  a  general  power  of  appointment,  and  which  will  not  come 
into  the  possession  and  control  of  the  executor  or  administrator. 

(6)  Beneficiaries  other  than  the  executor  who  receive  insurance 
upon  the  decedent's  life,  provided  the  total  amount  of  the  insurance 
receivable  by  all  such  beneficiaries  exceeds  $40,000. 

The  primary  duty  of  filing  notice  with  respect  to  property  which 


1492 


MISCELLANEOUS   TAXES 


will  not  come  into  the  executor's  control  rests  upon  the  person  actu- 
ally in  possession  at  the  time  of  death.  It  is  the  duty  of  the  succeed- 
ing owner,  however,  where  property  of  this  character  is  held  at  the 
tmie  of  death  by  an  agent  or  fiduciary,  to  give  notice  w^ithin  60  days 
of  the  date  of  taking  possession,  unless  he  finds  that  notice  has  already 
been  filed.  For  example,  the  appointee  of  property,  under  a  general 
power  of  appointment  exercised  by  the  decedent,  should  file  notice 
within  60  days  of  receiving  possession,  unless  the  notice  has  already 
been  filed.     (Reg.  37,  Art.  70,) 

Insurance  companies'  sixty-day  notice. — 

Regulation.  Sixty-day  notice  upon  Form  787  must  be  filed  by 
every  insurance  company  which  pays  insurance  upon  the  life  of  a 
resident  decedent  to  beneficiaries  other  than  the  executor  or  adminis- 
trator in  amounts  aggregating  more  than  $40,000,  or  which  has  knowl- 
edge of  insurance  payable  to  such  beneficiaries  by  other  insurance 
companies,  aggregating,  with  amounts  payable  by  the  company  it- 
self, more  than  $40,000.  If  the  proceeds  of  any  policy  are  payable  in 
the  form  of  an  annuity,  the  present  worth  of  such  annuity,  for  the 
purpose  of  deducting  the  $40,000  exemption,  should  be  computed  in 
accordance  w'ith  the  provision  of  Article  20.  Notice  should  be  filed 
with  the  collector  of  the  district  in  which  the  decedent  had  his  domicile 
within  60  days  of  receipt  by  the  company  of  notification  of  death.  If 
the  insurance  company  is  in  doubt  as  to  its  liability  to  give  notice, 
the  notice  should  be  filed. 

Where  insurance  is  taken  out  with  a  foreign  branch  of  a  domestic 
insurance  company,  the  notice  should  be  given  by  the  home  office  of 
the  company  within  60  days  of  the  receipt  by  the  foreign  branch  of 
information  of  the  decedent's  death.     (Reg.  37,  Art.  71.) 

Where  military  exemption  claimed  sixty-day  notice 

required. — 

Regulation.  The  executors  of  estates  exempted  from  the  tax 
(see  Art.  9)  are  required  to  file  the  60-day  notice  with  the  proper 
collector  in  the  same  manner  as  the  executors  of  taxable  estates.  The 
executor  should,  in  addition,  write  across  the  face  of  the  form  the 
words   "Military   exemption  claimed.'"      (Reg.   37,   Art.   72.) 

Under  the  provision  covering  military  exemptions  (section 
401 )  the  regulations  demand  that  a  formal  claim  for  such 
exemption  be  submitted  with  the  sixty-day  notice,  or  as  soon 
as  possible  thereafter,  on  form  793.^** 

'°Reg.  ZT,  Art.  10, 


FEDERAL   ESTATE   TAX 


1493 


Non-resident  estates. — 


Regulation.  A  60-day  notice  on  Form  705  should  be  filed  with 
the  Commissioner  of  Internal  Revenue,  Washington,  D.  C,  by  every 
executor  or  administrator  appointed  in  the  United  States.  The  notice 
is  necessary  if  any  part  of  the  decedent's  gross  estate  was  situated 
in  the  United  States  at  the  time  of  death,  regardless  of  the  value  of 
that  part  or  of  the  entire  gross  estate.  If  no  executor  or  adminis- 
trator has  been  appointed  in  this  country,  notice  must  be  filed  within 
60  days  of  the  date  of  death  by  every  person  in  possession  of  any 
part  of  the  gross  estate  in  the  United  States.  If  such  person  has  no 
knowledge  of  the  decedent's  death  within  60  days  of  its  occurrence, 
he  should  file  this  notice  immediately  upon  obtaining  such  knowledge. 
The  filing  of  notice  by  a  foreign  executor  or  administrator  does  not 
relieve  persons  in  possession  from  the  duty  of  filing  notice.  If  there 
is  a  delay  in  the  appointment  of  a  local  executor  or  administrator  of 
more  than  60  days  after  the  death,  persons  in  possession  should  file 
notice.  The  term  "person  in  possession  of  property  of  the  decedent" 
includes  the  decedent's  agents  or  representatives,  donees  and  trans- 
ferees or  trustees  of  property  transferred  in  contemplation  of  death ; 
the  surviving  owner  of  property  held  jointly;  safe-deposit  companies, 
warehouse  companies,  and  similar  custodians  of  property  in  this 
country  of  a  nonresident  decedent;  brokers  holding  as  collateral 
securities  belonging  to  the  decedent  or  investment  funds  owned  by 
the  decedent ;  banking  institutions  holding  money  on  deposit  or  for 
any  specific  purpose,  such  as  purchase  of  goods,  if  the  title  rests 
in  the  decedent;  and  debtors  of  the  decedent  in  this  country.  (Reg. 
37,  Art.  73.) 

Transfer  agents'  sixty-day  notice. — 

Regulations.  A  60-day  notice  upon  Form  714  is  required  to  be 
filed  whenever  a  corporation,  its  transfer  agent,  register,  or  paying 
agent,  is  called  upon  to  make  a  transfer  of  stocks  or  bonds,  or  to  pay 
interest  or  dividends,  to  any  successor  in  interest  of  any  nonresident 
stockholder  or  bondholder  who  died  after  September  8,  1916,  unless 
the  transfer  is  made  upon  the  order  of  an  executor  or  administrator 
appointed  in  the  United  .States.  The  notice  is  required  for  dividends 
declared  prior  to  the  day  of  death,  and  for  interest  which  had  ac- 
crued on  bonds  prior  to  the  death  of  the  decedent  although  payable 
thereafter.  Notice  should  be  filed  with  the  Commissioner  of  Internal 
Revenue  at  Washington,  D.  C,  within  60  days  of  the  date  of  death,  or 
immediately  upon  receipt  of  the  order  of  transfer  or  payment.  A 
transfer  agent  should  be  vigilant  to  report  all  cases  in  which  the  fact 
of  the  death  of  a  nonresident  appears.  Where  the  securities  are  re- 
ceived without  the  personal  assignment  of  the  decedent,  but  with  the 
transfer  order  of  the  foreign  executor,  it  is  clear  that  the  case  should 


1494  MISCELLANEOUS   TAXES 

be  reported.  Where  the  securities  bear  the  personal  assignment  of  the 
decedent,  the  transfer  should  be  reported  if  made  upon  the  order  of  a 
foreign  executor,  or  if  information  is  received  in  any  other  manner 
that  the  record  owner  has  died  a  nonresident  of  the  United  States. 
(Reg.  37,  Art.  74.) 

In  order  to  prevent  loss  of  the  tax  upon  nonresident  estates,  it  is 
essential  that  transfer  agents  should  exercise  great  care  in  reporting 
all  transfers  of  the  kind  described.  Their  records  will  be  examined 
from  time  to  time  by  internal-revenue  ofificers  to  determine  whether 
this  regulation  is  being  strictly  complied  with.  Failure  to  file  notice 
in  the  manner  prescribed  will  render  the  transfer  agent  liable  to  a 
fine.      (Reg.  37,  Art.  75.) 

Transfer  of  stock  of   non-resident  decedent,  how 

MADE. 

Regulation.  Wherever  a  transfer  agent  is  required  to  file 
60-day  notice  as  provided  in  Article  74,  he  shall  not  make  transfer  of 
the  stock  standing  in  the  name  of  the  decedent  until  there  has  been  de- 
livered to  such  collector  of  internal  revenue  as  may  be  designated  by 
the  Commissioner  the  bond  of  the  party  to  whom  the  stock  is  to  be 
transferred  with  corporate  surety  in  an  amount  to  be  fixed  by  the 
Commissioner,  conditioned  for  the  payment  of  the  tax  upon  the  trans- 
fer of  the  decedent's  estate,  not  exceeding  in  amount  the  value  of  the 
stock  to  be  transferred.  Upon  receipt  of  the  60-day  notice  the  Com- 
missioner will  at  once,  upon  request,  fix  the  amount  for  which  the 
bond  is  to  be  given.  In  lieu  of  the  bond  a  deposit  of  the  amount  so 
fixed  may  be  made  with  such  collector  of  internal  revenue  as  the 
Commissioner  may  designate.  Where  a  sum  of  money  is  deposited 
in  lieu  of  the  bond,  and  it  exceeds  the  amount  of  the  tax  as  finally 
determined,  the  excess  will  be  refunded  to  the  person  making  deposit. 
In  lieu  of  the  provisions  and  restrictions  hereinbefore  set  forth, 
transfer  agents  are  authorized  to  make  a  transfer  of  stock  standing 
in  the  name  of  a  nonresident  decedent  to  the  duly  qualified  ancillary 
executor  or  administrator  within  the  United  States,  who  shall  make  a 
return  on  Form  706,  as  any  other  executor  is  required  by  law  to 
do,  provided  that  such  transfer  agent  at  the  time  of  making  such  trans- 
fer gives  notice  thereof  in  writing  to  the  Commissioner  of  Internal 
Revenue.     (Reg.  37,  Art.  75  A.) 

Insurance  companies'  .sixty-day  notice. — 

Regulation.  The  60-day  notice  upon  Form  788  must  be  filed  by 
every  domestic  insurance  company  which  pays  insurance  upon  the 
life  of  the  nonresident  decedent  in  any  amount  either  to  a  foreign 
executor  or  administrator,  or  to  individual  beneficiaries.  The  notice 
should  be  filed  with  the  Commissioner  of  Interna]   Revenue,   Wash- 


FEDERAL   ESTATE   TAX 


1495 


ington,  D.  C,  within  60  days  of  receipt  of  proof  of  claim.  No  notice 
is  required  to  be  filed,  if  the  only  insurance  paid  is  receivable  by  an 
executor  appointed  in  the  United  States.  If,  however,  the  company 
is  liable  to  give  notice,  it  is  required  to  report  insurance  of  all  classes 
in  order  that  its  statement  may  be  complete.     (Reg.  37,  Art.  y6.) 

Payment  of  life  insurance  policy. — 

Regulation.  Wherever  an  insurance  company  is  required  to 
file  a  60-day  notice,  as  provided  in  Article  76,  where  the  insured  was 
a  nonresident  it  shall  not  make  payment  of  any  policy  or  policies  to  a 
foreign  executor  or  administrator,  or  to  an  individual  beneficiary, 
until  there  has  been  delivered  to  such  collector  of  internal  revenue 
as  may  be  designated  by  the  Commissioner  the  bond  of  the  party  to 
whom  the  insurance  is  to  be  paid,  with  corporate  surety  in  an  amount 
to  be  fixed  by  the  Commissioner,  conditioned  for  the  payment  of  the 
tax  upon  the  transfer  of  the  decedent's  estate,  not  exceeding  the 
amount  of  insurance  payable  under  such  policy  to  the  executor,  and 
the  excess  over  $40,000  of  the  aggregate  insurance  payable  to  specific 
beneficiaries  other  than  the  executor  or  the  estate  of  the  decedent. 
Upon  receipt  of  the  60-day  notice  the  Commissioner  will  at  once,  upon 
request,  fix  the  amount  of  the  bond  to  be  given.  In  lieu  of  such  bond 
a  deposit  of  the  amount  fixed  may  be  made  with  such  collector  of  in- 
ternal revenue  as  the  Commissioner  may  designate.  If  in  lieu  of 
the  bond  a  sum  of  money  is  deposited,  and  such  sum  exceeds  the 
amount  of  tax  as  finally  determined,  the  excess  will  be  refunded  to  the 
person  making  the  deposit.  In  lieu  of  the  bond  or  a  deposit  of  money, 
where  insurance  is  payable  to  a  foreign  executor  or  administrator, 
the  insurance  may  be  paid  to  ancillary  executor  or  administrator  ap- 
pointed within  the  United  States,  provided  that  such  ancillary  exe- 
cutor or  administrator  shall  have  given  bond  with  corporate  surety 
in  an  amount  sufiicient,  in  the  opinion  of  the  Commissioner,  to  dis- 
charge the  tax  liability  of  the  estate,  not  exceeding  the  amount  of 
insurance  subject  to  be  included  within  the  gross  estate  of  the  de- 
cedent. 

Wherever  insurance  companies  are  required  to  file  a  60-day  notice, 
as  provided  in  Article  71,  where  the  decedent  is  a  resident  and  there 
is  subject  to  be  included  within  the  decedent's  gross  estate  any  excess 
over  $40,000  in  the  aggregate  of  insurance  payable  to  specific 
beneficiaries  other  than  the  executor  or  the  estate  of  the  decedent, 
the  same  provisions  and  restrictions  in  regard  to  payment  of  insur- 
ance shall  apply  and  govern  insurance  companies  as  are  set  forth 
in  this  article  in  the  case  of  nonresidents. 

Where  insurance  companies  are  required  to  file  a  60-day  notice, 
as  provided  in  Article  71  or  in  Article  76,  if  the  decedent  is  a  resi- 
dent or  nonresident,  and  there  is  an  excess  over  $40,000  in  the  aggre- 


1496  MISCELLANEOUS    TAXES 

gate  of  all  insurance  payable  to  specific  beneficiaries  other  than  the 
executor  or  the  estate  of  the  decedent,  insurance  companies  are 
authorized,  in  lieu  of  the  provisions  and  restrictions  hereinbefore  set 
forth,  upon  consent  of  the  beneficiaries  to  make  payment  of  such 
insurance  to  such  beneficiaries  through  the  duly  qualified  executor 
or  administrator  within  the  United  States  or  through  the  duly  qual- 
ified ancillary  executor  or  administrator  in  the  United  States 
who  shall  make  return  on  Form  706  of  the  excess  over  $40,000 
of  such  insurance,  if  the  estate  be  that  of  a  nonresident,  or  that  of  a 
resident  if  there  be  a  net  estate  subject  to  tax.     (Reg.  37,  Art.  76A.) 

Returns 

Returns  for  resident  estates. — As  with  returns  called  for 
under  the  income  tax  laws,  the  returns  under  this  title  literally 
impose  upon  the  executor  the  duty  of  assessing  the  amount  of 
tax  due.  The  correctness  of  this  assessment  is  subject  to  final 
determination  by  the  Commissioner. 

The  form  of  the  return  is  practically  a  series  of  information 
schedules  which  may  be  summarized  as  follows : 

1.  General  information  sheet  in  regard  to  decedent,  heirs, 

legatees,  and  beneficiaries. 

2.  Items  under  separate  captions,  going  to  make  up  the 

gross  estate  (schedules  A  to  D). 

3.  Transfers,  property  passing  under  power  of  appoint- 

ment, and  property  taxed  within  five  years  (sched- 
ules E  to  G). 

4.  Deductions  classified  (schedules  H  to  K). 

5.  Recapitulation   (schedule  L). 

6.  Rates  and  tax  due  (schedule  AI). 

7.  Jurat  for  executors,  etc. 

Schedule  AI  also  calls  for  details  to  be  supplied  by  non- 
residents as  to  gross  estate  situated  outside  the  United  States. 

Explicit  and  concise  instructions  are  given  regarding  the 
information  required,  and  these  instructions  should  be  fol- 
lowed in  every  particular. 

Law.     Section    404 The    executor    shall    also,    at    such 

times  and  in  such  manner  as  may  be  required  by   regulations  made 


FEDERAL   ESTATE   TAX 


1497 


pursuant  to  law,  file  with  the  collector  a  return  under  oath  in  dupli- 
cate, setting  forth  (a)  the  value  of  the  gross  estate  of  the  decedent 
at  the  time  of  his  death,  or,  in  case  of  a  nonresident,  of  that  part  of 
his  gross  estate  situated  in  the  United  States;  (b)  the  deductions 
allowed  under  section  403;  (c)  the  value  of  the  net  estate  of  the  de- 
cedent as  defined  in  section  403;  and  (d)  the  tax  paid  or  payable  there- 
on; or  such  part  of  such  information  as  may  at  the  time  be  ascer- 
tainable and  such  supplemental  data  as  may  be  necessary  to  establish 
the  correct  tax. 

Return  shall  be  made  in  all  cases  where  the  gross  estate  at  the 
death  of  the  decedent  exceeds  $50,000,  and  in  the  case  of  the  estate 
of  every  nonresident  any  part  of  whose  gross  estate  is  situated  in 
the  United  States.  If  the  executor  is  unable  to  make  a  complete  re- 
turn as  to  any  part  of  the  gross  estate  of  the  decedent,  he  shall  include  in 
his  return  a  description  of  such  part  and  the  name  of  every  person  hold- 
ing a  legal  or  beneficial  interest  therein,  and  upon  notice  from  the  collec- 
tor such  person  shall  in  like  manner  make  a  return  as  to  such  part  of  the 
gross  estate.  The  commissioner  shall  make  all  assessments  of  the 
tax  under  the  authority  of  existing  administrative  special  and  general 
provisions  of  law  relating  to  the  assessment  and  collection  of  taxes. 

Date  of  filing  return. — 

Regulation.  A  return  on  Form  706  is  required  in  the  case  of 
every  resident  decedent  who  died  on  or  after  February  25,  1919, 
leaving  a  gross  estate  exceeding  $50,000  in  value.  This  return  must 
be  filed  with  the  collector  in  whose  district  the  decedent  resided.  It  must 
be  filed  within  one  year  after  the  date  of  death,  unless  an  extension 
is  granted,  and  must  be  in  duplicate.  In  the  case  of  decedents  who 
died  before  February  25,  1919,  the  effective  date  of  the  Revenue 
Act  of  1918,  the  return  is  required  if  the  gross  estate  exceeds  $60,000, 
or  if  there  is  any  net  estate  after  the  legal  deductions,  including  the 
$50,000  exemption,  have  been  taken.  In  the  case  of  estates  of  non- 
residents return  is  required  if  the  decedent  owned  any  property  in 
the  United  States  regardless  of  value.  (See  Art  88.)  (Reg.  37, 
Art.  77.) 

Procedure  where  no  return  has  been  made. — 

Regulation.  The  statute  provides  that  if  no  return  is  filed  for 
the  estate  of  a  decedent,  or  if  a  return  contains  a  false  or  incor- 
rect statement  of  a  material  fact,  the  collector  or  deputy  collector 
shall  make  a  return.  The  Commissioner  may  amend  this  return  from 
such  knowledge  or  information  as  he  can  obtain,  through  testimony 
or  otherwise.  A  return  so  made  by  the  Commissioner,  or  made  by 
the  collector  and  approved  by  the  Commissioner,  is  a  sufficient  basis 
for  assessing  the  tax.     Where  a  tax   is  found  to  be  due  upon   such 


1498  MISCELLANEOUS    TAXES 

a   return,  the  estate   will   be   liable   for   penalties   as  well   as   for  the 
tax.     {Reg.  37,  Art.  78.) 

Investigation  where  return  has  been  filed. — 

Regulation.  An  investigation  of  every  return  for  estate  tax 
will  be  conducted  to  verify  the  accuracy  of  the  return.  The  investi- 
gation will  be  made  by  special  officers  of  the  Bureau.  The  fact  that 
an  investigation  is  made  does  not  reflect  upon  the  competence  or  good 
faith  of  the  executor,  since  investigations  are  required  in  all  cases 
as  a  matter  of  administrative  procedure.  The  executor  should  cooper- 
ate with  the  examining  officer  in  order  that  the  full  tax  liability  may 
be  definitely  determined  and  the  case  closed.  During  the  course  of 
the  investigation  the  examining  officer  will  inspect  the  books  and 
records  of  the  estate,  interview  the  executor  and  other  persons  hav- 
ing knowledge  of  the  decedent's  affairs,  verify  the  value  of  the 
assets  and  the  amounts  of  debts  and  administration  expenses,  and  take 
such  other  steps  as  may  be  necessary  to  determine  the  correct  tax. 

It  is  the  purpose  of  the  Bureau  to  make  these  investigations  as 
soon  as  practicable  after  the  filing  of  the  return.  Whenever  there 
are  special  and  urgent  reasons  for  an  early  investigation,  the  col- 
lector should  be  notified  in  order  that  the  case  may  be  given  special 
attention.  Upon  completion  of  the  investigation  the  executor  will 
be  apprised  by  the  examining  officer  of  his  findings,  and  will  be  given 
an  opportunity  to  discuss  the  case  and  present  such  data  as  he  may 
desire,  to  be  considered  by  the  Bureau  in  connection  with  the  ex- 
amining officer's  report.  Upon  the  completion  of  the  review  and 
audit  by  the  Bureau  of  the  return  and  the  examining  officer's  report, 
the  executor  will  be  informed  by  letter  from  the  Commissioner  of 
the  result  of  the  audit.  If  the  letter  contains  notification  of  an 
unpaid  balance  of  tax,  the  executor  should  make  payment  to  the  col- 
lector. After  the  expiration  of  30  days  from  receipt  of  the  notification 
interest  will  accrue  upon  the  excess  tax  at  the  rate  of  ten  per 
centum  per  annum.  If  the  executor  wishes  to  file  claim  for  abate- 
ment of  any  part  of  the  excess  tax,  such  claim  must  be  filed  within 
30  days  of  receipt  of  notification,  or  he  may  pay  the  tax  in  order 
to  prevent  the  running  of  interest,  and  submit  claim  for  refund. 
(Reg.  37,  Art.  79.) 

The  foregoing  regulation  is  in  the  nature  of  an  outHne  of 
procedure  which  the  Treasury  follows  after  the  executor  has 
performed  the  requirements  of  the  law  in  fihng  form  706. 
It  is  unfortunate  that  the  Treasury  is  not  subjected  to  a  Hmi- 
tation  of  titne  as  is  tlie  exectitor.  In  many  cases  there  are 
'^special   and  tirgent   reasons"    why   estates   should  l)e   settled 


FEDERAL   ESTATE    TAX 


1499 


with  despatch.  Particularly  may  this  be  said  of  an  estate 
which  must  remain  under  the  administration  of  an  executor, 
with  consequent  cost  and  inconvenience  to  the  legatees.  While 
section  407  provides  that  the  Commissioner,  on  written  appli- 
cation of  the  executor,  shall  make  a  final  settlement  of  the  tax 
within  one  year  from  the  receipt  of  such  application,  there 
seems  to  be  no  reason  why  the  Treasury  should  not  be  com- 
pelled by  law  to  do  its  business  with  ordinary  despatch  without 
a  special  application  for  settlement  being  necessary.  A  maxi- 
mum time  should  be  established,  within  which  time  the  inves- 
tigation must  be  completed  and  a  final  assessment  agreed  upon. 
Promise  of  more  speedy  operation  on  the  part  of  the  sec- 
tions responsible  for  audit  and  examination  of  estate  tax  re- 
turns is  reflected  in  the  statement  that  ''changes  in  procedure 
and  personnel  have  resulted  in  bringing  work  to  a  current 
basis  and  increased  efficiency."  '  There  were  11,833  estate 
tax  returns  filed  during  the  year  ended  June  30,  192 1,  which 
produced  just  over  $103,000,000.  Examinations  of  these  re- 
turns disclosed  additional  taxes  due  to  the  government  amount- 
ing to  over  $13,000,000,  or  12.9  per  cent,  an  indication  of  the 
necessity  for  prompt  audit  so  that  executors  may  close  estates 
within  a  reasonable  time. 

Who  shall  make  the  return. — 

Regulation.  The  statute  provides  that  the  executor  or  admin- 
istrator shall  file  the  return.  If  there  is  more  than  one  executor  or 
administrator,  the  return  must  be  made  jointly  by  all.  Where  no 
executor  or  administrator  has  been  appointed,  every  person  in  pos- 
session of  any  part  of  the  gross  estate  is  considered  to  be  an  executor 
for  the  purposes  of  the  tax,  and  is  liable  for  a  return  as  to  the  property 
in  his  possession.  The  executor  or  administrator  is  required  to  make 
a  return  of  the  entire  gross  estate  of  the  decedent,  including  property 
which  will  not  come  into  his  possession,  such  as  property  transferred 
by  the  decedent  before  death,  and  property  owned  by  tenants  in 
the  entirety.  If  the  executor  is  unable  to  make  a  complete  return 
as  to  any  part  of  the  gross  estate,  he  is  required  to  give  all  the  in- 
formation he  has  as  to   such   property,   including  a   full  description, 


Report  of  Commissioner  of  Internal  Revenue,  1921. 


I500 


MISCELLANEOUS    TAXES 


and  the  name  of  every  person  holding  a  legal  or  beneficial  interest 
in  the  property.  Where  the  execntor  is  unable  to  make  a  return  as 
to  any  property,  the  statute  requires  every  person  holding  a  legal 
or  beneficial  interest  therein,  upon  notice  from  the  collector,  to  make 
return  as  to  such  part  of 'the  gross  estate.  For  penalties  for  delin- 
quency in  filing  return,  or  filing  of  false  or  fraudulent  return,  see 
Articles  103  and  104.     (Reg.  37,  Art.  80.) 

Extension  of  time  for  filing  return. — 

Regulation.  If  it  is  impossible  for  the  executor  to  file  a  com- 
plete return  within  a  year  from  the  date  of  death,  he  may  make  ap- 
plication to  the  collector  for  an  extension  of  time  for  filing  the  return, 
stating  in  detail  in  his  application  the  circumstances  which  prevent 
the  filing  of  the  return  by  the  due  date  and  setting  forth  briefly  but 
fully  a  statement  of  what  the  gross  estate  consists,  together  with  a 
statement  of  the  amount  of  deductions  claimed,  provided  that  in  the 
first  instance  the  application  be  made  at  least  30  days  prior  to  the 
due  date  of  the  return.  If  the  collector  is  satisfied  that  a  complete 
return  can  not  be  made  he  may  grant  extensions  of  time  not  to  exceed 
180  days  from  the  due  date,  no  single  extension  exceeding  60  days. 
At  the  expiration  of  the  last  extension  period  granted  a  return  must 
be  filed.  If  at  that  time  it  is  still  impossible  to  file  a  complete  and 
accurate  return,  on  account  of  the  unsettled  condition  of  the  affairs 
of  the  estate,  the  return  filed  by  the  executor  must  be  as  complete  as 
possible,  and  must  set  forth  all  the  facts  in  his  possession  as  to  the 
gross  and  net  estate.  Such  a  return  will  be  accepted  by  the  collector; 
but  the  executor  must  file  an  amended  return  as  soon  as  the  condi- 
tion of  the  estate  permits.  The  granting  of  an  extension  of  time 
for  filing  a  return  does  not  operate  to  extend  the  time  for  the  pay- 
ment of  the  tax,  which  is  due  one  year  after  decedent's  death  unless 
the  time  for  payment  thereof  be  extended  by  the  Commissioner,  as 
provided  in  Article  93.  Where  application  has  been  made  for  an 
extension  of  time  to  file  a  return,  but  no  extension  of  time 
for  the  payment  of  the  tax  has  been  granted,  the  executor 
will  be  required  to  pay  on  the  due  date  a  sum  of  money 
sufiicient,  in  the  opinion  of  the  collector,  to  discharge  the  tax,  even 
though  an  extension  of  time  to  file  the  return  has  been  or  may  be 
granted.  The  statements  accompanying  the  application  will  be  sub- 
ject to  investigation  and  verification  in  acting  upon  the  application 
for  extension  and  in  fixing  the  amount  which  the  executor  will  be 
required  to  pay  on  the  due  date  of  the  tax  as  sufficient  in  the  opinion 
of  the  collector  to  discharge  the  tax.     (Reg.  37,  Art.  81.) 

Form  of  return. — 

Regulations.  The  return  must  be  made  on  Form  706,  copies  of 
which  will  be  supplied  by  the  collector.     It  must  contain  an  itemized 


FEDERAL   ESTATE   TAX 


1 501 


inventory,  by  schedule,  of  the  property  constituting  the  gross  estate, 
together  with  a  full  statement  of  deductions  claimed,  as  therein  pro- 
vided. The  instructions  printed  on  the  form  should  be  carefully 
followed.  All  documents  and  vouchers  used  in  preparing  the  return 
should  be  retained  by  the  executor,  so  as  to  be  available  for  in- 
spection whenever  required.  Certified  copies  of  the  will,  if  any, 
must  be  submitted  with  the  return,  together  with  duplicate  copies  of  the 
other  documents  required  by  the  instructions  printed  on  the  form, 
or  any  documents  which  the  executor  may  desire  to  submit  with  the 
return  in  explanation  thereof.     (Reg.  37,  Art.  82.) 

The  statute  provides  that  the  executor,  in  addition  to  filing  notice 
and  return,  shall  furnish  such  supplemental  data  as  may  be  necessary 
to  establish  the  correct  tax.  It  is  therefore  the  duty  of  the  executor 
to  furnish  upon  request  copies  of  any  documents  in  his  possession 
relating  to  the  estate,  or  on  file  in  any  court  having  jurisdiction 
over  the  estate,  appraisal  lists  of  any  items  included  in  the  gross 
estate,  copies  of  balance  sheets  or  other  financial  statements  relating 
to  the  value  of  stock,  and  any  other  information  obtainable  by  him 
that  may  be  found  necessary  in  the  determination  of  the  tax.  Failure 
to  comply  with  such  a  request  will  render  the  executor  liable  to  a  fine 
not  to  exceed  $500,  and  proceedings  may  be  instituted  in  the  proper 
United  States  court  to  secure  compliance  with  the  requirement.  (Reg. 
Z7,  Art.  83.) 

Form  of  return — non-resident  estates. — 

Regulations.  Pursuant  to  this  provision  the  executor  of  a 
nonresident  decedent  is  required  to  file  with  the  return: 

(i)  Certified  copy  of  will,  or,  if  the  decedent  left  several  wills, 
to  govern  in  different  jurisdictions,  certified  copy  of  each  will. 

(2)  Certified  copy  of  inventory  of  foreign  property  filed  under  a 
foreign  estate,  succession  or  death-duty  act;  or,  if  no  such  inventory 
was  filed,  copy  of  inventory  filed  with  the  foreign  court  of  probate 
jurisdiction. 

(3)  Certified  copy  of  schedule  of  claims  filed  under  a  foreign 
taxing  act  in  cases  where  such  claims  are  presented  for  deduction. 
If  any  item  of  deduction  is  not  included  in  the  schedule,  the  affidavit 
of  the  foreign  executor  or  administrator  with  reference  thereto  should 
be  submitted. 

The  specified  information  is  required,  whether  or  not  the  executor 
wishes  to  claim  deduction,  and  is  subject  to  the  provision  of  the 
statute  (see  Sec.  403)  requiring  him  to  include  in  his  return  the  value 
of  the  gross  estate  situated  in  the  United  States.     (Reg.  ^y.  Art.  84.) 

A  return  on  Form  706  must  be  filed  in  duplicate  with  the  Com- 
missioner of  Internal  Revenue,  Washington,  D.  C,  or  with  such 
collector   of   internal   revenue   as   the   Commissioner   may   designate, 


I502 


MISCELLANEOUS    TAXES 


within  a  year  from  the  date  of  death  of  every  nonresident  decedent, 
if  any  part  of  the  gross  estate  of  such  decedent  was  situated  in  the 
United  States  at  the  time  of  his  death.  It  is  the  duty  of  any  executor 
or  administrator  appointed  in  the  United  States  to  file  a  return  for 
the  whole  of  that  part  of  the  gross  estate  situated  in  the  United  States, 
whatever  its  value.  If  there  is  no  such  executor  or  administrator,  every 
person  in  possession  of  any  part  of  the  gross  estate  in  the  United 
States  may  be  required  to  file  a  return  for  such  part.  Except  as 
otherwise  specifically  provided  by  these  Regulations,  notice  will  be 
given  to  such  persons,  however,  where  a  return  is  required;  and 
they  are  relieved  of  the  duty  of  filing  returns  by  the  appointment  of 
an  executor  or  administrator  in  the  United  States,  but  not,  however, 
by  the  appointment  of  a  foreign  executor  or  administrator.  If,  how- 
ever, a  complete  return  is  actually  filed  by  the  foreign  executor  of 
property  in  the  United  States,  the  person  in  possession  need  not  file 
a  return,  except  as  otherwise  specifically  required  by  these  Regulations. 
(Reg.  37,  Art.  88.) 

Returns  are  privileged  communications. — 

Regulations.  All  estate  tax  returns  and  notices  are  treated  as 
privileged  communications  and  may  not  be  exhibited  to  any  person 
other  than  the  executor  or  his  duly  authorized  attorney,  except  as 
stated  in  Article  86.  This  requirement  of  secrecy  will  be  rigidly 
enforced,  a'nd  extends  to  information  of  a  private  nature  submitted  or 
obtained  in  connection  with  a  return  or  notice.  The  requirement 
does  not  operate  to  prevent  internal  revenue  officers  from  disclosing 
the  returned  value  of  any  item  or  the  amount  of  any  specific  deduc- 
tion where  such  disclosure  is  necessary  in  order  to  arrive  at  a  cor- 
rect determination  of  the  tax.  This  right  of  disclosure,  however, 
does  not  extend  to  such  information  as  the  amount  of  the  estate, 
^he  amount  of  tax,  or  other  general  data.  Nor  are  the  records  in 
possession  of  the  Bureau,  whether  on  file  with  the  Commissioner  or 
the  collector,  open  to  inspection,  except  as  provided  herein.  (Reg. 
Z7,  Art.  85.) 

Where  any  person  other  than  the  executor  has  a  material  interest 
in  ascertaining  any  fact  disclosed  by  the  return,  or  in  obtaining  in- 
formation as  to  the  payment  of  the  tax,  he  shall  make  a  written  ap- 
plication to  the  Commissioner  of  Internal  Revenue  for  such  informa- 
tion, setting  forth  the  nature  of  his  interest  and  the  purpose  of  the 
application.  The  Commissioner  will  review  the  application,  and, 
if  it  is  approved,  give  written  instruction  to  the  collector  to  exhibit 
the  return  to  the  applicant,  or  give  him  such  information  as  is  spec- 
ified. LTnder  no  circumstances  shall  the  collector  give  information  to 
persons  other  than   the   executor   except  upon   the   written   order   of 


FEDERAL  ESTATE  TAX  1503 

the  Commissioner,  and  to  the  extent  authorized  by  such  order.      (Reg. 
Z7,  Art.  86.) 

In  all  cases  where  information  is  sought  regarding  an  estate, 
or  an  interview  asked,  by  an  attorney  whose  name  does  not  appear 
on  form  706  as  the  attorney  for  the  estate,  the  information  or  in- 
terview will  be  denied  unless  the  attorney  presents  a  signed  state- 
ment from  the  executor,  authorizing  him  to  appear  in  his  behalf. 
The  limitation  does  not  apply  where  an  attorney  asks  a  general 
ruling  on  a  question  relating  to  a  specific  estate,  or  where  he  asks 
information  of  the  procedure  to  be  followed  in  regard  to  filing  notice 
or  making  payment.  Where  an  attorney  asks  information,  or  an 
interview,  and  his  name  appears  on  the  return  as  attorney  for  the 
estate,  the  information  or  interview  will  be  granted  if  his  identity 
is  established.     (Reg.  37,  Art.  87.) 

Return  by  collector. — 

Law.  Section  405.  That  if  no  administration  is  granted  upon 
the  estate  of  a  decedent,  or  if  no  return  is  filed  as  provided  in  section 
404,  or  if  a  return  contains  a  false  or  incorrect  statement  of  a  material 
fact,  the  collector  or  deputy  collector  shall  make  a  return  and  the 
Commissioner  shall  assess  the  tax  thereon. 

Law.  Section  131 1.  [Rev.  Stat.,  Section  3176.]  If  any  per- 
son, corporation,  company,  or  association  fails  to  make  and  file 
a  return  or  list  at  the  time  prescribed  by  law  or  by  regulation 
made  under  authority  of  law,  or  makes,  willfully  or  otherwise,  a  false 
or  fraudulent  return  or  list,  the  collector  or  deputy  collector  shall 
make  the  return  or  list  from  his  own  knowledge  and  from  such  in- 
formation as  he  can  obtain  through  testimony  or  otherwise.  In 
any  such  case  the  Commissioner  may,  from  his  own  knowledge  and 
from  such  information  as  he  can  obtain  through  testimony  or  other- 
wise, make  a  return  or  amend  any  return  made  by  a  collector  or 
deputy  collector.  Any  return  or  list  so  made  and  subscribed  by  the 
Commissioner,  or  by  a  collector  or  deputy  collector,  and  approved 
by  the  Commissioner,  shall  be  prima  facie  good  and  sufficient  for  all 
legal  purposes. 

Regulation.  Where  the  executor  fails  to  file  a  return,  or  files 
an  inaccurate  one,  the  collector  or  deputy  collector  is  required  to 
make  a  return  from  such  information  as  he  possesses  or  is  able  to 
obtain.  In  such  cases  the  Commissioner  assesses  the  tax  in  the 
same  manner  as  though  the  return  had  been  filed  by  the  estate.  (Reg. 
37,  Art.  89.) 


1504 


MISCELLANEOUS    TAXES 


Payment  of  Tax 

When  tax  due  and  payable. — In  contradistinction  to  pay- 
ments required  in  the  case  of  income  and  excess  profits  taxes, 
the  amount  of  an  estate  tax  is  not  payable  in  instahnents  but 
in  full  one  year  after  the  date  of  the  decedent's  death.  In 
view  of  the  fact  that  the  payment  is  made  directly  out  of  the 
corpus  of  the  decedent's  estate,  there  would  be  little  reason  for 
the  spreading  of  such  payment  over  any  particular  period. 
Should  it  happen  that  the  selling  of  property  or  securities,  in 
order  to  liquidate  the  liability  at  one  certain  time,  would  ob- 
viously be  detrimental  to  the  estate,  but  an  extension  of  time 
might  mean  an  alleviation  of  this  hardship,  the  law  empowers 
the  Commissioner  to  grant  such  an  extension  up  to  a  period 
of  three  years.  Whether  extension  be  granted  or  not,  any  tax 
due  and  not  paid  within  one  year  and  six  months  after  date 
of  decedent's  death  will  be  subject  to  interest  at  the  rate  of 
6  per  cent  per  annum  from  the  date  when  the  whole  tax  was 
originally  due  and  payable. 

Law.  Section  406.  That  the  tax  shall  be  due  and  payable  one 
year  after  the  decedent's  death;  but  in  any  case  where  the  Commis- 
sioner finds  that  payment  of  the  tax  within  such  period  would  im- 
pose undue  hardship  upon  the  estate,  he  may  grant  an  extension 
or  extensions  of  time  for  payment  not  to  exceed  three  years  from 
the  due  date. 

The  executor  shall  pay  the  tax  to  the  collector  or  deputy  collector, 
and  to  such  portion  of  the  tax,  not  paid  within  one  year  and  six 
months  after  the  decedent's  death,  interest  at  the  rate  of  6  per  centum 
per  annum  from  the  expiration  of  one  year  after  such  death  shall  be 
added  as  part  of  the  tax  irrespective  of  any  extension  or  extensions 
of  time  that  may  have  been  granted  for  the  payment  of  the  tax,  or 
any  portion  thereof. 

Regulation.  The  tax  is  due  and  payable  one  year  from  the 
date  of  death.  No  discount  will  be  allowed  for  -payment  in  advance 
of  the  due  date.  The  collector  will  grant  to  the  person  paying  the 
tax  duplicate  receipts,  eitlier  of  which  will  be  sufficient  evidence 
of  such  payment,  and  entitle  the  executor  to  be  credited  with  the 
amount  by  any  court  having  jurisdiction  to  audit  or  settle  his  accounts. 

Payment  will  not  be  accepted  before  a  return  in  proper  form 
has  been  filed,  except  in  cases  where  an  extension  of  time  to  file  a 
return  has  been  granted  but  no  extension  of  time  has  been  granted 


FEDERAL    ESTATE    TAX  1 505 

within  which  to  pay  the  tax,  and  the  executor  desires  to  make  pay- 
ment under  section  407  of  the  act  of  an  amount  sufficient  in  the 
opinion  of  the  collector  to  discharge  the  tax.  Payment  of  the 
amount  of  tax  shown  to  ])e  due  by  a  return  accepted  by  the  col- 
lector, executed  in  good  faith  and  accurate  so  far  as  the  executor 
could  ascertain  from  his  own  knowledge  and  in  the  exercise  of  dil- 
igence, will  be  considered  payment  of  the  tax  in  full  under  section 
407  of  the  act,  subject  to  adjustment  resulting  from  investigation, 
except  as  to  any  item  which  should  have  been  but  was  not  embodied 
in  the  return.  If  at  the  time  payment  is  made  the  exact  amount  of  the 
tax  can  not  be  determined,  the  payment  of  a  sum  of  money  sufficient, 
in  the  opinion  of  the  collector,  to  discharge  the  tax  will  be  considered 
payment  in  full,  except  as  the  tax  is  adjusted  after  investigation. 
(See  Arts.  78,  95.)  If  the  return  filed  contains  a  gross  or  fraudulent 
misstatement  of  fact,  the  payment  of  the  amount  of  tax  shown  to 
be  due  thereby  will  not  be  deemed  to  be  payment  in  full  of  the  tax, 
since  the  collector's  decision  is  based  upon  the  assumption  that  the 
return  is  made  in  good  faith.      (Reg.  37,  Art.  90.) 

Payment  of  tax  in  Liberty  bonds. — In  accordance  with 
.section  14  of  the  Second  Liljerty  Bond  Act,  as  amended  by  the 
Third  Liberty  Bond  Act,  Lilierty  bonds  bearing  interest  at  a 
rate  higher  than  4  per  cent  may  be  used  in  payment  of  estate 
tax  to  the  amount  of  par  and  interest  accrued  at  the  time  of 
payment,  provided  such  bonds  have  been  owned  continuously 
l)y  the  decedent  for  at  least  six  months  prior  to  his  death. 

Regulation.  Payment  of  the  estate  tax  may  be  made  by  the 
delivery  of  Liberty  Bonds  or  other  bonds  of  the  United  States  bear- 
ing interest  at  a  higher  rate  than  4  per  cent  per  annum,  provided 
they  were  owned  by  the  decedent  for  at  least  six  months  prior  to 
the  date  of  his  death.  Such  bonds  are  received  in  payment  to  the 
amount  of  par  and  interest  accrued  at  the  time  of  the  payment. 
....    (Reg.  37,  Art.  91.) 

The  issues  of  Liberty  bonds  available  for  this  purpose  are : 

First  4%'s  issued  May    9,  1918 

First.  Second  4J4's         "  Oct.  24,  1918 

Second  4J4's  "  May    9,  1918 

Third  4^'s  "  May     9,  1918 

Fourth  4J4's  "  Oct.  24,  1918 

Victory  4-}4's  "  May  20,  1919" 

°'  Victory  4^  notes  are  acceplaljle  under  the  Victory  Liberty  Loan  Act 
of  March  3,  1919. 


l^o6  MISCELLANEOUS    TAXES 

The  use  of  Liberty  bonds  for  payments  of  the  estate  tax 
will  prove  advantageous  where  such  bonds  are  selling  below 
par.  In  any  case  in  which  it  is  proposed  to  pay  the  tax  in 
Liberty  bonds,  reference  should  be  made  to  Department  Cir- 
cular 225,  dated  January  31,  1921,  containing  detailed  instruc- 
tions which  are  too  lengthy  to  reproduce  here.  The  computa- 
tion of  accrued  interest  is  to  be  made  in  accordance  with  the 
tables  issued  with  the  circular  referred  to. 

Payment  of  tax  by  uncertified  check. — Uncertified  checks, 
if  collectible  at  par,  may  be  accepted  in  payment  of  the  estate 
tax.     The  regulation  is  permissive,  not  mandatory. 

Regulation Collectors  may  accept  uncertified  checks  in 

payment  of  the  estate  tax  provided  such  checks  are  collectible  at  par — 
that  is,  for  their  full  amount,  without  any  deduction  for  exchange 
or  other  charges.  If  the  bank  on  which  any  such  check  is  drawn 
should  refuse  to  pay  it  at  par,  the  check  should  be  returned  through 
the  depositary  bank,  and  be  treated  in  the  same  manner  as  a  bad 
check.  All  expenses  incident  to  the  attempt  to  collect  such  a  check 
and  the  return  of  it  through  the  depositary  bank  must  be  paid  by 
the  drawer  of  the  check  to  the  bank  on  which  it  is  drawn,  since  no 
deduction  can  be  made  from  amounts  received  in  payment  of  taxes. 
(See  Revised  Statutes,  Sec.  3210.)     (Reg.  37,  Art.  91.) 

Right  to  reimbursement  not  enforcible  by  Treasury. — 

Regulation.  Two  rights  are  here  given.  Persons  in  possession 
of  property,  and  paying  the  tax,  are  entitled  to  reimbursement,  either 
out  of  the  undistributed  estate  or  by  contribution  from  other  ben- 
eficiaries, of  any  excess  of  the  amount  paid  over  the  amount  of  the 
tax  upon  the  particular  property  in  their  possession.  The  executor  is 
also  entitled  to  require  beneficiaries  under  insurance  policies  to  bear 
their  proportion  of  the  tax.  These  provisions,  however,  are  not 
designed  to  curtail  the  right  of  the  Bureau  to  collect  the  tax  from 
any  person,  or  out  of  any  property,  liable  therefor.  The  Bureau  may 
not  be  required  to  apportion  the  tax  among  the  persons  liable.  For 
example,  where  a  transfer  has  been  made  in  contemplation  of  death, 
the  Bureau  may  hold  both  the  executor  and  the  transferee  liable  with 
respect  to  the  tax  upon  the  property  transferred.  In  such  case,  if 
the  tax  is  paid  by  the  executor,  he  may  not  look  to  the  Bureau  for 
relief  by  refund  of  part  of  the  tax.     (Reg.  37,  Art.  98.) 


FEDERAL   ESTATE    TAX 


1507 


Liability  of  transferee  and  insurance  beneficiary. — Though 
property  may  have  passed  into  the  possession  of  a  bene- 
ficiary through  the  medium  of  a  trust  made  in  contempla- 
tion of  death  or  to  take  effect  at  or  after  death  of  decedent, 
and  even  in  the  case  of  insurance  passing  under  contract  to  a 
specific  beneficiary,^"  the  property  or  proceeds  are  subject  to 
a  lien  to  secure  payment  of  taxes  due,  to  the  extent  of  the 
decedent's  interest  therein  at  the  time  of  transfer. 

Law.  Section  409.  ....  If  (a)  the  decedent  makes  a  transfer 
of,  or  creates  a  trust  with  respect  to,  any  property  in  contemplation 
of  or  intended  to  take  effect  in  possession  or  enjoyment  at  or  after 
his  death  (except  in  the  case  of  a  bona  fide  sale  for  a  fair  considera- 
tion in  money  or  money's  worth)  or  (b)  if  insurance  passes  under  a 
contract  executed  by  the  decedent  in  favor  of  a  specific  beneficiary, 
and  if  in  either  case  the  tax  in  respect  thereto  is  not  paid  when  due, 
then  the  transferee,  trustee,  or  beneficiary  shall  be  personally  liable  for 
such  tax,  and  such  property,  to  the  extent  of  the  decedent's  interest 
therein  at  the  time  of  such  transfer,  or  to  the  extent  of  such  beneficiarjr's 
interest  under  such  contract  of  insurance,  shall  be  subject  to  a  like 
lien  equal  to  the  amount  of  such  tax.  Any  part  of  such  property  sold 
by  such  transferee  or  trustee  to  a  bona  fide  purchaser  for  a  fair  con- 
sideration in  money  or  money's  worth  shall  be  divested  of  the  lien 
and  a  like  lien  shall  then  attach  to  all  the  property  of  such  transferee 
or  trustee,  except  any  part  sold  to  a  bona  fide  purchaser  for  a  fair 
consideration  in  money  or  money's  worth. 

Regulation.  The  amounts  of  the  lien  and  of  the  personal  lia- 
bility of  the  transferee,  trustee,  or  insurance  beneficiary  are  limited 
to  the  amount  of  the  tax  upon  the  transfer  of  the  particular  property 
in  the  possession  of  the  person  liable.  Where  the  transferee  or 
trustee  sells  the  property  to  a  bona  fide  purchaser  for  a  fair  con- 
sideration in  money  or  money's  worth,  the  lien  upon  such  property 
is  divested ;  but  there  is  substituted  a  lien  upon  all  of  the  property 
of  the  transferee  or  trustee,  except  such  part  as  may  be  sold  to  a 
bona  fide  purchaser  for  a  valuable  consideration.     (Reg.  37,  Art.  loi.) 

The  question  of  the  taxability  of  insurance  in  favor  of  a 
third  party  has  already  been  discussed  in  this  chapter.*'"  The 
right  of  recovery  against  the  beneficiary,  allowed  the  executor 
under  section  408,  in  the  case  of  the  tax  on  such  portion  of 
the  benefits  received  by  him  in  excess  of  $40,000,  inflicts  a 


See  page  1465. 
See  page  1466. 


1508  MISCELLANEOUS    TAXES 

direct  tax  on  the  Ijenefieiar}-  which  is  not  in  keeping  with  the 
general  character  of  the  tax  imposed  by  the  law.  If  an  indi- 
vidual were  bequeathed  $50,000.  he  would  receive  the  $50,000. 
provided  there  was  sufficient  residual  property  out  of  v^hich  the 
estate  tax  could  be  paid.  In  the  case  of  an  insurance  policy 
in  favor  of  a  beneficiary  for  a  like  sum,  the  executor  is  given 
the  power  to  collect  the  portion  of  tax  applicable  thereto  from 
such  beneficiary,  irrespective  of  whether  or  not  there  is  a  suffi- 
cient residual  estate  to  meet  the  demands  of  the  tax.  The  rate 
at  which  a  beneficiary,  under  these  circumstances,  would  be 
taxed  at  the  will  of  the  executor,  must  necessarily  be  an  arbi- 
trary one  dependent  entirely  upon  the  bracket  which  the  final 
amount  of  the  decedent's  net  estate  reaches.  An  individual  is 
interested  to  the  extent  of  $3,000  insurance  benefit  in  total 
benefits  of  this  nature  aggregating  $100,000;  the  net  estate 
amounts  to  $3,000,000.  He  is  taxed  15.38  per  cent  on  $2,000. 
i.e.,  40/60  of  his  benefit.  The  amount  of  his  legacy  would  be 
impaired  to  the  extent  of  $307.60.  or  more  than  10  per  cent. 
Apart  from  any  question  of  the  legality  of  taxing  proceeds 
from  third  party  insurance,  this  provision  not  only  works  a 
hardship  and  imposes  a  direct  tax  on  the  beneficiary,  but  also 
has  a  further  fault;  the  amount  by  which  the  beneficiary's 
legacy  is  reduced  depends  entirely  on  the  total  net  estate  of 
the  decedent.  This  is  an  obviously  unfair  way  of  basing  a 
tax  on  a  beneficiary  who  has  no  other  interest  in  the  size  of 
the  estate. 

Unpaid  tax  a  lien  on  estate. — 

Law.  Section  409.  That  unless  the  tax  is  sooner  paid  in  full, 
it  shall  be  a  lien  for  ten  years  upon  the  gross  estate  of  the  decedent, 
except  that  such  part  of  the  gross  estate  as  is  used  for  the  payment 
of  charges  against  the  estate  and  expenses  of  its  administration,  al- 
lowed by  any  court  having  jurisdiction  thereof,  shall  be  divested  of 
such  lien.  If  the  Commissioner  is  satisfied  that  the  tax  liability  of 
an  estate  has  been  fully  discharged  or  provided  for,  he  may,  under 
regulations  prescribed  by  him  with  the  approval  of  the  Secretary, 
issue  his  certificate  releasing  any  or  all  property  of  such  estate  from 
the  lien  herein  imposed. 


FEDERAL   ESTATE   TAX  1 509 

Regulation.  This  lien  attaches  to  every  part  of  the 
gross  estate,  whether  or  not  the  property  comes  into  the  custody  or 
control  of  the  executor.  The  only  property  divested  of  the  lien 
is  such  part  as  is  used  to  pay  charges  against  the  estate  and  ad- 
ministration expenses  allowed  by  the  court  which  administers  the 
estate.  With  this  exception,  the  lien  can  only  be  divested  by  pay- 
ment. It  attaches  to  the  extent  both  of  the  original  tax  shown  to  be 
due  by  the  return  and  of  any  additional  tax  found  to  be  due  upon 
investigation.  Payment  of  the  entire  tax  is  necessary  in  order  to 
destroy  the  lien.     (Reg.  37,  Art.  99.) 

Release  of  lien. — 

Regulation.  The  statute  provides  that,  if  the  Commissioner  is 
satisfied  that  the  tax  liability  of  an  estate  has  been  fully  discharged 
or  provided  for,  he  may  issue  his  certificate  releasing  any  or  all  prop- 
erty of  the  estate  from  the  lien.  The  issuance  of  certificates  is  a 
matter  resting  within  the  discretion  of  the  Commissioner,  and  cer- 
tificates will  be  issued  only  in  case  there  is  actual  need  therefor. 
In  most  cases  the  receipts  issued  by  the  collector  constitute  sufficient 
acquittance. 

The  tax  will  be  considered  fully  discharged  for  the  purpose  of 
the  issuance  of  a  certificate  only  when  investigation  has  been  com- 
pleted, and  payment  of  the  excess  tax  determined  to  be  due,  if  any, 
has  been  made.  A  certificate  of  release  of  lien  may  be  issued  by 
the  Commissioner  under  these  circumstances  upon  any  or  all  prop- 
erty of  the  estate,  upon  the  filing  by  the  executor  of  an  application 
in  duplicate  on  Form  791.  The  form  must  contain  all  the  informa- 
tion called  for. 

Where  the  tax  liability  has  not  been  fully  discharged,  as  pro- 
vided above,  no  general  certificate  of  release  will  be  granted,  but  re- 
leases of  lien  upon  particular  items  of  property  will  be  issued  upon 
the  filing  with  the  Commissioner  of  such  security,  if  any,  as  he  may 
require.  Where  security  is  required,  a  corporate  indemnity  bond 
must  be  furnished,  or  Liberty  Bonds,  or  other  bonds  of  the  United 
States,  must  be  deposited  with  the  collector.  In  lieu  of  such  security, 
the  Commissioner  may  in  any  case  issue  the  release  upon  payment 
of  the  estimated  tax  upon  the  transfer  of  the  property  released,  com- 
puted at  the  highest  rate  applicable  to  the  estate.  If,  upon  consider- 
ation of  the  application,  the  Commissioner  finds  the  issuance  of  the 
certificate  to  be  warranted,  the  collector  will  notify  the  executor  of 
the  amount  of  the  bond,  as  fixed  by  the  Commissioner.  (Reg.  37, 
Art.  100.) 

Penalties 

There  is  only  one  penalty  section  under  this  title,  making- 
s])ccific  allusion   to   the  sections  dealing-  with  the  estate  tax. 


I^io  MISCELLANEOUS    TAXES 

The  general  provision  of  the  Revised  Statutes  regarding  penal- 
ties, claims  for  abatement  or  refund,  and  other  administrative 
questions  are  the  same  as  appi}-  to  the  other  titles  of  the  192 1 
law.  These  are  dealt  with  in  detail  in  the  respective  chapters 
of  this  book. 

Law.  Section  410.  That  whoever  knowingly  makes  any  false 
statement  in  any  notice  or  return  required  to  be  filed  under  this 
title  shall  be  liable  to  a  penalty  of  not  exceeding  $5,000,  or  imprison- 
ment not  exceeding  one  year,  or  both. 

Whoever  fails  to  comply  with  any  duty  imposed  upon  him  by< 
section  404,  or,  having  in  his  possession  or  control  any  record,  file, 
or  paper,  containing  or  supposed  to  contain  any  information  concern- 
ing the  estate  of  the  decedent,  or,  having  in  his  possession  or  control 
any  property  comprised  in  the  gross  estate  of  the  decedent,  fails  to 
exhibit  the  same  upon  request  to  the  Commissioner  or  any  col- 
lector or  law  officer  of  the  United  States,  or  his  duly  authorized 
deputy  or  agent,  who  desires  to  examine  the  same  in  the  performance 
of  his  duties  under  this  title,  shall  be  liable  to  a  penalty  of  not  ex- 
ceeding $500,  to  be  recovered,  with  costs  of  suit,  in  a  civil  action  in 
the  name  of  the  United  States. 

Classification  of  penalties. — 

Regulation.  Two  kinds  of  penalties  are  provided  for  delinquency 
with  respect  to  the  duties  imposed  by  the  estate  tax  law : 

(i)  A  specific  penalty,  to  be  recovered  by  suit,  unless  adjusted 
by  an  offer  in  compromise ;  and 

(2)  A  penalty  of  a  certain  percentage  of  the  tax,  to  be  added 
to  the  tax  and  collected  in  the  same  manner  as  the  tax. 

In  any  case  of  delinquency  for  which  more  than  one  penalty  is 
provided  the  Government  may  impose  either  or  both  penalties.  (Reg. 
37,  Art.  102.) 

False  and  fraudulent  notice  or  return. — 

Regulation.  Where  statements  in  the  60-day  notice  or  in  the 
return  are  knowingly  and  willfully  false,  the  person  making  them 
is  subject  to  a  penalty  of  $5,000,  or  imprisonment  for  one  year,  or 
both ;  and,  for  the  false  return,  50  per  cent  may  be  added  to  the 
amount  of  the  tax.     (Reg.  37,  Art.  103.) 

Failure  to  file  notice  or  return. — 

Regulation.  For  failure  to  file  the  60-day  notice  or  the  return 
within  the  time  prescribed,  the  person  in  default  is  subject  to  a  penalty 
not  to  exceed  $500;  and,  for  the  failure  to  file  the  return,  25  per 
cent   may  be   added  to  the  amount  of  the  tax.     Where  it  appears, 


FEDERAL   ESTATE   TAX  151 1 

however,  that  the  failure  to  file  the  return  was  due  to  a  reasonable 
cause  and  not  to  willful  neglect,  no  addition  is  made  to  the  tax.  (Reg. 
37,  Art.  104.) 

Failure  to  exhibit  records  or  property. — 

Regulation.  Where  a  person  in  possession  or  control  of  any 
record,  file,  or  paper,  supposed  to  contain  information  relating  to  the 
estate,  fails  to  exhibit  the  same,  upon  the  request  of  the  Commissioner 
or  any  collector,  he  is  liable  to  a  penalty  not  to  exceed  $500,  to  be 
recovered  by  civil  action.  He  must  comply  with  such  a  request  whether 
or  not  he  believes  that  the  documents  contain  information  relating 
to  the  estate.  A  person  in  possession  of  property  forming  part  of  the 
gross  estate,  and  refusing  to  exhibit  the  same  upon  the  request  of 
the  Commissioner  or  a  collector,  is  subject  to  a  similar  penalty. 
(Reg.  37,  Art.  105.) 

Claims  for  Abatement  and  Refund 

Regulation.  Under  these  provisions  of  law  two  forms  of  relief 
are  afforded  the  executor  in  cases  where  he  believes  that  an  excessive 
amount  of  tax  has  been  assessed  against  or  paid  by  him,  either  upon 
the  basis  of  the  return  or  of  the  investigation  conducted  by  the 
Bureau.    The  two  forms  of  relief  are : 

(i)  Claim  for  abatement  on  Form  47  where  the  tax  has  been 
assessed  but  not  paid. 

(2)  Claim  for  refund  on  Form  46  where  the  tax  has  been  paid. 
(Reg.  37,  Art.  106.) 

Form  843  will  not  be  used  instead  of  46  or  47. 

Claim  for  abatement. — 

Regulation.  Claims  for  the  abatement  of  taxes  or  penalties  il- 
legally assessed  must  be  made  upon  Form  47,  and  must  be  sustained 
by  the  affidavits  of  the  parties  against  whom  the  taxes  were  assessed 
or  of  other  parties  cognizant  of  the  facts.  When  a  tax  has  been 
assessed,  the  presumption  is  that  the  assessment  is  correct;  and  the 
burden  of  showing  that  it  was  improperly  or  illegally  assessed 
rests  upon  the  applicant  for  abatement.  The  affidavit  must  therefore 
contain  a  full  and  explicit  statement  of  all  the  material  facts  re- 
lating to  the  claim  in  support  of  which  they  are  offered  and  which 
are  essential  to  proper  consideration.  Nothing  should  be  left  to 
inference,  but  all  the  facts  relied  upon  should  appear  upon  the  papers 
themselves.  The  filing  of  a  claim  for  the  abatement  of  a  tax  al- 
leged to  have  been  erroneously  assessed  does  not  necessarily  operate 
as  a  suspension  of  the  collection  of  the  tax.  The  collector  may  col- 
lect the  tax  if  he  thinks  it  necessary,  and  leave  the  taxpayer  to  his 
remedy  of  a  claim  for  refund.     (Reg.  37,  Art.  T07.) 


I5I2 


MISCELLANEOUS    TAXES 


Accrual    of    interest    as    affected    by    abatement 

CLAIM. 

Regulation.  Where  a  claim  for  abatement  is  rejected,  the 
making  of  the  apphcation  does  not  affect  the  running  of  interest. 
The  allowance  of  the  claim,  however,  in  whole  or  part,  discharges 
all  interest  obligations  upon  the  portion  of  the  claim  allowed.  The 
same  rules  apply  where,  upon  the  request  of  the  executor,  a  rein- 
vestigation is  made  of  the  amount  of  an  additional  tax.  (Reg.  37, 
Art.  108.) 

Limitation  of  time  to  file  claim  for  abatement  of 

EXCESS  tax. — 

Regulation.  If  it  is  desired  to  file  claim  for  abatement  of  the 
excess  amount  of  tax  disclosed  upon  investigation,  such  claim  should 
be  filed  with  the  collector  within  30  days  of  receipt  of  the  Com- 
missioner's letter  of  notification.  After  that  period  the  claim  will 
not  be  considered,  but  the  tax  must  be  paid,  and  adjustment  made  by 
claim  for  refund.     (Reg.  37,  Art.  109.) 

Power  to   compromise   or  remit  penalties. — 

Regulation.  The  Commissioner,  with  the  advice  and  consent 
of  the  Secretary  of  the  Treasury,  may  compromise  any  civil  or 
criminal  case  arising  under  the  internal-revenue  laws  instead  of  com- 
mencing suit  thereon,  and  with  the  advice  and  consent  of  the  Secre- 
tary, and  upon  the  recommendation  of  the  Attorney  General,  may 
compromise  any  such  case  after  suit  thereon  has  been  commenced 
by  the  United  States.  Accordingly,  the  power  to  compromise  extends 
to  (a)  both  civil  and  criminal  cases;  (b)  cases  whether  before  or 
after  suit;  and  (c)  both  taxes  and  penalties.  Refunds  can  not  be 
made  of  accepted  ofTers  in  compromise  in  cases  where  it  is  subse- 
quently ascertained  that  no  violation  of  law  was  involved.  Xo  power 
exists,  however,  to  compromise  a  tax  where  its  existence  and  amount 
are  not  disputed  in  good  faith,  and  the  taxpayer  is  solvent.  Where 
a  fine,  penalty,  or  forfeiture,  not  exceeding  $1,000  is  incurred  without 
willful  negligence  or  fraud,  it  may  be  remitted  by  the  Secretary  of 
the  Treasury ;  and  he  may  remit  other  fines,  penalties,  forfeitures, 
and  disabilities  where  the  court  has  inquired  into  the  matter  and 
made  findings.     (Reg.  37,  Art.  112.) 

Claim  for  refund. — 

Regulation.  Claims  for  refund  of  assessed  taxes  and  penalties 
nuist  be  made  on  Form  46.  Tn  this  case,  as  in  the  case  of  claims  for 
abatement,  the  burden  of  proof  rests  ui)on  the  claimant.     All  the  facts 


FEDERAL   ESTATE   TAX 


1513 


relied  upon  in  support  of  the  claim  should  be  clearly  set  forth  under 
oath.  With  the  claim  should  be  presented,  in  addition  to  the  evi- 
dence : 

(i)    Collector's  receipt  evidencing  payment  of  tax. 

(2)  W^here  the  claim  is  made  by  the  executor  or  administrator,  a 
certified  copy  of  the  letters  testamentary  or  of  administration,  and  a 
certificate  that  the  appointment  remains  in  full  force  and  effect. 

(3)  Where  the  executor  or  administrator  has  been  discharged, 
a  certified  copy  of  the  decree  discharging  him,  and  evidence  as  to 
the  persons  entitled  to  receive  the  refund,  setting  forth  their  names. 
Where  the  claim'  is  made  on  behalf  of  a  number  of  persons,  there 
should  be  furnished  a  power  of  attorney  duly  executed  by  all  the 
beneficiaries  showing  the  claimant's  authority  to  act  in  their  behalf. 
(Reg.  37,  Art.  no.) 

Payment  of  claims. — 

Regulation.  Warrants  in  payment  of  claims  allowed  will  be 
drawn  in  the  names  of  the  parties  entitled  to  the  money,  and  will, 
unless  otherwise  directed,  be  sent  by  the  Treasurer  of  the  United 
States  directly  to  the  proper  parties,  or  their  duly  authorized  at- 
torneys or  agents;  but  if  the  claimants  are  indebted  to  the  United 
States  for  taxes  such  taxes  must  be  paid  before  the  warrants  are 
delivered.     (Reg.  37,  Art.  in.) 

Refund  of  tax  arising  from  change  in  law. — Due  to 
the  changes  in  the  deductibility  of  certain  items  made  by  sec- 
tion 403  (a-2-3)  and  (b-2-3),  a  refund  of  tax  is  possible  in 
certain  cases. 

Law.  Section  403.  (b)  (3)  ....  In  the  case  of  any  estate  in 
respect  to  which  the  tax  has  been  paid,  if  necessary  to  allow  the  benefit 
of  the  deduction  under  paragraphs  (2)  and  (3)  of  subdivision  (a) 
or  (b)  the  tax  shall  be  redetermined  and  any  excess  of  tax  paid  shall 
be  refunded  to  the  executor. 

The  paragraphs  referred  to  in  the  foregoing  have  reference 
to  the  deductibility  from  the  value  of  the  gross  estate  in  the 
case  of  (i)  residents  and  non-residents,  of  (2)  the  value  of 
property  forming  part  of  the  gross  estate  of  any  person  who 
died  within  five  years  of  decedent,  and  (3)  the  amount  of 
bequests,  legacies,  etc. 

The  deductions  may  be  made  in  the  case  of  the  estate  of 
any  decedents  who  have  died  since  Deceml)er  31,  191 7.    Janu- 


I5I4 


MISCELLANEOUS    TAXES 


ary  i,  1918,  is  the  effective  date  of  the  law  of  19 18,  which  first 
provides  for  the  deduction  of  property  coming  under  the 
specific  headings  enumerated  in  section  403  of  the  1921  law. 

Personal  liability  of  executor. — 

Law.  Revised  Statutes,  Sec.  3467  (Comp.  Sts.,  1916,  Sec.  6373.) 
Every  executor,  administrator,  or  assignee,  or  other  person,  who  pays 
any  debts  due  by  the  person  or  estate  for  whom  or  for  which  he  acts, 
before  he  satisfies  and  pays  the  debts  due  to  the  United  States  from 
such  person  or  estate,  shall  become  answerable  in  his  own  person  and 
estate  for  the  debts  so  due  to  the  United  States,  or  for  so  much  thereof 
as  may  remain  due  and  unpaid. 

But  see  section  407  of  the  present  law,  discussed  on  page 
1522. 

Miscellaneous  Provisions 

Examination  of  records  and  taking  of  testimony. — 

Regulations.  In  order  to  ascertain  the  correctness  of  a  return, 
or  to  make  a  return  where  none  has  been  made,  the  Commissioner 
has  power  to  require  the  attendance,  and  to  take  the  testimony,  of 
the  person  rendering  the  return,  or  any  officer  or  employee  of  such 
person,  or  any  other  person  having  knowledge  in  the  premises.  Such 
person  may  be  required  to  produce  any  relevant  book,  paper  or  other 
record.  This  power  may  be  exercised  by  any  revenue  agent  or  in- 
spector designated  for  the  purpose.     (Reg.  37,  Art.  114.) 

Where  any  person  is  summoned  to  appear  and  testify,  or  to 
produce  books,  papers,  or  other  data,  the  District  Court  of  the  United 
States  for  the  district  in  which  such  person  resides  has  power  to 
compel  the  giving  of  the  testimony,  or  the  production  of  the  books, 
papers,  or  data,  and  to  issue  any  appropriate  process,  writ,  or  order. 
(Reg.  37,  Art.  115.) 

Executor's  duty  to  keep  records. — 

Regulation.  It  is  the  duty  of  the  executor  to  keep  such  records 
as  the  Commissioner  may  require.  Executors  are  required  to  keep 
complete  and  detailed  records  of  the  affairs  of  the  estate,  sufficient 
to  enable  the  Bureau  to  determine  accurately  the  amount  of  the  tax 
Hability.     (Reg.  37,  Art.  117.) 

Executor's  duty  to  render  statements. — 

Regulation.  It  is  also  the  duty  of  the  executor  not  only  to  make 
the    formal   return,   but    also   to    render   any   other   sworn    statement 


FEDERAL  ESTATE  TAX  1515 

which  the  Commissioner  may  require  for  the  purpose  of  determining 
whether  a  tax  liabiHty  exists.     (Reg.  zy,  Art.  118.) 

Scope  of  repeal. — 

Law.  Section  1400.  (a)  That  the  following  parts  of  the  Revenue 
Act  of  1918  are  repealed   ....   to  take  effect   .... 

Title  IV  (called  "Estate  Tax") ;  on  the  passage  of  this  act 

(b)  The  parts  of  the  Revenue  Act  of  1918  w^hich  are  repealed  by 
this  Act  shall  (unless  otherwise  specifically  provided  in  this  Act)  re- 
main in  force  for  the  assessment  and  collection  of  all  taxes  which  have 
accrued  under  the  Revenue  Act  of  1918  at  the  time  such  parts  cease 
to  be  in  effect,  and  for  the  imposition  and  collection  of  all  penalties 
or  forfeitures  which  have  accrued  or  may  accrue  in  relation  to  any 
such  taxes.  In  the  case  of  any  tax  imposed  by  any  part  of  the  Rev- 
enue Act  of  1918  repealed  by  this  Act,  if  there  is  a  tax  imposed  by  this 
Act  in  lieu  thereof,  the  provision  imposing  such  tax  shall  remain  in 
force  until  the  corresponding  tax  under  this  Act  takes  effect  under 
the  provisions  of  this  Act.  The  unexpended  balance  of  any  appro- 
priation heretofore  made  and  now  available  for  the  administration  of 
any  such  part  of  the  Revenue  Act  of  1918  shall  be  available  for  the 
administration  of  this  Act  or  the  corresponding  provision  thereof. 

Regulation.  The  Revenue  Act  of  1918  retains  in  force  all  taxes 
or  penalties  which  had  accrued  prior  to  February  25,  1919.  The 
procedure,  however,  with  reference  to  the  assessment  and  collection 
of  all  taxes,  whenever  they  accrued,  is  governed  by  the  statute  from 
the  time  when  it  went  into  effect  on  February  25,  1919.  (Reg.  37, 
Art.  119.) 

Interest  under  Revenue  Act  of  1916. — 

Regulation.  The  Revenue  Act  of  1916  provides  that,  where 
the  tax  is  not  paid  within  one  year  and  90  days  from  the  date  of 
the  decedent's  death,  interest  shall  be  added  at  the  rate  of  ten  per 
centum  per  annum  from  the  date  of  death.  Where  the  specified 
period  had  elapsed  prior  to  February  25,  1919,  this  penalty  has  been 
incurred,  and  is  not  affected  by  the  passage  of  the  Revenue  Act  of 
1918.  Where,  however,  the  period  of  one  year  and  90  days  had  not 
elapsed  prior  to  February  25,  1919,  the  Revenue  Act  of  1918  extends 
the  time  of  payment  to  one  year  and  180  days  from  the  date  of 
death.    These  rules  operate  as  follows : 

Example :  The  year  and  90  days,  in  a  given  case,  expired  on  Feb- 
ruary 15,  1919,  or  ten  days  before  the  effective  date  of  the  Revenue 
Act  of  1918.  In  this  case  interest  at  the  rate  of  ten  per  centum  per 
annum  should  be  computed  for  the  period  of  one  year  and  100  days 
from  the  date  of  death,  or  until  the  Revenue  Act  of  1918  took  effect. 


1516  MISCELLANEOUS    TAXES 

If  the  tax  is  thereafter  paid  within  the  time  prescribed  by  the  new 
act  (which  allows  an  additional  80  days),  no  further  interest  ac- 
crues. If  it  is  not  paid  within  that  period,  additional  interest  accrues 
at  the  rate  of  six  per  cent  from  February  25,  1919,  when  the  Revenue 
Act  of  1918  took  effect. 

Example:  On  February  25,  1919,  in  a  given  case,  only  one  year 
and  80  days  from  the  date  of  the  decedent's  death  had  elapsed.  No 
penalty  having  been  incurred,  the  estate  has  100  additional  days  in 
which  to  make  payment,  viz..  the  year  and  180  days  prescribed  by 
the  Revenue  Act  of  1918.  If,  however,  the  tax  is  not  paid  within  this 
period,  interest  accrues  at  the  rate,  of  six  per  cent  from  the  expiration 
of  one  year  from  the  decedent's  death,  as  provided  by  the  Revenue 
Act  of  1918  (see  Art.  94). 

While  no  interest  may  be  added  to  the  tax  unless  payment  thereof 
has  not  been  made  within  one  year  and  180  days  after  decedent's 
death,  the  tax  itself  is  due  and  must  be  paid  within  one  year  after 
the  decedent's  death  unless  an  extension  of  time  for  the  payment 
thereof  has  been  granted  by  the  Commissioner.     (Reg.  37,  Art.  120.) 

Repeal  of  previous  regulations. — 

Regulation.  The  foregoing  regulations  are  prescribed  in  pur- 
suance of  the  authority  conferred  by  the  statute,  and  all  rulings 
inconsistent  with  them  are  hereby  revoked.     (Reg.  37,  Art.   121.) 

Proceedings  in  United  States  Court  for  China. — 

Law.  Section  411.  (a)  That  the  term  "resident"  as  used  in  this 
title  includes  a  citizen  of  the  United  States  with  respect  to  whose 
property  any  probate  or  administration  proceedings  are  had  in  the 
United  States  Court  for  China.  Where  no  part  of  the  gross  estate 
of  such  decedent  is  situated  in  the  United  States  at  the  time  of  his 
death,  the  total  amount  of  tax  due  under  this  title  shall  be  paid  to  or 
collected  by  the  clerk  of  such  court,  but  where  any  part  of  the  gross 
estate  of  such  decedent  is  situated  in  the  United  States  at  the  time 
of  his  death,  the  tax  due  under  this  title  shall  be  paid  to  or  collected  by 
the  collector  of  the  district  in  which  is  situated  the  part  of  the  gross 
estate  in  the  United  States,  or,  if  such  part  is  situated  in  more  than 
one  district,  then  the  collector  of  such  district  as  may  be  designated 
by  the  Commissioner. 

(b)  For  the  purpose  of  this  section  the  clerk  of  the  United  States 
Court  for  China  shall  be  a  collector  for  the  territorial  jurisdiction  of 
such  court,  and  taxes  shall  be  collected  by  and  paid  to  him  in  the 
same  manner  and  subject  to  the  same  provisions  of  law,  including  pen- 
alties, as  the  taxes  collected  by  and  paid  to  a  collector  in  the  United 
States. 

(c)  The  proviso  in  the  Act  entitled,  "An  Act  making  appropriation 


I 


FEDERAL  ESTATE  TAX  1517 

for  the  Diplomatic  and  Consular  Service  for  the  fiscal  year  ending 
June  30,  1921,"  approved  June  4,  1920,  which  reads  as  follows:  Pro- 
vided. That  in  probate  and  administration  proceedings  there  shall  be 
collected  by  said  clerk,  before  entering  the  order  of  final  distribution, 
to  be  paid  into  the  Treasury  of  the  United  States,  the  same  inheritance 
taxes  from  time  to  time  collected  under  the  laws  enacted  by  the  Con- 
gress of  the  United  States  from  the  estates  of  decedents  residing  within 
the  territorial  jurisdiction  of  the  United  States,"  is  hereby  repealed. 

Apart  from  the  particular  application  of  the  term  ''resi- 
dent" indicated  by  the  above  section,  there  is  the  ordinary 
meaning  of  the  term  as  generally  used  in  the  law.  The  ques- 
tion of  citizenship  does  not  enter  into  the  matter  at  all;  the 
two  types  of  taxpayers  involved  being  resident  and  non-resi- 
dent. The  interpretation  of  what  constitutes  a  resident  is 
given  in  the  following : 

Regulation.  The  following  rules  of  evidence  shall  govern  in 
determining  whether  or  not  an  alien  within  the  United  States  has 
acquired  residence  therein  within  the  meaning  of  the  Revenue  Act. 
An  alien,  by  reason  of  his  alienage,  is  presumed  to  be  a  nonresident 
alien. ''I  Such  presumption  may  be  overthrown  (i)  in  the  case  of  an 
alien  who  presents  himself  for  determination  of  tax  liability  prior  to 
departure  for  his  native  country,  by  (a)  proof  that  the  alien,  at  least 
six  months  prior  to  the  date  he  so  presents  himself,  has  filed  a  declara- 
tion of  his  intention  to  become  a  citizen  of  the  United  States  under 
the  naturalization  laws,  (b)  proof  that  the  alien,  at  least  six  months 
prior  to  the  date  he  so  presents  himself,  has  filed  Form  1078  or  its 
equivalent,  or  (c)  proof  of  acts  and  statements  of  the  alien  showing 
a  definite  intention  to  acquire  residence  in  the  United  States  or  show- 
ing that  his  stay  in  the  United  States  had  been  of  such  an  extended 
nature  as  to  constitute  him  a  resident;  (2)  in  other  cases  by  (a) 
proof  that  the  alien  has  filed  a  declaration  of  his  intention  to  become 
a  citizen  of  the  United  States  under  the  naturalization  laws,  (b)  proof 
that  the  alien  has  filed  Form  1078  or  its  equivalent,  or  (c)  proof 
of  acts  and  statements  of  an  alien  showing  a  definite  intention  to  ac- 
quire residence  in  the  United  States  or  showing  that  his  stay  in  the 
United  States  has  been  of  such  an  extended  nature  as  to  constitute 
him  a  resident.'^-   ....      (Art.  312.) 

The  definition  contained  in  the  regulations  covering  this 
title  is  not  as  fully  explanatory  as  is  that  offered  in  the  fore- 
going.    The  latter  are  not  in  conflict  therewith,  but   form  a 

'"  This  presumption  rever.ses  that  of  Reg.  45,  Art.  312. 

""'These  factors  were  previously  to  be  found  in   Reg.  45,  Art.  313. 


i5i8 


MISCELLANEOUS    TAXES 


detailed  interpretation  of  what  should  actually  constitute  a  resi- 
dent under  this  title. 

The  particular  definition  included  in  section  411  having 
regard  to  citizens  of  the  United  States  coming  under  the  juris- 
diction of  the  extra-territorial  court  in  China,  is  necessitated 
in  order  to  carry  out  the  provision  of  the  act  alluded  to  in 
(c)  of  that  section. 

Who  shall  pay  the  tax. — The  tax  is  paid  by  the  executor. 
The  mode  of  payment  has  already  been  fully  discussed  in  this 
chapter,  but  a  new  provision  in  the  192 1  law  whereby  the 
executor  can  be  freed  from  his  responsibility  under  certain 
circumstances  *'*  calls  for  further  comment.  This  relief  pro- 
vision is  more  apparent  than  real.  Under  the  rule  laid  down 
in  the  statute  he  cannot  get  the  promised  relief  until  the  Com- 
missioner has  notified  him  of  the  amount  of  the  tax,  and  such 
tax  has  been  paid.  Further,  the  Commissioner  is  permitted 
to  take  one  year  in  which  to  furnish  this  information.  In 
other  words,  the  executor  has  to  await  the  examination  of 
his  original  return,  the  reassessment,  if  any,  arising  out  of  such 
examination,  and  the  payment  of  the  amount  of  any  additional 
tax,  before  he  can  obtain  his  release,  all  of  which  proceedings 
may  occupy  a  year  to  carry  out.  By  the  time  he  is  relieved 
of  his  liability  his  executive  duties,  in  the  majority  of  instances, 
would  have  terminated  and  the  liability  for  any  further  tax 
thereafter  found  to  be  due  would  be  held  against  the  bene- 
ficiaries, to  the  extent  of  their  interests  in  the  original  estate. 

Regulation.  The  statute  provides  that  the  executor  shall  pay 
the  tax.*^^  This  duty  applies  to  the  tax  upon  the  transfer  of  the 
entire  estate,  including  property  which  will  not  come  into  the  possession 
of  the  executor  or  administrator.  As  to  the  personal  liability  of  the 
executor,  see  Article  113.     (Reg.  ^,7,  Art.  92.) 

Extension  of  time  for  payment. — 

Regulation.  In  any  case  where  the  Commissioner  finds  that 
payment  of  the  tax  within  one  year  after  the  decedent's  death  would 

"'  Law,  section  407,  see  page  1521. 
^^  Law,  section  407. 


FEDERAL  ESTATE  TAX  1519 

impose  undue  hardship  upon  the  estate,  extensions  of  time  will  be 
granted  for  the  payment  of  the  tax  for  a  period  not  to  exceed  in  all 
three  years  from  the  due  date.  Extensions  of  time  for  tax  pay- 
ment will  be  granted  only  in  exceptional  cases,  where  it  is  evident 
that  the  payment  of  the  tax  within  the  statutory  period  would  cause 
the  estate  serious  financial  loss.  No  extension  shall  be  for  more 
than  one  year,  and  a  substantial  payment  shall  be  made  before  each 
extension.  Application  for  extension  of  time  for  payment  should  be 
filed  with  the  collector,  and  should  contain  a  full  statement  of  the 
facts  upon  which  the  application  is  based.  The  collector  will  refer 
the  application  to  the  Commissioner,  with  suitable  recommendations. 

The  extension  of  time  for  the  payment  of  the  tax  should  not  be 
confused  with  extension  of  time  for  filing  the  return.  An  extension 
of  time  to  pay  the  tax  does  not  relieve  from  the  duty  of  filing  the 
return  within  one  year  from  the  date  of  death.  An  extension  of  time 
for  tax  payment  will  not  operate  to  prevent  the  accrual  of  interest 
upon  the  tax.     (Reg.  37,  Art.  93.) 

The  provision  in  article  93  regarding  extension  of  time  for 
payment  has  been  uniformly  interpreted  to  require  the  pay- 
ment of  at  least  25  per  cent  of  the  tax  on  the  due  date. 

The  tax  is  due  and  payable  one  year  after  decedent's  death 
(section  406).  Under  the  foregoing  section,  proceedings  for 
the  collection  of  the  amount  due  may  be  instituted  directly 
thereafter.  The  same  section  in  the  1918  law  allowed  a  period 
of  grace  for  payment  to  the  extent  of  180  days  after  the  due 
date.  In  one  case  it  was  desired  to  take  advantage  of  this  sec- 
tion and  the  collector,  ignoring  section  408  of  the  19 18  law  and 
justifying  his  action  under  Revised  Statutes,  section  3157,  per- 
mitting distraint  for  recovery  of  taxes  ten  days  after  notice 
and  demand,  threatened  immediately  to  distrain  unless  tax 
was  paid  in  full.  The  180-day  period  did  not  elapse  for  a 
further  four  months.  The  collector's  right  to  collect  under 
distraint  was  denied  him."^  Out  of  this  case  has  probably 
arisen  the  change  in  the  law  omitting  any  reference  to  180  days 
and  making  the  tax  due  and  payable  date  one  year  after  de- 
cedent's death. 

'"'■PoIk  ct  al.  V.  Pane  U.  S.  Dist.  Court,  Rhode  Tslaiid,  Advance  Cpin- 
ion.s,  276  Fed.  128,  November  17,  1921. 


I520 


MISCELLANEOUS    TAXES 


Adjustment  of  tax  after  investigation. — 

Regulation.  An  investigation  of  every  return  for  estate  tax 
will  be  made  by  an  internal-revenue  officer,  and  the  tax  liability  of 
the  estate  w^ill  be  finally  determined  by  the  Commissioner  upon  the 
basis  of  such  investigation.  If  at  the  time  the  Commissioner's  de- 
termination is  made  the  tax  has  been  paid  upon  the  basis  of  the 
return,  an  adjustment  will  be  made  of  the  amount  of  tax.  If  the 
amount  of  tax  already  paid  exceeds  the  amount  of  tax  as  finally 
determined,  the  Commissioner  will  refund  such  excess  payment  to 
the  executor.  If  the  amount  of  tax  as  finally  determined  exceeds  the 
amount  of  tax  already  paid,  the  collector  will  notify  the  executor  of 
the  amount  of  the  unpaid  balance  of  the  tax  and  will  demand  pay- 
ment thereof.  Payment  should  be  made  by  the  executor  immediately 
upon  the  receipt  of  such  notification.  Where  the  investigation  of 
the  return  shows  that  no  further  tax  is  due,  the  executor  will  be  noti- 
fied to  this  effect.  Until  the  receipt  of  such  notification,  he  should  re- 
serve a  sufficient  portion  of  the  estate  to  satisfy  any  excess  tax.  (Reg. 
37,  Art.  95.) 

While  the  foregoing  regulation  demands  immediate  pay- 
ment on  notification  of  the  unpaid  balance,  the  law  imposes 
interest  on  such  balance  only  after  a  lapse  of  thirty  days  sub- 
sequent to  notification.    A  month's  credit  is  implied  thereby. 

Interest  ox  additional  tax. — 

Regulation.  If  an  unpaid  balance  of  tax  is  found  to  be  due  by 
the  Commissioner  after  investigation,  the  statute  provides  that  in- 
terest shall  be  added  to  the  amount  of  such  excess  part  of  the  tax 
at  the  rate  of  ten  per  centum  from  the  expiration  of  30  days  after 
notification  to  the  executor,  provided  the  tax  is  not  paid  within  such 
30-day  period.  This  interest  will  not  begin  to  accrue,  however,  until 
the  expiration  of  one  year  and  180  days  after  the  decedent's  death. 
(See  Art.  94.) 

If  a  return  is  filed  containing  a  gross  or  fraudulent  misstatement 
of  fact,  and  payment  made  of  the  tax  shown  to  be  due  thereby,  such 
payment  will  not  be  considered  payment  in  full  within  the  meaning 
of  the  statute.  (See  Art.  90.)  Consequently,  in  such  a  case,  interest 
upon  the  unpaid  balance  of  tax,  determined  after  investigation,  will 
be  added  at  the  rate  of  six  per  centum  per  annum  from  the  expiration 
of  one  year  after  the  decedent's  death.     (Reg.  37^  ^^^-  9^-) 

Interest  on  unpaid  tax. — 

Regulation.  The  statute  provides  that,  if  the  tax  is  not  paid 
within  one  vear  and  180  davs  after  the  decedent's  death,  interest  at 


I 


FEDERAL   ESTATE   TAX 


1521 


six  per  centum  per  annum  from  the  expiration  of  one  year  after  the 
decedent's  death  shall  be  added  as  part  of  the  tax.  This  provision 
applies  to  the  original  amount  of  tax  shown  to  be  due  by  the  return 
accepted  by  the  collector.  It  applies  in  all  cases  in  which  penalties 
have  not  accrued  under  the  Revenue  Act  of  1916.  (See  Art.  120.) 
(Reg.  37,  Art.  94.) 

Interest  on  additional  assessment. — 

Law.  Section  407.  That  where  the  amount  of  tax  shown  upon 
a  return  made  in  good  faith  has  been  fully  paid,  or  time  for  payment 
has  been  extended,  as  provided  in  section  406,  beyond  one  year  and 
six  months  after  the  decedent's  death,  and  an  additional  amount  of 
tax  is,  after  the  expiration  of  such  period  of  one  year  and  six  months, 
found  to  be  due,  then  such  additional  amount  shall  be  paid  upon  notice 
and  demand  by  the  collector,  and  if  it  remains  unpaid  for  one  month 
after  such  notice  and  demand  there  shall  be  added  as  part  of  the  tax 
interest  on  such  additional  amount  at  the  rate  of  10  per  centum  per 
annum  from  the  expiration  of  such  period  until  paid,  and  such  addi- 
tional tax  and  interest  shall,  until  paid,  be  and  remain  a  lien  upon  the 
entire  gross  estate 

Collector  must  issue  duplicate  receipts. — 

Law.    Section  407 The  collector  shall  grant  to  the  person 

paying  the  tax  duplicate  receipts,  either  of  which  shall  be  sufficient 
evidence  of  such  payment,  and  shall  entitle  the  executor  to  be  credited 
and  allowed  the  amount  thereof  by  any  court  having  jurisdiction  to 
audit  or  settle  his  accounts 

Commissioner  to  determine  tax  within  one  year. — 

Law.  Section  407.  ....  If  the  executor  files  a  complete  re- 
turn and  makes  written  application  to  the  Commissioner  for  determin- 
ation of  the  amount  of  the  tax  and  discharge  from  personal  liability 
therefor,  the  Commissioner,  as  soon  as  possible  and  in  any  event 
within  one  year  after  receipt  of  such  application,  shall  notify  the 
executor  of  the  amount  of  the  tax,  and  upon  payment  thereof  the  ex- 
ecutor shall  be  discharged  from  personal  liability  for  any  additional 
tax  thereafter  found  to  be  due,  and  shall  be  entitled  to  receive  a  re- 
ceipt or  writing  showing  such  discharge:  rmvldcd.  nowcver,  That 
such  discharge  shall  not  operate  to  release  the  gross  estate  from  the 
lien  of  any  additional  tax  that  may  thereafter  be  found  to  be  due  while 
the  title  to  such  gross  estate  remains  in  the  heirs,  devisees,  or  distrib- 
utees thereof;  but  no  part  of  such  gross  estate  shall  be  subject  to 
such  lien  or  to  any  claim  or  demand  for  any  such  tax  if  the  title 
thereto  has  passed  to  a  bona  fide  purchaser  for  value. 


1522 


MISCELLANEOUS    TAXES 


The  paragraph  in  section  407  which  permits  an  executor, 
by  fihng  written  apphcation,  to  obtain  his  discharge  from  per- 
sonal HabiHty  "  for  any  subsequent  assessment  is  a  new  pro- 
vision. Under  the  19 18  law,  executors  have  been  held  respon- 
sible for  estate  taxes  imposed  long  after  the  estates  themselves 
have  been  closed. 

Collection  of  tax. — 

Law.  Section  408.  That  if  the  tax  herein  imposed  is  not  paid 
on  or  before  the  due  date  thereof  the  collector  shall,  upon  instruction 
from  the  Commissioner  proceed  to  collect  the  tax  under  the  provisions 
of  general  law,  or  commence  appropriate  proceedings  in  any  court  of 
the  United  States,  in  the  name  of  the  United  States,  to  subject  the 
property  of  the  decedent  to  be  sold  under  the  judgment  or  decree  of 
the  court.  From  the  proceeds  of  such  sale  the  amount  of  the  tax, 
together  with  the  costs  and  expenses  of  every  description  to  be  al- 
lowed by  the  court,  shall  be  first  paid,  and  the  balance  shall  be 
deposited  according  to  the  order  of  the  court,  to  be  paid  under  its 
direction  to  the  person  entitled  thereto 

The  foregoing  section  omits  a  provision  which  appeared 
in  the  19 18  Act  restraining  the  collector  from  enforcing  pay- 
ment should  there  be  reasonable  cause  for  further  delay.  Since 
the  procedure  is  now  dictated  by  instructions  from  the  Com- 
missioner, appeal  to  him  is  required  if  delay  is  necessary 
(section  406). 

Regulations.  The  remedy  by  action,  here  provided  for,  is  not 
exclusive.  For  other  available  remedies  for  the  collection  of  the  tax, 
see  Article  116.     (Reg.  37,  Art.  97.) 

The  provision  of  the  statute  quoted  above  applies  to  the  estate 
tax  law ;  and  three  remedies  are  thus  provided  for  the  collection  of 
the  tax : 

(i)  The  collector  may  issue  warrant  of  distraint  authorizing  the 
seizure  and  sale  of  any  or  all  of  the  assets  of  the  estate.  (See  R.  S. 
Sees.  3187  et  seq.;  Comp.  Sts.,  1916,  Sec.  5909  et  seq.) 

(2)  The  collector  may  commence  in  any  court  of  the  United 
States  appropriate  proceedings,  in  the  name  of  the  United  States 
to  subject  the  property  of  the  decedent  to  sale  under  the  judgment 
or  decree  of  the  court.     (See  Sec.  408 ;  Art.  97.) 

(3)  The  personal   liability  of  the  executor,  of  the  transferee  or 


Rev.  Stat.,  .section  3467. 


FEDERAL    ESTATE    TAX 


1523 


trustee  of  property  transferred  in  contemplation  of  death,  and  of 
the  beneficiary  of  taxable  life  insurance  (See  Art.  loi)  may  be  en- 
forced by  any  appropriate  action.      (Reg-.  37,  Art.  116.) 

Reimbursement. — 

Law.     Section  408 If  the  tax  or  any  part  thereof  is  paid 

by,  or  collected  out  of  that  part  of  the  estate  passing  to  or  in  the 
possession  of,  any  person  other  than  the  executor  in  his  capacity  as 
such,  such  person  shall  be  entitled  to  reimbursement  out  of  any  part 
of  the  estate  still  undistributed  or  by  a  just  and  equitable  contribution 
by  the  persons  whose  interest  in  the  estate  of  the  decedent  would  have 
been  reduced  if  the  tax  had  been  paid  before  the  distribution  of  the 
estate  or  whose  interest  is  subject  to  equal  or  prior  liability  for  the  pay- 
ment of  taxes,  debts,  or  other  charges  against  the  estate,  it  being  the 
purpose  and  intent  of  this  title  that  so  far  as  is  practicable  and  unless 
otherwise  directed  by  the  will  of  the  decedent  the  tax  shall  be  paid 
out  of  the  estate  before  its  distribution.  If  any  part  of  the  gross 
estate  consists  of  proceeds  of  policies  of  insurance  upon  the  life  of  the 
decedent  receivable  by  a  beneficiary  other  than  the  executor,  the  ex- 
ecutor shall  be  entitled  to  recover  from  such  beneficiary  such  portion 
of  the  total  tax  paid  as  the  proceeds,  in  excess  of  $40,000,  of  such 
policies  bear  to  the  net  estate.  If  there  is  more  than  one  such  bene- 
ficiary the  executor  shall  be  entitled  to  recover  from  such  beneficiaries 
in  the  same  ratio.  » 


CHAPTER   XLI 

FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX 

As  a  means  of  raising  additional  revenue,  Congress  in  1916 
imposed  an  excise  tax,  effective  January  i,  1917,^  on  corpora- 
tions for  the  privilege  of  doing  business.  Since  that  date 
many  imsuccessful  attempts  have  been  made  to  repeal  or  change 
the  law.^  The  net  result  of  the  changes  from  1916  to  January 
I,  1922,  is  an  increase  in  the  rate  and  a  reduction  in  the  exemp- 
tion. The  1 92 1  law  (which,  as  to  the  capital  stock  section^ 
does  not  become  effective  until  July  i,  1922)  re-enacted  the  tax 
in  substantially  the  same  form  as  it  appeared  in  the  1918 
law,  the  principal  change  being  that  insurance  companies  sub- 
ject to  tax  imposed  by  section  243  or  section  246  of  the  192 1 
law  are  exempt  from  the  capital  stock  tax.^ 

The  rate  now  in  force  for  domestic  corporations  is  $1°  for 
each  full  $1,000  of  the  average  fair  value  of  the  capital  stock 
for  the  year  preceding  the  taxable  year  in  excess  of  the  ex- 
emption of  $5,000."  The  rate  is  comparatively  low  and  the 
exemption  such  that  the  total  tax  is  not  excessive. 

In  his  report  for  1919  the  Commissioner  states:  "The 
early  regulations  touching  valuations  have  been  radically  elab- 
orated and  modified  until  under  present  approved  methods  it 


'Title  1\"  of  the  Revenue  Act  of  September  8,  1916  (Public  No.  271, 
64th  Congress). 

'  In  considering  the  Revenue  Act  of  1921  the  Senate  Finance  Committee 
omitted  the  tax. 

"  Section   1000. 

*  [Former  Procedure]  Section  1000  (c)  of  1918  law  read  "The  taxes 
imposed  by  this  section  shall  apply  to  mutual  insurance  companies."  Stock 
companies  were  taxable  as  ordinary  corporations  (Reg.  50,  Art.  22).  Or- 
ganizations doing  business  on  reciprocal  or  inter-indemnity  plan  were  sub- 
ject to  tax.     (C.  B.  4.  page  272;  L.  O.  1003.) 

^  The  rate  under  the  1916  law  was  50  cents  for  each  $1,000,  and  the 
exemption  was  $99,000.  The  rate  was  increased  to  $1  and  the  exemption 
reduced  to  $5,000  by  the  1918  law.  The  provisions  of  the  1918  law  (passed 
February  24,  1919)   were  made  retroactive  to  July  i,   1918. 

'  Foreign  corporations,  however,  are  not  permitted  anv   deduction. 

1524 


FEDERAL   CAPITAL    STOCK    (EXCISE)    TAX  1525 

has  become  necessary  to  individualize  each  case,  considering- 
all  elements  and  factors  which  throw  light  on  values  and 
harmonizing  them  so  far  as  possible  in  the  ultimate  values 
found." 

This  is  an  admission  that  the  earlier  regulations  were 
wrong.  The  early  administration  of  the  law  did  not  reflect 
credit  on  the  Treasury.  Originally  an  attempt  was  made  to 
divide  corporations  into  a  few  classes  and  value  the  capital 
stock  of  all  companies  in  each  on  practically  the  same  basis. 
During  recent  years,  however,  there  has  been  a  continuous 
improvement  in  administration. 

Theoretically,  the  tax  is  on  the  privilege  of  doing  business 
in  a  corporate  capacity,  but  it  is  difficult  to  assess  a  tax  on  the 
''fair"  value  of  capital  stock  without  considering  past  earn- 
ings, so  that  in  this  respect  the  tax  amounts  to  a  duplication 
of  the  income  tax.'^ 

When  the  law  was  enacted  all  the  arguments  as  to  the 
difficulty  of  administering  a  property  tax  were  ignored.  The 
injustice  of  placing  a  burden  upon  an  unprofitable  business 
was  brushed  aside.  The  tax  does  not  apply  to  individuals  and 
partnerships.  It  is  somewhat  similar  to  various  state  laws 
imposing  what  are  known  as  taxes  on  "corporate  excess."  Tax 
commissions  have  frequently  commented  on  this  system  of 
taxation  as  having  caused  much  difficulty,  and  litigation  has 
been  frequent.  Apparent  market  value  is  never  to  be  taken  as 
conclusive,  because  the  courts  will  permit  a  taxpayer  to  point 
out  any  unfairness  in  an  assessment  based  thereon.  Earning 
l^ower  is  never  to  be  taken  as  the  sole  factor  of  valuation  be- 
cause earnings  fluctuate  too  greatly. 

All  the  corporations  (educational,  fraternal,  etc.)  exempt 
under  the  income  tax  law  are  also  exempt  from  this  tax.  In 
addition,    many    corporations    organized    for    profit    but    not 


'  This  condition  is  to  some  extent  overcome  by  reason  of  the  fact  that 
the  capital  stock  tax  is  an  allowable  deduction  from  gross  income  in  deter- 
mining the  net  income  subject  to  the  income  and  excess  profits  taxes.  With 
the  repeal  of  the  high  excess  profits  ta.x  rates  the  relative  burden  of  the 
capital  stock  tax  increases. 


1526 


MISCELLANEOUS    TAXES 


"doing  business,"  as  interpreted  by  the  Supreme  Court  of  the 
United  States,  are  also  exempt.  This  apphes  to  lessor,  inactive 
and  similar  corporations. 

The  tax  is  due  in  advance  and  the  next  return  will  be  due 
in  July,  1922.  The  law  [section  1000  (a-i)]  provides  that  the 
computation  of  the  tax  of  a  domestic  corporation  shall  be 
based  on  "the  fair  average  value  of  its  capital  stock  for  the 
preceding  year."  Therefore,  the  return  due  in  July,  1922, 
will  be  based  on  the  average  value,  etc.,  during  the  year  July 
I,  1921.  to  June  30,  1922 — the  government's  fiscal  year.* 

The  Treasury  has  issued  regulations^  which  are  reproduced 
.in  the  following  pages,  governing  the  preparation  of  returns, 
etc.  The  law  is  wisely  silent  as  to  many  details  which  usually 
encumber  tax  bills. 

In  his  report  for  1920  the  Commissioner  states  that — 

Owing  to  the  retroactive  feature  of  the  Revenue  Act  of  19 18, 
which  was  passed  February  24,  19 19,  changing  the  rate  and  lowering 
the  exemption,  the  work  of  the  division  was  greatly  increased;  but 


*  The  following  provision  is  made  on  form  707  for  a  corporation's 
fiscal  year  which  ends  at  some  date  other  than  June  30:  "In  item  7  on 
page  I  hereof  the  taxpayer  will  show  the  closing  date  of  its  fiscal  year 
ended  between  July  I,  1921,  and  June  30.  1922,  if  other  than  June  30, 
and  the  information  furnished  under  exhibits  A,  B  and  C  will  be  as  of 
the  year  or  years  ended  on  such  date,  which  should  be  used  annually." 

'  [Former  Procedure]  Regulations  38  were  issued  October  19,  1916. 
Regulations  38  (revised)  were  issued  August  9.  1918.  Regulations  50 
were  issued  April  29,  1919.  Regulations  50  (revised)  were  issued  June  21, 
1920,  and  are  still  in  effect.  In  the  opinion  of  the  author  the  require- 
ments of  the  1916  regulations  were  reasonable  but  T.  D.  2503  (June  25. 
1917)  imposed  new  methods  of  ascertaining  the  "fair  value"  of  the  cor- 
porate stock  which  were  fallacious,  not  in  accord  with  the  law  and  unen- 
forceable. 

As  the  valuation  of  capital  stock  is  the  basis  for  the  assessment  of 
the  tax,  the  importance  of  a  correct  formula  for  calculating  "fair 
value"  should  not  be  underestimated.  Detailed  criticism  of  the  regula- 
tions will  be  found  in  Income  Tax  Procedure,  1918,  pages  628  to  677. 

Regulations  38  (revised,  1918)  and  Regulations  50  (April,  1919)  did 
not  continue  the  former  objectionable  instructions.  Therefore,  it  is  con- 
sidered unnecessary  to  repeat  in  this  book  most  of  the  comments  on  the 
original  regulations.  But  taxpayers  whose  returns  for  the  fiscal  year  ended 
June  30,  1918,  and  earlier  periods  have  not  been  examined  or  finally 
settled  should  refer  to  the  1918  edition  of  this  manual. 

From  information  which  has  come  to  the  author  it  seems  that 
very  many  close  corporations  were  over-assessed,  but  that  practically 
no  corporation  whose  stock  was  listed  on  an  exchange  was  so  treated. 
The  corporations  which  were  over-assessed  should  apply  for  a  refund. 


FEDERAL   CAPITAL    STOCK    (EXCISE)    TAX  1527 

the  audit  of  returns  for  the  taxable  period  ended  June  30,  1919,  was 
practically  completed  by  January  i,  1920,  except  in  the  case  of  cor- 
porations delinquent  in  filing  returns,  or  cases  reopened  by  reason  of 
additional  information  contained  in  subsequent  returns  or  obtained  by 
field  investigation.  The  audit  of  the  returns  for  the  taxable  period 
ended  June  30,  1920,  was  begun  immediately,  and  it  will  be  completed 
by  the  time  the  returns  filed  for  the  coming  year  are  arranged  for 
audit. 

Difficulty  has  been  encountered  in  procuring  and  retaining  capable 
examiners,  owing  to  the  qualifications  required.  This  division  has 
evolved  into  a  staff  of  valuation  experts  on  questions  of  estimating 
the  worth  of  collateral  securities  and  all  forms  of  property.  It 
requires  men  of  sound  judgment,  a  general  knowledge  of  business 
conditions,  and  some  knowledge  of  law,  accounting  practice,  and 
financing  procedure.  During  the  year  the  number  of  employees  was 
reduced  from  148  to  an  average  working  force  of  115,  and  at  the 
same  time  the  work  has  been  kept  on  a  current  basis. 

A  revision  of  capital  stock  tax  regulations  has  been  accomplished 
with  a  view  to  putting  into  taxpayers'  hands  complete  information 
for  the  preparation  of  returns.  The  modifications  in  the  regulations 
are  not  extensive,  but  changes  of  importance  have  been  made  in  the 
provisions  relative  to  tentative  returns ;  to  cases  where  a  change  in 
number  of  shares  has  occurred  in  the  outstanding  stock  of  a  cor- 
poration during  the  year  immediately  preceding  the  taxable  period; 
to  questions  of  parent  and  subsidiary  corporations  or  affiliated  cor- 
porations; and  to  questions  of  classifying  corporations  exempt  on 
account  of  personal  service. 

Returns  are  checked  with  those  of  previous  years  to  detect  in- 
consistencies. Periodical  conferences  are  held  between  group  heads 
and  administrative  officers  of  the  division,  in  order  that  the  examining 
force  may  receive  the  benefit  of  conclusions  reached  and  the  inter- 
pretations placed  upon  the  law  and  regulations,  from  the  considera- 
tion of  intricate  cases  actually  before  the  division  for  determination. 

And  in  his  report  for  1921  the  Commissioner  states  :  "Dur- 
ing the  year  this  division  has  evolved  a  staff  of  valuation  ex- 
perts on  questions  pertinent  to  an  equitable  administration  01 
the  capital-stock  tax." 

For  convenience  the  text  of  the  192 1  law  and  such  part 
of  Regulations  50  (revised  June,  1920)  applicaljle  thereto 
will  be  reproduced  herein. 

Regulations  50  (revised  June,  1920)  interpret  the  19 18 
law.  Regulations  under  the  192 1  law  have  not  yet  been  issued. 
The  capital  stock  tax  section  of  the  192 1  law  becomes  effec- 


1528  MISCELLANEOUS    TAXES 

tive  Inly  i,  192-'.  The  1918  law  continues  in  effect  nntil  the 
1 92 1  law  becomes  effective/" 

Domestic;   Corporations 

Effective  date. — 

Regulation Special  taxes  of  which  this  is  one,  become 

due  on  the  first  day  of  July'^  in  each  year,  or  on  commencing  any 
trade  or  business  on  which  such  tax  is  imposed.  In  the  former  case 
the  tax  is  for  one  year,  and  in  the  latter  case  it  is  for  the  period  from 
the  first  day  of  the  month  in  which  the  liability  to  the  special  tax  is 

incurred  to  the  first  day  of  July  following Xo  portion  of  the 

tax  is  refundable  where  a  corporation  ceases  to  do  business  during 
the  year.     (Reg.  50,  revised.  Art.  i.) 

The  foregoing"  regulation  is  based  on  section  3237,  Revised 
Statutes,^"  which  applies  to  the  assessment  of  special  taxes.  As 
to  corporations  organized  and  l)eginning  corporate  activities 
after  July  i  in  any  year,  however,  section  3237  is  superseded 
by  the  act  imposing  the  federal  capital  stock  tax.  Section 
1 000  (b)  of  the  law,  quoted  on  page  1535,  specifically  pro- 
vides that  the  tax  "shall  not  apply  in  any  year  to  any  corpora- 
tion which  was  not  engaged  in  business  ....  during  the 
preceding  year  ending  June  30."  This  limitation  is  recognized 
in  article  26  of  Regulations  50,  which  will  be  foimd  on  page 
1536. 

Scope  of  tax. — 

Law.  Section  1000.  (a)  ....  (i)  Every  domestic  corpora- 
tion  .... 


'"  Section  1400  of  1921  law. 

"  Corporations  whose  fiscal  years  end  at  dates  other  than  June  30 
may  submit  figures  based  on  their  own  fiscal  years.  (Instructions  2, 
form  707). 

'"Law.  "All  special  taxes  shall  become  due  on  the  ist  day  of  July,  1891, 
and  on  the  ist  day  of  July  in  each  year  thereafter,  or  on  commencing 
any  trade  or  business  on  which  such  tax  is  imposed.  In  the  former  case 
the  tax  shall  be  reckoned  for  one  year,  and  in  the  latter  case  it  shall  be 
reckoned  proportionately  from  the  ist  day  of  the  month  in  which  the 
liability  to  a  special  tax  commenced  to  the  ist  day  of  July  following." 
[Section  3237,  Revised  Statutes,  as  amended  by  Section  53  of  the  act  of 
October   i,   1890   (26  Stats.,  567)-] 


FEDERAL    CAPITAL    STOCK    (EXCISE)    TAX  1529 

Definition  of  domestic  corporations. — 

Regulations.  A  domestic  corporation  is  a  corporation  created 
or  organized  in  the  United  States,  which  includes  the  States,  Terri- 
tories of  Alaska  and  Hawaii,  and  the  District  of  Columbia.  (Reg.  50, 
revised,  Art.  8.) 

The  term  "corporation"  includes  associations,  joint-stock  com- 
panies, whether  created  by  statute  or  by  contract,  and  insurance  com- 
panies, but  not  partnerships,  properly  so  called,  and  whether  or  not 
organized  for  profit  or  having  a  capital  stock  represented  by  shares. 
(Reg.  50,  revised.  Art.  2.) 

Personal  service  corporations.^' — Section  1000  of  the  19 18 
law  imposes  a  capital  stock  tax  upon  all  domestic  corporations 
except  those  enumerated  in  section  231  of  that  act.  Among 
the  corporations  thus  exempted  [subdivision  (14)]  are  per- 
sonal service  corporations.  Section  1000  of  the  192 1  law  pro- 
vides that  on  and  after  July  i,  1922,  "in  lieu  of  the  tax  im- 
posed by  Section  1000  of  the  Revenue  Act  of  1918,"  every 
domestic  corporation,  except  those  enumerated  in  section  231 
of  that  law,  shall  pay  a  capital  stock  tax.  Section  231,  sub- 
division (14),  exempts  personal  service  corporations  with  this 
limitation :  "This  subdivision  shall  not  be  in  effect  after 
December  31,  1921."  Both  laws  specifically  provide  that  the 
taxes  imposed  shall  not  apply  to  any  corporation  which  was 


''[Former  Procedure]  Under  the  1918  law  [section  231  (14)]  per- 
sonal service  corporations  were  exempt  because  they  were  taxed  as  part- 
nerships. Insurance  companies  were  subject  to  tax  under  the  1918  law 
(including  tax  for  the  year  beginning  July  i,  1021)  but  not  under  the  1921 
law.  The  capital  stock  tax  section  of  the  1921  law  is  not  effective,  how- 
ever, until  July   i.  1922. 

To  be  exempt  from  the  capital  stock  tax  under  the  1918  law,  personal 
service  corporations  were  required  to  be  granted  full  classification  as  such 
by  the  Income  Tax  Unit  for  the  purpose  of  the  income  and  profits  taxes. 

Art.  28,  Reg.  50  (revised),  required  that  returns  be  filed  and  fair  value 
of  capital  stock  shown.  Tax  was  not  to  I)e  computed,  however,  and  in  lieu 
thereof  the  words  "exemption  claimed"  inserted.  A  full  statement  of  the 
reasons  for  claiming  exemption  was  required  to  be  attached  to  the  return. 

Regulation.  "  ....  To  be  exempt  from  capital  stock  tax,  corpora- 
tions must  have  previously  been  granted  full  classification  as  personal  ser- 
vice corpcjrations  for  llie  purpose  of  Federal  income  and  profits  taxes  under 
K'e.i^nlations  45,  revised."      (Keg.   50,   revised,   Art.   27.) 


I530 


MISCELLANEOUS   TAXES 


not  engaged  in  business  during  the  preceding  year  ending 
June  30.  It  will  be  noted  that  the  capital  stock  tax  imposed 
by  the  Act  of  192 1  takes  effect  "on  and  after  July  i,  1922,'' 
and  is  "in  lieu  of  the  tax  imposed  by  Section  1000  of  the  Rev- 
enue Act  of  19 18."  It  would  seem  that  by  virtue  of  section 
1400  (b)  of  the  1 92 1  law  the  capital  stock  provisions  of  the 
1918  law  remain  in  effect  until  July  i,  1922,  except  that  after 
December  31,  1921,  personal  service  corporations  are  no 
longer  exempt  from  the  tax  imposed  thereby.  It  may  readily 
be,  therefore,  that  Congress  intended  that  a  tax  should  be 
imposed,  under  the  19 18  law,  upon  personal  service  corpora- 
tions from  and  after  December  31,  192 1. 

The  statute,  however,  affords  no  justification  for  the  impo- 
sition thereof.  Presumably,  as  the  tax  imposed  by  both  the 
19 18  and  1 92 1  laws  is  an  excise  tax,  it  was  for  the  privilege  of 
doing  business  for  the  whole  year  or  such  part  thereof  as  any 
corporation  might  see  fit  to  remain  in  business.  The  192 1  law 
sets  up  no  standard  by  which  it  is  possible  to  determine  what 
proportion  of  the  tax  shall  be  imposed  for  the  privilege  of 
doing  business  from  December  31,  1921,  until  July  i,  1922. 
There  is  nothing  in  the  law  to  show  that  Congress  intended  to 
make  the  tax  retroactive  so  as  to  cover  the  period  from  July 
I,  192 1,  to  December  31,  1921.  Indeed,  by  failing  to  subject 
personal  service  corporations  to  the  tax  in  question  as  soon  as 
the  law  should  take  effect,  demonstrates  a  contrary  intent. 
Without  express  authority  from  Congress,  it  would  certainly 
be  improper  to  impose  a  tax  equal  to  that  which  is  exacted  from 
corporations  for  the  privilege  of  doing  business  for  a  whole 
year.  On  the  other  hand,  to  attempt  to  apportion  the  tax  would 
be  illegal  because  there  is  no  statutory  authority  for  doing  so. 
Taxes  .cannot  be  imposed  or  exacted  except  by  express  legisla- 
tive authority.  There  thus  appears  to  be  a  lapse  in  the  law 
(a  situation  of  frequent  occurrence),  and  bv  reason  thereof  no 
tax  can  be  imposed  under  the  1918  law  on  personal  service 
corporations,  nor  under  the  192 1  law  until  July  i,  1922.  Sec- 
tion  3237  of  the  Revised  Statutes   is  not  applicalile  because 


FEDERAL    CAPITAL    STOCK    (EXCISE)    TAX  1531 

the  provisions  thereof  which  proxidc  lor  tlie  reckoning  of 
taxes  proportionately  apply  only  to  a  trade  or  business  which 
was  commenced  after  the  first  of  Jul}'  in  any  given  year. 

Associations   and   limited   partnerships   which   are 

included. 

Regulations.  Associations  and  joint-stock  companies  include 
organizations,  by  whatever  name  known, '^  which  act  or  do  business 
in  an  organized  capacity,  whether  created  under  and  pursuant  to 
State  laws,  agreements,  declarations  of  trust,  or  otherwise,  the  net 
income  of  which,  if  any,  is  distributable  among  the  members  or  share- 
holders on  the  basis  of  the  capital  stock  held  by  each,  or,  where 
there  is  no  capital  stock,  on  the  basis  of  the  proportionate  share  of 
capital  which  each  has  or  has  invested  in  the  business  or  property 

of  the  organization An  organization,  the  membership  interests 

in  which  are  transferable  without  the  consent  of  all  of  the  members, 
however  the  transfer  may  be  otherwise  restricted,  and  the  business 
of  which  is  conducted  by  trustees  or  directors  and  officers  without 
the  active  participation  of  all  the  members  as  such,  is  an  association. 
(Reg.  50,  revised,  Art.  3.) 

The  test  of  liability  in  all  cases  involving  trusts  of  the  Massa- 
chusetts type  is  whether  the  cestuis  que  trustent  have  by  the  terms 
of  the  trust  agreement  a  voice  in  the  management  or  control  of  the 
trust.  Where  the  trustees  are  in  complete  control  of  the  business, 
the  beneficiaries  having  no  control  except  the  right  of  filling  vacan- 
cies among  the  trustees  or  of  consenting  to  a  modification  of  the 
terms  of  the  trust  or  of  dissolving  the  trust,  no  association  exists. 
If,  however,  the  cestuis  que  trustent  have  a  voice  in  the  control  or 
management  of  the  business  of  the  trust,  whether  through  the  right 
to  elect  trustees  periodically  or  to  remove  the  trustees  or  to  restrict 
the  trustees  as  to  the  management  of  the  trust  or  otherwise,  the 
trust  is  an  association  within  the  meaning  of  the  statute.  Where 
the  trustees  hold  in  their  own  right  a  sufficient  number  of  the  cer- 
tificates of  beneficial  interest  to  constitute  control  as  between  the 
beneficiaries,  the  trust  will  be  held  to  be  an  association  regardless 
of  the  powers  conferred  upon  the  trustee  by  the  instrument  creating 
the  trust.     (Reg.  50,  revised.  Art.  7.) 

A  partnership  bank,  conducted  like  a  corporation  and  so  organ- 


'*  "Massachusetts  trusts"  were  held  (o  be  exempt  from  the  excise 
tax  in  Eliot  v.  Freeman,  el  al.  [220  U.  S.  178,  55  L.  Ed.  424,  31  Sup.  Ct. 
360,  (T.  D.  1686)],  ami  corporations  in  hands  of  a  receiver  are  exempt. 
(T.  D.  2424.)  In  Crocker  v.  Malley  (249  U.  S.  223,  63  L.  Ed.  573.  39  Sup. 
Ct.  270,  2  A.  L.  R.  looi)  certain  types  of  Massachusetts  trusts  were  held 
not  to  be  "associations"  of  the  corporate  type. 


1532 


MISCELLANEOUS    TAXES  ♦ 


ized  that  the  interests  of  its  members  may  be  transferred  without 
the  consent  of  the  other  members,  is  a  joint-stock  company  or  asso- 
ciation within  the  meaning  of  the  statute.  A  partnership  bank,  the 
interests  of  whose  members  can  not  be  so  transferred,  is  a  partner- 
ship.     (Reg.  50,  revised,  Art.  6.) 

Partnerships  with  limited  liabiHty  or  partnership  associations  au- 
thorized by  the  statutes  of  Pennsylvania  and  a  few  other  States  are 
only  nominally  partnerships.  Such  so-called  limited  partnerships, 
offering  opportunity  for  limiting  the  liability  of  all  the  members, 
providing  for  the  transferability  of  partnership  shares,  and  capable 
of  holding  real  estate  and  bringing  suit  in  the  common  name,  are 
more  truly  corporations  than  partnerships,  and  are  taxable  as  cor- 
porations. In  all  doubtful  cases  limited  partnerships  will  be  treated 
as  corporations  unless  they  submit  satisfactory  proof  that  they  are 
not  in  effect  so  organized.  Michigan  partnership  associations  are 
corporations.  The  liability  of  Virginia  limited  partnerships  is  deter- 
mined in  each  case  from  a  consideration  of  the  certificate  of  part- 
nership and  all  pertinent  facts  relative  thereto.  (Reg.  50,  revised, 
Art.  4.) 

Since  the  tax  is  imposed  upon  the  privilege  of  doing  busi- 
ness as  a  corporation,  the  foregoing  article  appears  to  be  too 
sweeping  in  its  terms.  The  courts  may  be  expected  to  interpret 
the  law  so  as  to  exclude  rather  than  include  doubtful  cases. ^^ 

Article  1506  of  Regulations  45,  issued  in  regard  to  income 
and  profits  taxes,  originally  provided  that  ''Michigan  and  \^ir- 
ginia  partnership  associations  are  corporations" ;  but  this  arti- 
cle was  amended  by  T.  D.  2943  (November  6,  19 19)  to  ex- 
cltide  Virginia  partnership  associations.  See  further  articles 
1505  and  1506  of  Regulations  62. 

Limited  partnerships  which  are  not  included. — 

Regulation.  So-called  limited  partnerships  of  the  type  author- 
ized by  the  statutes  of  New  York  and  most  of  the  States  are  partner- 
ships and  not  corporations  within  the  meaning  of  the  statute.  Such 
limited  partnerships  which  can  not  limit  the  liability  of  the  general 
partners,  although  the  special  partners  enjoy  limited  liability  so  long 
as  they  observe  the  statutory  conditions,  which  are  dissolved  by  the 
death  or  transfer  of  the  interest  of  a  general  partner,  and  which 
can  not  hold   real   estate   or   sue   in   the   partnership  name,   are   so 


'°  Crocker  v.   Mallry.  24Q  U.   S.  222.   63   L.   Kd.   S73'  39   Sup.   C"t.   270. 
2  A.  L.  R.  looi. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1533 

like  common  law  partnerships  Ihat  they  can  not  be  differentiated  there- 
from for  tax  purposes.  Miclugan  and  Illinois  limited  partnerships 
are  partnerships.  California  special  partnerships  are  partnerships. 
(Reg.  50,  revised,  Art.  5.) 

Corporation  Must  be  "Doing  Business'*  to  be  Taxed 

Law.  Section  1000.  (a)  ....  (i)  ...  .  shall  pay  annually 
a  special  excise  tax  with  respect  to  carrying  on  or  doing  busi- 
ness,  .... 

Regulation.  The  basis  of  the  tax  in  the  case  of  a  domestic  cor- 
poration is  "carrying  on  or  doing  business"  in  the  capacity  of  a  cor- 
poration, association,  or  insurance'*'  company.  The  words  "carrying 
on  or  doing  business"  must  be  given  their  ordinary  and  natural  sig- 
nification. "Business"  is  a  very  comprehensive  term  and  embraces 
whatever  occupies  the  time,  attention  or  labor  of  men  for  the  purpose 
of  livelihood  or  profit.  In  other  words,  business  necessarily  involves 
the  idea  of  gain. 

The  true  basis  of  distinction  is,  in  the  first  instance,  between — 

(a)  A  corporation  organized  for  the  purpose  of  doing  business 

as  above  defined,  and 

(b)  A  corporation  organized  for  the  sole  purpose  of  owning  and 

holding  property  and  distributing  its  avails; 

and,  in  the  second  instance,  between — 

(c)  A  corporation  of  class  (a)  which  is  continuing  the  body  and 

substance  of  the  business  for  which  it  was  organized  or  is 
still  active  and  maintaining  its  organization  for  the  purpose 
of  continued  efforts  in  the  pursuit  of  profit  or  gain,  and 

(d)  A  corporation   which,   although   included   in   clas3    (a),   has 

substantially  retired  from  the  business  for  which  it  was 
organized  and  has  reduced  its  activities  to  the  mere  owner- 
ship and  holding  of  property,  distributing  its  avails,  and 
doing  only  the  acts  necessary  to  the  maintenance  of  its 
corporate  existence  and  the  private  management  of  its 
purely  internal  affairs. 

The  distinction  in  each  case  must  depend  upon  the  peculiar  facts 
in  the  case.  Corporations  of  class  (a)  will  be  presumed  to  be  sub- 
ject to  the  tax  unless  they  submit  proof,  satisfactory  to  the  Com- 
missioner, that  they  are  not  actually  carrying  on  or  doing  business. 
If  a  corporation  claim  exemption  on  the  ground  that   it  belongs  to 

'"Insurance  companies  subject  to  the  income  lax  imposed  by  section 
243  or  246  of  the  1921  law  are  now  exempt  from  capital  stock  tax.  They 
were  taxable  under  the  igi8  law.  Certain  other  insurance  companies,  de- 
scribed in  section  231    (10),  are  also  exempt. 


1534 


MISCELLANEOUS    TAXES 


class  (b),  it  will  be  required  to  file  an  excerpt  from  its  charter  set- 
ting forth  its  corporate  powers  together  with  a  full  and  comprehensive 
statement  showing  the  nature  of  the  activities  in  which  it  is  and  has 
been  actually  engaged.  If  it  claim  exemption  on  the  ground  that  it 
belongs  to  class  (d),  it  will  be  required  to  furnish  a  copy  of  any 
amendment  of  its  charter,  resolution  of  its  board  of  directors,  or 
other  evidence,  satisfactory  to  the  Commissioner,  showing  that  it  has 
reduced  its  activities  to  the  mere  ownership  of  property,  receipt  of 
its  avails,  and  the  doing  of  only  what  is  necessary  to  the  maintenance 
of  its  corporate  existence. ^^      (Keg.  50,  revised,  Art.  10.) 

"Doing  business"  illustrated. '^ — 

Regulation.  Corporations  organized  for  the  purpose  of  and  actu- 
ally engaged  in  such  activities  as  buying,  selling,  or  dealing  in  mineral 
or  timber  land,  or  other  real  estate;  leasing  property,  collecting  rents, 
managing  office  buildings,  making  investments  of  profits ;  leasing  lands 
and  collecting  royalties,  managing  wharves,  dividing  profits;  and  in 
some  cases  investing  the  surplus,  are  engaged  in  "carrying  on  or 
doing  business"  within  the  meaning  of  the  statute. 

A  corporation  organized  for  the  purpose  of,  and  actually  engaged 
in,  buying  mineral  or  timber  land  or  other  real  estate  and  holding 
it  with  a  view  to  future  sale  at  an  advance  is  carrying  on  or  doing 
business. 

A  corporation  organized  for  the  purpose  of  owning  and  leasing 
real  estate  which  has  leased  all  of  the  property  under  its  control 
is  still  engaged  in  doing  business  unless,  under  the  terms  of  its  lease, 
its  activities  have  been  reduced  to  the  mere  receipt  and  distribution 
of  the  avails  of  the  leases  at  the  actual  cost  of  so  doing.  If  it  is 
still  maintaining  its  organization  for  the  purpose  of  continued  effort 
in  the  pursuit  of  profit  and  gain  it  is  doing  business. 

A  corporation  ow-ning  or  managing  real  estate  which  leases  all  of 
its  property  but  under  the  terms  of  the  lease  is  required  to  maintain 
or  keep  the  property  in  repair  is  doing  business. 

A  corporation  engaged  in  mining  or  in  developing  and  speculat- 
ing in  mineral  lands  is  doing  business. 

A  corporation  engaged  in  buying  and  selling  securities  or  other 
property  is  doing  business  even  though  for  a  period  it  makes  no 
purchases  or  sales  because  of  unfavorable  market  conditions. 

A  corporation  formed  to  take  over  miscellaneous  stocks,  bonds  or 
other  property  (as  of  an  estate),  to  negotiate  sales  of  various  items 
from  time  to  time  as  opportunity  and  judgment  dictate,  and  to  dis- 


"  This   regulation  elaborates  the   foriiuT   regulation   but  makes  no  im 
portant  change  in   substance. 

"For  court  decisions  bearing  on   liability  and   non-liability   to  tax,  see 
Income  Tax  Procedure.  1918,  pages  654-659. 


FEDERAL    CAPITAL    STOCK    (EXCISE)    TAX  1535 

tribute  the   profits   from  time  to   time   as   liquidation   is   effected,   is, 
while  so  engaged,  carrying  on  or  doing  business. 

A  parent  corporation  which  finances  or  manages  the  operations 
of  its  subsidiaries  is  doing  business. 

A  so-called  holding  company  which,  under  its  charter,  is  author- 
ized to  and  does,  in  addition  to  receiving  and  distributing  the  avails 
of  the  property  or  securities,  held  by  it,  finance  the  operations  of  its 
subsidiaries,  is  engaged  in  doing  business. 

A  corporation  organized  for  the  purpose  of  taking  over  and  hold-' 
ing  securities,  timber  lands,  coal   lands,  or  other  real  estate,  is  held 
to  be  doing  business,  if  it  makes  investments  or  reinvestments  of  its 
surplus  income  or  funds  in  excess  of  an  amount  necessary  to  main- 
tain its  original  investments.'-'     (Reg.  50,  revised,  Art.  ll.) 

Not  "doing  business"  illustrated. — 

Regulation.  Holding  companies  as  distinguished  from  parent 
corporations,  and  corporations  all  of  whose  property  and  business  is 
operated  by,  or  is  in  the  hands  of,  a  receiver  or  the  Alien  Property 
Custodian,  are  not  doing  business. 

A  holding  company  is  defined  as  one  whose  corporate  powers  are 
limited  to  the  mere  owning  and  holding  of  property  and  distribution 
of  its  avails,  or  one  which,  although  incorporated  for  the  purpose 
of  doing  business  as  defined  in  article  10,  has  substantially  retired 
from  the  business  for  which  it  was  organized  and  has  reduced  its 
activities  to  the  mere  ownership  and  holding  of  property,  distributing 
its  avails,  and  doing  only  such  acts  as  are  necessary  to  the  main- 
tenance of  its  corporate  existence  and  the  private  management  of 
its  purely  internal   affairs. 

A  holding"  company,  as  above  defined,  will  not  be  considered 
to  be  doing  business  by  reason  of  the  reinvestment  of  its  surplus 
income  or  funds  to  the  extent  only  of  maintaining  its  original  in- 
vestments.-"    (Reg.  50,  revised.  Art.  12.) 

Corporations  Which  Are  Not  Subject  to  the  Tax 

Law.  Section  1000.  ....  (b)  The  taxes  imposed  by  this 
section  shall  not  apply  in  any  year  to  any  corporation  which  was  not 


"This  is  only  clalxiration  of  a  former  regulation. 

""  [Former  Procedure]  T.  D.  2429,  dated  January  4,  1917,  held 
that  a  holding  company  (having  several  subsidiaries),  the  only  busi- 
ness of  which  was  "to  receive  dividends  and  interest  from  the  oper- 
ating companies,  pay  interest  on  its  own  indebtedness  and  distribute 
its  surplus  income  as  dividends  among  its  own  stockholders,"  is  en- 
gaged in  business  within  the  meaning  of  the  act  of  September  8, 
1916,  and  is  subject  to  the  capital  stock  tax.  It  will  be  noted  that 
this  decision  has  been  reversed  and  corporations  with  activities  limited  to 
those  described  are  not  liable  to  the  tax. 


1536  MISCELLANEOUS    TAXES 

engaged  in  business  (or,  in  the  case  of  a  foreign  corporation,  not  en- 
gaged in  business  in  the  United  States)  during  the  preceding  year  end- 
ing June  30,  nor  to  any  corporation  enumerated  in  section  231,  nor 
to  any  insurance  company  subject  to  the  tax  imposed  by  section  243 
or  246. 

If,  on  June  30,  1922,  or  prior,  a  corporation  formally  de- 
cides to  liquidate,  no  return  need  be  made  thereafter. 

Period  of  doing  business  determines  tax  liability.-^ — 

Regulation.  The  tax  being  payable  in  advance  does  not  apply 
to  any  corporation  which  was  not  engaged  in  business  during  any 
part  of  the  fiscal  year  preceding  the  year  for  which  the  tax  is  due, 
but  if  it  was  in  business  even  one  day  of  the  preceding  year  and 
one  day  of  the  taxable  year  it  is  subject  to  the  tax.  There  is  no 
relation  between  the  amount  of  the  tax  payable  and  the  length  of 
time  the  corporation  was  in  business.  A  corporation  engaged  in 
business  during  a  part  of  the  preceding  year,  but  not  engaged  in 
business  at  the  beginning  of  the  taxable  year,  is  not  required  to 
make  any  return  if  it  is  dissolved  or  in  process  of  dissolution,  but 
if  it  is  only  temporarily  inactive  and  subsequently  during  the  year 
reengages  in  business  it  should  file  a  return  in  the  month  in  which 
it  recommences  business  and  pay  the  tax  due  from  the  first  of  such 
month  to  the  end  of  the  taxable  year.  A  corporation  organized 
and  beginning  corporate  activities  on  or  after  July  i  is  not  subject 
to  tax  for  the  remainder  of  the  taxable  period  in  which  the  com- 
pany was  organized,  unless  as  of  July  i,  it  takes  over  the  business 
of  an  organization  which  was  subject  to  capital  stock  tax,  in  which 
event  the  new  corporation  is  required  to  file  a  return  and  pay  the 
tax.  In  the  case  of  foreign  corporations  '"engaged  in  business," 
means  the  transaction  of  any  business  within  the  United  States. 
(Reg.  50,  revised.  Art.  26.) 

Exempt  corporations. — In  addition  to  corporations  not 
"doing  business"  the  thirteen  classes  of  corporations  enumer- 
ated in  section  231  of  the  income  tax  law,  and  insurance  com- 


"  [Former  Procedure] 

"Doing  business"  by  railroad  corporation  under  federal  control. — 

Regulation.  "A  corporation  owning  a  railroad  controlled  and  operated 
by  the  Government  is  exempt  from  liability  for  a  given  tax  year  only 
in  case  it  does  no  business  during  such  year.  The  liability  of  a  corporation 
which  actually  does  business  is  not  affected  by  the  control  over  its  rail- 
road exercised  by  the  Government "     (Reg.  50,  Art.  20.) 

For  detailed  procedure  regarding  railroads,  see  Reg.  50,  Arts.  20  and 
21;  T.  D.  2800  (March  12,  1919)  ;  and  T.  D.  3156  (April  11,  1921). 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1537 

panics  (taxed  under  sections  243  or  246),  are  exempt.     For 
details,  see  Chapter  II. 

Return  by  corporation  claiming  exemption. — 

Regulation.  Where  the  officers  of  a  corporation  are  of  the 
opinion  that  it  is  exempt  from  the  tax  under  section  231  of  the 
Revenue  Act  of  1918,  or  on  account  of  not  being  engaged  in  business, 
Form  707  (Revised)  [Appendix  B]  should  be  filled  out  and  filed  with 
the  collector,  together  with  a  comprehensive  statement  of  the  reasons 
for  claiming  exemption.  In  such  case  the  fair  value  should  be 
reported  on  page  i  of  the  form,  but  the  tax  not  computed,  notation 
"Exemption  claimed"  being  made  instead.  If  exemption  has  been 
allowed  for  the  preceding  taxable  year  and  there  has  been  no  change 
in  the  status  or  conditions  of  the  company  then  the  first  14  lines  of 
Form  707  (Revised)  should  be  completed  and  a  statement  attached 
to  the  effect  that  exemption  is  claimed  for  the  same  reasons  as 
for  the  previous  year  and  that  the  same  status  and  conditions  of 
the  company  exist  for  the  taxable  period  in  question.  In  this  way 
the  records  of  the  collectors'  offices  will  be  complete  and  corpora- 
tions will  avoid  requests  for  the  filing  of  returns  and  unnecessary 
correspondence.  The  determination  of  liability  rests  in  the  first  in- 
stance with  the  Commissioner  of  Internal  Revenue  and  without  com- 
plete information  it  is  impossible  to  make  a  decision.  (Reg.  50, 
revised,  Art.  28.) 


Rate  and  Computation  of  Tax  for  Domestic  Corporations 

Law.     Section  1000.     (a)    .    .    .    .   (i)  Every  domestic  corporation 

shall  pay  annually  a  special  excise  tax equivalent  to  $1   for 

each  $1,000  of  so  much  of  the  fair  average  value  of  its  capital  stock  for 
the  preceding  year  ending  June  30  as  is  in  excess  of  $5,000.  In  estimat- 
ing the  value  of  capital  stock  the  surplus  and  undivided  profits  shall 
be  included;   .    .    .    .-- 


J"  [Former  Procedure]     Both  the  1916  and  1918  laws  imposed  this  tax 
on  insurance  companies. 

1918  Law.  Section  1000.  "  .  .  .  .  (b)  In  computing  the  tax  in  the  case 
of  insurance  companies  such  deposits  and  reserve  funds  as  they  are  re- 
quired by  law  or  contract  to  maintain  or  hold  for  the  protection  of  or  pay- 
ment to  or  apportionment  among  policyholders  shall  not  be  included. 

"(c)  ....  and  in  the  case  of  every  such  domestic  [mutual  insur- 
ance] company  the  tax  shall  be  equivalent  to  $1  for  each  $1,000  of  the 
excess  over  $S,ooo  of  the  sum  of  its  surplus  or  contingent  reserves  main- 
tained for  the  general  use  of  the  business  and  any  reserves  the  net  addi- 
tions to  which  are  included  in  net  income  under  the  provisions  of  Title  II, 
as  of  the  close  of'  the  preceding  accounting  period  used  by  such  company 
for  purposes  of  making  its  income  tax  returns." 


1538 


MISCELLANEOUS    TAXES 


Regulation.  The  tax  is  at  the  rate  of  $i  for  each  full  $i,ooo 
of  the  fair  average  value  of  the  capital  stock  of  the  corporation 
in  excess  of  the  prescribed  deduction  of  $5,000.  The  tax  is  com- 
puted not  upon  the  par  value  of  the  stock,  but  upon  the  fair  average 
value  for  the  preceding  year,  or  for  the  period  during  which  it  has 
been  issued,  if  less  than  a  year,  of  the  capital  stock  outstanding  at 
the  date  of  the  incidence  of  the  tax.  In  the  case  of  a  domestic  cor- 
poration it  is  on  an  entirely  different  basis  from  the  excess  profits 
tax,  which  is  concerned  with  invested  capital  and  not  with  the  fair 
average  value  of  the  capital  stock.  Stock  in  the  treasury  of  a  cor- 
poration is  not  regarded  as  outstanding  unless  pledged  as  security 
for  a  debt.  No  deduction  is  allowed  corporations  organized  in  the 
United  States  for  capital  invested  outside  of  the  United  States.  If 
the  corporation  is  doing  business  it  is  taxed  on  its  entire  capital  stock 
even  though  most  of  it  may  not  be  employed  in  the  business.  (Reg. 
50,  revised,  Art.  13.) 

The  foregoing  regulation  states  (negatively)  that  pledged 
treasury  stock  must  be  regarded  as  outstanding.  The  author 
is  unable  to  follow  this  reasoning. 

The  net  effect,  apparently,  is  to  increase  the  value  of  gross 
assets,  but  the  net  worth  of  a  corporation  does  not  increase 
proportionately  to  an  increase  in  gross  assets.  Treasury  stock 
is  of  value  as  collateral  to  the  pledgee  only  for  purposes  of  con- 
trol or  similar  reason.  Its  value  as  collateral  is  nil  if  the  cor- 
poration's indebtedness  to  a  creditor  is  acknowledged. 

Methods  of  ascertaining  fair  value. — 

Regulations.  Every  domestic  corporation  shall  make  return  on 
Form  707  (Revised)  regardless  of  the  par  value  of  its  capital  stock. 
Also  see  articles  28  and  33.  The  fair  average^"  value  of  the  capital 
stock  of  a  corporation  and  the  tax  payable  thereon  shall  be  deter- 
mined in  accordance  with  the  instructions  in  the  form,  which  pro- 

°'Form  707  (revised  1919)  calls  for  the  total  stock  outstanding  on 
the  last  day  of  the  corporation's  fiscal  year.  The  law  [section  1000 
(a-i)],  however,  provides  that  the  amount  of  the  tax  shall  be  computed  on 
the  basis  of  the  "fair  average  value  of  its  capital  stock  for  the  preceding 
year." 

Regulation.  "If  a  corporation  has  increased  or  decreased  its  capital 
stock  during  the  fiscal  year,  a  statement  should  be  attached  to  the  back 
of  the  return  setting  forth  the  number  of  shares  of  stock  outstanding 
each  month,  with  the  average  fair  value  of  the  stock  for  that  month,  com- 
puted under  one  of  the  three  cases."     (T.  D.  2503,  June  25,  1917.) 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1539 

vides  in  Exhibit  A  for  tlie  book  or  fair  value  of  the  assets,  in  Exhibit 
B  for  the  market  value  of  the  shares,  and  in  Exhibit  C  for  the  value 
of  the  capital  stock  based  on  the  capitalized  earnings.  All  the  in- 
formation called  for  must  be  given  in  every  case  where  it  is  pro- 
curable.    (Reg.  50,  revised.  Art.  31.) 

The  fair  average  value  of  the  capital  stock  for  the  purpose  of 
determining  the  amount  of  the  capital  stock  tax  must  not  be  confused 
with  the  market  value  of  the  shares  of  stock  where  it  may  be  neces- 
sary to  determine  such  value  under  other  provisions  of  the  revenue 
laws.  The  fair  average  value  of  the  capital  stock,  the  statutory 
basis  of  the  tax,  is  not  necessarily  the  book  value  or  the  value  based 
on  prices  realized  in  current  sales  of  shares  of  stock  or  even  the 
value,  determined  by  capitalization  of  earnings,  although  it  may  be 
more  directly  dependent  upon  the  last.  It  should  usually  be  capable 
of  appraisal  by  officers  of  the  corporation  having  a  special  knowledge 
of  the  affairs  of  the  corporation  and  general  knowledge  of  the  line 
of  business  in  which  it  is  engaged.  Provision  is  accordingly  made 
in  Exhibit  C  of  Form  707  (Revised)  for  the  tentative  determination 
of  the  fair  value  of  the  capital  stock  by  capitalizing  the  net  earnings 
of  the  corporation  on  a  percentage  basis  fixed  by  its  officers  as  fairly 
representing  the  conditions  obtaining  in  the  trade  and  in  the  locality. 
But  such  fair  value  ....  must  not  be  set  at  a  sum  less  than  the  re- 
constructed book  value  shown  by  Exhibit  A,  unless  the  corporation  is 
materially  affected  by  extraordinary  conditions  which  support  a  lower 
valuation.  In  any  such  case  a  full  explanation  must  accompany  the 
return.  The  Commissioner  will  estimate  the  fair  value  of  the  capital 
stock  in  cases  regarded  as  involving  any  understatement  or  under- 
valuation       (Reg.  50,  revised,  Art.  14.) 

The  capital  stock  tax  on  domestic  companies  is  measured 
by  the  fair  value  of  the  total  capital  stock,  including  the  sur- 
plus and  undivided  profits,  for  the  year  preceding  the  taxable 
year,  whether  the  conduct  of  the  business  is  profitable  or  other- 
wise.^* 

Regulation.  The  surplus  and  undivided  profits  of  a  corporation 
must  be  included  in  estimating  the  fair  average  value  of  its  capital 
stock.  If  the  fair  average  value  be  determined  from  the  book  value, 
the  surplus  and  undivided  profits  are  included  in  the  assets,  if  from 
sales,  they  are  necessarily  a  factor  in  determining  the  market  price, 
and  if  from  net  income,  they  are  reflected  to  a  greater  or  less  extent 
in  the  earnings.     (Reg.  50,  revised.  Art.  15.) 

For  the  purpose  of  this  tax  the  fair  value  of  the  entire 


Form  707,  page  4,  instructions   (see  Appendix). 


I540 


MISCELLANEOUS    TAXES 


capital  stock  of  a  going  concern,  regardless  of  stock  ownership 
or  the  ability  of  individual  stockholders  to  liquidate  their  hold- 
ings, is  required.  The  sales  prices  for  any  number  of  shares 
of  stock  less  than  a  majority  interest  are  not  necessarily  indica- 
tive of  the  fair  value  of  the  entire  capital  stock.  The  capital 
invested,  the  nature  of  the  business,  the  kind  of  assets  (slow 
or  quick  turning),  goodwill,  franchises,  earning  capacity,  etc., 
are  important  factors  that  affect  the  worth  of  enterprises  and 
must  be  given  due  consideration  in  arriving  at  the  fair  value 
at  any  given  date."' 

The  three  exhibits,  A,  B  and  C,  are  provided  to  indicate 
the  information  desired  and  the  manner  in  which  it  should  be 
furnished.  So  far  as  adaptable  these  forms  should  be  com- 
pleted by  taxpayers,  but  if  the}-  find  it  more  convenient  they 
may  attach  to  this  return  their  own  statements,  provided  sub- 
stantially the  same  information  is  furnished.  In  any  event, 
taxpayers  should  attach  any  additional  statements  that  will 
aid  in  a  comprehensive  understanding  of  the  taxpayer's  return, 
so  that  the  Commissioner  of  Internal  Revenue  may  more 
equitably  determine  the  correctness  of  the  fair  value  reported 
in  item  15  on  page  i  hereof.'" 

Exhibit  A  provides  for  adjusting  any  overstated  or  under- 
stated values  contained  in  the  taxpayer's  books  of  account, 
and  exhibit  C  provides  for  showing  an  adjusted  income,  which 
should  be  the  actual  operating  income  to  be  used  for  capitaliz- 
ing on  a  percentage  basis  fixed  b)'-  its  officers  as  fairly  repre- 
senting conditions  obtaining  in  the  trade  and  in  the  locality. 
If  the  reconstructed  book  value  shown  by  exhibit  A  or  the 
market  value  shown  by  exhibit  B  is  greater  than  the  valua- 
tion returned  by  the  taxpayer,  a  comprehensive  statement 
showing  any  extraordinary  conditions  which  are  relied  on  in 
support  of  the  valuation  claimed  must  be  submitted.  In  any 
case  in  which  the  fair  value  is  understated  the  amount  will  be 
redetermined  by  the  Commissioner."' 

"^Form  707,  page  4,  instruction  i. 
^  Form  707,  page  4,  instruction  3. 
"Form  707,  page  4,  instruction  i. 


FEDERAL   CAPITAL    STOCK    (EXCISE)    TAX  1541 

It  will  be  noted  that  the  balance  sheet  to  be  furnished  under 
exhibit  A  is  as  of  the  close  of  the  year  preceding  the  taxable 
year.  Since  such  a  balance  sheet  will  not  reflect  the  "average" 
book  value  for  the  year,  especially  when  material  changes 
have  been  made  in  either  the  assets  or  liabilities,  additional 
statements  which  will  reflect  the  desired  value  should  be  fur- 
nished. 

The  foregoing  is  a  clear  statement  of  corporations'  rights 
under  the  law.  Briefly  stated,  a  corporation  should  follow 
this  procedure : 

Fill  in  the  answers  called  for  by  exhibits  A,  B  or  C — any 
or  all.  If  the  result  does  not  produce  a  fair  value,  additional 
statements  supporting  the  value  claimed  to  be  fair  should  be 
prepared  and  attached  to  the  form.-®  It  is  wholly  unnecessary 
for  a  corporation  to  accede  to  an  assessment  which  overesti- 
mates the  "fair  average  value  of  its  capital  stock." 

The  exhibits  called  for  in  form  707  are  described  in  the 
official  instructions  (page  4, .form  707)  as  follows: 

Exhibit  A:     Condensed  balance  sheet. — 

Furnish  under  exhibit  A  a  condensed  balance  sheet  as  of  the 
closing  date  of  the  fiscal  year  given  in  item  7  on  page  i  hereof. 

"Books  of  account." — These  columns  must  show  the  amounts  as 
carried  in  the  taxpayer's  books  of  account. 

"Fair  value." — Refer  to  article  i  above,  defining  the  value  re- 
quired, and  in  the  event  the  columns  "books  of  account"  contain  any 
overstated  or  understated  values  show  herein  the  actual  values. 

"Difference." — These  columns  will  show  the  difference  between 
the  columns  "books  of  account"  and  "fair  value."  Any  material  dif- 
ferences must  be  explained  in  such  manner  as  to  enable  the  Commis- 
sioner of  Internal  Revenue  to  determine  if  they  are  proper  and 
acceptable.  For  this  purpose  the  differences  shown  herein  need  not 
be  covered  by  corresponding  adjustments  in  the  taxpayers'  books  of 
account. 

"Treasury  stock"-'^  and  "treasury  bonds." — Tn  the  event  the  tax- 


"*For  comments  on  methods  of  arriving  at  fair  value,  see  Income  Tax 
Procedure,  1918,  pages  628-654. 

"°  In  arriving  at  the  fair  value  of  a  corporation's  own  stock,  treasury 
stock  should  always  be  first  deducted  from  the  nominal  amount  outstand- 
ing. This  greatly  simplifies  the  calculation  and  prevents  complications 
which  develop  when  stock  is  worth  either  more  or  less  than  par. 


1542 


MISCELLANEOUS    TAXES 


payer  holds  in  its  treasury  any  of  its  own  stock  or  bonds,  advice  must 
be  furnished  as  to  whether  such  stock  and  bonds  are  pledged  or 
unpledged. 

''Other  assets"  and  "other  liabilities." — If  material  amounts  are 
shown,  a  comprehensive  analysis  of  them  must  be  attached. 

"Profit  and  loss." — If  the  "profit  and  loss"  balance  is  a  debit  the 
amount  should  be  shown  in  red. 

Exhibit  A  of  form  707  calls  for  the  deduction  of  treasury 
stock  from  the  gross  amount  of  capital  stock  so  that  the  net 
outstanding  stock  is  shown.  This  is  the  correct  basis  for  valu- 
ation of  the  stock.  Stock  in  the  treasury  has  in  effect  been 
paid  off  so  far  as  the  former  holders  thereof  are  concerned. 
Therefore,  only  the  stock  still  outstanding  in  the  hands  of 
stockholders  represents  capital  actually  employed  in  the  busi- 
ness. 

Why  "advice  must  be  furnished  as  to  whether  such  (treas- 
ury) stock  and  bonds  are  pledged  or  unpledged"  is  not  clear, 
since  it  can  neither  increase  nor  decrease  the  net  outstanding- 
stock,  the  fair  value  of  which  is  the  basis  of  the  tax.^° 

It  must  be  borne  in  mind  that  the  tax  is  to  be  computed 
on  the  basis  of  "the  fair  average  value  of  the  capital  stock  for 
the  preceding  year."  [Law,  section  1000  (a-i).]  If  the  book 
value  of  the  shares  is  used  as  a  proper  measure  for  taxation, 
and  if  a  net  profit  has  been  earned  during  the  preceding  year, 
the  average  value  of  each  share  will  be  less  than  the  value  at 
the  end  of  the  year. 

A  statement  of  net  worth,  prepared  by  adjusting  book 
values  to  actual  values,  is  of  great  service  in  ascertaining  the 
fair  value  of  corporate  stock,  but  book  value  is  only  one  factor. 

It  is,  how^ever,  not  always  practicable  to  place  a  "fair 
value"  on  fixed  assets ;  in  fact  it  is  usually  impossible  to  assign 
any  value  to  such  assets  other  than  the  book  value.  Also,  the 
value  of  manufactured  or  partly  manufactured  goods  on  hand 
is  extremely  difificult  of  determination,  especially  in  the  case 
of  an  unprofitable  concern.    The  fair  value  of  such  goods  at  a 

""  See  page  1538. 


I 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1543 

given  date  is  certainly  influenced  by  the  profitableness  or  other- 
wise of  the  manufacturing  operations. 

Capital  stock  is  not  worth  book  value  even  when  book 
values  are  adjusted,  unless  recent  earnings  produce  an  ade- 
quate return.  In  a  vast  majority  of  cases  when  earnings  of 
one  or  more  years  are  poor,  there  is  a  reflection  of  this  unsat- 
isfactory condition  in  the  fair  value  of  the  capital  stock.  In 
such  cases  or  when  the  earnings  have  fluctuated  greatly  or 
when  the  average  annual  earnings,  capitalized  at  a  proper  rate, 
do  not  fully  support  the  book  value  or  the  adjusted  book  value, 
it  is  quite  evident  that  the  real  "fair  value"  is  an  amount  less 
than  the  book  value  and  possibly  more  than  the  capitalized 
income  value,  depending  upon  the  character  of  the  assets,  i.e., 
quick  or  slow  turning,  liquid  or  otherwise,  etc. 

Buyers  simply  will  not  pay  book  value  for  the  shares  of  a 
corporation  unless  a  fair  average  annual  return  is  being  real- 
ized on  such  book  value. 

If  a  corporation  reports  that  the  fair  average  value  of  its 
capital  stock  is  equal  to  the  aggregate  of  capital  stock  and  sur- 
plus when  its  average  net  earnings  thereon  for  several  preced- 
ing years  have  been  less  than  20  per  cent,  it  is  in  effect  placing 
a  higher  value  on  its  fixed  assets  than  has  usually  been  found 
to  be  justified. 

Exhibit  B  :    Quotations  or  outside  sales  prices. — 

Furnish  under  exhibit  B  the  prices  quoted  on  a  recognized  stock 
exchange  or  on  the  New  York  curb,  or  the  prices  at  which  outside 
sales  were  made  if  the  stock  is  not  listed,  for  the  period  of  12  months 
ending  with  the  close  of  the  taxpayer's  fiscal  year  as  given  in  item 
7  on  page  i  hereof. 

If  the  stock  is  listed  the  name  of  the  exchange  from  which  re- 
ported quotations  are  taken  must  be  shown  in  the  space  provided 
therefor,  and  the  prices  reported  will  be  the  mean  of  the  highest 
and  of  the  lowest  bid^^  price  during  each  month,  from  which  the 
average  for  the  year  will  be  obtained.  If  the  taxpayer  prefers,  a 
schedule  may  be  attached  to  this  return  showing  the  highest  and 


"This  is  a  correct  basis.    Reg.  38,  1916,  Art.  6  (a),  called  for  averaging 
highest  bid  prices. 


1544  MISCELLANEOUS    TAXES 

lowest  bid  price  at  which  stock  was  quoted  for  each  day  of  the  year 
and  the  average  obtained  therefrom. 

If  the  stock  is  not  listed  and  outside  sales  have  been  made  at 
prices  known  or  determinable  by  the  officers  making  this  report,  such 
prices  will  be  reported  herein.  A  statement  of  the  number  of  shares 
involved  and  the  conditions  under  which  sales  were  made  at  other 
than  exchange  quotations  must  accompany  this  return.  Sales  to 
employees  or  directors  for  qualifying  purposes,  or  sales  which  are 
restricted  as  to  resale,  or  sales  at  prices  otherwise  specially  influ- 
enced, will  not  be  considered  representative  of  the  fair  value  of  the 
entire  capital  stock  and  should  not  be  included. 

In  the  column  "No.  shares  outstanding"  should  be  shown  the 
total  number  of  shares  outstanding  at  the  close  of  each  month.  The 
average  value  per  share  will  be  determined  as  follows: 

First.  If  no  change  occurred  in  the  number  of  shares  outstand- 
ing during  the  year,  total  the  quotations  or  sales  prices  for  the 
months  reported  and  divide  by  the  number  of  months  in  which 
quotations  or  sales  prices  are  shown. 

Second.  If  any  change  occurred  in  the  number  of  shares  out- 
standing during  the  year,  total  the  quotations  or  sales  prices  for  the 
months  reported  during  which  the  number  of  shares  outstanding 
at  date  of  incidence  of  the  tax  has  been  outstanding  and  divide  by 
the  number  of  months  used  in  the  computation. 

"Date  of  incidence  of  the  tax"  is  July  i  of  the  taxable 
year.^^ 

Exhibit  C  :    Annual  income. — 

Furnish  under  exhibit  C  the  annual  income  and  other  data  for 
the  five  fiscal  years  ended  with  the  close  of  the  taxpayer's  fiscal  year 
as  given  in  item  7  on  page  i  hereof,  or  for  the  period  during  which 
the  corporation  has  been  engaged  in  business  if  for  a  shorter  period. 

"Net  income." — In  this  column  will  be  shown  the  income  re- 
turned for  the  purpose  of  the  income  tax  and  excess  profits  tax. 

"Deductions"  and  "additions." — Refer  to  article  i  of  these  special 
instructions,  and  show  in  these  columns  such  amounts  as  should  be 
deducted  from  or  added  to  "net  income"  to  arrive  at  the  adjusted 
income  which  may  be  capitalized  to  determine  the  fair  value  of  the 


^-  [Former  Procedure]  Form  707  for  tax  year  July  i,  1919,  to  June 
30,  1920,  provided : 

"If  any  change  occuTed  in  the  number  of  shares  outstanding  during  the 
year,  calculate  the  total  value  of  the  outstanding  shares  each  month  upon 
the  reported  prices  and  divide  the  total  of  such  monthly  valuations  by  the 
sum  of  the  number  of  shares  outstanding  each  month." 

The  former  regulation  is  sound  hut  it  is  doubtful  if  the  present  regu- 
lation is  equitable. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1545 

capital  stock.  A  comprehensive  analysis  of  any  amounts  reported 
therein  should  be  attached  to  this  return.  Some  of  the  principal  items 
frequently   requiring  adjustment   follow: 

Deductions : 
Income  and  profits  taxes  not  deductible  in  computing  income 

subject  to  tax. 
Depreciation  and  depletion. 
Interest  charges  not  deductible  in  computing  income  subject 

to  tax. 
Losses  not  fully  deductible  in  computing  income  subject  to  tax. 
Additions : 

Dividends  from  other  corporations  not  included  in  computing 

income  subject  to  tax. 
Income  from  securities  of  a  state,  municipality,  or  of  the  United 

States,  not  included  in  the  income  tax  return. 
Expenditures  made  for  additions  and  betterments,  or  reserves 

for  such  purposes,  made  against  income  whether  direct  or 

through  expenses. 

"Adjusted  income." — This  column  will  reflect  the  amounts  result- 
ing from  adjustment  of  amounts  shown  in  three  preceding  columns. 

"Number  shares/' — Herein  should  be  given  total  number  of  shares 
of  all  classes  of  stock  outstanding  at  close  of  each  fiscal  year. 

"Dividends  declared." — Herein  should  be  reported  the  percentage 
of  dividends  declared  on  the  par  value  of  each  class  of  stock  out- 
standing each  year.  The  amount  represented  by  the  percentages 
shown  in  this  column  must  not  be  deducted  from  the  columns  "net 
income"  or  "adjusted  income." 

"Depreciation." — Hereunder  will  be  reported  the  amount  actually 
charged  against  income  each  year  in  the  taxpayer's  books  of  account 
for  depreciation. 

"Depletion." — In  the  case  of  mines,  oil  and  gas  wells,  other  natu- 
ral deposits,  and  timber,  valuations  reported  as  the  basis  of  depletion 
in  computing  Federal  income  and  profits  taxes  should  be  shown  in 
the  "Fair  value"  column  [of  Exhibit  A]. 

Capitalising  net  income. — The  officers  making  the  return  will 
capitalize  the  average  annual  income  on  a  percentage  basis  that 
fairly  represents  the  conditions  obtaining  in  the  trade  in  the  locality 
that  representative  enterprises  must  earn  in  order  to  maintain  their 
stock  at  par.  In  other  words,  if  enterprises  engaged  in  a  similar 
business  must  on  the  average  earn  12  per  cent  on  their  issued  capital 
stock  to  keep  the  value  of  their  stock  at  par,  the  net  income  should 
be  capitalized  by  dividing  it  by  .12. 

Some  of  the  best  stocks  in  this  country,  which  are  valued 
for  the  purpose  of  this  tax  at  their  average  quotations  on  the 


1546  MISCELLANEOUS   TAXES 

New  York  Stock  Exchange  (a  fair  basis  in  many  cases,  as  the 
sales  are  numerous  and  actual  transactions  between  willing 
buyer  and  willing  seller  are  after  all  the  best  indication  of 
value)  have  during  recent  years  shown  30,  40  or  even  50  per 
cent  per  annum  earned  on  their  par  value,  though  their  selling 
prices  in  the  open  market  have  often  not  been  above  par. 

An  industrial  stock  to  be  valued  at  par  should  have  net 
tangible  assets  equal  to  par,  unless  the  average  earnings  exceed 
20  per  cent  per  annum  on  the  capital  stock. 

If  the  earnings  are  considerably  above  20  per  cent  per 
annum,  fair  value  may  be  more  than  par,  but  the  physical 
assets  must  always  be  considered.  If  earnings  are  on  a  down- 
ward trend,  the  average  may  be  disregarded.  Only  in  ex- 
ceptional cases  should  the  item  of  goodwill  be  a  factor  in 
valuations  under  this  act.  If  the  goodwill  actually  has  a  pres- 
ent value,  it  will  be  reflected  in  the  earnings  shown  in  exhibit  C. 

An  excise  tax  imposed  on  the  privilege  of  doing  business 
as  a  corporation  should  be  construed  in  favor  of  the  taxpayer, 
and  speculative  values  and  other  items  which  sometimes  in- 
fluence high  prices  for  shares  should  be  ignored. 

In  considering  earnings  as  a  basis  for  valuation,  it  should 
be  remembered  that  if  the  earnings  include  unusual  profits, 
which  it  is  not  expected  will  recur  periodically,  a  prospective 
purchaser  of  the  stock  would  not  pay  a  price  based  on  cap- 
italizing such  extraordinary  profits.  Unless  exhibit  A  sup- 
ports the  capitalized  value  of  profits  of  an  unusual  nature,  it 
would  be  fallacious  to  capitalize  them  for  valuation  purposes. 

Income  and  excess  profits  taxes  should  be  deducted  before 
earnings  are  capitalized  for  the  purposes  of  the  excise  tax. 

When  net  profits  of  past  years  are  used  in  calculating  aver- 
age earnings,  net  losses  must  also  be  used  in  the  computation. 

Issuance  of  new  stock  does  not  affect  average  in- 
come CAPITALIZED. 

Ruling.  Should  adjustment  be  made  in  determining  average  in- 
come under  Exhibit  C,  when  capital  increased  from  ten  thousand  to 
fifty  thousand  in  nineteen  nineteen? 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1547 

(Answer.)  Your  wire  twenty-sixth.  Disregard  number  shares 
outstanding  when  capitalizing  net  income,  Exhibit  C  of  Form  707. 
(Telegram  of  inquiry  from  Morris  F.  Frey,  the  Guaranty  Trust 
Company,  New  York,  N.  Y.,  and  the  reply  thereto  signed  by  Deputy 
Commissioner  James  Hagerman,  Jr.,  and  dated  July  27,  1920.) 

Preferred  and  common  stock. — Since  many  corporations 
have  more  than  one  class  of  stock,  provision  must  be  made  for 
a  calculation  which  gives  due  weight  to  the  fair  value  of  the  en- 
tire outstanding  capitalization.  It  is  believed  that  a  short  and 
simple  rule  will  settle  any  apparent  difficulties  in  determining 
a  proper  valuation. 

As  TO  PREFERRED  STOCK. — If  preferred  stock  has  a  market 
value,  the  actual  number  of  shares  of  preferred  stock  outstand- 
ing multiplied  by  the  average  market  value  of  each  share  will 
produce  the  desired  result.  If  preferred  stock  has  no  market 
value,  but  if  its  book  value  is  in  excess  of  par,  and  if  some 
value  is  ascribed  to  the  common  stock,  the  preferred  stock 
should  be  listed  at  par. 

There  are,  however,  many  classes  of  preferred  stocks. 
When  there  is  no  cumulative  provision  as  to  dividends ;  no.  or 
only  partial,  preference  as  to  assets;  a  low  rate  of  dividend,  or 
other  factors  which,  as  compared  with  similar  preferred  stocks 
having  a  market  value,  would  tend  to  lower  the  fair  value  of 
the  preferred  stock,  full  weight  must  be  given  to  all  factors 
and  that  value  must  be  placed  upon  each  share  of  preferred 
stock  which  can  be  supported  as  being  a  fair  value. 

As  TO  COMMON  STOCK. — If  it  be  borne  in  mind  that  the 
one  base  of  the  tax  is  the  net  worth  of  the  corporation,  it  will 
simplify  the  calculations  whenever  more  than  one  class  of  stock 
is  concerned.  In  all  cases  (exclusive,  of  course,  of  corpora- 
tions the  market  value  of  whose  shares  can  be  ascertained) 
the  fair  value  of  a  corporation's  entire  capitalization  will  have 
to  be  determined.  This  should  be  done  regardless  of  the  dif- 
ferent classes  of  shares,  if  any.  After  a  trustworthy  estimate 
has  been  made,  the  aggregate  valuation  placed  upon  the  one 


1548  MISCELLANEOUS    TAXES 

or  more  classes  of  preferred  stock  should  be  deducted;  the 
balance  represents  the  proper  valuation  for  the  common  stock. 

Deductions  and  Credits 

Law.  Section  1000.  (a)  (i)  ....  a  ....  tax  ...  .  equivalent 
to  ....  so  much  of  the  fair  average  of  its  capital  stock  .... 
as  is  in  excess  of  $5,000 

Corporation  must  file  return  even  though  the  fair  average 

value  of  its  stock  does  not  exceed  $5,000. — 

Regulation.  From  the  total  fair  average  value  of  the  capital 
stock  the  sum  of  $5,000'"  is  to  be  deducted,  and  the  tax  is  upon  each 
full  $1,000  of  any  balance.  Accordingly,  corporations  the  fair  aver- 
age value  of  whose  capital  stock  is  not  more  than  $5,000  are  not 
subject  to  tax,  but  for  the  purpose  of  avoiding  error  every  corpora- 
tion is  required  to  file  a  return  as  directed  in  article  31.  (Reg.  50, 
revised.  Art.   16.) 

Returns 

Time  of  making  returns. — 

Regulation.  It  shall  be  the  duty  of  every  corporation  liable 
to  the  tax  on  or  before  the  31st  day  of  July  in  each  year  to  make 
a  return,  verified  by  oath,  to  the  collector  of  the  district  in  which 
its  principal  place  of  business  is  located.  If  any  corporation  fails 
to  make  and  file  a  return  within  the  time  prescribed  by  law  or  by 
regulation  made  under  authority  of  law,  or  makes,  willfully  or  other- 
wise, a  false  or  fraudulent  return,  the  collector  or  deputy  collector 
shall  make  the  return  from  his  own  knowledge  and  from  such  infor- 
mation as  he  can  obtain  through  testimony  or  otherwise.  In  any 
such  case  the  Commissioner  may,  from  his  own  knowledge  and  from 
such  information  as  he  can  obtain  through  testimony,  or  otherwise, 
make  a  return  or  amend  any  return  made  by  a  collector  or  deputy 
collector.  Any  return  so  made  and  subscribed  by  the  Commissioner, 
or  by  a  collector  or  deputy  collector  and  approved  by  the  Commis- 
sioner, shall  be  prima  facie  good  and  sufficient  for  all  legal  purposes. 
If  on  account  of  sickness  or  absence  of  the  officer  of  the  corporation 
charged  with  making  the  return,  it  is  impossible  to  prepare  and 
file  a  return  on  or  before  the  31st  day  of  July  (the  due  date),  the 
collector,  upon  application  in  writing,  may  allow  an  extension  of 
time  not  exceeding  30  days  from  July  31,  in  which  to  file  the  return. 
If  extension  is  granted,  the  letter  of  the  collector  should  be  attached 


Prior  to  July  i,  1918,  the  exemption  was  $99,000. 


FEDERAL   CAPITAL    STOCK    (EXCISE)    TAX  1549 

to  the  return.  On  no  account  is  the  Commissioner  of  Internal  Revenue 
or  the  collector  authorized  to  grant  an  extension  of  time  in  which 
to  file  capital  stock  returns  in  excess  of  30  days  from  July  31,  the 
due  date.  If  for  reasons,  other  than  absence  or  sickness,  beyond 
the  control  of  the  officers  making  the  return,  it  becomes  impossible 
to  file  a  completed  return  within  the  time  prescribed  by  law,  a  tenta- 
tive return  may  be  filed,  thus  avoiding  penalty  for  failure  to  file 
within  the  prescribed  time.  See  following  article.  (Reg.  50,  revised, 
Art.  33.) 

Tentative  return. — 

Regulation.  The  filing  of  a  tentative  return  will  avoid  the 
penalty  for  delinquent  filing,  but  does  not  authorize  the  withholding 
of  the  tax.  The  regulations  do  not  permit  the  filing  of  a  tentative 
return  to  stay  indefinitely  the  filing  of  a  completed  return  and  the 
collection  of  the  tax  due;  therefore,  a  tentative  return  clearly  marked 
"Tentative  return"  should  be  prepared  in  as  complete  a  manner  as 
possible,  including,  among  other  information,  a  basis  for  the  com- 
putation of  the  tax — that  is,  an  estimate  by  the  officers  of  the  cor- 
poration of  the  approximate  fair  value  of  the  capital  stock  in  order 
that  an  initial  assessment  may  be  made.  When  the  completed  return 
is  filed,  it  should  be  clearly  marked  "Completed  return,"  showing 
that  a  tentative  return  was  filed.  Such  action  will  prevent  duplicate 
assessments  and  ordinary  penalties.  In  every  case  a  statement  should 
be  attached  to  the  tentative  return,  indicating  the  approximate  date 
the  completed  return  may  be  expected.  Upon  receipt  of  the  com- 
pleted return  any  adjustment  necessary  in  the  assessment  of  the  cor- 
rect tax  due  will  be  made.     (Reg.  50,  revised.  Art.  34.) 

When  return  must  be  filed  before  information  is  available.— 

Ruling.  Answering  your  letter  of  July  3,  1919,  in  which  you 
make  inquiry  as  follows : 

"What  is  the  best  procedure  for  reporting  net  income  under 
exhibit  C  of  capital  stock  tax  returns,  form  707,  in  the  case  of 
corporations  whose  fiscal  year  ends  June  30,  and  who  have  not 
filed  return  for  Federal  income  tax  purposes  before  the  time  for 
filing  capital  stock  tax  returns  has  expired?" 

you  are  advised  paragraph  3,  special  instructions  i,  page  4,  form  707, 
states : 

"  .  .  .  .  and  the  taxpayer  will  complete  each  exhibit  or  state  why 
the  required  data  are  not  available." 

The  law  provides  that  capital  stock  tax  returns  shall  be  filed  dur- 
ing the  month  of  July  for  the  taxable  period  beginning  July  i  and 
that  the  collector  is  empowered  to  grant  an  extension  of  thirty  days 


I5SO 


MISCELLANEOUS    TAXES 


beyond  the  due  date  of  filing  only  in  case  of  sickness  or  absence  of 
the  officer  charged  with  the  preparation  of  the  return.  You  will 
therefore  note  there  is  no  authority  under  the  law  for  granting  an 
extension  for  any  reason  beyond  thirty  days  from  July  31,  1919. 

Capital  stock  tax  returns  should  therefore  be  completed  so  far  as 
practicable  and  filed  with  the  collectors  within  the  prescribed  time 
with  the  statement  that  unavailable  data  will  be  furnished  in  a  sup- 
plemental report  at  the  earliest  possible  date. 

In  the  case  of  any  failure  to  make  and  file  a  return  within  the 
prescribed  time  a  penalty  of  25  per  centum  of  the  amount  of  the 
tax  attaches,  except  that  when  the  failure  to  file  was  due  to  a  rea- 
sonable cause  and  not  to  willful  neglect  no  such  addition  shall  be 
made  to  the  tax. 

The  above  procedure  will  avoid  any  assertion  of  the  penalty  or 
question  as  to  what  constitutes  a  reasonable  cause.  (Letter  to  The 
Corporation  Trust  Company,  signed  by  Deputy  Commissioner  J. 
Hagerman.  and  dated  July  11,   1919) 

The  law  should  be  amended  to  provide  ample  time  within 
which  to  file  accurate  returns. 

Affiliated  corporations,  returns  of. — 

Regulation.  Although  section  240  of  the  Revenue  Act  of  1918 
requires  a  consolidated  return  for  affiliated  corporations  for  the  pur- 
pose of  income  tax^*  for  the  purpose  of  capital  stock  tax  each  cor- 
poration must  render  a  separate  return  in  complete  form.  So-called 
subsidiary  corporations,  all  or  a  part  of  the  stock  of  which  is  owned 
by  another  corporation,  must  render  separate  returns,  the  same  as 
every  other  corporation.  No  deductions  from  the  assets  are  per- 
mitted on  account  of  inter-company  balances,  and  the  shareholdings 
must  be  reported  in  the  "Fair  value"  column  at  their  actual  worth 
at  the  time  of  making  the  return.  No  deduction  is  allowed  in  the 
return  of  one  corporation  for  the  tax  paid  by  another.  If  the  fair 
value  is  determined  by  any  method  other  than  herein  provided,  the 
following  requirements  must  be  complied  with:  (a)  The  parent 
company  must  submit  with  its  return  a  list  of  all  subsidiaries  and  the 
districts  in  which  the  returns  were  filed;  (b)  the  return  of  the  sub- 
sidiary company  must  show  the  name  of  the  parent  company  and  the 
district  in  which  the  return  was  filed;  (c)  the  method  of  determining 
the  fair  value,  if  other  than  by  Exhibits  A,  B,  and  C,  must  be  fully 
explained;  (d)  a  copy  of  any  agreement  existing  between  parent 
company  and  subsidiary  must  be  furnished,  or  a  statement  made  that 
none  exists;  and   (e)   a  combined  balance  sheet  and  a  combined  net 


**  The  1921  law  provides  for  filing  either  consolidated  or  separate  in- 
come tax  returns  for  tax  years  beginning  on  or  after  January  i,  1922.  Th:» 
change  will  have  no  effect  on  the  capital  stock  tax  returns. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1551 

income  statement  must  be  submitted  for  consideration  in  connection 
with  any  estimate  of  fair  value  made  on  behalf  of  the  reporting 
corporation.     (Reg.  50,  revised,  Art.  35.) 

Rulings.  In  reply  to  your  letter  of  May  17,  1919,  requesting  an 
interpretation  of  article  106  of  Regulations  50,^^  regarding  capital 
stock  tax  returns  required  of  affiliated  corporations,  you  are  advised 
that  the  sentence,  "If  the  fair  value  of  its  capital  stock  is  based  upon 
a  consolidated  report,  a  copy  of  such  report  should  be  attached  to  the 
capital  stock  tax  return  of  each  affiliated  corporation,"  refers  to  each 
corporation  of  an  affiliated  group,  that  is,  the  parent  company  as  well 
as  each  subsidiary. 

Article  loi,  Regulations  50,^*^  requires  every  domestic  corporation 
to  file  a  return  regardless  Of  the  par  value  of  its  capital  stock  unless 
specifically  exempt  under  section  23 1.^'  An  exemption  of  $5,000  is 
allowed. 

In  many  cases,  as  for  instance,  in  the  case  of  selling  agencies 
separate  corporations  are  formed  in  order  properly  to  handle  certain 
business  under  various  state  laws  and  in  reality  are  branches  or  de- 
partments of  the  parent  corporation.  The  business  is  controlled  by 
the  parent  corporation  and  the  result  of  operations  is  a  matter  of 
bookkeeping. 

The  capital  stock  tax  being  imposed  upon  the  fair  value  of  the 
capital  stock  of  corporations  it  makes  little  difference  by  what  method 
such  fair  value  is  determined.  Therefore,  if  affiliated  corporations 
are  best  able  to  determine  the  fair  value  of  the  respective  companies 
through  a  consolidated  report  such  privilege  is  permitted  by  the  De- 
partment, but  it  seems  preferable  to  leave  this  to  the  corporations 
interested  subject  to  approval  by  the  Commissioner  of  Internal  Rev- 
enue rather  than  attempt  to  outline  a  specific  method  that  would 
apply  to  all.  (Letter  to  The  Corporation  Trust  Company,  signed  by 
Deputy  Commissioner  J.  Hagerman,  and  dated  June  2,  1919.) 

Referring  to  office  letter  of  June  2,  1919,  it  has  come  to  the 
attention  of  this  office  that  a  number  of  taxpayers  are  construing 
this  letter  as  granting  special  privileges  not  intended  and  not  per- 
mitted under  the  law  and  regulations.  This  letter  properly  inter- 
preted reflects  the  views  of  this  office  and  is  applicable  to  such  cases. 
The  taxpayers,  however,  may  have  been  misled  by  the  wording  of 
the  heading,  which  reads : 

"Consolidated  Returns  of  Affiliated  Corporations" 
and  it  is  suggested  with  a  view  to  avoiding  further  misunderstand- 
ing that  the  heading  be  revised,  as  follows : 


"Art.  35  of  Reg.  50,  revised,  is  substantially  the  same. 
"Art.  33  of  Reg.  50,  revised. 

"The  1921  law  also  exempts   from  this  tax  insurance  companies  tax- 
able under  section  24.3  or  246. 


1552 


MISCELLANEOUS   TAXES 


"Returns  of  Affiliated  Corporations  based  upon  a  Consolidated 
Report." 

The  difficulty  of  outlining  a  general  ruling  that  covers  all  ques- 
tions relating  to  affiliated  corporations  should  be  appreciated  and  the 
taxpayer  must  realize  that  the  tax  is  imposed  upon  the  fair  value  of 
the  capital  stock  of  each  individual  corporation  as  disclosed  by  the 
facts  in  a  given  case,  regardless  of  corporate  affiliations.  Only  under 
certain  conditions  are  corporations  permitted  to  arrive  at  the  fair 
value  of  the  capital  stock  of  the  respective  companies  through  a  con- 
solidated report,  that  is,  where  the  fair  value  cannot  be  determined 
independently. 

In  interpreting  the  letter  above  mentioned,  distinction  must  be 
drawn  between  the  word  "return'"  and  the  word  "report."  Under 
all  circumstances  individual  returns  are  required  of  every  corpora- 
tion regardless  of  the  basis  used  in  arriving  at  the  fair  value.  (Let- 
ter to  The  Corporation  Trust  Company,  signed  by  Deputy  Commis- 
sioner J.  Hagerman,  and  dated  November  ii,  1919.)'^ 


^'  [Former  Procedure] 

Additional  returns  for  taxable  year  ended  June  30,  1919,  when 
required  on  accoimt  of  retroactive  features  of  law. — 

Regulation.  "Under  the  Revenue  Act  of  1916  the  time  for  filing 
capital  stock  tax  returns  for  the  fiscal  year  ending  June  30,  1919,  was 
extended  to  September  30,  1918,  and  in  the  case  of  Hawaii  to  October  31, 
1918.  Any  corporation  which  failed  to  file  a  return  for  such  fiscal  year 
for  the  former  tax,  whether  or  not  it  was  liable  thereto,  must  file  a  return 

for  such  fiscal  j'ear  under  the  present  statute  before  June  i,   1919 

Where  returns  were  filed  for  the  fiscal  year  ending  June  30,  1919,  such 
returns  will  be  used  so  far  as  practicable  in  making  the  additional  or  orig- 
inal assessments  for  such  taxable  period.  In  the  case  of  domestic  and 
foreign  mutual  insurance  companies,  the  new  basis  for  the  tax  will  neces- 
sitate supplemental  statements,  which  should  be  furnished  upon  request. 
For  the  taxable  period  July  i,  1918,  to  June  30,  1919,  letters  will  be  for- 
warded to  taxpayers  showing  how  the  original  or  additional  assessment  has 
been  determined,  in  order  that  the  collector's  bill  when  presented  may  be 
understood  and  payment  promptly  made "     (Reg.  50,  Art.  105.) 

As  previousl}^  stated,  the  provisions  of  the  1918  law  were  made  retro- 
active to  July  I,  1918.  Formerly  some  corporations  were  not  required  to 
file  returns,  but  due  to  the  small  exemption  provided  by  the  1918  law  the 
Treasury  decided  to  require  returns  from  all  corporations  beginning  with 
returns  for  the  taxable  year  July  i,  1918,  to  June  30,  1919.  Returns  made 
necessary  by  the  new  regulations  of  the  Treasury  were  due  before  June 
I,  1919.  So  far  as  practicable  the  tax  at  the  increased  rate,  after  giving 
effect  to  the  reduced  exemption  for  the  year  ended  June  30,  1919,  was 
computed  by  the  Treasury  from  information  contained  in  the  returns  pre- 
viously filed. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1553 

Payments^'' 

Time  of  payment  of  tax. — The  tax  is  assessed  annually  in 
advance.*" 

Decision.  The  capital  stock  tax  imposed  by  the  Act  of  Septem- 
ber 8,  1916,  is  not  illegal  because  assessed  and  collected  in  advance 
under  regulations  of  the  Treasury  Department,  the  act,  by  sections 
407  and  409,  contemplating  that  a  corporation  must  pay  a  tax  on  its 
capital  stock  for  the  preceding  year  in  order  to  do  business  for  the 
coming  year. 

Regulation.  All  assessments  shall  be  made  by  the  Commissioner. 
The  collector  shall  within  10  days  after  receiving  any  list  of  taxes 
from  the  Commissioner  give  notice  to  each  corporation  liable  to  pay 
any  tax  stated  therein,  to  be  left  at  its  place  of  business  or  to  be 
sent  by  mail,  stating  the  amount  of  such  tax  and  demanding  payment 
thereof.  If  such  corporation  does  not  pay  the  tax  within  10  days 
after  the  service  or  the  sending  by  mail  of  such  notice,  it  shall  be 
the  duty  of  the  collector  to  collect  the  tax  with  a  penalty  of  5  per  cent 
additional  upon  the  amount  of  the  tax  and  interest  at  the  rate  of  I 
per  cent  a  month.  A  collector  has  no  authority  to  extend  the  time 
for  payment  of  the  tax,  and  any  extension  granted  by  him  will  be 
at  his  own  risk.  All  taxes  are  payable  direct  to  the  collector  of 
internal  revenue  of  the  district  in  which  return  is  filed.  The  col- 
lector may  accept  payment  of  the  tax  when  the  return  is  filed  as  an 
"advance  collection,"  subject  to  any  adjustment  later  found  neces- 
sary, but  no  corporation  is  required  to  pay  the  tax  until  after  notice 
and  demand.  Tax  due  from  a  corporation  is  legally  collectible  from 
the  stockholders  or  others  who  have  received  its  assets  upon  liquida- 
tion.     (Reg.   50,   revised,  Art.  36.) 


°'  [Former  Procedure] 

Tax  paid  under  former  law,  credit  for. — 

RiT.ULATioN.  "Where  a  corporation  has  paid  the  tax  for  tlie  fiscal 
year  July  i,  1918,  to  June  30,  1919,  under  the  Revenue  Act  of  1916,  the 
amount  so  paid  may  be  credited  against  the  tax  imposed  by  the  present 
statute  for  such  period  and  only  the  excess  of  the  tax  over  such  amount 
will  be  collected.  For  the  rates  of  the  former  tax  and  its  other  provisions 
see  Reg.  38  (revised).  Because  of  the  reduction  of  the  exemption  from 
$99,000  to  $5,000  in  the  case  of  domestic  corporations  and  of  the  abolition 
of  any  exemption  in  the  case  of   foreign  corporations,  many  corporations 

must  now  pay  the  tax  which  were  formerly  exempt "     (Reg.  50, 

Art.  81.) 

*"  Washington  Water  Power  Co.  7".  U.  S.  (not  yet  rc])ortcd),  U.  S. 
Court  of  Claims,  February  14.  1921.   (T.  D.  3160). 


1^54  MISCELLANEOUS    TAXES 

Penalties 

Failure  to  pay. — 

Regulation,  (a)  Any  corporation  which  fails  to  pay  the  tax 
when  due  and  payable  is  liable  to  a  penalty  of  $i,ooo.  If  it  willfully 
refuses  to  pay  or  willfully  attempts  to  evade  the  tax,  it  is  liable  also 
to  a  fine  of  $10,000.00  and  costs  and  to  a  100  per  cent  penalty  to  be 
added  to  the  tax.  See  also  article  41.  (b)  Any  officer  or  employee 
of  a  corporation  who  in  the  course  of  his  duty  fails  to  pay  the  tax 
when  due  and  payable  is  liable  to  a  penalty  of  $1,000.  If  he  willfully 
refuses  to  pay  or  willfully  attempts  to  evade  the  tax,  he  is  liable  also 
to  a  fine  of  $10,000  and  costs  and  to  imprisonment  for  a  year,  and 
to  a  penalty  of  the  amount  of  the  tax  unpaid  or  evaded.  (Reg.  50, 
revised.  Art.  42.) 

It  is  to  be  noted  that  the  specific  penalties  of  $1,000  and 
$10,000  are  additional  to  the  5  per  cent  penalty  and  i  per  cent 
per  month  interest  penalty  referred  to  in  article  36.     (See  page 

1553  ) 

Failure  to  make  return  and  penalty  for  false  return. — 

Regulation,  (a)  Any  corporation  which  fails  to  make  a  return 
within  the  required  time  is  liable  to  a  penalty  of  $1,000.  If  it  will- 
fully refuses  to  make  a  return  it  is  liable  also  to  a  fine  of  $10,000  and 
ousts,  (b)  Any  officer  or  employee  of  a  corporation  who  in  the 
course  of  his  duty  fails  to  make  a  return  within  the  required  time 
is  liable  to  a  penalty  of  $1,000.  If  he  willfully  refuses  to  make  a 
return  he  is  liable  also  to  a  fine  of  $10,000  and  costs  and  to  imprison- 
ment for  a  year,  (c)  Section  3176  of  the  Revised  Statutes,*^  as 
amended  by  section  1317  of  the  Revenue  Act  of  1918,  also  provides: 

In  case  of  any  failure  to  make  and  file  a  return  or  list  within 
the  time  prescribed  by  law,  or  prescribed  by  the  Commissioner  of 
Internal  Revenue  or  the  collector  in  pursuance  of  law,  the  Commis- 
sioner of  Internal  Revenue  shall  add  to  the  tax  25  percentum  of  its 
amount,  except  that  when  a  return  is  filed  after  such  time  and  it  is 
shown  that  the  failure  to  file  it  was  due  to  a  reasonable  cause  and 
not  to  willful  neglect,  no  such  addition  shall  be  made  to  the  tax.  In 
case  a  false  or  fraudulent  return  or  list  is  willfully  made,  the  Com- 
missioner of  Internal  Revenue  shall  add  to  the  tax  50  percentum  of 
its  amount. 

The  amount  so  added  to  any  tax  shall  be  collected  at  the  same 


"Section   1311   of  the  1921  law  re-enacts  section  3176,  Rev.  Stat.,  as 
amended  by  the  1918  law. 


F£:deral  capital  stock  (excise)  tax       1555 

time  and  in  the  same  manner  and  as  part  of  the  tax  unless  the  tax 
has  been  paid  before  the  discovery  of  the  neglect,  falsity  or  fraud, 
in  which  case  the  amount  so  added  shall  be  collected  in  the  same 
manner  as  the  tax.     (Reg.  50,  revised,  Art.  43.) 

Doing  business  without  payment  of  tax. — 

Regulation.  Every  corporation  which  does  business  without 
having  paid  the  tax  is  liable  to  a  penalty  of  $1,000.  A  corporation 
paying  the  capital  stock  tax  is  not  on  that  account  exempt  from  any 
occupational  tax.  For  other  penalties  see  articles  42  and  43.  (Reg. 
50,  revised,  Art.  41.) 

Foreign  Corporations 

Law.  Section  1000.  (a)  .  .  .  .  (2)  Every  foreign  corporation 
shall  pay  annually  a  special  excise  tax  with  respect  to  carrying  on  or 
doing  business  in  the  United  States,  equivalent  to  $1  for  each  $1,000 
of  the  average  amount  of  capital  employed  in  the  transaction  of  its 
business  in  the  United  States  during  the  preceding  year  ending  June 
thirtieth 

Definition  of  foreign  corporation. — 

Regulation.  A  foreign  corporation  is  a  corporation  created 
or  organized  outside  the  United  States  as  defined  in  Article  8.*'  (Reg. 
50,  revised.  Art.  9.) 

Scope  of  tax. — 

Regulation.  The  basis  of  the  tax  in  the  case  of  a  foreign  cor- 
poration is  "carrying  on  or  doing  business  in  the  United  States." 
A  foreign  corporation  is  carrying  on  or  doing  business  in  the  United 
States  if  it  maintains  an  agent  or  an  office  or  warehouse  in  the  United 
States,  or,  in  the  case  of  an  insurance  company,  if  it  writes  insurance 
policies  here,  or  in  any  other  way  enters  the  United  States  for  the 
purposes  of  its  business.  The  purchase  of  supplies  in  the  United 
States  in  the  furtherance  of  continued  efforts  in  the  pursuit  of  profit 
or  gain  is  carrying  on  or  doing  business  in  the  United  States.  (Reg. 
50,  revised.  Art.  17.) 

It  may  be  assumed  that  the  term  "doing  business"  as  ap- 
pHed  to  the  activities  of  a  foreign  corporation  in  the  United 
States,  will  be  interpreted  in  the  same  manner  as  when  applied 
to   a   domestic  corporation   doing  business   in  another   state. 

"  See  page  1529. 


1556  MISCELLANEOUS    TAXES 

If  so,  the  mere  purchase  of  suppHes  does  not  constitute  "doing 
business."" 

Rate  of  tax. — 

Regulation.  The  tax  is  at  the  rate  of  $1  for  each  full  $1,000 
of  the  capital  of  a  foreign  ^corporation  actually  employed^*  in  the 
transaction  of  its  business  in  the  United  States,  and  is  in  all  cases 
to  be  computed  on  the  basis  of  the  average  amount  of  capital  so 
employed  during  the  preceding  year  ending  June  30.  The  measure 
of  the  tax  is  accordingly  different  from  that  in  the  case  of  domestic 
corporations  which  pay  a  tax  measured  by  the  fair  average  value 
of  their  capital  stock.  No  deduction  from  the  total  fair  average 
amount  of  capital  so  employed  is  allowed  in  computing  the  tax.  (Reg. 
50,  revised,  Art.  20.) 

Capital  "employed"  in  the  United  States. — 

Regulation.  The  "'capital  employed  in  the  transaction  of  its 
business  in  the  United  States"  means  the  portion  of  the  total  capital, 
surplus,  and  undivided  profits,  of  the  foreign  corporation,  utilized 
for  the  purpose  of  doing  business  in  the  United  States.  A  foreign 
corporation  may  have  income  from  sources  within  the  United  States 
for  the  purpose  of  the  income  tax,  and  yet  not  have  capital  em- 
ployed in  the  transaction  of  business  here  for  the  purpose  of  the 
capital  stock  tax.  Compare  articles  91-93  and  550  of  Regulations  45. 
A  foreign  corporation  not  actually  doing  business  in  the  United 
States  is  not  subject  to  tax,  and  accordingly  the  investment  of  a 
part  of  its  funds  in  United  States  stocks  and  securities  will  not  con- 
stitute capital  employed  in  its  business  in  the  United  States.  For 
the  definition  of  "doing  business"  see  article  lo."^^  If  a  corporation 
does  business  here,  then,  although  the  mere  investment  of  funds  in 
United  States  securities  is  not  such  a  taxable  employment  of  capital, 
such  investment  will  constitute  capital  employed  in  the  transaction 
of  business  in  the  United  States,  if  made  in  a  subsidiary  corporation 
which  the  foreign  corporation  uses  as  an  instrumentality  for  the  suc- 
cessful conduct  of  its  own  business  in  the  United  States.  Thus  the 
investment  of  the  funds  of  a  foreign  corporation  in  the  purchase  of 
facilities,  although  apparently  independent,  for  the  purpose  of  its 
business  here,  or  the  purchase  of  stock  and  securities  of  a  subsidiary 
corporation  for  the  same  purpose,  will  constitute  the  employment  of 
capital  in  the  transaction  of  business  in  the  United  States.  A  foreign 
corporation   may  not   escape  taxation   by   organizing,   or   purchasing 


See  page  1533- 

^The  word  "invested"   was  used  in  the   1916  law. 
'See  page  i533- 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1557 

the  stock  of  another  corporation  to  own  the  facihties  which  the  for- 
eign corporation  needs  in  its  business.  See  article  352,  Regulations 
45.     (Reg.  50,  revised.  Art.   18.) 

If  the  foreign  corporation  does  no  business  whatever  in 
the  United  States,  a  separate  domestic  corporation  being  util- 
ized for  the  carrying  on  of  business  in  this  country,  it  is  obvi- 
ous that  the  law  imposes  the  capital  stock  tax  only  on  the  sub- 
sidiary. The  mere  ownership  of  the  stock  of  an  American 
corporation  by  a  foreign  corporation  does  not  of  itself  con- 
stitute doing  business  by  the  latter  in  the  United  States. 

"Capital  'employed'  in  the  United  States"  illustrated. — 

Regulation.  A  foreign  corporation  may  employ  capital  in  the 
transaction  of  its  business  in  the  United  States  in  various  ways.  For 
example,  the  investment  of  funds  in  property  in  the  United  States 
used  in  its  business,  in  stocks  and  securities  of  subsidiary  corpora- 
tions as  explained  in  article  18,  in  bills  and  accounts  receivable  repre- 
senting business  done  in  the  United  States,  in  merchandise  kept  here 
for  sale,  in  materials  manufactured  here,  and  in  deposits  in  United 
States  banks  maintained  for  use  in  business  here.  Generally 
speaking,  approximately  such  proportion  of  the  entire  capital  of  a 
foreign  corporation  will  presumably  be  emploj^ed  in  the  transaction 
of  its  business  in  the  United  States  as  the  gross  amount  of  its  busi- 
ness in  the  United  States  bears  to  its  total  gross  business,  but  this 
will  not  always  be  true,  since  a  corporation  may  conceivably  transact 
a  greater  or  less  volume  of  business  in  one*  country  than  in  another 
on  the  same  amount  of  capital.     (Reg.  50,  revised,  Art.  19.) 

Basis  of  tax,  foreign  corporation, — 

Regulation.  The  measure  of  the  tax  is  the  average  amount  of 
capital  employed  in  the  transaction  of  business  in  the  United  States 
during  the  preceding  fiscal  year.  It  will  usually  be  sufficient  to 
determine  the  amount  of  capital  so  employed  at  the  beginning  of 
each  year  and  the  amount  so  employed  at  the  end  of  such  year,  and 
to  divide  the  sum  of  such  amounts  by  two.  Where,  however,  there 
have  been  material  changes  in  the  amount  of  capital,  the  average 
amount  should  be  determined  with  due  regard  to  the  times  at  which 
such  changes  occurred.  A  foreign  corporation  may,  if  it  so  desire, 
compute  the  average  amount  of  capital  employed  on  a  monthly 
basis.     (Reg.  50,  revised.  Art,  21,) 


1558  MISCELLANEOUS    TAXES 

Capital  "employed"  includes  borrowed  capital. — 

Ruling.     Following  question  submitted  on  behalf  our  client  the 
Company,  a  foreign  corporation.     Referring  Article  33   [Art. 


18],  Reg.  50,  is  capital  stock  tax  to  be  computed  on  entire  amount  of 
capital  employed  in  this  country  irrespective  of  whether  that  capital 
consists  in  part  of  company's  own  capital  and  in  part  of  borrowed 
capital?     Kindly  wire  reply  collect. 

(Answer'.)  Your  wire  25th.  Capital  stock  tax  is  imposed  upon 
capital  employed  irrespective  of  its  nature  whether  borrowed,  paid 
in  or  earned.  (Telegram  of  inquiry  from  E.  G.  Shorrock  &  Co., 
Seattle,  Washington,  and  the  reply  thereto,  signed  by  Deputy  Com- 
missioner J.  Hagerman,  and  dated  October  30,  1919.) 

Form  708,  which  provides  for  determining  the  capital  em- 
ployed in  the  United  States  by  a  foreign  corporation,  calls 
for  a  statement  of  the  total  capital,  surplus  and  undivided 
profits  (whether  employed  within  or  without  the  United 
States)  and  a  statement  of  the  assets  employed  in  the  trans- 
action of  business  in  the  United  States.  The  latter  statement 
makes  no  provision  for  deducting  liabilities  incident  to  the 
transaction  of  business  in  the  United  States.  In  the  case  of 
a  foreign  corporation  all  of  whose  capital  was  employed  in 
the  United  States,  this  would  lead  to  the  absurd  result  of  show- 
ing a  larger  amount  of  capital  employed  in  the  United  States 
than  its  actual  total  capital.  Of  course,  if  the  corporation  had 
absolutely  no  liabilities  the  result  would  be  the  same  in  both 
statements;  but  as  practically  all  corporations  have  liabiHties, 
proper  deduction  should  be  made  from  the  United  States 
assets  for  the  liabilities  incident  to  the  business  in  this  country. 

Return  by  foreign  corporations. — 

Regulation.  Every  foreign  corporation  carrying  on  or  doing 
business  in  the  United  States  shall  make  return  on  Form  708  (Re- 
vised) irrespective  of  the  amount  of  capital  employed  in  this  coun- 
try in  the  transaction  of  its  business.  The  capital  actually  employed 
in  the  transaction  of  the  business  of  a  foreign  corporation  in  the 
United  States  and  the  tax  payable  thereon  shall  be  calculated  in 
accordance  with  the  instructions  on  the  form.**'  See  also  articles 
17,  18,  19,  20  and  21.     (Reg.  50,  revised.  Art.  32.) 

'"  See  Appendix  B. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1559 

Inspection  of  Returns 

Regi^lation.  The  returns  upon  which  the  tax  has  been  deter- 
mined by  the  Commissioner,  although  public  records,  are  in  general 
open  to  inspection  only  to  the  extent  authorized  by  the  President. 
All  bona  fide  stockholders  of  record  owning  i  per  cent  or  more  of 
the  outstanding  stock  of  any  corporation  shall,  upon  making  request 
of  the  Commissioner,  be  allowed  to  examine  the  annual  income  re- 
turns of  such  corporations  and  of  its  subsidiaries,  but  such  privilege 
of  examination  is  personal  and  can  not  by  power  of  attorney  be  dele- 
gated by  the  stockholder  to  another.  Only  such  officers  of  any  State 
as  are  charged  with  the  enforcement  of  a  State  income-tax  law  shall 
have  access  to  the  returns  of  any  corporation,  or  to  an  abstract  thereof 
showing  the  name  and  income  of  the  corporation,  at  such  times  and 
in  such  manner  as  the  Secretary  may  prescribe,  and  then  only  in 
case  the  information  is  to  be  used  by  them  in  connection  with  such 
enforcement.  Any  stockholder  who  is  allowed  to  examine  the  return 
of  any  corporation,  and  who  makes  known  in  any  manner  whatever 
not  provided  by  law  the  amount  or  source  of  income,  profits,  losses, 
expenditures,  or  any  particular  thereof,  set  forth  or  disclosed  in  any 
such  return  shall  be  guilty  of  a  misdemeanor  and  be  punished  by  a 
fine  not  exceeding  $1,000,  or  by  imprisonment  not  exceeding  i  year, 
or  both.     (Reg.  50,  revised.  Art.  30.) 

Section  257  of  the  lav^,  which  referred  specifically  to  in- 
come tax  returns  and  on  which  the  foregoing  regulation  is 
based,  was  by  section  1000  (c)  also  made  applicable  to  capital 
stock  tax  returns. 


Abatement  and  Refund  of  Taxes 

Regulation.  Section  3220.  of  the  Revised  Statutes,  as  amended 
by  section  1316  of  the  Revenue  Act  of  1918  [re-enacted  without 
change  as  section  1315  after  1921  law]  provides: 

Section  3220.  The  Commissioner  of  Internal  Revenue,  subject  to 
regulations  prescribed  by  the  Secretary  of  the  Treasury,  is  authorized 
to  remit,  refund,  and  pay  back  all  taxes  erroneously  or  illegally  as- 
sessed or  collected,  all  penalties  collected  without  authority,  and 
all  taxes  that  appear  to  be  unjustly  assessed  or  excessive  in  amount, 
or  in  any  manner  wrongfully  collected;  also  to  repay  to  any  collector 
or  deputy  collector  the  full  amount  of  such  sums  of  money  as  may 
be  recovered  against  him  in  any  court,  for  any  internal-revenue  taxes 
collected  by  him,  with  the  cost  and  expenses  of  suit;  also  all  damages 
and  costs  recovered  against  any  assessor,  assistant  assessor,  collector, 
deputy  collector,  agent,  or  inspector,  in  any  suit  brought  against  him 


1560  MISCELLANEOUS    TAXES 

by  reason  of  anything  done  in  the  due  performance  of  his  official 
duty,  and  shall  make  report  to  Congress  at  the  beginning,  of  each 
regular  session  of  Congress  of  all  transactions  under  this  section. 

Section  3225  of  the  Revised  Statutes,  as  amended  by  section 
1316  of  the  Revenue  Act  of  1918  [re-enacted  without  change  as 
section  1323  of  the  1921  law],  however,  provides: 

Section  3225.  When  a  second  assessment  is  made  in  case  of  any 
list,  statement,  or  return,  which  in  the  opinion  of  the  collector  or  deputy 
collector  was  false  or  fraudulent,  or  contained  any  understatement  or 
undervaluation,  such  assessment  shall  not  be  remitted,  nor  shall  taxes 
collected  under  such  assessment  be  refunded  or  paid  back  or  recovered 
by  any  suit,  unless  it  is  proved  that  such  list,  statement,  or  return  was 
not  willfully  false  or  fraudulent  and  did  not  contain  any  willful  under- 
statement or  undervaluation. 

For  the  procedure  regarding  claims  for  abatement  or  refund,  see 
Regulations  14  (Revised).     (Reg.  50,  revised,  Art.  ^y.) 

Medium  of  Payment  of  Tax 

Regulation.  Collectors  may  accept  uncertified  checks  in  payment 
of  taxes,  provided  such  checks  are  collectible  at  par — that  is,  for 
their  full  amount,  without  any  deduction  for  exchange  or  other 
charges.  The  collector  will  stamp  on  the  face  of  each  check  before 
deposit  the  words,  "This  check  is  in  payment  of  an  obligation  to  the 
United  States  and  must  be  paid  at  par.  No  protest,"  with  his  name 
and  title.  The  day  on  which  the  collector  receives  the  check  will  be 
considered  the  date  of  payment  so  far  as  the  taxpayer  is  concerned, 
unless  the  check  is  returned  dishonored.  If  one  check  is  remitted 
to  cover  the  taxes  of  two  or  more  corporations,  the  remittance  must 
be  accompanied  by  a  letter  of  transmittal  stating  (a)  the  name  of 
the  drawer  of  the  check;  (b)  the  amount  of  the  check;  (c)  the  amount 
of  any  cash,  money  order,  or  other  instrument  included  in  the  same 
remittance;  (d)  the  name  of  each  corporation  whose  tax  is  paid  by 
the  remittance;  (e)  the  amount  of  the  payment  on  account  of  each 
corporation;  and  (f)  the  kind  of  tax  paid.     (Reg.  50,  revised.  Art  39.) 

Dishonored  checks,  procedure. — 

Regulation.  If  the  bank  on  which  any  such  check  is  drawn  shall 
refuse  to  pay  it  at  par,  the  check  shall  be  returned  through  the  de- 
positary bank  and  be  treated  in  the  same  manner  as  a  bad  check.  All 
expenses  incident  to  the  attempt  to  collect  such  a  check  and  the  return 
of  it  through  the  depositary  bank  must  be  paid  by  the  drawer  of  the 
check  to  the  bank  on  which  it  is  drawn,  since  no  deduction  can  be 
made  from  amounts  received  in  payment  of  taxes.     See  section  3210 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1561 

of  the  Revised  Statutes.  If  any  taxpayer  whose  check  has  been  re- 
turned uncollected  by  the  depositary  bank  shall  fail  at  once  to  make  the 
check  good,  the  collector  shall  proceed  to  collect  the  tax  as  though 
no  check  had  been  given.  A  taxpayer  who  tenders  a  certified  check 
in  payment  for  taxes  is  not  released  from  his  obligation  until  the 
check  has  been  paid.  See  chapter  191  of  the  act  of  March  2,  191 1. 
(Reg.  50,  revised,  Art.  40.) 

Credit  of  Munition  Manvifacturer's  Tax 

Regulation.  From  the  tax  payable  as  above  determined  the 
amount,  if  any,  of  the  munition  manufacturer's  tax  imposed  by  Title 
III  of  the  Act  of  September  8,  1916  (no  longer  in  effect  since  Janu- 
ary I,  1918),  actually  paid  by  the  corporation  since  making  its  last 
previous  return  hereunder  is  deductible.  If  a  munition  manufacturer's 
tax  is  due  and  payable  but  has  not  been  paid  at  the  time  the  capital 
stock  tax  becomes  due  and  payable  no  credit  of  the  munition  manu- 
facturer's tax  is  permissible,  until  after  the  munition  manufacturer's 
tax  has  been  paid.  After  it  has  been  paid  the  credit  may  be  availed 
of  by  a  claim  for  the  refund  of  so  much  of  the  capital  stock  tax 
actually  paid  as  is  not  in  excess  of  the  munition  manufacturer's  tax 
which  became  due  and  payable  within  the  same  calendar  year.  (T. 
D.  3009,  signed  by  Commissioner  Wm.  M.  Williams,  and  dated  April 
22,  1920.)     (Reg.  50,  revised.  Art.  10.) 

Election  to  be  taxed  as  corporation. — The  192 1  law^'  pro- 
vides that  in  the  case  of  the  organization  as  a  corporation, 
within  four  months  of  the  passage  of  the  act,  of  any  trade  or 
business  in  which  capital  is  a  material  income-producing  factor 
and  which  was  previously  owned  by  a  partnership  or  individual, 
the  net  income  of  such  trade  or  business  from  January  i,  192 1 
(if  it  was  not  less  than  20  per  cent  of  its  invested  capital), 
may  at  the  option  of  the  individual  or  partnership  be  taxed 
as  the  net  income  of  a  corporation  is  taxed  under  the  income 
and  excess  profits  taxes.*^    The  invested  capital  and  net  income 


*'  Section  229. 

"  [Former  Procedure] 

Election  to  be  taxed  as  corporation. — 

Regulation.  A  business  enterprise  (a)  which  was  organized  as  a 
corporation  before  July  i,  1919,  (b)  in  which  capital  is  and  has  been  a 
material  income-producing  factor,  and  (c)  which  was  previously  owned 
by  a  partnership  or  individual,  may  elect  to  be  taxed  as  a  corporation  on 
its  net  income  from  January  i,  1918,  to  the  date  of  organization  of  the 
corporation.    In  such  event  the  corporation  shall  be  treated  as  if  in  existence 


1562  MISCELLANEOUS    TAXES 

shall  be  computed  in  the  same  manner  as  they  would  be  de- 
termined if  the  corporation  had  been  in  existence  on  January 
I,  1 92 1.  All  other  provisions  of  law  with  respect  to  tax  on 
corporations  are  made  efifective  as  of  January  i,  192 1.  It  is 
specifically  provided  that  any  taxpayer  who  takes  advantage 
of  this  provision  shall  pay  the  capital  stock  tax  imposed  by  the 
191 8  law,  commencing  with  January  i,  1921. 

Under  the  191 8  law,  a  corporation  commencing  business 
January  i,  1921,  would  pay  capital  stock  tax  from  July  i,  1921. 
The  intention  is  fairly  clear  that  the  capital  stock  tax  is  to  be 
paid  for  the  first  six  months  of  192 1,  but  the  language  is  not. 
In  this  respect  the  law  differs  from  the  provisions  concerning 
personal  service  corporations  as  to  which  no  intention  to  tax 
from  January  i,  1922,  can  be  found. 

Final  determination  and  assessment. — Section  13 12  of  the 
1 92 1  lav/  permits  of  an  agreement  in  writing  between  the  tax- 
payer and  the  Commissioner  with  respect  to  the  amount  of  tax 
liability.  It  is  provided  that  when  such  agreement  is  entered 
into,  the  case  shall  not  be  reopened  by  either  the  government 
or  the  taxpayer  and  no  suit  to  overthrow  it  shall  be  enter- 
tained by  any  court,  except  upon  a  showing  of  fraud  or  mal- 
feasance or  misrepresentation  of  fact  materially  affecting 
the  determination  of  the  tax  liability.^" 

This  is  a  reasonable  and  wise  provision  of  law.  It  will, 
however,  undoubtedly  be  more  beneficial  with  respect  to  taxes 


since  January  i.  1918,  for  the  purposes  of  the  income  tax,  the  war  profits 
and  excess  profits  tax,  and  the  capital  stock  tax.  The  adoption  of  any 
other  date  than  January-  i,  igi8,  for  such  purpose  is  not  permissible.  But 
this  option  is  not  extended  to  a  business  enterprise  with  a  net  income  for 
the  taxable  year  1918  less  than  20  per  cent  of  its  invested  capital. 

The  clauses  of  section  407,  Revenue  Act  of  1916,  as  amended,  and 
section  1000,  Revenue  Act  of  1918,  which  require  that  a  corporation  must 
have  been  engaged  in  business  some  part  of  a  year  preceding  the  taxable 
period  in  order  to  be  liable  for  the  tax,  are  not  applicable  to  corporations 
filing  returns  under  section  330  of  the  Revenue  Act  of  1918;  that  is  to 
say,  organizations  electing  to  report  as  corporations  under  the  provisions  of 
this  section,  are  required  to  file  capital  stock  tax  returns  for  the  six  months' 
period  from  January  i  to  June  30,  1918,  and  for  all  subsequent  taxable 
periods.     (Reg.  50,  revised.  Art.  29.) 

"  See  page  210. 


FEDERAL   CAPITAL   STOCK    (EXCISE)    TAX  1563 

other  than  the  capital  stock  tax.  The  section  of  the  Bureau 
handling  this  tax  is  on  a  fairly  current  basis  and,  so  far  as 
the  author  knows,  cases  in  the  capital  stock  tax  section  are 
not  reopened  as  frequently  as  in  some  other  sections  of  the 
Bureau. 

Treasury  decisions  not  necessarily  retroactive. — Section 
1 3 14  of  the  1 92 1  law  provides  that  Treasury  decisions  or  rul- 
ings of  the  Commissioner  or  the  Secretary  which  are  not  im- 
mediately occasioned  or  required  by  a  decision  of  a  court  of 
competent  jurisdiction,  are  not  necessarily  retroactive  in  effect. 
The  question  of  retroactive  appliance  of  such  rulings  is  left 
to  the  discretion  of  the  Commissioner  with  the  approval  of 
the  Secretary. 

Limitations  upon  additional  assessments  and  refunds. — 
Section  1322  provides  that,  notwithstanding  the  provisions  of 
section  3182  of  the  Revised  Statutes,  assessments  of  addi- 
tional taxes  must  be  made  within  four  years  after  such  taxes 
become  due.  This  provision  applies  only  in  the  absence  of 
fraud  or  an  attempt  to  evade  tax.  In  the  latter  case,  assess- 
ment may  be  made  at  any  time. 

This  section  became  effective  upon  the  passage  of  the  1921 
law,  November  23,  192 1,  and,  as  it  modifies  the  limitation  in 
section  3182,  Revised  Statutes,  additional  assessments  of  capi- 
tal stock  tax  for  the  tax  period  beginning  July  i,  1918,  may 
be  made  at  any  time  before  July  31,  1922. 

Section  1316  of  the  1921  law  amends  section  322tS.  Revised 
Statutes,"  and  provides  for  the  filing  of  claims  for  refund 
of  taxes  erroneously  or  illegally  assessed  or  collected  at  any 
time  within  four  years  next  after  payment  of  such  tax. 

Limitation  upon  suits. — Section  1320  of  the  192 1  law 
provides  that  no  suit  or  proceeding  for  the  collection  of  any 
internal  revenue  tax  shall  be  begun  after  the  expiration  of  five 


See  Chapter  IX. 


1564  MISCELLANEOUS    TAXES 

years  from  the  time  such  tax  was  due,  except  in  the  case  of 
fraud. ^^  Suits  begun  prior  to  the  passage  of  the  192 1  law 
are  not  affected  by  this  Hmitation. 

Limitation  of  criminal  prosecution. — Section  1321  of  the 
192 1  law  amends  the  Act  of  July  5,  1884,  and  provides  that 
no  person  shall  be  prosecuted,  tried,  or  punished  for  any  of 
the  various  offenses  arising  under  the  internal  revenue  laws 
unless  the  indictment  is  found  or  the  information  is  instituted 
within  three  years  of  the  commission  of  the  oft'ense.  This  pro- 
vision became  eff'ective  with  the  passage  of  the  192 1  law  on 
November  23,  1921. 

Interest  on  refunds  and  judgments. — Section  1324  pro- 
vides, with  certain  limitations,  for  the  payment  of  interest  by 
the  government  on  refunds  and  judgments.^' 

Unnecessary  examinations. — Section  1309^^  of  the  1921 
law  provides  that  taxpayers  shall  not  be  subject  to  unnecessary 
examinations  or  investigations.  Only  one  inspection  of  the 
taxpayer's  books  of  account  shall  be  made  for  each  taxable 
year,  unless  the  taxpayer  requests  otherwise,  or  unless  the 
Commissioner,  after  investigation,  notifies  the  taxpayer  in 
writing  that  an  additional  investigation  is  necessary. 


''  See  Chapter  VIIL 

'^  See  Chapter  IX. 

^^  See  page  115. 
[Former  Procedure] 

Credit  for  munition  manufacturers'  tax. — Section  407  of  the  1916  law 
provided  for  a  credit  of  the  munition  manufacturers'  tax  actually  paid 
against  the  capital  stock  tax  under  certain  conditions.  The  Treasury  at 
first  construed  tliis  section  literally  and  disallowed  claims  for  refund  where 
the  capital  stock  tax  became  due  and  payable  before  the  munitions  tax  in 
the  same  calendar  year.  T.  D.  3009,  dated  April  20,  1920,  reversed  this 
procedure  and  permitted  claims  for  refund  to  be  filed.  This  Treasury  de- 
cision was  intended  to  validate  crior  claims,  but  section  3228,  Revised 
Statutes,  as  it  then  read,  limited  the  period  of  claim  to  two  years.  Had 
taxpayers  followed  the  law  and  not  the  regulations,  the  claims  would  have 
been  in  order. 

Section  3228,  Revised  Statutes,  has  been  revised  by  the  1921  law  (sec- 
tion 1326)  and  extends  the  limitation  period  to  four  years,  applying  the 
change  to  claims  submitted  under  the  1916,  1917,  1918  and  1921  laws.  Un- 
less the  right  to  claim  accrued  before  November  23,  1917,  they  are  barred 
and  the  revision  of  section  3228,  Revised  Statutes,  is  of  no  benefit. 


APPENDIX   A 


SUPPLEMENT  TO 

EXCESS  PROFITS  TAX  PROCEDURE 

1921 

The  material  contained  in  this  appendix  is  pro- 
vided for  the  purpose  of  bringing  up  to  date  Excess 
Profits  Tax  Procedure,  1921.  The  appendix  is 
divided  into  chapters  corresponding  to  those  of  the 
1921  book,  and  all  comments  and  rulings  are  pre- 
ceded by  a  page  reference.  It  is  thought  that  by 
this  means,  the  reader  v^ill  be  enabled  to  bring  up 
to  date  his  copy  of  Excess  Profits  Tax  Procedure, 
1921. 


CHAPTER     I 

INTRODUCTION   (and  FAREWELL) 

The  excess  profits  tax  law  became  effective  January  i, 
1917;  it  became  inoperative  December  31,  1921.  It  was  con- 
ceived in  the  necessities  of  the  war.  It  has  been  called  illegiti- 
mate (certainly  no  one  claims  the  distinction  of  being  its 
father)  but  the  United  States  Supreme  Court  has  thrown  the 
protection  of  the  Constitution  around  it.  It  had  no  friends; 
but  it  raised  more  money  than  any  other  tax  measure  in  the 
history  of  the  world.  Why  not  let  it  die  in  peace?  If  we  do 
not,  the  agricultural  bloc  will  revive  it  to  raise  the  money  for 
the  soldiers'  bonus. 


CHAPTER    II 

ADMINISTRATION    AND    APPLICATION    OF    THE 

LAW 

Page  12 
Administration. — The  excess  profits  tax  section  of  the  law 

is  administered  by  the  Commissioner  in  the  same  manner  as  is 

the  income  tax  law. 

Changes  in  administrative  procedure  during  1921  are  fully 

discussed  in  Chapter  VII  of  this  book. 

Page  14 

Types   of   corporations   subject  to  the  tax. — Aside   from 

adding  a  few  corporations  to  the  exempt  list/  the  new  law  does 

not  change  the  applicability  of  the  excess  profits  tax  law.     A 

change  has  been  made  in  case  of  the  income  of  foreign  cor- 


1  Section  231,  see  page  34  et  seq. 

1567 


1568  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

porations  engaged  in  shipping-  and  in  case  of  domestic  cor- 
porations which  derive  the  major  part  of  their  income  from  the 
possessions  of  the  United  States.^ 


CHAPTER     III 

EXEMPTIONS 

The  1 92 1  law  makes  the  following  changes  in  the  pro- 
visions which  govern  exemption  from  the  excess  profits  tax. 

Pages  18  and  23 
Income  from  gold  mining.— Under  section  304  (c)  of  the 
1 9 18  law,  that  proportion  of  the  net  income  of  a  corporation 
which  is  derived  from  the  mining  of  gold  is  exempt  from  the 
excess  profits  tax.  There  w'as  no  similar  exemption  under 
the  1 91 7  law.  The  1921  law  makes  the  income  from  gold 
mining  exempt  from  the  excess  profits  tax  as  imposed  by  the 
191 7,  1918,  or  192 1  laws. 

Law.     Section  304 (c)  In  the  case  of  any  corporation 

engaged  in  the  mining  of  gold,  the  portion  of  the  net  income  derived 
from  the  mining  of  gold  shall  be  exempt  from  the  tax  imposed  by  this 
title  or  any  tax  imposed  by  Title  II  of  the  Revenue  Act  of  1917,  and 
the  tax  on  the  remaining  portion  of  the  net  income  shall  be  the  same 
proportion  of  a  tax  computed  without  the  benefit  of  this  subdivision 
which  such  remaining  portion  of  the  net  income  bears  to  the  entire 
net  income. 

The  Senate  amendment  to  this  section  applied  only  to  ex- 
cess profits  taxes  assessed  under  the  19 17  law  and  which 
remained  mipaid.  This  discrimination  between  taxpayers  who 
had  paid  their  taxes  for  191 7  and  those  who  for  some  reason 
had  been  able  to  suspend  the  date  of  payment  until  after  the 
eft'ective  date  of  the  1921  law,  was  removed  in  conference,  so 
that  all  taxpayers  engaged  in  the  mining  of  gold  will  either 


Sections  217  and  233. 
Sections  262,  see  page  1324. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1569 

have  the  1917  tax  refunded  if  already  paid  or  will  not  be 
assessed  if  the  tax  has  not  yet  been  paid. 

The  method  of  computing  the  tax  shown  on  page  24  of 
Excess  Profits  Tax  Procedure,  1921,  can  be  applied  in  prin- 
ciple to  19 1 7  taxes. 

Page  19 

The  rate  of  10  per  cent,  being  the  rate  of  income  tax  un- 
der the  1 9 18  law,  must  be  amended  to  read  12^  per  cent,  effec- 
tive January  i,  1922. 

Exempt  corporations. — Certain  changes  have  been  made 
in  section  231  of  the  law,  which  defines  the  corporations  that 
are  exempt  from  tax.  These  changes  are  fully  dealt  with  in 
Chapter  II. 

,    Page  21 
Personal  service  corporations. — The  status  of  personal  ser- 
vice corporations  for  1921  is  unchanged.     From  January  i, 
1922,  this  class  of  corporations  will  be  taxed  as  ordinary  cor- 
porations. 

The  constitutionality  of  the  method  of  taxing  personal 
service  corporations  under  the  19 18  law  is  still  in  doubt.  That 
the  doubt  is  a  strong  one  is  evidenced  by  the  extraordinary 
provision  of  section  1332  of  the  192 1  law,  which  provides  for 
the  taxation  of  personal  service  corporations  as  ordinary  cor- 
porations— retroactive  to  January  i,  1918 — if  the  method  of 
taxation  provided  under  the  1918  law  is  finally  adjudged 
invalid.  Full  consideration  is  given  to  this  question  in  Chapter 
XXIV. 

Page  27 
[Former  Procedure] 

Income  from  isolated  transactions. — An  officer  of  a  cor- 
poration secured  an  option  on  its  control  several  years  prior 
to  191 7,  exercised  the  option  in  191 7,  and  earned  a  commis- 
sion on  the  transaction.     The  Treasury  held  that  the  income 


1570  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

"was  made  possible  through  his  business  connections"  and 
assessed  the  excess  profits  tax  imposed  by  section  209  of  the 
1917  law.^ 

The  foregoing  ruHng  is  hardly  consistent  with  a  recent  de- 
cision of  the  United  States  District  Court  for  the  Eastern 
District  of  Pennsylvania.^  The  court  held  that  the  commis- 
sions received  by  a  lawyer  as  executor  of  the  estate  of  a 
friend  need  not  be  included  in  income  subject  to  the  excess 
profits  tax  imposed  by  section  209. 

The  court  said : 

Decision.  With  respect  to  the  theory  on  which  the  case  was 
tried,  it  seems  to  us  that  it  is  very  fairly  and  clearly  stated  in 
article  8  of  the  regulations.  A  contrast  is  there  drawn,  or  at  least 
distinction  made,  between  what  a  person  makes  it  his  trade,  profession, 
business,  or  emphatically  vocation  to  do,  what  he  holds  himself 
out  as  prepared  to  do,  and  some  particular  thing  of  the  same  kind, 
which  he  does,  but  which  is  an  incidental,  accidental,  isolated,  particu- 
lar thing,  which  he  happened  to  do.  We  confess,  however,  our 
inability  to  grasp  the  thought  of  a  distinction  between  such  isolated 
things,  growing  out  of  the  importance  of  the  thing  done  or  the 
demands  which  it  makes  upon  the  time  of  the  person  doing  it. 
It  seems  to  us  that  this  works  confusion  in  the  thought  of  the  real 
distinction  as  expressed  in  the  regulations. 

The  whole  thought  is  conveyed  in  an  expression  which  is  not 
uncommon  when  a  person  is  asked  to  do  something  which,  as  another 
expression  goes,  is  "out  of  his  line."  The  expression  first  referred 
to  is,  "I  don't  make  a  business  of  doing  this,  but  I  will  do  it  for  you." 
The  doing  of  it  may  result  in  such  person  devoting  practically  his 
whole  time  to  it,  without  involving  the  thought  of  making  it  his 
business.  There  is  much  the  same  distinction  made  between  amateurs 
and  professionals  in  athletics,  although  the  test  usually  applied  there 
is  the  commercial  test.  Nevertheless  the  distinction  referred  to 
exists.  The  amateur  does  not  make,  as  the  professional  ex  vi  termini 
does,  the  sport  his  trade,  occupation,  business,  or  profession,  even 
although  he,  as  he  not  infrequently  does,  devotes  more  time  in  de- 
veloping and  perfecting  skill  in  it  than  the  avowed  professional  does. 
The  difference  is  suggestive  of  a  dift"erence  in  motive,  but  there  is 
the  other  thought  also. 

This  case,  however,  has  taken  a  turn  which  compels  us  to  take  an 


^  C.B.  4,  page  350,  A.R.R.  350. 

'  Cadzivlader  v.  Lederer,  273  Fed.  879;  affirmed,  August  18,  1921,  274 
Fed.  753. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1571 

altogether  practical  view  of  the  disposition  to  be  made  of  it.  The 
burden  was,  of  course,  upon  the  plantiff  to  make  out  his  case.  This 
he  did,  if  the  theory,  upon  which  the  case  was  submitted,  was  the 
true  theory,  by  his  testimony  that  his  profession  was  that  of  a  lawyer, 
and  that  he  did  not  make  a  business  of  acting  as  executor,  although 
he  had  so  acted  in  one  isolated  case,  wholly  disassociated  from  his 
professional  work. 

It  would  seem  that  the  commissions  of  a  lawyer  who  acted 
as  executor  were  "made  possible  by  his  business  connections" ; 
but  the  court  found  in  efifect  that  section  209  applies  only  to 
one's  regular  business,  but  not  to  isolated  transactions  which 
grow  out  of  it. 


CHAPTER     IV 

RETURNS 

The  1 92 1  law  provides  in  general  (section  336)  that 
every  corporation  not  specifically  exempt^  must  make  a  re- 
turn for  purposes  of  the  excess  profits  tax  for  the  year  1921. 
After  1 92 1,  excess  profits  tax  returns  are  no  longer  required. 
Special  provisions  are  made,  however,  which  provide  that  the 
returns  of  corporations  which  report  on  a  fiscal  year  basis  shall 
show  the  tax  properly  attributable  to  the  respective  'calendar 
years.^  A  new  class  of  corporations  is  referred  to  in  section 
262  (corporations  in  which  the  major  part  of  the  income  is 
from  a  possession  of  the  United  States).  These  are  to  be 
treated  as  foreign  corporations,  and  for  purpose  of  the  excess 
profits  tax  they  are  assessed  under  sections  327  and  328.^  In- 
asmuch as  foreign  corporations  are  not  assessed  on  the  basis 
of  invested  capital,  in  making  returns  of  income  on  form  1120 
no  computation  of  invested  capital  need  be  made.* 


1  See  Chapter  II. 

2  Section  335. 

^  The  relief  sections — see  page  1637. 
*Reg.  62,  Art.  870,  Reg.  45,  Art.  871. 


1572  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

Corporations  whose  entire  income  is  derived  from  gold 
mining  need  not  compute  invested  capital,  because  the  exemp- 
tion of  such  income  from  the  excess  profits  tax  provided  for 
in  the  1918  law  is  extended  to  192 1  by  the  new  law,° 

Returns  of  "government  contract"  corporations. — The 
1 92 1  law  re-enacts  those  provisions  of  the  19 18  law  which 
impose  a  tax  at  the  high  19 18  rates  on  net  income  in  excess 
of  $10,000  derived  from  "government  contracts"  realized  in 
1921. 

Law.     Section  301 (b)  For  the  calendar  year  1921  there 

shall  be  levied,  collected,  and  paid  upon  the  net  income  of  every 
corporation  which  derives  in  such  year  a  net  income  of  more  than 
$10,000  from  any  Government  contract  or  contracts  made  between 
April  6,  1917,  and  November  11,  1918,  both  dates  inclusive,  a  tax 
equal  to  the  sum  of  the  following: 

(i)  Such  a  portion  of  a  tax  computed  at  the  rates  specified  in 
subdivision  (a)  of  section  301  of  the  Revenue  Act  of  1918,  as  the 
part  of  the  net  income  attributable  to  such  Government  contract  or 
contracts  bears  to  the  entire  net  income.  In  computing  such  tax  the 
excess-profits  credit  and  the  war-profits  credit  which  would  be  applicable 
to  such  calendar  year  under  the  Revenue  Act  of  1918  if  it  had  been 
continued  in  force,  shall  be  used; 

(2)  Such  a  portion  of  a  tax  computed  at  the  rates  specified  in 
subdivision  (a)  of  this  section  as  the  part  of  the  net  income  not  attri- 
butable to  such  Government  contract  or  contracts  bears  to  the  entire 
net  income. 

For  the  purpose  of  determining  the  part  of  the  net  income  attri- 
butable to  such  Government  contract  or  contracts,  the  proper  appor- 
tionment and  allocation  of  the  deductions  with  respect  to  gross  income 
derived  from  such  Government  contract  or  contracts  and  from  other 
sources,  respectively,  shall  be  determined  under  rules  and  regulations 
prescribed  by  the  Commissioner  with  the  approval  of  the  Secretary. 

For  the  purpose  of  computing  the  higher  tax  applicable  and 
the  proper  apportionment  thereof,  form  1120S  must  be  filed. 

It  should  be  noted  particularly  that  while  the  higher  19 18 
rates  are  applied  to  "government  contract"  income,  the  excess 
profits  credit  and  the  war  profits  credit  for  the  year  1921  are 


°  [Former  Procedure]  The  1921  law  (section  304-6)  specifically 
extends  to  1917  the  exemption  from  excess  profits  tax  of  income  from 
gold  mining.     See  page  1568. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1573 

the  same  as  would  have  been  obtained  if  the  1918  law  had 
been  continued. 

Returns  for  fiscal  year  1920-1921. — Although  the  tax  rates 
on  corporations  for  the  calender  years  1920  and  1921  are  the 
same,  net  income  is  determined  differently  under  the  19 18 
law,  which  was  in  effect  in  1920,  than  under  the  1921  law, 
which  governs  1921  returns. 

Law.     Section  335 (a)  That  if  a  corporation  (other  than 

a  personal  service  corporation)  makes  a  return  for  a  fiscal  year  begin- 
ning in  1920  and  ending  in  1921,  the  war-profits  and  excess-profits  tax 
for  the  taxable  year  1921  shall  be  the  sum  of:  (i)  the  same  proportion 
of  a  tax  for  the  entire  period  computed  under  the  Revenue  Act  of 
1918,  which  the  portion  of  such  period  falling  within  the  calendar 
year  1920  is  of  the  entire  period,  and  (2)  the  same  proportion  of  a  tax 
for  the  entire  period  computed  under  this  title,  which  the  portion  of 
such  period  falling  within  the  calendar  year  1921  is  of  the  entire 
period.  Any  amount  heretofore  or  hereafter  paid  on  account  of  the 
tax  imposed  for  such  taxable  year  by  the  Revenue  Act  of  1918  shall 
be  credited  towards  the  payment  of  the  tax  as  above  computed,  and  if 
the  amount  so  paid  exceeds  the  amount  of  such  tax,  the  excess  shall 
be  credited  or  refunded  to  the  corporation  in  accordance  with  the 
provisions  of  section  252  of  this  Act. 

It  will,  therefore,  be  necessary  to  make,  in  effect,  two  re- 
turns; one  in  which  the  net  income  and  the  tax  are  computed 
under  the  provisions  of  the  1918  law,  and  the  other  in  which 
the  net  income  and  the  tax  are  computed  under  the  provisions 
of  the  1 92 1  law. 

Returns  for  fiscal  year  1921-1922. — Since  the  excess  profits 
tax  provisions  are  not  in  effect  after  December  31,  1921,*^  it  is 
necessary,  in  making  return  for  a  fiscal  year  beginning  in  1921 
and  ending  in  1922,  to  allocate  to  192 1  the  proper  proportion 
of  the  excess  profits  tax  attributable  to  the  period  prior  to 
January  i,  1922. 

Law.     Section  335 (b)  If  a  corporation   (other  than  a 

personal  service  corporation)   makes  a  return  for  a  fiscal  year  begin- 


Section  301   (a). 


1574  KXCESS  PROFITS  TAX  PROCEDURE— 1921 

ning  in  1921  and  ending  in  1922,  the  war-profits  and  excess-profits 
tax  for  the  portion  of  the  year  falling  within  the  calendar  year  192 1 
shall  be  an  amount  equivalent  to  the  same  proportion  of  a  tax  for  the 
entire  period  computed  under  this  title,  which  the  portion  of  such 
period  falling  within  the  calendar  year  1921  is  of  the  entire  period. 

There  is,  of  course,  the  increased  income  tax  at  the  1922 
rate  which  must  be  shown  to  be  allocated  to  1922  income  in 
the  return. 

Consolidated  returns. — Affiliated  corporations  are  given 
the  option  of  filing  either  consolidated  returns  or  separate 
returns  for  any  taxable  year  beginning  on  or  after  January  i, 
1922.^  The  excess  profits  tax  provisions  of  the  19 18  law, 
however,  are  in  effect  until  December  31,  1921,  so  that  returns 
for  192 1  or  for  fiscal  years  beginning  in  1921  must  be  on  a 
consolidated  basis  if  the  corporations  are  affiliated. 

Law.     Section  240 (e)  Corporations  which  are  affiliated 

within  the  meaning  of  this  section  shall  make  consolidated  returns  for 
any  taxable  year  beginning  prior  to  January  i,  1922,  in  the  same 
manner  and  subject  to  the  same  conditions  as  provided  by  the  Revenue 
Act  of  1918. 

The  question  of  what  constitutes  affiliation  and  the  relevant 
provisions  of  the  19 18  law  governing  procedure  for  1921  are 
discussed  in  detail  in  Chapter  XIV  of  Excess  Profits  Tax 
Procedure,  192 1.  Reference  should  also  be  made  to  the  cor- 
responding chapter  of  this  appendix  for  rulings  issued  in  192 1. 

The  Treasury  required  consolidated  returns  for  excess 
profits  tax  for  the  taxable  year  19 17,  although  the  191 7  law 
did  not  specifically  so  provide.  The  1921  law  (Section  1331)* 
in  effect  validates  the  Treasury  regulations  under  the  191 7 
law  requiring  consolidated  returns,  and  extends  affiliation  to 
partnerships  for  191 7.  In  specific  cases,  the  Treasury  had  re- 
fused to  accept  returns  of  partnerships  affiliated  with  cor- 
porations. 


"  Law,  section  240  (a).    See  Chapter  XIV  of  this  appendix. 
^  See  page  1627. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1575 

Foreign  corporations. — Foreign  corporations  are  still  ex- 
cluded from  the  benefits  (if  any)  of  consolidated  returns. 
A  domestic  corporation  which  owns  a  majority  of  the  voting 
stock  of  a  foreign  corporation,  although  still  allowed  a  credit 
for  foreign  taxes  paid  on  account  of  such  shares  against  the 
taxes  assessed  in  the  United  States,  has  had  such  credit  ma- 
terially restricted  by  sections  238  (e)  of  the  1921  law  which 
has  been  substituted  for  section  240  (c)  of  the  1918  act.^ 


CHAPTER    V 

COMPUTATION  AND  RATES  OF  THE  TAX  , 

The  rates  of  the  19 18  law  applicable  to  1919  and  subse- 
quent years,  apply  to  192 1  for  purposes  of  the  excess  profits 
tax.  Special  provision,  however,  is  made  in  the  case  of  fiscal 
year  corporations.  In  the  case  of  fiscal  years  beginning  in 
1920  and  ending  in  1921,^  separate  computations  have  to  be 
made  under  each  act  (with  different  methods  of  determining 
net  income),  and  the  sum  of  the  proper  proportion  of  each 
resulting  tax  is  taken.  For  a  fiscal  year  ending  in  1922,  the 
computation  is  made  for  a  full  year  and  then  prorated.^  Net 
income  from  government  contracts  received  in  192 1  (if  in  ex- 
cess of  $10,000)  is  subjected  to  the  higher  rates  at  which  this 
type  of  income  was  taxed  under  the  1918  law,  viz.,  30  and  65 
per  cent  excess  profits  tax,  and  80  per  cent  war  profits  tax.^ 

The  limitation  of  tax  (section  302)  providing  for  lower 
rates  of  tax  on  corporations  with  small  net  incomes,  has  been 
re-enacted  in  the  new  law. 

The  profits  taxes  are  imposed  upon  the  net  income  for  the 
taxable  year  as  determined  for  federal  income  tax  purposes.* 
In  case  of  corporations  which  have  a  fiscal  year,  part  of  which 


"  For  a  full  discussion  of  the  limitation  on  credit  for  foreign  taxes  to 
domestic  parent  corporation  having  a  foreign  subsidiary,  see  page  948. 
^  Section  335  (a). 
2  Section  335   (b). 
•'  Section  301    (b). 
•*  Section  320. 


1576  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

falls  in  1920,  the  net  income  as  determined  under  the  19 18 
law  must  also  be  ascertained,  and  the  computation  of  the  tax 
must  be  made  under  that  act  in  order  to  obtain  the  proper 
proportionate  tax  applicable  to  the  1920  income.^ 

Page  54 
Income  from  government  contracts. — It  is  important  to 
note  that  while  the  higher  rates  (war  profits  tax)  apply  to  net 
income  exceeding  $10,000  which  was  realized  in  192 1  from 
government  contracts,  the  excess  profits  credits  and  war  profits 
credits  applicable  to  the  year  1921,  computed  under  the  19 18 
law,  are  to  be  used. 

The  limitation  of  tax  under  section  302^  is  also  specifically 
made  applicable  to  the  taxes  computed  at  the  1918  rates. 

In  some  cases  in  which  it  was  not  feasible  to  allocate  costs 
and  expenses  on  the  basis  of  gross  income,  the  ratio  of  govern- 
ment and  non-government  sales  to  total  sales  has  been  used  as 
an  equitable  method  of  arriving  at  the  income  to  be  taxed  at 
the  rates  applicable.^ 

Page  62 
Lower  rates  applicable  in  certain  cases — no  prorating  of 
limitation  under  section  302. — The  new  law  re-enacts  the  limi- 
tation provisions  in  order  to  give  relief  to  corporations  which 
have  small  net  incomes.  The  provision  also  applies  to  "gov- 
ernment contract"  income  which  is  subjected  to  the  higher 
19 1 8  rates. 

The  Secretary  of  the  Treasury  had  previously  recom- 
mended that  the  old  law  be  amended  in  order  to  provide  for 
the  reduction  of  the  limitations  of  $3,000  and  $20,000  in  case 
of  corporations  which  report  for  less  than  a  full  year.  The 
Treasury  had  required  such  reduction,  as  set  forth  in  Regula- 
tions 45,  articles  732-733.  However,  Congress  did  not  act  on 
the  recommendation,  and  the  1921  law  contains  no  such  re- 
quirement.     The   Treasury  has   now   amended   articles   732 


5  Section  335. 

^  See  Appendix  C. 

^  See  also  C.B.  i,  page  269;  A.R.M,  i. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1577 

and  733  in  order  to  allow  the  limitations  to  be  applied  with- 
out any  proportionate  reduction,  as  follows : 

Regulations.  Limitation  zvhen  return  for  fractional  part  of  year. 
— When  a  return  is  rendered  for  a  fractional  part  of  a  year,  the 
limitation  shall  be  computed  in  the  same  manner  as  if  the  period 
covered  by  the  return  were  a  full  taxable  year. 

Illustration  of  computation  of  limitation  of  tax.—li  in  the  il- 
lustration used  in  Article  720  the  invested  capital  had  been  $100,000 
and  the  net  income  $80,000,  the  tax  computed  under  section  301  (a) 
of  the  statute  would  be  $56,200.  Section  302  provides,  however,  that 
tax  under  section  301  (a)  shall  not  be  more  than  30  per  cent  of  the 
net  income  in  excess  of  $3,000  and  not  in  excess  of  $20,000  plus  80  per 
cent  of  the  net  income  in  excess  of  $20,000.  The  tax  at  the  30  per  cent 
rate  will  be  $5,100  (art.  731)  and  the  balance  of  the  tax  will  be  80  per 
cent  of  $60,000  (the  net  income  in  excess  of  $20,000),  or  $48,000. 
The  total  tax  will  therefore  be  $5,100  plus  $48,000,  or  $53,100.  The 
tax  under  section  301  (a),  amounting  to  $56,200,  will  accordingly  be 
reduced  to  $53,100.  (T.  D.  3245,  amending  Arts.  732  and  733.  Reg. 
45,  dated  November  14,  1921.) 

Articles  732  and  733  of  Regulations  62  incorporate  the 
above  changes,  the  example,  liowever,  using  1921  rates  in- 
stead of  those  for  1918. 

In  the  official  illustration  given  in  article  733,  before 
amendment,^  in  which  the  limitations  were  prorated  : 

The  excess  profits  tax  amounted  to $55,825 

In  the  amended  article,  the  tax  is  (for  details  see  illustration  on 
page  1579)    53,100 


Excessive  tax  imposed  $2,725 


The  excessive  tax  may  be  accounted  for  as  follows : 
Part  of  year  not  prorated   (3  months)   3/12 

3/12  of  $17,000  ($20,000  — $3,000)  =  $4,250  at  ^0%  = $1,275 

3/12  of  $20,000 (limitation  not  re- 
duced)     =  $5,000  at  80%  = 4,000 


Net  reduction  in  tax  due  to  not  reducing  limitations $2,725 


The  19 18  rates  are  used  in  the  official  illustration.  Of 
course,  for  192 1,  the  excess  profits  tax  rates  are  20  and  40 
per  cent. 

In  all  instances  in  which  taxpayers  have  paid  an  excessive 
tax  due  to  the  reduction  of  the  limitations  under  section  302, 
a  claim  for  refund,  or  a  claim  for  credit  should  be  filed. 


^  See  Excess  Profits  Tax  Procedure,  1921,  pages  70-71. 


1578 


EXCESS  PROFITS  TAX  PROCEDURE— 1921 


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EXCESS  PROFITS  TAX  PROCEDURE— 1921  1579 

But  section  302  provides  that  the  tax  shall  not  exceed  30 
per  cent  of  the  net  income  in  excess  of  $3,000  and  not  in  ex- 
cess of  $20,000  plus  80  per  cent  of  the  net  income  in  excess 
of  $20,000.  Article  732  of  Regulations  45  (as  amended 
by  T.  D.  3245)  does  not  now  require  these  amounts  to  be  re- 
duced when  computing-  the  limitation  of  the  tax  for  less  than 
twelve  months : 

Net  Income  in  excess  of  $3,000  but  not  in  excess  of 

$20,000=$! 7,000  at  30%=   $    5,100 

80%  of  net  income  ($80,000)  in  excess  of  $20,000  48,000 

Total    $S3,ioo 

Therefore  the  Excess  and  War  Profits  Tax  to  be  paid  is  $53,100 

Page  93 
Computation  of  tax  for  fiscal  years  ending  in  1921  and 
1922. — Two  computations  should  be  made,  both  for  income 
and  for  excess  profits  tax  purposes — one  under  the  19 18  law, 
with  its  definition  of  net  income,  the  other  under  the  192 1  law, 
which  differs  in  a  number  of  particulars  (deductibility  of 
additions  to  reserves  for  bad  debts,  interest  on  loans  to  carry 
Liberty  bonds,  etc.).  The  sum  of  the  pro  rata  parts  of  the 
total  tax  for  each  full  year  is  the  total  tax  for  the  fiscal 
period. 

If  the  income  of  a  taxpayer  for  a  fiscal  year  ending  in 
1 92 1  is  the  same  whether  computed  under  the  19 18  law  or 
under  the  192 1  law,  the  computation  of  the  tax  need  only  be 
made  for  one  year,  since  the  rates  of  the  excess  profits  tax 
(except  in  the  case  of  government  contract  income)^"  and  the 
income  tax  are  the  same  for  1920  (under  the  19 18  law)  as  for 
192 1. 

Law.  Section  335.  (a)  That  if  a  corporation  (other  than  a  per- 
sonal service  corporation)  makes  return  for  a  fiscal  year  beginning  in 
1920  and  ending  in  1921,  the  war-profits  and  excess-profits  tax  for  the 
taxable  year  1921  shall  be  the  sum  of:  (i)  the  same  proportion  of  a 
tax  for  the  entire  period  comp\ited  under  the  Revenue  Act  of  1918, 


h 


1"  See  page  1572. 


1580  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

which  the  portion  of  such  period  falling  within  the  calendar  year 
1920  is  of  the  entire  period,  and  (2)  the  same  proportion  of  a  tax  for 
the  entire  period  computed  under  this  title,  which  the  portion  of  such 
period  falling  within  the  calendar  year  1921  is  of  the  entire  period. 
Any  amount  heretofore  or  hereafter  paid  on  account  of  the  tax  im- 
posed for  such  taxable  year  by  the  Revenue  Act  of  1918  shall  be 
credited  towards  the  payment  of  the  tax  as  above  computed,  and  if 
the  amount  so  paid  exceeds  the  amount  of  such  tax,  the  excess  shall 
be  credited  or  refunded  to  the  corporation  in  accordance  with  the 
provisions  of  section  252  of  this  Act. 

(b)  If  a  corporation  (other  than  a  personal  service  corporation) 
makes  a  return  for  a  fiscal  year  beginning  in  1921  and  ending  in  1922, 
the  war-profits  and  excess-profits  tax  for  the  portion  of  the  year 
falling  within  the  calendar  year  1921  shall  be  an  amount  equivalent 
to  the  same  proportion  of  a  tax  for  the  entire  period  computed  under 
this  title,  which  the  portion  of  such  period  falling  within  the  calendar 
year  1921  is  of  the  entire  period. 

For  fiscal  years  which  ended  in  1921,  two  computations 
of  the  excess  profits  tax  are  made,  each  for  a  full  year,  one 
under  the  1918  law,  and  one  under  the  1921  law,  and  these 
are  then  prorated.  The  sum  of  the  proportional  parts  is  the 
total  excess  profits  tax  payable. 

Since  the  computations  are  made  under  two  separate  laws 
in  which  some  of  the  items  which  make  up  net  income  and  in- 
vested capital  are  treated  differently,  care  must  be  taken  to  see 
that  these  are  handled  in  accordance  with  the  law  under  which 
the  computation  is  being  made.  It  is  probable  that  a  special 
form  of  return  wnll  be  provided  by  the  Treasury  for  fiscal  year 
corporations,  which  will  show  the  items  that  require  different 
treatment  under  the  two  laws. 

In  the  case  of  fiscal  years  which  end  in  1922,  the  excess 
profits  tax  is  first  computed  for  the  entire  period  and  then 
prorated.  For  example,  assume  the  case  of  a  corporation  with 
a  fiscal  year  ending  May  31,  1922,  and  that  the  excess  profits 
tax  computed  for  a  full  twelve  months'  period  was  $36,000. 
The  excess  profits  tax  payable  would  be  7/12  thereof,  or 
$21,000.  For  the  method  of  computing  the  income  tax  in  the 
case  of  fiscal  years  ending  in  1922,  see  page  165. 

The  computation  of  the  tax  in  the  case  of  personal  ser- 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1581 

vice  corporations  which  have  tiscal  years  ending  in  1921  and 
1922,  is  dealt  with  in  Chapter  XXIV. 

[Former  Procedure] 

The  confusion  that  arises  in  the  minds  of  taxpayers,  par- 
ticularly in  dealing  with  those  provisions  of  the  law  which 
provide  for  computations,  is  illustrated  in  two  recent  decisions 
involving  the  interpretation  of  section  201  of  the  191 7  law. 
In  the  first  case^^  the  court  said,  in  part : 

Decision.  According  to  section  201  of  the  Revenue  Act  of  1917, 
supra,  a  tax  is  imposed  at  the  rate  of  20  per  cent  upon  "the  amount  of 
the  net  income  in  excess  of  the  deduction  ....  and  not  in  excess  of 
fifteen  per  centum  of  the  invested  capital  for  the  taxable  year,"  etc. 
While  the  entire  section  is  not  free  from  ambiguity,  the  court  is  of. 
the  opinion  that,  having  in  mind  the  necessity  of  adopting  a  con- 
struction in  accordance  with  the  intent  of  Congress  when  the  act 
was  adopted,  that  urged  by  the  government  must  prevail.  If  it  had 
been  the  purpose  of  Congress  to  have  the  tax  computed  as  plaintiff 
contends,  the  first  paragraph  of  section  201  would  have  provided  for 
the  levy  of  a  tax  "equal  to  the  following  percentages  of  the  net 
income  less  the  deduction  determined  as  hereinafter  provided,"  making 
no  mention  of  any  deduction  in  the  following  paragraph. 

If  the  section  as  it  now  reads  is  carefully  analyzed,  it  is  apparent 
that  the  amount  of  the  net  income  which  is  to  be  taxed  at  the  rate 
of  20  per  cent  is  not  more  than  15  per  cent  of  the  invested  capital 
for  the  taxable  year.  But  not  so  much  of  the  net  income  as  is 
represented  by  such  15  per  cent  is  to  be  so  taxed  because  there  must 
first  be  allowed  the  deduction. 

The  court  uses  a  method  that  will  prove  helpful  in  inter- 
preting any  of  the  sections  involving  computations,  viz.,  to 
restate  the  law  so  as  to  give  effect  to  an  alternative  compu- 
tation. 

The  same  point,  viz.,  that  the  exemption  (in  effect,  excess 
profits  credit)  was  not  to  be  first  deducted  from  the  entire  net 
income,  but  was  to  be  applied  to  the  net  income  in  the  first 
bracket,  was  also  decided  in  another  case.     The  effect  of  the 


"  Greenport  Basin   &  Construction  Co.  v.   U.  S.,  269  Fed.   58    (U.   S. 
District  Court  for  the  Eastern  District  of  New  York,  November  18,  1920). 


1582  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

difference  in  the  two  methods  is  clearly  stated  by  the  court^*  as 
follows : 

Decision.  A  comparison  of  the  two  methods  shows  that,  by 
making  the  deduction  from  the  first  item  of  15  per  cent  of  invested 
capital,  the  amount  taxed  at  the  20  per  cent  rate  is  diminished  by 
the  amount  of  the  deduction,  and  the  amount  taxed  at  the  60  per  cent 
rate  is  increased  by  the  amount  of  the  deduction 

A  large  part  of  the  difficulty  in  construing  the  20  per  cent  par- 
agraph arises  from  the  fact  that  the  amounts  involved  are  expressed 
in  descriptive  terms  and  not  in  figures.  If  the  act  taxed  the  amount 
of  the  net  income  in  excess  of  $50,000,  and  not  in  excess  of  $100,000 
we  would  have  no  difficulty  in  understanding  that  the  amount  to  be 
taxed  was  the  difference  between  $100,000  and  $50,000. 

The  last  sentence  quoted  above  indicates  admirably  how, 
by  substituting  actual  figures,  a  clearer  conception  of  the  mean- 
ing of  the  law  may  be  obtained. 


CHAPTER     VI 

CREDITS  AND  SPECIFIC  EXEMPTIONS 

Page  109 

Domestic  corporations  which  derive  more  than  80  per  cent 
of  their  gross  income  from  sources  within  possessions  of  the 
United  States,  do  not  receive  the  $3,000  exemption.^  This  is 
the  only  change  made  by  the  new  law  in  the  excess  profits 
credit  and  the  specific  exemption  of  $3,000,  except  that  it 
eliminates  the  provisions  dealing  with  the  war  profits  credit 
and  specific  exemption.  This  has  resulted  in  a  few  changes 
in  the  numbering  of  paragraphs  and  subdivisions.  For  in- 
stance, section  301  (d)  of  the  19 18  law  now  becomes  section 
301    (c). 


^^ Ehret  Magnesia  Mfg.  Co.  v.  Lederer,  273  Fed.  689.  (U.  S.  District 
Court  for  the  Eastern  District  of  Penna.,  No.  7044,  May  23,  1921,  issued 
as  T.D.  3200,  dated  July  19,  1921. 

1  Section  312. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1583 

[Former  Procedure]  Page  120 

Computation  of  average  deduction. — The  Treasury  has 
ruled  that  in  computing  the  "average  deduction"  under  section 
205  of  the  19 1 7  law,  the  averaging  is  to  be  done  after  the 
limitations  provided  in  section  203  have  been  applied.^ 


CHAPTER    VII 

INVESTED  CAPITAL— BORROWED  MONEY 

Page   123 

The  excess  profits  tax  is  a  tax  on  net  income,  but  the  tax 
is  measured  by  a  computation  of  invested  capital.  Congress 
adopted  a  formula  for  the  computation  which,  considering 
war  conditions,  corporate  records,  and  the  utter  impossibility 
of  using  an  actual  value  basis,  is  as  nearly  equitable  as  could 
be  devised.  From  the  time  of  the  passage  of  the  191 7  law  it 
was  certain  that  the  constitutionality  of  the  formula  and  of 
other  sections  of  the  law  would  be  tested  in  the  courts.  For- 
tunately, the  first  case  decided  by  the  United  States  Supreme 
Court  was  one  which  squarely  raised  the  most  important  con- 
troversial points  which  have  been  raised. 

Constitutionality  of  excess  profits  tax, — In  handing  down 
its  decision  in  the  case  of  La  Belle  Iron  Works  v.  United 
States,'^  the  Supreme  Court  dealt  with  the  contention  raised 
by  the  appellant,  that  the  excess  profits  tax  was  unconstitu- 
tional. The  digest  of  the  decision,  published  as  T.  D.  3181,^ 
states  succinctly  the  salient  points  of  the  decision,  as  it  relates 
to  constitionality,  as  follows : 

Decision.  It  was  not  unreasonable  for  Congress,  in  adjusting 
the  excess  profits  tax,  to  accord  preferential  treatment  to  capital  repre- 


2  1-2-24;  A.  R.  R.  716. 
^41  Sup.  Ct.  528. 
2  C.  B.  4,  page  144- 


1584  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

senting  actual  investments,  as  compared  with  capital  representing 
higher  valuations  based  upon  estimates,  however  reliable,  of  what 
probably  could  be  realized  were  the  property  sold  instead  of  re- 
tained  

Cases  decided  under  the  equal  protection  clause  of  the  fourteenth 
amendment  to  the  Constitution  are  not  authority  in  determining 
whether  a  Revenue  Act  operates  to  produce  baseless  and  arbitrary 
discriminations,  to  the  extent  of  rendering  the  tax  invalid  under  the 
due  process  clauses  of  the  fifth  amendment,  as  the  fifth  amendment 
has  no  equal  protection  clause,  and  the  only  rule  of  uniformity  pre- 
scribed with  respect  to  duties,  imports,  and  excises  laid  by  Congress 
is  the  territorial  uniformity  required  by  section  8  of  article  I ;  nor 
are  cases  based  upon  the  due  process  clause  of  the  fourteenth  amend- 
ment applicable 

The  Act,  in  basing  "invested  capital"  upon  actual  costs  to  the  ex- 
clusion of  higher  estimated  values,  is  not  violative  of  the  due  process 
clause  of  the  fifth  amendment  to  the  Constitution  in  that  it  is  so  wholly 
arbitrary  as  to  amount  to  confiscation ;  the  Act  treats  all  corporations 
and  partnerships  alike  so  far  as  they  are  similarly  circumstanced, 
and  if  in  its  application  the  tax  in  particular  instances  may  seem  to 
bear  upon  one  corporation  more  than  upon  another,  this  is  due  to 
differences  in  their  circumstances,  not  to  any  uncertainty  or  want 
of  generality  in  the  tests  applied. 

Page  127 
Computation  of  invested  capital — cash  or  accrual  basis. — 

Ruling.  A  corporation  which  reports  its  income  on  a  cash 
receipts  and  disbursements  basis  may  not  take  accrued  items  into 
consideration  in  computing  its  invested  capital.  (B.  34-21-1787; 
O.  D.  1007.) 

The  effect  of  this  ruling  is,  that  corporations  keeping  their 
accounts  by  the  single-entry  system  of  bookkeeping  are  com- 
pelled to  compute  their  invested  capital  on  a  cash  basis, 
omitting  both  accounts  payable  and  accounts  receivable,  even 
though  in  a  statement  made  up  in  such  a  form  the  net  worth 
does  not  truly  represent  the  amount  of  capital  invested  in  the 
business. 

Page  129 
When  demand  notes  payable  to  stockholders  do  not  con- 
stitute liability. — 

Ruling.  Recommended,  that  treasury  demand  notes  drawn  by 
order  of  the  president  of  a  corporation  payable  to  its  stockholders, 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1585 

but  not  in  proportion  to  shareholdings,  do  not  constitute  a  liability 
of  the  corporation  even  though  such  notes  are  charged  against  sur- 
plus on  the  books  of  the  company.     (C.  B.  4,  page  362;  A.  R.  R.  473.) 

This  case  is  somewhat  unusual  and  does  not  enumerate  a 
principle  to  be  generally  applied.  In  arriving  at  this  decision, 
the  Committee  on  Appeals  and  Reviews  pointed  out  that  a 
corporation  cannot,  without  consideration,  issue  notes  to  its 
stockholders  for  the  amount  of  its  surplus,  except  by  declaring 
a  dividend  pro  rata  according  to  stockholdings;  and  without 
such  formal  declaration  the  notes  do  not  constitute  a  liability, 
no  matter  what  entries  have  been  made  in  the  books  of  account. 
Furthermore,  in  the  instant  case,  the  notes  were  not  delivered 
to  the  stockholders,  but  were  held  by  the  treasurer  of  the 
company.  Hence,  the  amount  of  the  notes  payable  should  be 
included  in  invested  capital. 

Page  133 
Dividends  left  in  business. — 

Ruling.  A  Massachusetts  corporation  formally  declared  a  divi- 
dend duly  recorded  in  the  minutes  book,  the  resolution  stating  that 
the  date  of  payment  would  be  determined  at  a  later  date.  Later  a 
second  dividend  by  informal  action  was  credited  to  the  stockholders, 
although  its  declaration  was  not  recorded  in  the  minutes  book.  Both 
dividends  were  credited  to  the  respective  accounts  of  the  stockholders 
with  the  understanding  among  them  that  they  were  not  to  be  drawn 
against  and  were  not  to  bear  interest.  They  have  been  treated  as 
liabilities  of  the  corporation  from  1916  and  no  interest  has  been  paid 
or  accrued  thereon. 

Held,  under  Massachusetts  court  decisions,  that  the  amount  of 
surplus  credited  to  the  stockholders  without  formal  action  was  equiva- 
lent to  a  dividend.  Accordingly,  the  corporation's  surplus  must  be 
reduced  from  the  date  the  first  dividend  was  formally  declared  and 
in  the  case  of  the  second  dividend,  from  the  date  the  agreement  was 
made  informally  to  credit  the  stockholders'  accounts.  ('B.  34-21-1786; 
O.  D.  1006.) 

This  decision  should  be  compared  with  A.  R.  M.  71  (C. 
B.  3,  page  348).  The  controlling  feature  would  seem  to  be 
the  application  of  the  Massachusetts  corporation  law.  If  the 
credit   balances  were  treated  as  liabilities   in   statements  for 


1586  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

credit  purposes,  such  as  those  furnished  to  mercantile  agencies, 

the  ruHng  is  sound. 

Page  137 
[Former  Procedure] 

Amended  returns  for  1917 — community  property  of  hus- 
band and  wife. — 

Ruling.  In  filing  amended  returns  under  T.  D.  3071  (C.  B.  3, 
p.  221),  husband  and  '^vife  may  file  separate  excess  profits  tax  returns 
for  1917,  in  which  the  community  income  may  be  divided  between 
them.  The  invested  capital  of  either  the  husband  or  the  wife  should 
be  computed  by  adding  that  portion  of  the  invested  capital  which  is 
his  or  her  separate  property  to  one-half  of  that  portion  of  the  in- 
vested capital  which  is  community  property.  The  full  amount  of  the 
specific  exemption  authorized  by  the  statute  may  be  claimed  by 
each.     (C.  B.  4,  page  254;  O.  D.  881.) 

Page  140 
Advances  to  partners  to  purchase  stock. — Where  stock  in 
controlled  companies  was  purchased  by  a  partnership,  the  cost 
being  prorated  among  the  partners  and  charged  to  their  per- 
sonal accounts,  the  stock  being  from  time  to  time  used  as 
collateral  for  loans  obtained  by  the  partnership,  it  has  been 
held  that  the  amounts  charged  to  the  partner's  personal  ac- 
counts represent  advances  by  the  partnership  to  the  partners, 
and  do  not  reduce  invested  capital.  Partners  received  interest 
on  the  credit  balances  in  their  capital  accounts  and  were 
charged  interest  on  the  debit  balances  referred  to  above.*  The 
distinction  is  made  between  specific  advances  to  purchase  stock 
and  debit  balances  representing  withdrawals  of  capital. 

Page  141 
Invested  capital  of  partnerships. — The  Treasury  has  held 
that  debit  balances  of  partners  representing  moneys  advanced 
by  the  partnership  may  be  included  in  invested  capital.'  The 
ruling  is  somewhat  inconsistent  with  former  rulings.  Em- 
phasis is  placed  upon  the  fact  that  interest  was  charged  on 


*B.  39-21-1848;  A.  R.  R.  619. 
5B.  39-21-1848;  A.  R.  R.  619. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1587 

the  balances  and  that  the  securities  individually  purchased  and 
owned  by  the  partners  were  available  as  collateral. 

There  is  not  the  slightest  difference  between  large  debit 
and  credit  balances  and  one  account  with  a  net  balance.  Thus 
a  partner  has  a  credit  balance  of  $i,cx)0,ooo;  he  withdraws 
$500,000  and  invests  it  in  securities.  According  to  the  rulings 
the  partnership  would  have  $1,000,000  of  invested  capital 
if  it  kept  two  ledger  accounts,  and  $500,000  if  it  kept  one  ac- 
count! The  treatment  of  interest  is  similar;  crediting  interest 
on  $1,000,000  and  debiting  interest  on  $500,000  is  precisely 
the  same  as  one  calculation  of  interest  on  a  net  credit  balance. 
The  invested  capital  of  partnerships  in  191 7  depends  on 
facts — not  on  bookkeeping  methods. 


CHAPTER    VIII 

INVESTED     CAPITAL— ADJUSTMENT     OF     ASSET 

VALUES 

The  decision  of  the  Supreme  Court  in  La  Belle  Iron  Works 
V.  United  States-^  has  clarified  many  matters  relating  to  in- 
vested capital.  It  is  held  that  unrealized  appreciation  has 
no  place  in  invested  capital,"  cost  alone  being  admissible ;  how- 
ever, the  court  clearly  brought  out  the  fact  that  the  cost  (less 
adjustments  for  depreciation,  depletion,  etc.)  of  all  assets  in 
existence  on  January  i,  191 7,  should  be  included  in  invested 
capital  at  that  date. 

The  application  of  this  decision  to  specific  phases  of  the 
subject  is  brought  out  in  the  following  pages. 

Page   146   (footnote) 

Revaluation  at  January  i,    1914. — In    the    La    Belle   Iron 

Works  case,^  the  court  disallowed  appreciation  in  value  as  an 


Mi  Sup.  Ct.  528;  issued  as  T.  D.  3181. 

~  Except  when  January  i,   1914,  revaluations  are  provided   for. 

^41   Sup  Ct.  528. 


1588  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

element  in  invested  capital,  but  commented  at  some  length  upon 
the  exception  to  the  rule  found  in  the  191 7  law.  In  view  of 
previous  attempts  by  the  Treasury  to  restrict  the  scope  of  the 
section,  it  is  of  interest  to  note  that  the  court's  references  in- 
dicate that,  when  called  upon  to  interpret  section  207  (a)  of 
the  191 7  law,  the  intention  of  Congress  to  permit  the  inclusion 
of  appreciation  will  be  upheld.  The  cases  in  which  advantage 
of  the  section  can  be  taken  are  extremely  few,  but  when  a  case 
arises  it  should  receive  the  full  benefit  of  the  privilege. 

Appreciation  in  values  must  not  be  included. — The  La 
Belle  Iron  Works,  prior  to  1904,  acquired  a  tract  of  ore  lands 
for  $190,000.  Through  development  and  exploration  large 
bodies  of  ore  were  discovered,  and  by  19 12  the  ore  body  was 
valued  at  $10,105,400.  In  19 12  the  company  revalued  its 
property  on  its  books  and  declared  a  stock  dividend  of  $9,- 
915,400.  In  making  its  tax  return  for  1917  the  company  in- 
cluded the  19 12  revaluation  in  its  invested  capital.  The  Treas- 
ury disallowed  the  appreciation;  the  company  paid  an  addi- 
tional tax  and  then  brought  suit  for  refund.  The  lower  court 
decided  against  the  company,  and  the  Supreme  Court  affirmed 
the  decision  of  the  lower  court  on  May  16,  1921.* 

The  decision  is  voluminous,  but  does  not  require  extended 
comment.  The  court  refers  to  the  consideration  which  Con- 
gress gave  to  the  "value"  basis  for  invested  capital  and  the 
difficulties  and  possible  evasion  which  would  follow  if  inter- 
ested parties  were  permitted  to  use  their  own  estimates  of 
values.  The  court  comments  upon  the  final  adoption  of  the 
term  "invested  capital,"  and  places  peculiar  emphasis  upon  the 
word  "invested,"  which  it  holds  to  preclude  appreciation  or 
increment  in  value.  The  decision  greatly  strengthens  claims 
for  actual  values  paid  in.  This  point  is  commented  upon 
elsewhere.^ 

The  author  has  consistently  advised  taxpayers  that  appre- 


*4i  Sup.  Ct.  528. 
^  See  page  1609. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1589 

dated  values  cannot,  under  any  circumstances,  be  included  in 
invested  capital  until  realized,*'  nor  can  appraisals,  however 
scientifically  made,  increase  invested  capital  if  the  element  of 
unrealized  appreciation  is  in  any  way  included. 

The  difference  between  restoring  capital  items  improperly 
or  inadvertently  charged  off  prior  to  191 7,  and  including  ap- 
preciated values,  will  always  be  a  troublesome  point.  General 
rules  are  not  applicable.  Each  case  must  be  judged  according 
to  the  facts  which  a  careful  analysis  of  the  accounts  reveal. 

Where,  however,  it  can  be  shown  with  reasonable  assurance 
that  an  appraisal  value  does  not  contain  a  material  amount 
of  appreciation,  but  that  on  the  contrary  it  is  on  a  basis  sub- 
stantially of  cost  less  depreciation  actually  accrued,  the  author 
sees  no  objection  (nor  is  there  any  inhibition  against  it  in  the 
excess  profits  tax  laws)  to  using  such  an  appraisal  as  the  basis 
for  restoring  in  effect  capital  expenditures  which  were  absorbed 
in  operating  expenses  in  earlier  years. 

"Where  appraisals  were  made  prior  to  the  war  period,  or 
can  otherwise  be  shown  to  exclude  any  appreciation,  it  would 
appear  that  an  appraisal  may  in  some  cases  be  even  a  better  and 
more  effective  means  of  restoring  to  the  accounts  capital  ex- 
penditures previously  absorbed  in  operating  expenses,  than  the 
identifying  of  specific  expenditures  and  the  setting  up  of  theo- 
retical depreciation  thereon.  The  appraisal  has  the  advantage 
of  making  certain  that  the  plant  facilities  or  additions  repre- 
sented by  the  capital  expenditures  previously  written  off  are 
still  in  use;  also  the  depreciation  actually  sustained  or  accrued 
is  based  on  an  actual  survey  of  the  property. 

The  present  attitude  of  the  Treasury  regarding  appraisals 
is  shown  in  the  following: 

Ruling.  The  Committee  has  reconsidered  its  Recommendation 
490  (not  pubHshed)  in  the  matter  of  the  appeal  of  the  M  corporation 
from  the  action  of  the  Income  Tax  Unit  in  assessing  excess  profits 
taxes  for  the  year  1917  under  the  provisions  of  section  210  of  the 
Revenue  Act  of  1917  and  for  subsequent  years  under  the  provisions 
of  sections  327  and  328  of  the  Revenue  Act  of  1918. 


'^  Always  excepting  the  January  i,  1914,  provision. 


1590  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

In  a  memorandum  from  the  Unit  transmitting  this  case  to  the  Com- 
mittee the  following  statement  is  made : 

The  corporation  was  organized  in  1914  and  took  over  the  assets  and 
assumed  all  the  liabilities  of  two  going  concerns,  the  O  corporation  and  the 
P  partnership,  the  entire  capital  stock  of  the  new  corpraotion,  4x  dollars, 
issued  to  the  stockholders  of  the  old  corporation  and  the  members  of  the 
partnership.  The  evidence  submitted  in  the  form  of  various  appraisals 
shows  that  the  assets  acquired  had  a  valuation  far  in  excess  of  the 
capital  stock.  The  corporation,  however,  could  not  submit  any  data  show- 
ing the  cost  of  the  assets,  as  the  records  had  been  destroyed  by  water. 
In  January,  1921,  appraisals  of  the  different  classes  of  assets  were  made 
as  of  1914  by  different  individuals  assisted  by  others  who  were  employed 
by  the  corporation  in  1914.  In  the  conference  the  manager  of  the 
corporation  first  stated  the  method  used  in  determining  whether  the  assets 
listed  were  acquired  in  the  consolidation  in  1914  was  by  taking  an  appraisal 
made  in  1917  and  eliminating  therefrom  all  items  shown  by  the  books 
to  have  been  purchased  and  charged  to  the  asset  accounts  from  1914  to 
the  date  the  appraisal  was  made.  Later  he  stated  that  the  appraisal  was 
made  by  the  former  employees  going  through  the  department  and  listing 
the  assets  which  from  their  own  knowledge  were  acquired  in  the  con- 
solidation and  afterwards  comparing  these  items  with  the  appraisal 
made  in  1917. 

In  the  consideration  of  this  cast  it  is  necessary  to  refer  to  the 
provisions  of  the  Revenue  Act  of  1917  which  deals  with  tangible 
property  paid  in  for  stock.  The  pertinent  part  of  section  207  (a) 
reads  as  follows: 

....  (2)  the  actual  cash  value  of  tangible  property  paid  in  other 
than  cash,  for  stock  or  shares  in  such  corporation  or  partnership,  at  the 
time  of  such  payment  (but  in  case  such  tangible  property  was  paid  in  prior 
to  January  i,  1914,  the  actual  cash  value  of  such  property  as  of  January 
I,  1914,  but  in  no  case  to  exceed  the  par  value  of  the  original  stock  or 
shares  specifically  issued  therefor),  and  (3)  paid  in  or  earned  surplus  and 
undivided  profits  used  or  employed  in  the  business,  exclusive  of  undivided 
profits  earned  during  the  taxable  year 

Article  63,  Regulations  41,  interprets  the  foregoing  provisions  of 
the  statute  and  reads  as  follows : 

Where  it  can  be  shown  by  evidence  satisfactory  to  the  Commissioner 
of  Internal  Revenue  that  tangible  property  has  been  conveyed  to  a  corpora- 
tion or  partnership  by  gift  or  at  a  value,  accurately  ascertainable  or  definitely 
known  as  at  the  date  of  conveyance,  clearly  and  substantially  in  excess 
of  the  cash  or  the  par  value  of  the  stock  or  shares  paid  therefor,  then 
the  amount  of  the  excess  shall  be  deemed  to  be  paid-in  surplus.  The 
adopted  value  shall  not  cover  mmeral  deposits  or  other  properties  dis- 
covered or  developed  after  the  date  of  conveyance,  but  shall  be  confined 
to  the  value  accurately  ascertainable  or  definitely  known  at  that  time. 

Evidence  tending  to  support  a  claim  for  paid-in  surplus  under  these 
circumstances  must  be  as  of  the  date  of  conveyance,  and  may  consist,  among 
other  things,  of  (i)  an  appraisal  of  the  property  by  disinterested  author- 
ities, (2)  the  assessed  value  in  the  case  of  real  estate,  and  (3)  the 
market  price  in  excess  of  the  par  value  of  the  stock  or  shares. 

The  pertinent  part  of  the  Revenue  Act  of  1918  reads  as  follows: 

....   (2)    Actual   cash   value   of   tangible   property,  other   than   cash, 

bona  fide  paid  in  for  stock  or  shares,  at  the  time  of  such  payment,  but  in 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1591 

no  case  to  exceed  the  par  value  of  the  original  stock  or  shares  specifically 
issued  therefor ;  unless  the  actual  cash  value  of  such  tangible  property 
at  the  time  paid  in  is  shown  to  the  satisfaction  of  the  Commissioner  to 
have  been  clearly  and  substantially  in  excess  of  such  par  value,  in  vi^hich 
case  such  excess  shall  be  treated  as  paid-in  surplus 

Article  836,  Regulations  45,  interprets  the  foregoing  quoted  pro- 
vision of  the  statute  and  reads  in  part  as  follows : 

Evidence  ofifered  to  support  a  claim  for  a  paid-in  surplus  must  be  as  of 
the  date  of  the  payment,  and  may  consist  among  other  things  of  (a) 
an  appraisal  of  the  property  by  disinterested  authorities  made  on  or  about 
the  date  of  the  transaction;  (b)  certification  of  the  assessed  value  in  the 
case  of  real  estate;  and  (c)  proof  of  a  market  price  in  excess  of  the 
par  value  of  the  stock  or  shares.  The  additional  value  allowed  in  any 
case  is  confined  to  the  value  definitely  known  or  accurately  ascertainable 
at  the  time  of  the  payment 

The  records  in  the  case  show  that  for  several  years  prior  to 
1914  the  P  partnership  had  conducted  a  repair  business.  In  190-  a 
corporation  known  as  the  O  corporation  was  incorporated,  its  entire 
capital  stock  being  owned  by  the  P  partnership.  In  1914  this  corpora- 
tion and  the  P  partnership,  consisting  of  A,  B,  and  C,  were  con- 
solidated and  incorporated  under  the  name  of  the  M  corporation, 
with  a  capital  stock  issue  of  4X  dollars.  This  capitalization  was  nomi- 
nal and  was  not  based  on  any  valuation  of  either  plant,  as  it  was  not 
deemed  necessary  to  set  an  actual  value  on  the  asset  because  of  the 
fact  that  all  the  corporate  stock  was  held  by  the  three  members  of 
the  partnership.  During  the  lifetime  of  A  the  partnership's  account- 
ing system  was  very  lax  and,  as  shown  by  a  number  of  affidavits 
filed  in  behalf  of  the  M  corporation,  all  the  books,  balance  sheets,  and 
other  accounting  records  of  the  P  partnership  and  the  O  corporation 
were  rendered  useless  during  a  storm  in  1918,  so  that  at  the  present 
time  no  records  exist  from  which  might  be  obtained  a  complete  state- 
ment as  to  the  cost  of  the  assets  taken  over  by  the  M  corporation  in  the 
consolidation  of  1914.  Under  these  circumstances  the  Unit  holds 
that  the  statutory  invested  capital  of  the  corporation  can  not  be  satis- 
factorily determined,  and  proposes  to  make  assessment  of  excess 
profits  tax  under  the  provisions  of  section  210  of  the  Revenue  Act 
of  1917  and  section  328  of  the  Revenue  Act  of  1918.  The  corporation 
has  had  various  appraisals  and  estimates  made  in  an  effort  to  show 
the  value  of  the  assets  in  order  to  establish  a  claim  for  paid-in  sur- 
plus, which  appraisals  may  be  classed  as  follows : 

(i)  Two  appraisals  were  made  by  engineers  versed  in  the  par- 
ticular line  of  business  in  1917. 

Each  of  the  gentlemen  who  fixed  upon  the  values  shown  above 
was  undoubtedly  well  qualified  to  make  appraisals  covering  the  assets 
of  the  character  owned  by  the  M  corporation,  but  it  is  to  be  noted 
that  while  there  is  a  net  difference  of  but  2x  dollars  between  the  totals 
of  the  two  sets  of  figures  no  one  unit  was  given  the  same  value  except 


1592  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

in  the  case  of  automobiles,  etc.,  the  difference  in  the  values  given  the 
other  items  ranging  from  i/iox  dollars  in  the  case  of  office  furniture 
to  2^2^  dollars  in  the  case  of  other  property,  which  in  a  measure  in- 
dicates the  difficulties  experienced  in  fixing  upon  definite  values. 

(2)  Three  affidavits  as  to  the  value  of  the  property  taken  over 
by  the  M  corporation  were  submitted  by  persons  familiar  with  values 
of  such  property. 

Each  of  these  gentlemen  stated  in  his  affidavit  that  of  his  own 
knowledge  and  belief  the  plant  and  equipment  of  the  P  partnership 
in  1914  was  worth  6ox  dollars,  while  the  fair  value  in  1914  of  the 
plant  and  equipment  of  the  O  corporation  as  estimated  by  one  of 
them  was  241^1;  dollars  and  by  the  other  two  about  240.r  dollars,  al- 
though no  value  is  placed  upon  any  individual  assets. 

(3)  Three  affidavits  similar  to  the  next  above  made  give  a  value 
of  29i.r  dollars. 

(4)  A  composite  appraisal  made  in  1921 — assets  being  divided 
into  classes  and  itemized  and  each  class  appraised  by  men  particularly 
qualified  for  the  work,  showing  a  total  value  as  of  1914  of  304.1-  dol- 
lars. 

This  last  appraisal  was  taken  subsequent  to  a  conference  held 
in  1920  between  representatives  of  the  taxpayer  and  members  of  the 
Income  Tax  Unit,  during  which  the  former  were  advised  that  in  or- 
der to  establish  a  claim  for  paid-in  surplus  evidence  must  be  fur- 
nished showing  the  assets  taken  over  upon  consolidation,  the  cash 
value  of  the  assets  as  of  that  date,  the  cost  of  subsequent  additions 
by  years,  the  proportion  of  such  cost,  if  any,  which  had  been  included 
in  the  deductions  claimed  on  taxpayer's  returns,  and  the  assessed 
value  of  the  properties.  To  each  individual  appraisal  which  forms  a 
part  of  this  composite  appraisal  is  attached  an  affidavit  signed  by  the 
appraiser  indicating  the  character  of  the  work  performed  and  the 
experience  had  by  him  in  the  past  which  would  serve  to  qualify  him 
to  place  fair  and  just  values  on  the  particular  class  of  assets  covered 
by  his  appraisal,  but  the  appraisals  contain  little  or  no  evidence  of 
the  facts  upon  which  they  are  based  and  as  to  how  they  acquired 
their  information  or  data  to  make  up  the  appraisals,  or  as  to  how  the 
appraisals  were  constructed.  It  was  stated  during  a  conference 
granted  representatives  of  the  taxpayer  by  this  Committee  that  no 
assets  were  included  in  these  appraisals  except  such  as  were  positively 
known  to  have  been  in  the  possession  of  the  P  partnership  and  the  O 
corporation  and  taken  over  by  the  M  corporation  at  the  time  of  con- 
solidation except  an  item  of  "Hand  tools,"  etc.,  valued  at  4X  dollars, 
with  reference,  to  which  the  representatives  of  the  taxpayer  volun- 
teered the  information  that  such  item  was  a  mere  estimate.  No 
other  proof  is  submitted  to  show  how  it  was  known  that  nothing  was 
included  except  that  which  was  in  the  possession  of  the  company  in 
1914. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1593 

Accompanying  this  appraisal  are  statements  taken  from  the  books 
showing  the  amounts  expended  in  the  purchase  of  additional  assets 
during  the  years  1914-1919,  the  amount  of  depreciation  charged  off 
during  each  of  those  years,  and  a  summary  showing  the  adjusted 
values  of  all  lands,  buildings,  machinery,  and  equipment  for  the  years 
1914-1919  based  on  the  appraisal  made  as  of  January  i,  1914. 

As  shown  above,  the  appraisals  forming  the  first  set  were  taken 
in  1917  and  show  values  as  of  that  year.  The  affidavits  forming  the 
second  and  third  sets  contain  nothing  except  general  statements  to  the 
effect  that  in  the  opinion  of  the  affiants  the  assets  taken  over  upon 
consolidation  were  worth  certain  amounts  in  1914.  Neither  of  these 
appraisals  or  estimates,  therefore,  can  be  said  to  be  of  such  a  satis- 
factory and  convincing  character  as  to  justify  the  acceptance  of  the 
values  therein  stated  for  invested  capital  purposes  in  the  computation 
of  excess  profits  tax  liability  without  further  investigation  by  the 
Unit  to  ascertain  whether  such  values  were  computed  upon  the  basis 
outlined   herein. 

The  representatives  of  the  taxpayer  have  stated  to  the  Commit- 
tee that  their  whole  objection  to  assessment  under  the  provisions  of 
sections  210  and  328  of  the  Revenue  Acts  of  1917  and  1918,  respec- 
tively, is  on  the  ground  that  such  a  method  of  assessment  affords  no 
stable  basis  from  year  to  year  for  a  determination  of  the  corporation's 
tax  liability,  for  which  reason  they  desire  that  the  corporation  be 
classed  as  one  having  a  determinable  statutory  invested  capital  rather 
than  as  one  entitled  to  relief  under  the  provisions  of  the  said  sections 
even  though  its  tax  liability  be  greater  under  the  first  method  than 
under  the  latter. 

The  values  as  stated  in  the  four  sets  of  appraisals  mentioned 
above  were  apparently  fixed  by  men  who  were  well  qualified  for  the 
work,  but  a  different  value  is  stated  in  each  appraisal,  which  indicates 
the  difficulties  experienced  in  carrying  out  such  a  task  and  the  practi- 
cal difficulty  in  establishing  cost.  The  first  appraisal  being  taken  at 
1917  values,  and  the  affidavits  comprising  the  second  and  third  ap- 
praisals, so  called,  being  nothing  more  than  general  statements,  can 
not  be  accepted. 

The  fourth  appraisal,  while  stated  in  detail,  shows  in  some  cases 
approximations  and  not  actual  ascertainment  of  values.  That  part 
of  this  appraisal  which  covers  fire  protection  system,  plumbing  and 
piping,  indicates  that  the  great  majority  of  the  items  so  covered  was 
approximated,  while  that  part  which  covers  certain  other  property 
indicates  that  the  quantity  of  material  entering  into  the  construction 
of  such  assets  has  been  approximated.  Errors  in  stated  figures  which 
affect  the  total  value  shown  have  also  been  made.  While  many  of 
the  assets  covered  by  this  appraisal  are  of  such  character  and  size, 
such  as  lands,  large  machines,  etc.,  as  to  be  easily  identified  as  having 
been  among  the  assets  transferred,  even  after  a  lapse  of  years,  by 


k 


1594  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

those  who  had  worked  with,  around,  and  among  them,  and  their 
value  as  of  time  of  transfer  more  or  less  satisfactorily  established, 
yet  it  is  to  be  noted  that  this  appraisal  covers  hundreds  of  very 
minor  items  which,  because  of  their  lack  of  size,  importance,  and 
cost,  ranging  in  stated  figures  from  a  few  cents  to  not  more  than  $50, 
lack  distinctive  character,  and  the  Committee  finds  it  hard  to  believe 
that  such  assets  would  so  firmly  fix  themselves  in  the  remembrance 
of  any  man  or  men  as  to  permit  such  persons  to  positively  identify 
them  in  192 1  as  having  been  the  identical  articles  which  were  in  the 
hands  of  the  P  partnership  and  the  O  corporation  and  transferred  to 
the  M  corporation  in  1914,  especially  when  it  is  known  that  many  of 
such  items  were  removed  from  a  plant  and  reinstated  and  rearranged 
in  new  buildings  in  another  community.  It  is  also  shown  by  an  ap- 
praisal made  in  19 17,  by  competent  men,  and  before  the  loss  of  the 
book  records,  that  the  value  of  the  assets  at  that  time  was  a  little  less 
than  240.V  dollars  and  there  is  nothing  to  show  why  the  assets  were 
worth  approximately  6o.v  dollars  more  in  1914  than  in  1917. 

It  was  stated  in  conference  that  since  the  consolidation  in  1914 
accurate  book  records  have  been  kept  from  which  it  is  possible  to 
accurately  determine  just  what  additions  to  the  plant  had  been  made 
in  order  that  the  appraisals  as  of  1914  might  contain  nothing  ac- 
quired since  consolidation,  and  yet,  in  a  statement  filed  with  the  Unit, 
the  cost  of  such  additions  made  during  the  year  191 7  was  stated  as 
i%x  dollars,  while  in  a  later  statement  such  cost  is  stated  as  i  i/6x 
dollars,  which  fact  throws  doubt  upon  the  accuracy  of  such  book 
records  as  have  been  kept.  In  the  said  appraisal  the  value  of  all  flat 
lands,  regardless  of  location  or  character,  is  stated  at  a  certain  amount 
per  square  foot,  but  no  statements  have  been  submitted  showing  the 
values  placed  thereon  for  local  tax  purposes. 

In  the  consideration  of  the  case  the  Committee  has  pointed  out 
certain  discrepancies  in  the  appraisals  which  it  is  sought  to  have  the 
Income  Tax  Unit  accept  as  a  basis  for  the  allowance  of  a  paid-in 
surplus.  These  discrepancies  raise  a  doubt  as  to  the  accuracy  of  the 
figures  submitted  in  such  appraisals  and  of  the  facts  upon  which  such 
appraisals  are  based.  The  appraisals  in  question  are  apparently  based 
upon  the  opinions  of  persons  qualified  to  testify  in  a  matter  of  this 
kind,  but  it  does  not  appear  that  the  inventory  of  the  assets  of  this 
corporation,  as  enumerated  in  the  appraisals,  has  been  valued  upon  a 
cost  basis.  It  is  thought  possible  to  so  value  the  assets  in  this  case 
when  the  appraisals  have  been  modified  in  accordance  with  the  method 
hereinafter  outlined  and  to  this  end  the  Unit  should  make  or  have 
made  an  independent  appraisal  for  the  purpose  of  verifying  or  check- 
ing the  amounts  and  values  stated  in  the  appraisals  submitted  by  this 
company  before  accepting  same  as  representing  sound  values  of  the 
assets  at  the  time  they  were  paid  in  to  the  corporation  in  1914. 

In  the  past   it  has  been  the  policy  of  the   Bureau  to  construe 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  7595 

strictly  llic  requireuieiits  of  article  63,  Regulations  41,  and  article 
836,  Regulations  45  (1920  edition).  As  a  result  of  such  construction 
of  these  articles  numerous  retroactive  or  retrospective  appraisals 
have  been  rejected  as  a  basis  for  a  claim  for  paid-in  surplus.  The 
Committee  has  made  an  exhaustive  study  of  appraisals  and  their  re- 
lation to  invested  capital  of  corporations.  It  has  also  considered  ap- 
praisals in  connection  with  establishing  March  i  values  for  purposes 
of  depreciation  and  depletion,  and  for  purposes  of  establishing  certain 
values  in  connection  with  amortization  claims,  and  has  reached  the 
conclusion  that  the  Unit  has  been  too  strict  in  interpreting  the  pro- 
visions of  the  statute  and  the  articles  of  regulations  interpreting  same 
quoted  above,  and  that  retrospective  appraisals,  if  made  upon  the 
basis  hereinafter  outlined  and  proof  is  furnished  of  the  facts  upon 
which  they  are  based,  may  properly  be  accepted  as  a  basis  for  the  al- 
lowance of  a  paid-in  surplus.  The  Unit,  as  well  as  the  Committee,  is 
continually  fixing  values  for  one  purpose  or  another.  This  is  par- 
ticularly true  in  fixing  the  March  i  values  for  the  purpose  of  com- 
puting gain  or  loss  upon  the  sale  of  an  asset  which  has  been  held 
for  some  time  and  which  is  of  a  class  not  regularly  dealt  in  by  the 
public. 

In  the  instant  case  it  is  not  only  necessary  to  determine  the  actual 
cash  value  of  the  tangible  assets  at  the  time  paid  in  in  1914  for  the 
purpose  of  invested  capital,  but  it  is  necessary  to  determine  the  fair 
market  value  of  the  depreciable  property  so  paid  in  as  at  March  i, 
1913,  for  depreciation  purposes  and  also  for  the  purpose  of  ascertain- 
ing whether  or  not  the  stockholders  in  the  O  corporation  and  the 
partners  in  the  P  partnership  derived  any  profit  from  the  sale  of  these 
assets  to  the  M  corporation.  It  is  understood  that  the  stockholders  and 
copartners  did  not  include  any  profit  in  the  computation  of  their  net 
income  for  the  year  1914. 

In  making  a  retroactive  or  retrospective  appraisal  to  show  the 
actual  cash  value  of  tangible  assets  at  the  time  paid  in  at  some  date  in 
the  past,  care  should  be  exercised  in  order  to  eliminate  any  apprecia- 
tion written  upon  the  books  of  the  corporation  since  the  date  of  ac- 
quisition, and  also  to  value  the  assets  in  question  at  cost.  In  the  case 
of  the  La  Belle  Iron  Works  v.  United  States  (C.  B.  4,  page  373),  de- 
cided by  the  Supreme  Court  on  May  16,  1921,  it  was  held  that  any 
appreciation  in  value  of  property  over  its  cost  is  not  to  be  included 
in  invested  capital  as  paid-in  surplus.  Treasury  Decision  3220  (Bul- 
letin 37-21-1822)  was  promulgated  subsequent  to  this  decision  and 
requires  the  filing  of  amended  returns  in  all  cases  where  taxpayers 
have  written  appreciated  or  inflated  values  upon  their  books  and 
have  used  same  in  determining  the  amount  of  their  invested  capital. 
It  would,  therefore,  appear  that  no  appreciation  over  cost  can  be 
recognized  in  the  computation  of  invested  capital  and  that  appraisals 
made   for  the   purpose  of  establishing  invested  capital   and   for   the 


1596  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

purpose  of  allowance  of  a  paid-in  surplus  should  be  based  upon  the 
actual  cost  of  the  tangible  properties  as  they  existed  at  the  time  they 
were  paid  in,  giving  particular  attention  and  consideration  to  the  origi- 
nal cost  and  depreciated  reproduction  cost  as  at  the  basic  date  and  the 
remaining  expectancy  of  life.  In  order  to  accomplish  this  result  it 
will  be  necessary  to  inventory  at  cost  as  of  the  basic  date  (the  date 
of  acquisition)  the  property  then  on  hand  and  in  many  cases  to  es- 
tablish by  historical  investigation  the  date  of  original  acquisition, 
date  of  renewal,  and  the  cost  of  additions  made  subsequent  to  the  date 
the  property  was  paid  in.  Adjustments  should  be  made  for  property 
scrapped  or  discarded  and  for  depreciation. 

The  books  of  account,  if  available,  should  be  considered  the  best 
evidence  as  to  dates  of  acquisition  and  actual  cost.  The  asset  ac- 
count showing  the  tangible  property  may  be  incomplete  for  many 
reasons  and  may  include  property  still  on  the  books  that  has  been  dis- 
carded as  well  as  property  in  existence  that  has  never  been  capitalized 
or  entered  on  the  books  and  certain  arbitrary  amounts  charged  oft 
as  depreciation  which  have  no  relation  to  the  expired  and  remaining 
life  of  the  propertj^ 

The  tangible  property  actually  in  existence  and  in  use  should  be 
considered  as  the  basic  evidence  of  the  invested  capital  in  existence 
and  should  be  used  as  a  basis  for  the  proper  correction  of  the  ac- 
counts to  correctly  reflect  the  actual  investment  in  the  depreciable 
properties  in  existence  during  the  taxable  years. 

The  burden  of  proof  is  upon  the  taxpayer  when  a  claim  for  a 
paid-in  surplus  is  made,  and  in  so  far  as  the  records  of  the  taxpayer 
may  be  incomplete  or  the  regulations  permit  values  of  the  property 
at  the  date  paid  in  should  be  established  by  proof.  The  regulations 
quoted  above  do  not  prescribe  any  specific  method  for  ascertaining 
the  facts,  but  only  indicate  some  of  the  means  by  which  appropriate 
proof  may  be  furnished  which  would  be  acceptable  to  the  Bureau.  A 
retrospective  appraisal  is  in  substance  the  opinion  of  experts  based 
upon  the  facts  presented  to  them  and  as  such  is  admissible  as  evi- 
dence of  a  paid-in  surplus,  but  its  value  as  proof  of  a  paid-in  surplus 
must  depend  upon  the  truth  of  the  facts  upon  which  it  is  based. 
Necessarily,  if  any  of  the  facts  presented  to  the  experts  are  not  ac- 
curate, the  experts'  opinion  is  inaccurate  to  the  extent  that  such  facts 
are  inaccurate.  In  order,  therefore,  for  the  Bureau  to  accept  as  con- 
clusive a  retrospective  appraisal,  it  must  be  satisfied  under  the  regu- 
lations that  the  facts  upon  which  the  appraisal  is  based  are  true.  In 
determining  whether  or  not  the  facts  are  true  the  Bureau  should  ac- 
cept such  proof  of  the  facts  as  is  ordinarily  accepted  in  business 
transactions  of  like  character.  In  all  such  inquiries  the  Bureau  is 
dealing  with  facts  which  themselves  come  within  the  control  of  human 
will  or  human  caprice,  and  the  evidence  for  which  depends  on  the 
trustworthiness   of    human    informants.      Such    evidence    may    range 


EXCESS  PROFITS  TAX  PROCEDURE--1921  1597. 

through  every  degree,  from  the  barest  likelihood  to  that  undoubted 
moral  certainty  on  which  every  man  acts  without  hesitation  in  prac- 
tical affairs.  The  Bureau  must  receive  and  consider  such  appraisals, 
therefore,  with  a  sound  and  intelligent  discretion  as  it  considers 
much  other  evidence,  and  be  content  to  accept  them,  without  being 
able  to  prove  their  accuracy  as  mathematicians  judge  accuracy,  if 
they  convince  the  mind  of  their  correctness  to  that  moral  certainty 
upon  which  practical   men  of  affairs   act. 

In  view  of  the  foregoing,  it  is  recpmmended  that  the  action  of  the 
Income  Tax  Unit  in  holding  that  the  invested  capital  can  not  be 
satisfactorily  established  and  that  assessment  of  excess  profit  taxes 
for  the  year  191 7  should  be  made  under  the  provisions  of  section 
210  of  the  Revenue  Act  of  1917  and  for  the  subsequent  years  under 
the  provisions  of  sections  327  and  328  of  the  Revenue  Act  of  1918 
be  reversed;  that  Committee  on  Appeals  and  Review  Recommendation 
490  sustaining  the  action  of  the  Unit  be  revoked;  that  retrospective 
appraisals  be  accepted  as  evidence  of  paid-in  surplus  when  made 
upon  the  basis  herein  outlined  and  the  facts  upon  which  the  ap- 
praisals are  based  have  been  established  by  proof ;  that  the  retrospec- 
tive appraisals  and  the  facts  upon  which  they  are  based  in  the  instant 
case  be  verified  to  determine  the  method  of  their  construction  and 
the  truth  of  the  facts  upon  which  they  are  based ;  and  that  in  this 
and  in  all  similar  cases  where  the  law  directs  that  the  value  of  prop- 
erty at  a  given  basic  date  be  ascertained,  the  Unit  be  instructed  to 
receive  such  proof  of  the  facts  as  is  ordinarily  accepted  in  important 
business  transactions  of  like  character  and  that  the  practice  which 
has  obtained  in  the  Unit  in  refusing  to  receive  such  proof  on  the 
ground  that  it  consisted  of  so-called  retroactive  appraisals  be  dis- 
continued.    (I-5-60;  A.  R.  R.  747.) 

Page  152 
Salaries  waived  by  officers  of  corporation  constitute  paid-in 
surplus. — 

Ruling.  The  return  of  a  corporation  for  the  j^ear  1920  showed 
a  deficit  of  2jr  dollars.  One  of  the  liabilities  of  the  corporation  was  a 
valid  obligation  to  pay  its  three  officers  salaries  amounting  to  t,x 
dollars.  The  officers  waived  their  right  to  these  salaries  and  in 
January,  192 1,  the  corporation  credited  its  surplus  account  in  the 
amount  of  ^x  dollars. 

Held,  that  the  amount  of  the  salaries,  the  right  to  which  was 
waived,  is  paid-in  surplus  and  not  income  of  the  corporation  for  the 
year  1920.    (B.  Digest  37-21-1821;  O.  D.  1034.) 

Cancellation  by  stockholders  of  claims  owing  to  them. — 

Ruling.  The  original  paid-in  capital  of  a  corporation  is  un- 
changed by  an  operating  deficit,  and  the  cancellation  by  stockholders 


1598  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

of  claims  owing  to  such  stockholders  resulted  in  effect  in  an  additional 
contribution  to  the  corporation's  capital  account  which  assumed  for  the 
purposes  of  invested  capital  the  nature  of  paid-in  surplus.  This  is 
true  regardless  of  any  transfers  of  stock  as  between  the  stockholders 
which  may  or  may  not  have  been  a  consideration  moving  to  the  cancel- 
lation of  the  claims.     (B.  47-21-1936;  A.  R.  R.  678.) 

Property  acquired  by  merger  must  be  valued  at  cost. — 

Ruling.  The  M  Company  was  organized  subsequent  to  1919. 
Soon  thereafter  it  acquired  all  the  capital  stock  of  the  N  Company 
by  issuing  to  the  stockholders  of  the  N  Company  its  own  stock  in  an 
amount  equal  to  the  par  value  of  their  shares  of  stock.  The  M 
Company  thereupon  by  merger  absorbed  the  N  Company  and  became 
the  owner  of  all  the  property  of  the  N  Company,  which  consisted  of 
real  estate,  buildings,  machinery  and  equipment,  stock  on  hand,  and 
work  in  process.  This  property  had  been  purchased  by  the  N  Com- 
pany in  the  same  year  at  a  bargain,  as  shown  by  an  appraisal  made 
of  the  property  about  the  time  it  was  taken  over  by  the  M  Company. 

Held,  that  the  company  could  not  include  in  its  invested  capital 
as  paid-in  surplus  the  excess  of  the  value  of  the  property  over  the  pur- 
chase price  paid  therefor.  Any  excess  resulted  from  a  successful  bar- 
gain and  is  not  paid-in  surplus.  Paid-in  surplus  as  used  in  section  326 
of  the  Revenue  Act  of  1918  does  not  mean  the  excess  value  of  property 
purchased  in  a  bona  fide  sale  over  the  purchase  price  thereof.  To 
constitute  paid-in  surplus  of  a  corporation  there  must,  in  effect,  be  a 
gift  to  the  corporation.     (C.  B.  4,  page  384;  O.  D.  813.) 

The  above  ruling  is  sound  unless  the  stockholders  of  M  and 
N  companies  were  to  a  substantial  degree  the  same.  In  such 
case  the  element  of  gift  would  be  present. 

Paid-in  surplus. — The  decision  of  the  United  States  Su- 
preme Court  in  the  La  Belle  Iron  Works  case'  greatly 
strengthens  the  position  of  taxpayers  who  legitimately  claim 
that  at  the  date  of  acquisition  assets  were  undervalued.  The 
claim  of  the  La  Belle  Iron  Works  Company  was  rejected  be- 
cause it  was  conceded  that  the  appreciation  in  value  arose  after 
the  acquisition  of  the  property.  The  company  was  allowed 
the  full  value  of  the  capital  which  it  "invested" ;  subsequent 
increments  in  value  were  disallowed.     When  values  existed  at 

'41  Sup.  Ct.  528. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1599 

the  time  property  was  paid  in,  the  Supreme  Court  held  that 
Congress  intended  that  full  effect  must  be  given  to  such  values, 
even  though,  at  the  time,  the  values  in  excess  of  the  par  value 
of  the  stock  were  not  set  up  on  the  books. 

In  specific  language  the  Supreme  Court  holds  that  the 
definition  of  invested  capital  in  the  laws  contemplates  the  in- 
clusion of  "what  actually  was  embarked  at  the  outset  or  added 
thereafter,  disregarding  any  appreciation  in  values." 

The  court,  in  defining  the  word  "invested,"  discussed  the 
two  major  elements  which  must  be  present  and  added,  "in 
either  case  involving  a  conversion  of  wealth  from  one  form 
into  another  suitable  for  employment  in  the  making  of  the 
hoped-for  gains." 

Pago  156 
When  contracts  constitute  paid-in  surplus. — 

Ruling.  Paid-in  surplus  must  consist  of  tangible  property  trans- 
ferred to  the  corporation,  either  as  a  gift  or  at  a  value  which  is  less 
than  its  actual  cash  value;  and  in  practically  all  cases  where  allow- 
able, involves  no  substantial  change  of  beneficial  interest. 

Contracts  which  are  regarded  as  tangible  assets  can  only  con- 
stitute paid-in  surplus  when  such  contracts  are  made  between  outside 
parties,  and  the  rights  of  either  of  such  parties  are  transferred  to 
the  corporation  without  adequate  compensation.  Contracts  to  which 
the  corporation  itself  is  a  party  may  not  be  so  included.  (C.  B.  3, 
page  347;  A.  R.  R.  233.) 

Amended  returns  resulting  from  increase  in  book  values 
of  assets. — 

Ruling.  Where  a  corporation  claims  as  an  addition  to  its  in- 
vested capital  for  1917  and  subsequent  years  the  excess  of  the  value 
of  its  patterns  over  the  value  at  which  they  have  been  carried  on  its 
books,  and  such  claim  comes  within  the  provisions  of  articles  840 
(2)  and  841  (i)  of  Regulations  45,  amended  returns  may  be  filed 
for  each  year  for  which  an  erroneous  return  has  been  made  both 
before  and  after  March  i,  1913.  Any  overpayment  of  taxes  for  the 
years  1917  to  1920  shown  on  the  basis  of  the  amended  returns  may 
be  made  the  subject  of  a  claim  for  refund.  (C.  B.  4,  page  391; 
O.  D.  901.) 


i6oo  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

Page  162 
Reduction  of  surplus  because  of  alleged  failure  to  charge 
off  sufficient  depreciation.— In  the  192 1  edition  of  Excess 
Profits  Tax  Procedure,  the  author  questioned  the  growing 
practice  of  revenue  agents  of  going  back  (sometimes  fifty 
years)  and  restating  plant  accounts  "with  a  result  on  Januar)'^ 
I,  19 1 7,  which  is  absurd."  The  further  statement  was  made 
that  the  burden  of  proof  was  not  on  taxpayers  to  establish  the 
propriety  of  the  January  i,  191 7,  book  values  of  plant  assets. 
The  author's  contentions  have  been  fully  recognized  in  the 
following  rulings. 

Ruling.  The  Committee  is  in  receipt  of  a  request  for  advice 
relative  to  the  practice  of  field  agents  in  reducing  earned  surplus  by 
deductions  for  depreciation  where  none  have  been  claimed  in  the 
past,  or  where  a  lower  rate  has  been  claimed  than  is  ordinarily  al- 
lowable with  respect  to  the  depreciable  assets  in  question. 

It  is  the  judgment  of  the  Committee  that  there  is  no  warrant  for 
reducing   earned   surplus  because   of    alleged    failure   to   charge   off 
sufficient  depreciation  in  the  past,  unless  the  depreciable  assets  of 
the  corporation   are   valued  on   its  books   at   the   beginning   of  the 
taxable  year  at  an  amount  in  excess  of  their  actual  value  at  that 
time.     This  is  particularly  true  where  the  corporation  in  prior  years 
earned  positive  income  from  which  larger  deductions  for  deprecia- 
tion  might   have   been   taken,   if   in   the  opinion   of   the   officers   and 
directors  of  the  corporation  such  larger  charges  had  been  justified. 
Nothing  herein   is   to   be   construed   as   precluding  the   Income   Tax 
Unit  from  adjusting  depreciation,  either  by  way  of  increase  or  de- 
crease, where  there  is  at  hand  affirmative  evidence  that  as  at  the  be- 
ginning of  a  taxable  year  the  amount  of  depreciation  written  off  in 
prior  years  was  insufficient  or  excessive.     The  correct  attitude  of  the 
Bureau    and   the   proper    conduct   of   its    field    agents,    in   particular, 
are  plainly  set  forth  in  that  part  of  Art.  839  of  Reg.  45,  which  reads: 
"Adjustments  in  respect  of  depreciation  or  depletion  in 
prior  years  will  be  made  or  permitted  only  upon  the  basis 
of  affirmative  evidence  that  as  at  the  beginning  of  the  taxable 
year  the  amount  of  depreciation  or  depletion  written  off  in 
prior  years  was  insufficient  or  excessive,  as  the  case  may  be." 
(C.  B.  4,  page  390;  A.  R.  M.  106,  dated  February  26,  1921.) 

This  very  important  memorandum  was  followed  by  an 
almost  equally  important  statement  defining  "actual  value"  and 
explaining  very  specifically  how   depreciation  shown  on  the 


I 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1601 

books  is  to  be  compared  with  the  actual  assets.    The  text  of  the 
memorandum  is  as  follows : 

Ruling.  Specific  inquiry  lias  been  made  as  to  the  meaning  of 
the  words  "actual  value"  as  used  in  Committee  on  Appeals  and 
Review  memorandum  No.  106.  For  the  purposes  of  taxation  de- 
preciation is  based  upon  cost.  Accordingly,  the  words  "actual  value'' 
mean  "sound  value",  which  is  "original  cost"  (or  value  as  of  March 
I,  1913,  if  applicable),  including  additions  and  betterments  charged 
to  capital  account,  less  depreciation  sustained. 

Article  161,  Regulations  45  (1920  edition)  defines  the  proper 
allowance  for  depreciation  as  "that  amount  which  should  be  set 
aside  for  the  taxable  year  in  accordance  with  a  consistent  plan  by 
which  the  aggregate  of  such  amounts  for  the  useful  life  of  the 
property  in  the  business  will  suffice,  with  the  salvage  value,  at  the 
end  of  such  useful  life  to  provide  in  place  of  the  property  its  cost, 
or  its  value  as  of  March  i,  1913,  if  acquired  by  the  taxpayer  before 
that  date." 

It  follows  from  this  definition  that  any  action  on  the  part  of  a 
particular  taxpayer  which  extends  the  useful  life  of  a  depreciable 
asset  beyond  the  normal  or  usual  terln,  and  any  circumstance  which 
serves  to  increase  the  salvage  value  of  a  depreciable  asset,  operates 
to  justify  a  reduction  in  the  normal  rate  of  depreciation.  The  de- 
preciation of  an  asset  is  arrested  where  it  is  maintained  at  a  high 
standard  of  efficiency  either  by  the  exercise  of  unusual  care  in  its 
use  or  by  unusual  maintenance  expenditures. 

Invested  capital,  as  defined  in  the  Excess  Profits  Tax  Law,  is  a 
statutory  concept  and  is  composed  of  two  elements:  (a)  original 
contribution,  and  (b)  earnings  of  the  corporation  available  for  dis- 
tribution but  not  distributed  and  not  dissipated  by  subsequent  oper- 
ating losses.  The  exhaustion  of  this  capital  through  use,  wear  and 
tear  has,  for  the  purpose  of  computing  invested  capital,  the  same 
effect  as  an  operating  loss  and  unless  this  loss  is  properly  taken  care 
of  out  of  earnings  in  one  way  or  another,  earned  surplus  must  be 
adjusted  in  accordance  with  the  provisions  of  the  regulations.  There 
are  two  ways  of  taking  care  of  this  loss  out  of  income.  One  is  by 
charging  ordinary  repairs  directly  to  expense  and  setting  up  a  de- 
preciation reserve  against  which  are  properly  chargeable  all  re- 
newals and  replacements ;  the  other  is  where  renewals  and  replace- 
ments, as  well  as  repairs,  have  been  charged  directly  against  gross 
income.  Either  way  has  the  effect  of  reducing  the  amount  added 
during  the  year  to  earned  surplus.  Consequently,  the  mere  fact  that 
no  depreciation,  or  a  minimum  depreciation,  has  been  charged  as 
such,  is  not  sufficient  reason  for  reducing  the  earned  surplus,  where 
renewals  and  replacements  sufficient  to  care  for  the  decrease  in 
value   of   capital    assets   have   been   charged   directly   to   expense,   or 


l602 


EXCESS  PROFITS  TAX  PROCEDURE— 1921 


where  for  any  of  the  other  reasons  hereinbefore  suggested  less  than 
the  normal  rate  of  depreciation  is  properly  chargeable.  When  a  tax- 
payer makes  this  claim  there  are  two  methods  of  verifying  it.  One 
is  by  determining  the  plant  efficiency  and  the  other  is  by  determining 
the  value  of  the  capital  assets  remaining.  From  an  administrative 
standpoint  the  latter  is  probably  move  practical  even  though  it  may 
be  said  that  the  former  is  more  accurate. 

Many  cases  have  been  l^rought  to  the  attention  of  the  Committee 
where    corporations   have    been    in    existence    for    a    long   period    o 
years,   some   of   which   corporations   have   been   in   existence   severai 
times  the  ordinary  estimated  life  of  the  depreciable  assets,  and  yei 
those  assets  are  today  in  first-class  condition  and  worth  the  figur 
at   which   they  are  carried  on   the  books,   although   no   depreciatio 
has  been  charged  as  such  and  no  additions  to  capital  account  have 
been  made.     In  such  cases  it  is  obvious  that  depreciation  has  been 
adequately  cared  for  by  charges  to  expense,   although   it  frequentlyj 
happens  that  it  is  impossible  at  this  late  date  to  segregate  and  specif 
such    charges   and   there   is   no   warrant   in   the   law   or   the   regula 
tions  for  requiring  the  depreciable  assets  in  such  cases  to  be  writte 
down  below  the  figure  at  which  they  are  carried  on  the  books,  sine 
to  do  so  is  to  reduce  earned  surplus  twice,  once  through  the  origina! 
charge  to  expense  (whether  proper  or  improper),  and  again  througl 
an   arbitrary  depreciation  charge  required  by  the   Bureau  to  be   se 
up   against   earned    surplus    for   the   purpose   of   computing    investe 
capital. 

The  controlling  rule  in  this  matter  is  found  in  that  part  of  Articl 
839  of  Regulations  45,  which  reads:  "Adjustments  in  respect  of  de 
preciation  or  depletion  in  prior  years  will  be  made  or  permitted  onl 
upon  the  basis  of  affirmative  evidence  that  as  at  the  beginning  o 
the  taxable  year  the  amount  of  depreciation  or  depletion  written  o 
in  prior  years  was  insufficient  or  excessive,  as  the  case  may  be.' 
Mere  fail-lire  in  prior  years  to  have  zvritten  off  on  the  book's  th 
tnaxinnitn  or  ordinary  rate  of  depreciation,  is  not  in  itself  "affinnativ 
evidence."  There  is  no  warrant  for  reducing  earned  surplus  becaus' 
of  alleged  failure  to  charge  off  sufficient  depreciation  in  the  pa.^t 
unless  the  depreciable  assets  of  the  corporation  are  valued  on  it 
books  at  the  beginning  of  the  taxable  year  at  an  amount  in  exces 
of  their  sound  value  at  that  time.     (B.  30-21-1748.) 

This  meniorandum  explanatory  of  A.  R.  M.  106  was  fol- 
lowed by  an  office  decision,  signed  by  Commissioner  David  H^ 
Blair,  reading  as  follows : 

Ruling.  Reference  is  made  to  Committee  on  Appeals  anc 
Review  Memorandum  106  (C.  B.  4,  p.  390)  and  explanatory  mem-i 
orandum  of  the  Committee  dated  July  6,   1021    (Bui.  30-21-1748.) 


i 


EXCESS  PROFJTS  TAX  PROCEDURE— 1921  1603 

'J"he  attention  of  the  Commissioner's  office  has  been  called  to  the 
fact  that  article  839  of  Regulations  45  as  interpreted  by  Committee 
Memorandum  106  and  the  memorandum  of  July  6th  has  not  been 
properly  followed. 

When  the  Regulation  (art.  839  of  Reg.  45)  was  being  drafted 
it  was  the  intention  of  the  draftsmen  that  a  corporate  surplus  ac- 
count was  not  to  l)e  disturbed  lightly  and  that  no  change  should  be 
made  in  it  either  by  the  Government  or  by  the  taxpayer  except  upon 
adequate  evidence  that  the  surplus  account  was  incorrect.  It  was 
the  view  of  the  draftsmen  that  unless  the  taxpayer  could  show  a 
state  of  error  the  Government  should  deny  a  claim  for  an  increase 
in  the  surplus  shown  by  the  taxpayer's  books ;  conversely,  before  a 
deduction  could  be  made  from  the  taxpayer's  surplus  account,  the 
Government  must  show  that  such  an  adjustment  is  necessary  to 
correct  the  account.  The  view  was  also  held  that  such  proof  must 
be  in  the  form  of  affirmative  evidence ;  that  it  could  not  rest  upon 
mere  assertion  or  the  working  out  of  the  theoretical  formula. 

It  is  my  opinion  that  no  doubt  ever  should  have  existed  as  to  the 
correct  interpretation  of  article  839.  A  taxpayer's  corporate  sur- 
plus should  not  be  reduced  by  the  arbitrary  adjustment  of  deprecia- 
tion and  depletion  for  past  years.  Surplus  accounts  should,  however, 
always  be  carefully  scrutinized  and  checked  up  for  the  purpose  of 
preventing  the  inclusion  therein  of  appreciated  values  of  property 
In  case  of  doubt  in  such  case  the  burden  should  be  cast  upon  the 
taxpayer  to  prove  that  no  appreciated  values  were  included  in  the 
surplus.  A  presuinption  should  always  exist  that  a  taxpayer's  books 
of  account  reflect  actual  facts.  The  burden  of  proof  is  upon  any 
one  who  attempts  to  impugn  the  correctness  of  the  books  of  account — 
upon  the  Government  if  it  seeks  to  reduce  its  surplus  account  by 
charging  off  depreciation  and  depletion  which  have  not  been  claimed 
by  the  taxpayer  and  upon  the  taxpayer  where  he  claims  that  too  much 
depreciation  and  depletion  have  been  charged  off  in  prior  years. 
(B.  46-21-1926;  O.  D.  1 104.) 

The  practical  value  to  taxpayers  of  A.  R.  M.  106  was 
much  reduced  by  the  decision  of  the  Supreme  Court  in  the 
La  13 die  Iron  Works  case."*  In  that  decision  the  right  of 
taxpayers  to  include  in  invested  capital  at  January  i,  19 17, 
the  cost  (less  actual  depreciation  to  date)  of  all  assets  on  hand 
at  that  date  was  definitely  established.  Whether  such  is  per- 
mitted by  A.  R.  M.  106  is  more  or  less  irrelevant. 

'41  Sup.  Ct.  528. 


l6o4  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

All  insistence  on  its  rights  as  to  the  inclusion  in  invested 
capital  as  at  Januan-  i.  191 7,  of  the  cost  of  all  its  assets,  does 
not  preclude  a  taxpayer  from  claiming  depreciation  on  the 
March  i,  1913,  value  of  its  assets,  cpiite  independent  of  the 
fact  that  the  latter  value  includes  appreciation.  The  bases 
for  iiiz'cstcd  capital  and  for  depreciation  are  entirely  distinct. 

When  appreciation  has  been  included  in  invested  capital, 
amended  returns  are  required. — The  United  States  Supreme 
Court  in  the  La  Belle  Iron  lJ\)rks  case'"^  has  decided  once  for  all 
that  the  formula  for  the  computation  of  invested  capital,  set 
forth  in  the  191 7  and  1918  laws,  is  legal  and  must  therefore 
be  enforced.  From  the  time  of  the  enactment  of  the  1917 
law  the  author  has  contended  that  the  cost  basis  is  arbitrary 
and  inequitable  in  many  cases,  but  that  it  is  legal  and  more 
workable  than  if  the  proposed  basis  of  value  (irrespective  of 
cost)  had  been  adopted.  There  was  no  justification  under  the 
laws  for  including  unrealized  appreciation  of  tangible  or  in- 
tangible assets.  So-called  "experts"  who  widely  advertised 
their  ability  to  compel  the  Treasury  to  accept  such  bases  have 
deceived  their  victims. 

In  cases  like  that  of  La  Belle  Iron  IVorks,  the  law'S  afforded 
reasonable  relief.  It  is  obvious  that  an  invested  capital  of  less 
than  $190,000  for  an  ore  body  worth  $10,000,000  would  have 
brought  the  company  within  the  relief  sections  of  the  191 7  and 
191 8  laws. 

The  Treasury,  following  the  decision  referred  to  above, 
issued  the  following  decision  on  August  26,  192 1.  This  re- 
c[uires  the  submission  of  amended  returns  in  all  cases  where 
appreciated  values  were  used  in  computing  ini-ested  capital. 

Ruling.  An  examination  of  income  and  excess  profits  tax  re- 
turns for  1917  and  subsequent  years  has  disclosed  that  many  tax- 
payers   have    used    appreciated    and    inflated    values    in    determining 


^  La  Belle  Iron   IVorks  v.   U.  S..  41   Sup.  Ct.  528. 


EXCESS  PKOl  ri\S  'I'AX   PROCEDURE— 1921  1605 

invested  capital  shown  in  such  returns  contrary  to  Section  207  of  the 
Revenue  Act  of  191 7  and  Section  326  of  the  Revenue  Act  of  1918. 

This  office  has  held  consistently  that  the  use  of  appreciated  or 
inflated  values  in  determining  invested  capital  is  not  permissible  and 
this  ruling  has  been  sustained  by  the  United  States  Supreme  Court 
in  the  case  of  the  La  Belle  Iron  Works  v.  The  United  States  (41 
Sup.  Ct.  528;  T.  D.  3051.) 

All  taxpayers  who,  in  the  preparation  of  their  income  and  excess 
profits  tax  returns  for  1917  and  subsequent  years,  have  used  appre- 
ciated or  inflated  values  in  determining  the  amount  of  their  invested 
capital  are  required  to  file  with  the  Collector  of  Internal  Revenue 
within  90  days  from  date  of  this  decision  amended  returns  for  each  of 
such  years,  in  which  the  invested  capital  shall  be  computed  strictly 
in  accordance  with  the  law  and  regulations  and  without  the  use  of 
appreciated  or  inflated  values.  It  is  not  required  that  such  amended 
returns  shall  include  the  figures  shown  in  the  original  returns  which 
are  unaffected  by  this  decision.  Only  such  figures  as  are  necessary 
to  show  the  correct  values  used  in  the  computation  of  invested  capital 
and  such  totals  as  are  necessary  to  a  redetermination  of  the  tax  need 
be  shown.  Payment  of  the  additional  tax  shown  to  be  due  on  such 
amended  returns  must  also  be  made  at  the  time  the  returns  are  filed. 

Failure  to  file  amended  returns  within  the  time  specified  will  sub- 
ject taxpayers  to  the  penalties  provided  for  in  Section  3176,  United 
States  Revised  Statutes,  as  amended.       (B.  37-21-1822;  T.  D.  3220.) 

The  intention  of  the  government  in  requiring  amended 
returns  within  ninety  days  from  the  date  of  the  Treasury  de- 
cision (i.e.,  on  or  before  November  24,  1921)  was  to  have 
the  tax  due  as  the  result  of  appreciated  values  paid  imme- 
diately, rather  than  to  allow  it  to  wait  until  the  returns  were 
finally  reached  in  the  course  of  audit.  An  extension  of  time 
from  November  24,  192 1,  until  January  15.  1922,  was  after- 
wards granted  in  which  to  file  the  amended  returns  and  make 
payment  of  the  tax  due.'"  The  fact  that  no  further  tax  may  be 
shown  to  be  due  on  the  amended  rettirns  in  such  cases  is  not 
sufiicient  to  waive  the  filing  of  such  returns.'' 

Amended  returns  not  required  in  certain  ca.se.s. — 
The  Treasury  has  excepted  certain  cases  from  the  requirements 
of  T.  D.  3220. 


'"  T.  D.  3243. 

"  B.  49-21-1968;   O.  D.   1 131. 


l6o6  EXCESS  PROEJTS  TAX  PROCEDURE— 1921 

Rulings.  WJiere  for  the  year  19:8  returns  were  filed  and  the 
war  and  excess  profits  tax  paid  was  equal  to  50  per  cent  of  the  net 
income,  relief  having  been  requested  under  sections  327  and  328  of 
the  Revenue  Act  of  1918,  or  where  for  the  year  1917  returns  were 
filed  under  article  64  of  Regulations  41,  and  full  disclosure  was  made 
on  the  return  of  the  inclusion  therein  of  restorations  to  invested 
capital,  amended  returns  will  not  be  required  under  T.  D.  3220  (Bui. 
37-21,  p.  18)  and  T.  D.  3243  (Bui.  48-21,  p.  18).  However,  in  cases 
where  returns  were  filed  under  article  64  of  Regulations  41  and  no 
disclosure  was  made  of  the  inclusion  therein  of  restorations  to  in- 
vested capital,  the  requirements  of  T.  D.  3220  and  T.  D.  3243  must 
be  complied  with.     (I-2-25,  I.  T.  1163.) 

In  determining  invested  capital  for  1917  and  subsequent  years  the 
taxpayer,  an  insurance  company,  used  security  valuations  demanded 
and  furnished  by  the  insurance  department  of  the  State  and,  as  re- 
quired, filed  a  copy  of  its  State  report  with  this  office. 

Owing  to  its  inability  to  furnish  cost  values  of  securities,  advice 
was  requested  as  to  what  action  should  be  taken  in  order  to  comply 
with  the  provisions  of  Treasury  Decision  3220  (Bulletin  37-21,  p. 
18). 

Held,  that  as  the  invested  capital  of  insurance  companies  is  ad- 
justed by  this  office  on  the  basis  of  cost  from  annual  statements  ren- 
dered to  the  insurance  departments  at  the  close  of  the  previous  year, 
it  will  not  be  necessary  for  insurance  companies  to  file  amended  re- 
turns under  the  provisions  of  Treasury  Decision  3220,  if  in  the  origi- 
nal returns  securities  or  real  estate  have  been  valued  on  the  basis  of 
book  or  market  as  reported  to  the  insurance  department  of  the  State. 
( 1-6-82;  I.  T.  1201.) 

Page    164 

Intangible  property  acquired  for  tangible  property. — 

Ruling.  Held,  that  intangible  property  when  acquired  fur  tang- 
ible property  must  be  taken  into  account  at  the  value  of  such  in- 
tangible property  at  the  date  of  acquisition.  It  being  assumed  that 
the  tangible  property  before  and  after  transfer  had  an  immediately 
realizable  market  value,  the  value  of  the  intangible  property  is 
measured  by  the  then  fair  market  value  of  the  tangible  property  ex- 
changed therefor  and  not  by  the  original  cost  of  such  tangible 
property.     (C.  B.  4,  page  395;  A.  R.  M.  131.) 

If  tangible  property,  under  the  foregoing  ruling,  costing 
$100,000  in  1914,  was  worth,  in  19.20,  $50,000,  and  was  ex- 
changed for  intangible  property,  the  "cost"  to  the  purchaser 
of  such  intangible  property  would  be  $50,000.     It  is  assumed 


EXCESS   PROEITS  TAX   PROCEDURE— 1921  jGo/ 

tliat  $50,000  has  been  lost  and  slioukl  be  debited  to  surplus. 
If  the  transaction  occurred  after  January  i.  1917,  taxpayers 
would  hardly  object  to  the  ruling;  if  before  1917,  it  would 
result  adversely  to  taxpayers  unless  it  could  be  shown  "that 
there  was  no  readily  realizable  market  value,  in  which  case 
the  intangible  property  could  be  carried  at  the  book  value  of  the 
tangible  property. 

Page  175 
Improvements  in  leaseholds. — 

Ruling.  In  1904  the  M  Company  as  lessee  leased  certain  property 
for  a  term  of  ten  years.  Under  the  terms  of  the  lease  the  M  Com- 
pany made  certain  improvements  which  became  the  property  of  the 
lessor.     The  lease  expired  in  19 15  and  was  again  renewed. 

Held,  that  the  amount  invested  by  the  M  Company  in  improve- 
ments, if  paid- out  of  original  capital  or  surpkis,  constituted  invested 
capital  for  the  taxable  year  in  which  expended,  such  invested  capital 
to  be  reduced  at  the  beginning  of  each  subsequent  year  by  an  amount 
equal  to  the  result  obtained  by  dividing  the  total  cost  of  such  improve- 
ments by  the  number  of  years  the  lease  was  to  run. 

Since  the  lease  under  which  the  improvements  were  made  ex- 
pired in  191 5,  the  taxpayer  had  no  right  nor  title  under  the  lease 
to  any  asset  which  constituted  a  part  of  such  improvements  subse- 
quent to  that  year,  not  even  the  right  of  usage.  Therefore,  subse- 
quent to  191 5  it  possessed  nothing  therein  which  could  be  said  to  con- 
stitute invested  capital  for  the  purpose  of  computing  excess  profits 
tax  under  the  provisions  of  the  Revenue  Act  of  1917  or  1918.  (C. 
B.  4,  page  366;  A.  R.  R.  384.) 

In  the  foregoing  case  the  lessee,  upon  renewal  in  191 5, 
became  the  owner,  for  a  limited  term,  of  the  improvements. 
The  cost  of  such  improvements,  less  depreciation  to  January 
I,  191 7,  w-as  a  capital  investment.  Under  the  La  Belle  Iron 
IVorks  case,  it  would  seem  that  such  investment  could  be  in- 
cluded in  invested  capital.  If  the  improvements  were  charged 
off  after  1909,  it  might  be  in  order  to  file  amended  returns. 

Page    176 

Cash  surrender  value  of  insurance  policies. — It  has  been 

held'"  that  the  surrender  value  of  an  insurance  policy  taken  out 


B.  47-21-1938;  ().  D.  I  UK). 


l6o8  EXCICSS   PROFITS  TAX  PROCEDURE— 1921 

by  a  corjjoration  on  the  life  of  a  guarantor  of  a  debt  cannot  be 
included  in  invested  capital.  This  ruling  is  apparently  based 
on  the  fact  that  the  policy  has  no  asset  value  in  addition  to 
the  face  value  of  the  debt  which  is  still  being  carried  at  its 
face  value.  If  the  debt  becomes  bad.  a  claim  against  the  guar- 
antor would  replace  it.  Such  insurance  is  a  mere  protection 
and  has  only  a  potential  value. 

If  the  debt  has  been  charged  off  and  no  claim  against  the 
guarantor  is  set  up  in  the  books,  the  surrender  value  of  the  in- 
surance policy  would  be  included. 

Page  177 
Discount  on  bonds. — 

Ruling.  Held,  that  a  corporation  which  issued  bonds  at  a  dis- 
count in  January,  1900,  and  elected  then  to  charge  such  discount  to 
profit  and  loss  for  the  year  of  issue  and  the  next  two  succeeding 
years,  may  not  now  revise  its  accounts  and  file  amended  returns  for 
the  purpose  of  reinstating  to  invested  capital  the  unexpired  portion 
of  such  discount  and  claiming  as  a  deduction  from  income  that 
portion  applicable  to  each  year.     (C.  B.  4,  page  391 ;  A.  R.  R.  394.) 

The  foregoing  ruling  may  or  may  not  be  sound.  It  is  to  be 
regretted  that  the  Treasury  places  so  much  weight  on  court 
decisions  which  are  not  Relevant.  The  case  cited  in  support 
of  the  ruling^''  was  brought  under  the  1909  law,  which  was 
not  an  income  tax  law,  and  it  did  not  refer  even  remotely  to 
invested  capital. 

The  court  followed  the  decision  handed  down  in  another 
case'*  in  which  it  was  held  in  effect  that  discount  on  l)onds  is 
not  an  expense  until  the  maturity  of  the  bonds.  If  the  lan- 
guage of  the  court  had  the  slightest  connection  with  invested 
capital  (it  has  not),  it  might  be  urged  that  the  property  pur- 
chased with  the  proceeds  of  bonds  should  be  set  up  at  the  par 
of  the  bonds.  This  principle  at  one  time  was  considered  good 
accounting  practice  and  was  adopted  by  the  Interstate  Com- 
merce Commission.^"' 


''^Chicago  &  Alton  R.  R.  v.  V.  S.,  53  Ct.  Cls.  41. 

'^  Baldwin  Locoinolivc  Jl'ks.  ::  McCoach,  221  Fed.  59,  136  C.  C.  A.  660. 

^■'' Montgomery's   Dicksee's  Auditing    (revised  edition),   page   50. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1609 

What  constitutes  invested  capital  is  not  settled  by  book- 
keeping" entries  made  in  1900,  nor  by  court  decisions  inter- 
preting the  1909,  1913,  or  1916  laws.  In  some  respects  the 
La  Belle  Iron  JVorks  case^"^  is  controlling  because  in  that  case 
the  court  discussed  the  allowable  elements  of  invested  capital 
under  the  191 7  and  1918  laws.  It  is  a  fair  inference  from  the 
decision  that  any  item  of  capital  investment  remaining  as  at 
January  i,  19 17  (excluding  appreciation)  will  be  allowed  as 
invested  capital  even  though  the  cost  may  have  been  written 
off  the  books.  If  discount  on  bonds  is  an  asset  at  any  time 
after  January  i,  191 7,  logically  it  should  be  such  at  January, 
I,  19 1 7,  because  prior  thereto  taxpayers  were  not  on  notice 
that  books  should  be  kept  in  a  certain  way.  It  would  be  grossly 
unfair,  in  19 18,  to  penahze  a  taxpayer  who  in  1900  did  some- 
thing entirely  legal  but  which  might  have  been  done  in  some 
other  legal  way.  Invested  capital  is  not  a  question  of  book- 
keeping; it  is  a  question  of  fact. 

Page  179 
When  expenditures  for  intangibles  charged  off  prior  to 
1917  may  be  included  in  invested  capital. — Prior  to  the  hand- 
ing down  of  any  court  decisions  dealing  with  the  computation 
of  invested  capital,  the  Treasury  took  the  position  that  devel- 
opment, exploitation,  and  similar  expenses  when  charged  off 
to  expense  accounts  as  incurred  could  not  be  restored  to 
invested  capital.^'  In  the  La  Belle  Iron  Works  case^*  the 
Supreme  Court  said,  in  speaking  of  exploration  and  devel- 
opment expenses  charged  off  in  prior  years,  "we  assume  that 
a  proper  sum,  not  exceeding  the  cost  of  the  work  might  have 
been  added  to  earned  surplus  on  that  account."  It  became 
obvious  that  the  regulations  which  specifically  permitted  the 
restoration  of  tangible  property  written  off  prior  to  191 7 
were    discriminatory.      The    cost    of    intangible    property    of 


^641  Sup.  Ct.  528. 

^■^  Reg.  45,  Art.  841.     See  Exrcsx  Profits  'lax  Procedure,  1921,  pages 
159,   179-184. 

18  41  Sup.  Ct.  528. 


l6io  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

one  taxpayer  which  still  existed  at  January  i,  1917,  was  just 
as  much  an  expenditure  for  income-producing  purposes 
(sometimes  much  more  so)  than  the  expenditures  of  another 
taxpayer  for  tangible  property. 

It  is  evident  from  the  La  Belle  Iron  Works  case  that  all 
forms  of  appreciation^^  must  be  excluded  from  invested  capi- 
tal, but  that  all  forms  of  cash  investment  in  capital  must  l>e 
included.  The  inadvertent  charging  ofif  of  intangible  capital 
items  prior  to  191 7  cannot  ht  penalized  any  more  than  the 
charging  off  of  tangible  items  can  be.  The  changed  position 
of  the  Treasury  is  best  illustrated  in  a  recent  decision  whereby 
publishers  who  wrote  off  expenditures  to  build  up  subscription 
lists  are  permitted  to  restore  all  of  the  items  which  can  be 
identified. 

Ruling.  The  Committee  is  of  the  opinion  in  the  matter  of  the 
argument  of  the  M  Company  and  the  O  Company,  taxpayers  engaged 
in  the  publication  of  newspapers,  that  moneys  expended  out  of  earned 
surplus  or  current  earnings  for  the  sole  purpose  of  building  up  the 
circulation  structure  may  be  added  to  capital  invested  when  proper 
proof  of  such  expenditures  is  made  and  amended  returns  for  prior 
years  have  been  filed (B.  47-21-1937;  A.  R.  M.  141.) 

In  one  case'"  a  corporation  claimed  that  it  had  only  nominal 
capital  in  191 7  because  it  had  no  tangible  assets  except  cash 
which  it  did  not  need.  The  government  claimed  that  $19,000 
expended  upon  a  certain  process  between  1909  and  191 7 
"should  be  taken  as  a  surplus  used  and  employed  in  the  busi- 
ness." The  process  was  found  to  have  substantial  value. 
The  court  held  that  the  corporation  had  more  than  nominal 
capital.  The  writing  off  of  the  expenditures  was  not  deemed 
to  influence  the  one  fact  at  issue,  viz :  What  n.'os  the  invested 
capital  as  at  January  i,  191 7? 

Contracts. — 

Ruling an  unperformed  contract  to  furnish  man- 
ufactured products  represents  no  rights  in  tangible   property  which 


^9  Except  when  January  i,  1914,  values  can  be  used. 
^Lincoln    Chemical    Co.    7:    Edwards.    272    Fed.    142,    Dist.    Ct.    So. 
Dist.  N.  Y.,  April  19,  1921. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  )6ii 

would  entitle  it  to  be  regarded  as  deriving  its  value  chiefly  therefrom. 
On  the  contrary,  the  value  of  the  contract  is  of  an  intangible  nature, 
contingent  upon  the  performance  of  its  terms  and  the  realization  of 
the  anticipated  profit.  The  intangible  rights  under  such  a  contract 
would,  therefore,  be  subject  to  the  limitation  contained  in  section 
207  of  the  Revenue  Act  of  1917,  and  section  326  of  the  Revenue  Act 
of  1918,  in  the  case  of  intangible  property  purchased  with  corporate 
stock.     (C.  B.  3,  page  324;  O.  D.  635.) 

Page  181 
Goodwill. — 

Ruling.  Goodwill  in  a  corporation  can  not  be  allowed  as  in- 
vested capital  under  a  claim  that  a  price  paid  to  stockholders  by 
certain  individuals  was  in  excess  of  corporate  book  value  of  the 
stock.  Good  will  must  be  acquired  by  direct  purchase;  it  can  not 
be  determined  bv  a  collateral  transaction.  (C.  B.  4,  page  379;  A. 
R.  R.  413.) 

If  an  individual  acquires  substantially  all  of  the  stock  of  a 
corporation  for  a  price  largely  in  excess  of  its  book  value,  such 
excess  does  not  constitute  goodwill  acquired  by  the  corpora- 
tion. There  has  been  no  change  in  the  price  paid  for  the 
original  assets  by  the  corporation,  but  merely  a  change  in  the 
stockholders  of  the  corporation.  The  transaction  might  be 
pertinent  in  a  claim  for  relief  on  the  ground  that  the  earnings 
of  the  corporation  were  abnormal.  It  would  be  necessary  to 
find  representative  corporations  in  the  same  line  of  business 
whose  invested  capital  is  comparable  with  the  purchase  price  of 
the  shares. 

Page  185 
Patents. — In  a  recent  case^^  it  was  held  that  "the  value 
of  certain  patents  for  which  stock  of  a  corporation  was  issued 
must  be  measured  by  the  cash  consideration  paid  therefor 
l)y  certain  incorporators  of  the  company  just  prior  to  incor- 
poration." 

The  peculiar  feature  about  this  case  was  that  the  original 
owner  had  neglected  to  develop  the  patents  in  question.  On 
sale   to  a   syndicate  which  actively  developed  their  use,   the 


-^  C.  B.  4,  page  369;  A.  R.  R.  396. 


l6i2  EXCESS   PROFITS  TAX   PROCEDURE— 1921 

latent  value  of  the  patents  became  apparent,  and  on  this  devel- 
oped value  the  claim  for  paid-in  capital  was  based.  The  claim 
was  disallowed. 


CHAPTER     IX 

INADMISSIBLE    ASSETS 

The  new  law  defines  inadmissible  assets  in  the  same  terms 
as  the  1918  law.  However,  the  stocks  of  two  types  of  cor- 
porations which  were  formerly  inadmissibles  are  taken  out 
of  that  class  and  made  admissible  assets.  The  change  arises 
from  a  new  provision  in  the  192 1  law  which  affects  the  deduc- 
tibility of  dividends  in  arriving  at  the  net  income  of  the  recipi- 
ent corporation. 

Inadmissible  assets  are  defined  as  follows : 

Law.  Section  32;.  (a)  ....  The  term  "inadmissible  assets" 
means  stocks,  bonds,  and  other  obligations  (other  than  obligations  of 
the  United  States),  the  dividends  or  interest  from  which  is  not  included 
in  computing  net  income 

The  deduction  of  dividends  allowed  a  corporation  in  com- 
puting its  net  income  is  stated  as  follows : 

Law.  Section  234.  (a)  .  .  .  .  (6)  The  amount  received  as 
dividends  (A)  from  a  domestic  corporation  other  than  a  corporation 
entitled  to  the  benefits  of  section  262,  or  (B)  from  any  foreign  cor- 
poration when  it  is  shown  to  the  satisfaction  of  the  Commissioner  that 
more  than  50  per  centum  of  the  gross  income  of  such  foreign  corpora- 
tion for  the  three-year  period  ending  with  the  close  of  its  taxable 
year  preceding  the  declaration  of  such  dividends  (or  for  such  part  of 
such  period  as  the  foreign  corporation  has  been  in  existence)  was  de- 
rived from  sources  within  the  United  States  as  determined  under 
section   217;   .    .    .    . 

Dividends  received  from  a  foreign  corporation  which 
does  not  derive  more  than  50  per  cent  of  its  gross  income  from 
sources  within  the  United  States  are  not  deductible.  Hence, 
when  the  dividends  are  not  deductible  the  stock  of  such  foreign 


EXCESS  ]'ROI>rrS  tax  procedure— 1921  1613 

corporation  becomes  an  adniissible  asset.  Under  the  1918  law, 
if  even  a  small  part  of  the  income  from  a  foreign  corporation 
was  derived  from  sources  within  the  United  States,  and  thus 
rendered  subject  to  taxation,  the  dividends  from  such  foreign 
corporation  were  deductible  in  arriving  at  the  net  income  of 
the  corporation  receiving  them,  and  the  stock  of  such  foreign 
corporation  was  an  inadmissible  asset/ 

The  stocks  of  domestic  corporations  entitled  to  the  benefits 
of  section  262"  are  also  fully  admissible  because  dividends 
from  such  corporations  are  not  deductible  by  the  recipient 
corporations. 

Page   193 

Bonds   not   obligations   of   the   United   States. — Securities 

which  are  in  the  nature  of  government  bonds,  but  which  are 

not  direct  obligations  of  the  United  States,  are  inadmissible 

assets  if  the  income  therefrom  is  non-taxable. 

Ruling.  Since  the  income  from  Federal  land  bank  bonds  is  tax 
free  and  since  such  bonds  are  not  obligations  of  the  United  States, 
they  are  inadmissible  assets  within  the  meaning  of  section  325  (a) 
of  the  Revenue  Act  of  1918,  and  should  be  so  treated  in  computing 
the  invested  capital  of  a  corporation.     (B.  42-21-1875;  O.  D.  1069.) 

For  similar  reasons,  4  per  cent  bonds  of  the  government 
of  the  Philippine  Islands  are  held  to  be  inadmissible  assets,^ 
as  are  bonds  of  Porto  Rico  and  Hawaii.^ 

School  warrants  issued  by  a  county  of  a  state  are  inadmis- 
sible assets,^  except  where  they  have  been  cashed  by  a  bank 
for  the  accpmrriodation  of  teachers  and  where  no  remuneration 
was  received  for  that  service),"  as  is  the  principal  of  municipal 
assessments  issued    for  improvements.' 


^  [Former  Procedure].  The  1918  law  [section  234  (a-6)]  permitted 
as  a  deduction  "Amounts  received  as  dividends  from  a  corporation  which 
is  taxable  under  this  title  updn  its  net  income " 

-  See  page  1324. 

"  B.  40-21-1857;  O.  D.  10S7. 

*B.  38-21-1836;  O.  D.  1044. 

"  C.  B.  4,  page  363 ;  O.  D.  929. 

«  B.  4S-21-1915;  O.  D.  1096. 

'  B.  34-21-1778;  O.  D.    999. 


l6i4  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

Page  194 
Reserve  for  bad  debts  affects  computation  of  admissible 
assets. — In  the  case  of  a  corporation  reporting  for  the  calen- 
dar year  1921,  the  reserve  for  bad  debts  at  the  beginning  of 
192 1  has  not  been  allowed  as  a  deduction  in  computing  net 
income,  and  should  therefore  not  be  deducted  from  accounts 
receivable.  At  the  end  of  1921,  however,  any  addition  to 
the  reserve  during  1921  which  has  been  allowed  as  a  deduc- 
tion from  gross  income  must  be  deducted  from  accounts  re- 
ceivable. Since  192 1  is  a  year  of  transition,  so  far  as  the 
reserve  for  bad  debts  is  concerned,  the  reserve  must  be  treated 
differently  at  the  beginning  of  1921  than  at  the  end  of  1921. 
However,  in  subsequent  calendar  years,  no  computation  of 
inadmissibles  will  be  necessary,  because  the  excess  profits  tax 
law  is  not  in  effect  after  December  31,  192 1. 

Valuation  of  assets  for  purposes  of  inadmissible  compu- 
tation.— The  new  \a.w^  provides  for  valuation  of  assets  in 
accordance  with  sections  326  and  331.  The  1918  law  provided 
for  the  valuation  of  assets  in  accordance  with  sections  326, 
330,  and  331  of  that  act.  Reference  to  section  330  in  the 
19 18  law  is  not  carried  forward,  since  section  330  was  elim- 
inated in  the  new  act.  Section  330  of  the  19 18  law  provided 
for  the  valuation  of  assets  on  the  same  basis  in  the  prewar 
period  and  taxable  year,  but  as  no  computation  of  prewar 
invested  capital  is  necessary  in  determining  excess  profits  tax^ 
at  1 92 1  rates,  the  section  is  no  longer  necessary. 

This  method  of  valuation  would  still  apply,  however,  in 
the  case  of  any  corporation  which  received  net  income  of 
$10,000  or  more  from  government  contracts  in  192 1.  In  such 
cases  the  provisions  of  the  1918  law  are  to  be  followed  and 
it  becomes  necessary  to  compute  the  prewar  invested  capital.' 


I 


8  Section  325. 

3  Section  301    (b). 


EXCESS  PROFITS  TAX   PROCEDURE— 1921  jf,[5 

Page  211 
Fiscal  year  corporations — changes  in  admissibles  due  to 
computation  under  two  laws. — The  percentage  of  average 
inadmissible  assets  to  average  total  admissible  and  inadmis- 
sible assets  is  to  be  applied  in  determining  the  reduc- 
tion of  invested  capital  necessary  because  of  the  possession 
of  inadmissible  assets.  The  total  average  assets  will  ordinarily 
be  ascertained  from  the  balance  sheets  at  the  beginning  and 
end  of  the  taxable  year.  In  the  case  of  a  corporation  report- 
ing for  a  fiscal  year  ending  in  1921,  however,  two  computa- 
tions are  made,'*'  one  under  the  19 18  law  and  one  under  the 
1921  law.  Due  to  a  different  classification  of  assets  under 
the  two  laws  (such  as  stocks-of  certain  foreign  corporations 
and  those  under  section  262^').  the  average  inadmissibles 
will  be  different  in  the  two  computations,  the  resulting  per- 
centage will  be  different,  and  the  adjustment  of  invested  capi- 
tal required  will  also  be  different. 

Under  the  1918  law  additions  to  a  reserve  for  bad  debts 
were  not  deductible.  Accordingly,  since  such  reserve,  for 
tax  purposes,  was  considered  as  a  part  of  surplus,  accounts 
receivable  were  not  reduced  by  the  amount  of  such  reserve 
in  making  the  computation  of  admissible  assets. ^^  However, 
the  1 92 1  law  permits  additions  to  a  reserve  for  bad  debts  to  be 
deducted  in  computing  net  income.  Therefore,  in  the  com- 
putation of  admissible  assets  under  the  192 1  lav^r,  the  reserve 
for  bad  debts  would  be  deducted  from  accounts  receivable, 
the  converse  of  the  procedure  followed  in  making  the  com- 
l)Utation  under  the  1918  law. 

Inadmissible  assets  of  dealers  in  securities. — Dealers  in 
securities  cannot  include  in  invested  capital  any  securities 
which  come  within  the  definition  of  inadmissible  assets,  even 
though  their  business  consists  of  dealing  in  such  securities. 


"»  Section  335  (a). 

*'  Sec  page  1324. 

'-  See  Excess  Profits  Tax  Froccdun    1921,  page  ic 


i6i6  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

Ruling.  A  corporation  which  is  a  "dealer  in  securities"  within 
the  meaning  of  article  1585  of  Regulations  45  is  not  entitled  to  include 
in  invested  capital  amounts  invested  in  inadmissible  assets,  even 
though  such  assets  are  held  as  merchandise,  except  under  conditions 
entitling  it  to  the  benefits  of  article  817  of  Regulations  45.  (T-1-14; 
I.  T.  1155.) 


CHAPTER     X 

ADJUSTMENT  OF  CAPITAL,  SURPLUS,  RESERVES 
AND  LL\BILITIES 

Page  226 
Capital  stock  paid  for  in  instalments. — 

Ruling.  Subscription  payments  made  in  instalments^  when  a 
corporation  increased  its  capital  stock,  are  properly  included  as  in- 
vested capital  from  the  date  of  receipt.  So-called  interest  paid  to  the 
subscribers  on  the  installment  payments  from  the  .  date  of  receipt 
to  the  date  of  issuance  of  the  stock  certificates  •  is  not  deductible. 
(B.  32-21-1765;  O.  D.  991.) 

Page  238 
Surplus  arising  from  revaluations. — The  opinion  of  the 
Solicitor  of  Internal  Revenue  ( B.  43-21)  is  fully  discussed 
on  page  1620.  The  author's  contentions  as  to  the  date  when 
realized  appreciation  should  be  included  in  invested  capital, 
and  the  illegality  of  taxing  distributions  of  surplus  accrued 
prior  to  March  i,  1913.  are  unchanged.  This  subject,  includ- 
ing the  Supreme  Court  decision  in  the  La  Belle  Iron  Works 
case,  is  discussed -further  on  page  1620  et  seq. 

Page  233 
Reserves  for  bad  debts. — The  192 1  law  includes  among 
alKJwable  deductions  additions  to  reserves  for  bad  debts.  This 
has  little  effect  on  the  excess  profits  tax,  since  the  tax  is  re- 
pealed effective  December  31,  1921.  Reserves  for  bad  debts 
at  the  beginning  of  the  taxable  year  1921  are  includea  in  in- 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1617 

vested  capital.  The  effect  on  the  computation  of  the  deduction 
for  inadmissible  assets  is  dealt  with  in  Chapter  IX  of  this 
appendix. 

Page  239 
Deductions  for  depletion. — 

Ruling.  Held,  that  a  mining  corporation,  in  computing  its  in- 
vested capital  for  the  purpose  of  the  war  excess  profits  tax,  is  re- 
quired to  reduce  its  earned  surpkis  by  the  amount  of  its  sustained 
depletion  to  the  beginning  of  the  year  for  which  the  tax  is  computed. 

In  the  ruling  of  the  Committee  on  Appeals  and  Review, 
there  appears  the  following  opinion  of  the  Solicitor  of  In- 
ternal Revenue,  dealing  with  the  taxpayer's  contention  : 

It  is  contended  by  the  taxpayer  that,  owing  to  the  peculiar  char- 
acter of  mining  properties,  there  is  no  depletion  so  long  as  "discovery 
and  development  outrun  depletion,''  and  that  any  actual  prior  de- 
pletion is  taken  care  of  by  the  provision  for  the  valuation  of  tangible 
property  paid  in  as  of  January  i,  1914. 

The  peculiar  character  of  mining  property  was  well  stated  in 
StrattO'ii's  Independence  v.  Hozvbert,  231  U.  S.  399,  413,  as  follows: 

The  peculiar  character  of  mining  property  is  sufficiently  obvious. 
Prior  to  development  it  may  present  to  the  naked  eye  a  mere  tract 
of  land  with  barren  surface,  and  of  no  practical  value  except  for 
what  mav  be  found  beneath.  Then  follow  excavation,  discovery, 
development,  extraction  of  ores,  resulting  eventually,  if  the  pro- 
cess be  thorough,  in  the  complete  exhaustion  of  the  mineral  con- 
tents so  far  as  they  are  worth  removing.  Theoretically,  and  ac- 
cording to  the  argument,  the  entire  value  of  the  mine,  as  ultimately 
developed,  existed  from  the  beginning.  Practically,  however,  and 
from  the  commercial  standpoint,  the  value — that  is,  the  exchangeable 
or  market  value — depends  upon  different  considerations.  Beginning 
with  little,  wheri  the  existence,  character,  and  extent  of  the  ore 
deposits  are  problematical,  it  may  increase  steadily  or  rapidly  so 
long  as  discovery  and  development  outrun  depletion,  and  the  wiping 
out  of  the  value  by  the  practical  exhaustion  of  the  mine  may  be 
deferred  for  a  long  term  of  years. 

This  statement  contains  the  answer  to  the  contention  of  the 
taxpayer.  The  reason  that  in  the  case  of  mines  the  Supreme  Court 
has  consistently  held  that  no  deduction  for  depletion  or  depreciation 
in  computing  net  income  can  be  allowed,  in  the  absence  of  statutory 
authority,  is  that  by  reason  of  the  fact  that  discovery  and  develop- 
ment may  outrun  depletion  there  is  not  necessarily  any  actual  de- 
crease in  the  value  of  the  taxpayer's  property,  and,  therefore,  the 
entire  net  receipts  may  well  be  considered  income.  The  rule  is  not 
new  but  has  come  down   to  us   from  the  common   law   of   England. 


i6i8 


EXCESS  PROFITS  TAX  PROCEDURE— 1921 


i'liis,  however,  does  not  negative  the  fact  that  the  removal  of  each 
ton  of  ore  depletes  pro  tanto  the  ore  originally  known  to  exist  in  the 
mine  and  which  was  originally  valued.  The  maintenance  or  in- 
crease of  the  original  value  is  solely  due  to  the  fact  that  the  loss 
of  value  through  depletion  is  equalled  or  exceeded  by  the  appreciation 
in  value  through  discovery  or  development.  To  treat  the  entire 
net  income  as  earnings  and  as  constituting  earned  surplus  in  the 
succeeding  year  when  not  distributed  by  the  company  would,  there- 
fore, to  the  extent  of  the  depletion  actually  sustained  during  the 
year,  be  to  permit  the  inclusion  of  appreciation  in  the  value  of  the 
mine,  by  reason  of  development  and  discovery,  in  invested  capital, 
a  thing  which  is  not  contemplated  by  the  statute  nor  permitted  by 
the  regulation.     (C.  B.  4.  page  385;  A.  R.  R.  Si/.) 

The  foregoing-  opinion  is  sound  in  so  far  as  it  relates  to 
1918  and  subsequent  years.  It  would  appear,  however,  that 
an  attempt  is  made  to  apply  old  court  decisions  and  the  pro- 
visions of  the  1918  law  to  a  specific  section  of  the  191 7  law. 
Section  207  of  the  19 17  law^  provides  that  appreciation  at 
January  i,  19 14,  may  be  included  in  invested  capital  up  to 
the  par  value  of  stock  specifically  issued  for  tangible  property. 
Assume  that  a  mining  company  issued  $1,000,000  in  stock 
for  property  worth  $500,000;  that  on  January  i,  1914,  one- 
half  of  the  mineral  content  was  exhausted;  that  the  value  of 
the  remaining  half  was  $1,000,000.  There  is  nothing  in  the 
law  to  indicate  that  in  computing  invested  capital  for  191 7, 
depletion  of  $250,000  (that  being  one-half  of  the  original 
cost)  must  be  deducted  from  the  value  of  the  property  on 
January  i,  1914;  on  the  contrary,  the  framers  of  the  law  went 
to  a  great  deal  of  trouble  to  insert  a  specific  provision  that 
appreciation  up  to  the  par  value  of  the  stock  should  be  included 
in  invested  capital. 

If  they  had  intended  that  depletion  should  be  deducted, 
it  would  have  been  extremely  easy  to  provide  for  it.  The 
section  is  perfectly  clear  as  it  stands  and  is  not  afifected 
by  the  decision  in  Strattons  Independence  1'.  Howhert,^  wliich 
was  handed  down  in  19 13  under  the  1909  (cash  basis)  law^ 
The  change  made  in  the  19 18  law  merely  carries  out  the  inten- 


'231  U.  S.  399,  58  L.  Ed.  285,  34  Sup.  Ct.  136. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  i6iy 

tion  to  eliminate  appreciation  as  an  element  in  invested  capi- 
tal. The  Treasury  cannot  change  the  19 17  law  in  one  of  its 
few  unambiguous  sections. 

Page  240 
Reserves  for  depletion. — A  further  illustration  of  the  use 
of  the  depletion  reserve  and  of  the  surplus  arising  from  the 
revaluation  of  mines,  is  given  in  Chapter  XXXIII  of  the  in- 
come tax  section  of  this  volume. 

Page  248 
Decrease  in  invested  capital  by  payment  of  federal  taxes. — 
The  author  wishes  to  reiterate  the  comment  made  in  the  192 1 
edition  of  Excess  Profits  Tax  Procedure. 

The  position  of  the  Treasury  is  equivalent  to  the  imposi- 
tion of  a  tax  in  a  past  year  which  was  not  authorized  by  Con- 
gress. The  law  defines  invested  capital  in  a  specific  and  tech- 
nical manner.  The  deductions  are  limited.  If  any  doubt 
exists,  the  Treasury  cannot  successfully  decide  the  doubt  in 
favor  of  the  government.^  If  in  192 1  the  government  claims 
that  an  additional  tax  is  now  due,  arising  from  net  income  for 
191 7,  it  cannot  also  be  claimed  that  as  of  some  date  in  1918 
the  amount  was  due  and  payable  and  that  there  was  an  actual 
diminution  in  invested  capital  at  tJiat  time.  There  was  no 
diminution  until  192 1.  The  corporation  had  in  hand,  without 
restriction  or  lien,  the  full  amount  until  some  time  in  192 1. 
To  say  that  it  did  not  have  it,  is  to  run  counter  to  the  spirit 
and  letter  of  the  law. 

It  is  a  decrease  of  invested  capital  by  fallacious  construc- 
tion and  not  by  fact. 

Page  250 
Tax  overpaid — included  in  invested  capital. — 

Ruling.  A  taxpayer  made  an  overpayment  of  income  taxes  for 
the  year  1917  in  1918,  which  amount  was  refunded  to  him  in  the 
year  1921. 


Gould  V.  Gould,  245  U.  S.  151,  62  L.  Ed.  211,  38  Sup.  Ct.  53. 


l620  EXCESS  PROEITS  TAX  PROCEDURE— 1921 

The  question  presented  is  whether  the  taxpayer  may  include 
in  its  invested  capital  the  amount  so  refunded  for  the  calendar 
year  1921. 

Held,  that  under  the  provisions  of  article  845  of  Regulations  45 
the  amount  of  tax  overpaid  for  1917  and  refunded  may  be  included 
in  the  invested  capital  of  the  taxpayer  for  1918  and  subsequent 
years.     (B.  43-21-1889;  O.  D.  1079.) 

The  principle  followed  in  the  foregoing  ruling  must  be, 
that  as  of  the  time  of  overpayment  a  correcting  entry  would 
debit  the  government  and  credit  earned  surplus.  It  is  ques- 
tionable how  far  corrections  in  the  accounts  of  past  years 
should  he  carried. 

Reserves  of  insurance  companies. — Article  870  of  Regu- 
lations 45  was  amended  by  T.  D.  3153,  'dated  April  9,  192 1, 
to  read  as  follows  : 

Regulation.  The  reserve  funds  of  life  insurance  companies, 
the  net  additions  to  which  are  deductible  from  gross  income  under 
the  provisions  of  section  234  of  the  statute,  can  not  be  included  in 
computing  invested  capital.  The  like  reserve  fimds  of  insurance 
companies,  other  than  life  insurance  companies,  may  be  included 
in  computing  invested  capital.  See  sections  325  and  326  (a)  (3) 
and  (b)  and  articles  569  and  814.  (Reg.  45,  Art.  870.  as  amended  bv 
T.  D.  3153.) 

In  view  of  the  change  of  the  method  of  taxing  the  income 
of  life  insurance  companies  for  192 1  and  subsequent  years, 
this  regulation  will  be  no  longer  effective.  For  further  dis- 
cussion of  this  change,  see  Chapter  XXXVUI  of  the  income 
tax  section  of  this  volume. 


CHAPTER     XI 

CHANGES  IN   INVESTED  CAPITAL 

Page  256 

Surplus  from   sale   of  capital  assets  may  be  additions  to 
invested  capital  during  year. — In  a  recent  ruling^  the  Treas- 


1  B.  43-21-1878;  L.  O.  1073.     See  page  71? 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1621 

ury  reiterates  its  position  that  realization  of  appreciation  of 
assets  accrued  before  March  i,  1913,  are  earnings  or  profits 
of  the  year  wlien  reahzed,  rather  than  reaHzations  of  capital. 
Ilie  riiHng  is  fully  discussed  elsewhere.  In  the  La  Belle  Iron 
\W)rks  case"  the  Supreme  Court  declined  to  permit  the  inclu- 
sion of  unearned  or  unrealized  increment,  in  invested  capital, 
but  emphasized  the  right  of  taxpayers  to  include  all  items  of 
cash  or  equivalent.  The  Treasury,  in  effect,  says  that  appre- 
ciation at  March  i,  191 3,  cannot  be  included  in  invested  capi- 
tal until  the  first  day  of  the  year  following  its  realization. 
"A"  sells  capital  assets  on  January  2,  1918,  and  realizes 
v$ 1 00,000  above  March  i,  191 3,  value.  The  excess  is  not 
taxable.  It  is  allowed  as  invested  capital  from  and  after 
January  i,  1919.  "B"  sells  and  realizes  on  December  31.  1917, 
and  may  add  $100,000  to  invested  capital  the  next  day.  The 
Treasury's  position  is  not  in  line  with  the  definition  of  invested 
capital  in  the  laws  and  as  discussed  by  the  Supreme  Court  in 
the  La  Belle  Iron  Works  case. 

Invested  capital  must  be  paid  in  or  arise  from  earned  sur- 
plus. Earned  surplus  is  taxable  surplus,  that  is,  it  arises 
from  current  earnings.  Realization  of  appreciation  is  not 
earned  surplus.  The  only  limitation  on  the  dates  when  the 
items  of  invested  capital  are  to  be  included,  refers  to  earned 
surplus.  All  other'  items  are  included  on  the  dates  when 
paid  in. 

In  a  recent  case^  a  taxpayer  paid  $500  for  property  which 
was  worth  $695  on  March  i,  1913,  and  wdiich  was  sold  in 
1916  for  $13,931.22.  The  court  referred  to  the  March 
I,  191 3,  value  as  "his  capital  investment."  If  it  had  been 
a  corporation  and  the  sale  had  taken  place  in  191 7,  can  it 
be  assumed  that  the  $195  appreciation  prior  to  March  i,  19 13, 
referred  to  as  "capital,"  would  follow  the  same  course  as  the 
$13,236.22  taxable  gain  arising  after  March  i,  1913?  Is  it 
not  more  reasonable  to  assume  that  the  court  would  direct 


-41  Sup.  Ct.  528. 

^  Goodrich  v.  Edwards,  U.  S.  Supreme  Court,  March  28,  1921. 


l622  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

that  there  be  credited  to  capital  account  on  the  day  of  reaHza- 
tion,  $695,  and  to  current  earnings,  the  sum  of  $13,236.22? 
Invested  capital  would  be  increased  by  $195  on  day  of  realiza- 
tion, and  by  the  net  earnings  at  the  end  of  the  year,  including 
the  $13,236.22. 

The  inhibition  against  the  inclusion  of  unearned  increment 
or  appreciation  in  invested  capital  ceases  the  moment  the 
appreciation  is  converted  into  the  equivalent  of  paid-in  capital ; 
when  it  becomes  actual  instead  of  prospective. 

Furthermore,  no  formula  has  been  devised  which  reason- 
ably can  be  applied  to  the  segregation  of  March  i,  191 3,  values 
into  capital  and  accumulated  profits.  The  revenue  laws  and 
the  courts  use  the  words,  "gain,  profits  and  income,"  inter- 
changeably. It  has  been  immaterial  whether  a  taxpayer's  capi- 
tal on  March  i,  1913,  represented  cost  to  him  or  whether  it 
included  appreciation.  But  if  the  Treasury  is  right  in  its 
contentions,  it  is  important  to  revise  all  values  at  March  i,  19 13, 
in  order  to  reduce  the  apparent  appreciation,  at  that  date,  and 
set  up  the  maximum  amount  as  cost.  In  many  cases,  so-called 
appreciation  at  March  i,  1913,  is  merely  restoration  of  capital 
assets  theretofore  charged  off.  When  taxpayers  are  not  able 
to  sustain  the  written-up  figures,  invested  capital  is  limited 
to  the  book  values.  The  segregation  of  subsequent  realiza- 
tion of  all  or  any  part  of  the  appreciation*  is  not  justified  by 
the  law.  If  an  asset  at  March  i,  19 13,  is  not  allowed  as  in- 
vested capital  because  it  represents  unrealized  appreciation, 
the  theory  of  invested  capital  requires  that  on  the  date  of 
realization  it  automatically  be  included  in  invested  capital. 
It  is  not  a  gain  or  profit  to  be  related  to  the  period  after  March 
I,  1913;  what  it  was  before  that  date  is  not  an  element  in 
the  computation  of  invested  capital. 

In  this  connection,  too,  it  is  important  to  consider  Section 
201  of  the  1 92 1  law  and  article  1543  of  Regulations  62  inter- 
preting that  section.  The  regulation  after  stating  that  "Any 
distribution  by  a  corporation  out  of  earnings  or  profits  ac- 
cumulated prior  to  March  i,  191 3,  or  out  of  increase  of  value 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1623 

of  property  accrued  prior  to  March  i,  19 13  (whether  or  not 
realized  by  sale  or  other  disposition)  is  not  a  dividend  within 
the  meaning  of  the  Act,"  goes  on  to  state  that  "the  provisions 
of  the  preceding  sentence  shall  be  appHed  uniformly  to  cases 
arising  under  the  Revenue  Act  of  1916,  the  Revenue  Act  of 
191 7,  the  Revenue  Act  of  19 18,  as  well  as  the  Revenue  Act 
of  192 1."  It  is  clear  from  the  law,  and  Regulations  62  as 
above  quoted,  evidently  so  hold,  that  appreciation  in  value  of 
property  prior  to  March  i,  191 3,  is  deemed  to  be  capital  at 
that  date  and  that  subsequent  realization  does  not  represent 
a  profit  of  the  year  of  realization.  Consequently,  the  1922 
regulations  would  appear  to  overrule  A.  R.  M.  51  (C.  B.  2, 
page  297),  quoted  on  page  256  of  Excess  Profits  Tax  Pro- 
cedure, 192 1,  and  appreciation  accrued  prior  to  March  i,  191 3, 
would  therefore  be  allowable  as  an  addition  to  invested  capital 
from  the  date  of  realization  and  not  merely  from  the  beginning 
of  the  following  taxable  year. 

Page  259 
Computation    of   average    invested   capital. — It    should   be 
noted  that,  as  1920  was  a  leap  year,  adjustments  of  invested 
capital  should  be  made  on  the  basis  of  366  days.* 

Page   264 
Effect  of  ordinary  dividend. — 

Ruling.  Held,  that  the  expression,  in  a  declaration  by  the  di- 
rectors of  a  corporation,  that  a  dividend  is  ''payable  as  convenient 
to  the  funds  of  the  company"  creates  a  condition  precedent.  Divi- 
dends so  declared  are  not  necessarily  to  be  considered  payable  as 
of  the  date  of  the  declaration,  and  in  such  a  case  the  invested  capital 
should  be  adjusted  as  of  the  date  the  dividend  is  made  payable  rather 
than  the  date  it  is  declared.     (C.  B.  4,  page  396;  A.  R.  R.  408.) 

Article  858,  of  Regulations  45,  states  that  when  no  date  is 
set  for  the  payment  of  dividends,  the  date  when  they  are 
declared  will  be  considered  also  the  date  when  they  are  payable. 
The  date  of  declaration  can  hardly  be  regarded  in  determin- 


*C.  B.  4,  page  396;  O.  D.  822. 


l624  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

ing  tax  liability.  If  a  dividend  is  declared  "payable  as  con- 
venient," an  administrative  decision  by  the  officers  of  the 
company  is  necessary  before  stockholders  have  the  right  to 
demand  payment.  Until  such  decision  is  made,  the  dividend 
is  not  taxable  to  the  stockholders,  and  it  has  no  effect  on 
invested  capital. 

Dividend  paid  in  interest-bearing  notes. — 

Ruling.  Where  a  corporation  issues  interest-bearing  notes  to 
its  stockholders  in  lieu  of  a  cash  dividend,  invested  capital  should  be 
reduced  as  of  the  date  of  the  notes,  provided  the  dividend  was  not 
declared  from  current  earnings.       (B.  42-21-1876;  O.  D.  1070.) 

If  the  notes  were  subordinated  to  all  the  liabilities  of  the 
corporation  and  interest  payments  were  conditional,  it  is  pos- 
sible that  invested  capital  might  not  have  to  be  reduced. 

Page  271 
Accruals  of  taxes  should  not  be  deducted  from  invested 
capital. — 111  Bulletin  30-21,  the  Treasury  merely  reiterates  the 
principle  laid  down  in  article  857^  and  attempts  to  justify  it 
under  accounting  principles.  It  cannot  be  disputed  that  "ex- 
penses of  a  year  should  be  charged  against  the  income  of  that 
year,"  but  it  is  difficult  to  see  what  this  has  to  do  with  the 
computation  of  invested  capital.  In  the  La  Belle  Iron  Works 
case,  the  Supreme  Court  observed  that  book  entries  could 
not  affect  the  highly  technical  and  arbitrary  definitions  of 
invested  capital  which  are  found  in  the  laws.  The  court  says 
that  invested  capital  consists  of  "investment"  plus  accessions, 
and  emphasizes  the  element  of  cost  as  distinguished  from  ac- 
cruals of  value.  Certainly  an  estimated  accrual  of  a  future 
liability  which  is  not,  for  tax  purposes,  deductible  from  the 
current  earnings,  is  not  a  reduction  of  invested  capital.  The 
court  wisely  disallowed  unrealized  appreciation  as  an  addition 
to   invested   capital;  it   is  a  fair  assumption  that   it   will   be 


^Excess  Profits    Tax  Procedure,   1921,   page   266. 


EXCESS    rJ<OEITS    lAX   PROCEDURE— 1921  1625 

equally  wise  in  overruling  the  Treasury  in  its  attempt  to  reduce 
invested  capital  unduly. 

Page  272 
Corporation  in  process  of  liquidation. — 

Ruling.  The  invested  capital  of  a  corporation  whose  assets 
are  in  the  custody  of  trustees  in  liquidation  should  be  computed  in 
the  same  manner  as  in  the  case  of  an  active  corporation,  making  due 
allowance  for  any  amount  of  capital  assets  which  have  been  liquidated 
and  returned  to  the  stockliolders  during  the  taxable  year.  The  trustees 
nia}',  owing  to  abnormal  conditions  affecting"  the  cajiital  or  income, 
make  application  for  assessment  in  accordance  with  sections  327 
and  328  of  the  Act.     ( B.  27-21-1720;  O.  1).  969.) 

Compliance  with  this  ruling  should  be  a  simple  matter, 
because  trustees  in  liquidation  are  required  to  file  corpcjrate 
returns  which  give  all  the  necessary  information  for  the  peri- 
ods prior  and  subsequent  to  their  appointment. 


CHAPTER    XII 

PRE-WAR  INVESTED  CAPITAL 

E^xcept  when  there  is  net  income  of  $10,000  or  more  from 
government  contracts,  the  ascertainment  of  pre-war  invested 
capital  is  not  a  factor  in  returns  for  the  calendar  year  192 1. 

What  has  been  said  with  reference  to  the  effect  upon  pre- 
war invested  capital  of  adjustments  of  net  income  of  prior 
years  by  revenue  agents,^  applies  equally  to  proposed  adjust- 
ments of  assets  resulting  from  recomputations  of  depreciation. 
If  depreciation  for  prior  years  is  increased,  invested  capital 
of  the  pre-war  period  is  correspondingly  decreased.  In  consid- 
ering adjustments  of  191 7  and  1918  returns,  the  effect  on 
invested  capital  of  the  pre-war  years  191 1,  1912,  and  1913, 
should  always  be  kept  in  mind. 

^  See  page  1600. 


1626  EXCESS   PROFITS    T  \X   PROCEDURE— 1921 

Page   281 

Goodwill  and  patents. — 

Ruling.  Where  the  cost  of  patents  has  been  charged  against 
surplus  or  otherwise  disposed  of  in  such  a  manner  as  not  to  benefit 
the  taxpayer  in  computing  his  net  income  since  January  i,  1909, 
any  amount  so  written  off  may  be  restored  in  computing  the  in- 
vested capital  if  it  be  shown  to  the  satisfaction  of  the  Commissioner 
that  the  amount  so  written  off  represented  a  mere  book  entry  as- 
cribable  to  a  conservative  policy  of  management  or  accounting  and 
did  not  represent  a  realized  shrinkage  in  the  value  of  such  assets. 
(Extract  from  Tax  Reviewers'  Recommendation  i,  quoted  in  C.  B. 
4,  page  392;  A.  R.  R.  436.) 

Such  adjustnicnts  necessarily  affect  pre-war  invested  capi- 
tal, if  the  aniounts  were  written  off  during  the  year  191 1, 
1912.  or    1913. 

Limitation  on  intangibles. — in  computing  invested  capi- 
tal for  ])re-war  }ears,  under  the  1917  law,  the  inclusion  of 
intangibles  at  not  to  exceed  20  per  cent  of  the  capital  stock 
outstanding  at  the  beginning  of  the  year,  will  have  to  be 
remembered,  \\hereas  under  the  19 18  and  1921  laws  the  limi- 
tation is  25  per  cent.  It  is  well  to  bear  in  mind  that  the  limita- 
tion applies  separately  to  each  year,  particularly  where  changes 
in  the  amounts  of  issued  stock  and  in  the  amounts  of  treasury 
stocks  (which  are  deducted  in  arriving  at  outstanding  stock) 
have  occurred  in  each  of  the  pre-war  years. 


CHAPTER    XIV 

CONSOLIDATED    RETURNS    OF    AFFILIATED 
CORPORATIONS 

General 

Page  304 

Consolidated  returns^  for  the  calendar  year  191 7  or  for 

fiscal  years  ended  therein  were  not  specifically  called  for  in 


^  The  reader  who  is  desirous  of  a  more  detailed  discussion  of  the  ac- 
counting aspects  of  consolidated  balance  sheets  and  income  statements,  is 
referred  to  Chapt'er  XVIII  of  the  author's  Auditing  Theory  and  Practice 
(third  edition)  in  which  this  subject  is  treated  at  length. 


EXCESS   PROFITS  TAX  PROCKDURE— 1921  1627 

the  1917  law,  but  were  peniiitted  under  Treasury  regula- 
tions. In  order  to  remove  any  doubt  as  to  the  legality  of  the 
Treasury's  action,  a  section  has  been  included  in  the  192 1 
law  to  ratify  the  Treasury's  procedure. 

Law.  Section  1331.  (a)  That  Title  II  of  the  Revenue  Act  of 
1917  shall  be  construed  to  impose  the  taxes  therein  mentioned  upon 
the  basis  of  consolidated  returns  of  net  income  and  invested  capital 
in  the  case  of  domestic  corporations  and  domestic  partnerships  that 
were  affiliated  during  the  calendar  year  1917. 

(b)  For  the  purpose  of  this  section  a  corporation  or  partnership 
was  affiliated  with  one  or  more  corporations  or  partnerships  (i) 
when  such  corporation  or  partnership  owned  directly  or  controlled 
through  closely  affiliated  interests  or  by  a  nominee  or  nominees  all 
or  substantially  all  the  stock  of  the  other  or  others,  or  (2)  when 
substantially  all  the  stock  of  two  or  more  corporations  or  the  business 
of  two  or  more  partnerships  was  owned  by  the  same  interests: 
Provided,  That  such  corporations  or  partnerships  were  engaged  in 
the  same  or  a  closely  related  business,  or  one  corporation  or  partner- 
ship bought  from  or  sold  to  another  corporation  or  partnership  prod- 
ucts or  services  at  prices  above  or  below  the  current  market,  thus 
effecting  an  artificial  distribution  of  profits,  or  one  corporation  or 
partnership  in  any  way  so  arranged  its  financial  relationships  with 
another  corporation  or  partnership  as  to  assign  to  it  a  disproportionate 
share  of  net  income  or  invested  capital.  For  the  purposes  of  this 
section,  public  service  corporations  which  (i)  were  operated  inde- 
pendently, (2)  were  not  physically  connected  or  merged  and  (3)  did 
not  receive  special  permission  to  make  a  consolidated  return,  shall 
not  be  construed  to  have  been  affiliated;  but  a  railroad  or  other  public 
utility  which  was  owned  by  an  industrial  corporation  and  was  operated 
as  a  plant  facility  or  as  an  integral  part  of  a  group  organization  of 
affiliated  corporations  which  were  required  to  file  a  consolidated  return, 
shall  be  construed  to  have  been  affiliated. 

(c)  The  provisions  of  this  section  are  declaratory  of  the  pro- 
visions of  Title  II  of  the  Revenue  Act  of  1917. 

A  partnership  may  be  included  in  a  consolidation  made 
under  the  191 7  law,  whereas  under  the  191 8  and  1921  laws 
such  inclusion  is  not  permitted,  except  as  provided  in  section 
240   (d)   uf  the  1921  law  (see  page  1629). 

Consolidated  returns  optional  after  January  i,  1922. — The 
1921  law  makes  the  consolidated  returns  provision  of  the  1918 
law  applicable  to  tlie  returns  of  taxable  years  beginning  before 


1628  EXCESS  I'KOFl'l'S    I'AX    l"R()( 'EDURE-^iyji 

Jaiiuar\'  1,   1  <;-'-',  Imt  makes  const^lidated  returns  optional  after 
that  (late. 

Law..  Section  240.  (e)  Corporations  which  are  affiliated  within 
the  meaning  of  this  section  shall  make  consolidated  returns  for  any 
taxable  year  beginning  prior  to  January  i,  1922,  in  the  same  manner 
and  subject  to  the  same  conditions  as  provided  by  the  Revenue  Act 
of  1918. 

For  taxable  \-ears  beginning  on  or  after  January  i.  1922, 
the   following  provisions   apply. 

Law.  Section  240.  (a)  That  corporations  which  are  affiliated- 
within  the  meaning  of  this  section  may,  for  any  taxable  year  beginning 
on  or  after  January  i,  1922,  make  separate  returns  or,  under  regulations 
prescribed  by  the  Commissioner  with  the  approval  of  the  Secretary, 
make  a  consolidated  return  of  net  income  for  the  purpose  of  this  title, 
in  which  case  the  taxes  thereunder  shall  be  computed  and  determined 
upon  the  basis  of  such  return.  If  return  is  made  on  either  of 
such  bases,  all  returns  thereafter  made  shall  be  upon  the  same  basis 
unless  permission  to  change  the  basis  is  granted  by  the  Commissioner. 

Affiliated  corporations  whose  taxable  years  commence  on 
or  after  January  i,  1922,  are  given  the  option  of  filing  separ- 
ate returns  or  of  tiling  a  consolidated  return.  An  election  once 
having  been  made,  no  change  in  the  basis  used  can  be  made 
without  obtaining  permission  fnjm  the  Commissioner. 

1  f  consolidated  returns  are  made,  intercompany  transac- 
tions which  involve  profits  or  losses  can  be  freely  made  without 
affecting  the  net  taxable  income. 

Two  important  points  should  be  considered  in  making 
the  decision:  (a)  losses  of  affiliated  companies,  and  (b)  loss 
of  specific  credits. 

(a)  The  loss  sustained  by  an  affiliated  company  included 
in  a  consolidation  is  applied  against  the  net  income  of  the 
other  member  or  members  (jf  the  grou[),  thereby  reducing  the 
net  taxable  income.  If  a  consolidated  return  were  not  ren- 
dered, it  is  true  that  under  certain  conditions,  as  contained  in 
section   204,''   taxpayers  may  deduct   losses  sustained   in  one 


^  For   a   definition   of   affiliated   corporations,    see   Excess   Profits    Tax 
Procedure,  1921,  page  308. 
'  See  page  1021. 


EXCESS  PROFITS  TAX   PROCEDURE— 1921  1629 

}'ear  from  the  net  income  of  the  succeeding  year  or  years. 
However,  a  consohdation  makes  it  possible  to  apply  a  loss 
against  any  net  income  in  the  current  year.  Since  corpora- 
tion earnings  and  losses  do  not  run  consistently  from  year  to 
\'ear,  and  since  one  corporation  may  lose  year  after  \-ear,  it 
seems  that  consolidated  returns  are  desirable. 

(b)  The  question  of  the  specific  credit  also  has  a  direct 
bearing  on  the  advisability  of  consolidation. 

].A\v.  Section  236.  (b)  In  the  case  of  a  domestic  corporation  the 
net  income  of  which  is  $25,000  or  less,  a  specific  credit  of  $2,000;  but 
if  the  net  income  is  more  than  $25,000  the  tax  imposed  by  section  230 
shall  not  exceed  the  tax  which  would  be  payable  if  the  $2,000  credit 
were  allowed,  plus  the  amount  of  the  net  income  in  excess  of  $25,000; 
and  .... 

A  consolidation  is  entitled  to  but  one  specific  credit  of 
v$2.ooo,  whereas,  if  separate  returns  are  rendered,  each  cor- 
poration in  the  group  having  a  net  income  of  less  than  $25,000 
may  claim  a  specific  credit  of  $2,000,  which,  taxed  at  12^ 
per  cent,  means  a  saving  of  $250  per  corporation. 

The  framers  of  the  192 1  law  evidently  thought  that  the 
option  of  rendering  separate  returns  opens  the  possibility  of 
evasion  of  taxation  by  intercompany  manipulations.  For  this 
or  for  some  other  reason,  a  provision  has,  beei.<  inserted  which 
empowers  the  Commissioner  to  make  consolidated  returns 
for  certain  enterprises. 

Law.     Section  240 (d)   Provided,  That  in  any  case  of  two 

or  more  related  trades  or  businesses  (whether  unincorporated  or  incor- 
porated and  whether  organized  in  the  United  States  or  not)  owned  or 
controlled  directly  or  indirectly  by  the  same  interests,  the  Commis- 
sioner may  consolidate  the  accounts  of  such  related  trades  and  busi- 
nesses, in  any  proper  case,  for  the  purpose  of  making  an  accurate  dis- 
tribution or  apportionment  of  gains,  profits,  income,  deductions,  or 
capital  between  or  among  such  related  trades  or  businesses. 

Regulation.  Subdivision  ( d)  of  section  240  provides  that  in  any 
case  of  two  or  more  related  trades  or  businesses  (whether  incorpor- 
ated or  not,  and  whether  organized  in  the  United  vStates  or  not), 
owned  or  controlled  directly  or  indirectly  by  the  same  interests,  the 
Commissioner  may  consolidate  the  accounts  of  such  related  trades  or 
businesses,   in   any   proper   case,    for   the   purpose   of   making  an   ac- 


1630  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

curate  distribution  or  apportionment  of  gains,  profits,  income.,  deduc- 
tions, or  capital  between  or  among  such  related  trades  or  businesses. 
This  provision  relates  not  to  the  payment  of  taxes,  but  to  the  de- 
termination of  the  true  income  of  related  trades  or  businesses  and  thus 
indirectly  to  the  amount  of  taxes  which  may  be  due  under  Title  H 
and  Title  III  of  the  statute.    (Art.  637.) 

It  is  unfortunate  that  the  foregoing  provision  of  the  law- 
appears  at  the  end  and  as  a  part  of  a  paragraph  which  deals 
with  corporations  entitled  to  the  benefits  of  section  262.*  Tax- 
payers may  infer  that  the  power  granted  to  the  Commissioner 
is  limited  to  corporations  embraced  in  section  262.  A  careful 
analysis  of  this  provision  demonstrates  that  it  could  not  so 
apply  because  it  contains  the  stipulation  "whether  organized 
in  the  United  States  or  not,"  which  could  not  apply  to  a  cor- 
poration which  qualifies  under  section  262.  The  power  evi 
dently  is  granted  to  the  Commissioner  in  order  to  determine 
the  true  income,  whether  or  not  the  businesses  are  affiliated 
within  the  meaning  of  section  240. 

The  power  given  to  the  Commissioner  to  require  con- 
solidated returns  for  the  express  purpose  of  ascertaining  the 
true  net  income  of  affiliated  interests,  applies  to  any  form  of 
business,  whether  individual,  partnership,  or  corporation. 

To  sum  up,  taxpayers  may  render  consolidated  returns 
if  they  so  elect;  their  right  to  render  separate  returns  may 
be  challenged  by  the  Commissioner. 

Page  309 
Corporations  classed  under  section  262  excluded. — ^Domes- 
tic corporations  which  derive  the  major  portion  of  their  income 
from  sources  within  the  territorial  possessions  of  the  United 
States  are,  under  the  provisions  of  section  262  of  the  1921  law, 
treated  as  foreign  corporations  and  cannot  be  included  in 
a  consolidated  return,  by  the  taxpa)'er,  although  the  Com- 
missioner may  consolidate  the  returns  to  ascertain  the  true 
income.^      Where    equity   demands    consolidation,    taxpayers 


■*  Section    262    deals    solely    with    citizens    and    domestic    corporatfc)iis 
operating  in  possessions  of  the  United  States.    See  Chapter  XXXV  I. 
^  Supra,  section  240  (d). 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1631 

should   request   the   Commissioner   to  exercise  his  discretion 
to  require  consoHdated  returns. 

Law.     Section  240 (d)   For  the  purposes  of  this  section  a 

corporation  entitled  to  the  benefits  of  Section  262  shall  be  treated  as  a 
foreign  corporation. 

Certain  government  contract  corporations. — Under  sec- 
tion 240  (a)  of  the  1918  law,  an  affiliated  corporation  "organ- 
ized after  August  i,  1914,  and  not  successor  to  a  then  exist- 
ing business,  50  per  centum  or  more  of  whose  gross  income 
consists  of  gains,  profits,  commissions,  or  other  income,  de- 
rived from  a  Government  contract  or  contracts,  made  between 
April  6,  1917  and  November  11,  1918,  both  dates  inclusive," 
could  not  be  included  in  a  consolidation  under  that  law.  This 
inhibition  has  not  been  carried  forward  into  the  192 1  law 
and  it  is  therefore  possible  to  include  such  corporations  in  a 
consolidation  after  January  i,  1922,  if  they  meet  the  tests  of 
affiliation  prescribed  by  section  240   (c)®  of  the  1921  law. 

Page  311 
"Substantially  all  the  stock"  interpreted. — The  following 
rulings,  which  deny  permission  to  consolidate,  are  illustrative 
of  the  Treasury's  interpretation  of  this  phrase  in  cases  where 
there  is  less  than  95  per  cent  stock  control  without  substantial 
intercompany  transactions. 

Rulings.  Held,  that  where  19  per  cent  of  the  stock  of  a  corpora- 
tion is  owned  by  minority  interests,  13  per  cent  of  which  is  owned  un- 
conditionally by  one  of  the  officers,  and  where  39  per  cent  of  the  stock 
of  another  corporation  is  held  by  minority  interests,  10  per  cent  of 
which  is  held  unconditionally  by  a  different  officer,  and  in  each  in- 
stance the  officer  has  no  other  interest  in  the  otherwise  controlled  cor- 
porations, there  should  be  no  consolidation  in  the  years  1917,  1918, 
and  1919  for  tax  purposes.     (C.  B.  4,  page  314;  Digest  A.  R.  R.  448.) 

Held,  that  stock  control  of  69.04  per  cent  in  the  year  1918,  without 
intrt-company  operating  transactions  or  artificial  intercorporate  re- 
lationship, is  insufficient  to  authorize  a  consolidated  tax  return  for 
that  year.     (C.  B.  4,  page  309;  Digest  A.  R.  R.  378.) 


"  See  Appendix  C. 


1632  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

The  last  ruling  intimates  that:  (i)  if  the  companies  had 
been  operated  as  one  business  enterprise,  and  (2)  if  profits 
could  have  been  shifted,  a  consolidated  return  should  be  made. 
This  is  sound. 

The  author  is  of  the  opinion  that  the  Treasury  has  given 
too  much  weight  to  the  size  of  the  minority  interest.  A  5 
per  cent  minority  have  the  same  rights  as  a  30  or  40  per  cent 
minority.  Tlie  primary  tests  are :  ( i )  Have  the  companies 
been  operated  as  one  enterprise?  (2)  Could  the  profits  have 
been  shifted  in  an}-  material  extent? 

In  another  case  a  corporation  owned  all  of  the  stock  of 
a  subsidiary,  but  deposited  all  of  such  stock  with  a  trust 
company  as  collateral  to  cover  the  issue  of  its  preferred 
stock.  It  retained,  during  the  period  of  the  agreement,  no 
control  therein.  A  consolidation  of  the  parent  and  subsidiar}- 
company  was  denied/ 

Page  312 
Interpretation  of  the  phrase,  "the  same  interest." — Separ- 
ate companies  are  sometimes  the  outgrowth  of  one  business 
which  has  been  divided  in  order  to  distribute  an  estate  satis- 
factoril}'.  Before  the  distribution  three  beneficiaries  may 
jointly  own  three  businesses,  in  which  event  the  law  calls 
for  a  con.solidated  return.  After  the  distribution  the  same 
interests  own  precisely  the  same  assets.  Conditions  do  not 
permit  that  each  business  be  divided  into  three  equal  parts : 
therefore  the  proportions — not  the  same  interests — change. 
If  the  change  inadvertently  results  in  an  inequitable  tax,  a 
consolidated  return  should  be  permitted  or  relief  should  be 
granted  to  the  corporation  which  suffers  unduly. 

A  ruling  issued  in  1919,^  which  in  effect  substituted  the 
words  "in  substantially  the  same  proportions"  for  the  words 
of  the  law,  "the  same  interests,"  should  be  reversed. 


^B.  43-21-1888;  A.  R.  R.  641. 

8  Dated    April    11.    igiQ.      See    Excess    Profits    Tax   Procedure,    1921, 
page  313. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1633 

Page  315 

Specific  credit  in  case  of  consolidated  return. — 

Law.  Section  240 (b)  There  shall  be  allowed  in  comput- 
ing the  income  tax,  only  one  specific  credit  computed  as  provided  in 
subdivision   (b)   of  section  236. 

Under  the  1918  law  one  specific  credit  of  $2,000  was 
allowed  in  computing  the  net  income  of  a  consolidation.  In 
making  consolidated  returns  for  taxable  years  beginning  on 
or  after  January  i,  1922,  this  specific  credit  will  be  permitted 
only  if  the  net  income  of  the  consolidation  does  not  exceed 
$25,000. 

Page  317 
Transfer  of  assets  between  affiliated  companies  not  con- 
sidered a  replacement. — 

Ruling.  Where  one  of  an  affiliated  group  of  corporations  which 
files  a  consolidated  return  established  a  replacement  fund  in  accordance 
with  the  provisions  of  Article  50,  Regulations  45,  the  expenditure  of 
the  replacement  fund  so  established  to  replace  a  steamship  in  kind  is 
not  a  replacement  within  the  meaning  of  that  term,  when  the  steam- 
ship acquired  to  replace  the  one  lost  was  acquired  from  another  of 
the  affiliated  corporations.     (B.  Digest  48-21-1942;  A.  R.  M.  142.) 

In  refusing  to  consider  the  purchase  of  assets  of  one 
affiliated  company  from  another  affiliated  company  in  the 
same  group  as  constituting  a  "replacement"  as  defined  in 
articles  49  and  50,  of  Regulations  45,  the  Treasury  is  main- 
taining its  contention  that  a  group  of  affiliated  companies 
must  be  considered  as  an  integral  whole. 

Page  323 
Distribution  of  the  tax  among  the  subsidiaries. — The  ques- 
tion frequently  arises  as  to  the  most  equitable  method  of  dis- 
tribution to  affiliated  companies  of  the  total  tax  for  which  a 
consolidation  is  liable.  The  Treasury  has  suggested  a  method 
of  apportionment  based  on  net  income.^ 

As   an   alternative   method   which   may   work   substantial 


See  Excess  Profits  Tax  Procedure,  1921,  page  323. 


l634  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

justice  in  certain  cases,  it  is  suggested  that  the  tax  may  be 
apportioned  on  the  basis  of  the  tax  which  would  have  been 
paid  l)v  each  company  had  separate  returns  been  filed.  By 
this  method,  if  there  is  a  saving  in  tax  by  the  consolidation, 
all  of  the  companies  receive  a  share  of  the  benefit. 

Example 

Total  tax  payable  by  parent  or  principal  reporting  com- 
pany       $100,000 

Tax  computed  separately : 

Apportionment 
of 
Separate  Total  Tax  of 

Company  Tax  Percentage  Consolidation 

A $  12.000  10%  $  10,000 

B 60,000  50%  50,000 

C 48,000  40%  40,000 

$120,000  100%  $100,000 

Should  the  consolidation  result  in  the  payment  of  a  larger 
tax  by  the  group  than  would  have  been  payable  had  each 
company  filed  a  separate  return,  minority  interests,  if  any. 
might  have  cause  for  complaint  if  their  proportion  of  the 
tax  exceeds  the  amount  which  their  company  would  have 
])aid  had  it  filed  a  separate  return. 

Allocation  of  tax  when  partnerships  are  included 
IN  coN.soLiDATiON. — When  partnerships  and  corporations  are 
both  includetl  in  the  consolidation,  under  the  1917  law,  the 
Treasury  considers  two  ''groups."  viz.  : 

1.  Partnerships 

2.  Corporations 

and  first  allocates  the  tax  on  the  basis  of  the  net  income  and 
invested  capital  assignable  to  each  group.  The  tax  thus  allo- 
cated is  then  apportioned  on  the  same  basis  within  each  group. 

Ruling While  the  units  of  the  two  groups  (units  of  the 

partnership  group  here  mean  the  individual  partners)  will  pay  their 
income  taxes  at  different  rates,  the  units  of  the  same  group  will  pay 
their  income  taxes  at  the  same  rates,  and  if  the  excess  profits  tax  is 
allocated  to  each  group,  according  to  the  invested  capital  and  net  in- 


EXCESS  I'ROEITS  TAX   PROCEDURE— 1921  1635 

come  assignable  to  tlic  ip-oup.  all  difficulties  (lisai)pcar  and  the  tax  is 
equitably  allocated. 

Tt  is  held,  therefore,  that  where  corporations  and  partnerships 
are  consolidated  the  excess  profits  tax  should  l)e  allocated  to  the 
partnerships  as  a  group  according  to  the  invested  capital  and  net 
income  assignable  to  the  partnership  group.  After  the  proper  amount 
of  the  excess  profits  tax  has  been  allocated  to  the  partnership  group, 
article  78  may  then  be  applied  within  the  partnership  group  as  it  is 
now  applied  within  the  corporation  group.      (I-3-37;  I-  O.   1083.) 

Page  327 
Pre-war  invested  capital. — The  I'oniniittee  on  Appeals  and 
Review  has  issued  a  meiiioraiidum,'"  explanatory  of  articles 
802  and  869  of  Regulations  45,  which  deals  with  the  compu- 
tation of  pre-war  invested  capital  and  income  of  corporations 
affiliated  in  191 7  or  19 18  whose  affiliations  in  the  pre-war 
years  were  not  the  same  as  in  the  taxable  years  19 17  and  19 18. 

Ruling The  Committee  is  accordingly  of  the  opinion  that 

there  can  be  taken  into  consideration  in  the  prewar  years  only  such 
corporate  units  for  the  purpose  of  determining  average  prewar  income 
and  average  prewar  invested  capital  as  may  be  properly  consolidated 
into  one  corporate  unit  for  the  taxable  year  1917  or  1918. 

This  ruling  adds  little  to  the  articles  in  question,  except 
by  inference.  Article  802  merely  deals  with  a  case  such  as 
the  following : 

Corporations  in  Corporations 

existence  in  affiliated  in 

pre-war  period  taxable  year 


D  (unaffiliated) 
E  (unaffiliated) 

In  a  case  such  as  the  above,  where  A,  B,  C,  D,  and  E  are 
affiliated  in  the  taxable  year,  but  where  only  A,  B,  and  C  were 
affiliated  in  the  pre-w'ar  period,  D  and  E  being  separate  cor- 
porations subsequently  affiliated  with  A,  the  article  provides 
that  the  comparative  pre-war  net  income  is  to  be  arrived  at  by 


C.  B.  4,  page  ,361;  A.  R.  Al.   116. 


1636  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

adding  that  of  the  group,  A,  B,  C,  to  the  separate  net  incomes 
of  D  and  E.  Similarly  with  invested  capital.  A.  R.  M.  116 
confirms  this  procedure. 

One  oversight  in  the  Committee's  ruling  is  patent.  If  in 
the  pre-war  period  corporation  A  had  a  subsidiary  B.  which 
was,  say,  a  selling  organization  for  A's  product,  and  if,  since 
the  pre-war  period,  B  has  been  dissolved  and  its  activities 
carried  on  as  a  branch  of  A,  then  it  is  not  correct  to  limit  the 
number  of  pre-war  units  (2)  to  the  number  affiliated  in 
the  taxable  year  (i).  The  pre-war  comparative  of  A  is  A 
plus  B. 

As  a  further  illustration,  assume  in  the  taxable  year  three 
affiliated  corporations  (two  having  been  sold  since  the  close 
of  the  pre-war  period  but  before  the  beginning  of  the  taxable 
year).  In  the  pre-war  period  five  corporations  were  affiliated, 
because  four  were  owned  by  a  holding- company.  The  pro- 
cedure in  such  a  case,  under  the  ruling,  is  as  follows : 

Corporations  in  Corporations 

existence  in  pre-war  affiliated  in 

period  taxable  year 

A  A 

//V  /\ 

BCDE  B        C 

D   (unaffiliated) 
E   (unaffilialed) 

According  to  the  ruling,  the  pre-war  comparative  net 
income  and  invested  capital  will  l)e  that  of  A,  B,  and  C,  exclud- 
ing D  and  E.  That  is  to  .say,  an  artificial  cleavage  must  be 
made  in  the  pre-war  affiliated  group.  However,  no  attempt  is 
made  in  the  ruling  to  indicate  the  procedure  for  determining 
the  pre-war  income  and  invested  capital  of  the  group,  A,  B,  C. 
The  difficult  point  left  unsolved  by  the  Committee  is  how  to 
eliminate  D  and  E  from  the  affiliated  group,  A,  B,  C,  D  and  E. 
Is  the  elimination  to  be  made  merely  by  treating  the  invest- 
ment in  the  stock  of  D  and  E  on  A's  books  as  inadmissible 
assets?  Or.  should  the  investment  accounts  be  eliminated 
from  the  balance  sheet  entirely;  and  if  so,  how?     The  illus- 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1637 

trations  given  above  are  the  simplest  possible;  many  more 
difficult  combinations  occur  in  actual  experience.  The  intrica- 
cies of  the  problem  can  best  be  gauged  by  the  perusal  of  a 
recent  paper  on  this  subject/^ 

Each  case  in  which  pre-war  affiliations  were  not  the  same 
as  in  the  taxable  year  must  be  dealt  with  on  its  own  merits. 
The  author  cannot  lay  down  any  hard-and-fast  rule  which  will 
fit  all  cases;  neither  should  the  Treasury  attempt  to  do  so. 
The  method  used  must  be  that  which  is  "necessary  to  place 
the  computation  of  the  invested  capital  for  such  pre-war 
year  on  the  basis  employed  in  determining  the  invested  capital 
for  the  taxable  year."'^  The  important  word  is  "basis,"  and 
that  basis  must  be  one  which  will  result  in  a  true  comparison 
between  the  pre-war  years  and  the  taxable  year. 

[Former  Procedure] 

Ruling.  The  M  Company  and  the  O  Company  were  engaged  in 
entirely  dissimilar  enterprises  with  no  artificial  distribution  of  profits 
or  arrangement  of  financial  relationship  to  assign  to  either  a  dispro- 
portionate share  of  net  income  or  invested  capital. 

Recommended,  that  they  be  authorized  to  file  separate  corporate 
tax  returns,  notwithstanding  that  the  M  Company  owned  all  the 
capital  stock  of  the  O  Company  and  that  more  than  50  per  cent  of  the 
sales  of  the  latter  company  were  made  at  market  prices  to  the  former 
company.      (B.  Digest  38-21-1834;  A.  R.  R.  624.) 

Under  the  191 8  law  the  foregoing  case  would  have  been 
decided  otherwise,  as  the  100  per  cent  stock  ownership  would 
have  necessitated  a  consolidated  return. 


CHAPTER     XV 

INVESTED  CAPITAL  IN  SPECIAL  CASES 
"THE  RELIEF  SECTIONS" 

Page  331 

The  192 1  law  does  not  change  the  relief  provisions  of  the 

19 1 8  law,  except  that  section  328   (a)   provides  that  in  the 


"  Walter  A.   Staub,   "Consolidated   Returns,"   in    The   Federal  Income 
Tax   (Columbia  University  Press,  1921). 
^-  1918   law,   section   330. 


1638  EXCESS  PROFITS  TAX   PROCEDURE— 1921 

case  of  a  cori)oration  coming  within  the  provisions  of  section 
262^  (  which  deals  witli  income  received  by  domestic  corpora- 
tions from  sources  within  possessions  of  the  United  States), 
neither  the  taxpaver  nor  the  representative  corporations  shall 
l)e  entitled  to  the  specific  exemption  of  $3,000  when  the  tax  is 
computed. 

The  administration  of  this  section  of  the  law-  is  and  must 
be  confidential.  Therefore,  the  rulings  which  have  been  pul)- 
lished  since  the  publication  of  Escess  Profits  Tax  Procedure. 
192 1,  do  not  throw  any  additional  light  on  this  subject. 

As  a  general  rule  the  published  decisions  merely  state  the 
reasons  why  an  application  should  or  should  not  be  granted. 
The  relief  granted  is  not  indicated. 

In  1 9 18,  the  Treasury  published  statistics  of  corporate 
earnings  as  Senate  Document  No.  259;  it  is  presumed  that 
similar  compilations  w'ill  be  issued  from  time  to  time.  Such 
statistics  should  aid  taxpayers  in  ascertaining  the  probability 
of  relief. 

Selection  of  representative  concerns. — The  relief  sections 
were  designed  by  Congress  to  grant  relief.  Congress  anti- 
cipated that  unusual  cases  would  arise  to  which  a  general 
rule  could  not  be  applied.  Consecjuently  the  Commissioner  was 
vested  wath  very  broad  powers. 

When  a  taxpayer  has  established  a  meritorious  case  for 
relief  the  Commissioner  should  select  comparatives  (repre- 
sentative corporations)  which  will  carry  out  the  language  and 
intent  of  the  law. 

When  discretionary  powers'-  are  given  to  an  administrative 
officer,  he  should  not  l)ind  himself  l)y  restrictive  rules. 

The  author  again  quotes  Senator  Simmons'  statement 
which  shows  the  spirit  in  which  Congress  intended  that  the 
relief  sections  should  be  administered. 


^  See  page  1324. 

-  For    distinction    between    discretionary    and    ministerial    powers,    see 
29  Cyc.   1433,   1442-4- 


EXCESS   PROFITS  TAX   PROCEDURE— 1921  1639 

The  general  opinion  of  the  conferees  and  of  tlic  Department,  and 
1  concur  in  that  opinion,  is  that  the  amendment  as  rcth'afted  broadens 
rather  than  restrains  the  powers  of  the  Commissioner  in  the  matter 
of  rehef  against  injustice,  inequality,  and  discrimination 

They  (referring  to  the  business  interests  of  the  country)  may 
know  that  there  is  some  provision  here  by  which  the  Commissioner 
can  help  them  in  case  of  difficulties  of  the  kind  I  have  described,  but 
I  do  not  think  they  have  yet  come  to  realize  the  breadth  of  the  dis- 
cretion which  is  lodged  in  the  Commissioner  in  this  amendment  and 
what  it  may  be  worth  to  them  under  the  conditions  which  now  con- 
front us.^ 

The  author's  experience  is  to  the  effect  that  all  a])p]ications 
for  relief  are  carefully  considered,  and  that  at  the  present 
time  every  effort  is  being  made  to  administer  the  relief  sec- 
tions as  was  intended  by  the  framers  of  the  law. 

Comparatives  where  net  income  of  pre-war  period  is  ab- 
normally low.^ — ,V  point  of  interest,  where  19 17  corporation 
returns  are  still  under  review,  arises  in  a  ruling  given  under 
the  following  circumstances :  The  appellant  corporation  con- 
tended that  by  reason  of  foreign  competition  in  its  particular 
product,  which  reached  a  high  inark  in  the  years  1911-1913. 
incktsive,  its  average  profits  for  those  years  did  not  reflect 
its  true  earnings  for  the  purposes  of  establishing  a  pre-war 
income.  Relief  was  sought  under  section  205  of  the  191 7 
law.     In  refusing  to  grant  the  relief  the  C^ommittee  stated : 

Ruling This  contention,  however,  was  not  peculiar  to 

this  appellant.  It  is  admitted  that  the  act  of  the  foreign  government  af- 
fected approximately  all  American  concerns  engaged  in  the  same 
business.  It  is  admitted,  therefore,  that  while  this  was  an  unusual 
year  of  depression,  all  like  trades  were  affected  to  the  same  extent 
as  that  of  the  appellant (B.  39-21-1849;  A.  R.  R.  618.) 

The  crux  of  the  situation  lies  in  the  fact  that  the  peculiar 
conditions  affected  the  particular  trade  as  a  whole.  This 
very  fact  would  rob  the  application  of  section  205,  of  the 
191 7  law,  of  its  effectiveness.  The  relief  to  be  provided  by 
that  section  is  the  deduction  of  1 


^Congressional  Record,  February  11,  1919,  page  3135. 


1640  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

(i)  An  amount  equal  to  the  same  percentage  of  its  invested  capi- 
tal for  the  taxable  year  which  the  average  deduction  ....  for  such 
year  of  representative  corporations  ....  engaged  in  a  like  or  simi- 
lar trade  or  business  is  of  their  average  invested  capital  for  each 
year.  .  .  . 

In  other  words,  no  relief  is  offered  by  the  law  except 
where  conditions  of  the  one  concern  in  a  trade  are  contrary 
to  those  of  other  concerns  in  that  same  trade.  The  same 
principle  is  true  in  the  application  of  section  328  (a)  of  the 
19 18  and  1921  laws,* 

Can  the  Treasury's  decisions  in  relief  cases  be  reviewed 
by  the  courts? — Jlie  question  has  been  asked:  Can  the  courts 
review  the  action  of  the  Treasury  in  relief  cases?  If  tax- 
pa}'ers  are  not  satisfied  with  the  decisions  of  the  Treasiu^y, 
can  they  seek  relief  in  the  courts?  Some  lawyers  are  of  the 
opinion  that  relief  sections  cannot  be  reviewed  by  the  coiuls. 
They  believe  that  final  action  lies  entirely  within  the  discre- 
tion of  the  Commissioner.  Section  328  defines  how  the  tax 
shall  l)e  computed:  "the  Commissioner  shall  compare  the  tax- 
payer only  with  representative  corporations."^  The  law  does 
not  say  that  the  taxpayer  shall  be  compared  with  representative 
concerns  selected  by  the  Commissioner,  although  it  is  obvious 
that  the  Commissioner  must  select.  The  point  is  that  the 
exercise  of  this  particular  task  is  ministerial  and  not  discre- 
tionary." Failure  to  select  representative  concerns  as  defined 
in  the  law  would  seem  to  permit  an  appeal  to  the  courts. 

Subdivision    (b)   of   section   328  provides   that: 

Law.     Section  32S (b)   For  the  purposes  of  subdivision 

(a)  the  ratios  between  the  average  tax  and  the  average  net  income 
of  representative  corporations  shall  be  determined  by  the  Commis- 
sioner in  accordance  with  regulations  prescribed  by  him  with  the  ap- 
proval of  the  Secretary. 


*  For  procedure  in  the  case  of  affiliated  corporations,  see  page  327. 

5  Section  328    (a). 

6  For  distinction  between  discretionary  and  ministerial  powers,  see 
29  Cyc.  1433.  1442-4- 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1641 

The  foregoing  does  not  say,  however,  that  the  Commis- 
sioner's action  shall  be  final.  Broad  powers  of  this  kind  are 
not  usually  invested  in  an  administrative  officer  without  giving 
the  right  of  appeal  to  the  courts. 

If  the  Commissioner  were  ordered  to  certify  to  a  court 
the  representative  corporations  which  were  used  in  a  particular 
case,  the  court  should  have  very  little  difficulty  in  deciding 
whether  or  not  they  meet  the  requirements  of  the  statutory 
definition.  And  in  cases  where  applications  had  been  refused, 
a  court  should  also  have  little  difficulty  in  determining  whether 
or  not  concerns  meet  the  requirements  of  section  327. 

Page  334 
Method  of  payment  of  tax  for  1921  when  relief  is  ex- 
pected.— When  the  profits  taxes  included  rates  up  to  80  per 
cent,  the  relief  sections  provided  that,  pending  consideration 
of  claims,  a  maximum  of  50  per  cent  could  be  paid.  With 
the  maximum  rate  of  excess  profits  tax  standing  at  40  per 
cent,  the  privilege  (?)  of  paying  50  per  cent  pending  con- 
sideration is  somewhat  of  a  joke. 

The  author  is  still  of  the  opinion  that  the  procedure  out- 
lined in  his  192 1  edition  of  Excess  Profits  Tax  Procedure, 
page  335,  is  valid. 

Articles  912  and  913  were  revised  in  1921  to  read  as 
follows.  The  corresponding  articles  of  Regulations  62  contain 
similar  provisions.. 

Determination    of    first    instalment    in    case    of 

DOMESTIC  corporations. 

Regulation.  In  the  case  of  any  corporation,  other  than  a  foreign 
corporation,  where  absolutely  no  data  are  available  for  the  determina- 
tion of  invested  capital  for  the  taxable  year,  the  installments  of  the 
tax  shall  in  the  first  instance  be  determined  upon  the  basis  of  a  war 
profits  and  excess  profits  tax  equal  to  50  per  cent  of  the  net  income, 
except  that  for  19 19  and  subsequent  taxable  years,  in  the  case  of  any 
corporation  other  than  a  foreign  corporation,  such  installments  shall 
be  determined  upon  the  basis  of  an  excess  profits  tax  equal  to  20  per 
cent  of  the  net  income  in  excess  of  $3,000,  but  not  in  excess  of  $20,000, 


1642  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

plus  40  per  cent  of  the  net  income  in  excess  of  $20,000.  In  any  other 
case  under  section  328  of  the  statute  other  than  the  case  of  a  foreign 
corporation,  but  inckiding  a  case  where  the  invested  capital  for  the  tax- 
able year  can  not  be  accurately  determined,  but  where  a  minimum 
amount  of  invested  capital,  as  to  which  there  is  no  question,  can  be 
determined,  the  installments  shall  in  the  first  instance  be  determined 
upon  the  basis  of  a  war  profits  and  excess  profits  tax  computed  by  using 
the  minimum  invested  capital,  the  tax  in  any  such  case  not  to  exceed  an 
amount  equal  to  50  per  cent  of  the  net  income,  and  for  1919  and  sub- 
sequent taxable  years  not  to  exceed  20  per  cent  of  the  net  income 
in  excess  of  $3,000,  but  not  in  excess  of  $20,000,  plus  40  per  cent  of 
the  net  income  in  excess  of  $20,000.  (Art.  912,  amended  by  B. 
42-21-1877;  T.  D.  3235.) 

Determination    of    first    instalment    in    case    of 

foreign  corporations. 

Regulation.  In  the  case  of  a  foreign  corporation  the  install- 
ments of  the  tax  shall  in  the  first  instance  be  determined  upon  the 
basis  of  a  war  profits  and  excess  profits  tax  computed  by  using  its 
invested  capital  for  the  taxable  year  1917,  such  tax  for  any  taxable 
year  not  to  exceed  an  amount  equal  to  50  per  cent  of  the  net  income, 
and  for  1919  and  subsequent  taxable  years  not  to  exceed  20  per  cent 
of  the  net  income  not  in  excess  of  $20,000,  plus  40  per  cent  of  the  net 
income  in  excess  of  $20,000.  For  the  purpose  of  this  article  the  in- 
vested capital  for  1917  shall  be  adjusted  for  any  subsequent  changes 
in  its  amount  due  to  cash  or  property  paid  in  or  withdrawn  or  to 
surplus  or  undivided  profits  of  prior  years  retained  in  the  business  and 
properly  attributable  to  its  business  within  the  United  States.  If  the 
tax  for  1917  was  determined  under  section  210  of  the  Revenue  Act 
of  1917,  the  constructive  capital  which  would  result  in  a  tax  equivalent 
to  the  tax  determined  under  that  section  shall  be  used.  In  the  case  of 
a  foreign  corporation  which  was  organized  subsequent  to  the  taxable 
year  1917,  or  which  had  no  income  from  sources  within  the  United 
States  during  1917,  the  installments  of  the  tax  shall  in  the  first  in- 
stance be  determined  upon  the  basis  of  a  war  profits  and  excess 
profits  tax  equal  to  50  per  cent  of  the  net  income,  except  that  for  1919 
and  subsequent  taxable  years  such  installments  shall  be  determined 
upon  the  basis  of  an  excess  profits  tax  equal  to  20  per  cent  of  the  net 
income  not  in  excess  of  $20,000,  plus  40  per  cent  of  the  net  income  in 
excess  of  $20,000.     (Art.  913,  amended  by  B.  42-21-1877;  T.  D.  3235.) 

Claims  for  credit  against  overpayments  under  section 
328. — The  following  ruling  indicates  that  the  procedure  sug- 
gested by  the  author  will  not  be  acceptable  to  the  Treasury. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1643 

Ruling.  Reference  is  made  to  your  letter  of  March  8,  1921,  rela- 
tive to  corporation  returns  to  be  filed  for  1920  under  the  provisions  of 
Sections  327  and  328  of  the  Revenue  Act  of  1918. 

You  state  that  it  is  your  understanding-  that  in  filing  returns  for 
1920  uiider  the  above-mentioned  sections,  claim  for  credit  may  be  ap- 
plied against  the  amount  of  the  first  installment  of  tax  due  thereon  to 
the  extent  that  it  is  estimated  the  amount  of  tax  paid  was  in  excels 
of  the  amount  due  as  computed  under  the  provisions  of  Section  328. 
You  inquire  as  to  a  justifiable  percentage  of  tax  on  income  for  1919 
to  be  used  as  the  basis  for  a  claim  for  credit  against  the  first  install- 
ment of  the  tax  for  1920. 

In  reply  your  attention  is  invited  to  Section  328  (a)  which  pro- 
vides in  part  that  "In  the  cases  specified  in  section  327  the  tax  shall 
be  the  amount  which  bears  the  same  ratio  to  the  net  income  of  the  tax- 
payer (in  excess  of  the  specific  exemption  of  $3,000)  for  the  taxable 
year,  as  the  average  tax  of  representative  corporations  engaged  in  a 
like  or  similar  trade  or  business  bears  to  their  average  net  income  (in 
excess  of  the  specific  exemption  of  $3,000)  for  such  year."  The  special 
relief  afforded  by  Sections  327  and  328  is  based  upon  the  merits  of 
the  individual  case,  and  the  provisions  of  section  328  do  not  permit 
the  determination  of  a  general  average  for  any  trade  or  business. 

Claim  for  credit  may  not  under  any  circumstances  be  applied  against 
taxes  due  until  the  Bureau  has  definitely  determined  that  the  amount 
of  the  claim  is  actually  in  excess  of  the  amount  of  taxes  due  on  the 
previous  return.  Until  complete  audit  comparatives  are  available  for 
use  in  computing  under  Section  328  the  taxes  due  on  1919  returns,  the 
exact  amount  of  tax  due  thereon  can  not  be  determined,  and,  conse- 
quently, claims  for  credit  in  the  amounts  believed  to  be  in  excess 
of  tax  due  for  the  previous  year  may  not  be  applied  against  the  amount 
of  the  first  installment  of  the  1920  taxes.  (Letter  to  The  Corporation 
Trust  Company,  signed  by  Commissioner  Wm.  M.  Williams,  and 
dated  March  23,  1921.) 

If  it  is  obvious  that  the  appHcation  of  the  reHef  sections 
will  disclose  an  overpayment,  no  harm  can  be  done  by  per- 
mitting the  estimated  overpayments  to  be  credited  against  any 
taxes  which  may  be  due.  Subsequent  adjustments,  if  any,  in 
favor  of  the  government  would  bear  interest  at  the  rate  of  6 
per  cent  per  annum  from  the  time  when  they  were  originally 
due.  This  is  a  privilege  which  could  be  abused,  but  until 
there  is  evidence  of  abuse,  credits  should  be  allowed.  Recent 
cases  have  come  to  light  in  which  the  assessment  of  excessive 
taxes  has  thrown  corporations  into  bankruptcy.     In  all  cases, 


l644  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

such  as  the  foregoing,  in  which  the  Commissioner  has  discre- 
tion to  permit  claims  for  credit,  every  effort  should  be  made  to 
extend  aid  to  all  taxpayers  who  deserve  it. 

Page  343 
Relief  will  not  be  granted  when  expenditures  for  intangi- 
bles can  be  restored. — The  Treasury  has  reconsidered  its  posi- 
tion regarding  the  restoration  of  expenditures  for  intangible 
assets  previously  charged  to  expenses.'^  The  logical  result 
of  its  original  position  was  that  corporations  which  had  a  large 
investment  in  intangible  assets  (paid  for  in  cash)  and  a 
negligible  investment  in  tangible  assets  at  January  i,  191 7, 
were  forced  to  seek  relief.  An  embarrassment  arose  when  it 
was  found  that  representative  concerns  were  similarly  situated, 
so  that  little  if  any  relief  could  be  granted.  The  decision  of 
the  United  States  Supreme  Court  in  the  La  Belle  Iron  Works 
case  clearly  indicates  that  the  entire  actual  investment  in  capi- 
tal assets  at  January  i,  191 7,  must  be  included  in  invested 
capital.  This  throws  upon  taxpayers  the  burden  of  support- 
ing claims  for  restoration  of  capital  items  charged  off.  In 
many  cases  the  task  is  feasible  because  it  is  merely  a  problem 
of  the  analysis  of  accounts. 

In  A.  R.  M.  141,  Bulletin  47-21-1937,  the  Committee  on 
Appeals  and  Review  takes  the  position  that  when  expenditures 
can  be  restored  other  relief  is  not  necessary. 

Page  353 
Relief  not  granted  merely  because  corporation  earned  a 
high  rate  of  profit. — Relief  is  usually  denied  in  cases  in  which 
the  capital  employed  has  been  ample  for  the  needs  of  the  busi- 
ness and  in  which  abnormal  profits  in  the  war  years  resulted 
from  the  high  prices  and  profits  which  prevailed  in  those  years. 
Even  where  contracts  made  in  19 16  resulted  in  large  profits  in 
191 7,  relief  was  denied.' 


■  See  page  1644  for  full  discussion. 
C.  B.  4,  page  401;  A.  R.  R.  518 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1645 

Much  seems  to  depend  upon  the  trend  of  representative 
concerns.  If  most  concerns  in  an  industry  were  prosperous 
and  paid  higher  taxes  during  the  war  years,  there  will  be 
difficulty  in  securing  relief;  but  if  many  concerns  in  an  industry 
paid  relatively  low  rates  of  tax,  a  concern  in  that  industry 
which  claims  to  be  affected  by  abnormal  conditions  has  a  fair 
chance  of  securing  relief.  The  following  is  an  illustration  of 
the  latter  class. 

Ruling The  Committee  is,  however,  of  the  opiiaion  that 

due  to  conservative  capitalization,  the  realization  of  net  income  in 
1918  resulting  from  the  investment  of  capital  which  was  nonincome 
producing  during  the  prewar  period  and  for  a  number  of  years  sub- 
sequent thereto,  and  the  payment  of  salaries  to  officers  which  were 
extremely  low  as  compared  to  salaries  paid  by  other  concerns  engaged 
in  the  same  line  of  business  of  similar  volume  (one  salary  only  being 
paid  to  an  officer  of  the  company  for  1918),  abnormal  conditions  ex- 
isted during  1918  and  that  the  assessment  of  excess  profits  and  war 
profits  taxes  for  that  year  under  section  301  of  the  Revenue  Act  of 
1918  will  work  upon  the  corporation  an  exceptional  hardship  evi- 
denced by  gross  disproportion  between  the  tax  so  computed  and  the 

tax   assessed  against  representative   corporations (B.   28-21- 

1730;  A.  R.  R.  538.) 

Taxpayers  seeking  relief  should  read  the  decision  of  the 
United  States  Supreme  Court  in  the  La  Belle  Iron  Works 
case.®  In  many  cases  it  is  possible  to  show  an  investment  at 
January  i,  191 7,  in  excess  of  the  invested  capital  as  shown 
by  the  books.  Before  seeking  relief,  attention  should  be 
given  to  restoring  any  expenditures  charged  off  in  prior  years 
the  benefits  of  which  extend  into  191 7  and  subsequent  years. 
The  court  held  that  invested  capital  must  not  include  appreci- 
ation, but  that  the  entire  cost  of  the  investment  at  January  i, 
191 7,  could  be  included. 

In  one  case  a  taxpayer  claimed  relief  on  the  ground  that 
goodwill  was  worth  more  than  the  capital  stock  issued  for  it, 
and  that,  in  addition,  machinery  in  use  in  19 17  had  been 
charged  off  in   1907.     The  decision^"  refers  to  the  right  of 


*4i   Sup.  Ct.  528  (published  as  T.  D.  3181). 
'"B.  37-21-1823;  A.  R.  R.  599. 


1646  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

taxpayers  to  restore  property  charged  off  prior  to  191 7,  and 
states  that,  since  the  goodwill  was  not  purchased,  no  good 
reason  for  reHel   was  shown. 

Page  356 
Computation  of  tax  of  foreign  corporations. — Under  both 
the  1 918  and  1921  laws,  foreign  corporations  must  be  taxed 
under  section  328. 

The  author  knows  of  several  instances  in  which  foreign 
corporations  are  engaged  in  business  solely  in  this  country  and 
are,  of  course,  able  to  determine  their  invested  capital.  Such 
corporations  should  not  be  taxed  in  excess  of  what  they  would 
pay  if  the  tax  were  measured  by  invested  capital.  In  making 
application  for  relief  the  facts  should  be  shown. 


CHAPTER    XVI 

ADJUSTMENT    OF    NET    INCOME    FOR    TAXABLE 
AND  PRE-WAR  YEARS 

Page  362 
Interest  received. — The  changes  made  by  the  192 1  law  in 
the  exemption  of  income  from  Liberty  bonds  are  fully  cov- 
ered in  Chapter  XX ;  reference  thereto  should  l^e  made  to 
determine  the  amount  of  Liberty  bond  interest  which  is  sub- 
ject to  the  excess  profits  tax  in  192 1. 

Page  363 
Dividends. — The  changes  in  the  taxability  of  dividends  are 
fully  discussed  in  Chapter  XXII. 

Depreciation. — Where  the  Treasury  has  reduced,  for  191 7 
and  subsequent  years,  the  depreciation  rates  applied  by  the 
taxpayer,   an   adjustment   of   all   returns   should  be   made   in 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  ]647 

order  to  secure  the  advantage  of  the  higher  pre-war  income 
thereby  obtained,  as  well  as  to  increase  the  invested  capital 
for  1 91 7  and  subsequent  years. 

Adjustment  of   Net   Income   for  Pre-war   Period 

The  foregoing  comments  on  interest,  dividends,  salaries 
and  depreciation  should  be  noted. 

Sale  of  assets  prior  to  1913. — If  income  was  derived  from 
the  sale  of  capital  assets  in  191 1,  or  1912,  and  if  the  gain 
thereon  was  based  on  cost  prior  to  January  i,  1909,  it  has 
been  decided"  that  such  property  may  be  valued  as  at  January 
I,  1909.  and  the  gain,  in  the  event  that  such  value  exceeds  the 
original  cost,  measured   by  such   determined  value. 

Page  364 
Salaries. — Where  the  salaries  paid  to  officers  of  close  cor- 
porations have  been  reduced  by  the  Treasury  for  the  years 
19 1 7  or  19 18  to  an  amount  less  than  those  paid  in  the  pre-war 
years,  consideration  should  be  given  to  the  possibility  that 
the  salaries  paid  in  pre-war  years  may  have  been,  in  part,  dis- 
tributions of  profits.  An  adjustment  in  such  cases  can  be 
made,   thereby   increasing  the  average  pre-war  income. 

A  full  discussion  of  the  reduction  of  salaries  by  the  Treas- 
ury is  given  in  Chapter  XXVI.^ 


CHAPTER    XVII 

REORGANIZATIONS 

Page  382 

The   192 1   law  makes  no  changes  in  those  excess  profits 
tax  provisions  of  the  19 18  law  which  deal  with  reorganizations. 


'See  also  B.  39-21 -i 841 ;  A.  R.  M.  138. 

"  G.   N.   Rv.   Co.   V.   Lynch,   U.    S.    D.   C,    Minn.    No.    797,   issued  as 
T.  D.  3147  (C.  B.  4,  page  277). 


1648  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

l"he  changes  which  vitally  affect  taxable  profits  under  the 
income  tax  provisions  of  the  law  are  dealt  with  in  Chapters 
XVI  and  XVII.  A  new  section^  is  added  which  permits  part- 
nerships, under  certain  conditions,  to  incorporate  and  to  be 
taxed  as  corporations  as  from  January  i,  1921,  even  though 
incorporated  as  late  as  March  23,  1922. 

Very  few  rulings  have  been  published  on  this  subject  since 
the  issue  of  Excess  Profits  Tax  Procedure,  1921. 

Page  383 
Determination  of  new  corporate  entity. — 

Ruling.  Where  under  the  laws  of  a  State  a  charter  granted  to  a 
corporation  is  limited  to  a  period  of  years,  the  renewal  of  such  char- 
ter merely  prolongs  the  existence  of  the  original  corporation  and  does 
not  of  itself  constitute  a  reorganization  within  the  meaning  of  the 
excess  profits  tax  laws.     (B.  21-21-1657;  O.  D.  930.) 

The  foregoing  office  decision  merely  affirms  existing 
practice. 

Page  390 
Invested    capital    of    corporations    reorganized   before   or 
after  March  3,  1917. — Practically  all  of  the  rulings  in   1921 
deal  with  reorganizations  made  after  March  3,  191 7. 

Reorganizations  prior  to  March  3,  191 7. — The  fol- 
lowing recommendation  of  the  Committee  emphasizes  the  point 
that  property  taken  over  in  reorganizations  prior  to  March  3, 
191 7,  must  be  valued  as  at  the  date  of  transfer,  and  also  pro- 
vides that  an  appraisal  may  be  used  to  establish  such  value. 

Ruling.  Held,  that  the  appraised  value  of  the  plant  of  a  corpora- 
tion based  on  cost  as  of  December  22,  1919,  plus  depreciation  from 
February  14,  1917,  the  date  the  property  was  taken  over  to  that  date, 
be  used  to  determine  the  value  at  February  14,  1917;  that  depreciation 
rates  be  determined  by  the  life  of  the  property  and  applied  to  value 
determined   at   acquisition,    with    an    accelerated    rate    on    machinery 

during  1917  when  the  plant  was   running  at  double  capacity 

(C.  B.  4,  page  371 ;  A.  R.  R.  390.) 


1  Section  229.     See  page  1657. 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1649 

The  foregoing  ruling  may  be  sound.  The  law  was  intended 
to  give  effect  to  valuations  prior  to  March  3,  19 17,  when  re- 
organizations had  been  made  without  notice  of  an  invested 
capital  law.  The  law^  does  not  state  that  reorganizations,  the 
inadvertent  effect  of  w^hich  reduces  invested  capital,  should 
be  penalized  by  having  the  invested  capital  of  the  new  entity 
reduced  below  that  of  the  old  one. 

The  court  decisions  handed  down  during  1921  shed  no 
light  on  the  effect  of  reorganizations  made  prior  to  March  3, 
191 7.  In  the  Phellis  case,^  the  Supreme  Court  said,  "We  recog- 
nize the  importance  of  regarding  matters  of  substance  and 
disregarding  forms  in  applying  the  provisions  of  the  sixteenth 
amendment  and  income  tax  laws  enacted  thereunder."  In  the 
La  Belle  Iron  Works  case,^  the  court  repeatedly  said  that  the 
actual  investment  of  taxpayers  must  be  allowed  as  invested 
capital. 

It  is  therefore  reasonable  to  assume  that  when  called 
upon,  the  Supreme  Court  will  decide  that  in  case  of  reorgan- 
izations made  before  March  3,  191 7,  when  the  "new"  interests 
are  substantially  the  same  as  the  old,  a  mere  change  in  corpor- 
ate identity  will  not  result  in  a  reduction  of  the  invested  capi- 
tal of  the  new  entity. 

Page  395 

Reorganizations  after  March  3,  191 7. — It  is  often 
difficult  to  decide  whether  or  not  the  old  owners  retain  50 
per  cent  or  more  of  the  control  of  a  reorganized  corporation. 
This  is  purely  a  question  of  fact.  Therefore,  each  case  must 
be  carefully  considered.  Published  rulings,  for  this  reason, 
are  not  very  helpful. 

Ruling.  A  corporation  upon  organization  after  March  3,  1917, 
issued  its  entire  capital  common  stock  for  the  net  assets  of  a  partner- 
ship as  a  going  concern  and  x  dollars  in  cash.  The  principal  officers 
of  the  corporation  were  the  partners.     A  few  shares  less  than  a  ma- 


-  U.  S.  V.  C .  W .  PhcUis,  U.  S.  Supreme  Court,  November  21,  1921, 
"  41  Sup.  Ct.  528. 


1650  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

jority  were  authorized  by  the  officers  of  the  corporation  to  be  recorded 
by  the  transfer  agent  in  the  names  of  the  former  partners,  the  remain- 
ing shares  being  issued  to  their  nominees  and  becoming  well  dis- 
tributed to  the  public.  The  corporate  books  were  in  the  hands  of  one 
of  the  former  partners,  and  from  this  record  he  had  intimate  knowl- 
edge of  stock  held  by  outside  interests. 

Held,  that  the  partners  remained  in  control  of  the  business  and 
exercised  this  control  in  naming  their  nominees,  and  that  an  item  of  x 
dollars  or  any  part  thereof,  representing  "good  will,  trade-marks,  and 
foreign  agencies"  transferred  to  the  corporation,  should  be  disallowed 
as  invested  capital  of  the  corporation  in  accordance  with  section  208 
of  the  Revenue  Act  of  1917.  the  amounts  expended  by  the  partnership 
for  such  assets  being  charged  to  cost  of  conducting  the  business. 
(C.  P..  4,  page  405;  A.  R.  R.  409.) 

The  facts  of  the  forefroiiiir  rulin<r  are  sriven  in  the  detailed 


&' 


opinion  as  follows : 

The  M  Corporation  was  incorporated  April,  1917,  with  a  capital 
stock  of  looj  shares,  taking  over  the  net  assets  of  the  N  partnership 
as  a  going  concern  as  of  January  i,  191 7,  and  in  addition  thereto  the 
sum  of  X  dollars  in  cash.  The  consideration  for  the  net  assets  of  the 
partnership  and  the  additional  cash  was  the  sum  of  4.r  dollars  to  be 
paid  by  the  corporation  issuing  to  the  partners,  or  to  their  nominees, 
the  entire  issue  of  capital  common  stock  of  the  corporation  consisting 
of  lOOT  shares.  Certain  adjustments  were  made  of  salaries  of  the 
partners  to  offset  the  credit  for  earnings  from  January  i,  1917,  to 
April,  1917 

Of  the  looy  shares  of  stock  issued  by  the  corporation,  the  follow- 
ing shares  were  authorized  by  the  officers  of  the  corporation  to  be 
recorded  by  the  transfer  agent  in  the  names  of  the  former  partners: 

B iSy  shares 

C loy  shares 

A 21 V  shares 

Total 493'  shares 

or  a  few  shares  less  than  50  per  cent  of  the  total  issue  of  stock  to 
them.  According  to  the  records  of  the  transfer  agent,  the  remain- 
ing shares  were  issued  to  the  stockholders  in  number  from  i  to  253' 
shares.  The  stock  issued  to  the  public  was  very  well  distributed.  In 
the  corporate  organization  B  became  president  and  general  man- 
ager, C  vice  president  and  secretary,  and  A  chairman  of  the  board 
of  directors  and  treasurer  of  the  corporation. 

The  Committee  supported  its  opinion  as  follows ; 


EXCESS  PROFITS  TAX  PROCEnURE— 1921  1651 

....  It  would  appear,  therefore,  that  the  sole  question  at  issue 
rests  upon  the  intent  of  the  words  "'remains  in  control"  as  used  in 
the  Act.  It  is  clear  from  the  above  facts  that  the  partners  who  be- 
came the  principal  officers  of  the  corporation  continued  in  position 
to  exercise  direct  and  effective  control  over  the  affairs  of  the  business. 
The  corporate  books  were  in  the  hands  of  one  of  the  former  partners 
and  from  this  record  he  had  intimate  knowledge  of  the  ownership  of 
stock  held  by  outside  interests. 

Apart  from  this  effective  control  it  is  clear  that  by  agreement  and 
bill  of  sale  the  partners  received  the  entire  capital  stock  of  the  cor- 
poration for  the  net  partnership  assets  and  for  other  valuable  consid- 
erations. This  gave  the  partners  immediate  authority  to  dispose  of 
such  stock  in  any  manner  they  might  desire.  Technically,  the  pro- 
ceeds from  the  sale  of  any  or  all  of  the  stock  passed  to  the  partner- 
ship. Out  of  these  proceeds  the  partners  paid  to  the  corporation  such 
amount  or  amounts  as  the  partners  had  agreed  to  pay  in  part  con- 
sideration for  the  stock  received  by  them.  In  other  words^  the  trans- 
action was  between  the  corporation  and  the  partners  and  the  latter 
named  the  proportion  in  which  they  desired  the  stock  distributed  to 
them  and  to  their  nominees.  Hence,  the  partners  did  remain  in  con- 
trol. They  exercised  this  control  in  naming  their  nominees.  It  is 
immaterial  that  this  stock  control  was  not  continuing — that  it  imme- 
diately passed  by  a  small  fraction  into  other  hands. 

Without  a  complete  knowledge  of  all  the  facts,  it  is  diffi- 
cult to  comment  upon  cases  of  this  kind,  but  it  appears  that 
the  Committee  has  permitted  a  technicality  to  defeat  the  inten- 
tion of  the  law. 

In  all  cases  in  which  new  interests  invest  capital  at  the 
increased  valuations,  such  capital  is  entitled  to  be  fully  recog- 
nized. If  a  technicality  is  applied  it  should  be  applied  against 
the  government,  not  against  taxpayers.  New  interests  might 
pay  old  interests  $100,000  for  assets  carried  at  $10,000  and 
receive  99  per  cent  of  the  capital  of  a  new  corporation.  The 
old  stockholders  would  be  heavily  taxed  on  a  closed  transac- 
tion. If  the  old  interests  were  retained  to  exercise  coinplete 
control  over  the  new  corporation,  under  the  ruling  the  invested 
capital  of  the  new  corporation  would  be  $10,000! 

The  foregoing  case  may  be  compared  with  a  more  recent 
one.  The  Solicitor,  at  the  request  of  the  Committee,  prepared 
an  opinion  on  the  following  case.  The  cjuotations  are  from 
his  opinion,  which  was  accepted  by  the  Committee. 


1652  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

Ruling.  In  December,  1917,  A  was  the  owner  of  a  certain  busi- 
ness, which  he  engaged  in  under  the  name  of  X.  In  that  month  his 
son,  B,  together  with  two  other  persons,  formed  a  corporation  known 
as  the  M  Company  for  the  purpose  of  acquiring  the  assets  of  the 
business  conducted  by  A  so  that  the  business  might  be  continued  by 
the  corporation.  On  December  — ,  1917,  A  offered  to  sell  to  the  cor- 
poration all  his  right,  title,  and  interest,  in  and  to  the  assets  of  the 
business  that  had  been  conducted  by  him,  in  consideration  of  the  is- 
suance of  48%  3;  shares  of  stock  of  the  corporation  to  seven  persons, 
who  were  named  in  the  oft'er.  A  was  to  receive  3^3;  shares,  his  chil- 
dren and  close  connections  were  to  receive  the  remainder.  The  cor- 
poration was  authorized  to  issue  not  more  than  503;  shares  of  stock 
under  its  charter.  The  offer  was  accepted  by  the  corporation.  The 
assets  were  then  transferred  to  the  corporation  and  the  stock  was 
issued  to  the  designated  persons  in  accordance  with  the  agreement, 
with  the  exception  of  two  qualifying  shares  issued  to  other  persons. 
After  the  consummation  of  this  transaction  A  held  iy2y  shares  of  the 
corporate  stock,  y  shares  being  purchased  by  him  for  cash. 

Two  questions  are  raised  (i)  whether  the  transaction  in  question 
constituted  a  reorganization  of  the  business  or  a  sale  of  the  business 
to  the  corporation,  and  (2)  whether  an  interest  or  control  .of  50  per 
cent  or  more  of  the  business  remained  in  A,  the  owner  of  the  business 
prior  to  its  transfer  to  the  corporation 

As  A  chose  to  specify  in  his  offer  the  persons  who  were  to  re- 
ceive the  stock,  which,  on  acceptance  by  the  corporation,  obligated  it 
to  issue  the  shares  to  the  persons  designated  (which  obligation  was 
promptly  carried  out),  it  is  clear  that  the  limitations  of  the  statute 
do  not  apply,  notwithstanding  the  relationship  existing  between  A  and 
the  persons  whom  he  designated  to  receive  the  stock,  provided  the 
transaction  was  bona  fide  and  not  designed  to  conceal  the  real  owner- 
ship of  the  stock. 

It  appears  from  the  evidence  that  the  transaction  was  bona  fide. 
An  explanation  of  the  transaction  lies  in  the  fact  that  A  desired  to 
provide  for  his  children  during  his  own  life  time  and  retire  from  active 
business.  Almost  immediately  after  he  transferred  the  assets  of  his 
individual  business  to  the  corporation  he  retired  from  business  and 
died  about  two  months  later.  There  seems  to  be  no  doubt  that  the 
issuance  of  the  stock  to  the  persons  designated  in  the  oft'er  was  ab- 
solute and  unconditional  and  that  A  made  no  attempt  to  retain  any 
interest,  either  directly  or  indirectly,  in  the  stock. 

For  these  reasons  it  is  the  opinion  of  this  office  that  A  did  not 
retain  an  interest  or  control  of  50  per  cent  or  more  in  the  trade  or 
business  previously  owned  and  engaged  in  by  him  under  the  name  of 
X  and  that,  therefore,  the  case  does  not  come  within  the  provisions 
of  section  208  of  the  Revenue  Act  of  1917  and  section  331  of  the 
Revenue  Act  of  1918. 

It  is  immaterial  in  determining  the  question  of  invested  capital 
whether  the  transaction  in  question  constituted  a  sale  or  reorganiza- 
tion, and  no  opinion  in  connection  therewith  is  expressed.  (B. 
43-21-1890;  A.  R.  R.  645.) 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1653 

Page  397 
Article  941*  of  the  new  regulations  continues  the  same 
article  of  Regulations  45,  which  had  been  amended  on  De- 
cember/, 1921,  to  read  as  follows: 

Regulation.  Where  a  business  is  reorganized,  consolidated  or 
transferred,  or  property  is  transferred,  after  March  3,  1917,  and  an 
interest  or  control  of  50  per  cent  or  greater  in  such  business  or  prop- 
ert}'  remains  in  the  same  persons  or  any  of  them,  then  for  the  purpose 
of  determining  invested  capital  each  asset  so  transferred  is  valued 
(a)  at  an  amount  representing  its  actual  cash  value,  subject  to  the 
limitations  imposed  by  section  326,  but  not  exceeding  its  allowable 
value,  for  invested  capital  purposes,  in  the  possession  of  the  previous 
owner,  if  a  corporation,  or,  if  not  a  corporation,  (b)  at  its  cost  to 
such  previous  owner,  with  proper  adjustments  for  losses  and  im- 
provements       (Art.  941.) 

The  foregoing  amendment  was  made  pursuant  to  an  opinion 
of  the  Solicitor  of  Internal  Revenue  which  read  as  follows : 

Ruling The  validity  of  article  941,  in  so  far  as  it  pro- 
vides that  section  331  applies  only  when  an  interest  or  control  of  50 
per  cent  or  more  remains  "in  any  of  the  previous  owners,"  has  been 
questioned. 

The  following  hypothetical  case,  which  is  merely  illustrative  of 
actual  cases  which  have  arisen,  has  been  presented.  The  N  corpora- 
tion transfers  to  O  corporation,  subsequent  to  March  3,  191 7,  tangible 
property  in  exchange  for  20  per  cent  of  its  stock.  Seventy-five  per 
cent  of  the  stock  of  corporations  N  and  O  is  owned  by  the  same  indi- 
vidual but  the  corporations  are  not  affiliated. 

It  is  apparent  in  this  case  that  an  interest  or  control  of  50  per  cent 
or  more  in  the  property  does  not  remain  after  the  exchange  "in 
any  of  the  previous  owners,"  inasmuch  as  the  N  corporation,  the 
previous  owner  of  the  asset,  owns  only  a  small  proportion  of  the 
outstanding  stock  of  the  O  corporation.  Thus,  if  article  941  cor- 
rectly interprets  this  section  of  the  statute,  the  O  corporation  can 
include  in  invested  capital  the  actual  value  of  the  property  exchanged, 
subject  to  the  limitations  contained  in  section  326,  even  if  such  value 
is  in  excess  of  the  allowable  value  for  invested  capital  purposes  of 
the  property  to  the  N  corporation. 

Section  331,  however,  limits  the  amounts  to  be  included  in  the  in- 
vested capital  of  the  new  owner  if  an  interest  or  control  in  the  prop- 
erty of  50  per  cent  or  more  "remains  in  the  same  persons  or  any  of 
them."     In  the  case  stated  above  it  is  apparent  that,  by  virtue  of 


*  Art.  941   as   it  originally   read  appears  in  Excess  Profits   Tax  Pro- 
cedure, 1921,  page  397. 


i654 


EXCESS  PROEITS  TAX.  PROCEDURE— 1921 


stock  holdings,  a  control  in  excess  of  50  per  cent  in  the  property 
transferred  "remains  in  the  same  persons,"  i.  e.,  the  stockholders  of 
the  N  and  O  corporations. 

Article  941  of  Regulations  45,  therefore,  is  incorrect,  in  so  far  as 
it  provides  that  in  order  that  section  331  be  applicable  an  interest 
or  control  of  50  per  cent  or  more  in  the  property  exchanged  must 
remain  in  the  previous  owners. 

Article  941  provides  further  that  where  section  331  applies  the 
jiroperty  transferred,  if  transferred  by  a  corporation,  is  valued,  for 
the  purpose  of  determining  invested  capital,  as  if  still  in  the  posses- 
sion of  the  previous  owner. 

The  provisions  of  article  941  on  this  point  can  be  most  clearly 
shown  by  application  to  a  specific  case :  The  N  corporation,  which 
owned  50  per  cent  of  the  outstanding  stock  of  the  O  corporation, 
transferred  subsequent  to  March  3,  1917,  unimproved  real  estate, 
which  cost  it  $100,000  but  which  at  the  time  of  the  exchange,  due  to 
a  decrease  in  market  value,  was  worth  only  $20,000,  to  the  O  cor- 
poration in  exchange  for  stock.  Under  the  provisions  of  article  941 
the  asset  so  transferred  should  be  valued,  for  the  purpose  of  determin- 
ing the  invested  capital  of  the  O  corporation,  ''as  if  still  in  the  pos- 
session of  the  previous  owner."'  That  is,  the  O  corporation  should 
include  in  invested  capital,  on  account  of  the  asset  transferred,  $100,- 
000,  the  allowable  value  of  the  asset,  provided  for  invested  capital 
purposes,  to  the  N  corporation,  in  spite  of  the  fact  that  the  actual 
cash  value  of  the  asset  at  the  time  of  the  exchange  was  only  $20,000. 

Section  326  provides  that  invested  capital  includes  "the  actual  cash 
value  of  tangible  property  other  than  cash,  bona  fide  paid  in  for  stock 
or  shares,  at  the  time  of  such  payment  .  .  .  ."  Section  331  makes 
an  exception  to  this  general  rule  in  the  case  of  a  change  of  owner- 
ship of  property  between  corporations  subsequent  to  March  3,  191 7, 
where  an  interest  or  control  of  50  per  cent  or  more  remains  in  the 
same  persons,  and  provides  that  in  such  case  the  property  transferred 
shall  not  be  allowed  a  greater  value,  for  invested  capital  purposes, 
"than  would  have  been  allowed    ....    in  computing  the  invested 

capital  of  such  previous  owners "     In  the  case  stated  above, 

the  asset  paid  into  the  O  corporation  for  stock  should  be  included  at 
its  actual  cash  value  at  the  time  paid  in,  under  the  provisions  of  sec- 
tion 326  unless  the  case  falls  within  the  exception  covered  by  section 
331.  This  latter  section  merely  provides,  however,  that  an  asset  so 
transferred  shall  not  be  allowed  a  greater  value  than  would  have  been 
allowed  the  previous  owner,  if  a  corporation,  and  is,  therefore,  by  its 
own  terms,  inoperative  unless  the  actual  cash  value  of  the  property 
at  the  time  of  the  exchange  is  in  excess  of  the  allowable  value  of  the 
property,  for  invested  capital  purposes,  in  the  hands  of  the  previous 
owner.  Inasmuch  as  the  actual  cash  value  of  the  asset  transferred, 
in  the  instant  case,  was  $20,000,  a  lesser  amount  than  the  allowable 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1655 

value  of  the  asset,  for  invested  capital  purposes,  in  the  hands  of  the 
N  corporation,  section  331  is  not  operative.  Therefore  the  O  corpor- 
ation should  include  in  invested  capital,  under  section  326,  $20,000, 
the  actual  cash  value  of  the  asset  at  the  time  paid  in  for  stock. 

It  is  concluded  that: 

(i)  Section  331  of  the  Revenue  Act  of  1918  is  not  made  inap- 
plicable because  of  the  fact  that  a  control  of  50  per  cent  or  more,  in 
the  trade,  business,  or  property  reorganized,  consolidated,  or  ex- 
changed, subsequent  to  March  3,  1917,  does  not  remain  in  any  of  the 
previous  owners,  provided  such  control  does  remain  in  the  same  per- 
sons, or  any  of  them. 

(2)  Where  section  331  applies  to  the  transfer  of  assets  from  one 
corporation  to  another,  the  assets  transferred  shall  be  valued,  for  in- 
vested capital  purposes,  in  accordance  with  the  provisions  of  section 
326,  provided  such  value  does  not  exceed  the  allowable  value,  for  in- 
vested capital  purposes,  of  the  assets,  if  such  assets  had  not  been 
transferred (1-3-39;  L.  O.  1081.) 

Whatever  may  be  said  for  the  foregoing  opinion  as  an  at- 
tempt to  construe  the  letter  of  the  law,  it  certainly  does  not 
express  the  intent  which  has  been  evident  from  the  inception 
of  the  section  in  question.  The  intent  of  the  law  is  clearly 
to  prevent  the  increasing  of  invested  capital  by  a  reorganiza- 
tion or  apparent  sale  of  property  when  in  fact  there  has  not 
been  a  decided  change  of  ownership  or  control,  i.e.,  at  least 
50  per  cent.  To  prevent  such  increase  in  invested  capital, 
the  1917,  1918  and  1921  laws  have  each  provided  that  after 
March  3,  1917  (the  date  of  the  first  excess  profits  tax  law), 
unless  a  reorganization,  consolidation  or  change  of  owner- 
ship of  a  trade  or  business  (and  under  the  1918  and  1921  laws, 
also  in  cases  of  cliange  of  ownership  of  property)  resulted  in 
at  least  a  50  per  cent  change  of  interest  or  control,  the  assets 
acquired  by  the  new  corporate  entity  should  not  be  allowed  a 
greater  value  for  invested  capital  purposes  than  if  there  had 
been  no  such  transfer  of  title. 

The  phrase  ''greater  value"  which  it  is  stated  shall  not  be 
allowed  is  restrictive  and  its  apparent  intent  is  to  require  the 
computation  of  the  new  corporation's  invested  capital  to  be 
made  on  the  same  basis  as  though  the  predecessor  corporation 
were  still  the  owner  of  the  business  or  property.     This  is 


1656  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

further  supported  by  the  latter  part  of  section  331  of  the 
1918  and  192 1  laws,  which  provides  for  the  computation  of 
invested  capital  for  the  new  corporation,  when  its  business  or 
property  was  acquired  from  an  individual,  individuals  or 
partnership  which  continue  to  have  50  per  cent  or  more  in- 
terest in  or  control  of  the  new  corporation.  The  computation 
of  invested  capital  in  such  case  is  to  be  based,  not  on  value 
of  the  assets  at  date  of  acquisition  by  the  corporation,  but  on 
their  cost  to  the  previous  owners. 

There  is  no  reason  to  think  that  Congress  intended  the 
invested  capital  of  a  corporation  organized  after  March  3, 
191 7,  to  be  computed  on  one  basis  if  the  preceding  holder  of 
title  to  the  property  was  a  corporation,  and  on  an  entirely  dif- 
ferent basis  if  the  preceding  holder  of  title  was  one  or  more  in- 
dividuals or  was  a  partnership.  In  both  cases  the  present 
corporate  owner  and  the  preceding  corporate,  individual  or 
partnership  owner  represented  to  the  extent  of  at  least  50  per 
cent  the  same  interests. 

The  only  reason  for  distinguishing  in  section  331  of  the 
1918  and  192 1  laws  cases  of  preceding  ownership  by  corpora- 
tions from  those  of  preceding  ownership  by  individuals  or 
partnerships,  is  that  only  corporations  had  invested  capital  for 
excess  profits  tax  purposes.  Under  the  191 7  law,  which  im- 
posed an  excess  profits  tax  on  corporations,  partnerships,  and 
individuals,  no  such  distinction  was  necessary,  nor  was  it  made 
in  section  208  which  corresponds  to  section  331  of  the  19 18 
and  1 92 1  laws. 

Valuation  of  assets  of  domestic  corporation  ac- 
quired  FROM    A    foreign   ONE. 

Ruling.  The  M  Company  was  incorporated  for  the  purpose  of 
acquiring  that  part  of  the  business  of  the  N  Company,  a  foreign  cor- 
poration, which  it  carried  on  in  the  United  States  and  Canada. 

The  M  Company  issued  common  and  preferred  stock  to  the  N 
Company,  in  the  amount  of  x  dollars,  in  exchange  for  its  business  in 
the  United  States  and  Canada.  The  domestic  corporation  requested 
permission  to  set  up  on  its  books  as  invested  capital  several  increases 


EXCESS  PROFITS  TAX  PROCEDURE— 1921  1657 

over   the   amounts  carried  on   its  books   for   the   same   items  by  the 
foreign  corporation. 

Held,  that  where  a  foreign  corporation  has  been  taxed  on  its  ac- 
tivities in  this  country,  and  its  activities  in  Canada  and  this  country 
are  subsequently  taken  over  by  a  domestic  corporation  organized  for 
that  purpose,  and  fifty  per  centum  or  more  of  the  stock  of  the  domes- 
tic corporation  is  held  by  the  foreign  corporation,  the  assets  of  the 
domestic  corporation  are  to  be  valued  under  section  331,  Revenue 
Act  of  1918.  In  the  case  presented  the  domestic  corporation  may 
set  up  on  its  books  as  invested  capital  the  assets  taken  over  from  the 
foreign  corporation  at  such  values  as  could  have  been  established  had 
the  previous  owner  been  required  to  set  up  invested  capital  as  a 
domestic  corporation.     (C.  B.  4,  page  405;  O.  D.  789.) 

Incorporation  of  an  individual  or  a  partnership  before 
March  23,  1922. — The  192 1  law^  re-enacts  that  part  of  section 
330  of  the  1918  law  which  permitted  partnerships  or  indi- 
vidtials  to  incorporate  before  July  i,  1919,^'  but  under  the  new 
law  (section  229)  the  incorporation  must  take  place  not  later 
than  March  23,  1922. 

Law.  Section  229.  That  in  the  case  of  the  organization  as  a  cor- 
poration within  four  months  after  the  passage  of  this  Act  of  any  trade 
or  business  in  which  capital  is  a  material  income-producing  factor,  and 
which  was  previously  owned  by  a  partnership  or  individual,  the  net 
income  of  such  trade  or  business  from  January  i,  1921,  to  the  date  of 
such  organization  may  at  the  option  of  the  individual  or  partnership 
be  taxed  as  the  net  income  of  a  corporation  is  taxed  under  Titles  II 
and  III;  in  which  event  the  net  income  and  invested  capital  of  such 
trade  or  business  shall  be  computed  as  if  such  corporation  had  been 
in  existence  on  and  after  January  i,  1921,  and  the  undistributed 
profits  or  earnings  of  such  trade  or  business  shall  not  be  subject  to 
the  surtaxes  imposed  in  section  211,  but  amounts  distributed  on  and 
after  January  i,  1921,  from  the  earnings  or  profits  of  such  trade  or 
business  accumulated  after  December  31,  1920,  shall  be  taxed  to  the 
recipients  as  dividends;  and  all  the  provisions^  of  Titles  II  and  III 
relating  to  corporations  shall  so  far  as  practicable  apply  to  such  trade 


°  [Former  Procedure]  The  Committee  has  held  that  the  provisions  of 
the  1918  law  do  not  apply  to  1917. 

Ruling.  Held,  that  a  corporation,  organized  in  October,  1917,  which 
acquires  the  business  and  properties  of  a  partnership  as  of  January  i,  1917, 
the  ownership  continuing  identical  as  does  the  business,  can  not  make  a 
return  for  the  entire  year,  as  if  it  were  a  corporation,  using  the  invested 
capital  of  the  partnership  as  of  January  i,  1917,  as  its  invested  capital. 
(B.  Digest  16-21-1586;  A.  R.  R.  467.) 


[6;8 


EXCESS  PROEITS  TAX   PROCEDURE— 1921 


or  business:  Provided,  That  this  section  shall  not  apply  to  any  trade 
or  business,  the  net  income  of  which  for  the  taxable  year  1921  was  less 
than  20  per  centum  of  its  invested  capital  for  such  year:  Provided 
further,  That  any  taxpayer  who  takes  advantage  of  this  section  shall 
pay  the  tax  imposed  by  section  1000  of  the  Revenue  Act  of  1918  as  if 
such  taxpayer  had  been  a  corporation  on  and  after  January  i,  1921. 

In  order  to  qualify :  (i)  capital  must  have  been  a  material 
income-producing  factor;  (2)  the  net  income  for  the  taxable 
year  must  have  been  at  least  20  per  cent  of  the  invested  cap- 
ital for  the  taxable  year;  and  (3)  the  taxpayer  must  pay  a  cap- 
ital stock  tax  for  the  year  1921  in  the  same  manner  as  if  the 
taxpayer  had  been  a  corporation. 


CHAPTER    XVIII 

INCOME  FROM  GOVERNMENT  CONTRACTS 


The  tax  on  income  from  government  contracts  made  be- 
tween April  6,  1917,  and  November  11,  1918,  is  continued  to 
include  the  year  1921.  With  the  conclusion  of  1921,  this 
provision  automatically  expires  with  Title  III  of  the  law 
(war  profits  and  excess  profits  tax  for  1921),  of  which  it 
forms  a  part.  The  basis  of  computation  is  identical  with 
that  called  for  by  the  19 18  law. 

Supplementary  contracts. — The  Treasury  has  ruled  as 
follows  :^ 

Ruling.  Income  arising  from  a  contract  entered  into  subsequent 
to  November  11,  I9i8,,which  is  supplementary  to  an  original  contract 
entered  into  witli  the  Government  between  April  6,  1917,  and  No- 
vember II,  1918,  is  taxable  under  Section  301  (c)  of  the  Revenue 
Act  of  1918.     (B.  42-21-1867;  O.  D.  1063.)  ' 

The  imposition  of  the  higher  rate  of  taxation  on  revenue 
from    government    contracts   was   primarily   intended   to   tax 


'See  also  I-2-16;  Sol.  Op.  128, 


EXCESS   PROFITS  TAX    I'ROCEDURE— 1921  1659 

the  abnormal  proHts  which  might  possibly  accrue  under  war 
conditions. 

The  extension  of  the  provision  to  include  continuation  con- 
tracts is  an  unwarranted  imposition  in  principle,  and  it  is 
opposed  to  the  spirit  of  the  law  under  which  this  form  of 
contract  was  first  taxed. 

Nevertheless  the  ruling  is  sound.  Contractors  could  not 
legally  be  compelled  to  execute  supplementary  contracts. 
When  they  did  so  they  were  on  notice  that  any  contract  which 
was  merely  supplementary  to  one  executed  before  November 
II,  1918,  would  be  construed  as  if  it  were  part  of  the  original 
contract. 


CHAPTER    XIX 

NOMINAL  CAPITAL— THE  1917  LAW 
FORMER  PROCEDURE 

The  meaning  of  the  words,  "no  invested  capital  or  not 
more  than  a  nominal  capital,"'  in  section  209  of  the  1917  law, 
have  been  construed  so  strictly  by  the  Treasury  that  few  con- 
cerns have  been  able  to  qualify  as  having-  "not  more  than  a 
nominal  capital."  The  Treasury,  in  many  such  cases,  has 
denied  the  claims  of  corporations  to  be  assessed  under  section 
209,  and  has  assessed  the  tax  under  section  210  (the  "relief" 
section). 

As  a  part  of  its  effort  to  vitiate  the  obvious  intent  of  the 
1917  law,  the  Treasury  has  attempted  to  enforce,  for  the 
year  1917,  two  restrictions^  found  in  the  1918  law  (section 
200)  regarding  personal  service  corporations,  viz.:  (i)  the 
corporation  must  be  engaged  principally  in  rendering  personal 
service;  and    (2)   the  earnings  must  be  ascribed  primarily  to 

*Reg.  41,  Art.  71. 


l66o  EXCESS   PROFITS  TAX   PROCEDURE— 1921 

[Former  ProcedureJ 


the  activities  of  the  owners.     That  such  a  construction  of  sec- 
tion 209  is  not  warranted,  is  indicated  in  the  following : 

Decision.  In  determining  the  question  whether  such  a  corpora- 
tion, deriving  its  income  solely  from  royalties  or  licenses  from  patents, 
can  be  said  to  be  a  corporation  "having  no  invested  capital  or  not 
more  than  a  nominal  capital,"  within  the  meaning  of  section  209, 
reference  is  made  in  behalf  of  the  collector  to  the  Congressional 
Record  of  October  6,  1917,  containing  a  statement  by  Hon.  Claude 
Kitchin,  who  was  at  that  time  chairman  of  the  Ways  and  Means 
Committee.  It  appears  from  this  statement  that  the  Excess  Profits 
Tax  Law,  as  contained  in  the  House  Bill,  applied  only  to  corporations 
and  partnerships,  and  not  to  individuals.  The  Senate  brought  within 
the  scope  of  the  law  individuals  in  trade  or  business,  but  excluded 
lawyers,  doctors,  professional  men,  and  officers  of  corporations,  as 
well  as  governmental  officers.  The  House  conferees,  it  would  seem 
from  Mr.  Kitchin's  statement,  opposed  the  inclusion  of  individuals, 
unless  they  were  all  brought  in.  The  Senate  insisted  upon  the  exemp- 
tions, and  section  209  of  the  act  resulted,  which,  it  is  the  claim  of  the 
collector,  was  intended  to  apply  to  a  definite  class  of  persons;  i.e.. 
lawyers,  doctors,  professional  men,  and  high-salaried  officers  of  cor- 
porations and  the  government. 

If  this  idea  of  providing  especially  for  those  rendering  a  personal 
service  was  all  that  was  in  the  minds  of  the  conferees,  there  seems 
to  be  no  reason  why  the}-  should  not  have  used  more  exact  language 
to  convey  their  meaning,  and  further  there  is  no  reason  at  all  why 
Congress  should  have  specifically  provided  that,  in  a  case  of  a  trade 
or  business  '"having  no  invested  capital  or  not  more  than  a  nominal 
capital,"  there  should  be  assessed  a  tax  other  than  the  tax  to  which 
such  trade  or  business  would  otherwise  be  liable  under  section  201, 
unless  there  was  to  be  a  distinction  between  those  employing  '"in- 
vested capital"  and  those  employing  ""nominal  capital."  These  terms 
admit  of  exact  definitions.- 

The  court  then  disposes  uf  the  contention  that  b}-  '"nominal 
capital"  what  is  really  meant  is  "nominal  (invested)  capital" 
as  follows : 

Decision.  The  determination  of  this  case  must,  as  already  in- 
dicated, depend  upon  the  meaning  of  the  words  '"not  more  than  a 
nominal  capital."  It  is  clear  from  section  207  that  the  patents  from 
which  the  plaintiff  derived  its  revenue  cannot  be  regarded  as  '"invested 


"  DeLaski  &  Tliropp  Circular  Woven  Tire  Co.  v.  Iredell,  Collector,  268 
Fed.  277- 


EXCESS   PROFITS   TAX    PROCEDURE— 1921  1661 

[Former  Procedure] 


capital."  Counsel  for  the  plaintiff,  in  a  most  exhaustive  and  painstak- 
ing brief,  has  shown  that  the  treasury  rulings  indicate  that  the  word 
"invested"  was  omitted  in  the  act  by  oversight  in  the  phrase  "not 
more  than  a  nominal  (invested  ) capital."  This  suggestion,  however, 
is  not  well  taken,  for  the  reason  that,  whatever  the  treasury  rulings 
may  have  been,  they  can  be  given  no  force  to  modify  or  add  to  tlie 
clearly  expressed  language  of  Congress." 

The  real  test  in  all  these  cases  is  found  in  an  ansv\er  to 
the  question :  What  enabled  the  corporation  to  earn  its  in- 
come? If  the  capital  is  in  fact  "nominal,"  as  determined 
by  the  sources  of  its  net  income,  so  that  it  cannot  be  said  that 
capital  was  a  material  factor,  such  capital  must  be  ''nominal." 
The  application  of  this  test  is  admirably  stated  by  the  court, 
as  follows : 

Decision.  The  decision  of  this  case,  however,  need  not  depend 
solely  upon  the  meaning  of  the  word  "capital."  to  be  found  in  the  dis- 
tinction between  "invested  capital"  and  "nominal  capital,"  as  used 
in  the  act.  The  patents  which  the  plaintiff  owned  were  the  concrete 
embodiment  of  the  skill  which  the  plaintiff  possessed  in  its  field  of 
activity.  This  skill  or  service  is  bartered  for  a  consideration.  Such 
skill  or  service  is  like  the  service  a  lawyer  in  a  large  practice  ren- 
ders for  an  annual  retainer,  and  is  very  nearly  akin  to  the  service 
which  a  commission  house  renders  to  those  who  buy  and  sell  through 
it,  or  the  service  of  a  concern  engaged  in  selling  or  leasing  real 
estate,  and  in  writing  insurance.  The  plaintiff's  source  of  income  was 
that  which  certain  persons  were  willing  to  pay  it  for  the  use  of  its 
skill  and  knowledge.  It  is  true  that  skill  and  knowledge  had  been  re- 
duced to  concrete  form ;  but  the  payment  was  for  the  use  of  the  skill 
and  knowledge,  and  not  for  any  part  or  parcel  of  the  form  to  which 
the  skill  and  knowledge  had  been  reduced.  Hence  it  would  seem  that 
in  a  very  real  sense  the  plaintiff  was  engaged  in  rendering  a  personal 
service,  and  was  not  employing  "capital,"  and  certainly  no  more  than 
a  "nominal  capital."* 

In  another  case"'  the  court  assumed  that  "  'nominal  capital' 
in  Section  209  means  'nominal  invested  capital'  without,  of 
course,  passing  upon  that  question." 


'^  DeLaski  &  Thropp  Circular  Woven  Tire  Co.  v.  Iredell,  Collector,  268 
Fed.  277- 

*  Ibid. 

''Lincoln  Chemical  Company  v.  William  H.  Edwards,  Collector,  272 
Fed.  142. 


J  662  EXCESS  PROFITS  TAX   PROCEDURE— 1921 

I  Former  Procedure! 


The  question  is  iinpurtaiU  because  the  decisions  of  the 
courts  as  to  the  kinds  of  corporations  entitled  to  be  classed 
as  those  having  "not  more  tlian  a  nominal  capital  under  the 
J 91 7  law,"  will  strongly  influence  the  determination  as  to 
whether  or  not  similar  corporations  can  secure  personal  ser- 
\-ice  classification  under  the  1918  law. 

Corporations  should  be  taxed  under  section  209  at  the 
8  per  cent  rate  when  there  is  a  gross  disproportion  between 
the  amount  of  gross  btisiness  and  the  actual  capital  of  the 
corporation.  This  does  not  include  corporations  which  had 
small,  but  ample,  capital ;  there  must  be  taken  into  consideration 
the  character  of  the  business  and  the  manner  in  which  it  is 
conducted.  If  capital  is  not  material  as  compared  with  the 
income  earned,  such  a  corporation  is  entitled  to  the  8  per  cent 
rate,  if  the  trend  of  court  decisions  is  to  be  relied  upon. 

In  the  case  of  a  partnership,  classification  under  section 
209  was  denied  for  the  following  reasons : 

Ruling.  .  .  '.  .  Because  of  the  volume  of  business  transacted 
by  the  partnership  during  the  year  1917  through  direct  buying  and 
selling  of  merchandise,  and  the  numerous  accounts  receivable  and 
payable  shown  on  the  firm's  balance  sheets,  both  at  the  beginning  and 
close  of  the  taxable  year,  the  Unit  denied  assessment  under  section 
209,  ....     (C.  B.  4,  page  16;  A.  R.  R.  364.) 

Where  a  substantial  part  of  the  income  received  was  deemed 
to  be  from  the  company's  superintendents  and  salesmen,  as- 
sessment under  section  209  was  denied.*' 

In  both  of  the  foregoing  cases  assessment  was  made  under 
section  210  (the  "relief"  section). 

In  a  case  in  which  the  actual  work  was  done  by  laborers, 
but  was  supervised  by  principals  of  the  corporation  who  were 
able  to  secure  the  contract  for  the  work  because  of  their  expe- 
rience and  ability,  it  was  held  that  the  earnings  were  not  de- 
rived from  capital." 


•C.  B.  4,  page  17;  A.  R.  R.  464. 
'B.  41-21-1858;  A.  R.  R.  463. 


EXCESS  PROFITS  TAX   PROCEDURE— 1921  1663 

[Former  Procedure] 


In  the  following  case  (metal  brokerage  business)  although 
the  broker  might  be  sued  on  his  contracts,  entered  into  on 
behalf  of  his  principal,  the  Treasury  looked  through  the  form 
and  decided  that  the  business  had  ''not  more  than  a  nominal 
capital." 

Ruling.  In  the  instant  case  it  is  clearly  apparent  that  only  nomi- 
nal capital  was  employed  in  the  business.  No  advances  were  made 
to  the  manufacturer,  and  collections  from  the  purchaser  only  passed 
through  the  hands  of  the  brokers.  The  goods  were  shipped  direct 
to  the  purchaser,  and  therefore  the  officers  of  the  corporation  re- 
quired no  offices  and  no  clerical  assistance.  It  was  merely  a  matter 
of  securing  orders  for  the  product  and  placing  these  orders  with  the 
manufacturer.  It  was  admitted  in  conference  that  under  the  contracts 
with  the  purchaser  the  M  Company  might  be  sued,  but  in  view  of  the 
recognition  by  the  purchaser  that  the  M  Company  was  merely  acting 
m  a  brokerage  capacity,  without  capital  to  insure  recovery  under  any 
breach  of  contract,  the  real  responsibility  rested  in  the  manufacturer, 
and  that  in  event  there  should  be  any  right  of  action  it  would  rest 
against  the  purchaser.  In  view  of  this,  the  representatives  of  the  tax- 
payer contend  that  for  the  purpose  of  arriving  at  a  proper  tax  the  De- 
partment should  look  beyond  corporate  form  if  it  is  considered  the 
corporation  was  trading  as  a  principal. 

The  Committee  recognizes  that  it  is  only  on  the  theory  that  the 
M  Company  might  be  held  responsible  under  its  contracts  that  assess- 
ment under  section  209  can  be  denied.  It  considers,  however,  that  the 
nominal  capital  of  the  corporation  clearly  established  the  fact  that  it 
was  not  contemplated  it  should  be  held  responsible  except  by  way 
of  personal  service  to  both  the  buyer  and  seller,  and  accordingly  the 
corporation  clearly  comes  within  the  contemplation  of  the  section  of 
the  Act  itself  which  provides  that  a  corporation  doing  business  on  a 
nominal  capital,  or  without  any  capital,  should  be  assessed  for  excess 
profits  tax  at  the  rate  of  8  per  cent  on  its  net  income.  (C.  B.  4, 
page  20;  A.  R.  R.  500.) 

It  cannot  be  said  that  during  the  year  192 1  the  question, 
"What  is  nominal  capital?"  has  been  solved  until  all  phases 
of  the  question  are  passed  upon  by  the  United  States  Supreme 
Court.  Corporations  should  protect  their  legal  rights  by  filing 
claims  for  refund  within  the  statutory  time. 

The  following  decision  reversing  the  district  court  in  the 


1664  EXCESS  PROFITS  TAX   PROCEDURE— 1921 

[Former  Procedure] 

case  of  which  the  syllabus  was  given  in  Excess  Profits  Tax 
Procedure  192 1,  makes  it  clear  that  a  business  conducted  en- 
tirely ^vith  borrowed  capital  may  quahfy  under  the  191 7  law 
as  a  "nominal  capital"  corporation.  The  important  points 
in  the  decision  are : 

1.  A  corj^oration  has  no  "invested  capital"  if  the  cai)ital  it 
employs  does  not  come  within  the  definition  of  invested 
capital  as  stated  in  the  law. 

2.  Partners,  debit  balances  (drawings)  are  not  to  be  con- 
sidered as  accounts  receivable  of  the  partnership,  repre- 
senting "profits"  left  in  the  business,  or  as  accounts 
receivable  which  might  l)e  used  as  a  basis  of  credit. 

3.  Collateral  deposited  by  a  partner  (being  his  individual 
property)  as  security  for  repayment  of  a  loan  to  the 
partnership  by  a  bank  does  not  constitute  "tangible 
property  paid  in"  to  the  partnership  and  is  therefore 
not  invested  capital. 

Decision.^  The  only  question  presented  by  this  record  is  whether 
or  not  the  partnership  of  Cartier-Holland  Lumber  Company  during 
the  year  1917  had  an  invested  capital  within  the  meaning  of  Section 
201,  207  and  210  of  Title  II  of  the  Act  of  Congress  approved  October 

3>  1917- 

If  this  question  were  to  be  determined  separate  and  apart  from  the 
act  levying  this  excess  profit  tax,  then  it  would  be  of  easy  solution. 
Money  invested  in  a  partnership  business,  whether  paid  in  by  the 
partners  or  borrowed  from  a  partner  or  a  bank,  in  the  absence  of  leg- 
islation to  the  contrary,  would  constitute  invested  capital  in  the  or- 
dinary meaning  and  acceptation  of  that  term.  Congress,  however, 
evidently  for  the  purpose  of  protecting  the  government  from  claims  of 
inflated  capitalization,  thought  it  w-ise  and  necessary  to  define  the  term 
"invested  capital,"  which  is  made  the  basis  of  the  computation  of  the 
tax  to  be  levied  under  the  authority  conferred  by  this  Act.  To  that 
end  Section  207  provided  among  other  things  the  following: 

"As  used  in  this  title  'invested  capital'  does  not  include 

stocks,  bonds  (other  than  obligations  of  the  United  States),  or 


'  Charles  E.  Carticr  and  Edzvard  M.  Holland  v.  Doyle,  Collector,  U.  S. 
Circuit  Court  of  Appeals.  Sixth  Circuit   (December  15,  1921). 


EXCESS  PROFITS  TAX   PROCEDURE— 1921  1665 

[Former  Procedure] 


other  assets,  the  income  from  which  is  not  suhject  to  tlie  tax 
imposed  hy  this  title  nor  money  or  other  property  borrowed, 
and  means,  subject  to  the  above  limitations : 

"(a)  In  the  case  of  a  corporation  or  partnership:  (i) 
Actual  cash  paid  in,  (2)  the  actual  cash  value  of  tangible  prop- 
erty paid  in  other  than  cash,  for  stock  or  shares  in  such  cor- 
poration or  partnership,  at  the  time  of  such  payment  (but  in 
case  such  tangible  property  was  paid  in  prior  to  January  first, 
nineteen  hundred  and  fourteen,  the  actual  cash  value  of  such 
property  as  of  January  first,  nineteen  hundred  and  fourteen,  but 
in  no  case  to  exceed  the  par  value  of  the  original  stock  or  shares 
specifically  issued  therefor),  and  (3)  paid  in  or  earned  surplus 
and  undivided  profits  used  or  employed  in  the  business,  ex- 
clusive of  undivided  profits   earned   during   the  taxable   year : 


In  the  construction  of  the  Act  of  Congress  of  which  this  defini- 
tion is  a  part,  this  legislative  definition  of  the  term  "invested  capital" 
must  be  accepted  as  final  and  conclusive,  regardless  of  any  precon- 
ceived notion  the  public  generally,  or  this  court,  may  have  as  to  the 
meaning  of  that  term. 

In  the  construction  of  this  statute  it  must  also  be  remembered 
that  it  is  the  settled  rule  not  to  extend  the  provisions  of  taxing 
statutes  by  implication,  or  to  enlarge  their  operation,  so  as  to  embrace 
matters  not  specifically  covered  thereby.   Gould  v.  Gould,  245  U.  S.  141. 

The  trial  court  based  its  judgment  for  the  defendant  upon  the 
conclusion  of  law  that  the  collateral  deposited  by  Cartier  as  security 
for  his  liability  as  an  indorser  of  the  partnership  notes  became  a 
part  of  the  working  capital  and  was  used  and  employed  in  the  busi- 
ness of  the  company  to  the  same  extent  as  if  it  had  been  paid  directly 
into  the  partnership  funds. 

This  conclusion  of  law  is  not  supported  by  the  facts  found  by  the 
court  or  by  any  evidence  in  this  record.  The  articles  of  co-partner- 
ship provide  that  the  paid-in  capital  of  the  partnership  is  to  be  $30,- 
000.00,  any  or  all  portions  of  which  amount  is  to  be  furnished  to  the 
partnership,  upon  notes  signed  by  it,  and  to  be  paid  at  the  earliest 
practicable  opportunity  out  of  the  net  earnings  of  the  partnership. 

It  would  seem  unnecessary  to  say  that  a  private  contract  between 
these  parties  would  not  change  or  affect,  in  the  slightest  degree,  the 
plain  and  positive  terms  of  the  statute,  declaring  what  shall  be  included 
and  what  shall  not  be  included  as  "invested  capital,"  for  the  purpose 
of  this  tax.  If  the  articles  of  co-partnership  had  provided  that  the 
paid-in  capital  of  the  partnership  should  be  $30,000.00,  one-third  of 
which   should  be   paid   in   cash   or   in   property  by  the  partners,   and 


1 666  EXCESS  PROFITS  TAX  PROCEDURE— 1921 

[Former  Procedure] 

$20,000.00  to  be  borrowed  from  a  bank  upon  the  notes  of  the  partner- 
ship, indorsed  by  the  partners,  and  further  secured  by  the  deposit  of 
such  collateral  as  the  bank  might  demand,  the  money  borrowed  in 
pursuance  of  such  partnership  agreement,  fixing  the  total  capital  of 
the  partnership  at  $30,000.00,  would  necessarily  be  rejected  as  in- 
vested capital  in  the  computation  of  surplus  income  taxes  levied  under 
this  act.  It  logically  follows  that,  if  under  this  statutory  definition  of 
invested  capital,  money  borrowed  could  not  be  included  as  capital 
where  some  substantial  amount  of  cash  had  actually  been  paid  into 
the  partnership  fund  by  the  partners,  such  borrowed  money  can  not 
be  reckoned  as  invested  capital  where  the  partners  contributed  neither 
cash  nor  property  to  the  partnership  capital. 

The  original  plan  of  operation  written  in  the  partnership  agree- 
ment was  abandoned  as  early  as  1914,  and  thereafter  the  money  used 
in  the  partnership  business  w-as  borrowed  directly  from  the  bank  upon 
the  notes  of  the  partnership,  payable  unconditionally  and  at  certain 
fixed  times,  regardless  of  net  earnings  or  any  other  contingency. 
While  these  notes  were  indorsed  by  the  individual  partners,  neverthe- 
less the  money  was  borrowed  by  the  partnership  for  partnership  pur- 
poses, and  it  was  primarily  liable  for  the  payment  of  these  notes. 
Collateral  held  by  the  bank,  a  stranger  to  the  partnership,  whether 
the  property  of  one  or  of  both  partners,  was  a  mere  incident  to  the 
loan,  and  can  in  no  wise  affect  the  character  of  the  transaction. 

It  is  therefore  wholly  unnecessary  to  determine  whether  under  the 
original  agreement  the  money  to  be  furnished  by  Cartier,  to  be  re- 
paid out  of  the  partnership  earnings,  would  or  would  not  be  borrowed 
money  w^ithin  the  meaning  of  this  act.  Nor  is  it  important  at  whose 
suggestion  this  plan  of  operation  was  changed  and  the  new  plan 
adopted.  It  is  sufficient  for  the  purposes  of  this  opinion  to  determine 
the  legal  effect  of  these  transactions  as  they  occurred  during  the  tax- 
ing period  of  191 7.  The  evidence  in  relation  to  these  transactions 
permits  of  no  conclusion  other  than  that  the  money  borrowed  from  the 
bank  upon  the  notes  of  the  partnership  was  ''borrowed  money,"  with- 
in the  meaning  of  Section  207  of  the  Act  of  Congress  approved 
October  3,  1917. 

The  clear,  positive  and  unambiguous  language  of  Section  267  of 
this  act  is  not  subject  to  any  other  construction,  regardless  of  the 
exigencies  of  any  particular  case.  First  it  provides  that  borrowed 
money  or  other  property  shall  not  be  included  in  the  term  "invested 
capital"  as  used  in  that  title.  Paragraph  "A"  of  that  section  then 
specifically  states  what  shall  be  included  in  determining  the  "invested 
capital"  of  a  corporation  or  partnership  as  follows:  "(1)  Actual  cash 
paid  in."   There  is  no  claim  made  by  the  government  that  there  was 


EXCESS  PROFITS  TAX  PROCEDURE— 1921       .      1667 
[Former  Procedure] 

any  "actual  cash  paid  in"  to  the-  partnership  funds  other  than  the 
money  borrowed  from  the  bank  on  the  notes  of  the  partnership,  en- 
dorsed by  the  partners,  the  endorsement  of  Cartier  being  secured  by 
collateral  deposited  by  him.  "(2)  The  actual  cash  value  of  tangible 
property  paid  in  other  than  cash  for  stock  or  shares  in  such  cor- 
poration or  partnership."  In  this  case  there  was  no  tangible  property 
paid  in  by  either  partner  for  the  purpose  named  or  for  any  other 
purpose.  The  collateral  deposited  by  Cartier  could  not  upon  any 
reasonable  hypothesis  be  held  to  be  "tangible  property  paid  in"  to  the 
partnership.  It  was  not  deposited  with,  transferred  or  assigned  to 
the  partnership  and  the  partnership  never  acquired  any  right,  title 
or  property  interest  therein,  legal  or  equitable.  This  collateral  was 
deposited  with  the  bank  as  part  of  the  loan  transaction.  Cartier  never 
parted  with  the  title  of  ownership  therein.  The  bank  held  it,  not  as 
owner  but  as  pledgee  merely.  "(3)  Paid-in  or  earned  surplus  and  un- 
divided profits  used  or  employed  in  the  business  exclusive  of  undi- 
vided profits  earned  during  the  taxable  year." 

Whether  this  partnership  used  or  employed  in  its  business  paid-in 
or  earned  surplus  and  undivided  profits  exclusive  of  undivided  profits 
earned  during  the  taxable  year  is  a  question  of  fact.  The  trial  court 
found  as  a  fact  that  at  the  beginning  of  the  taxable  year  the  liability 
of  the  firm  exceeded  its  assets  by  the  sum  of  $7,218.85.  This  court  has 
no  authority  to  determine  the  weight  of  the  evidence.  R.  S.  Sections 
649  and  loii.  If  the  finding  of  fact  made  by  the  trial  court  is  sus- 
tained by  some  substantial  evidence,  then  it  must  be  accepted  by  this 
court  as  a  final  determination  of  the  facts  in  issue. 

There  is  practically  no  dispute  in  the  evidence  upon  which  the  trial 
court  made  this  finding  of  fact.  It  had  been  the  custom  of  each 
partner,  with  the  consent  of  the  other,  practically  from  the  time  the 
partnership  was  organized,  to  withdraw  earnings  of  the  partnership 
in  advance  of  the  ascertainment  of  the  exact  profits  and  a  formal  di- 
vision of  the  same.  These  withdrawals  were  charged  against  the  part- 
ners respectively  on  the  partnership  books  of  account,  and  whenever 
there  was  a  formal  division  of  the  profits  the  amount  due  to  each 
partner  was  credited  to  his  account  as  against  amounts  that  were 
withdrawn  by  him.  On  the  first  day  of  January,  1917,  it  appeared  that 
Cartier  had  withdrawn  in  the  aggregate,  during  the  life  of  the  part- 
nership, the  sum  of  $11,556.37,  in  excess  of  all  sums  credited  to  him. 
Holland  had  also  withdrawn  $18,106.28  in  excess  of  his  credits.  The 
evidence  further  shows  that  these  withdrawals  were  made  in  anticipa- 
tion of  a  distribution  of  the  profits,  to  be  credited  to  them  as  against 
these  withdrawals,  that  would  finally  balance  their  accounts.  That 
this  was  the  purpose  and  understanding  of  the  partners  fully  appears 


l668  EXCESS  PROFITS  TAX   PROCEDURE— 1921 

[Former  Procedure] 


by  their  testimony,  and  particularly  the  testimony  of  Holland,  as 
follows : 

"The  Court :    It  would  be  liquidated  by  dividends  you  declared  ? 

''A.     Eventually. 

"The  Court:     And  credited  yourself  with? 

"Yes." 

In  the  absence  of  an  express  agreement  to  the  contrary,  the  part- 
nership could  not  require  a  partner  to  return  to  it  his  share  of  the 
actual  profits  anticipated  by  these  withdrawals.  The  strongest  infer- 
ence which  anything  in  this  record  would  justify  as  to  the  duties  of 
the  partners  to  each  other  to  repay  these  items  charged  against  them 
is  that  each  should  repay  the  amount  he  had  withdrawn  in  excess  of 
his  share  of  the  profits.  This  would  mean  in  the  aggregate  $7,218.85, 
just  enough  to  pay  the  general  debts  and  leave  no  surplus.  In  any 
event,  these  profits  were  drawn  by  the  partners  and  were  not  used 
in  the  partnership  business.  The  claim  that  they  were  used  in  the 
partnership  business  as  bills  receivable,  so  they  would  furnish  a  basis 
of  credit,  is  not  tenable.  These  partners  were  the  sole  owners  of  the 
partnership  business  and  in  full  control  of  its  affairs:  they  were  each 
individually  liable  for  all  the  debts  of  the  partnership,  so  that  whether 
they  were  liable  to  the  partnership  for  the  full  amount  of  these  with- 
drawals, regardless  of  profits,  could  in  no  wise  affect  the  security  of 
creditors  for  the  payment  of  their  debts. 

It  w'ould  therefore  appear  that  this  finding  of  the  trial  court  is 
fully  sustained  by  substantial  evidence. 

Section  9  [209]  of  this  act  provides  that  in  the  case  of  a  trade  or 
business  having  no  invested  capital  (and,  of  course,  that  means  in- 
vested capital  within  the  meaning  of  the  act),  or  not  more  than  a 
nominal  capital,  there  shall  be  levied,  assessed,  collected  and  paid,  in 
addition  to  the  taxes  under  existing  law  and  under  this  act,  in  lieu 
of  the  tax  imposed  by  Section  201,  a  tax  equivalent  to  eight  per  centum 
of  the  net  income.  This  section  of  the  act  w^ould  appear  to  have  been 
intended  to  cover  just  such  conditions  as  are  here  presented. 

For  the  reasons  above  stated,  this  judgment  must  be  reversed  and 
the  cause  remanded  for  a  new  trial  in  accordance  w^ith  this  opinion. 

Page  427 
Definition  of  "trade  or  business." — 

Ruling.  Royalties  received  in  1917  by  a  taxpayer  from  a  license 
under  a  license  contract  to  manufacture,  use,  and  sell  certain  auto- 
mobile inventions  did  not  result  from  a  mere  ownership  of  property. 
The  time  and  attention  devoted  by  the  taxpayer  during  that  year  and 
prior  years  to  the  invention  of  automobile  devices,  the  placing  of  same 
on  the  market,  and  the  protection  of  same  were  sufficient  to  constitute 


EXCESS  PROFITS  TAX   PROCEDURE— 1921  1669 

[Former  Procedure] 

a  trade  or  business  within  the  meaning  of  section  200  of  the  Revenue 
Act  of  1917.  The  royalties  were  therefore  subject  to  excess  profits 
tax  under  the  provisions  of  section  209  of  the  Act.  (B.  42-21-1874; 
A.  R.  R.  425-) 

Where  a  taxpayer  received  an  amount  from  a  decedent's 
estate  as  compensation  for  services  rendered  in  boarding,  car- 
ing for,  and  nursing  members  of  the  decedent's  family,  this 
compensation  was  held  not  to  be  from  a  vocation,  trade,  or 
business  when  this  was  not  the  regular  occupation  of  the  re- 
cipient. The  opinion  of  the  Solicitor  of  Internal  Revenue 
quoted  in  the  ruling  is  as  follows : 

Ruling.  The  facts  do  not  fully  appear  on  the  record,  but  it  seems 
that  the  taxpayer  received  35^-  dollars  in  1917  in  payment  of  a  claim 
against  the  estate  of  B,  his  relative,  covering  services,  etc.,  which  ex- 
tended over  a  period  of  years  from  188-  to  190-  and  from  191 1  to 
19 16.  The  Unit  ....  holds  that  of  this  amount  23 ^^a"  dollars  is 
subject  to  both  income  tax  and  excess-profits  tax  at  the  1917  rates, 
the  difference  between  the  amounts  being  deductible.  I  concur  in  the 
view  that  this  was  not  a  claim  on  March  i,  1913,  because  the  under- 
standing between  the  parties  was  too  indefinite  and  intangible  and  it 
does  not  even  appear  that  accounts  were  kept.  It  appears  proper, 
therefore,  to  subject  the  233/2^  dollars  to  income  tax.  I  believe,  how- 
ever, that  this  income  was  not  derived  from  a  trade  or  business  or  vo- 
cation within  the  meaning  of  the  statute  and  the  regulations  and 
therefore  is  not  subject  to  the  excess-profits  tax. 

Analyzing  the  taxpayer's  statement  reproduced  on  page  i  of  the 
recommendation,  which  seems  to  be  the  only  statement  of  the  facts 
in  the  record,  the  claim  embraced  the  following  principal  items:  (l) 
Services  rendered  in  boarding,  caring  for,  and  nursing  members  of 
B's  family;  (2)  boarding  and  caring  for  teams;  (3)  use  of  automo- 
biles, teams,  wagons,  carriages,  servants  and  employees;  (4)  expenses 
incurred  at  his  relative's  direction.  The  taxpayer  was  permitted  to 
deduct  Sx  dollars  representing  item  (4)  and  also  the  expense  of  col- 
lection of  claim.  The  remaining  items  seem  to  me  to  come  within 
clause  (a)  of  the  second  paragraph  of  article  8,  Regulations  41  ("gains 
or  profits  from  transactions  entered  into  for  profit  but  which  are 
isolated,  incidental,  or  so  infrequent  as  not  to  constitute  an  occupa- 
tion"), and  therefore  not  to  be  subject  to  excess-profits  tax.  The 
conclusion  is  based  upon  the  assumed  facts  that  the  taxpayer  per- 
formed the  above  kind  of  services  only  for  his  relative,  and  not  for 
others,  had  no  agreement  as  to  prices  or  charges,  and  kept  no  ac- 


1670  EXCESS  PROFITS  TAX   PROCEDURE— 1921 

[Former  Procedure] 

counts,  but  expected  to  be  recompensed  in  some  way  and  to  some 
extent  on  his  relative's  death.  If,  however,  it  is  true  of  any  of  the 
three  items  that  he  performed  similar  services  for  others  in  addition 
to  the  services  casually  and  incidentally  rendered  his  relative,  it 
might  be  held  that  he  was  engaged  in  that  particular  business,  but  I 
find  nothing  in  the  record  to  warrant  such  finding.  Certainly  in  the 
absence  of  any  definite  agreement  between  the  parties  nursing  and 
-caring  for  relatives  would  not  ordinarily  be  considered  a  vocation, 
trade,  or  business  of  a  person  whose  regular  occupation  is  that  of 
a  farmer.     (B.  52-21-1996;  A.  R.  R.  706.) 


APPENDIX  B 
FORMS 


APPENDIX  B 

FORMS 

On  the  following  pages   will  be   found   reproductions   of 
the  forms  listed  below : 

Form  No.     Pages 

Abatement,  Credit  and  Refund— Claim  for 843        1675-1676 

Taxes  erroneously  or  illegally  assessed  (but  not 
paid),  claim  for  credit  against  the  tax  due  under 
any  other  return  and  refund  claim  for  taxes  errone- 
ously or  illegally  collected.  Old  forms  46,  47  and 
47A  are  combined  into  this  new  one. 
Alien,  Certificate  of,   Claiming   Residence  in  the  United 

States 1078  1677 

To  be  filed  with  withholding  agent  (employer)  by 
alien  residing  in  the  United  States,  for  the  pur- 
poses of  claiming  the  benefit  of  such  residence  for 
income  tax  purposes. 

Bond,  Income  and  Profits  Tax 1 127B  1678 

To  be  filed  in  connection  with  an  extension  of  time 
under  section  250  (f). 
Extension  of  Time,  Application   for,   Payment  of  Defi- 
ciency in  Tax   [section  250   (f)] 1127         1679-1680 

Application  for  extension  to  pay  deficiency  in  income 
and  profits  tax  on  account  of  understatement  not 
due  to  negligence  or  fraud. 

Farm  Income  and  Expenses,  Schedule  of 1040F      1681-1684 

To  be  filed  with  form  1040  or  1040A  when  income  is 
derived  from  farming. 

Guide  Form  for  Calculation  of  Amortization 1007M  1685 

To  support  claim  for  amortization. 
Ownership    and    Exemption    Certificate — Foreign    Cor- 
poration       1086  1686 

To  be  filed  by  foreign  corporations  having  an  office 
or  place  of  business  in  the  United  States. 
Personal  Exemption,  Non-resident  Alien — Claim  for....    11 15  1687 

To  be  filed  by  non-resident  alien  claiming  benefit  of 
personal  exemption  of  $1,000. 
Report   of  Income   of  $1,000  or   More   Paid   during  the 

Calendar  Year  1921 1099  1688 

These  forms  are  summarized  on  form  1096  and  are 
filed  with  that  return. 

Return,  Annual,  Information    1096         1689-1690 

Payments  of  interest,  salaries,  rent,  etc.,  of  $1,000  or 
more  to  be  filed  annually,  accompanied  by  returns 
on  form  1099,  by  every  individual  or  organiza- 
tion making  such  payments. 

1673 


Form  No.    Pages 

Return,   Capital   Stock   Tax — Domestic   Corporation 707        1691-1694 

Return,  Corporation  Income  and  Profits  Tax — Calendar 

Year  1921,  or  for  Fiscal  Year  ended  in  1921 1120        1695-1700 

Return,    Fiduciary    Income    Tax 1041         1701-1706 

Where  net  income  of  estate  is  $1,000  or  over  and  is 
distributed  periodically,  or  if  a  beneficiary  is  a 
non-resident  alien. 

Return,  Individual  Income  Tax 1040        1707-1712 

Where  net  income  is  more  than  $5,000  for  taxable 
year. 

Return,  Individual  Income  Tax 1040A      1713-1716 

Where  net  income  is  not  more  than  $5,000  for  tax- 
able year. 
Return,  Information — Subsidiary  or  Affiliated  Corpora- 
tion       1122  1717 

Return,   Partnership  and   Personal   Service   Corporation 
•        Income  Tax — Calendar  Year  1921,  or  Fiscal  Year 

Ended  in  1921 1065         1718-1721 

Statement  of   Income  Received  by  Non-Resident  Alien 
from    Sources    within    United    States     (Personal 

Exemption  Claimed)    lOOiB  1722 

To  be  filed  with  withholding  agent  by  non-resident 
alien  owning  bonds  of  a  domestic  corporation 
which  contain  a  tax-free  covenant  clause. 


1674 


IMPORTANT 

Fill  ullh  Cotteclor  of  Internal 

Recenue  where  asieismenl  wai 

made.      Not    aeccfytMe   unleu- 

completely  fiUeJ  In. 


State  of  .... 
County  <^ . 


CLAIM  FOR 

J  ABATEMENT  OF  TAX  ASSESSED 

1  CREDIT  AGAINST  OUTSTANDING  ASSESSMENTS 

J  REFUND  OF  TAXES  ILLEGALLY  COLLECTED 

J  REFUND  OF  AMOUNTS  PAID  FOR  STAMPS 
USED  IN  ERROR  OR  EXCESS 


NOTICE  TO  COLLECTOR 


I    COLLECTOR'S  NOTATION 
DMrlct 


TYPE 

OR 
PRINT 


(N'amo  of  taxpayer  or  purchaser  o(  stamps.) 


Ceilmtot  af  tntunai  Retmui 


(Re3idenco—gl\  6  street  aoil  number  as  well  as  city  or  town  and  State.; 


(Business  address.) 

This  deponent,  being  duly  sworn  according  to  law.  deposeo  and  aays  that  this  statement  is  m&de  on  behalf  of  the  taxpayer  i 
that  the  facta  given  below  with  reference  to  said  statement  are  true  and  complete: 


s  ossessad  or  the  stamps  alTixcd.) 


1.  Buaineaa  in  which  engaged 

2.  Character  of  aaeesement  or  tax ' 

(State  for  or  upon  wtut  the  tax 

3.  Amount  of  asaeaement  or  stamps  purchased _ 

4.  Reduction  of  Tax  Liability  requested  (Income  and  Profits  Tax) .; $ 

5.  Amount  to  be  abated _ _ „ _ „ $. 

6.  Amount  to  be  refunded  (or  such  greater  amount  a^  is  legally  refundable) $. 

7.  Dat«8  of  payment  (see  Collector's  receipts  or  indoraomenta  of  canceled  checks) 

(If  statement  covers  income  tax  liability,  items  8-11,  inclusive,  must  be  answered.) 

8.  District  in  which  return  (if  any)  was  filed _ 

9.  District  in  which  unjl)aid  assessment  appears 

10.  Amotint  of  overpayment  claimed  as  credit „ „ „ 5, 

11.  Unpaid  assessment  against  which  credit  is  asked;  period  from to $. 

Deponent  verily  believes  that  this  application  ehoukl  be  allowed  for  the  following  reasons: 


PEDIOO 

YEAR 

Fro-i: 

IB 

» 

To; 

(Attacb  adaitlonal  sbeets  If  necessary.) 

Sworn  to  and  subscribed  before  me  thifl  ..„,_ „ day 

of .  19 


Signed: 


iTi}^»im»^t  may  be  sworn  to  before  a  Oepaty  Collector  of  iDtcraal  BeTeaae  or  ReT«nne  Agent  vltb«at  charge.)  rt— ii7M 


1675 


CERTIFICATES  a 

I  certify  that  an  examination  of  the  .records  of  the  Bureau  of  Internal  Revenue  shows  the  following  facts  as  to  g_ 
the  assessment  and  payment  of  the  tax:  c. 


Name  or  ta^tates. 

Character  of  assessment      j^j^^ 

y«ar. 

UanUt 

Pag.. 

Line. 

Amount. 

Dslepsld. 

District  hi 
vhlehpud. 

$ 



--- 

"    1       "'" 

Collector  of  Internal  Reraiue. 
Assessment  Clerk,  Commiiatojifr's  Office. 


I  certify  that  the  records  of  my  office  show  the  following  facts  as  to  the  purchase  of  stamps: 

Number. 

Dcsonunati  aa . 

Viie  of  sale 
or  issue. 

Amormt. 

If  Fpecial  tax  stamp,  state: 

To  -WHOM  BOLD  OB  ISSUED.                                           Kind. 

Serial  oumbeT. 

Period 

commenciDS— 

\ 

s. 

1 



— 

jZZ. 1 

Schedule  Number 

Allowed  or  Rejected  Number. 

Claimant 

Address 


claim  examined  by- 


Claim  approved  by— 


Dislrict- 


District . 


(Nacunortax.) 


Examined  and  submitted  for  action  _ _ _ ,  19_ 

COMMITTEB  OIT  CLAIMS 


Amount  claimed..^  $.. 
Amount  allowed...  $.. 
Amount  rejected $.. 


1676 


CO    o 

5  s 

00    g 

u  S 

ES   o 


-as 
S  &^ 

—J    OQ  K 

.   <D  as 


o  s 

r^  to 


fci  o  w  5 

Q.J2  Eh    t^ 


I**  C"H 


OS 


0) 


> 


c4 


2  ^ 
■^  -*-> 

^  a 

O  OS 

Pi  13 

"So 

4)  a 

"5  '^ 

-S  <u 

w  S3 

•rH     n 

-^ 

be  a 
>  © 


II 


.J       i-^ 


a 

o 


>>   a 

*3  «;  *< 

3|| 


00. 


O  03  q 
OwO 


o 

>^ 

<a 


1677 


TKEAStmV  TJEPARTMEMT 

r.  S.  Internal  Rkvknuf, 

IsroMETAX-Jjn..  IKJ 

Form  112IB 


INCOME  AND  PROFITS  TAX  BOND 


To  be  filed  in  connection  with  an  extension  of  time  under  Section  250  (f )  of  the  Revenue 
Act  of  1921,  for  payment  of  deficiency  in  tax 


KNOW  ALL  MEN  BY  THESE  PRESENTS  that  ,  as 

principal,  and _ ,  as  surety,  arc  held  and  firmly  hound  unto  the 

United  States  of  America  in  the  sum  of , _ dollars, 

lawful  money  of  the  United  States,  for  the  payment  whereof  we  bind  ourselves,  our  heirs,  executors,  admin- 
istrators, successors,  and  assigns,  jointly  and  severally,  firmly  by  these  presents. 

Whereas,  there  is  due  from  the  above  bounden  principal  certain  additional  income  or  profits  taxes 
resulting  from  a  deficiency  in  tax  (not  due  to  negligence  or  to  fraud  with  intent  to  evade  tax) ;  and 

Whereas,  to  exact  payment  of  the  deficiency  in  tax  at  this  time  will  result  in  undue  hardship  to  the  above 
bounden  principal ;  and 

Whereas,  section  250  (0  of  the  Revenue  Act  of  1921  provides  that  the  Commissioner,  with  the  approval 
of  the  Secretary,  may  extend  the  time  for  the  pa3rment  of  such  deficiency  in  tax,  or  any  part  thereof, 
for  such  period  as  may  be  considered  necessary  not  in  excess  of  eighteen  months  from  the  passage  thereof 
(November  2.3,  1921),  and  provides  further  that  the  Commissioner  may  require  the  taxpayer  to  furnish  a 
bond  with  sufficient  sureties  conditioned  upon  the  payment  of  the  deficiency  in  accordance  with  the  tei-ms 
of  the  extension  granted;  and 

Whereas,  it  appears  that  the  amount  of  this  bond  is  sufficient  to  cover  the  deficiency  of  tax  plus  penalty 
and  interest: 

Now,   THEREFORE,   THE   CONDITION   OF  THE   FOREGOING   OBLIGATION  IS   SUCH    that  if   the   principal  shall 

on  or  before  the  day  of .• ,  192     ,  pay  such  deficiency  in  tax  found 

to  be  due  by  the  Commissioner,  plus  penalty  and  interest,  in  accordance  with  the  terms  of  the  extension 
granted,  and  shall  otherwise  well  and  truly  perform  and  observe  all  the  provisions  of  law  and  the  regulations, 
then  this  obligation  is  to  be  void,  but  otherwise  to  remain  in  full  force  and  virtue. 


Witness  our  hands  and  seals  this day  of ,  192 


.[l.  8.] 


Sigrud,  aeaUd,  and  delivered  in  the  presence  of—  _[l.  g.] 

Principal. 

[L.  8.] 
.-[L.  8.] 


Bond  recommended  for  df3Ppp';.oval. 


Sxtrtly. 
Surety. 


Collector. 


B-'l  disced  ^h-  -- ^<^y  «^ ^«2 


r  Miirmo  ornci  Commiasioner  of  Internal  Revenue. 


1678 


TKEASIRV  DEPABTMENT 

II.  8.  Int;:rmal  Rpvr»jrrE 

INCOMKTAX-Jan.,  1D2-1 

Form  1127 

Application  for  Extension  of  Time  for  Payment  of  Deficiency  in  Tax,  under 
Section  250  (f)  of  the  Revenue  Act  of  1921. 

Commissioner  of  Internal  Revenue: 

Through  the  Collector  of  Internal  Revenue  at „. 

Sir: 

Application  for  an  extension  of  time  until  is  hereby  requested  in 

which  to  pay  a  deficiency  in  income  and  profits  tax  in  the  amount  of  $ ,  due  for  the  year 

ended on  account  of  an  understatement  therein  not  due  to  negligence 

or  fraud. 

The  collector  demanded  payment  of  the  above  amount  of  tax  on  or  before ,  192 

This  extension  is  necessary  by  reason  of  the  following  facts: 


As  evidence  of  the  necessity  for  the  extension,  I  herewith  submit  a  balance  sheet  showing  the  condition 
of  my  business  as  of  the  last  day  of  the  preceding  month  or  the  last  taxable  period. 

Sworn  to  and  subscribed  before  me  this  _ 

day  of  _.._ _ ,  192 


Applicant. 


The  collector  of  infernal  revenue  for  your  district  will  advise  you  of  the  action  of  this  office  and  will  funrieh  you  with  the  necesaaiy 
form  of  bond,  if  required  by  the  Department.   He  will  also,  upon  application  therefor,  furnish  you  with  a  list  of  approved  surety  companiee. 

I  hereby  recommend  the  ,.  ^  ,  of  this  application  with — 

•'  disapproval  '^' 

1.  A  bond  with  an  approved  surety  company  as  surety. 

2.  Bond  with  Liberty  bonds  or  other  bonds  or  notes  of  the  United  States  as  security.  ^ 

3.  Without  bond. 


(See  instructions  on  back)  covt»i»t»t  r»i«™c  ornci  2— iin9«  Collector. 


1679 


Instructions  relative  to  filing  application  for  extension  of  time  for  payment  of  deficiency 
under  Section  250  (f)  of  the  Revenue  Act  of  1921. 


Section  250  (f)  of  the  Revenue  Act  of  1921  contains  a  special  relief  provision  which  will  be  in  effect  for 
only  eighteen  months  after  November  23,  1921,  the  date  of  the  passage  of  the  act.  It  provides  that  in  the 
case  of  any  deficiency  in  tax  revealed  on  the  examination  of  an  income  or  profits  tax  return  (except  where  the 
deficiency  is  due  to  negligence  or  to  fraud  with  intent  to  evade  tax),  where  it  is  shown  to  the  satisfaction  of 
the  Commissioner  that  the  payment  of  such  deficiency  would  result  in  imdue  hardship  to  the  taxpayer,  the 
Commissioner  may,  with  the  approval  of  the  Secretary,  extend  the  time  for  the  payment  of  such  deficiency 
or  any  part  thereof  for  a  period  not  to  extend  beyond  eighteen  months  from  November  23,  1921.  Where 
such  an  extension  is  granted  there  is  to  be  added  as  part  of  the  deficiency,  in  lieu  of  other  interest  provided 
by  law,  interest  at  the  rate  of  two-thirds  of  1  per  cent  per  month  from  the  time  the  extension  is  granted. 
Where  such  other  interest  provided  by  law,  however,  is  in  excess  of  two-thirds  of  1  per  cent  per  month  the 
higher  rate  wiU  be  charged.  If  the  deficiency  or  any  part  thereof  is  not  paid  in  accordance  with  the  terms  of 
the  extension  agreement  there  is  to  be  added  as  part  of  the  deficiency,  in  lieu  of  other  interest  and  penalties 
provided  b}'  law,  the  sum  of  5  per  cent  of  the  deficiencj'  together  with  interest  on  the  deficiency  at  the  rate  of 
1  per  cent  per  month  from  the  time  it  became  payable  under  the  terms  of  the  extension  agreement.  The 
extension  wiU  be  granted  only  in  case  the  taxpayer  establishes  to  the  satisfaction  of  the  Commissioner  that 
without  such  extension  undue  hardship  wiU  result  to  the  taxpayer.  The  term  "undue  hardship"  means 
more  than  an  inconvenience  to  the  taxpayer.  It  is  defined  as  meaning  that  substantial  financial  loss  or 
sacrifice  will  result  to  the  taxpayer  from  making  payment  of  the  deficiency  at  the  due  date.  This  provision 
of  the  statute  is  apphcable  only  to  deficiencies  in  taxes  which  have  accrued  or  may  accrue  under  the  Revenue 
Act  of  1917,  the  Revenue  Act  of  1918,  or  the  Revenue  Act  of  1921,  and  the  deficiency  referred  to  is  only  such 
deficiency  in  tax  as  is  revealed  on  the  examination  of  an  income  or  profits  tax  return.  It  has  no  application 
to  deficiencies  in  taxes  other  than  deficiencies  in  income  and  profits  taxes  imder  the  three  acts  named. 

^Iny  application  for  the  extension  must  be  made  under  oath  on  Form  1127  in  accordance  with  instruc- 
tions printed  thereon,  and  must  be  accompanied  by  evidence  showing  that  undue  hardship  to  the  taxpayer 
would  result  if  the  extension  were  refused.  The  extension  will  not  be  granted  on  a  general  statement  of 
hardship,  but  in  each  case  there  must  be  furnished  a  statement  of  the  specific  facts  showing  what,  if  any, 
financial  loss  or  sacrifice  will  result  if  the  extension  is  not  granted.  ^  The  application,  with  the  evidence,  must 
be  filed  with  the  collector,  who  will  at  once  transmit  it  to  the  Commissioner  ^vith  his  recommendations  as  to 
the  extension.  WTien  it  is  received  by  the  Commissioner  it  will  be  examined  and  within  thirty  days  either 
rejected  or  tentatively  approved.' 

The  application  should,  wherever  practicable,  contain  a  certified  statement  of  assets  and  liabilities  of 
the  taxpayer.  Wbere  the  application  is  tentatively  approved  and  a  bond  is  required,  it  must  be  filed  with 
the  collector  wtliin  ten  days  after  the  notification  by  the  Commissioner  that  a  bond  is  required.  It  shall  be 
conditioned  for  the  payment  of  the  deficiency  and  applicable  penalties,  if  any,  and  interest  in  accordance 
with  the  terms  of  the  extension  to  be  granted  and  shall  be  executed-by  a  surety  company  holding  a  certificate 
of  authority  from  the  Secretary  of  the  Treasury  as  an  acceptable  sm-ety  on  Federal  bonds  and  shall  be  subject 
to  the  approval  of  the  Commissioner.  In  lieu  of  such  a  bond  the  taxpayer  may  file  a  bond  secured  by  depofit 
of  Liberty  bonds  or  other  bonds  or  notes  of  the  United  States  equal  in  their  total  par  value  to  the  amount 
of  the  deficiency  and  applicable  penalties,  if  any,  and  interest,  as  provided  in  section  1329  of  the  Revenue 
Act  of  1921.  "  ,_,„» 


i68o 


ATTACH  THIS   FORM 
TO  YOUR  INCOME 

TAX  RETURN  FORM 

1040A  OR  1040  AND 

FILE  IT  WITH  THE 

COLLECTOR  OF 

INTERNAL  REVENUE. 


Page  1. 

Form  lOtOF.-CNITED  STATES  INTERNAL  REVENUE  BEBVICE. 

SCHEDULE  OF  FARM  INCOME  AND   EXPENSES 

FOR  THE  YEAR  1921 


( Post  office  and  State. ) 


IF  YOUR  ACCOUNTS 

ARE  KEPT  ON  A 
CASH  RECEIPT  AND 

DISBURSEMENT 
BASIS,  FILL  IN  PAGES 

1  AND  3  ONLY. 

IF  YOU  KEEP   BOOKS 

OF  INCOME  AND 

EXPENSES  ON  AN 

ACCRUAL  BASIS,  FILL 

IN  PAGES  2  AND  3 

INSTEAD. 


FARM  INCOME  FOR  TAXABLE  PERIOD. 


1.  BiLS  OF  LrvE  Stock  Raised  on  and  Peoducts  | 

FBOH  TOUB  FaRU.                                     [ 

2.  Sale  of  Chops  and  rsoDucTS  Ghown  on  todb  Faau. 

3.  Othke  Recdi-is. 

Kind  ol  aniinals. 

Quantity. 

Amount 

Kind  of  crop. 

Quantity. 

Amount. 

Items. 

Amount. 

$ 

Cora 

Wheat  _ — 

Cotton 

Tobacco 

Merchandise  rec'd  for  produce. 

$ 

Bulla 

- 

Hire  of  teams .- 

Horses 

TftlTfl 

1 

. 

1 

Cotton  Seed 

Ducks 

Mi  IV 

$    

Total... 

« 

(Enter  on  11] 

ae2.) 

(Enter  on  line  8.) 

4.  Sale  of  Live  Stock,  Cbops,  oa  Othee  Items  Puechased. 

DoscripttoiL 

Received. 

Cat. 

Proat. 

W-rmT 

$    .       ...- 

$ — 

t 

^ 

? 

(Enter  on  L 

nol.) 

(Enter  on  line  4.) 

SUMMARY  OF  INCOME  AND  EXPENSES  COMPUTED  ON  A  CASH  RECEIPT  AND  DISBURSEMENT  BASIS. 


1.  Sale  of  live  stock  and  stock  products  raised. 

2.  Sale  of  crcps  and  crop  products  grown . 

3.  Other  receipts . — 

4.  Bale  of  stock,  or  other  items  purchased 

6.  Geoss  Paonra _ — 


7.  Expenses  (column  1,  page  3).. 

8.  Expenses  (column  2,  page  3)_ 


10.  Depreciation 

11.  Total  Expenses  . 


6.  Net  farm  profit  to  be  reported  in  Item  5.  Form  1040A,  or  Form  1040  (Item  5  minus  Item  11)- 

>— IIHO 


i68i 


Page  2. 

FARM  roVENTORY  FOR  INCOME  COMPOTED  ON  AN  ACCRUAL  BASIS. 

Description. 

(KlDd  of  animals,  crops, 

or  other  products.) 

Om  Hakd  at 
Beoowdio  or  Ye»b. 

PuBcnisED  During 

Raised  Duking 
Yeah. 

CONSimED  TiR  LOST 

During  Year. 

Sold  Durmo  Year. 

Oh  Hahd  at  Ehd 

or  YEiE. 

Quan- 

lily. 

Invonlory 
value. 

QlUD' 

Illy. 

AnioiiDt 

lily. 

laventory 

value. 

QlUB' 

Inventory 
vaJue. 

Quan- 
lily. 

Amount 
received. 

Quan- 

lity. 

InTOTtarj 
value. 

$ 

$ 

$ 

$. — 

$._ 

$ 

— 

1 



' 

Totals 

$ 

$ 



$ 

s...... 

% 

$ 

1  line  4)  (Emer  on  hne  6.)  (Enter  on  liDe  2.) 

SUMMARY  OF  INCOME  AND  EXPENSES  COMPUTED  ON  AN  ACCRUAL  BASIS. 


1.  Inventory  of  live  stock,  cropa,  and  products  at  end  of  year  . 

2.  Sales  of  live  stock,  crops,  and  products  during  year 

2a.  Other  miscellaneous  receipts 

3.  Total ; 


4.  Inventory  of  live  Block,  crops,  and  products  at 
beginning  of  year 


5.  Coetoflive  fatock  and  products  purcha/;ed  duriug 
year 


fi.  Gross  profits  (Item  3  minus  the  sum  of  Itema  A  and  5)  — 


7.  Expenses  (column  l,page3). 

8.  Expenses  (celumn  2,  page  3). 

9.  Repairs 

10.  Depreciation 


Total  Extehses  . 


12.  Net  farm  profit  to  be  reported  in  Item  5,  Form  1040A,  or  Form  1040  (Item  6  fliinus  Item  1 1  >.. 


1682 


Page  3. 


FARM  EXPENSES  FOR  TAXABLE  PERIdO. 


ITircd  help  for  farm 

Feed,  liay,  straw,  etc — 

Seed,  plants,  etc 

Threshing  and  baling 

Cotton  ginning 

Silo  filling 

Milling  and  grinding  feed _ 

Fertilizers  and  spraying  materials 

Blackarailhlng — 

Fuel  and  oil  for  farm  vrork 

Barrels,  bags,  crates,  and  twino — 

Taxes  (except  Federal  income  ta.^es) 

loGniute  oa  prcpertj  olbor  than  joar  jffoHmg  and  pcrsond  cIImIs.. 

Interest  on  farm  notes  and  mortgages 

Water  rent - 

Rent  for  farm 


(I)  Amount. 


(Enter  on  lino  7.) 

REPAIRS  AND  DEPRECMTION. 


(Enter  on  lino  8.) 


Descp-iptiov. 
(It  builJing!;.  slato  the  material  ol  which  constructed.) 

Ace  When 

ActjUUlED. 

Date  AcQimiED 

COST, 
OBtFACQUIKED  PRIOR 

TO  March  1,1913.  THE 

Fair  Uaeeet  Valux 

ON  That  Date. 

Repairs. 

Depreoatioh. 

Farm  buildings 

- 

? :- 

?— 



^ 

.„•. 

1 
1 

TOTAI.3 - - 

$ 

5 

$ 

(£ateroiilme9.)         (Enter  on  line  10.) 


1683 


P«ge4. 


INSTRUCTIONS. 


Pases  1  and  3  arc  to  be  (llled  In  by  farmers  who  either  keep 
no  recorils  or  only  records  of  rash  receipts  and  dislmrse- 
raenls.  Pases  2  and  3  are  to  he  tilled  in  hy  farmers  who  keep 
comi)letG  aeconnls  on  an  aoerual  basis  with  invoulories  to 
deteriuino  net  prolits.  Returns  on  an  inventory  basis  are 
not  acceptable  unless  the  inventories  were  actnally  taken 
and  so  recorded  at  the  beginning  and  end  of  the  taxable 
period. 

H  you  do  not,  as  a  matter  of  settled  practice,  keep  books  of 
accouut  upon  an  accrual  basis,  no  attempt  should  be  made  to  fill 
out  the  items  in  the  form  relating  to  inventories,  and  the  omission  of 
those  items  in  that  case  will  not  result  in  an  incorrect  computation 
'  of  your  farm  net  profit.  If,  however,  you  regularly  keep  books  of 
account  upon  an  accrual  basis,  which  clearly  reflect  your  net  income, 
you  should  report  the  value  of  yoiu-  crops  and  stock  on  hand  at  the 
end  of  the  year  in  gross  profits,  as  provided  on  the  form. 

This  schedule  may  be  used  by  farmers  who  work  their  own  farms 
or  rent  them  out  on  shares,  and  if  two  or  more  farms  are  owned  it 
may  be  desirable  to  fill  out  a  separate  schedule  for  each  farm. 

Attach  this  schedule  to  your  income  tax  return  (Form  1040.\  or 
Form  1040).     You  should  keep  a  copy  for  future  reference. 

When  you  have  determined  the  net  farm  profit,  transfer  the 
amount  to  Item  5  of  the  income  tax  return  Form  1040A,  or  Form  1040. 

Cash  Receipts  and  Disdursemests  Basis. 
A  farmer  reporting  on  the  basis  of  cash  receipts  and  disburse- 
ments shall  include  in  his  gross  income  for  the  taxable  year  the 
amount  of  cash  or  the  value  of  merchandise  or  other  property  received 
from  the  sale  of  live  stock  and  produce  which  were  raised  during  the 
taxable  year  or  prior  years,  also  the  profits  from  the  sale  of  any 
stock  or  other  items  which  were  purchased.  The  farm  expenses 
will  be  the  actual  amounts  paid  out  during  the  taxable  year. 

Accrual  Basis. 

If  your  farm  books  of  account  are  kept  on  an  accrual  basis,  the 
filing  of  this  form  is  optional. 

For  those  reporting  on  the  accrual  basis,  the  gross  profits  are 
obtained  I)y  adding  to  the  inventory  value  of  live  stock  and  products 
on  hand  at  the  end  of  the  year  the  amount  received  from  the  sale 
of  stock  and  products  and  other  miscellaneous  receipts,  for  hire  of 
teams,  machinery,  etc.,  during  the  year,  and  deducting  from  this 
sum  the  inventory  value  of  stock  and  products  on  hand  at  the 
beginning  of  the  year  plus  the  cost  of  stock  and  produce  purchased 
during  the  year.  The  farm  expenses  will  be  of  the  actual  expenses 
incurred  during  the  yeai.  whether  paid  or  not. 

hientory. — If  you  render  a  return  for  the  taxable  period  of  1921 
upon  an  accrual  basis,  you  may  value  the  closing  inventory  for  1921 
according  to  the  farm  pric«  method,  which  contemplates  valuation 
of  inventories  at  market  less  cost  of  marketing.  In  the  event  the 
use  of  the  farm  price  method  of  valuing  your  closing  inventory  for 
1921  represents  a  change  in  method  of  taking  inventories  from  that 
employed  by  you  for  1920,  the  opening  inventory  for  1921  should 
be  brought  in  at  the  same  value  as  the  closing  inventory  for  1920 
(this  being  the  same  in  effect  as  valuing  the  opening  inventory  on 
the  new  basis  and  crediting  income  with  tlie  excess  valuation 
brought  in).  If  such  treatment  of  your  opening  inventory  for  1921 
results,  however,  in  an  abnormally  large  income  for  1921.  then  adjust- 
ments in  the  form  of  an  adjustment  sheet  attached  to  your  1921 
return  may  be  made  of  your  taxes  for  1917  and  each  succeeding 
year  to  1921.  based  on  the  new  method  of  taking  inventories  (using 
lor  each  of  such  years  prior  to  1921  the  same  method  employed 
for  1921). 

Farmers  may  change  the  basis  of  their  returns  from  that  of  receipts 
and  disbiusements  to  that  of  an  inventory  basis,  which  necessitates 
the  use  of  opening  and  closing  inventories  for  the  year  in  which^he 
change  is  made.  There  should  be  included  in  the  openinginventory 
all  farm  iJroducts  (including  live  stock)  purchased  or  raised,  which 
were  on  hand  at  the  date  of  the  inventory,  and  there  must  be  sub- 
mitted with  the  return  for  the  current  taxable  year  an  adjustment 
sheet  for  1917  and  each  year  thereafter  (prior  to  the  year  in  which 
the  change  is  made)  based  on  the  inventory  method;  upon  the 
amount  of  which  adjustments  the  Lix  shall  be  assessed  and  paid 
(if  any  be  due)  at  the  rate  of  tax  in  effect  for  each  respective  year. 
Where  it  is  impossible  to  render  complete  inventories  from  the  begin- 
ning of  the  taxable  year  1917,  the  Department  will  accept  estimates 
whuh,  in  its  opinion,  substantitallv  rcllect  the  income  on  the 
inventory  b.asis,  for  the  year  1917  and  thereafter;  but  inventories 
must  not  include  real  estate,  buildings,  permanent  improvements  or 
any  other  aaseta  subject  to  depreciation. 

Income. 
All  the  farm  income  from  whatever  source  must  be  reported  in 
this  schedule.  Anything  of  value  received  instead  of  cash  must  be 
treated  as  income  to  the  extent  of  its  cash  value.  Thus,  the  total 
value  of  groceries,  merchandise,  etc.,  received  in  exchange  for  cgs, 
butter,  or  other  produce  must  be  reported  as  income.  ° 


1 


Hail  and  fire  insurance  on  giowing  crops  should  be  included  in 
pross  income  to  the  amount  received  in  cash  or  the  equivalent  fo- 
the  crop  destroyed. 

If  you  sold  your  farm  or  any  part  of  it,  report  the  profit  iii  Item  G 
of  Form  1040A  or  Form  1040. 

The  yahie  of  farm  produce  which  is  consumed  by  the  f.irmer  and 
his  family  need  not  be  reported  as  income;  but  expenses  incurred 
in  raising  produce  thus  consiuned  must  not  be  claimed  as  deductions. 

The  term  "farm"  embraces  the  farm  in  the  ordinarily  accepted 
sense,  and  includes  stock,  dairy,  poultry,  fruit,  and  trucl:  farms, 
also  plantations,  ranches,  and  all  land  used  for  farming  operations'. 
All  indiWduals.  partnerships,  or  corporations  that  cultivate,  operate, 
or  manage  farms  for  gain  or  profit,  either  as  oimers  or  tenants,  are 
designated  farmers.  A  person  cultivating  or  operating  a  farm  for 
recreation  or  pleasure  is  not  regarded  as  a  fanner. 

Expenses  and  Other  Deductioxs. 

Labor. — Only  that  part  of  the  board  of  hired  labor  which  is  pur- 
chased should  be  included  as  a  deduction.  The  value  of  products 
furnished  by  the  farm  and  used  in  the  board  of  hired  labor  is  not  a 
deductible  expense.  Rations  purchased  and  furnished  to  laborers 
or  share  croppers  are  deductible  as  a  part  of  the  labor  expense. 
Do  not  deduct  the  value  of  your  own  labor  or  that  of  your  wife  or 
dependent  minor  children,  unless  you  report  such  value  as  income 
in  Item  1,  Form  lO-lOA  or  Foim  1010.  Do  not  deduct  amounts 
paid  to  persons  engaged  in  household  work,  except  to  the  extent 
that  the  services  of  such  employees  are  used  in  boarding  and  other- 
wise caring  for  farm  laborers.  Services  of  such  employees  engaged  in 
caring  for  the  farmer's  own  household  are  not  a  deductible  expense. 

Fertilizers,  manures,  etc. — The  cost  of  manures,  commercial  fer- 
tilizers, lime,  raw  rock  phosphate,  etc.,  that  were  bought  during 
the  year  may  be  deducted  as  an  expense. 

Taxes. — Do  not  deduct  Federal  income  taxes  nor  taxes  for  any 
improvement  or  betterment  tending  to  increase  the  value  of  the 
property.  (See  Articles  131  to  135,  Income  Tax  Regulations,  1922 
edition.)  Be  ready  to  show  tax  receipts  for  taxes  claimed  as  a 
deduction.  Taxes  on  yo\ir  dwelling  or  household  property  should 
be  reported  in  Item  11,  Form  1040A,  or  Item  13,  Form  1040. 

Interest  on  indebtedness. — All  interest  paid  on  farm  mortgages, 
notes,  and  other  obligations  incurred  to  carry  on  the  farm  business 
sh(Tuld  be  deducted. 

Bud  debts. — Report  only  debts,  or  portions  thereof,  arising  from 
sales  that  have  been  reported  as  income,  which  have  been  definitely 
proved  within  the  year  to  be  worthless,  or  such  reasonable  amount 
as  has  been  added  to  a  reserve  for  bad  debts  within  the  year.  If 
you  report  your  farm  income  on  a  cash  basis,  bad  debts  arising  from 
sales  are  not  an  allowable  deduction. 

Repairs  and  depreciation. — Depreciation  claims  should  not  exceed 
the  actual  cost  of  buildings  and  equipment  (or  it  acqxiired  prior  to 
March  1, 1913,  the  fair  market  value  on  that  date)  di\'ided  by  its  prob- 
able life  in  yearssince  acquisition.  In  computing  depreciation  do  not 
include  the  value  of  farm  land  nor  the  land  on  which  farm  buildings 
are  located.  Do  not  deduct  repairs  or  depreciation  on  the  dwelling 
you  occupy  or  on  your  peraonal  or  household  equipment.  Do  not 
claim  as  a  separate  item  depreciation  on  live  stock  or  any  other 
property  included  in  yoiu-  inventory,  as  such  depreciation  is  taken 
care  of  la  the  reduced  amount  of  the  inventory  at  the  close  of  the 
year.  Depreciation,  however,  may  be  claimed  on  draft  or  work 
animals  and  animals  held  for  breeding  pmposes  which  were  pur- 
chased and  which  are  not  included  in  your  inventory  of  stock  bought 
or  raised  for  sale. 

Losses. — You  may  deduct  in  Item  12,  Form  1040A,  or  Item  14, 
Form  1040,  losses  of  buildings,  machinery,  and  other  property  not 
included  in  your  inventory,  resulting  from  fires  or  other  casualties 
and  not  compensated  for  by  insurance  or  otherwise.  Losses  of  prop- 
erty included  in  your  inventory  are  taken  care  of  by  the  reduced 
amount  of  the  inventorv  at  the  close  of  the  year.  The  loss  of  growing 
crops  hy  frost,  storm,  flood,  or  fire,  or  the  loss  of  animals  raised,  is 
not  deductible. 

Tools,  machincrij,  and  equipment. — The  cost  of  small  tools  of  short 
life,  such  as  shovels,  rakes,  etc.,  may  be  deducted  as  an  expense. 
You  may  deduct  expenses  of  operation,  repairs,  and  depreciation 
on  automobiles  used  exclusively  in  fann  business.  If  an  automobile 
is  used  in  farm  business  for  a  part  of  the  time  only,  a  corresponding 
part  of  the  expense  may  be  deducted.  Amounts  expended  for 
automobiles,  fann  machinery,  farm  buildings,  or  other  farm  equip- 
ment of  a  permanent  nature  are  not  deductible  as  expenses,  as  such 
expenditmes  are  regarded  as  investment  of  capital  which  is  re- 
turned to  the  owner  through  depreciation  allowances  prorated  over 
the  useful  life  of  the  property. 

Rent  paid  in  crops. — ^Tiere  a  tenant  farmer  pays  his  rent  to  the 
landlord  in  form  of  crops  raised  on  the  farm  (the  agreement  being 
on  a  crop-share  basisV  the  tenant  may  not  deduct  as  rent  the  value 
of  the  croj)  given  to  the  landlord,  but  he  may  deduct  all  amounts 
paid  by  him  in  raising  the  crop.  2— iieM 


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K  nomwldent  alien  who  deslrw  to  data  tho  nersnnol  fxempllon  o(  $1 ,000  with  resp»-t  to  saliries  or  wajres  received  In  poyme nt  (nr  Mrvtcea  rendered  In  the  tJnlted  St«to 
should  file  this  lorm  with  his  employer  not  later  than  February  1  succeeding  the  year  during  which  the  Income  was  received . 


THE  WITHHOUJINC  AGENT 
OR  COLLECTOR  RECEIVING 
THIS  CLAIM  SHALL  ENTER 
DATE  OF  RECEIPT  IN  THIS 
SPACE. 


CLAIM  BY  NONRESIDENT  ALIEN  INDIVIDUAL 

FOR  BENEnT  OF  PERSONAL  EXEMPTION  OF  $1,000 


FOR  TAXABLE  YEAR   1921 


DO  NOT  WRITE  HERE 


(Name  of  withholding  agent.) 


(Street  and  number.) 


Claim  is  hereby  made  for  benefit  of  the  personal  exemption  provided  xmder  section  216  of  the  Revenue 
Act  of  1921  by  (or  for)- 

Name  of  claimant - 


Address  in  the 
United  States. 


1.  Of  what  country  are  you  a  citizen  or  subject? 

(Name  of  country. ) 

2.  State  or  Province? — 3.  Are  you  single? 

(Name  of  State  or  Province.) 

4.  If  married,  has  your  wife  or  husband  derived  income  during  the  taxable  year  to  date  from  sources  in  the 

United  States  separate  from  your  own? 

5.  If  so,  is  such  income  included  in  the  income  stated  below?. 

6.  Have  you  filed  a  return  of  net  income  for  all  or  any  of  the  past  four  years  ? ;...    7.  If  so,  state 

for  which  years  and  the  Internal  Revenue  Districts  in  which  fiJed. 


INCOME  OF  CLAIMANT,  DURING  TAXABLE  YEAR  TO  DATE,  FROM  SOURCES  WTTHIN  THE  UNITED  STATES. 

(1)  Salary  on  Wages. 


Name  ov  Emploteii. 

Addbess. 

Peiuod. 

AMOtTOT. 

1-        .      . 

$ 

1 

(2)  Other  Income. 

$ 

$ 

Name  or  SotTRcs. 

Address. 

Period  or  Date. 

AMOUNT. 

$ 

Total  income  of  claimant,  during  taxable  year  to  date,  from  sources  within  the  United  States  (X) 

STATEMENT  OF  PERSONAL  EXEMPTION  CLAIMED. 

Amount  of  personal  exemption  to  which  entitled (Y)  $    1,000    00 

Total  income  of  claimant,  during  taxable  year  to  date,  from  sources  within  the  United  States  (item  X  from  above) 

Balance  of  credit  (item  Y  minus  item  X) $ « 


I  swear  (or  afiirm)  that  the  above  is,  to  the  best  of  my  knowledge  and  belief,  a  true  and  complete  state- 
ment of  facts  in  connection  with  the  claim  for  credits  above  made. 


(U  claim  is  made  by  agent  the  reason  therefor  must  be  stated  on  this  line.) 

Sworn  to  (or  affirmed)  and  subscribed  before  me 
this day  of 192 

(Signature  of  Individual  or  agent.) 


(Official  capacity.) 


COVUWHINT  raiNTWC  0 


(Address  of  Individual  or  agent.) 


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UNITED  STATES  INTERNAl    REVENUE  SERVICE 


ANNUAL  INFORMATION  RETURN 

OF  PAYMENTS   OF   INCOME.  ETC.,   REQUIRED  TO  BE  REPORTED  UNDER  REVENUE  ACT 

OF    1921 

FOR   CALENDAR  YEAR    1921 

(Return  for  Fiscal  Year  Can  Not  Be  Accepted) 

FOR  INSTRUCTIONS  SEE  REVERSE  SIDE 


THIS  RETURN, 

ACCOMPANIED  BY 

REPORTS  ON 

FORM  1099,  MUST  BE 

FpRWARDED  SO  AS 

TO  REACH  THE 
COMMISSIONER  OF 
INTERNAL  REVENUE, 
SORTING  SECTION, 
WASHINGTON,  D.  C, 
ON  OR  BEFORE 
MARCH  IS,  1922. 


(Name  o(  person  or  organization  rendciing  this  rctnrn.) 


(Street  and  number  or  rural  route.) 


CHARACTER  OF  INCOME  PAID. 


NUMBER  OF 

REPORT 
FORMS  1099 
ATTACHED. 


Interest,  rent,  salaries,  wages,   prcroiumj,  anniaties,  compensation,  remuneration,  emoluments,  or  other 
fixed  or  determinable  gains,  profits,  and  income  of  $1,000  or  more 


(DO    NOT  WRITE  IN  THIS  SPACE.) 


IMPORTANT  NOTICE 

Returns  of  Information  »re  required  to  be  rendered  on  the  basis  of  the  calendar  year.  Returns  for  any  other  period 
of  time  will  not  be  accepted. 

If  list  showing  names  and  addresses  of  payees  is  compiled  or  an  adding  machine  tape  used  in  executing  Forms  1099.  it  should  be 
submitted  with  forms. 

The  name  of  the  individual,  corporation,  partnership,  etc.,  using  Form  1099  may  be  printed  or  stamped  on  each  form,  if  so  desired. 

Returns  -of  individuals  on  this  form  must  be  signed  and  sworn,  to  by  the  individual  or  his  duly  authorized  agent.  Retimis  of 
corporations,  partnerships,  etc.,  must  be  signed  and  sworn  to  by  an  officer  of  the  aorporation  or  member  of  firm. 


I'  Swear  (or  affirm)  that  to  the  best  of  my  knowledge  and  belief  the  foregoing  return  and  the  accompanying  reports  constitute  a  true 
and  complete  statement  of  payments  of  the  above-described  classes  of  income  made  by  the  person  or  organization  named  at  the  head 
of  this  return  during  the  calendar  year  1921 


Sworn  to  and  subscribed  before  me  this 


day 


(State  address  of  person  signing  ifdiflerent  from  that  ^ven  at  head  of  n 
(THIS  RETtIRN  MUST  BE  SIGNED  AND  SWORN  TO) 


1689 


INSTRUCTIONS 

Forms  1096  and  1099  (Interest,  Rent,  Salaries,  etc.,  of  $1,000  or  more)  must  be  made  by  every  individual,  corporation, 
partncrehip,  personal  service  corporation,  association,  or  insurance  company,  including  lessees  or  mortgagors  of  real  or  personal  property, 
trustees,  executors,  administrators,  receivers,  employers,  and  all  officers  and  employees  of  the  United  States  who  paid  interest,  rent, 
salaries,  ete,,  to  another  individual,  partnership,  personal  service  corporation,  or  fiduciary  during  the  calendar  year  1921.  A  separate 
report  on  Form  1099  must  be  made  (and  forwarded  with  this  return)  for  each  indi\'idual,  partnership,  personal  service  corporation,  or 
iiduciar}'  to  whom  such  income  was  paid,  credited,  or  distributed. 

Interest,  rent,  salaries,  etc.,  regardless  of  amount  paid  to  nonresident  alien  individuals,  should  not  be  included  in  this  return  buc 
should  be  reported  on  return  Form  1042. 

In  executing  Form  1099,  an  employer  who  is  required' to  withhold  fax  from  an  employee  under  a  State  income  tax  law,  shouH  report 
on  each  form  the  amount  of  salary  paid  to  the  employee  plus  the  amount  of  tax  withheld.  The  employee  should  report  the  same  amouat 
on  Form  1040  or  Form  1040A,  as  the  case  may  be. 

ORGANIZATIONS  HAVING  A  MAIN  OFFICE  OR  PLACE  OF  BUSINESS,  AND  ONE  OR  MORE  BRANCH  OFFICES, 
SHOULD  FILE  COMPLETE  RETURNS  ON  FOR5IS  1096  AND  1099  SHOWING  ALL  PAT3IENTS  MADE  BY  MAIN  AND 
BRANCH  OFFICES.    THIS  RETURN  SHOULD  BE  MADE  FROM  THE  MAIN  OFFICE  AND  THE  LOCATIONS  OF  ALL 
BRANCH  OFFICES  COVERED  BY  THE  RETURN  SHOULD  BE  NOTED  THEREON. 
Reports  on  Form  1099  are  not  requirerj  in  the  folloxping  cases: 

Interest  on  the  obligations  of  the  United  States,  of  States,  Territories,  or  political  eubdlTiaions  thereof  or  of  the  District  of 
Colimibia,  and  compensation  paid  officers  and  employees  by  a  State  or  political  subdivision  thereof  for  personal  senieee. 
Bills  paid  for  merchandise,  telegrams,  telephone,  freight,  storage,  and  similar  charges. 
Amounts  paid  to  employees  for  expenses  incurred  in  businees. 
Premiums  paid  to  insurance  companies. 
Annuities  representing  return  of  capital. 
Interest  accrued  on  bant  deposits  if  not  credited. 
Payments  made  by  domestic  establishments  or  foreign  branch  houses  thereof  to  nonresident  alien  employees  for  serviceB 

performed  entirely  in  foreign  countries. 
Interest  on  bonds  of  domestic  and  foreign  corporations.    (See  Forms  1012  and  1096A.) 
.Salaries,  wages,  etc.,  paid  to  nonresident  alien  individuals  and  foreign  corporations.    (See  Form  1042.) 
The  rental  value  of  a  dwelling  house  and  appurtenances  thereof  furnished  to  a  minister  of  the  gospel  as  a  part  of  his 

compeiMation. 
Distributions  to  members  of  a  partnership,  personal  ser\'ice  corporation,  and  beneficiaries.    (Distributions  made  to  members 
of  partnerships,  personal  service  corporation,  and   to  beneficiaries  of  estates  or  trusts  must  be  shown  on  Partnership  and 
Fiduciar)'  Retunw.) 
TENANTS  ARE  NOT  REQUIRED  TO  REPORT  PAYMENTS   OF  RENT  MADE  TO  REAL  ESTATE  AGENTS  OR 
REPRESENTATIVES,    BUT    AGENTS    OB    REPRESENTATIVES    ARE    REQITRED    TO    REPORT    PAYMENTS    TO 
LANDLORD  OR  OWNER  IF  THEY  AMOUNT  IN  THEAGGBEGATE  TO  $1,000  OR  MORE  FOR  THE  YEAR. 

2— IIMS 


1690 


Fornx  707— Ucvised  Fub.,  1021. 


1922  RETURN 

CAPITAL  STOCK  TAX 


RETURN   FOR    DOMESTIC  CORPORATIONS 


(Page.) 
Audita!  by: 


e  of  corporatloa,  Joint-stock  company,  or  association.) 


(Sbcw  former  n 


CI  pal  i>liioo  of  bu^ioti^s. 


3.  Name  of  parent  ( 


i  number,"  "City  or  towu,"  and  "Si. 
(Diatrict  filed.. 


(District  Clod., 


6.  Nature  of  busineas  in  detail -  

G,  Incoiporated  or  org:aiiized  in  State  of Month. 

(June  30,  1921, 
\    Firo  inaurance  carried,  if  any,  $.. 


9  Special  Instructions  No.  2,  page  4  hereof.) 


(Nearest  earlier  dtiic) 


Cum.  or 

DMdesd  1  Number  of 

Par  Talua 
per  Bhare. 

Total  par  valoa. 

ToiaL 

Capital  stock  outetanding: 

ry 

s 

$ 

X  X 
XX 

zxx 

_ft, 

<r. 

11.                    Total      _ 

II. 

13.  Amouut  of  undivided  profita___ 

14.  Grand  Total. 

TAX  PAYABLE  ANNUALLY  IN  ADVANCE 

RETURN  FOR  TAXABLE  PERIOD  JULY  1,  1921.  TO  JUNE  30.  192J,  BASED  ON  FAIR  AVERAGE  VALUE  OF  CAPITAL  STOCK  FOR  PRECEDING  YEAR 

CAREFULLY  READ  ALL  INSTRUCTIONS  BEFORE  MAKING  RETURN 


(fl                                             COMPUTATION   OF  TAX. 

This  column  tor  uia  ot '                                Ttala  colaxon  tor  use  ot 
toipayei.                                                    DopaitmenL 

^          Domestic  corporationa  will  report: 

,      15,           Fait  value  of  total  capital  atock  for  fiscal  year  detemined  b;  Exhibit 

$ 

$ 

b                 . 

O          Domestic  mutual  insurance  companies  will  report- 

Z  IG.  (a)  Sumcf  surplua  or  contingent  reserves  maintiiined  for  general  use  of  tho 
business 

$ 

t 

Q          (6)  Plus  any  reserves  tho  net  additions  to  which  are  included  in  net  in- 
O                   come  under  the  provisions  of  Title  II,  Revenue  Act  of  1918 

17.                   Total 

13.  Deduction  alloired  by  law._ _ 

5 

0  0  0 

0  0 

5 

0  0  » 

00 

19.                     Aciount  in  excess  of  $5,000 (Oiiiit<:«nt^) 

1 

X    X 

X  X 

20.  Tax  at  rate  of  $1  for  each  full  $1,000  in  excess  of  $5,000 (Omitcnt.  ) 

X  X 

21.  Penalty 

23.                   Total  tax  and  penaltt  

1 _ 

_._ 1 :.. 

CLAIM  SETTLEMENT  RECORD 


Allowed $.. 

Rejected.: J.. 

Fair  Value C 


Every  corporation,  must  file  a  return  or  submit 
conclusive  evidence  that  It  l3  not  l^aWe.  Deter- 
mination of  liability  re3ta  witb  the  Commlasioner. 
This  applies  to  companiea  claiming  exoRiption  on 
account  ot  not  toeing  engagod.  in  bujaUiosa  or  aa 
personal  sor^'lco  corporations,  etc.,  under  Section 
231,  Title  II,  of  tbe  Revenue  Act  of  1»18.  See  Arta. 
2S  ana  31,  lEegoilatlous  CO,  Revisea. 


ALL  TAXES  ARE  PAYABLE  TO  THE  OOLLECTOR  OF  THE  DISTRICT  IN  WHICH  RETURN  IS  FILED. 


ADDITIONAL  ASSESSMENT  RECORD 


,19 

Lur 

Pack 

..    Uvi. 

(Sec  IffoxsucTtoira  ok  Paqk  4.> 


(1) 


1691 


EXHIBIT  A.     (See  Special  Instructions  No.  4,  page  4.) 
CONDENSED  BALANCE  SHEET  AS  OF 


(8ftm«  d*t«  u  lt«iii  7,  pa^  1.) 


DEBITS  AA'D   ASSETS. 

BCX)ES  OF  ACCOUNT. 

lAIE  VALUE. 

DlTTEREnCE. 
*  (iiiplatn  any  laxg«  unsiuiti.) 

1. 

t 

t    . 

Tftflh 





Totals .„ 

1 

---..-.. 





...._ 

i.     .._.. 

CREDITS  AND   LIABILITIES. 

BOOKS  OF  ACCOUWT. 

TAISVALUB. 

SIFFES£1TCE. 

Bonded  debt $ 

% 

( 

J. 







Capital  Block; 

— 

Common, $    

" 

Totals 

1 

, ! 

, _J._.._ 1 L._ 

RECAPITULATION  OF  EXHIBIT  A 

Thla  calnnui  for  tue  of 
(uparer. 

This  cohinm  tor  use  ot 

Domestic  Corpofu 
ToUl  of  dehili  ud  usetJ  after  deJaeifng  ttoTU  rwt  actual 
Lets  loUl  ef  truSts  and  Cabi&ties  cfler  itJucUng  capi 

.cs. 

S 

•-- 

S 

al  stoc^,  surplus,  and  other  Hans  not 

Stock  iNsraANCE  Compantes 

- 





5 

t 





*  lC»t«ri»l  diSoranoN  wUl  not  b«  tUowed  aDl«sa  satialftctorll;  explained. 


(SXX  l59TSUCnOKS  OS  f  40S  4.) 


(2) 


1692 


EXHIBIT  B.     (Se 
QUOTATIONS  OR  OUTSIDE  SALES 

3  Special  Instructions  No.  5,  page  4.) 

.-^■:— 

SPECIAL  INFORMATION. 

(Give  oaiuo  of  exchoDge  or  specify  "  Outaldt 

Manufacturing  and  trading  corporation* 

COMMON. 

FIRST  PKEFEREED. 

will  report  annual  gross  sales  for  the  five 
years  shown  under  Exhibit  C. 

MOKTH. 

Hiimbcir  ot  rfuiea 

Prlc«. 

Numbor  ot  shares 

Pric. 

TEAS 
ENDED— 



$-_ 

$ 

BALES. 

- 



191      .... 



191 





191    

19 

19      .... 

Total 



Average i  x  x  i  i  x 

X  X  X  X  X  X 

RECAPITULATION  OF  EXHIBIT  B.                               | 

This  ulunm  lor  um  ot  Uxpayer. 

■mi.  column  lor  use  ol  D«p«tme«t 

Average  sale  value  of  common  stock  per  sh 
by number  of  sbares 

Average  sale  value  of  firat  preferred  stock 
by .. number  of  shares 

Average  sale  value  of  second  preferred  stoc 

$ 

outstanding. 

per  share,  $ ,  multiplied 

k  per  share,  $ ,  multiplied 

Total  fvalue  of  total  capital  stock  reflected  by  Exhibit  B)  

..„.—.- 

Preferred . 
Preferred  . 


Approximate  numTjer  of  shares  traded  in  during  tho  year;  Common 

Capital  stock  outstanding  as  of  June  30,  1921;  Common __ — . 

EXHIBIT  C.     (See  Special  Instructions  No.  6,  page  4.) 
ANNUAL  INCOME. 


FISCAL 
TEAR 
Ended- 



■ 

~ 

~~~ 

NUMBER 

OF 
SHARES. 

DIVIDENDS  DECLARED. 

(Dedclt  in  red.) 

DEDUCTIONS. 

ADDITIONS. 

INCOME. 

C«.m.on. 

Flnl         Second 
prstened.  preferred. 

DEPRECIATION. 

$ 

-  -56 

fi 

..     .56 

^ 

^ 

/, 

5. 

..  .a 

56 



fi 

19 

f. 



19 

— % 

% 

% 

Total 

1, 

AverBge. 

$ 

X  X  I  X  X  X 

$    - 

% 

..._..% 

% 

$ 

RECAPITULATION  OF  EXHIBIT  C. 

TUB  eolmim  lor  use  ol  tsipayer. 

This  column  tor  use  ot  DepsrtmenL 

=d 

*  -     -  - 

$ 

Capitali 
hibit 

zed  at 
0)..... 

...  per 

cen 

t  (value  of  total  capital  stock  reflected  by  Ex- 

State  of 1 

We, ,  President,  and _ _ ,  Treasurer, 

of  the  above-named  company,  whone  return  for  sjiecial  excise  tax  is  herein  set  forth,  being  severally  duly  sworn,  each  for  himself,  deposes  and  says 
that  the  items  enlpred  in  the  foregoing  report  and  in  any  additional  list  or  lists  attached  to  or  accompanying  this  return  are,  to  his  best  knowledge  and 
belief  and  from  such  information  as  he  has  been  able  to  obtain,  true  and  correct. 


Sworn  to  and  subscribed  before  me  this  . 


.day 


[seal.] 


(Offldal  Mjmclty.) 


(3) 


Trcasvrer. 
rSEB  lN3TttucnoN8  ON  Page  4.) 


1693 


SPECIAL  INSTRUCTIONS 


the  year  preceding  the  taxable  year,  whether  or  not  It  is  organized  (or  proBt  < 
has  a  capital  atock  repreaented  by  sberei.  For  domesttc  tsatual  Insurance 
companies,  see  page  1,  Form  707,  Bevlsed. 

For  the  purpose  cf  this  tai  the  fair  ralne  of  the  entira  cfipitnl  stock  as  a 
going  concern,  re:^rdle89  of  stocs  ownership  or  the  ability  of  Individual  stock- 
Boldera  to  liquidate  their  holdings.  Is  required.  The  sales  prices  for  any  num- 
ber of  shares  of  stock  less  than  a  majority  Interest  are  not  necessarily  ludic- 


any  given  date. 

In  order  that  consideration  may  be  given  the  various  factors  affecting  fair 
value,  three  eihlblta  are  provided  for  furnishing  information,  and  the  taxpayer 
win  complete  each  erhlbft  or  state  why  the  required  data  are  not  available. 

Exhibit  A  provides  for  adjusting  any  overstated  or  understated  values  con- 
tained In  the  taxpayer's  books  of  account,  and  Exhibit  C  provides  for  showing 
an  adjusted  Income,  which  should  be  the  actual  operating  Income  to  be  used  for 
capitalizing  on  a  percentage  bnsis  fixed  by  its  officers  as  fairly  representing 


:  for       quotations  i 


of  the   ex  chance  from   wblcb   reported 

In  the  space  provided  therefor,  and  the 

of  the  highest  and  of  the  lowest  bid  price 

■—  — rage  for  the  year  — *"  "--   -■-'-■-    ■ 

'     "  to  thiL _ 

quoted  for  each  day  of  the 


highest  and  lowest  bid  price  at  which  stock  ' 
yeer  and  the  average  obtained  therefrom. 

If  the  stock  Is  not  listed  end  outside  sales  have  been  made  at  prices  known 
or  determinable  by  the  Oulcers  making  this  report,  such  prices  will  t>e  reported 
herein.  A  statement  of  the  number  of  shares  Involved  and  the  condllions 
under  which  sales  were  made  at  other  than  exchange  quotations  must  accorn- 
pany  this  return.     Sales  to  employees  or  directors  for  qualifying  purposes.  ■ 

capltai  stock  and  should  not  be  Included. 

In  the  column  *'  Number  of  shares  outstanding"  should  he  shown  the  total 
number  of  shares  outstanding  at  the  close  of  each  month.  The  average  value 
per  share  will  be  determined  as  follows: 

First.  Tf  no  change  occurred  In  the  number  of  shares  outstanding  during  the 
year,  total  the  quotations  or  sales  prices  for  the  months  reported  and  divide 
by  the  cumber  of  montiis  In  which  quotations  or  sales  prices  arc  shown. 

Second.  If  any  change  occurred  In  the  number  of  shares  outstanding  during 


;  relied  on  In  support  of  the  valuation  claimed  must  be  sabmitted.     In 
any  case  In  which  the  fair  value  Is  und»rBtat*3  the  1  "      ' 

by  the  Commissioner  and  the 
wlU  be  asserted. 


:  tax  assessed  ;    alsc 


shoaid  ~oe  used  annually. 

Uutual  iBsursnc 
th«  closing  of  the 
poM  •!  making  Its  Tacome-fax  return. 

3.  BxHiBiTs — Tht  three  exhibits.  A,  B,  and  C, 


,     .     .  provided  to  Indicate  th« 

iMformation  desired  and  the  manner  in  which  It  should  be  famished.  8o  far 
ea  adaotable  these  forms  should  be  completed  by  taxpayers,  but  If  th«y  And  It 
more'convenlent  they  may  cttach  to  this  return  fhslr  own  statements  (as  In 
the  case  of  banks  and  inaorance  compaDiea),  provided  substantlelly  the  same 
Information  is  furnished.  In  any  event,  taxpavera  should  attach  any  addi- 
tional stattments  that  will  aid  In  a  comprthenslve  anderstaadlsg  of  the  tax- 
payer's rcturm,  so  that  the  Commissioner  of.  lutemal  Bsvenue  may  equitably 
determine  the  correctness  of  the  fair  value  reported  In  Item  17  on  pace  1  herooiL 

•  4,  EiHiBrP  A :  Condsnsib  Balarcb  Sheet. — SSimleh  under  Exhibit  A  r 
condensed  balance  sheet  as  of  tb«  doting  d«tw  of  the  flscaJ  year  glv«a  in  item 
T  oo  page  1  hereof. 

**  Books  of  acsynMt'* — ^Th«ia  columns  mo^t  ahow  the  amonnta  as  carried  U 
tbe  taxpayer's  books  of  accoont 

^ Ffiir  value" — Refer  to  article  1  tbove.  fleflnlag  the  valne  required,  snd  In 
th»  tTint  that  the  columns  "Books  of  account'*  contain  any  overstated  or  under- 
stated values,  stiow  hersla  the  actual  Taluca» 

"  Difffrence." — These  colocnas  will  show  tbe  difference  be^wecn  the  columns 


been  outstanding  and  divide  by  the  number  of  months  used  la  the  computation. 

6.  ExHXBrr  C:  Ankual  Imcome. — Furnish  under  Exhibit  C  the  annca!  In- 
come and  other  data  for  the  five  fiscal  years  ended  with  tbe  close  of  the  tax- 
payer's fiscal  year  as  given  in  Item  7  on  page  1  hereof,  or  for  the  period  daring 
which  the  corporation  has  been  engaged  In  business  U  for  a  ahorter  period. 

*'  JTef  income," — In  this  column  will  be  shown  the  Income  returned  for  the 
purpose  of  the  income  tax  and  excess  profits  tax. 

"Deductions"  and  "Additions." — Refer  to  article  1  of  these  Speda!  InBtrnc- 
tions.  and  show  in  these  columns  such  amounts  as  shouJJ  be  deducted  from 
or  added  to  '"  Net  income"  to  arrive  at  the  adjusted  incoma  which  may  be  capl- 
tho  oearest  earlier  date  of  taJisefl  te  determine  the  fair  valne  of  the  capital  rtock.  A  comprehensive 
analysis  of  any  amounts  reported  therein  should  be  attached  to  this  return. 
SMse  of  the  principal  items -frequently  requiring  adjustment  are: 

Deduciiont: 

Income  and  profits  taxes  not  deductlblo  In  computing  Income  subject  to  tax. 


,.  --    „ J  tax. 

Losses  not  fully  deductible,  In  computing  income  subject  to  tax. 
Additions: 

Dividends  from  other  corporations  not  Included  In  computing  income  snb- 


nicipallty,  or  of  the  rolled  BUtea. 


Any  1 


I  dllTerences  i 


"  and  "  Fair  valae.' 
.snner  as  to  enable  the  Commissioner  of  Internal   Beven 

proper  and  acceptable.     For  this  purpose  the  dlifer- 


:  be  covered  by  corresponding  adJnstmaPEts  in  the 


to  determine  if  ' 
ences  shown  her' 
taxpayer's  booka  of  account. 

*'  Treasuiy  atock  "  and  "  Trraswry  "btm^y — In  the  oreat  the  taxpayer  kolds 
In  Its  treasury  any  of  Ita  own  stock  or  bonds,  advice  must  be  fuinlBhed  as  to 
whether  sach  stock  and  bonds  are  pledged  or  unpledged. 

"Other  atsfta"  and  "Other  ItaUltttee.'* — If  material  amotints  are  shewn, 
a  comprehensive  analysis  of  them  zaust  be  attached. 

*'  Profit  and  Jcta." — Tf  the  "  Profit  and  loss  "  balance  la  a  debit,  the  acBoimt 
should  be  Bhown  In  red. 


dividend  period  may  be  so  considered  if  the  dividend  has  been  declared  and  iMt 
disbursed.     If  deducted,  show  date  declared  and  date  of  actual  payment. 

6.'  Exhibit  B  :  Otjotations  on  Otrnitfa  Bai^b  P»icbs. — Furnish  under  Ex- 
hibit B  the  prices  quoted  on  a  recognised  stock  exehaage  or  on  the  New  York 
curb,  or  the  prices  at  which  uutslde  sales  were  made  If  the  stock  la  not  listed, 
for  the  period  of  12  menths  ending  with  the  close  of  the  taxpayer's  fiscal 


jeor  glveu  in  Itam  7  oa  page  1  htreof. 


Income  from  securltlea  of  a  State, 

not  included  In  the  Income-tax  return. 
Expenditures  made   for  additions  and  betterments,  or  reserves  for  such 
purposes,  made  against  income,  whether  direct  or  through  expenses. 
*'Ad}H9ted  income."— This  column  will  reflect  the  amounts  resulting  from 
the  adjustment  of  th«  amounts  shown  in  the  three  preceding  columns. 

"  yumher  of  sTioret." — Herein  should  he  given  the  total  number  ot  shares  of 
all  classes  of  stock  outstancUng  at  the  close  of  each  fiscal  year. 

"  Dirtde?tda  declared." — Herein  ehouM  be  reported  the  percentage  of  divi- 
dends declared  on  the  par  vclue  of  each  class  of  stock  outstanding  each  year. 
The  amount  represented  by  the  percentages  shown  in  this  column  must  not  be 
deducted  from  the  columns  "'  Net  Income  "  or  "Adjusted  Income," 

"Depreciation." — Hereunder  will  be  reported  the  amount  actually  charged 
agulnst  Income  each  year  in  the  taxpayer's  books  of  account  for  depredation. 

"  Dfpietion." — In  the  ease  of  mines,  oil  and  gas  wells,  other  awtural  de- 
[Kislts.  and  timber,  valuittons  n^ported  ss  the  basis  of  depletion  in  computing 


:  par.     In  other  words,  U  enter- 
prises engaged  In  a  similar  bnalner '     -  "- '"  — 

their  Issued  capltai  stock  to  keep  tt 

should  be  caplmlized  hj  dividing  it  by  .12. 

7.  Domestic  Insurance  companies  (other  than  mutual  companies)  most 
attach  to  the  return  a  list  of  such  deposits  and  reserve  funds  as  they  are  re- 
quired by  la^  or  contract  to  maintain  or  hold  for  the  protection  of  or  payment 
to  or  apportionment  among  policyholders,  stating  the  came  and  amount  of 
each  such  deposit  or  fund. 

8.  Domestic  mutual  Insurance  companies  must  attach  to  the  return  a  supple- 
mentary list  showlog  the  name  and  amount  of  each  rsserve.  the  net  addlt^ooa 
to  which  are  included  la  the  nvt  Income. 


GENERAL  INSTRUCTIONS 


;0,  1922. 
,  Datb  of  B'iluto  WwruaNB. — During  the  month  of  July  and  annually  there- 


4.  Thh  Collectoe  Hat  Make  Retd 
falls  to  make  and  file  a  return  withic  V. 
tlon  made  under  authority  of  I 
frauduleiit  return,  the  collt 


-If  any  corporation  i 
me  prescribed  by  law 

tviltfplly  or  otherwise,  a  falsi 


6.  SiaHATUttEa  and  Vebxticatios. — Returns  most  be  signed  and  Terlfled  hf 
two  officers  of  the  corporation,  that  Is.  by  the  president,  vice  president,  or  other 
principal  officer,  and  by  the  treasurer  or  other  financial  officer,  and  must  be 


The  name  of  the  corporation  and  the  names  of  the  officers  slgnlngtbe 
return  should  be  pUUnJy  written  or  printed  on  the  return. 

7.  Tax. — From  tbe  tot"  I  fair  average  value  of  tbe  capital  stock  the  sum  of 
55.000  is  deductible  and  the  tax  is  at  tbe  rate  of  $1  for  each  full  $1,000  of  any 
balance  except  In  thu  case  ot  mutual  Insurance  companies  (see  lines  16  to  20 
on  page  1). 

8.  Penalties. — la  case  of  any  failure  to  make  and  file  a  return  or  list  within 
the  time  prescribed  by  lew.  or  prescribed  by  the  Commissioner  of  InternsI  Eev- 


his  deputy  l3  authorized  1  . 

uch  Information  as  he  can  obtain  tiirough  testimony  or  otherwise.  Such 
return,  when  subscribed  by  the  collector  or  his  deputy,  shall  be  prima  facie  good 
and  sufficient  for  all  legal  purposes. 


writing,  may  alio 


the  collector  la  pu_. 
shall  add  to  the  tax  25  per 
filed  after  such  time  and  1' 
reasonable  cause  and  not  t( 
the  tax.     In  case  a  false  < 


Is  shown  that  the  fallore'  to  file  it  ' 

willful  neglect,  no  such  addition  shall  be  made  to 
fraudulent  return  or  list  Is  willfully  made,  the 


I  the  tax  50  per  ( 


of  Its 
time  after 
days  after 


July  1,  1921.  bat  penalties  for  noapayment  do  not  attach  until  .^^  >* 
notice  and  demand  has  been  served  by  the  collector  upon  the  taxp.7yer, 

9.  BEocLAnoKS. — For  farther  InforoutloQ  regarding  the  tax  see  Begutatlou 
No.  60.  BeviseO, 


1694 


Form  1120 

V.  S    iNTEBMiL  RnyEND! 

CORPORATION  INCOME  AND  PROFITS  TAX  RETURN 

FOR  CALENDAR  YEAR  1921 
Or  for  period  begun ,  1920,  and  ended ,  1921 

Page  1  of  Return 

(00  nor  WRITE  in  THEiE  SFAIXSl 

Eunntdbr 

BE  FILED  NOT  LATER 

$     """'"""' 

THAN  THE  ISTH  DAY 
OF  THE  THIRD   MONTH 

PRIKT  MAIW.V  COWORATIONS  NAME  A,-,  BUSINESS  ADDRESS 

(Oahiar'f  Stampt 

FOLLOWING  THE  CLOSE 

OF  Tl«;  TAXABLE 

PERIOD 

" (Stmt'iadiiumtaM')                     " 

(Pastomooud'Suu'} " " ~ 

CASH     CHECK     M.O.     CEtT.OfOfO, 

KIND  OF  BUSINESS ;......::_:,.;.:;;... is  this  a  consolidated  return;  . 


SCHEDULE  A~TAXABLE  NET  INCOME. 


CROSS  INCOME. 

,  Groas  Bales,  leas  relurnsaod  allowaocos _ „ y 

-  Leas  co9t  of  goo^la  aold,  exclusive  of  it«ma  called  for  eeparately  below  (from  Schedule  A2). 

.  Orosa  income  from  operatioDa  other  ibao  trading  or  manufacturiDg,  lese  altowanc«8  (from  Schedule  A3 

.  Taxable  iatcroston  Liberty  Bonda,  etc.  (from  Schedule  A-1) 

Tjxabie  ioterest  from  all  other  sourcea 


iDcotae  earDe<J  by  peraooal  service  corporation  (whether  received  or 

3  stock  of  [oreigQ  and  domestic  corpcratiooa 

>  from  all  other  eources  (oot  including  aoy  amount  reported  in  lu 


t  23,  below)  (from  Schedule  AlO).. 


)  10.. 


DEDUCTIONS. 

.  Expenaea  (except  amouots  reported  in  Item  2  above,  or  called  for  separately  below 
CumpousalioD  of  ofBreredn  whalcvei  form  paid)  (from  Schedule  A13)  

.  R^'paira  (inrludiug  labor,  aupplies^etc  )  (from  Schedule  A14) 

Inlt-rest  (sim?  page  2  of  InBtnicttone.  paragraph  0) 

.  Ta:^e9f(rom  Schedule  .\16)  

.  Bad  debta  (from  Schedule  AK) 

.  Exhauiilou,  wear  and  tear  (iDcluding  obsoleececce)  (from  Schedule  A1S).  . 

,  Depletion  (from  Schedule  AID). 

,  Amortization  of  war  faciltliea  (from  Schcdul-'   \ .  ' 
Total  of  Items  12  to  JO 


i21  . 


.  Profit  or  loss  on  sales  of  capital  awwls  and  iiiisccllaiieoua  investmenta  (from  Schedule  A23) „ '$ .  .  .     I     .        i  I 

Loeaea  by  lire,  storm,  etc     (From  Schedule  A24,)    (Extend  ditlcrence  between  or  sum  of  ItemB  23  and  24* | | | .  .  .      I  ) 

,  NetincomeexcliieiveofdeductioDafordividendadtemZ".  miLua2l.  extended)  „ 1^ 

.  Dividends  deductible  under  Section  234;a)  C.  of  the  Revenue  Act  of  1021,  ((rum  .Schedule  A26) _ _ 

Net  Income  (Item  2^  ininua  Item  2ti)  (If  return  in  for  a  period  lea.^  Ihjo  twelve  months,  aee  page  1  of  Instructiona.  paragraph  10)   .     '$ 


SCHEDULE  B— INVESTED  CAPITAL. 


1  Capital,  surplus,  aud  undivided  profits  at  begiiinint^  of  taiuble  period  (from  Schedule  E,  li' 

2  riu9  adjualnicnu  by  way  of  additiona  (from  Schedule  F,  Item  ■)) 

3.  TOTAI- 

4.  Li.>e6  adjuslmenta  by  way  of  deductions  (from  Schedule  O,  Item  7) 


I'liisor  minus  changes 

Total  (or  Remainder) 

Lena  deduction  ou  account  of  inadmiaaibic 
InveateiJ  capital  for  taxable  period 


eated  capital  during  taxable  period  (r.et  Increase  or  Decrease  from  Schedule  IIi 

») - 

(from  Schedule  J) ; 


SCHEDULE  C-EXCESS  PROFITS  CREDIT. 


!-ight  per  cent  of  invested  capital  for  taxable  period  (Item  9  of  Schedule  B) ,,.„.., 

I^^emption  ($3,000)  (except  for  a  foreign  corporation  or  a  corporation  eatUfying  the  condition*;  ]>r<ivi<loil  in  Sec 
[  ^re«  Profits  CTodit  (Item  1  plus  Item  2) _ 


SCHEDULE  D— COMPUTATION  OF  TAXES. 


••»— • 

"'^""'— "•    i   '- 

^i-vX'::^;:'^^^" 

..„.. 

.„,..,„,. 

-  |„f„.| 

..>.„.»,  „T.«. 

et  iocomf.  not  in  excess  of  20^  of  tiiveated  capital 

:::::!:::h:- 

't i 

: 1 

;       1 

1               i               ■ 

lataDce  of  net  income 

. .  1  Mr,  i  . 

1               '               1 

otalB  computed  under  Section  301(o) 

» ::-4.:....!izz] 

L....k 1. 

1 

• 's. 

!Arlof  I'lL'l  (»■<) 


(Item  27.  Schedule  A) 


10    BaUorrfttgm5.lfflaItemfl6. 7,^ld9.o^ll,^nll»6.fl,and9)-■'l.■ 


;  2  of  lostructiona.  fa 


adop,  of  111 
ume  does  Do 
9  of  S25.000.. 


.1    .      J. 


An  ■meiMJgJ  return  muat  b«  plainly  marked  "Amended.' 


Checks  and  draft*  will  be  accepted  only  if  payable 


1695 


i"aUyoiitii*Mtn:ai 


«  nlmA  in  tlu:  jchwlul* 


itioTK  of  surplus  a 
vt:  rreowiled  n-itl 


aby  th(r*rT«T»:it 


|T»r^l7«tpliiD»J.  be  fTiiertd  as  Il#t 


■•plUlilod;p»lJiipaM»cruallyoulstM 


SuTplos  aixl  Diidli-ld«d  preAU: 
S.  Feld-Ln  lurplos 


K  :"':"' 


«  detailed) » 


-ADJUSTMENTS  B 


f  or  ADDITIONS. 


3.  Schedule  F.  state  jpoaficaUy  th 


..etn. 

.,^n,. 

i^-''pix'".:''itk\'"::\''!"^^^^ 

si  Depffn..tion  or  dffH-iion  "<  nirrwl  >□  the  afrourt^  ot  the«i'rT>«»<ion  but 
<Jim:Io«  w  by  ine  U*i*ftnKtr-l  os  s  de-toclipi)  on  inrome  tix  iciuros 

SCt4EDULE  C.-ADJUSTMENTS  I 


IF  DEDUCTIONS. 


It  tb*  icrre^t*  o'  lu^^  asseU 

le  nock  ouuikDdlnt  at  Ihe  bedmuiiC 

D»nt  rhoifiric  vptrotely  «lili  respect 


ocn^o?lti«.h;r 

tbfl  tBiablo  period   i*ri.  -rf'tf 
kllnol  e«»ea  T  J  per  MOl  ol  tb 

per  value  of  Ibe  lota]  itork  oui^aodiDE  at  tb«beElaIul^e 

•table  penod 

i>mpm»iwii  under 
period. shall  be(^ 

e  basis  lof  tbe  computetioo. 

uHtandlDt  on  Maicb  3, 1017,  or  at  tse  l*einnloi.  o(  Uie 

.  ISft.-iy  ttnpbU 

roper.r.p»id.l>r«fs1ocl..M 

rn*d  as  an  asset  by  I^<  corpomiooT ...__.— 

BCtualcaih  value  wben  rfceivedT —    la 

HESr 

;«;>*ir.LrM^rparti« 

res,"  submit  a  statement  sbowlnj  (o)  kind  of  propefty, 
lor.  «f)  artual  fash  vb1.»  of  the  property  wben  pauHo. 

ris  or  Inthc  property  whicb  chanjed  ownerslilp  r« 


property  was  acquired  from  a  corporailoa  duriac  tbe  taxable  penoi, 

propertf  to  tbe  n>rporat.on  laakuic  tbe  return,  and  also  a  balance 
t  this  retoni  thowUie  tbe  values  at  srblcb  neb  property  rvcelved 


invested  capital  cacti  aoet  a 


I  iwan^ible  pfoparty)  p«i^  f 


pfoperiy  pa;d  t 


<a»ogniotc:^raidir>(tel<K.  ( 


OS.  tiaa  •dHiua'e  pro*tfios  b««s  made  la  the 
klDdt f')  depredalionT ,. 

If  ado  luaio  choree  has  sot  bceu  made  for  depreciaitoti^  depteiton.  obiolwcence.  and  o< 
value  ol  iho  p(open»  has  not  been  maimainiHl  by  leptacemcnts  that  h»v«  been  charged 


'.  VahiatlonoltanclMe  property  pMid Id  !aritnck ..-- ' 

.  %alitationo'a3ietsa^tilredlDrearfanJiatlO(U.. 

.   Deprei^itloa.  depletion,  and  other  leases 

SCHEDULE  H.-CHANCES  IN  IIWESTED  CAPITAL  DURING  TAXABLE  PERIOD. 

1.  Chantea  In  invMted  capital  ditUnc  the  laiable  pcnod  ordtnanly  oiIm  In  oea  or  moe*  of  tb*  foDovlnc 

(a)  By  saleofcapitalTtod:  tor  «4>  or  by  IMI«tieolrapiialstock  for  taaflMeoe  other  asset* 
(fi)  By  paynkpnt  of  wvscuMnt^  by  itvclrhoMen  or  by  ereaiua  of  pah.  la  iorplDs  by  r 

(f )  Hy  1i<)>itilallon  of  part  of  Ihe  capitMl  by  retirement  ol  stork  or  by  |wrcha>e  of  irvsmry  r 
(tf)  l)y  painsrnl  otcash  dividends  out  oreantlsci  ofprtuf  yean. 


as  an  addiOoo  or  deOortioa.  dcducirati  bone 


'  corporatloD  is  reacquired  but  not  paid  Igr  o< 


.  appbeable  only  to  the  issi:*  or  rcacTuistilon 
S.  The  net  chstDFes  not  r*[>oned  in  MhediiL 


«  petlud  (incliidlse  tl 


.  Adjusted  ar«a$e 


SCHEDULE  J.-INAOMISS1BLC  ASSETS. 

iaadmisnb:«  assess  (i.  a .  sioc^^i.  bonds,  ortd  Miier  obtliailons.  uoept  oMlcatuca 

nsent  showlot  lor  Ibe  taxable  period  ibc  facts  called  Icr  in  Itei&s  [•)  to  Ola""* 

eseu  consists  lo  part  «( jaic  or  profit  Trom  tbe  sale  or  other  disrwtion  tbvreof.  or 
red  [ram  such  asset s  it tn  ellKi  locluded  m  the  l>et  li>eoDM  because  ot  l^•  limltaiiOQ 


e  purpose  ol  this  scbedul 


,1  be  raloed  at  e«st  of  •c<;aUition.  eicept  11 


«t  as  at  Ibe  end  ol  the  period  correspoo'lioctv 
ilchaseabas  taien  pUce  in  Ihe  amount  oi  5 
o  the  Refutatioos  issued  under  authority  c 


1696 


KIND  OP  BUSINE3S. 

Item  pivfn  i-ilow,  i.l.nllfv  thn  rnrpnn 


QUESTIONS. 

N.  If  till 


uf  the  product.    D. — Consiructjon — exca\ 
,  alw  e^juipptng  and  inBtilUng  same  with 
lanuiacturc,     Stalo  niiture  c 


,  buildingf 


Idml  and  eperial  ; 

or  water);  clcrtric 

telephone. 

(elevators,  ■warehouses,  atoclaarda.  etc) 

tation  or  utilities.     State  kind  of  projuvt 

duced  bv  the  tndincj  ronrcni.     State  mac 

mis^nn,  and  product  handled.     Sak-3  with 

Scrnce — domestic,   including  hotels, 


personal. 


technical   eervice.     State 
leurance.     I. — Concerna  cf 
several  of  them  with  no  predominant  l> 


built,  matcrialfl 
El.— Tr.-r.<-:Arr>M"i"rii1    water,  local,  etc.    State  the 
i.J.     I'u'i  lie  iilititiea — gas  (natural,  coal, 
I     hrnting  (eteam  or  hot  water); 
,'  ;':    I.'  trading  or  profit  from  ealea— 
■r     :,  t    ?ii.red.     El.— Leasing  transpor- 
t". —  I  rn'iint;  in  goods  bought  and  not  pro- 
of trade,  whether  wholesale,  retail,  or  com- 
rade with  profit  primarilv  from  sales.     O. — 
mffl.  etc-  amiipements;  other  professional, 
rrM'e.     H.— Finance,  including  bankinK, 
.■  !■!  -' '■  .■  I  lr^-3  (ol  because  of  combining 


■ns  Wh: 

18,  where  the  same  prodnrt  n 
(  of  the  abo\e  general  clasin 


i :  111  two  or  more  of  the  above 

I    ■■■ '■,!'!  n-port  bueineaa  as  identified 

u.,.!'  ,  <.i.'ncerna  in  A  or  B  -which  also 

product  exctugively  ur  mainly,  should  still  be  identified 

,  C  {manufacturing)  whirh  own  or  control  their  source  of 

in  A  or  B  and  which  alao  transport,  ecll.  or  install  their  own  jiroduct 

ainly,  should  be  identified  with  manufacturing;  '      " 


exclusively    _-  ,,  _,  __  „, 

control  or  own  source  of  supply  of  materials  used  excluaivelv  or  mainly  i 
tive  work;  concerns  in  El  or  E2  may  own  or  control  the  eouroe  of  their  materhil  or  power; 
toncems  io  F  may  transport  or  store  their  own  merchandiee,  but  ita  production  would 
idoutify  them  v,-ith  A,  B,  or  G. 

3.  Answers: 

(rt)  Central  claBs  (use  kev  letter  designation) „ 

'■  Main  income-producing  business  'give  specificallv  the  information  cillcd  for 


uuder  each  key  lctt*?r,  also  whether  acting  as  principal, 
n;  state  if  inactive  or  in  liquidation!..., 


OTHER  CORPORATIONS  IN  SAME  BUSINESS. 


8  oi  fwe  representative  corpora- 


INCORPORATION 

5.  Date  of  incorporation  ....  _   _ 

C,  Under  llic  biTs  of  what  State  crtcjntr 

REORGANIZATION  AND  ACQUISITION  OF  MIXED  AGGRrCATES  OF  ASSETS 

7.  Haa  the  corporation,  or  anycfila  pre<}eecstors,hcon  reorcani/t'd,  or  has  it.  or  any 
of  its  pTcd'.ceisora .  taken  over  a,  going  business  or  acquired  a  mixed  agf  regat*  of  tangible 
and  intangible  property,  and  paid  for  such  property  m  whole  orin  part  with  stock  or  other 


If  E 


eibcwiEc;: 

{a\  The  name  of  the  concern  taken  over  for  from  which  the  property  was  acqu: 
ft)  The  nature  of  the  aiiscts  and  li-ibililies  en  acquired; 

(c)  The  total  par  v.-ilue  of  the  slock  issued  there/or; 

(d)  The  value  at  which  each  cla?a  of  assets  was  carried  on  the  books  of  the  i 
from  which  Required  (submit  a  balauce  ehect  of  the  predecessor  concern  as  at  the  date  of 


ecquifition  c 


id  full  details  of  any  adjustments  subsequently  made  pertaining  thereto  and 


thisretij    . 

the  bieiti  on  which  such  revaluation  was  made. 

9.  If  patents,  copyrights,  secret  processes  or  formula,  good  will,  trade-marks,  trade 
hrande,  franchises,  or  other  intangible  property  were  acquired,  state  the  baaia  on  which 
their  value  was  determined  and  how  they  were  paid  for. 

I  of  anypurchaM  or  reorganization  as  contemplated  in  queption  7,  any 

;ni  or  any  vendee  pre<lece8sor  at 

cd  on  Ific  books  of  the  vendor  concern,  state 


11.  Does  the  corporation  c 


ting  capital  stock  owned  by  another  c 


poration  or  Uy  two  or  more  corporations  that  are  affiliated? 

13.  Is  over  70  per  cent  of  your  outstanding  voting  capital  stock  a 
•  of  the  outstandin;;  voting  capital  stock  of  another  corporii  ' 


tions  owned  or  controlled  by  the  s 
or  partnerships? . 


individual  or  partnership  cr  by  the 


V  individuals 


to  qucstioDB  11, 12,  and  IS,  or  to  any  ot  them,  ia  "yeR,"  answer  tb< 
"  "(a)  Did  the  corporation  file  A  fTJiatcd  Corporations  Questionnaire,  IVm'  S'.l,  lor  1017  o 

Bubsequent  taxable  years?    -.- —    U  the  answer  to  this  questi.  i  ia   "yes,"  i 

questionnaire   is  not  required,    except  under  the  circumi 
fb).     If  the  answer  to  mis  question  is  "no,"  and  the  ane 

i.1   or  to  any  of  them,  ia  "ves,"  procure  from  the  Collector  .. - 

district  Form  819.  which  shall  be  filled  out  and  filed  as  a  part  of  Ihw  return.     If 
'  this  question  ia  "no."  question  ih)  need  not  bo  answered. 


(b)  Did  substantially  the  same  conditions, ; 


t  out  in  the  qucstio 


taxable  period 


1023  or  prior  y«*r8,  obtain  dunng  luv.  v— ..-. r--— ,  --.--         .     ,       .       ,  .  , 

If  the  answer  to  this  question  ia  "no."  a  statement,  setting  forth  thonarticulars  in  which 
the  situation  has  changed-  should  be  attached  to  aud  made  a  part  of  this  return,  if  there 
have  been  substantial  changes  in  stockholdings,  a  complete  schedule  of  such  changes 
should  be  submitted  in  the  form  prescribed  in  Tablea  3  and  6  of  the  questionnaire. 
If  there  arc  companies  other  than  those  covered  by  the  questionnaire  for  1920  or  prior 
voars  which,  applying  the  tostscoutained  in  questions  11,  12,  or  13,  may  have  come  into 
the  alhUated  group  since  1920,  a  questionnaire.  Form  S19,  is  required  for  the  entire 
group  for  the  taxable  period. 

VALUATION  OF  CAPITAL  STOCK. 
Vi.  What  was  the  (air  value  of  the  total  capital  stock  of  the  corporation  as  determined 
if  any,  of  the  capitil  etocU  tax?    ? — Patfl  of  that 


PREDECESSOR  BUSINESS. 

)  corporation  file  a  return  uuder  tho  same  nami 

If  not,  was  the  corporation  iu  any  way  an  out 

r  reoi^nization  of  a  business  or  businesses  in  existence  dui 

If  answer  is  "yea,"  give  name 


for  the  preceding-  taxable 


BASIS  OF  RETURN. 

17.  Is  this  return  made  on  the  baais  of  actual  receipt.'*  and  disbursements?.. 
If  not,  describe  fully  what  other  basis  or  method  was  used  in  computing  net  in< 


GOVERNMENT  CONTRACTS. 

18.  Have  any  adjustmenta  been  made  during  the  taxable  period  on  account  of  con- 
tract or  contracts  with  the  Government  or  its  agencies  or  in  any  GoveruD'cnt  contract  or 
contracts  from  which  the  corporation  derived  income  directly  or  indirectly,  through  the 

-_     If  the  a 


operations  of  a  claim  bo-ord  or  o'-herwiso?    

"  yes,  "  state  the  amounts  involved  ?..■ 


ir  to  \\\\:-  quG.gtii. 
:  whether  or  not  sticii  amoi 


,  tiled  for  the  taxable  period  in  which  the  coulrai.t 

lUB  terminated? _ Submit  a  cchcdnle  showing  full  particulars  of  iho  contract. 

ate  entered  into,  date  the  work  ceased  under  Riid  contract  or  coniracts,  aud  tho  aiiiount 
nd  nature  of  the  adjustment. 

AMORTIZATION. 

19.  Has  amortization  boon  claimed?    .    If  the  answer  to  this  question 

J  "yes, "  Btato  for  what  year Amount  $ ™.— . 

LIST  OF  ATTACHED  SCHEDULES. 

;  this  return,  giving  for  each  a  brief 


SCHEDULE  K.— BALANCE  SHEETS. 

Attach  hereto  balance  sheota  aaat  tho  beginning  and  end  ot  the  taxable  period  (preferably  in  parallel  columns),  showing  as  nearly  aa  pmcticable  the  details  called  for  bel. 
bftlanro^oets  should  be  prepar..dfroDifho  books  and  nhould  be  in  agreement  therewith,  or  any  differences  ehouli"  *  •■•...■.  


1  accordance  with  parn^raph  7 
ASSETS. 


ciled,  and  if  this  is  a  consolidated  r 


I  and  obllgailoDS  (CKhUim 


lolpm 


:t  (iU 


ASSET  S-Coo(lni 


balance  elieets  should 


CapliBl 


idlvlded  ixoAU. 
•ReMrvM  ror  dcprMlalloa  nu;  bo  deduoted  from  tho  respMtlve  umI  a»cnintj  or  I  t«iDli«d  on  tho  UahUit  r  sl<l«  ot  tho  batancc  sheet, 
intorstate  and  intraatate  trade  or  businesa  and  rpportin^  to  the  Interstate  Commerce  Commission  and  to  any  natinnal,  SLile,  municipal,  or  other  public 

State  and  municipal  authorities,  OB  at  tho  beginning  and  end  of  the  taxable  period. 


All  corporal  ions  enraged  in  an  intorBtate  and  intraatate  trade  or  busmesa  and  reporting 
0Oc«r,  may  submit  in  beu  of  obove  form,  copies  of  their  balance  sheets  prescribed  by  said  Co 


1697 


Page  -I  of  Retu 


II 


SCHEDULE  L.-RECONCILIATION  OF  NET  INCOME  AND  ANALYSIS  OF  CHANGES  IN  SURPLUS. 

^^ 

f«)  iDtwwi  oo  ^Iic*UaaJottb«UDli»d  Stttas  uwl  its  posMfiiou 

1 

13.  lTD»llo«ibUid«Jon.oas.:.                          ,                                                           1                  1                  !                 1 

_:_: 

•--• 

^«.^lon^,  or  foreign  wuntrtw _ , .^. 

(t)  SpcfiAl  Improveiocoi  lufcs  ifadicE  totocreaie  lb»  v>liu  ol  tba 
pro|>ertT  a5S*w«l 

1        i     '  1 

[i)  InUirfM  on  obl«^»  ^  SUM.  1  crrilofiii,  and  piiiu^  nib-' 

~ i "" 

1 

<e>  tDMret  oo  Finn  Lain  B<md>  l»ued  ucdtr  Fcduil  Fum  Uwi 

1      1 

(i)  Dlrldend.    dM.irt.bt.  unkr  5^rii„n' ;iir«V8'il'VhV'iu;ro.i;                  j 

(I^  R»p1«Mti»DU  *nd  PM»»6ls „,                          1 

.    .L...   )~~ 

(O  Dii-]<lPndl  00  Mnr«  of  ppfvmai  •e'r-ire  mrrMtntlon.-:  iii(  ol  Mra* 

tipoa  «hkb  b  wbirilr  eiempt  rram  tuaUcnTnapi  i merest 
'"bSibfd't?'"''**  <*■  cmnr  Vt«orT^i%  NotfS.  orteiiaJlj 

1        1        1 

C, „.. 



r-H-- 

i                i     ' 

*'  ^T'**'"'-' "**""'***''*•***»•  "'*«"'"'8*^"'» *•'""*'"  1 

1 

'"  *MteM«n"ISiSto*bJd«D^r^ 

j                i 

4.  Ctl•rcMa»Ua>t^K«T»rora)l>tlspRlClM,M■^4loMdMO•d):                     [ 

1 

1        !___  _l 

(fl) .„                                                                           I 

.3>... '               1               '         " 

m 1 

1 — 

(;>  OtheriiiuIhnnbladcdtictloitiCiotediUiM):                          J     '         1     '                '       1     ' 

~ 1 

m .„.„                „           1                       1            1 

1 

IS.  DI*ldad3iniddiuju;tto'bknblVpenad7siMirirtMi^ 

Mock  or  IhU  MfopMy.  or  other  property): 

s  ..  I   ..  1  ...  1.^...: 

e   Sorpraj  Md  ondlvided  proBu  as  Lbawa  bj  bttaan  ibi»i  at  ctoM  ol 
precedlo;  Im»Mo  perlwj ^ 

1 

1 

1 

r  " 

(i)Dw«pud Cbvacter 

1  - 

1        1 

"""" 

H.  Ottardob.uiosarp.a,(«b.d««IW,. 

1 

10  ToUl  of  Items  *  too  IqcIosIts                                                                      S             1 

1 

1 

1  ~ 

12.  Soiplm  and  ondlvldVd'prii'u  M'VbiWi'iy "wMM's'toirird^'if' 
t-Mbte  period  (Item  l6  talnas  It«a  11) 



1 

(0 -     ._                      ...                                1    ... 

"    i  "~ 

»_J 

1 

1 !, 

SCHEDULES  TO  BE  FURNISHED  IN  SUPPORT  OF  ITEMS  IN  SCHEDULE  A. 

The  followipg  acbedulea  mmt  be  fumiabed.  and  thoae  prepared  on  separate  eheets  should  be  firmly  atucbed  to  this  return.    Enter  name  and  addres  of  corporation  on  ea#.h  sheet 


(J)C 

Ti.'iio.TrtMSi'iE^nf' 

»n .  tno  minor  itams  bvlDg  groopad  Id  on* 

nir 

fy-r 

«5inTn.tor7MMidofy«r 

[  OPERATIOIfS  OTHKR  THAR 


<:  TAXABLE  IHTERBST  OR  LIBBSTT  BONDS.  ETC 

inlwwl  oo  ihe  obtl^Uiocu  liiWd  In  cohimn  I  ot  tbe  (oltoiriBf!  tabl*  is  wbri>TW«Dpt 

kM  ibe  oMlcBtkHU  held  exceed  tbcsa  exempiiocs,  the  prineipal  unoun 

le  uubie  period,  Bttach  »  stataoMat  showing  tb«  boldinn  ^7  periods. 
3  ii  »  consoUdUM  Tvtora,  oeb  carporstion  composms  the  AfllLued  erouj 


•CcnCM*  pottdp*!  kKHn 


1.  ObIi|Ktioas. 

ExempUou. 
(Affrepta  Principal  AmoimO. 

In  excess  or eirmp- 
tlons  spodfl«l  In 
oolumna2.3.aBd4. 

principal  amt 

3.  $30,000     3.tl25^      4.»S,000 

i^pS^ 

w  ^^^^t^^'^'^^- 

<»  F.ratand^wnd*  j,«id  Flrt. 
8««nd.   Tblrd,  and    Fourth 

September  1, 1917  (except  Vic- 
tory Md  TTeasury  Now*) 

(J>VWory    Uberty     Uma    ♦!% 

.Now Koire 

t  SOCBCBS  (Bol  iDdndtac  i 


lums  »eiDg  gnniped  !□  000  DCOOUQt-     Tboloul  of  tbescbelule  should  b«« 
SCSBDULE  AI2:  EXPENSES  (except  aommtt  caned  tor  aeptntely  In 


balsg  eronped  Id  oos  i 


i;  COMPEKSATJON  OP  OFnCSRS. 


SCHEDULE  AM:  REPAIRS  (bdndfaic  labor,  aappllea.  onthead,  an< 
repair* ). 


be  taxable  ptfiod, and  (t> 
la  properly  charteabla  le 
i.parsera^S.) 


SCHBDULEAl 

:  TAXES. 

e^auSmmi 

SS 

SCHKDtlLEAl 

:  BAD  oral 

k«>*4SUtf„ 

S!.%:^s' 

Kit:  EXdAtrSnOS.  WEAR  ARD  TEAR  (Isdndtsc 

I  eorrespood  whh  the  figorei  reflecud  In'tlM 


),  psracnfA  10,  and  Seclloi  Z 


Kind  of  propmr 
(KboUdlfljs.sm. 

D.>. 

Al. 

K?i* 

Con. or  If 

ABwaat  01  «tepT«(±Mtjo  ctar^  oi 

•"='"">""-" 

"T^  «,oM 

r,.^,^. 

1 

. .    _... 

, 

1 

1 

1 

T~...- 1 •• 

t._ ..1 

tioDDacosuy  tobrlaKFDurdcfiiattooscbedijIaupK 

abia  period  bu  bees  deCwmUwd.    lacueofilmbeT  thissfaoald  be  done  b?  Siilnf  la  Fc^T  (Usbcr). 

:  AMORTIZATION  OP  WAR  PACILmES. 

ictioaLselaicMdoDofcouQtofaDiortUitkui.  aschadoleshouldbe  submitted  eootaisini  Ike 

prtsented.     A  Copy  of  this  form  mar  be  obtained  rrom  the  Commtdcoer.     (See  Section  ni 
ue  Act  or  1921). 

OPIT  OS  LOSS  ON  SALES  OP  CAPITAL  ASSETS  AND  MI5CBLLA1ISOUS 

>f  property,  resaltlnc  In  a  profit  or  loo.  a  sebadLilela  the  loflovtiM:  tora  man  be  to> 
i>_-. . .     '"^sacaootaos,  23*(o)  t3ndSt{a)l4af  thaRereaueActoltSL) 


1  Ul<l<^fpI<^,«!7. 

3.XM* 

3.  Si)* 

rricc 

1.  c«t. 

:^^ 

«hs«iij«i 

f.  IV<pNd*- 

A 

L 

L_ 

_       ..._..          .|_            ._. 

1  ■■• 

- — 

. 

1 

1 

TotJ ^. i 

1 1  u)  y  of  t  be  asMts  leere  acquired  p 

4  or  eiChJA^e  ol  propotj,  n 


SCHEDULE  A2£:  DITIDEITDS  (dedncUble  n 

Sutotrit  a  acbodule  shoving  the 
thtti «  eorporaiioa  cn-.iilfd  to  the  b 


DISCOUNT  AND  PBEMIDM  ON  BONOS  SOLD. 


a dedottioQ In  prior  yeaii. 


W«,  the  uoderaigDed,  preetdent  and  treasurer  of  the  corporation  for  which  thia  return  is  made,  bein?  8ever»Hy  duly 
including  the  accompanying  schedules  and  statemeata,  has  been  examined  bv  him  and  is,  to  the  best  of  his  knovlod^e  and  \> 
taxable  period  as  stated,  pursuaatto  the  Revenue  Act  of  1921  and  the  R^nlataons iwoed  usdor  authority  thereof . 

Sworn  to  and  subscribed  befoie  me  this ,,.  day  of . ,  1922. 


1698 


Pago  r  of  Instructions* 


INSTRUCTIONS  FOR  CORPORATION   RETURN. 


LIABILITY  FOR  RLING  RETURNS. 

!.  Corporations  generally.— Every  domeatic  or  rosidont  corporation, 
joint-stock  coinpanv,  association,  or  insurance  company  not  specifically 
exempted  by  Section  231  of  the  Revenue  Act  of  1921,  whether  or  not 
having  any  net  income,  must  file  a  return. 

2.  A  corporation,  huving  a  net  income  of  less  than  $3,000  for  the 
taxable  period  need  not  fill  m  the  schedules  pertaining  to  excess  prufits 
tax,  but  if  the  net  income  is  $3,000  or  more,  it  is  subject  to  the  exci-ss 
profits  tax  and  must  file  a  complete  return  on  this  form. 

3.  Goveroment  Contracts. — In  addition  thereto,  if  net  income  ui 
excess  of  $10,0tXJ  was  derived  duruig  the  taxable  period  from  a  Govern- 
ment contract.  Form  1 120S  should  be  secured  from  the  Collector  of  Inter- 
nal Revenue  fur  your  district  and  filed  as  a  part  of  this  return. 

4.  Corporations  in  Possessions  of  the  United  States. — Domestic 
corporations  withm  the  possessions  of  the  United  States  (except  the 
Virgin  Islands)  may  report  as  gross  income  only  gross  income  from 
sources  within  the  Cnited  States,  provided,  (a)  80  per  cent  or  more  of 
the  total  gross  income  for  the  three-year  period  immediately  preceding 
liie  close  of  the  taxable  year  (or  such  part  thereof  as  may  bo  applicable) 
wiis  derived  from  sources  witlun  a  possession  of  the  United  States;  and 
(6)  50  per  cent  or  more  of  the  total  cross  income  for  such  thrco-ycar 
period  or  applicable  part  thereof  was  derived  from  tho  active  conduct  of 
a  trade  or  business  within  a  possession  of  the  United  States. 

However,  a  corporation  entitled  to  tho  above  benefits  is  not  entitled 
to  the  specific  exemption  of  53,000  in  computing  the  excess  profits  tax. 
(See  Sections  262  and  312,  Revenue  Act  of  1921.) 

5.  Foreign  Corporations. — A  foreign  corporation  subject  to  tho  law, 
regardless  of  the  amount  of  its  net  income,  is  required  to  file  a  return  with 
the  Collector  in  whose  district  is  located  it?  principal  office  or  agency 
through  which  is  transacted  the  business  in  the  United  States.  If  it  has 
no  otfice  or  agency  in  the  United  States,  the  return  should  be  filed  with 
the  Collector  of  Internal  Revenue,  Baltimore,  Maryland.  The  net  income 
should  be  computed  in  accordance  with  Section  217  of  the  Revenue  Act 
of  1921. 

6.  Personal  Service  Corporations. — Personal  service  cori)orations 
must  fiJe  a  return  on  Form  1065. 

CONSOLIDATED  RETURNS. 

7.  The  parent  or  principal  reporting  compan}'  of  afiiliated  corpora- 
tions as  defined  in  Section  240  of  the  Act  must  file  a  consolidated  return 
on  this  form  with  the  collector  of  the  district  in  which  its  principal  office 
is  located  and  attach  thereto  a  schedule  showing  the  names  and  addresses 
of  all  affiliated  corporations  in  the  group,  and  if  tho  tax  is  apportioned 
among  these  corporations,  tho  amount  allocated  to  each.  (See  partigraph 
9,  below.)  Each  of  the  other  aSiliated  corporations  shall  file  Form  1122 
in  the  office  of  the  Collector  of  its  district. 

Consolidated  invested  capital  p3ust  be  computrd  as  at  the  beginning 
of  the  taxable  period  of  the  parent  or  principal  reporting  company  and 
consolidated  income  must  be  computed  on  the  basis  of  its  taxable  period. 

AJl  supplementary  and  supporting  scbedulea  should  bo  prepared  in 
columnar  form,  one  column  being  provided  for  each  corj)oration  mcluded 
in  the  consolidation,  one  column  lor  a  total  of  like  items  before  adjust- 
ments are  made,  one  column  for  intercompany  eliminations  and  adjust- 
ments, and  one  column  for  a  total  of  like  items  after  giving  effect  to  the 
eliminations  and  adiustmenta.  The  items  included  in  the  column  for 
eliminations  and  adjustments  should  be  symbolized  so  ae  to  readily 
identify  contra  items  affected,  and  if  necessary,  in  order  to  aive  a  correct 
understanding  of  these  entries,  suitable  explanations  should  oe  appended. 

8.  If  one  domestic  corporation  owns  95  per  CMit  or  more  of  the 
outstanding  votuig  stock  of  another,  or  if  95  per  cent  or  more  of  the 
outstanding  voting  stock  of  two  or  more  domestic  corporations  is  owned 
by  the  same  individual  or  individuals,  partnership  or  partnerships,  in 
substantially  the  same  proportion,  a  consolidated  return  must  be  filed 
by  such  corporations,  except  that  the  purpose  of  the  statute  being  to 
prevent  tho  avoidance  or  reduction  of  tax  habUity,  corporations  engaged 
m  entirely  distinct  and  unrelated  lines  of  business,  there  being  no 
common  dealings  between  them  giving  rise  to  opportunity  to  avoid  or 
reduce  tax  habUity,  shall  not  be  required  to  file  a  consolidated  return. 
If  the  ownership  is  loss  than  95  per  cent  of  the  outstanding  voting  stock, 
but  exceeds  70  per  cent,  the  parent  or  principal  corporation  of  any  group 
of  affiliated  corporations  must  furnish  the  information  called  for  in  ques- 
tions II  to  14,  page  3. 

9.  The  Department  prefers  that  the  entire  tax  shown  on  a  consoli- 
dated return  be  paid  by  the  parent  or  principal  reporting  corporation, 
instead  of  being  apportioned  among  the  corporations  composing  the 
affiliated  group. 

If  apportionment  is  made,  each  subsidiary 
should  state  on  its  Form  1122  the  amount  of 
to  be  assessed  against  it  for  the  taxable  period 


affifiated  corporation 
and  profits  taxee 


PERIOD  COVERED. 


^  fiscal  period  ended 


10.  The  taxable  period  is  the  calendar  year  or  th 
in  such  calendar  year,  and  the  net  income  shall  be 
basit:  of  the  corporation's  onnual  accounting  period  (calendar  year  or  fiscal 
period)  in  accordance  with  tho  method  or  keeping  the  books,  unless 
such  method  does  not  clearly  reflect  the  income.  The  accounting  period 
establbuhed  for  the  taxaVde  year  immediately  preceding  miLst  bo  adhered 
'to  unless  p,enni3aion  has  been  received  from  tue  C-ommissioner  to  make  a 
change. 

In  the  case  of  a  return  for  a  period  of  less  than  one  year,  the  not 
income  shall  be  placed  on  an  annual  basis  by  multiplying  the  amount 


thereof  by  twelve  and  dividing  by  tho  number  of  months  includi'd  i 
period;  and  tho  tax  shall  bo  such  part  of  a  tax  computed  on  such  i 
basis  as  the  number  of  months  in  such  period  is  of  twelve  niorillis. 

If  th. 
fractions  of 

months  as  many  thirtieths  of 
parts  of  months. 


period  for  which  the  first  or  final  return  is  i 
ths,  there  shall  bo  added  to  tho  numbe 


mpb-i. 
there  are  days  in  the  fractional 


11.  If  1 


changes  it^  accounting  period,  it  shall  a: 
!oUector  for  transmission  to  tne  Commis 


corporatic 
as  possible  give  to  the  Collector  for  transmission  to  the  Commissioner 
written  notice  of  such  change  and  of  its  reasons  therefor.     Upon  approval 
by  the  Commissioner,  the  corporation  shall  thereafter  make  its  returns 
upon  the  basis  of  tho  new  accounting  peri    '      "     ^    •-  -  -  n.n*-N 
226,  Revenue  Act  of  1921. 


See  Sections  212ff)  i 


the  United  States  shall 

,  trustees  in  bankruptcy,  or 

usiness  of  the  corporation,  such 

ute  the  return  for  such  corpora- 


•  pay  it  in  person  except  at 


I 


TIME  AND  PLACE  FOR  FILING. 

12.  The  return  must  bo  sent  to  the  Collector  of  Iiilornal  Revenue  for 
the  district  in  which  the  corporation's  prijicipal  office  is  located,  so  a:i  to 
reach  the  Collector's  office  on  or  before  tno  fifteenth  day  of  the  third  month 
following  the  close  of  the  taxable  period.  In  the  case  of  a  foreign  cor- 
poration not  having  any  office  or  place  of  business  in  the  United  States 
the  return  shall  be  filed  on  or  before  tho  fifteenth  day  of  tho  sixth 
month  following  the  close  of  the  taxable  period. 

13.  The  Collector  is  authorized  to  grant  an  extension  of  not  more 
than  thirty  days  for  filing  returns  in  cases  of  absence  or  sickness.  In 
meritorious  cases  the  Commissioner  is  authorized  to  grant  a  further  ex- 
tension. 

SIGNATURES  AND  VERIFICATION. 

14.  The  return  shall  be  sworn  to  by  the  president,  vice  president,  or 
other  principal  officer  and  by  the  treasurer  or  assistant  treasurer.     The 
return  of  a  foreign  corporation  having  an  agent 
be  sworn  to  by  such  agent.     If  re 
assignees  are  operating  the  property 
receivers,  trustees,  or  assignees  shall 
tioQ,  under  oath. 

PAYMENT  OF  TAXES. 

15.  The  tax  should  be  paid  by  sending  or 
a  check  or  money  order  drawn  to  the  order  c 
Revenue  at  (insert  name  of  city  and  State)." 

16.  Do  not  send  cash  through  the  mail  t 
the  office  of  the  Collector. 

17.  The  total  tax  may  be  paid  at  the  tijnc  of  filing  the  return  or  in 
four  equal  installmf^nts,  as  follows: 

The  first  installment  shall  be  paid  at  the  time  fixed  by  law  for  fifing 
the  return,  the  second  installment  shall  be  paid  on  the  fifteenth  day  of 
the  thL-d  month,  the  third  installment  on  the  fifteenth  day  of  the  sixth 
month,  and  the  fourth  installment  on  the  fifteenth  day  of  the  ninth  month 
after  the  tijue  fixed  by  law  for  filing  the  return. 

PENALTIES. 
For  Making  False  or  Fraudulent  Return. 

18.  Not  exceeding  $10,000  or  not  exceeding  one  year's  imprisonment, 
or  both,  in  the  discretion  of  the  court,  and,  in  addition,  50  per  centum  of 
the  total  tax  evaded. 

For  Failing  to  Make  Return  on  Time. 

19.  Not  more  than  $1,000,  and,  in  addition,  25  per  centum  of  the  total 
amount  of  the  tax. 

For  Falling  to  Pay  Tax  When  Due  or  Underetatement  of  Tax,  Through 
Negligence,  Etc. 

20.  Five  per  centum  of  the  tax  due  but  unpaid  plus  interest  at  the 
rate  of  1  per  centum  per  month  during  the  period  m  v.hich  it  remains 
unpaid. 

WORKING  PAPERS. 

21.  Every  corporation  should  preserve,  available  for  inspection  by  a 
revenue  officer,  working  papers- showing — 

(a)  Tlie  balance  in  each  account  on  the  corporation's  books  that  was 
used  in  preparing  Schedule  A. 

(ft)  The  amount  deducted  from  each  such  balance  on  account  of  each 
class  of  nontaxable  income,  unallowable  deductions,  and  other 
adjustments  indicated  in  Schedule  L,  with  a  reference  to  the 
number  of  the  item  in  Schedule  L  in  which  each  amount  so 
deducted  was  included. 

(c)  The  remainder  of  each  such  balance,  analyzed  to  show  the 
amount  included  in  each  item  of  Schedule  A,  with  a  reference 
to  the  number  of  the  item  in  Schedule  A  in  which  each  such 
amount  was  included 

INFORMATION  AT  THE  SOURCE. 

22.  Every  corporation  making  paj-ments  of  salaries,  wages,  interest, 
rent,  commissions,  or  other  flexed  or  determinable  income  of  $1,000  or 
more  during  the  calendar  year,  to  any  individual  or  partnership,  is  re- 
quired to  make  a  true  and  accurate  return  to  the  Comniisaioncr  of  Internal 
Revenue,  showing  tlie  nature  of  such  payments  and  the  name  and  addieaa 
of  the  recipient.  Forms  1096  and  1009,  for  reporting  such  information, 
will  be  furnished  by  any  coficctor  of  internal  revenue.  Such'  returns  of 
information  covering  the  calendar  year  1921  must  be  forwarded  to  the 
Commissioner  of  Internal  Revenue,' Sorting  Section,  Washington,  D.  C, 
in  time  to  be  received  not  later  than  March  15,  1922.  s-iocri 


1699 


F&«r«  3  of  ln9trucUoD9. 


INSTRUCTIONS  REGARDING  INCOME,  CREDITS,  COMPUTATION  OF  TAX,  ETC. 


CROSS  INCOME  AND  DEDUCTIONS. 

1  Rulrotd  corpiiratji.r'.  bank'.  in-njrancecoaipaDies,  and  other  corponiliooo  reqoifed 
to  submit  ftateiBAitd  cf  lOC'itnc  and  expeo»e9  to  any  DAtiooiI,  Statjj,  muaicipaJ,  or  other 
pubbc  ofhc<^r  ouy  aubmit  iostead  o(  Schedule  A  s  at^ktement  of  Income  aod  ezpeoBW  in 
tfa«  (prro  tb  which  aubirutud  to  such  officer-  In  such  cases  the  lAiable  net  income  wUI 
h*  rernncil^  by  meuis  of  Schedule  L  ^itb  tbe  net  profit  shown  by  the  income  and  expense 
statement  submitted,  uid  should  be  entered  as  Item  27,  Schedule  A.  p^e  1. 

2  A  life  insurance  company  iiffuiog  life  iRsuraoce  &od  luiouity  contracts  (indudiog 
contrwrla  ol  combined  life,  beatlh,  ftod  accident  intiuraDCel,  aa  defined  by  Section  242  of 
the  Revenue  Act  of  1921.  shall  file  its  tax  return  on  Form  1120L,  instead  of  Form  1120. 

3.  A  n  insurance  company  (other  than  a  company  taxed  under  Section  2-13  of  the  Act) 
isniingpoliaea  covering  life,  health,  and  accident  insurance  combined  in  one  poLiCy  issued 
on  ihe  weekly  premium  payment  plan,  continuing  for  life,  and  not  subject  tocaocellatioa, 
sball  file  Its  return  on  this  form,  and  report  aa  a  deduction  in  Schedule  A12  subject  to  the 
approval  of  the  Commiaeioner.  such  portion  of  tbe  net  addition  (not  req'iiied  by  law)  made 
^rithin  tbe  taxable  period  to  reaerve  hinds  as  may  be  required  for  the  protection  of  the 
holders  ol  such  polidee  only. 

4.  An  inrurancc  company  (othe>  than  a  life  insurance  company)  should  report  as 
a  deduction  in  Schedule  A12  of  this  form,  (a)  the  net  addition  required  by  law  to  be  made 
Tnthin  the  taxable  period  to  reserve  funds  (including  in  the  caK  of  an  assessment  iosur- 
an'-e  company  the  actual  deposit  of  eame  witli  Slate  or  Territorial  officers  pursuant  to  law 
as  additions  to  guarantee  or  rese^^'e  funds),  and  lb)  the  sums  other  than  dividends  paid 
srithin  the  taxable  penod  on  policy  and  annuity  coi.lracte. 

b  A  mutual  marine  insiuance  company  should  report  as  Item  3,  Schedule  A,  of  this 
torm.  the  groM  premiums  collected  and  received,  lose  amounts  paid  for  reineuraoce,  and 
report  as  a  deduction  jn  Schedule  A12  amounts  repaid  to  poU'-yholders  on  account  of 
premiums  preWoualy  paid  by  them  and  interest  paid  upon  such  amounts  between  aacer- 
tainment  and  the  payment  thereof. 

6  Tbe  receipts  of  a  shipowners'  mutual  protection  and  indemnity  association,  not 
organized  for  profit,  and  no  part  of  tbe  net  earnings  of  which  inures  to  the  benefit  of  any 
pnvate  stockholder  or  member,  are  exempt  from  taxation,  but  such  aasociation  shall  be 
subject  as  a  corporation  to  the  tax  upon  ils  net  income  from  interest,  dividends,  and  renls- 

7.  A  mutual  insurance  company  (including  interir.surance  and  reciprocal  nnder- 
wriiers,  but  not  including  a  mutual  life  or  mutual  marine  insurance  company)  requiring  its 
members  to  make  premium  depoeils  to  pTo\'idc  for  losses  and  expenses,  should  report  in 
Schedule  A12  of  this  form,  the  amount  of  premium  deposits  returned  to  its  poUc>'bolderB 
and  the  amount  of  premium  deposits  retained  for  the  payment  of  looses,  expenses,  and 
reinsurance  reserves  (unless  otherwise  allowed  in  Schc<lule  A). 

8  Incidental  repairs,  which  do  not  add  to  tbe  value  or  approciibly  prolong  the  life  of 
property,  are  deductible  as  expenses  (Item  14,  Schedule  A).  Expenditures  for  new  build- 
ingB.  m^chinerj',  equipment,  or  for  permanent  improvement  or  bet lerments  which  increasd 
the  value  of  the  property  are  chargeable  to  capital  account.  Expenditures  for  restoring 
or  replacing  pr.perly  are  notdeductible  under  tbisorany  otberitem  of  tbe  return.  Such 
expenditures  are  chargeable  to  capital  account  or  to  depreciation  ro!M?rve,  depending  on 
the  treament  of  depreciation  on  the  hooks  of  the  taxpayer. 

9  Thv  amount  of  interest  rleductihle  in  lt«m  15,  Schedule  A.  is  the  amount  of 
interest  paid  within  tbe  taxable  period  on  l  he  corporation's  indebtetincn.  except  on  indebt- 
e-i-fS'  I'.'-jrr'^'l  .  r  cordinued  to  purchase  or  carry  obligations  or  eecuntics  (other  than 

.  —  1  Suies  issued  after  September  2».  1917.  and  origin.illy  subscribed 
1  ibe  interest  upon  which  is  wholly  exempt  from  ta.^ation,    (See 

,  .H[b)  of  the  Revenue  Actof  1921,) 
L  .  .  ■  .i.>ductibleon  account  of  depreciation  in  Item  18,  Schedule  A.  isan 
amount  rhirije'i  off  which  fairly  measures  the  loss  during  tbe  year  in  the  value  of  physical 
property  by  reason  of  exhaustion,  wear,  tear,  and  obsolescence.  Such  an  amount  should 
be  determined  upon  the  basis  of  the  cost  of  the  property  or,  if  acquired  prior  to  March 
1,  1913,  the  fair  market  value  on  that  date  and  the  probable  number  of  yi'ars  remaining  of 
lis  useful  life.  The  capital  sum  to  be  replaced  should  be  charged  off  over  the  probable 
life  of  tbe  property  either  in  equal  annual  inatallmonts  or  in  accordance  with  any  other 
recogniiMi  trade  practice,  such  as  an  apportionment  ol  the  capital  sum  over  units  of 
production.  VrTiaievor  plan  or  method  is  adopted  must  be  reasonable  and  should  be 
described  in  the  return.  Stocks,  bonds,  and  like  securities  arc  not  subject  to  exhaustion, 
wear  and  tear  within  the  meaning  of  tbe  taw. 

11.  If  property  is  compulsoniy  or  involuntarily  converted  into  cash  or  iu  equivalent 
at>  a  result  of  (a)  its  dcstnictioa  in  whole  or  in  part,  (6)  theft  or  seizure,  or  (c>  an  exercise 
cf  the  power  of  requisition  or  condemnation,  or  the  threat  or  imminence  thereof;  and  if  the 
taxpayer  proceeds  forthwith  in  good  faith,  tinder  regulations  prescribed  by  the  Commis- 
sioner with  the  approval  of  the  Secretarj-,  to  expend  the  proceeds  of  such  conversion  in 
the  acquisition  of  other  property  of  a  character  amilor  or  related  in  service  or  use  to  the 
properly  80  converted,  or  in  the  acquisition  of  go  per  centum  or  more  of  the  stock  or  ebares 
of  a  corporation  owning  such  other  property,  or  ia  the  establishment  of  a  replacement  fund. 
then  there  shall  be  allowed  aa  a  deduction  such  portion  of  the  gain  derived  as  the  poriion 
of  the  proceeds  so  expended  bears  to  the  entire  proceeds.  The  gross  r«ceipts  and  deduc- 
tions claimed  should  be  included  in  Schedule  A23,  cS*-e  Section  234(o)  H  of  the 
Revenue  Act  of  1921  ) 


12,  If  a  iredit  is  claimed  in  Item  1-1,  Schedule  D,  a  copy  of  Form  1118,  completely 
filled  out  and  sworn  l>  or  affirmed,  must  be  submitted  with  tbis  return.  If  credit  is  sought 
luT  taxes  already  paid,  thv  i.  •i.j  m^^t  h,ive  attached  to  it  tbe  receipt  for  each  such  tax 
pa\TQcnl,     If  credit  j?  -  ::^,icd,  the  form  must  have  attached  to  it  the 

return  on  which  e^f  1-  -  -  t  ised. 

.         13.  Wlica  a  cred/  1  '-ixes.  the  Commissooer  nuy.  as  a  condition 

precedent  to  tbe  allo^' .  ■  r,  quire  the  corporation  to  .give  a  bond  (Form 

1119J.  with  suretii-a  sviL-ff,-..  :  ry  i.^  jr.d  to  be  approved  by  him  in  such  penal  sum  as  he 
may  require,  conditioned  for  tbe  paym-int  by  the  taxpayer  o(  any  amount  of  taxes  found 
due  if  the  tnxcs  when  faid  differ  from  tbe  amount  claimed  in  respect  tberool. 

PROVISIONS  AFFECTING  COMPUTATION  OF  TAX.    V 


(a)  Return  for  ■  fiscel  yea/.— If  return  La  for  a  fiscal  year  ended  io  1921,  the  tAz  ahcold 
be  computed  in  accordance  with  S-ectioaa  205, 236rc).  and  33&(a)Q(  the  Reveuue  Act  of  192L 

(b)  LimiutioQ  on  iacoms  tax.— If  the  net  income  reported  as  Item  5.  Schedule 
D,  is  more  than  $25,000  the  Ux  of  10  per  centum  imposed  by  Section  230  of  the  Act  on  the 
amount  of  tbe  net  income  sha:i  not  exceed  the  tax  which  would  be  payable  if  ibc  32,00iJ 
credit  were  allowed,  plus  the  amount  of  the  not  income  in  exces  of  J2^.O00. 

(c)  limjttbons  oa  excess  praflts  tax. — The  maximuoa  excess  profits  tax  iiDpose<l  shall 
in  DO  case  be  more  than  20  percent  of  the  net  income  io  excess  of  {3,000  and  nniineic«F^ 
of  $20,000  plus  40  per  cent  cf  the  net  income  in  exces  of  120.000  (Section  302),  unleoiQat 
income  amounting  to  more  than  $10,000  was  derived  from  a  Government  ciaUacl,  i^b'^j 
tbe  tax  on  such  income  shall  be  assessed  tinder  Section  301(6),  in  which  case  Ihe  tnaxim-jm 
excess  and  war  profits  tax  imposed  upon  this  proportion  of  the  net  income  shall  not  be  nv.rc 
than  30  per  cent  of  the  amo'int  of  net  income  in  excess  of  $3,000  and  not  in  excess  ol 
$20,000  plus  80  percent  of  the  amount  of  net  income  in  excess  of  $20,000.    (See  Section  302) 

(rf)  Tax  of  corporation  whose  income  is  derived  io  part  from  "Personal  Semce."— Ii 
part  of  the  net  income  (not  les  than  30  per  cent)  is  derived  from  a  separate  tnde  or  business 
of  the  character  of  "personal  service,"  the  tax  shall  be  computed  in  accordance  with  the 
provisbns  of  Section  303  of  the  Act. 

(r)  Tax  on  corporation  engaged  in  mining  of  gold.— If  a  corporation  is  engaged  in 
the  mining  of  gold,  ils  excess  profits  tax  shall  be  that  proportion  of  Item  3,  Schedule  D, 
which  the  net  income  not  derived  from  the  mining  of  gold  bears  to  the  total  net  income. 
(See  Section  304{c>  of  the  Act ) 

(/)  Tax  on  profits  from  sale  of  mineral  deposits.— In  tbe  case  of  a  bona  Gde  sale  of 
mines,  oil  or  gas  wells,  or  any  interest  therein,  where  the  principal  value  of  the  pr^iperty 
has  been  demonstrated  by  prospecting  or  exploration  and  discovery  work  done  by  the 
taxpayer,  the  portion  of  the  excess  profits  tax  attributable  to  such  sale  shall  not  exceed 
20  per  cent  of  the  selling  price, of  such  property  or  interest.    (See  Section  337  of  the  .\ci-) 

The  fim  step  is  to  find  the  excess  profits  Ux  computed  without  regard  to  this  provision ; 
the  ee<:ood  is  to  find  of  the  tax  thus  computed  such  portion  as  the  net  income  from  the 
sale  bears  to  the  total  net  income.  If  this  portion  equals  or  does  not  exceed  20  per  cent 
of  tbe  selling  price,  then  no  adjustment  is  permitted.  Should  such  portion  exceed  20  per 
cent  of  the  selling  price,  the  tax  will  be  that  portion  of  the  excess  profits  tax  which  the 
oet  income  not  attributable  to  the  sale  bears  to  tbe  total  net  income  plus  20  per  cent  of 
the  selling  price  of  tbe  mineral  deposits. 

15.  Statement  of  basis  of  claims. — If  a  corporation  claims  the  benefit  of  any  of  tbe 
provisions  outlined  in  (d"),  (f),  or  (/),  it  should  attach  to  the  retunj  a  complete  statement  of 
the  basis  for  such  claim  and  a  computation  of  the  tax  payable  in  the  event  that  such  claim 
is  allowed.    The  smouDt  cf  tax  so  computed  should  be  entered  in  Schedule  D. 

SPECIAL  CASES. 
16-  DefinitiDO  of  special  caaes.— Section  327  of  the  Act  provides  that  in  the  following 
caaes  tbe  tax  shall  be  determined  as  provided  in  Section  328: 

(a)  Where  the  Commissioner  is  unable  to  determine  tbe  invested  ca^^tal  as  provided 
io  Section  :;2fl. 

(b)  In  tbe  case  of  a  foreign  corporation  or  a  corporation  entitled  to  the  benefits  of 
Section  262  of  the  Revenue  Act  of  1921.     See  paragraph  4,  page  1  o(  Instructions. 

(c)  Where  a  mixed  a^^ate  of  tangible  property  and  intangible  property  has  been 
paid  in  for  stock  or  for  stock  and  bonds  and  the  Commissiooer  is  unable  sctisfactonly  to 
determine  the  respective  values  of  tbe  several  classes  of  property  at  tbe  time  of  piymeot, 
or  to  distinguish  the  claaes  of  property  paid  in  for  stock  aod  for  bonds,  respectively, 

{d)  Where,  upon  application  by  the  corporation,  the  Commissioner  finds  and  declares 
of  record  that  the  tax  if  determined  without  benefit  of  this  section  would,  owing  to  abnormal 
conditions  aflectiog  the  capital  or  income  of  the  corpontioo.  work  upon  tbe  corporation 
an  exceptional  hardibip  evidenced  by  gross  disproportion  between  the  tax  computed 
without  benefit  of  this  section  and  the  tax  computed  by  reference  to  the  represeotative 
corporations  specified  in  Section  323,  Thissubdi^-ision  shall  notapply  toany  case:  (I)  In 
which  tbe  tax  (computed  without  benefit  of  this  section)  is  high  merely  because  the  corpo- 
ration earned  within  the  taxable  period  a  high  rate  of  profit  upon  a  normal  invested  capital, 
nor  (2)  in  which  50  per  centum  or  more  of  the  gross  income  of  tbe  corporation  for  tbe  tjx.'vble 
period  (computed  under  Section  233  of  the  .\ct)  consisted  of  gains,  profits,  commiseior.s, 
or  other  income  derived  on  a  cost-plus  bai^is  from  a  Government  contract  or  contracts 
Qude  between  April  6.  1917.  aod  November  11,  191S.  both  dates  inclusive. 

17.  Trcatmeot  of  special  cases.— In  the  cases  specified  in  Section  327  the  tax  will  be 
specially  determined  under  tbe  provisions  of  Section  328,  A  corporation  which  ct.mes 
within  tbe  pri.vi^ions  of  sub<ii^t3uin  (d)  of  Section  327  (puagraph  IS.  above)  may  miake 
application  (or  a:i9e£3ment  under  the  pro^'isions  of  Section  328.  which  application  shall 
be  attached  to  its  return  in  the  form  of  a  sutemeot  setting  ioetb  in  full  (a)-Tbe  reasons 
why  tbe  tax  should  be  so  determined;  (b)  the  iicts  upon  which  such  reasons  are  based; 
(c)  on  exact  description  of  each  trade  or  busineu  or  important  branch  of  a  trade  or  busiaeoi 
earned  on  by  it;  (J)  a  statement  of  the  invested  capital  and  net  income  for  each  year 
since  the  beginning  of  tbe  prewar  period;  and  («>  a  statement  showing  tbe  amount  ct 
gains,  profits,  commissions,  or  other  income  derived  oo  a  cost-plus  basis  from  Govemmeot 
contracts  made  bt-tween  April  5.  1917.  and  November  12,  1918,  both  dates  inclusive, 
and  showing  the  per  cent  which  such  income  is  of  the  total  income  of  the  corporation. 

IS  Returns  id  special  cases. — Corporations  other  than  foreign  corporatioos  mabiiK 
claim  for  assessment  under  Section  3?S  of  the  Act  shovU  answer  alt  questions  and  file  all 
schedules  as  far  os  possible  and  attach  a  0tateme.1t  exp.ainu)g  wby  il  is  impracticable  to 
611  out  tbL'  eniijo  return 

UNDISTRIBUTED  PROFITS  TAXABLE  TO  STOCKHOLDERS. 

19  II  any  corporation,  however  created  or  organiied.  is  formed  or  a-ailed  ol  lor  the 
purpose  of  preventing  the  imposition  of  the  surtax  upon  itsslockhidders  or  members  thfOUgh 
the  medium  ol  permitung  gains  and  profits  to  accumulate  instead  of  being  divided  or 
distributed,  liiere  shall  be  levied,  collected  aod  paid  for  each  Uxable  >ear  upon  the  net 
income  of  ^uch  corponlioD  a  tax  equal  totweoty-fi'.  epcrceol(25'^  )  of  the  amount  thereof. 
which  shall  be  io  addition  to  tbe  Ux  imposed  by  Section  230.  Revenue  Act  of  1921,  aod 
shall  be  computed,  collected  and  paid  upon  the  same  basis  and  10  the  same  manner  and 
subject  to  the  eame  proviaons  of  law,  including  penalties,  as  that  tax,  (See  Section  220, 
Revenue  Act  of  1921  f  a-iam 


1700 


Form  1041 

n,   S.   IKTEHXAI,  Revinue 

FIDUCIARY   RETURN    OF 

FOR  CALENDAR  YEAR  1921 
Or  for  period  begun 1920,  and  ended. — 

INCOME 

„ ,  1921 

Do  not  write  in  thn  space 

Eutoined  b, 

BE  FILED  NOT  LATER 

Dat«  r*c«iv»d 

THAN  THE  ISTH  DAY 
OF  THE  THIRD  MONTH 

PRINT  NAMES  AND  ADDRESSES  PLAINLV 

FOLLOWING  THE  CLOSE 

N.maand 
address  of 

OF  THE  ACCOUNTING 

Name  of 

AFFIDAVIT 


r  (or  ftSrm)  that  this  return,  including  the  accompuyiDgBchedulea  aod 


a  and  Bub»cribed  before  me  tbia. 


1.  Was  a 

2.  Ifflo. 


eturo  oC  income  for  1920  filed  on  bcbajf  of  the  cstalc  or  trust  named  above? 

)  whai  coUector'a  office  wng  it  Boot  (^vc  diatrict  or  cily  and  State)? 


3.  Give  dale  of  creation  of  I 


r  decedent's  death.. 


™,  INCOME  * 

1.  Interest  on  Bank  Oepoeits,  Notes,  Mortgages,  and  Corporation  Bonds 

2.  Income  from  Partnershipe,  Fiduciaries,  rtc.    (State  name  and  addreas  of  partnerships,  etc.) 


3.  Rents  and  Royaltie 


e  from  piirtnerships).. 


4.  Profit  (or  loes)  from  Business  or  Profession  (not  iucludiog  ii 

5.  Profit  (or  loss)  from  Sale  of  Real  Estate - 

G.  Profit  (orloas)  from  Sale  of  Stocks,  Bonds,  elc — ~ 

7.  Dividends  on  Stock  of  Domestic  rorporations..- - - 

8.  Other  Income  (iocludiag  dividends  received  on  stock  of  foreign  corporations).    (State  c 


(«). 


9.  Total  Incoue  is  Item 

10.  Interest  Paid  (not  including  i] 
U.  Taxes  Paid  (not  inclading  tax 

12.  Loeoefl  by  Fire,  Storm,  etc^- 

13.  Contributions ^ — _. 


( Do  DoC  Includa  vij  loWiwt  oo  UberT;  Boads,  i 
?  8  0^^  losses  shown  therein,,  if  any)  ... 

DEDUCTIONS 
.  deducted  above) — , 


14.  Bad  Debts  (not  including  bad  debts  deducted  above)  . 

15.  Other  Deductions  Autboriwd  by  Law....™ 

16.  Total  or  Items  10  to  15 — 

17.  Net  Incoue  qtem  9  minus  Item  16) 


BENEFICIARIES*  SHARES  OF  INCOME  AND  CREDITS 


18.  Eolct  below  the  ihate  ol  Oct  income  (»hclher  diatribuled  or  not)  <il  e«cli  bcnrfic 
ehare  ol  ux  paid  by  the  debtor  corooration  on  tax-free  covcnint  bonds,  nod  ttic 
United  Statee.     (See  Instnictions  6  to  9,  indmivc  ) 
II  the  dietiibuuble  bencOcuil  inlcreet  in  Iho  net  income  u  deteniiinod  on  >  buia 

try  ol  the  c 
other  than 

J  prof 
apcrc 

u  taxcB  paid  by  the  erti 
ffOtaRO  basis,  attach  an  cs 

1  obligations 
planatory  Bta 

jt  the  UDi 
k  foreign  c 

uolry 

tcs):  eacti  benou 
01  to  a  pomeuion 

oi  the 

■  '"  (DalfUU  ooi.raia.oi  Ma.  | 

ii^si. 

„;.r=,. 

(MeHlTMlirvslTtMT). 

o'/t: 

"k^ 

S 

rouuaioit  or 

J 

* 

'"' -" 

"' ~ ■ 

1 

'" " "■■ 



<'" 

- 

. 

<'> - 

(/) - 



— 

(J) - 

* 





(») 

.. 



(J) ~ '•-       -" 

<i)      Total! — - 



1 



1 

1 - 



1 701 


SCHEDULE  A.-EXPLANATION  OF  ITEM  3.    (Rent. 

and  Royalt 

«.)    s 

1.  Kiro  OF  Piomti 

'PXiC^^ar 

'it'cTiS 

S,  Drpiice"i*Tiov 

Exrana- 

7.  Nct  PM 

" 

1 

~- 

1 

1- 

S«c  Instruction  10 

L 

Cost  or  Goods  Sold 

2.  Labor 

« 

Other  Bus 
10    Salarica 

ODiiD 

11.  Rent  on 

-vESsDEDUcnoNa: 

and  wages  not  reported  aa  "Labor" 

, 

t 

3    Material  and  au     hea 

business  property  in  which  esUte  or 

PP 

.      ,                . 

1 

A    Merchandise  bou"ht  (or  sale 

13,  Taxes  on  business  and  bueinese  property 
U.  Repairs,  wear  and  tear,  obsolescenee. 

» - 

5.  Other  cobu  (liat  principal  iu-ms  and  amouDla 

deple- 

pa 

15.  Amortization  of  war  facilit 

16.  Baddebtsarisingfromsales 

6-  Plus  inveDlory  at  beginniDg  of  year  



ii  already  reported 

as  IDC 

exnensca    (list    orincipal    itcma 

aod 

amounta  below  or  on  sepa 
18.          Total  (Items  10  to  17 

.J 1 

US  Item  !8) 

1 

19.  Net  Cost  flvs  Total  Dedcchons  {Item  9  p 

5 

20    Net  PRonT  (on  I,o 

38)    PR 

3u  BtiaiNEsa 

(Item 

1  minus  Iter 

nl9).. 

ExplanaitoD  of  dcductio 


SCHEDULE  C— EXPLANATIOrJ  OF  ITEM  5.     (Sale  of  Real  Estate.)     sm  Insiruction  17 

1.  Kanor  PaoraWT 

rv.,.^c«m^       3.A.O0KTB.C.^,.. 

.€<,« 

VM.^.™..,9,=.       1        f^™j2g^ 

,   D^^„o,. 

'■oTiTr 

_ t 

1 

' 1 

».... 

I 

1 

. 



1                 1 

■" 1            L.    ... 

1 1 

..; 1 

i 

::::::::::::::::j:;:::::i:::: 

1 



i 

If  not  acquired  by  purchase,  etate  how  acquired  . 


SCHEDULE  D.— EXPLANATION  OF  ITEM  6.    <S«1e  of  Stoclu,  Bondi.  etc.)    s«  Insinia 

»oU. 

,.K»norP..™,v                                                                        ,%?,;7„ .         |            3  Con             |     '  --^,i""- 

'nAt^lS 

6.  Nrr  Ftom 

• r 

i 

1 

1 

: ■ ' 1 

1 

1 
1 

1 



If  not  acqtured  by.purchaae.  slate  how  acquired  - 


SCHEDULE  E-EXPLANATION  OF  ITEM  12.    (Loom,  by  Fin.  Stoim,  «<c.)    B«Ii«nirtw.=. 

,    K™.o.P,»-».. 

1. 1913.  Value-          PftinovsLr  Taken. 

4    SAtVAO.  V*H)B. 

5.  ImuiAxcx 

G  Nlt  Ua. 

1. 

i 

1 



1 

SCHEDULE  F.-EXPLANATION  OF  DEDUCTIONS  CLAIMED  IN  ITEMS  13,  14,  AND  IS. 


An  amended  return  muet  be  plainly  marked  "AmendMl" 


t  tlie  face  of  the  return. 


I702 


DUPLICATE 


DETACH  AND  RETAIN 

THIS  COPY  AND 
THE  INSTRUCTIONS 


FIDUCIARY    RETURN    OF    INCOME 

FOR  CALENDAR  YEAR  1921 


DUPLICATE 


Or  for  period  begun i  1^20, 


PRINT  NAMES  J 


IF  YOU  NEED 
ASSISTANCE  CO  TO  A 
DEPUTY  COLLECTOR 

OR  TO  THE 
COLLECTOR'S  OFFICE 


FIDUCIARY'S  MEMORANDA 


1    Wa!  a  return  of  iocome  foi  1920  filed  < 
2.  H  BO,  to  what  collecloT'e  office  gaa  it  b 


1  behalf  o(  the  estate  or  Inisl  named  above? 

pt  (pve  difltrict  or  city  and  Sute)? 3.  Gri 


r  dccedent'B  death.. 


INCOME 

)t  on  Bank  Depoaits,  Notes,  Mortgagee,  and  Corpoiation  Bonds  — 

e  from  PartoeiBhipe,  Fiduciaries,  etc.    (State  name  and  addresa  of  partnerBhips, 


Rents  and  Royalliee... _ — 

Pro6l  (or  loee)  from  Bueinesa  or  Profeeaion  (not  iodudicg  income  from  partaerehipi} 

Profit  (or  loss)  from  Sale  of  Real  Estate « - 

.  Profit  (or  loae)  from  Sale  ol  Stock*,  Sonde,  etc - 

.  Dividends  on  Stock  of  Domeetic  Corpontioua - - - 

.  Other  Income  (including  dividends  received  on  etock  of  foreign  corporatiotu) .     (State  oatore  of  L 

(«) — - 


(c). 


Total  Income  ik  Itemb  1  to  8  (leaf 

DEDUCTIONS 

-  Interest  Paid  (not  including  interest  deducted  above) 

.  Taxes  Paid  (not  including  taxes  deducted  above) 

.  Loeaesby  Fire,  Sloroi,  etc — 

.  Contributions 

.  Bad  Debta  (not  including  bad  debte  deducted  above)  

.  Other  Deductions  Authorited  by  Law _ 

Total  of  Items  10  to  15 „ 

Net  Income  gtem  9  minuB  Hero  16) 


BENEFICIARIES'  SHARES  OF  INCOME  AND  CREDITS 

;  (whether  diatributed  or  not)  of  each  beneficiary  of  the  estate  or  truat  (except  interest  on  obligatio 
>rporatioQ  on  tax-free  covenant  boodd,  and  the  locouie  and  profits  taxee  paid  by  the  estate  or  trust 

B  determiDed  on  a  basis  other  than  a  percentage  basis,  attach  a 


1   N^».»m.^»D«u_OTjE.CB^Il.mi.c...r 

Ml 

.i,sr:i^.,. 

,„V.7,-SJ?Sf.".S,. 

-'-'BS'-- 

Taxes  Paid  to  a  Foreign 

^, 

' 1 

1 

../ 

1 

1 

1 

1 

1 

1 

.1 

1 

«)         TOIAU       _ 

-....1 

• 

$ 

( 

1703 


SCHEDULE  A.-EXPLANATION  OF  ITEM  3.    ( 

RcntH 

and  Royalt 

«..)      6 

to  Inauurtloo 

■  K™.»r.o-«„. 

'Fmi'vUtr" 

R^^u"'? 

i^'o'irS" 

EtrtKSt*. 

7.  Net  nown 

(0>  U>S9). 

J 

t— 

:::;:: 

_ 

._ 



.' 

Sute  fstimatPcl  life  of  property  ftod  bow  you  figured  depreciatio 


SCHEDULE  B.— EXPLANATION  OF  ITEM  4.     (BmineM  or  Profai 


1.  Total  iucome  Irom  busineBe  (state  kind  of  biuioesa) .. 
Cost  of  Goods  Sold 

2.  Labor  [»™ 


3-  1l]atenalandsuppU€ 


4.  Mprrhandise  bought  for  sale  - 

5.  Other  costs  (lisL  principal  items  and 

bi'low  or  on  separate  ebeet)  

6.  PluB  iDveot43ry  at  beginning  of  year  . 

7.  Total 

8.  Lee«  inventory  at  cod  of  year 

9    Net  Cost  op  Goods  Sold 


Other  Business  Deductions:  | 

10.  Salaries  and  wages  not  reported  as  "Labor" 

on  liae2 - - '$.„ 

11.  Rent  on  buainesa  property  in  which  esUie  or  I 

trust  hae  do  equity ..,. 

12.  Interest  on  business  indebtedness  to  others  ...   '     . 

LI.  Taxes  on  busioeas  and  business  property 

14    Repaint,  wear  and  tear,  obsolescense,   deple-  I 
tiori,  and  property  losses  (explain  below) 1.-. 


18-  Total  (Items  10  to  17.  inclusive) - X- 

19,  Net  Cost  pll-s  Total  DEOticTiONa  (Item  9  plus 

20.  Net  Proht  (or  Loss)  troh  Bubiwess  (Item  1 


Item  18) 

ttiinus  Item  19)- 


Explanation  ol  deductions .. 


SCHEDULE  C.-EXPLA^ATION  OF  ITEM  S. 

Sale  of  Real  Estate.)    B«»  Iwtrwtion 

I. 

,.k™.,P«„„,.                           ,.!>.„  a«™«.     ,.*-o™,B«.n,.o 

4.  Cost.            1     *  ""^  '•  '"^'     1      f  Swotoowt       1     .  DcraKJ.tioir      j       ''(**"i^'" 

1 

, 

.. , J..;..... 

1 

1 

1 

1 

f 

1       1 

"■■■             ,                                                            1                                                          1 

1 

::]::::i:: 

1                                                          1 

1 

1 ! 

Ill 

1          ! 

1                                  1                       1 

IlZITJIIZ 

If  not  acquired  by  purchase,  state  how  acquired  - 


SCHEDULE  D.-EXPLANATION  OF  ITEM  6.    (Sale  of  Stocks.  Bond*,  etc)    8m  tartmcttoo  is. 

1.  KiKD  or  moPSRTT. 

aU1.?». 

a.  com.              1      *•■  M'oa'  1. «".      1           5.Aiioin«T 

(oaLos; 

1. 

1, 

1 

1 

1 

!      1 



I...... 

If  not  acquired  by  purchase,  stale  how  acquired  .. 


SCHEDULE  E-EXPLANATION  OF  ITEM  12.    (LoMe.  by  Fir.,  Slorm.  etc.)    S»li»ini«i«i3j. 

>,  n™.  o.  >..o,..-r.                         ^  f°,s ";.?„■?"  I  r.'.>?o";Lf r;.°j» 

.S.L,..r.v.„. 

V  ,:»nu„.. 

S.  NETL038. 

.  1 

1 

1          1 

1 
1 

1 







i 

SCHEDULE  P.— EXPLANATION  OF  DEDUCTIONS  CLAIMED  IN  ITEMS  13,  14,  AND  15. 


An  amended  return  mu«t  be  plainly  marked  "Amended"  acrou  the  face  of  the  t 


1704 


INSTRUCTIONS  FOR  FIDUCIARY  RETURN 


I.  RETURNS  BY  FIDUCIARIES. 


Ruiinu  on  Form  ;w/  /or  uMu  ,nd  (nuu.-EvBiy  liduci.ry.  o,  one  in  tu,  ol  iou>t 

»M  «1  000  or  ova  or  (6)  .oy  beneficry  ol  mch  e««to  or  tnul  i,  .  oonrmideot  lOieo 
61.1  »,"lZ,°n,  ^rr,'""-^"  ?T  ""^  '^''  -I"""'  "I  (" '  «t.t«  ot  decedent,  belor. 

^r."',!!^  r,'T°' '°.''""'' " '"™"'  "'■''•  "'  "■'"■  "■"'"  'bo  term. 01 U,.^" 
Sr^l  ,^.  „^°'  ^'T  "'If^'""'''".  >«  "^ed  to  the  fiducmry  a.  .  .mgle  pe,„n,  except 
th.t&omtheinc»meol.de«e^of.o.t.tethe«m.yfi,«bededucted.nvunountp.T,periy 
^  JorT  .  ?  '  ^"'^"^"y-  1°  -uch  a*,  the  fiduciary  .hould  make  .  return  loMh, 
«Uteorlru.tonFomm0orl040A.     (Se.Se«ion.200.219,  Md225olthe Revenue  Aclol 

^Jji'^  °,l  ^T  "^^"  I^M-^.-t.  return  on  Fora,  10«  or  IWOA  ri,ould  be 
r«,dc«d  by  the  fiducu^  u,  the  c..,  ol  (o)  income  di.tnbut.ble  te  .  nonreddent  .Uen 
regudJee.  ol  .mount.  (I,)  u  ordiimry  guudijuahip  ol  .  minor  (unlem  .uch  minor  hun»U 
r!"  ".'  j'.'"^*'.^  °'°™"'«<'  •<>'  "  ii'«»ne  person,  if  the  net  income  for  the  t«t.blo  ymr 
amounted  to  K.OOO  or  over,  a  m.rned  .nd  U>-in8  w.th  hu.b.nd  or  wife  on  the  l„t  d/y  of 
the  l...bJe  ye.r.  er  tl  the  net  income  lor  the  t.x.ble  yew  nmom>ted  to  Jl.OOO  or  over  il 
not  m.mi.d  or  not  living  with  hujbuid  or  wile  on  the  iMt  d«y  dl  the  t»x.ble  ye»r  or  il  in 

^^''„,"°°^  ,!,fT"°T° ""  •*•** "'  ""'■  ■"  "■ «""'  "' '  <I"'J"'  >»'»"  l-^l  «'ll<^ 

men  .  .nd  (rf)  il  pm  ol  the  income  of  .  truat  eet.te  i,  dwtnbuted  to  beneliciane.  uid  pm 
,"      >,     ,7.  '°  ^°'"  °'  ""  '^  """^      "'"'"  "■"  «°<li"0».  described  in  i^. 

dutribuUble  to  .  beneficmry  ii  t.i.ble  directly  to  the  beneficinry 

K,l^/or  d^td^.-ll  the  net  income  ol  >  decedent  from  the  beginning  of  the  Ux.ble 
yeiw  to  the  d.te  ol  hi,  de.lh  w..  tl.OOO.  il  unmixed,  or  S2,000.  if  mmed  nnd  Uving  Mh 
Imitond  or  wile,  or  U  in  either  cue  the  groes  income  was  $5,000  or  over  the  executor  or 
luimini.tr.tor  ehaU  m.ke  .  return  on  Form  1040  or  IWOA  lor  »jch  decedent 

R,lu™/„r  ,„,  n^^^.-If  „o  „  „„„  ,^„  ,t,  i„^„„  ^,  ^^^^^^  ^^  ^^^^^^  ^ 
benefia.ne«.  were  crested  by  the  same  person  .nd  »re  in  ch.rge  ol  the  o.me  tnulee  the 
iruaee  »h.ll  m.ke  .  .ingle  return  on  Form  1041  lor  .11  ,uch  tr™,.,  notwithst.nding'tli.1 
hey  m.y  .„.e  Irom  different  in«rumenl..  II,  however,  .  tm«ee  hold.  tn«l.  c«t«i 
by  different  pcraons  for  the  benefit  ol  the.mme  beneficiuy,  he  gh.U  m.ke  •  return  on  Form 
iCMI  lor  Mch  trujt  wpar.tely 

2.  PERIOD  TO  BE  COVERED  BY  RETURN. 

In  general,  the  regulation,  governing  the  prepwation  ol  return,  by  fiduciarie*  .re  the 
same  a.  those  governing  individuals. 

The  return  must  be  filed  lor  the  calendar  year  ending  December  31,  1921  or  lor  the 
liK.1  year  ending  on  the  lust  day  ol  any  month  other  than  December.  The  d.l<.  on  which 
the  penod  covered  by  the  return  begir«  and  end.,  U  other  than  a  calendar  year  muM  be 
plainly  stated  at  the  head  ol  the  return. 

A  fiduciary  wa«  required  to  file  the  1918  return  for  an  estate  or  Iru.l  on  the  bam.  ol 
It.  annual  accounting  period.  The  period  for  which  the  return  for  1918  wa.  filed  mutt  be 
^Zlt  '"-h"  ■"'"*''"''°'  ***"'  '"^"'  P'™"""""  ""  'eceived  Irom  the  &)mmi»ioner 

3.  ACCRUED  OR  RECEIVED   INCOME. 

11  the  boots  of  an  estate  oi  trust  Me  kept  on  an  accrual  ba.,.,  report  all  mcome  .ccmed 
even  though  it  ha.  not  been  .ctu.lly  received  or  entered  on  the  book.,  .nd  expenM 
incurred  instead  ol  expenses  pud. 

II  the  books  do  not  eho»  income  aiyruod  and  expense,  incurred,  report  all  income 
rwPived  or  constructively  received,  such  a.  bank  interest  credited  to  the  account  ol  the 
eetatc  or  trust,  and  expeosefl  pud. 

4.  ITEMS  EXEMPT  FROM  TAX. 

The  following  item,  tkje  exempt  from  Federal  inc< 
unlc«  it  is  desired  to  establish  .  net  loss,  in  which  t 
Act  «f  1921 

l»)  The  proceeds  ol  life  insurance  policies  pai.l  upon  the  death  of  the  insund 

(H  The  amount  received  by  the  insured  u  a  return  ol  premium  or  premium,  paid  by 
him  under  hie  insurance,  endowment,  or  annuity  contract.,  either  during  the  term  or  at 
ihc  matunty  of  the  ttrm  mentioned  in  the  contract  or  upon  surrender  of  the  contract 

(c|  Gift,  (not  made  u  .  consideration  for  service  rendered),  and  money  and  property 
acquired  under  a  will  or  by  inheritance  (but  the  income  derived  from  money  or  property 
received  by  gift,  will,  or  inheritance  is  Uxable  and  mu«  be  report<-dl; 

Id)  Interest  upon  (H  the  obUg.tions  ol  .  SUte,  Territory  ,  or  any  political  subdivi,ion 
tbcreol  or  the  Duitrict  ol  C«lumbi.:  or  (2)  securitie.  issued  under  the  provisions  ol  the 
lederal  Farm  Loan  Act  ol  July  17,  1916,  or  (31  the  obhpation.  ol  the  United  Sutes  or  it. 
possession.;  or  (4)  bond,  uaued  by  the  W,r  Finance  CorfKjration,  In  the  cai«!  ol  obliga- 
tions  ol  the  Vmled  Stat««  issued  alter  Sentembcr  1.  1917  (other  than  postal  eavinga  cer. 
tific.tc.  ol  dopos.ll  and  in  the  ca«  of  bonds  issued  by  the  Wu  Finance  Corporation  the 
interest  is  exempt  only  il  and  to  the  extent  provided  in  the  resi,ective  uu  .uthori'zlng 
the  uwue  thereol  u  amended  and  supplemented  by  Section  1328  ol  the  Revenue  Act  of 
1921,  and  should  be  excluded  Irom  grow  income  only  il  and  to  the  extent  it  is  wholly 
exempt  to  the  Uxpayer  from  income  t.x 

(c)  Amount,  received  thrt>ugh  K-cident  or  health  insurance  or  under  workmen's  com- 
peniiation  act.,  a.  compcmiatlon  lor  pereon.1  injurie.  or  sickneM,  plus  the  amount  ol  any 
damages  received,  whether  by  suit  or  agreement,  on  account  ol  such  injurii.-,  or  sirkDciw 

(/)  Amount,  received  a.  compensation,  lamily  allotments  and  allowances  under  the 
proviinon,  ol  the  War  Risk  Insurance  and  the  Vocational  R».h.bilitation  Act.,  or  a.  [len- 
sion.  Irom  the  I'nited  .«UI»«  lor  service  ol  the  heneficiuy  or  .notber  in  the  milit.r)'  or 
naval  lortee  ol  the  fniled  .'^t.te.  in  time  ol  war. 


5.  FARMER'S  INCOME  SCHEDULE. 

II  the  eetata  or  trust  derive,  income  Irom  EwTniig.  and  no  book,  ol  w>»unt  u«  kept, 

or  book,  ue  kept  on  ft  cash  bams,  obtun  from  the  ,C<iIlector,  and  attach  to  this  return.' 

Form  1040F,  Schedule  ol  Fum  Income  and  Expeisee.     Enter  the  net  lum  income  u 

Item  i.  ptge  1  ol  the  return.     II  the  larm  book,  ol.iccount  are  kept  ..n  ui  .ccrual  bams. 

ilereet,  sales  ol  property. 


S.  DISTRIBUTION  OF  INCOME 

The  table  under  Item  18,  page  1  o!  the  return,  is  to  be  u»d  lor  shovting  each  bene- 
ficiary's share  ol  the  net  income,  whether  distributed  or  not. 

Enter  on  line,  (o),  (S),  (r),  etc.,  the  dijtributive  amount  ol  the  total,  dlown  in  columns 
3  Uld  4  to  which  each  beneficiary  is  entitled,  whether  distributed  or  not.  II  the  amount 
to  be  entered  in  column  4  i,  a  loss,  the  amount  should  he  indicted  bv  red  ink  or  a  minus 
si^ 

7.  TAX  PAID  AT  THE  SOURCE. 

If  the  estate  or  trust  received  interest  directly  or  through  .  partnership,  petBon.1 
service  corporation,  or  .nother  fiduciwy,  on  corporation  bonds  conuimng  a  claune  by 
which  the  debtor  corporation  agrees  to  pay  the  interest  without  any  de*luctiyn  lor  ta]i« 
and  there  were  filed  with  such  inter(»t  coupon,  a  white  certificate.  Fonn  1000,  not  claiming 
exempnon,  atax  ol  2  per  cent  was  paid  at  the  source,  and  thi^  ux  should  be  allocated  to  the 


,  Item 


8.  CREDIT  FOR   INCOME  AND   PROFITS  TAXES  PAID  TO  A  FOREIGN 
COUNTRY   OR   TO   A   POSSESSION   OF   THE   UNITED   STATES. 

II  any  amount  is  entered  in  column  6.  Item  18.  page  1  ol  the  return,  a  copy  ol  Form 
1116,  completely  filled  out  and  ,wom  to  or  affirmed,  must  be  eubmiited  with  this  return 
II  such  taxfa  have  been  paid.  Form  1116  must  have  atuched  to  it  the  receipt  ler  each 
■uch  tax  paj-ment.  II  such  taxa  have  been  accnied,  Fonn  1116  must  have  attached  to  it 
a  copy  ol  the  return  on  which  each  ,uch  «crued  t.x  wu,  bawd,  or  other  evidence  u  to 
the  Kcrual  ol  Uxeo.     (See  Section  222  ol  the  Revenue  Act  ol  1921) 

When,  crediti,  claimed  on  Fonn  1040  or  Form  1040A  lor  accnied  uxes.  the  CommL- 
sioner  may.  as  a  condiUon  precedent  to  the  allowance  ol  such  cnnlit.  require  the  taxpayer  to 
give  a  bond  on  Form  1117,  with  sureties  satu.l..tory  to  and  to  be  approved  by  him  in  such 
penal  sum  as  he  may  require.  condiUoned  lor  the  payment  by  the  taxpayer  ol  any  amount 
ol  taxes  lound  duo  il  the  taiio  when  paid  diller  Iron,  the  amount  claimed  in  respec't  thereol. 

9.  INTEREST   ON    LIBERTY   BONDS.    ETC. 

In  civo  the  estate  or  trust  owned  Liberty  Bonds  or  other  obligations  ol  the  United 
Slatw  i»ued  since  September  1.  1917(except  Victory  Liberty  Loan  3i<S  Notes  and  posul 
saving  certificate,  ol  deposit),  ot  a  share  ol  theM  obligation,  held  by  a  partnerrflip.  penonal 
service  corporation,  or  another  fiduciary,  the  fiduciary  ebould  advise  each  beneficiary  as 
to  his  proportionate  amount  ol  these  obligalions  and  the  interest  thereon,  in  order  thal'the 
beneficiary  may  determine  whether  such  interest  is  taxable  on  his  individual  income  tax 


•laes  ol  obligations  received  duriog  the  accounting 
cash  receipt,  and  disbujeemenl.  basis,  add  to  the 
lalLng  due  within  the  wrcounting 


the 


Tod. 
period,  where  the  book,  are  kept 
wnount  ol  all  coupon,  and  registered  bond  inl 
period  the  amount  ol  accrued  interest  received  on  sales  ol  obligai 
payment  dates,  uid  deduct  from  this  sum  tho  accrued  interest  paid  on  purchases  of  obligii 
tion.  between  interest  payment  dates.  Thi,  method  will  be  lollovied  where  book,  are  kept 
on  a  cah  bans,  whether  or  not  the  coupon,  tailing  due  within  the  accounUng  period  are 
actually  cashed.  II  the  book,  are  kept  on  the  accrual  baa«.  report  the  actual  amount  of 
interest  accrued  on  the  obligation,  owned  during  the  accounting  period. 

10.  AFFIDAVIT. 

The  .flid.vit  mu.t  be  executed  by  the  individual  or  organization  receiving  or  h.vinc 
custody  or  contiol  .nd  management  ol  the  income  ol  the  esute  or  trust.  II  two  or  morv- 
individual.  act  jointly  as  a  fiduciary,  the  affidavit  may  be  executed  by  any  one  of  them. 

The  oath  will  be  a.lmmistered  without  charge  by  any  collccUir^  deputy  collectot, 
or  mtemal  revenue  agent.  If  an  internal  revenue  officer  is  not  available,  the  return 
aho^d  i-»  eT::m  to  lieloie  .  notary  public,  justice  ol  the  peace,  or  other  pereon  .uthoriired 

e  to  the  officer  who  ulroinistere 

11.  WHEN   AND   WHERE  THE   RETURN    MUST   BE   FILED. 

II  the  return  i,  lor  the  calendar  year  1921,  file  it  with  the  rollcclor  ol  Internal  Reve. 
nue  lor  the  dUtrict  in  which  tho  fiduciary  rraidi ,  or  ha,  hi,  principal  place  ol  business 
so  a.  to  reach  the  coUector's  oflice  on  or  belore  March  15,  1922.  II  lor  a  period  other  than 
a  calendar  year,  the  return  should  be  filed  on  or  beloro  the  15th  day  of  the  third  month 
following  the  cineo  ol  such  period.  II  tho  fiduciary  has  no  legal  n-eidence  or  principal 
pl.ce  ol  business  m  the  United  Stales,  the  return  sliould  1»  lorward.d  to  the  follelMot  ol 
Internal  Reveuue,  Bijtimore,  Md.     (See  .Seclion  227  of  the  llevcnue  Act  ol  1921  ■ 

12.  PENALTY   FOR  FAILING  TO  MAKE  RETURN  ON  TIME. 

A  pemilly  ol  not  more  than  »1,000  attache,  lor  lailure  to  file  the  return  within  the 
tune  required  by  law.  II  Uie  lailure  is  willlul  or  an  attempt  is  made  to  defeat  or  evade 
the  tax.  the  pen.lty  is  not  more  than  JlO.OrW  or  imprisonment  lor  not  more  than  one  year 
or  both,  together  with  cost,  ol  prosecution. 

13.    INFORMATION  AT  THE  SOURCE. 

Every  fiduciary  who.  during  tho  calendar  j  ear  1921,  paid  to  any  individual,  partner, 
ship,  or  penonal  service  corporation,  sabrics,  wages,  commissions,  rentals  or  other  fixed 
or  determinable  income  of  Jl,000  or  more,  i,  required  to  make  a  true  and  accurate  return 
to  the  (  omrauiiioner  ol  Intcrtml  Revenue  ahowing  the  nature  and  nource  ol  such  payment, 
.nd  th-  name  and  address  ol  the  rcHripie nl  All  Form.  1099  must  be  accompanied  by  Form 
1096  Md  should  bo  lorw.rded  to  the  Comnussioner  ol  Internal  Revenue,  Sorting  Section 
Waahinglou,  D.  C,  in  lime  to  be  received  not  Inl.r  than  March  18,  1922  ,_,„„ 


I7OS 


U.  INCOME  FROM  PARTNERSHIPS.   FIDUCIARIES.   ETC. 


.•ceived  or  notWn  Uieproriteofap&rtiier- 
ie  of  another  estate  or  tniat,  except  the 
stock  of  domestic  corporalione,  which 
,  and  the  interest  on  obUgatione  of  the 


RejKin  tJioah  are  of  the  estate  or  trust  (whetht 
ahip  or  peiwnal  nervico  corporation,  or  in  the  in 
part  of  such  share  that  consiHtt'd  of  dividends 
Rhould  be  included  iu  Item  7,  page  1  of  tho  ret 
I'nited  States  (see  InotnirtioD  9). 

I(  Iheaccoimlinj;  j>criod  on  the  baBia  of  which  this  re) 
the  auntta]  accounting^wriod  of  the  partnerBhip,  personal 
then  you  should  inchidc  in  tlua  return  the  distributive  share  of  the  total  net  iocome  for 
such  acrouDling  period,  ending  within  your  taxable  period. 

IS.  INCOME  FROM   RENTS  AND  ROYALTIES. 

If  property  or  crops  was  received  in  lieu  of  cbbH  rent,  report  the  income  aa  thougii 
the  rent  had  been  reteived  in  cash.  Crops  received  as  rent  on  a  crop-ahare  basis  should 
be  reported  as  income  for  the  year  in  which  disposed  of  i"  unless  your  return  shows  income 
accrued). 

Explain  in  Schedule  A,  p^e  2,  repairs,  depreciation,  depletion,  and  other  eicpenses. 

Other  expenses  include  interopt.  taxes,  fire  inauiance,  fuel,  light,  labor,  and  other 
beceffliary  expenses  of  this  character". ' 

16.  INCOME  FROM   BUSINESS  OR  PROFESSION. 

Report  in  Item  4  the  net  profit  (or  loss)  from— 

(a)  Sale  of  roerchandise,  or  of  products  of  caanufaeturing,  conatruriion,  mining,  and 
agriculture. 

(6)  Business  service,  such  as  transportation,  storage,  laundering,  hotel  and  restaurant 
sen-ice.  livery  and  garage  service,  etc. 

In  general,  report  in  Item  4  any  income  in  the  earning  of  which  expenses  for  labor, 
rent,  etc.,  were  incurred. 

If  tlie  estate  or  trust  derives  income  from  farming,  see  Instruction  5. 

Describe  the  btisineas  or  services  rendered,  as  "grocery,"  "reiail  clothing,"  "dnig 
store,"  "jobber,"  "importer,"  "broker,"  "farmer."  etc..  on  lino  1,  Schedule  B,  page  2 
of  the  return. 

Enter  also  on  line  1 ,  Schedule  B,  the  total  income  from  business  or  sales,  less  any  dis- 
counts'or  allowances  from  the  sale  price. 

If  engaged  in  a  trade  or  business  in  which  the  production,  purchase,  or  sale  of  mer- 
chandise of  any  kind  is  an  income-producing  factor,  secure  from  the  Collector  of  Internal 
E«venue  and  file  as  a  part  of  this  return  a  CertiJicaU  of  Imerttrjjy,  Form.il?6. 

Solaria. — Enter  on  line  10  all  salaries  and  wages  not  reported  as  "Labor"  on  line  2. 

Rent. — Enter  on  line  11  rent  on  business  property  in  which  the  estate  or  trust  has  no 
equity.  Do  not  Include  rent  for  dwelling  occupied  by  any  beneficiary  for  residential 
purpoeea. 

Interest. — Enter  pn  line  12  interest  on  business  indebtedness  toothers.  Do  not  include 
interest  of  the  estate  or  truft  on  capital  invested  in  or  advanced  to  the  husinesB. 

Tojcs. — Enter  on  line  13  taxes  on  business  property  or  for  carrying  on  business.  Do 
not  io'-'Iude  taxes  assessed  against  local  benefits  of  a  kind  tending  to  increase  the  value  of 
the  property  assessed,  as  for  paving,  sewers,  etc, ,  nor  Federal  income  taxee. 

Repavs,  wear  and  tear,  obsoUsceitce.  depletion,  ajid  property  loiscs  (other  than  merehan- 
dige). — Enter  on  line  14.  (a)  ordinary  repaire  required  to  keep  property  in  uRable  condition, 
(t)  reasonable  allowance  for  exhaustion,  wear  and  tear  of  property  used  in  the  trade  or  busi- 
ness, including  a  reasonable  allowance  for  obsolescence,  and  (c)  losses  of  business  property 
by  fire,  etorm,  or  other  casualty,  or  theft,  not  compensated  for  by  insuranre  or  otherwise 
and  not  made  good  by  repairs  claimed  as  deductions.  Explain  these  deductions  in 
Schedule  B. 

The  amount  claimed  for  wear  and  tear  (depreciation),  including  obsolescence,  should 
not  exceed  the  original  cost  of  the  property  (or  if  acquired  prior  to  March  1,  1913,  the  fair 
market  value  on  that  date)  divided  by  its  estimated^  life  in  years.  If  obsplescence  ia 
claimed,  state  why  useful  life  ia  leas  than  actual  life.  \Mien  the  amount  of  depreciation 
and  obsolescence  allowed  equals  tho  cost  of  the  property  (or  if  acquired  prior  to  March  1, 
1913.  the  fair  market  value  on  that  date),  no  further  claim  should  be  made. 

Do  not  claim  any  deduction  for  depreciation  in  the  valye  of  a  building  occupied  by 
any  beneGciary  as  a  dwelling,  or  of  other  property  held  for  personal  use,  nor  for  land  (exclu- 
sive of  improvements  thereon),  nor  on  slocks,  bonds,  and  other  securities. 

Depredatvin  of  palenta,  copyrights,  etc.,  and  depletion  of  mxnet,  etc. — If  you  claim  a 
deduction  on  account  of  depreciation  in  the  value  of  patents,  copjTights,  franchises,  and 
other  legal  privileges,  or  on  account  of  depletion  of  mines  or  oil  and  gas  wells,  see  Section 
214  [a)  8  and  10,  of  the  Revenue  Act  of  1921. 

Arjurrtiiation  of  varfacililia. — If  amortization  of  war  facilities  is  claimed,  see  Section 
214  (a)9,  of  the  Revenue  Act  of  1921,  and  the  Regulations  issued  under  authority  thereof. 

Bad  dcbtt. — Enter  on  line  16  debts,  or  portions  thereof,  arising  from  sales  that  have 
been  reported  as  income,  which  have  been  definitely  ascertained  to  be  worthless  and 
charged  off  ■within  the  year,  or  such  reasonable  amount  as  has  been  added  to  a  reserve  for 
bad  debts  within  the  year.  A  debt  preWouely  charged  off  as  bad,  if  subsequently  collected, 
must  be  returned  as  income  for  the  year  in  which  collected. 

Other  expenaca. — Enter  on  line  17  all  ordinary  and  neceasan.-  bu^ness  expenses  not 
classified  above,  such  as  lire  insurance,'  heat,  and  light. 

Do  not  include  cost  of  business  equipment  or  furniture,  expenditures  for  replacements, 
or  for  permanent  improvements  to  property,  or  living  and  family  expenses  of  any  bene- 
ficiary- 

Dtfial  —If  line  20  shows  a  deficit,  indicate  by  urang  red  ink  or  a  minus  sign. 


17.  PROFIT   FROM   SALE  OF   REAL   ESTATE. 

Describe  the  property  briefly,  as  "farm,"  "house,"  "lot  " 

State  the  actual  consideration  or  price  received,  or,  in  case  of  an  exchange,  the  fair 
market  value  of  the  property  received. 

Enter  the  original  coet  of  the  property  if  purchased  by  the  fiduciary,  and  if  it  was 
acquired  in  any  manner  prior  to  March  1, 1913,  the  fair  market  valueon  that  date.  Incase 
the  property  was  owned  by  the  decedent,  the  basis  for  computing  pro6t  (or  loss)  u 
the  inventory  value  at  the  date  of  death.  Attach  statement  explaining  how  value  ai 
March  1,  1913,  was  determined.  Expenses  incidental  to  the  purchase  may  be  included 
in  the  cost  if  never  claimed  in  income  tax  returns  as  deductions  from  income 

Enter  as  depreciation  the  amount  of  wear  and  tear  and  obsolescence,  or  depletion, 
sustained  since  March  1, 1913  (or  si  nee  date  of  acquisirion,  if  subseqoent  to  March  1, 1913'. 

In  case  the  property  was  acquired  by  gift,  bequest,  devise,  or  inheritance  after  March 
I,  1913,  or  in  any  manner  prior  to  that  date,  see  Section  202  of  the  Revenue  Act  of  1921. 

If  the  net  result  to  be  entered  in  Item  5  is  a  deductible  Ices,  indicate  the  deficit  by 
using  red  ink  or  a  minus  sign 

18.  PROFIT   FROM   SALE   OF  STOCKS,    BONDS.    ETC. 

The  method  of  computation  and  the  information  to  be  submitted  in  the  case  of  sales 
of  stocks,  bonds,  etc  ,  is  similar  to  that  required  for  Item  5,  except  that  subsequent  improve- 
ments and  depreciation  are  not  involved.  The  profit  (or  loas)  should  be  computed  in 
accordance  with  Instruction  17  above. 


19.  OTHER   INCOME. 

Report  all  other  taxable  income  for  which  no  place  is  provided  elsewhere  on  page  1 
of  the  return,  including  dividends  received  on  stock  of  foreign  corporations,  and  corpora- 
tions satisfying  the  conditions  provided  in  Section  262  of  the  Revenue  Act  of  1921 

20.  INTEREST  PAID. 

Enter  as  Item  10  interest  paid  on  other  indebtednees  as  distinguished  from  business 
indebtedness  (which  should  be  deducted  under  Schedules  A,  B.  C,  or  D).  Do  not  include 
interest  on  indebtedness  incurred  for  the  purchase  of  bonds  and  other  obligations,  the  inter- 
est on  which  is  wholly  exempt  from  tax,  except  interest  on  indebtednees  incurred  to  pur- 
chase or  cany  Victory  Liberty  Loan  3J%  Notes,  originally  subscribed  for  by  the  taxpayer 

21.  TAXES  PAID. 

Enter  as  Item  11  personal  taxes  paid  and  all  taxes  on  property  not  used  in  business, 
not  including  those  assessed  against  local  benefits  of  a  kind  tending  to  increase  the  value 
of  the  property.  Do  not  include  Federal  income  taxes,  taxes  imposed  ujxin  the  estate  or 
trust  on  its  interest  as  stockholder  of  a  corporation,  which  are  paid  by  the  corporation  with- 
out reimbursement  from  the  taxpayer,  nor  income  and  profits  taxes  reported  in  column  b. 
Item  18,  page  1  of  the  return. 

22.  LOSSES  BY  FIRE,  STORM,  ETC. 

Enter  as  Item  12  losses  of  property  not  connected  with  the  trade,  or  business,  sustained 
during  the  year  from  fire,  storm,  shipwreck,  or  other  casualty,  or  from  theft,  which  were 
not* compensated  for  by  insurance  or  otherwise.  Loaies  claimed  should  be  explained  in 
Schedule  E,  on  page  2  of  the  return.    (See  Section  214(a)  6  of  the  Revenue  Act  of  1921  ) 

23.  CONTRIBUTIONS. 

Enter  as  Item  13  any  part  of  the  gross  income  which,  pumiant  to  the  terms  of  the  will 
or  deed  creating  the  trust,  was  during  the  accounting  period  paid  to  or  permanently  set 
aside  for  the  use  of:  (a)  the  United  States,  any  State,  Territory,  or  any  political  8ubdi\-iaion 
thereof,  or  the  District  of  Columbia,  for  exclusively  public  purposes;  (6)  any  corporation. 
or  community  chest,  fund,  or  foundation,  organized  and  operated  excluaisely  foe  religious, 
charitable,  scientific,  literary,  or  educational  purposes,  including  posts  of  the  American 
Legion  or  the  Women's  Auxiliary  units  thereof,  or  for  the  prevention  of  cruelty  to  children 
or  animals,  no  part  of  the  net  earnings  of  which  inures  to  the  benefit  of  any  private  etock- 
botder  or  individual;  or  (r)  the  special  hind  for  vocational  rehabilitation  authorized  by 
Section  7  of  the  \'ocatioQal  Rehabilitation  Act.  List  names  of  organizations  and  amounts 
contributed  to  each  in  Schedule  F. 

24.  BAD  DEBTS. 

Enter  as  Item  14  all  bad  debts  other  than  those  claimed  as  a  deduction  in  items  above 
State  in  Schedule  P,  (a)  of  what  the  debts  consisted,  (b)  when  they  were  created,  (c^  when 
they  became  due,  and  (d)  how  they  were  actually  determined  to  be  worthless. 


2S.  OTHER  AUTHORIZED  DEDUCTIONS. 


Enter  as  Item  15  all  other  deductions  a 
elsewhere  on  page  1  of  the  return.  Do  nc 
were  neither  connected  with  the  trade  o 
deduction  claimed  should  be  explained 


ithorized  by  law  for  which  i 
t  deduct  losses  incurred  in 
■  business  nor  entered  ini 
.n  Schedule  F. 


)  place  is  provided 
for  profit.    Any 


1706 


IF  RETURN  IS  FOR 

CALENDAR  YEAR  1921 

FILE  IT  WITH  THE 

COLLECTOR  OF  INTERNAL 

REVENUE  FOR  YOUR 

DISTRICT  ON  OR  BEFORE 

MARCH  15,  1922 

IF  FOR  A  PERIOD  OTHER 

THAN  A  CALENDAR 

YEAR  THE  RETURN 

SHOULD  BE  PILED  ON  OR 

BEFORE  THE  ISTH  DAY 

OP  THE  THIRD  MONTH 

FOUjOWINC  THE  CLOSE 

OF  SUCH  PERIOD 


INDIVIDUAL  INCOME  TAX  RETURN 

fOB  NTT  INCOMES  OF  HOK£  THAN  JS.W.  OR  SEPARATE  RETUHNS  OF  HUSBAND  AND  WIFE  IF  COMBINED  NH  INCOME  UCEEDS  iS,000 

FOR  CALENDAR  YEAR  1921 


Or  for  pertod  E>cgun 


_,  1920,  and  ended  . 


PRINT  NAME  AND  ADDRESS  PLAINLY  BELOW 


OCCUPATION.  PROFESSION,  OR  KIND  OF  BUSINESS  . 


Do  not  write  in  this  &fkace 
FIRST  PAYMENT 


Caihier's  Stntnp 


CASH    CHEa    MO.  CERT.  OF  If 


Sworn  to  and  nibacribed  before  me  thii . 


1.  Are  vou  a  citizen  or  reeident 
ot  the  United  States? 

4.  U  not.  is  a  Ecparatc  return  being                    If  ao,  etat«:  (a)  Namo  end  oddreea 
filed  by  your  hueband  or  wile? „ entered  at  head  of  that  return 

5.  Were  you  married  and  living  with  huoband  6.  If  not,  were  you  oq  tho  laat  day  of  vour  taxabl';  period  Bupporting  one  or  more  peraonB 

or  wile  on  Wife  lafll  day  of  your  tax*blo  period? living  in  yowbouBehold  whoare  cloecly  related  to  you  by  blood,  marrioge,  or  adoption?  . 

7.  How  many  dcpeodcut  persons  (other  than  huBband  or  wife)  under  18  years  of  age  or  incapable  of  ecU-support  becauso 


3.  la  this  a  joint  return 

of  huaband  and  wife? 

(6)  Exemptioa 
claimed,  j_ 


•ntally  t 


ly  dcpeodcut  persons  (otner  tfitn  ousoano  or  wiiej  under  JS  years  ol  age  or  lacapabio  ol  eclf -support  becauj 
phyaically  deicctive  were  receiving  their  chief  gupport  from  ycu  on  the  laat  d&y  o(  your  ta.table  period?^ 


ffi: 


INCOME. 


1 .  SaUriea.  Wages.  CommimooB.  c 


2.  lotereetonBank  Depouta,  Notea,  Mortgagea^-^nd  Corporation  Bond? , _ 

3.  iDCome  from  Futnerabips,  Pidudaries,  etc.    (State  name  and  address  ui  puinerehipa,  etc.) 

4.  Rents  and  Royalties - ^ , 

5.  Profit  (or'loflB)  from  Businees  or  Profeaaion  (not  including  income  from  parlnerehipe) 

C.  Profit  (or  loaa)  from  Sale  of  Real  Estate „ 

7.  Profit  (or  loao)  from  Sale  of  Stocks,  Bonds,  etc  ^ 

8.  Dividends  on  Stock  of  Domcetic  Corpoiationa 

9.  Taxable  Interest  on  Liberty  Bwiido,  tfic.,„ 

.0.  Other  locomo  (including  dividends  received  on  stock  of  fordgo  co:porations).    (State  oature  of  inoDme.) 


Total  Income  im  Iteus  I  to  10  (lees  looee  shown  therein,  if  any)..„ 

DEDUCTIONS. 

.  Interest  Paid  (not  including  intcroal  deducted  above) „ . 

.  Taxea  Paid  (not  including  taxes  deducted  above) _ ^ „ i„... 

.  Losses  by  Fire,  Slorro,  etc — — „ „„. 

.  Coolribuliona „ «, „ 

.  Bad  Debte  (not  including  bad  dcbu  deducted  above) 

.  Other  Dcduclioni  Authorized  by  Law _ _ 

Total  or  Items  12  to  17  .,_ _ 

Net  Income  (Hem  11  minua  Item  18) 


COMPUTATION  OF  TAX. 


20.  Net  Income  (Item  19  above). __^ 

21.  Ltm:  Dividrndn  (Item  8  above)... 

22.  Taxable  Intercnton  Liberty 

BoiidH,otc.(IIcmOabovc). 

£3.  Forsonal  Exemption  and 

Credit  for  Depcudonte 


24.  Total  or  Itkhs  21,  22  and  23 

25.  D4Jaoco(lt«m  20  minus  Item  24) 

26.  Amount  taxable  at  4%  (not  over  HOOO) 

27.  Balance  taxable  at  8%  (Item  2^  minus  Item  26} l> 

Chvcka  and  drafta  will  be  accepted  onljr  If  pareMe  at  par. 


28.  Normal  tax  (4%  of  Item  26} «. ._ 

29.  Normal  ux  (8J&  of  Item  27) _ 

30,  Surtax  on  Itom  ZK^'^eo  Io«lniclion  6)  .„.„„. 

31,  Total  Tax.. _, 


32.  I,«m;  Tax  paid  ataoureo ... 

33.  Income  and  proBia   Uxoa 

paid  to  foreifcn  countries 
ur  poaN,<nnuniior  the  V.  8. 
(»ltii<li  l\,rm  IlIC) „ 


34.  Balance  duo  (Uein*31  minus  Items  32  and  33)  . 
36.  Amonnt  of  tax  paid  when  flliag  rctura 


1707 


SCHEDULE  A.— EXPLANATION  OF  ITEM  4.    (Rnitt  • 

nd  Royaltle 

.)    s« 

UBtrarti™  13. 

■.K«„  «,■*,-„. 

^^i°v"Z!^" 

^1^ 

4.  Betaibs. 

4SD  DEPLtTWa. 

I.SSS. 

'SrfiST 

. 

.        I  _ 

1 

r 





L U. 



--l- 

._ L- 

SUte  CTtiniated  life  of  •property  ^nd  bow  yoo  figoretj  depreciatjop.^ 


SCHEDULE  B.— EXPLANATION  OF  ITEM  5.    (Bu 


1.  ToUl  income  inm  busic^sB  or:pn)fe£ 

Con  or  Goods  Solo: 

£.  lAbor _ 


S.  Uaterial  aod  supplic 


4.  UerchftadiBo  bought  lor  eale_ 

6.  Other  coets  (VibI  principal  ite 
below  or  on  aepaiate  Bheet)_ 


6.  Plu8  inventory  -at  begnxning  o£  y«ar„ 

7.  Total 


8.  LeeB  inveuioTy  at  sad  of  yau- 

9.  Net  Cobt  og  Goopa  Bold 


12.  Interest  on  busineaa  indcbtednes  to  nthas- 


13.  Taxee  on  bueincaa  and  business  property 

14.  Repairs,  wear  and  tear,  obsolcsccDCe.  deple- 

tion, and  property  Jotses  (explaia  below)  . 


15.  AmortizatioD  of  tr:if  [ocilities — 

16.  Bad  debts  ar^io?  irom  eaJes  c 
already  reported  a 


-LIZ 


18.  Total  (Items  10  to  17.  inclusive). 

19.  Nrr  Cost,  plvs  Total  Dcducoonb  CUem  0  plus  Item  18). 

20.  Net  Paonr  (or  Loss)  riroM  Bpatygga  on  pRon»eiow  (lf< 


ExplADation  of  dednctiooa  _ 


SCHEDULE  C.-'EXPLANATION  OF  ITEM  S.    (S«li  of  Re>l  EMite.)     E 

toIl»U<Ui«l 

1.  Ecn>  0 

,P.o™t,. 

:.  !>.„  AC,™.. 

..A«>™.Erm™,. 

1.  Cear.                ^  Uakh  I.  1S13. 

iMrKovuiem 

.  Dmixixmr. 

'■(■jLojuf" 

I 

■«                    1 

L 

1 

1 

1 

1           1 

1 

T  "T "■ 

1 

1    1 

If  not  acquired  by  purchaae,  state  how  acquired  - 


SCHEDULE  P.— EXPLANATION  OF  ITEM  7.     (Sale  of  Stocks.  Bonds. 


L  KXtta  OP  FXOFESTT. 

AC<lpiB?D.                                ^  *^*'"- 

4.  UMMCn  1,  1913, 

6.  Auoovr 

6.  Set  Pwmr 

(0&  L039]. 

' 

1 

1                1 

it  acquired  liy  purcbat 


r  acquired 


SCHEDULE  E.— EXPLANATION  OF  ITEM  9.     (Taxable  Interest  on  Liberty  Bonde,  etc) 

So  lastnnko  u 

(WhoUy  txiapt  bom  aonul  lu,  but  Mbjnt  tonutu  u  U,  excess  ovtr  exempthnu  specified.) 

Eitmrrovs. 

1' .TESSA'S" 

orExoim 

thtn. 

;.  oo.om. 

1  SIIS.OOO, 

4.K 

fl».            I  'SZi'sia^l^s^Ajra  " 

o». 

(c)  Other  ObligaUoM  iatued  eince  September  1,  1917(exc«pi  Vicisry  MdTwenryN-o(«). 

SOME 

(()         Total  Taxable  Ixtehest  (It  you  have  bought  or  eold  during  the  year  attach  statement  showioe  holdiogg  by  periods) 

^ 



SCHEDULE  F.— EXPLANATION  OF  ITEM  ».    (Lomct  by  Fir«.  Storm,  etcl    s«»  liMn«lo 


i.^  »«<«-«. 

t.  EuTAoe  Taoe.          £.  Ijraoaufcs. ' 

6.1<*7tLanL 

1     '. 

._      J 

, 

1 



SCHEDULE  C— EXPLANATION  OF  DEDUCTIONS  CLAIMED  IN  ITEMS  1,  IS.  16.  AND  17. 


(An  amended  retORimtiat  be  phinly  mailied  "Anaestled" . 


•  thefac*  of  the  retmn.) 


1708 


DUPLICATE 


INDIVIDUAL  INCOME  TAX  RETURN 

FOR  NET  INCOMES  OF  MORE  THAN  $5,000.  OR  SEPARATE  RETURNS  OF  HUSBAND  AND  WIFE  IF  COMBINED  NET  INCOME  EXCEEDS  JSjNt 

FOR  CALENDAR  YEAR  1921 


DUPLICATE 


Or  for  period  begun _.,  1920,  and 


OCCUPATION.  PROFESSION,  OR  KIND  OF  BUSINESS — 


TAXPAYER'S  RECORD  OF  PAYMENTS. 


Second  . 
Third... 


4.  If  DOt,  is  a  separate  return  being 
filed  by  your  bueband  or  wife? 

5.  Were  you  marriod  and  livint*  vith  husband 
or  wife  on  the  last  day  o!  your  tajtabic  period?. 


2.  If  you  61cd  a  return  for  1920,  to 
what  CoIIector'a  office  was  it  eent? ... 
(a)  Name  and  add  rce 


entered  at  bead  ol  (hat  r 


of  buaband  and  wile? .-.. 


1  the  last  day  of  your  taxable  period  euppurtine  one  or  more  pereont 
old  who  arc  cloeely  related  to  you  by  blood,  marnagc.  or  adoption?  ^ 


StClhk 


1    Salaries,  Wages,  Commis 


.  Interest  on  Bank  Deposits,  Notes,  Mortgageo,  and  Corporation  Bondfi 

.  locotno  from  PftrtnerBhipo,  Fiduciarica.  etc     (Suie  name  and  address  o(  partncrahipa,  ct 

Rcntaand  Royalties _ „ — ; . _ 

.  Prorit  (or  loea)  from  Business  or  Profoaaion  (oot  including  income  from  partoenhipa) 

Profit  (or  loea)  from  Sale  of  Real  Estate. - 

Profit  (or  loss)  from  Sale  of  Stocks,  Bonds,  cic — — 

Dividends  on  Stock  of  Domestic  Corporations ^ 

Taxable  Interest  on  Liberty  Bonds,  etc _ — -. 

Other  I  ocome  (including  dividends  received  on  stock  of  foreign  corporations)      (StAte  □ 


Total  If.-coue  i.>*  Items  1  to  10  (Icsb  losses  shown  ibcioin,  ii any) . — 

DEDUCTIONS. 
latcrcet  Paid  (not  including  inlercel  deducted  above) - 

.  Taxes  Paid  (not  iocludiog  laie«  deducted  above) _ 

.  Losaes  by  Fi/e,  Storm,  etc _._ — 

.  Bad  Debu  (not  including  bad  debts  deducted  above) . »»._ 

Other  Deductions  Authorized  by  Law - __...„,. _._., 

Net  Iscomk  (Hem  II  minus  Item  IS)  -.- _■■ 

COMPUTATION  OF  TAX. 


20.  Net  Incomo  (Item  19  above) 

21    Lett:  Dividcoda  (It«m  8  abovo).^..  | 

Taxable  Int«rcitoo  Liberty 

Boiids,  ('ic.(It«m9abpve) „.. .. 

Personal  Exemption  and 
Credit  for  Dependents | — |.. 

24  Total  of  Iteus  21,  22  and  23 - 

:i.  Balance  (Item  20  minus  Item  2A) __ 

C    Auiouul  taxable  at  4  ;i  (not  over  $4,000) 

7    Balance  laxabU  at  »f«  (Kern  26  minus  Iiom  2C)... 

Ch*cks  and  drafts  will  be  acespttd  only  If  payabi*  at  par. 


28.  Normal  tax  (4^  of  Item  2C) 

29.  N'omaJ  Ux  (8jC  of  Item  27) 

30.  Surtax  on  Item  20  (see  InstnicUoa  e) 

ToTAi.  Tax  ._„-__«_ ,..._ 

32.  Lm;  Tax  paid  at  source |.„ 

23.  InDjino  and  (>roflU   Uxes 

paid  to  (orrign  countries 

or  p^>w<.>noi(>aHo(  tho  U.  8. 

(atladi  Fonn  Itl6) -..|.- 

,  Balance  duo  ^Iirui  J1  minus  Items  32  and  33)  .„. 
3S.  Amount  of  u»  paid  wbcu  Clinp  rotuni 


1709 


SCHEDULE  A.-C3a>tANATI0M  OF  ITEM  4.    (R<ntc  • 

nd  Rojralties.)     SeetaawHrfilS. 

<.=„«,r««„. 

2.Ci»r.o«UAiCO 
1.1S13,  V^Cl. 

JtecovxD. 

..„.» 

«  DtnicuTiOT 

liSS. 

J.  KETPlOfn 

,_  ..  1 

1 

1 

i 

j;i_.. 

j 

.  ...1  . 

Stale  cgtiiP«tcd"li/e  of  property  and  bow  you  figured  depreciation^.. 


SCHEDULE  B.— EXPLANATION  OF  ITEM  5.     (Bui'neM  or  Profg«riOTi.)     8w  Ustrocttai  h 


1.  Total  iocome  bom  busine6S  or;profe£ 
Con-  or  Goods  Solo: 

2.  Labor 

3.  UftteriaJ  and  supplies 


4.  Merchaodiee  bou^t  for  calc. 

&.  Other  oofite  (list  principal  itema  aodj 
below  or  on  separate  tncet) „. 

6.  Plus  inventory  -tX  begimuiig  ol  year_ 

7.  Total 

8.  Lees  inve11t017.At.and  of  ywr 

9.  Net  Cost  01 -Goose  Sols.. 


line  2  (see  Icstruclioo  13). 

property  in  which  tixpayCT 


Othes  Bl-eine33  DeoDcnoKs: 

20.  Sal:irie9  uid  wa^  not  reported 

,_  line  2  (see  1  Hi" " 

IL  B«ot 

has  no  equity, 

42.  Interest  on  buanaaR  indebtedness  to  ntheiB.^ 

13.  Taxee  on  business  and  businese  property 

14.  Repaira,  wear  and  tear,  obeoleeccnce,  deple- 

tioc,  and  property  losses  (explain  below)  . 


12.  Other   cxpoa-ies   (list  principal 


below  or  on  eepaote  sheet) 

18.  Total  (Itema  10  to  17,  iocluaive) 

19.  Net  Cost,  plus  Total  Deduchovs  (Ilam  0  ptin  Item  18). 

20.  Net  Pboctt  foa  Loss)  tuoh  Boatwesa  or  PaorEasiow  (lt< 


Expl&nation  of  dedoctiooa- 


SCHEDULE  C.-^£XPLAWATIOW  OF  ITEM  6.    (Sale  of  R— I  Ertrtc.)     BtelMmiiaai: 


L  EtSD  or  FBorxBTT. 

7.  Dtn  AcQUiixp. 

3.  AMomr  RtconD. 

«.  Cost. 

i  Kyoi  1.  l»U. 

6.  Buaau)Vt^T 

7.  DmBcu-noK.            "^(^Lcwy"* 

r:            ..'.       . 

[. 

1 

r 

1 

1 

1 

1 



1 

_„. 

If  potncqnired  by  pnrchafie,  state  how  acqnired  .. 


SCHEDULE  P.— EXPLANATION  OF  ITEM  7.    (Sale  of  Stocka,  Bonda. 


.  Ecm  or  FxorcETT. 


If  pot  acquired  by  purcLa^^,  atAte  how  ac<]nirod.- 


SCHEDULE  £■— EXPLANATION  OF  ITEM  9.    (TaMblo  Inter— t  on  Uberty  Bondi. . 


(WhoQ;  exuopi  bom  Boaal  tax,  buEJUbisat  toauUx  u  to  exnas  orec  extt&pOom  fpKlfltd.) 

EirMrrowa. 

(AfptOte  PrtCQpsl  AEBOOat.) 

5.  PsnarAt  AMoinrT 

..ta«maro.^P«^ 

7.  O0.0M. 

xs;z$.ooo. 

*.iijcao. 

orExximioia- 

(0  Other  ObUgationfl  issued  ainM  September  1, 1917  (exoept  VictoiTud  TraaarrKcUs). 
(rf)  Vtcuiry  T.rr>«rty  Iran  -Ij^  Nftt«,  and  TrpaFiiryNotfw      

.... 

*:«., 

w«« 

TZZZE 


SCHEDULE  F.-EXPLANATION  OF  ITEM  H.    (Looea  br  Fir.,  Sto™..  «c)   So  Innuioo  a 

L  Ean>  <»  nonan. 

iCor.GsUjucB 

l.i»ii,vucx^ 

a.  DxnscuTKur 

«.  eu.**o<  Tjattx. 

■TSmcaAjrcx. 

A. 

»«L-. 

, 

. 

SCHEDinX  C.-EXPLANATION  OF  DEDUCXIONS  CLAIMED  IN  ITEMS  J,  J5,  IS,  AND  17. 



(»n«Tnmd»J»»tMBaMMtt».p)«lBl7jn«»JMJ  "^in«nil»il"<aw»th»>if»«lth»»«tB;n.) 
I7IO 


INSTRUCTIONS  FOR  INDIVIDUAL  RETURN 


I.  PERSONS  REQUIRED  TO  MAKE  A  RETURN  OF  INCOME. 

An  Incomo  ta:^  return  must  be  filed  by  every  citlren-  of  the  United  States 
whether  residing  at  homo  or  abroad,  and  every  person  residiDj;  In  the  United 
«toto«,  though  not  a  citizen  thereoP,  whose  gross  Income  for  the  taxable  period 
192lamoarrtcd  to  J5,000,  or  whosenetlncomeamoontcd  to— 

(i)  81,000  IfsingleorifmnniedandnotHvine  with  husband  or  wife. 
'  (6)  S2,000  Jf  mnrried  and  hvinc  with  husbana  or  wife. 

If  the  combined  net  income  of  Qusband,  wife,  and  dependent  minor  chil- 
dren equalled  or  exceeded  $2,000.  or  If  the  combined  gross  income  of  husband, 
wife,  and  dependent  minor  children  equalled  or  exceeded  $5,000  all  such  Income 
must  be  reported  on  a  joint  return ,  or  on  separate  returns  of  husband  and  wife. 
Ifslngloand  the  net  income.tncluding  that  of  dependent  minors.ifany,  equalled 
or  exceeded  $1,000,  or  if  Ibe  pross  income  equalled  or  e:tceeded  $5,000,  a  return 
must  be  filed.  A  minor,  however,  having  a  net  income  of  $1,000  or  $2,000,  ac- 
cording to  the  marital  statu»,OT  a  eross  Income  of  $5,000.  must  file  a  return. 

Under  each  of  the  above  -conditions,  a  return  must  be  filed  even  though 
no  taxis  due.  Note  especially  Histructfon  8,  "Credits  for  Personal  E:cemp- 
tionand  Dependents.'' 

The  Income  of  a  minor  or.  incompetent,  if  derived  ^rom  a  separate  estate 
under  control  df  a  guardian,  trustee,  or  other  fiduciary,  must  be  reported  by  his 
guardian  or  otatr legal  representative 

Income  of  ia>  estates  of  decedents  before  final  settlement;  (6)  trusts,  whether 
cfMted  by  ^tll  or>ie5d,  for  nnas«vrtalTied  persons  or  persons  with  contingent 
Interests,  or  income  held,  or  wbichyn'^der  the  terms  of  the  wUI  or  trust  may  bft 
held,  for  future  distribution,  i3f-«i:v.»'I  to  the  fiduriarv  as  a  single  person,  except 
t^at  from  theincome  olan  estate  there  may  first  be  deducted  any  amount  prop- 


administrator  ahaU  file  a  return  on  Form  1040  or  1040A  for  eucb  decedent. 
2.  WHEN  TO  USE  FORM  1040  INSTEAD  OF  THIS  FORM. 


lb)  Ifyoornetlncome exceeds $5,000. 

(e)  If  the  net  income  reported  In  this  rettuno  exceeds  $4,000  and  the  entire 

lamilr  cxemptlQQ  has  been  claimed  tn  a  e^arate  return  filed  by  husband 


3.  PERIOD  TO  BE  COVERED  BY  RETURN. 

Your  return  must  be  filed  for  the  calendar  year  ending  December  31.  1921. 
or  for  the  fiscal  year  ending  on  the  last  day  of  any  month  other  than  December. 
The  dates  on  which  the  period  covered  by  the  return  begins  and  ends,  If  otbw 
than  a  calendar  year  must  be  plainly  stated  at  the  head  of  the  return 

You  were  required  to  fUe  ymir  return  for  1918  on  the  basis  of  your  annua! 
accountingperiod,  HavingeatabUshed  an  accounting  period  for  1018  thteperiod 
must  be  adhered  to  for  subsequen  t  years,  unless  permission  was  receivod  from 
the  CommiasioD^  to  make  a  change.  In  the  case  of  a  return  for  a  period  of  less 
than  one  year,  the  net  income  ahaJl  bo  placed  on  an  annual  baeisbv  multiplying 
the  amount  thereof  by  twelve  and  dividing  by  the  number  of  months  included 
In  such  period:  and  the  tax  shaUbesuch  part  of  a  tax  computed  on  such  annual 
basis  as  the  muaber  of  monthsinsuch  period  Is  of  twelve  moDtbs. 

4.  ACCRUED  OR  RECEIVED  INCOME. 

'If  your  books  of  account  are  kept  on  an  accrual  basis,  report  all  Income 
accrued,  even  though  It  has  cot  been  actuallv  received  or  entered  on  the 
boo^,  and  expenses  incurred  instead  of  expenses  paid. 
If  your  books  do  not  show  income  accrued  and  expenses  Incarred.  report 


5.  INSTALLMENT  SALES. 

If  you  hava  used  the  lastiinineDt  method  In  computing  Inoamfi-  fmm  la- 
stallment  salts  you  most  attach  tu  y^r  rettmi  a  schedule  showing  separately 
for  the  years  191»,  1919,  1920,  anj  1921  the  fo&owing  Information:  (a)  Oross 
sales;  (6)  coat  of  goods  sold;  (c)  gross  pfofits;  (i)  percentage  of  profits  to  gross 
salw;  {e)  amount  collected;  (/)  gross  prt^t  on  amount  collected. 

6.  ITEMS  EXEMPT  FROM  TAX. 

The  following  Items  are  exempt  from  Federal  income  tax  and  sboald  not 
be  reported,  unless  It  is  desired  to  establish  a  net  loss.  In  which  case  see  Section 
264  of  the  Revenue  Art  of  1921: 

(a)  The  proceeds  of  life  Insurance  polldos  paid  upon  the  death  of  the  Insured; 

m  The  amount  received  by  the  Insured  as  a  return  of  premium  or  premiums 
paid  by  him  under  life  Insurance,  endcjwment,  or  annuity  contracts,  either 
daring  the  term  or  at  the  maturity  of  thertenn  mentioned  in  the  contrart  or 
upon  surrender  of  the  contract; 

(r)  Gifts  (not  roade  as  a  considaratlan  for  aervlce  rendered),  and  money  and 
property  acquired  under  a  will  or  by_ inheritance  (but  the  Income  derived  from 
money  or  property  received  by  gift,  wfll,  or  Inheritance  Ic  taxable  and  must  be 
reported); 

(d)  Interest  upon  (I)  the  obligations  of  a  State,  Temtoiy.  or  any  political 
subdiviKlon  thereof,  or  the  District  of  Columbia;  or  (2)  securities  Issued  under 
the  provisions  of  the  Federal  Farm  Loan  Act  of  July  17, 1916;  or  (3>  the  obliga- 
tions of  the  United  States  or  Its  poase-sslons;  or  (A)  bond.s  issued  by  the  War 
Finance  Corporation.  In  the  case  of  obligations  of  the  United  States  isntod 
aftf  r  September  1,  1917  (other  than  postal  savings  certificates  of  deposit),  and 
in  the  case  of  bonds  issued  by  the  war  Finance  Corporation,  the  interest  Is 
•xmpt  only  if  and  to  the  extent  provided  In  the  respertlv©  acts  authorizing 
thtt  L-isue  thereof  as  amended  and  supplemented  by  Section  1328  of  the  Revenue 
Act  of  1921,  and  should  be  excluded  from  grosslncomeonlylfand  to  the  extent 
It  is  wholly  exempt  to  the  taxpayer  from  Income,  war  profits,  and  excess  profits 
Kiles; 

(e)  Amounts  received  through  acddent  or  health  Insuranco  or  onder  work- 
men's compensation  acts,  as  compensation  for  personal  Injuries  or  sickness,  plus 
the  amount  of  any  damages  received,  whether  by  suit  or  agreement,  on  accoont 
of  iuch  in  hiries  or  sickness; 


(/)  Amoimts  received  as  eompensatloo,  family  allotment?  and  allowances 
und^  thtf  provisions  of  the  War  Risk  Insurance  and  the  Vocational  Rehabilita- 
tion Acts,  cr  as  penMons  from  the  United  States  for  ser\'Ico  of  the  beneQclary 
or  anotherin  the  military  or  naval  forces  of  the  United  Slates  In  time  of  war: 

(g)  The  rental  value  of  a  dwelling  house  and  appurtenances  thereof  famished 
to  a  minister  of  the  gospel  as  part  of  his  campensation; 
'  (A )  Compensation  paid  by  a  State  or  political  subdivision  thereof  to  Its  ofllcftts 
or  employees. 

7.   FARMER'S  INCOME  SCHEDULE. 

If  you  are  a  farmer  or  a  farm  owner  renting  your  farm  out  on  shares  and  keep 
no  books  of  account,  or  keep  books  on  a  cash  basis,  obtain  from  the  Collector, 
and  attach  to  this  return.  Form  1040  F,  Schedule  of  Farm  Income  and  Expenses. 
Enter  the  net  farm  Income'as  Tteni  6,  page  1  of  tlio  return.  If  vour  farm 
books  of  accoimt  are  kept  on  an  accrual  basis,  the  filing  of  Form  1040  F  its  optional. 
Report  income  from  salaries,  interest,  rents',  sales  of  property,  etc.,  in  Items  1  to 
7  of  the  return. 

8.  CREDITS  FOR  PERSONAL  EXEMPTION  AND  DEPENDENTS. 

If  you  were  married  and  living  with  yoitr  husband  or  wife  or  wore  head 
of  a  family  on  the  Last  day  of  your  taxable  period^  you  may  subtract  from  your 
net  income  on  Form  IOWA,  iktoTe  calculating  your  uorniJil  tax,  an  exemption 
of  $2,500,  plus  WOO  for  each  person  (ojhertlian  husband"  or  wife)  under  IS  years 
of  age  or  ini^pable  of  self-support  because  mentally  or  physically  detectlye,  who 
was  receiving  his  chief  support  from  yon  oiL^t^t  date.  If  husband  and  wifo 
make  separate  retnms,  the  exemption  or$2,500  may  be  claimed  by  either  (but 
not  by  both)  or  may  be  divided  between  them,  but  the  f -teinptlon  of  HOO  for 
each  dependent  may  be  clafmiid  only  by  the  person  fumishJng  tbe  chlel  support. 

If  you  were  noLjnarried  or  did  not  five  with  husband  or  vrife  and  wer© 
not  head  of  aftfnliJv  on  the  last  day  of  your  taxable  period,  you  are  entitled  to 
4  personal  esemption  of  $1,000  plus  $-tOO  for  each  dependent  person  under  J8 
years  ofage  orlncapable  o/solf-sQpport  because  mentally  or  physically  deleo- 
live,  who  was  receinng  hia  chief  support  from  you  on  that  date. 

An  exemption  of  $1,000  may  be  claimed  In  cases  where  Form  I040A  la  filed 
forestates  In  process  of  adminiatraUon,  or  with  respect  to  Income  held  lor  futore 
distribution. 

If  bv  reason  of  a  change  in  your  accounting  period  a  return  Is  filed  far 
part  of  a  year«  the  personal  exemption  and  credit  for  dependents  may  be  claimed 
In  accordance  with  your  statua-on  the  last  day  of  such  taxable  peilod.  (9e» 
olsoInstractlonS  on  this  page.) 

A  "bead  of  family"  is  a  person  who  actuaUy  supports  one  or  more  persons 
Uvlnx  in  his  (or  her)  houaebold,  who  are  closely  related  to  liim  (or  her)  by  blood, 
mamage,  or  adoption  .- 

9,  AFFIDAVIT. 

The  afQdavit  must  be  executed  by  the  peraqn  whoiSe  Income  Ls  reported 
onless  be  is  a  minor  or  Incompetent,  or  onlesshelslU,  absent  from  the  country^ 
or  otherwise  incapacitated,  In  Miich  case  the  legal  representative  or  agent  may 
execute  the  affidavit.  A  minor,  however,  making  his  own  return,  must  execute 
the  affidavit. 

The  oath  will  be  administered-  without  charge  by  any  collector,  deputy 
collector,  or  Inteoul  revenue  agent,  or  (If  you  are  in  the  military  or  naval  service 
of  the  United  States)  by  any  militaiy  or  naval  officer  who  is  autborlzed  to  admin- 
ister oatha  for  pwposea  of  military  or  naval  justice  and  administration.  If  an 


10.  WHEN  AND  WHERE  THE  RETURW  MUST  BE  FILED. 


on  or  before  March  \5,  1922.  If  tor  a  ptsriod  other  tiian  the  calendar  year,  the 
return  should  be  filed  on  or  before  the  15th  day  4>f  .tbo  third  month  following  the 
close  of  such  period. 

In  caso  the  taxpayer  had  no  legal  residence  or  plac«  of  business  in  the 
United  Otates,  the  rettim  should  be  forwarded  to  the  Collector  of  Internal  Revet 
nue,  Baltimore,  Md. 

IT  the  address  of  tbe  oolleotor  ^  not  prloted  on  the  return  and  yoa  do  not 
know  It,  ask  at  the  post  ofSce  <x  bank. 

11.  WHEN  AND  TO  WHOM  THE  TAX  MUST  BE  PAID. 

The  tax  should  be  pala,  If  possible,  by  sending  or  bringing  with  the  return 
a  ciieck  or  money  order  drawn  to  the  order  of "  Collector  of  Internal  Revenna 
at  (insert  name  of  dty  and  State).'' 

Do  not  send  cash  through  £hQ  maD;  or  pay  It  In  person,  except  at  the-offlca. 
ofthecolloctor. 

The  tax  may  be  paid  In  four  equal  installments  as  follows:  The  first  lostall- 
ment  shall  be  paid  at  the  time  fixed  by  law  for  filing  the  return,  the  second 
Installment  shall  bepaid  on  the  16th  day  of  the  third  month,  the  thirdinstalEmont 
on  the  I5thday  of  the  sixth  month,  and  the  fourth  installment  on  the  15th  day 
of  the  ninth  month  after  the  time  fixed  by  law  for  filing  tho  return. 

Tho  total  tax  may  bo  paid  at  the  time  of  filing  th»  return,  or  If  not  so  paid, 
one  installment  must  bo  paid  and  the  balance  may  bo  paid  in  instaUmentf,  or 
InfulJ,  on  or  prior  toany  subsequent  installment  daiereferredtoabovo.  Failtire 
to  pay  any  installmeut  on  the  date  fixed  by  law  makes  the  taxpay'er  liable  for  the 
payment  of  the  balanoe  of  tax  doe  upon  notice  and  demand  by  tho  collector. 

12.  PENALTIES. 

For  Makingr  Fala*  or  Fraudulent  Ratums. 

J  Imprisonment,  or  both, 
jntimao'"- '-*- 

For  Falling  to  Mak*  Ratum  on  Tim*. 

Not  more  than  |1,000,  and.  In  addition,  25  per  contmn  of  the  total  tax. 


r/ii 


IS.  INCONfE  FROM  SALARIES.  WAGES,  COMMISSIONS.  ETC. 

Report  all  Hbrirt  or  other  ccmpcnsaiioD  rreditcil  by  or  received  from  ouLndc  somcw, 
•od  auy  KiichcsiucluiJH  m  a  dciJu<  iico  on  line  10,  Scbedulc  If.  for  (a)  youisell,  (6)  your 
•■iCc  (cr  hu5l>aDd),  il  a  joint  rrnirn  13  Cilcd.  aod  (c)  each  dctK-odett  nuaor  child  ba\in?  a 
set  inooD\ooi  Ices  thHo  ;^l,00'J  peranoum.  Use  ascpaxaie  Uoc  ior  each  eairy,  giviog  the 
iDfoTCiaiion  requcetc^I. 

Auy  ainoiiDt  cliiinod  as  a  doductioo  (or  tuxfssary  cTpcnsra  acainpt  eaUries.  etc., 
ihould  be  (illy  r'vpI:uoed  la  S<'bedu!t^  O,  pa^c  ?  of  the  return,  or  10  an  iira<.-bed  eutemcot 

Travcli:>L'  c^;t(,r.■c^  (inrludiup  the  eonre  amount  expended  for  oii  nli  and  lodging) 
while  away  from  liouic  id  the  pursuit  of  a  trade  or  bu^iocs  arc  dcduciiblc. 

14.  INCOME  FROM  PARTNERSHIPS,  FIDUCIARIES,  ETC 

Tlf  port  your  (Icfc  fwbetbcr  rccencd  or  not)  in  the  profits  of  a  p-ilnc:i'iip  or  personal 
(cr\iro  eon>oratioi).  or  io  the  icromc  o(  an  csiaic  or  tnist,  e^f  cpl  iHe  part  &(  euib  t-bare 
that  con?iilc'I  01  dividccds  03  «locW  o(  doi"f5lic  corpora tioD'^,  anj  taxable  interest  on 
obli?alion-*o(  the  Untied  butcs.  which  fhoiild  beicciiidcd  id  ItcmvSaody.  rc*pccuvely, 
po~o  1  of  the  return 

r.oport  iQ  Item  1,  ralar>-  received  from  .t  partnership  or  ptrronal  service  corporalion. 

\i  ihc  ta.vabic  |>cnod  or.  the  bi-is  of  "h»  h  \ou  file  -.o-.ir  rc'.iUD  f*.U  to  comnde  «Tib 
ihc8Lnualarcciinlin7iviiwJof  ibcpaiiucr-hip.  peroDafscrvicccorporaiioD.  or  fiduciary'. 


IS.  INCOME  FROM  REI^TS  AND  ROYALTIES. 


Le  reported  a3  iniome  for  the  year  to  ubicb  disposed  of  (ualess  y 
occniedV 

Exptais  in  Schedule  A.  repairs,  dcpreciatioD,  depIetioD.  and  olh< 


',  hiel,  light,  labor,  and  other 


16.  INCOME  FROM  BUSINESS  OR  PROFESSION. 

Report  iD  Item  5  the  net  profit  (or  loas)  from— 

(n)  Sale  oC  mercbandiie.  or  of  producia  of  maDufaclimng.  construciioo.  m 
ftgrifuHuro 

<fe)  Busings  fervire,  eucb  as  traosponation,  alorHpe.  laundmn?.  hotel  and 
•ervive,  livery  and  parace  fervicc,  etc.,  if  you  owned  the  busintss.  If  y 
eanployee  of  a  hunnes-.  report  your  salary 


dentistry,  if  you  pncticed  il  OD  yoor  o»n 
5n!ary,  report  your  salary  in  Item  1. 

ncome  in  the  eamiof:  of  ubicb  you  ineurred  expenses 


Qg  yoiir  farm  to  another  person  on  shares), 

'  epace  provided  on  pa£0  1,  aa  "frocery," 
"docior,"  "lawyer,     "ianner,"  etc.,  and 


(r)  A  profession, 
Bccount.  .  If  vou  acre  employed  c 

Ineeneral,  report  in  I  tarn  ^,  any  income  1 
ior  tabor,  rent,  etc. 

If  you  are  a  farmer  (or  a  farm  owner  reo 

De^ribe  the  bu?ines3  or  jrclession  in  t 
"retail  clorhine,''  "drup  store,"  "laundry, 
fill  in  Schedule  B,  page  2  of  the  return. 

Enter  on  line  1,  Schedule  B,  the  total  income  from  sales  or  services,  less  any  disrounts 
01  alloyrances  from  the  -*ale  price  or  service ctLarge.  ( For  installmenlEalessce  Instruction  4), 

li  you  are  engaged  in  a  trade  or  business  in  which  the  prodooion.  purcbaee.  or  sale 
of  morchandiso  of  any  kind  is  an  income-producing  Lictor.  secure  from  the  Collector  of 
iDtemal  Revenue  and  file  aa  a  psirt  of  this  rciura  a  CerlificuU  of  Jntentory,  Form  11S6. 

Satarus  —Enter  on  line  10  all  ealancs  and  wages  not  reported  as  "  Libor"  on  line  2. 
Salary  or  wages  for  yourowu  ecr^ncesor  tho  een-icea  of  your  aepefident  minor  children,  if 
deducted,  must  be  reported  as  income  in  Item  1. 

/?fn/— Enter  on  line  11  rent  on  busineaa  property  in  which  you  Lcvo  do  equity.  Do 
not  include  rent  (or  dwelUng  vou  occupy  for  residcniial  purposes 

/mcrcjr— Enter  on  line  12  interest  on  busineflaindcbiedcosstoolhera.  Do  not  include 
interest  to  yourself  on  capital  invested  in  or  advanced  to  tbc  business. 

Taxes  —Enter  on  line  13  lanes  on  business  property  or  for  canying  on  busineaa.  Do 
not  include  uxca  aasessed  agaiait  local  benefits  of  a  kind  u-uding  10  increase  the  value  oi 
the  property  assessc-d,  m  for  paWng,  ecwcrs.  etc.,  nor  Federal  i 


,  obioUsccna: ,  iIcpUl 


.  ond  proptrii/  losses  ioHicr  than  TracAoTi. 
dii^).— 'Enter  on  lino  11,  (0)  ordinary  repair's  required  to  keep  property  in  usable  condition. 
(6)  rcasonihlc  allowance  lor  exhauaiion.  wear  and  tc-ar  of  properly  used  in  ihe  trade  erbusi- 
DOe.  including  a  reasonable  allowance  for  obsolcacence,  and  (c)  loiscs  oi  business  property 
by  fire,  storm,  or  other  casualty,  or  theft,  not  compensated  for  Wy  inaurr-ncc  or  otherwise 
and  not  made  e<xid  by  lepaita  claimed  as  deductions.  Explain  these  deductions  io 
Schedule  B.  ,    ,         .     , 

The  amount  claimed  for  wear  and  tear  (ucprcaalion).  including  obsolescence,  chouid 
not  exceed  the  original  cost  of  the  property  (or  if  acquired  prior  to  March  1,  1913.  the  Lir 
market  value  on  that  date)  dnidcd  by  its  estimated  life  in  yeara.  if  obsolescence  is 
claimed,  state  why  useful  life  is  loss  than  actual  life.  When  the  amount  of  depreciation 
and  obcolescenco  allowed  equals  the  cost  of  the  property  (or  if  acquired  prior  to  March  \, 


1  d^velbng.  or  of  other  property  held  for  personal  i 
ments  thereon),  nor  on  aiocka.  bonds,  and  other  secuj 
ir<cvi(io«  of  pr.icnis,  copynr,hts ,  c'r.,  and  dcpUtion  of  n 


r  for  land  (exclusive 


other  Icffal  pri>ilege= 


cr  oil  and  (^  wells,  see  Secuon 


214  (o)  9.  of  the  Revenue  Act  of  1021.  and  the  Rc^iUuons  issued  under  authority  iLcrecf. 

B<ii(/<'6:i.— Enter  on  line  16  debts.  0:  portions  thci-cof.  arising  fiorusalcd  or  proftisional 
6er\ncc3  that  have  been  reported  as  income,  which  h.ivc  been  definircly  ascertained  to 
be  worthlesa  and  chatted  oh  mihin  the  year,  or  such  reasonable  amouni.vi  has  been  added 
to  a  reserx-e  for  bad  debts  within  the  year  A  debt  previously  cbargcd  ofi  as  bad,  if  subse- 
quentlv  collected,  must  be  returned  as  income  for  the  veariu  v,hicfi  collected. 

Olher  crp<r,ifs— Enter  on  line  17  all  ordinary  and  necessary  biisine:;3  expenses  not 
cUfsificd  above,  such  as  fire  insurance,  beat,  li^ht.  and  traveliDj  c^petises  (sec  Insinic- 


D;j.cti.—\i  Item  20  tbot^  a  dcbcit,  indic 


17.  PROFIT  FROM  SALE  OF  REAL  ESTATE. 

Descril^e  the  property  briefly,  as  "iara,"  "•house,"  "lot." 

Sute  the  actual  consideration  or  price  received,  or,  in  case  of  an  exchange,  the  f:if 
marker  \  alue  of  the  property  received. 

Enter  the  original  cost  of  the  property,  and  if  it  waa  acquired  prior  to  March  I.  101.1. 
the  fair  market  value  on  that  date.  Attach  eutcmcnt  expLiinin;  now  value  Jt  March  1. 
1013,  was  determined.  Expenses  incidental  to  the  purchase  may  be  included  in  the  coat 
;f  never  cUimed  in  income  tax  returns  as  deductions  from  income. 

Enter  aa  depreciation  the  amount  of  wear  and  tear  and  obsolescence,  cr  dcpletinn. 
sustained  since  Ma  ch  1. 1913  (or  since  dale  of  acquisition,  if  subseqyent  to  March  1.  VjIZ).  ■. 

In  case  the  proper:y  c-as  acquired  bv  gift,  bequest,  devise,  or  inl>entancc  after  ilarr^i 
3,  1913.  or  in  any  nunncr  prinr  to  that  date,  sec  Section  202  of  the  Jlevcnuc  Act  of  l-i'Jl. 

If  the  net  lesc'ii  to  he  entered  in  Item  G  is  a  deductible  los£,  indicate  the  deficit  by 
ueiog  red  ink  or  a  nunus  cign. 

18.  PROnT  FROM  SALE  OF  STOCKS,  BONDS.  ETC. 

The  method  of  corupuUtion  and  t!ie  infoTsiaiion  to  be  submitted  in  the  case  01  ral-^a 
of  Elects,  bonds,  etc.,  iseii3ilart^tli.'lrc<iuucd  for  item  C.  except  that  subsequent  improve- 
ments and  <leprecuiian  .ire  net  in^ohcd.  The  ptofil  (or  lu;>a)  ebould  be  computed  in 
accordance  wtth  Instruction  17  above. 

19.  TAXABLE  INTEREST  ON  LIBERTY  BONDS,  ETC 

The  interest  on  Liberty  Bonds  and  other  oblisaiions  of  the  United  Slates  issued  since 
September  1,1917  (except  Victory  Lii»criy  Loan  O;  %  ^ot<.=,  and  postal  saving  cert  i6cai"3 
of  deposit),  is  subject  to  eurCa:^  to  the  extent  that  the  holding  exceed  the  exemptions 
provided  by  the  act  authorizing  the  issue  3nd  subsequent  acts. 

The  exemptions  specified  m  columns  2,3, and  -1.  Schedule  E.  are  applic.ble  to  the 
obligations  lifted  on  liaca  (1).  (6),  and  (0.  but  the  tout  amcunt  entered  on  these  lino  ia 
any  one  column  mu=t  not  exceed  the  exemption  specified.  The  exemptions  specified 
at  head  of  columns  do  not  apply  to  the  oblisations  where  the  word  ■■Noae"appes:3.  _ 

Enter  in  column  S  on  the  proper  lines  the  principal  amounta  of  the  varioi:5  obU^tions 
ownfd  m  cscess  of  the  exemptions  specified,  during  the  taxable  period,  including  your 
share  of  these  obligaiicTis  held  by  partnorihips.  personal  service  corporation?,  and  fiduciaries. 

To  determine  the  interest  on  any  ciaas  of  obhgauons  received  during  the  Wxabb 
period,  where  tiic  books  .ire  kept  on  a  cish  receipts  and  disijurscment  basis,  add  to  the 
amount  of  all  coupons  and  registered  bend  interest  falling  due  within  the  uxabl*  ncrioJ 
the  amount  of  accrued  interest  received  on  sales  of  obligations  between  interest  lav-cieni 
dates,  and  deduct  from  this  sum  the  accrued  interest  paid  on  purchases  of  obligatiL>ns 
Itct^con  interest  pa>TLent  dates.  This  cieih<5d  will  be  followed  where. l>ool!s  are  kept 
on  a  c^^h.  hz£i£.  whether  or  not  the  coupons  falling  due  within  ibc  taxable  period  are  actually 

If  the  books  are  kept  on  the  accrual  basis,  report  the  actual  amount  of  interest  accrued 
ot)  the  ohligaiiona  owned  dunng  the  tax^ible  period. 

20.  OTHER  INCOME. 


21.  INTEREST  PAID. 

Enter  aa  Item  12  intereet  paid  on  personal  indebtcdneas  as  distingxiished  from  business 
indebtedness  (which  should  be  deducted  under  Schedules  A,  B.  C,  or  Dl.  Do  not  include 
interest  on  indebtedness  incurred  or  continued  for  the  purchase  of  bonds  and  other  obUga- 
lions.  the  interest  on  which  ia  wholly  exempt  from  tax,  except  interest  en  indcbtedneBs 
incurred  to  purchase  or  carry  Victorj-  Liberty  Loan  Z\%  Notes,  onsinaily  subechbed  for 
by  the  taxpayer. 

22.  TA.\ES  PAID. 

Enter  as  Item  13  personal  taxes  paid  and  all  taxes  on  property  not  used  in  business  or 
profeaion,  not  including  those  as9e«sed  aaaintt  local  benefits  of  a  kind  tt-nding  to  increase 
the  value  of  the  property.  Do  not  include  Federal  income  taxes,  taxes  imposed  upon  the 
taxpayer  upon  his  interest  as  shareholder  or  mcmlx?r  of  a  corporaUon  which  are  paid  by 
the  conwraiioo  without  reimbursement  from  the  taxpayer,  nor  inctKne  and  profus  taxes 
claimed  as  a  credit  m  Item  33,  pa^  1  of  the  return. 

23.  LOSSES  BY  FIRE,  STORM.  ETC 
Enter  as  Item  14  losses  of  property  not  connected  wiili  your  trade,  busine?;.  or  profes- 
sion.  sustained  during  the  year  from  liro,6tonn.  shipwreck,  or  other  casual  ly,  or  from  theft, 
which  were  not  compensated  for  by  insi  "'     ~" 

explained  in  Schedule  F,  on  page  2  of  ih 


otherwise.    (Loascs  dauned  ahould  ba 
ithcr  connected  with  your 


I  deduct  losses  incurred  in  transactions  which  n 
trade  or  busineea.  nor  entered  into  for  pivtfit. 

24.  CONTRIBUTIONS. 

Enter  as  Item  15  contributions  nr  gifts  made  within  tlic  taxable  period  to  or  for  tho 
use  of-  (a)  the  United  States,  any  Sute.  Territory,  or  any  pcli'-icjl  sulKli\-isico  thereof, 
or  the  District  of  Columbia,  tor  exclusively  puMic  purposes;  (fc)  -iny  corporation,  1 


Diunity  chest,  fund,  or  loundatic 


„ ^  ^„ ., .  _j i  and  operate<l  excluaivdy  for  reli^ous,  char- 
itable. 6ciontiV:c.  bterary,  or  educational  purposes,  including  posts  o!  the  American  I^on 
or  the  Women's  Auxiliary  units  thcieo:.  or  tor  the  prevention  of  cruelty  to  children  or 
animalB.  no  part  of  the  net  earnings  of  which  inures  to  the  be  neht  of  anv  private  stockholder 
or  individual;  or  (c)  the  epecial  luod  for  vocational  rehabilitation  authorized  by  scctii^n  7 
of  the  Vocalioml  Rehabi'iiuiion  Act;  to  an  amount  which  in  all  the  above  c=sea  combined 
does  notexcecd  15  per  centum  of  the  taxpayer's  act  income  aa computed  without  the  bcocbt 
of  thiB  paragraph.  »  . 

Fiduaanes  tilin-  this  rc.tu.-Ti  for  estates  in  the  process  of  adnuniftrauon  are  allowed,  in 
lieu  of  this  deducuoa.  that  provided  in  Section  21?' ^*  of  the  Re\cn'..e  .\ci  oi  1921.  List 
names  of  orgamtauons  and  aaiounts  contributed  to  each  in  Schedule  (j. 

2S.  BAD  DEBTS. 

Enter  as  Item  IG  all  bad  debts  other  than  ihase  claimed  as  a  deduction  in  items  above. 
Sta(«inSchcduloG,(a)  of  what  the  debts  consisted,  (t)  when  they  were  created,  (c)  when 
they  became  due.  and  {d)  how  thoy  were  actually  determined  to  be  worthleee. 

26.  OTHER  AUTHORIZED  DEDUCTIONS. 

If  this  return  is  filed  for  aa  estate  in  the  process  of  adtniaistration.  there  may  be  d-j- 
ducted  the  amount  of  any  income  property  raid  or  credited  10  bcoc&cuiies.  Any  dcdup* 
tion  claimed  in  Item  17  sbould  be  explaincu  in  Schedule  G. 


1712 


FILE  RETURN 

WITH  THE 

COLLECTOR  OF 

INTERNAL 

REVEl<lliJE  FOR 

YOUR  DISTRICT 

ON  OR  BEFORE 

MARCH  15,  1922 


INDIVIDUAL  INCOME  TAX  RETURN 

FOR  NET  INCOMES  OF  NOT  MORE  THAN  $5,000 

For  Calendar  Year  1921 

Or  for  period  bejM ,  1920,  and «iided. ...:-. ,1921 

PRINT  NAME  AND  ADDRESS  PLAINLY  BELOW 

(Name.) 

(Street  aod  aumber  or  ruril  route). 

'(Yoitomcel)  (County.)  (Bt«t«.) 


FIRST  PAYMEKT 


(CuhUr'o  Stamp): 


CASH     CHECK     M.  O. 


EiiniaeJ  l>r 


OCCUPATION.  PROFESSION,  OR  KIND  OF  BUSINESS 


ScMul" 


20 

21 

22 

E 

23 

F 

24 

F 

2S 

F 

1.  Salaries,  ^Tagea.  Commisflions,  etc. 

(State  nacneana  addiess  of  person  from  whom  received.) 


—  f.. 


2.  Interest  on  Bank  Deposite,  Notes.  Mortgagee,  and  Corporation  Bonds 

3.  Income  from  Partnershipe,  Fiduciariea,  etc.     (Statonameandaddresacrpartnershlps.ctc.) 


4.  Rents  and  Royalties _ - — 

5.  Profit  (or  loss)  from  Business  or  Profession  (not  including  income  from  partnerships). 

6.  Pro6t  (or  loss)  from  Sale  of  Real  Estate _.. 

7.  Profit  (or  loss)  from  Sale  of  Stocks,  Bonds,  ctc« 


8.  Other  Income  (except  dividends  from  domestic  corporations  and  Interest  on  obllgatic 
U.S.)    (:^'tato  nature  oflncome) 


9.  Total  Income  ik  Items  1  to  8  (less  losses  shown  above,  j£  any). 

DEDUCTIONS. 

10.  Interest  Paid  (not  including  interest  deducted  above) 

11.  Taxes  Paid  (not  including  taxes  deducted  above)   _ 

12.  Losses  by  Fire,  Storm,  etc _ _ 

13.  Contributions _ _ 

14.  Bad  Debts  (nofincluding  bad  debts  deducted  above) — 

15.  Other  Deductions  Authorized  by  I.4iw 

16.  Total  op  Items  10  to  15 _ 

17^ Taxable  Net  Income  (Item  9  minus  Item  It). 


COMPUTATION  OF  TAX. 


18.  Net  Income  (Item  17  above) ?.. 


19.  Less  Personal  Exemption  and  Credit 
for  Dependents _ , 


20.  Balance  (Item  15  minus  Item  19) t '- 

a^ka  will  l>o  Lccepled  if  payabb  at  par  at  CoDwIor's  Office. 


21.  Tax  Due  (4^  of  It«m  20) „ 

22.  Less:  Tax  Paid  at  Source $ 

23.  IllOOlIlO   Vid   oioBl.  t.«M  piil   lo  > 
UoJtodSuU,  <.tUcb  iotm  UIO) 


24.  Balance  Due  (Item  21  minus  22  and  23).. 

25.  Ta»  Paid  when  Filing  Return 


I7I3 


SCHEDULE  A.-EXPLANATION  OF  ITEM  4.    (Rents  and  RoyaUiflff 

) 

1.  Kind  o(  property. 

2.  Cost,  or  March 
1, 1913,  value. 

3.  Amount 
received. 

4.  Repairs. 

5.  Depreciation 
and  depletion. 

6.  Other 

cxpengc^. 

7.  Net  profit 
for  Io3s). 

_ 



Stat»  Mtimat«d  life  of  property  and  how  yon  figured  deprgctattoD  - 


SCHEDULE  B.-EXPLANATION  OF  ITEM  S.    (Bu«bie«»  or  Profcttlon.^ 


Total  Income  from  Business  or  Professioa  ■. 

Total  Business  Expenses  (stnte  specifically,  see  Instruction  IC) 

KcT  Pmorrr  (ob  Loss)  (If  profit  Is  less  than  usu^l,  explain) . 
Explanation  of  busmec  expenses 


SCHEDULE  C -EXPLANATION  OF  ITEM  «.    (Sal«  of  Real  Eatate.) 


1.  Kind  of  property. 


Tf  not  acquirr d  by  purchase,  state  hov  acquired  . 


SCHEDULB  D.-EXPLANATION  OF  ITEM  7.    (Sala  of  Stocka.  Bond*,  etc.) 

I.  EiDd  of  propertx. 

2.  Data 
acquired. 

3.  Cost. 

4.  Uarch  1,1913,         5.  Amount 
value.                    received. 

6.  Net  profit 
(or  loss). 

1               1 

1 

1 1 - 

n  not  acquired  by  purchase,  state  how  acquired  . 


SCHEDULE  E.-EXPLANATION  OF  ITEM  12.    (Lo».s  by  Fi 

re.  Storm, 

•te.) 

1 .  Kind  of  property. 

3.  Cost,  or  March 
1,  ldl3,  value. 

3.  Depreciation 
previously  taken. 

4.  'Salvage  Taloa. 

&.  Insurance. 

6.  Net  loss. 

, 



SCHEDULE  F.-CXPLANATION  OF  DEDUCTIONS  CLAIMED  IN  ITEMS  t.  U,  14.  and  IS.) 


I.  Are  you  a  citizen  or  2.  If  you  filed  a  return  for 

r(>3ident  of  the  United  1920,  to  what  &}lIector's 

States? ^ office  was  it  sent? 

4.  WSfc  a  separate  If  so^  state: 


rstura  filed  by  your 


3.  Is  this  a  Joint 
return  of  husband 

— and  wife? 

>■  ou,  ovovc.  i%\  Name  and  address 

...  (a)  Exempticm  ent«red  at  head  of 

husband  or  wife? claimed,  t that  return _„ _ 

r..  Were  you  married  and  Uvlng  with  husband                          8.  If  not,  were  you  on  the  last  day  of  your  tiiable  period  supporting  one  or  more  persons 
or  wifeon  the  last  day  of  youj taxable  period? ._.    living  in  your  household  who  are  closely  related  to  you  by  blwd,  marriage,  or  adoption? 

7.  How  many  dependent  persons  (other  than  husband  or  wife)  under  18  yoors  of  age  or  incapable  of  self-support  because 

mentally  or  physically  defective  uere  receiving  their  chief  support  from  you  on  the  last  day  of  your  taxable  period? 

8.  State  aroounl  of  dividends  received  9.  State  amount  of  10,  State  amount.of  interest  received  om 
Irom  domestic  cor^rations  (Including                                     tnterest  received  on                                     other  obU^lions  of  the  United  Stales 


(except  Liberty  Bonds)  on  a  principal 


3  of  $5,000. 


I  swEA9(erafflrm)  that  this  return. Including  the  acccmpanying  schedules  and  statements  (ifanv),  has  been  examined  by  me,  and,  to  the  best  of  my  Imon^-iedgn 
and  belief,  is  a  true  ana  complete  return,  made  in  good  fattb,  for  the  taxable  period  as  suted,  pursuant  to  the  Revenue  Act  of  192]  and  the  Regulations  issued  under 
authority  thereof. 


<^ors  to  and  subscribed  before  me  this day  of ..« 


(SicQAture  of  iodividiuU  er  ftccot  > 


(An  amemded  rvtum  mu«e  b*  ^aialF  mArkad  **Am*ad«d" 


acroat  th«  (ace  of  the  return.) 


1714 


INSTRUCTIONS  FOR  INDIVIDUAL  RETURN 


I.  PERSONS  REQUIRED  TO  MAKE  A  RETURN  OF  INCOME. 

An  incoajc  tax  rphiro  mufit  be  filed  by  every  oitizon  of  (be  Uoiu-d  States  whether 
roaidiog  at  home  or  abroad,  antl  every  person  refaJiog  iq  the  I'liited  Sialee.  tbDU(>h  not 
Q  cilizeo  thereof,  nhoee  grofs  income  lor  the  laxBblc  period  1921  sunouutcd  lo  J'>.000.  or 
wboee  ocfciofoine  amounted  lo— 

(a)  Sl.OCM)  it  ;ior.le  or  it  married  and  nol  li\-ini;  with  hLshsnd  or  wite. 

(b)  $:.Ono  it  roamed  and  livin-!  Tviih  biisbasd  or  mfc. 

If  thecoinbiocd  net  inromc  of  husband,  Tnfe,  and  dcpcodcnt  minor  children  equalled 
or  exccpded  $2,000.  or  il  the  combined  croaa, income  of  bu?band,  wite.  and  dependent 
minor  rhildren  cr|ualled  or  c^tcccded  $5,000  all  Eucb  inromc  must  be  reported  ( 
return,  or  on  eeparate  reluma  ol  husband  and  wite.  If  einele  an  '  " 
chiding  that of dependent n 

c'lUAlIed  or  exceeded  $5,000,  a  return  must  be  Bled.  A  t 
income  of  $1,000  or  $?,000,  acconfmg  to  the  marital  etatui 
miutfilea  retiim. 

Under  each  of  tho  above  c 
Nolcespecially  Instruction  8. 

In  the  case  of  hu:Hand  and  wife  who^e  combined  net  income  exceeds  fo.OOO,  Form 
1040  (not  Form  10^0  A)  should  bf>  ueed  for  separate  returoe,  even  though  the  income  on 
one  or  both  retunu  is  lees  than  $5,000. 

The  income  of  a  minor  or  incompetent,  if  denved  from  a  separate  estate  under  control 
of  a  R:uardian,  trustee,  or  ofber  fiduciary,  muf  t  be  reported  by  euch  legal  representative 

Income  of  (u)  estates  of  decedents  before  fina]  Bettlcment,  (b)  trueta,  whether  created 
liv  will  or  deed,  for  unascertained  persona  or  pcreons  with  contingent  interests;  or  income 
held,  or  which  under  the  termn  of  the  will  or  trust  may  be  held,  for  future  dbtribution,  i3 
taxed  to  the  fiduciary  a3  a  ^^ngle  person,  except  that  from  the  income  of  a  decedent's 


hi3  death  waa  $1,000.  if  unmarried,  or  $2,000,  if  married  and  tivi 

Ic,  or  if  the  CToaa  income  was  $j,000  or  over,  the  esecutor  or  adminiplrator  ehall  file  a 

urn  on  Form  1040  or  1040A  for  euch  decedent. 

2.  PERIOD  TO  BE  COVERED  BY  RETURN. 

Your  return  muft  be  filed  for  the  calendar  year  ending  December  31,  1'j21.  or  for  the 
r.acal  year  ending  on  tho  taat  dayof  any  month  other  than  December.     Tho  dates  on  which 


the  period  covered  by  the  i 
plainly  stated  at  tho  head  of  the 
B  required  t 


betrina  and  ends,  if  other  than  a  calendar  yej 


1  for  1318  on  the  basie  of  your  an 
period.  Having  eelabliehed  an  accounting  period  for  191S  iliia  period  t 
to  for  subsequent  yeara,  \m'^ea  permiasion  waa  received  from  the  Commit 
•"baoge.    In  the  caae  ot  a  return  for  a  period  o(  le«8  than  one  yeJr.  the  n  ' 


3  annual  baaia  by  multiplying  tho 


t  thereof  by  twelve  and  dividing  by 


3.  ACCRUED  OR  RECEIVED  INCOME. 

If  your  books  of  account  are  kept  on  an  accrual  basis,  report  all  i 
ihiugh  it  baa  not  been  actually  received  or  entered  i     " 
insioTid  of  expea=o  paid 

If  your  books  do  not  ehow  income  accrued  and  expenses  incuned,  report  all  income 
r  coDfitnictivcly  received,  such  as  bank  interest  credited  to  your  account,  and 


xpetL 


4.  INSTALLMENT  SALES. 

33  puling  i 


If  you  ha\o  used  tho  inalallment  method  .        ^  .  _ 

Salea  j-ou  must  attach  to  your  return  a  Bcbedulo  ehowing  separately  for  tho  yc 
1919.  1920.  and  1921  tlw  foUowing  information:  (a)  Gross  aalee;  (J>)  cost  of  goods  eold". 
<c)  erose  profits:  (rf)  percentage  of  profits  to  gToa  sales;  {<)  amovmt  collected;  (/)  gross 
profit  on  amount  collected 

5.  ITEMS  EXEMPT  FROM  TAX. 

The  following  itcma  arc  exempt  from  Federal  income  tax  and  should  net  bo  reported, 
luileee  it  is  desired  to  cstabli£h  a  net  lose,  in  which  case  eee  Section  204  ol  the  Revenue 


(fc)The: 
him  under  life  L  ,  -    - 

Oic  maturity  of  the  term  mentioned  : 

(c)  Gifts  (not  mado  as  a  consideration  fop  ecrvic 
arijUired  under  a  will  or  by  inheritance  (but  the  in 
r^Hcivcd  by  gift,  will,  or  inheritance  b  taxable  and  ;  . .       .  ., , 

(d)  Interest  upon  (1)  tho  obligations  of  a  Slate.  Territory,  or  any  political  eubdiv 
— c  —  .1.™  TK^^^  „#  r-„t..™wi».  «-  /o^  securities  iasucd  under  tno  provisions  of  the 

:  (2)  the  obligations  of  the  United  States) 
r  Finaoco  Corporation.    In  the  caa 
s  of  the  United  Stales  isauod  after  Sel)tcmbcr  I,  1917  (other  than  postaff 


ing  tho  t 
r  upon  eurrendcr  of  the  c 


I  be  reported); 


thereof,  or  the  District  of  Colombia;  c 


s  of  oblig 


IcJcrai  Farm  Loan  Act  of  July  17, 191C; 
ptescasions;  or  (4)  bonds  ia?uea  by  the  War  1 

lions  of  the  United  States  issued  after  Se^tc^.^.;.  .,  .^..  v*"-"!-'  >.uuu  puoiui  mi 
tificates  of  deposit),  and  f  n  the  case  of  bonda  iuucd  bv  the  War  Finance  Corpora 
intirefit  is  exempt  only  if  and  to  tho  extoot  pro\-iJea  in  the  respective  acts  authorizing 
Ihp  issue  thereof  aa  amended  and  Eupplemcnted  by  oeclioa  1328  of  tho  Revenue  Act  of 
1921,  and  should  be  excluded  from  gross  incomo  only  if  and  to  tho  extent  it  is  wholly 
cxcmpttothe  taxpayer  from  income,  warprofilB,  and  excess  profits  taxes; 

(c)  Amounls  received  through  accident  or  health  insurance  or  under  workmen's  com- 
penaalion  acl^.  as  compeoaation  for  personal  injuries  or  eickneas,  plus  the  amount  of  any 
damages  received,  whether  by  suit  or  agreement,  on  account  of  euch  injuries  or  eickne^a; 

(J)  Amounts  received  aa  compenaation,  family  nUotmcnta  and  allowances  under  tho 

__- w ,  .^,_  ^„.  t,:,,,  , ^  ^^^  jj^^  Vocational  RehabiliUiion  Acta,  or  aa  pen- 

ncc  o{  the  bcne^iaxy  or  anotbeE  in  the  military  or 


proviBJonaof  the  War  Risk  In; 
dions  from  the  United  Sutes  for  sc 
naval  forces  of  the  United  States  in 

(g)  The  rental  voJue  of  a  dwelling  house  and  appuitcn; 


fol  the  gospel  as  part  of  bis    _    , 

ih)  Compensation  paid  by  a  Stato 
empluyces. 


thereof  tunuabcd  I 
political  subdivision  thereof  to  its  ofiiccr 


ipcnsalioo 


7.  FARMER'S  INCOME  SCHEDULE. 

r  i^r  a  farm  oi^ner  rcntin?  your  farm  out  on  shares  and  l<eepao  books 
toks  on  a  CKsh  hast^,  obt^n  from  the  Collector,  and  attach  (o  this 
rheduleot  farm  Income  and  Enpeosos,     Enter  the  net  farm  income 


8.  CREDITS  FOR  PERSONAL  EXEMPTION  AND  DEPENDENTS. 

If  vou  were  married  and  livSns  wiih  your  husband  or  wife  or  were  hijad  of  a  family 
1  the  last  day  of  your  taxable  period,  you  may  Bub tract  from  your  net  income  on  Form 
'"  xcmptionof  $2,000.  plus  $400  for  each  person 

■apable  of  self-support  because 

--    _T.  computed  with  an  cxemi 

woidd  be  payable  if  the  e\enjpiicn  were  $2,500,  by  mo_rc  than  the  amount  of  th< 
come  in  excess  of  J-i.OOO.     1 1  husband  and  vn  tc  make  separate  returns. 
of  $2,000  may  be  claimed  by  either  (but  no',  bv  bothl  or  may  be  divided  between 


but  the  credit  of  $400  for  each  depcndei 


the  chief  support 

If  you  wcro  not  married  or  did  not  li\c  with  husband 
family  on  the  last  day  of  your  taxahic  period,  y 


be  claimed  only  by  the  person  furnishing 
d  i^ere  not  head  of  a 


3  that  date. 

An  exemption  ot  *1.000  may  he  claimed  in  cases  where  Form  1040  is  filed  for  estates 
a  procc?9  0f  adniini3tr8Uoo,or  with  respect  to  lo-oroeheld  for  future  distribution. 

'"^     -         -     '      ■•  ling  period  a  return  is  filed  for  part  of  a  year 


on  2  on  this  pace  ) 


his  (or  her)  bouaebold,  i^ho  are  closely  related  lo  him  (or  her)  by  blood, 

9.  AFFIDAVIT. 

The  affidavit  must  be  executed  by  the  person  wboee  income  is  reported  unless  be 
is  a  minor  or  incompetent ,  or  unless  he  is  ill,  absent  from  the  country,  or  otherwise  incapaci- 
tated, in  flhich  case  iho  legal  represeniativeorag^it  nay  execute  the  affidaWt.  A  minyr. 
however,  making  his  own  return  must  execute  the  aflidavit, 

Tho  oath  will  be  administered  without  chan-o  by  any  collector,  deputy  collector, 
or  internal  revenue  agent,  or  (if  you  are  in  the  nulitary  or  naval  servico  of  the  United 
Stales)  by  any  military  or  naval  olhcerftlio  isauihoriifed  to  administer  oaths  tor  purposes 
of  military  or  naval  jueticeand  aduunistration.  If  an  internal  revenue  otlicer  is  Dot  avail- 
able, the  return  should  be  sworn  t>i  b^toio  a  notary  public,  justice  of  the  peace,  or  Olbet 
person  authorized  lo  administer  oaths. 

10.  WHEN  AND  WHERE  THE  RETURN  MUST  BE  FILED. 


;  the  taxpayer  had 


tek  at  the  post  office  er  bank. 

II.  WHEN  AND  TO  WHOM  THE  TAX  MUST  BE  PAID. 

The  tax  ehould  be  paid,  if  purfible.  by  Bending  or  bringing  with  tho  return  a  check 
or  money  order  drawn  to  the  order  of  "Collector  of  Internal  Revenue  at  (in&ert  name  of 
ciiy  and  Slate)." 

Do  not  send  cash  through  the  mail,  nor  pa/ it  in  person,  except  at  the  ofGceotths 


12.  PENALTIES. 

For  MaJcins  False  or  Fraudulent  Return. 

eeding  $10,000  or  not  e.'tceediog  om 
the  court,  and,  in  addition,  50  per  c 

For  Failing  to  Make  Return  on  Time. 

z  than  $1,000,  and,  in  addition,  25  per  centum  of  the  tout  amount  ot  the  v 
For  Failing  to  Pay  Tax  When  Duo.  or  Underitatcmcnt  of  Tax  Through 

I  the  rate  of  1  percenti 


C.  TABLES  OF  SURTAX  AND  INSTRUCTIONS  FOR  CALCULATION. 


SURTAX  RATES. 


(Item  19  0 

Second 
Third     I 


t  ihc  return). 


INSTRUCTIONS. 


which  is  Iocs  than  tho  toul  i 


.    lending  amount  of  total  surtax. 
>ir(.ix  touna  06  above  add  an  antouot  computed  as  follows:  Subtract  from  ibo  D 
:j  I  multiply  tho  remainder  by  tho  rate  ohown  on  the  next  lino  below  in  column 
.    f.    .  I  J,   iinls  is  ihu  toUl  BurUx  due. 
Ixjna  lido  nalc  of  mines,  oil  Of  gas  wells,  o 
uoIlhosclUng  price  as  provided  by  Section  211  (6)  of  tbo  Revenue  Act  of  1921, 

CALCULATION  OF  SURTAX. 


1.  Largest  sum  in  column  A  which  is  lees  tbaa  tbo  total  amount  of  the  net 

income _ „„.„...... _.......... 

2.  Total  surtax  thereon  ahowo  in  cotumn  C... 

3.  RcEoaindorof  net  income  after  lubtroctinf*  ItMD  1,  abov« 

4.  Surtax  on  this  remainder  at  nteihoirn  In  column  DooU&o  below  that  from 

which  Item  1  was  takoa _ ._„...-„ 

&.  7olaI  tujtax  du«  (mm  of  It«ma  2  ao<t  4)  {£at«r  ai  Item  30,  page  1  of  iho 


$12,000.00 

190.00 

1,800.00 

»0  00 

280.00 


t.  Coreputftt 


I715 


13.  INCOME  FROM  SALARIES,  WAGES.  COMMISSIONS,  ETC. 


noporb  all  sabrio'^  or  oth^r  comnensttion  crc/l.to.l  bv  or  TccnivcJ  from 
outside  source:;.  :\nd  :iiiy  sal.ulcs  included  m  a  dcuddion  in  Item  6  for 
(a)vourseir,(&)  your  wife  (or  husband),  lf:i  joint  rclnrriis  nted.and  (c>  eich 
(tfpondcnt  miDor  child  havinc  a  ntt  Income  of  Ies3  Ih&n  SI.WV)  por  annum. 
USo  a  separatoline  for  each  cnir/.  eivlnc  the  Information  request^-l. 

Anv  aniouDt  clntmed  as  a  deductioa  for  necessary  Mponsf3-HEftirt5t  salartos. 
etc.,  should  bo  fully  explained  in  Schedule  F,  page2  of  tUo  Mtnro,  or  in  an 
attached  statement."  ,         .  ^  ^  , ,   ■       i       ^  T^  i„ 

Trav^lin?  e\pen:^  (including  the  entire  amount  expended  formcal3  and  lodE- 
In^)  while  away  from  horaeinthopursuitof  a  Iradd  or  business  are  detluctible. 

14.  INCOME  FROM  PARTNERSHIPS,  FIDUCIARIES,  ETC 

Report  vour  share  (whether  received  or  not)  in  the  profits  of  a  partner- 
ship or  personal  service  corporation,  or  in  the-inoome  of  bd  estat*  or  trust, 
oitc*rt  tho  part  of  such  sharothatconsisted'bfdividettdsdn  stock  of  domestic 
corporations,  and  taxable  intercut  on  obligations  of  the  United  States,  which 
should  be  included  in  Items  8, 0,  and  10,  at  foot  of  page  2  of  the  return. 

Report  in  Item  1,  salary  received  from  a  partnership  or  personal  service 
corporation. 

If  the  taxable  period  on  the  basis  of  which  yon  file  your  return  fails  to 
coincide  with  the  annual  accounting  period  ofthe  pc^ner^ip,  pwsonalscrvico 
corporfttion,  or  fiduciary,  then  you  should  include  in  your  return  your  dis- 
tributive share  of  the  total  net  income  Sot  such  acconntlng  period,  ending 
within  your  taxable  period. 

15.  INCOME  FROM  RENTS  ANI>  ROYALTIES. 

If  you  received  property  or  crops  In  ilci]  of  cash  r«>it.  r*»port  the  Income  as 
though  the  rent  had  been  rfcoivod  in  oash.  Crops  roc^ved  a^  rent  on  acrop- 
sharo  basis  should  be  reported  as  Income  for  the  year  in  v-hlch  disposed  of 
(■.mless  your  return  showsincome  accrued). 

Ivxplain  In  Schedule  A ,  repairs,  depreciation,  depletion  ttSd  otbftf  ezpensM. 

Other  expenses  include  interest,  taxes,  fire  InWrance,  fuel,  Ught,  labor,  wd 
Otner  necessary  expenses  of  this  character. 

16.  INCOME  FROM  BUSINESS  OR  PROFESSION. 

Keport  in  Item  5  incorile  from— 

(a)  Sale  of  merchandise,  or  of  products  of  raanufaettiriDp.cpnstnicUon.  mln- 
inr.'and  agriculture. 

(b)  Kusiness  servicffe,  such  as  transportation,  storage,  lamidcririr,  hotel  and 
restaurant  service,  livery  and  garage  service,  etc.,  if  you  ou'ned  tno  business. 
if  vouaroonlvanemploveeofa  business, report  your  salary  or  wages  in  Item  1. 

(e)  A  profession,  such  "as  medicine,  law,  or  dentistry,  i  I  you  practiced  it  on 
vour  own  account.    If  you  wore  employed  on  a  salary,  report  your  salary  in 

In  general,  report  in  Item  5,  any  income  in  the  earning  of  which  you  in- 
curred expenses  for  labor,  rent,  etc. 

If  you  are  a  farmer  (or  a  farm  owner  renting  your  farm  to  another  person  on 
shares), see  Instruction  7. 

Describe  the  business  or  profession,  as  "grocery," '^fetaii  clothing,"  "drug 
rloro," "laundry,"  "doctor,"  "lawyer,"  "fanner,"  etc. 

Report  the  total  income  derived  from  sales  or  from  servicc^^  less  any  discounts 
or  almwances  from  the  sale  price  or  service  choice.  (Tor  instalhnent  sales  see 
Instructions.) 

I  "Total  Busing 

obtained  by  adding _        ^  „  -...-, 

cbandiso  and  supplies  purchased  during  the  year,  and  deductme  from  this 
iuaith6inventoryatthecnQoftheyear;(2)  business  cxptrflses,  which  includo 
-ill  ordinary  and  necessary  business  expenses  not  classified  above,  such  as 
TiiBce  -wages,  rent,  heat,  light,  and  traveUng  expctoscs  {sac  IhslTUctlon  13); 
(%)  repairs, -wear  and  tear,  obsolcsoence,  dcpletian,  and  propfrty  losses  (otlicr 
t.han  merchandise),  such  as  (a)  ordinary  repairs  feqplr^d  to  keep  property 
lii  usable  conditon,  (6)  reasonable  allowance  f6r  e^diaustlon  wear  and  tear 
oi  property  used  In  the  trade  or  boainess,  including  a  reasonable  allowance  for 
obsolescence,  and  (c)  losses  of  business  property  by  fire,  storm,  drother  casualty, 
or  theft,  not  compensatcdforby  Insurance  or  otnfericise  dndTiot  made  good  by 
Topairs  claimed  as  deductions;  and  H)  bad  debts,  or  portions  fbercor, arising 
■rom  sales  or  professional  services  that  have  been  rtfpirrted  as  fuCOCJe,  Tvhicli 
Have  been  definitely  asccrtjuncd  to  bs  worthless  aria'cVatjjed  off  witrilu  tho 
y^ar,  or  such  reasonable  amount  r.s  has  bee  n  added  to  a  reserve  for  bad  debts 
Cv-rthin  the  year.  A  debt  pre^ioi-sly  charged  off  as  bad.  if  siibsequently  col- 
'Uctcd.mustberetumedasincomeforlheycarin  which  canetted.  Explain 
these  deductions  under  Schedule  B,  page  2  of  the  return. 
'  Do  not  Include  cost  of  business  equiphient  or  furtiTtnrc,  expendltrifgs  for 
Replacements  or  for  permanent  imptovenlertts'to'iirOpcrty,  6r  pergonal  livlrig 
or  family  expenses,  nor  any  deduction  fordepredfltiotlih  th9^•ftIue  of  a  bond- 
ing occupied  by  you  as  a  dwelhng,  or  of  otherpfoperty  held  for  personal  use. 

if  Item  5  shows  a  deficit,  indicate  by  using  red  ink  or  a  minus  sign. 

17.  PROFIT  FROM  SALE  OF  REAL  ESTATE, 

DescribO'the  property  bricflv,  as  "farm,"  "house,"  "lot," 
Slate  the  actual  consideration  or  price  received,  or,  in  Cfts«  of  an  exchange, 
tho  fair  market  value  of  the  property  received. 


ir:  ir  it  was  ftConirM  prior  to 
lent  explain- 
ing how  value  at  "March  I,  ISl.-J,  was  determined.  Exp^nsesincidcntal  lotho 
purchase  may  be  included  In  the  cost  If  never  cbimed  Id  Inoorao  tax  returns 
as  deduct'oiis from  income.  ^     .     , 

Enter  as  dourcciaiion  tb«  emount  of  wes"-  and  teer  and  ct.solr-xcncc,  or 
depletion,  sustained  since  March  I,  1913  (or  since  fjite  of  acquisition,  if  sub- 
sequent to  March  1, 1913).  .    ,■    ,  ■!._.»._ 

In  caso  the  property  was  acquired  by  gs/l,  bequest,  devise,  or  Inheritance 
after  March  1 ,  1913,  or  in  any  manner  prior  to  that  date,  soe  Section  202  of^tho 

If  the  net  result  to  be  entered  In  Item  6  Is  o  deductible  loss.  Indicate  the 
deiiclt  by  using  red  inlc  or  a  minus  sign. 

18.  PROFIT  FROM  SALE  OF  ffTOCKS.  BONDS,  ETC. 

The  method  of  comptitati<-.n  and  the  Inronnatlon  to  be  submitted  In  the 
ca.'^e  of  sales  of  stocta,  bonds,  etc..  is  similar  to  that  required  for  Item  «. 
except  that  subsequent  improvements  and  depreciation  arenot  Involved .  The 
profit  (or  loss)  should  be  computed  In  accordance  witii  Instruction  17  above. 

19.  OTHER  INCOME- 


Rcport  all  other  taxable  locomo  for  which  i 
on  page  I  of  the  return,  including  dividends  r- 
poratiODS.    Dividends r" ''""""'         '""*"  -•  ->- 


»  place  Is  provided  elsewhere 
ived  on  stock  of  foreign  cor- 

.„^     J  stock  of  domestic  corporations  and  taxable 

interest  on  obligations  of  the  United  States  should  be  reported  in  Items  8, 9, 
and  10  at  the  foot  of  page  2  oJ  the  return. 

30.  INTEREST  PAID. 

Enter  as  Item  10  interest  paid  on  personal  Indebtednees  as  distinguished 
from  business  indebtedness  (which  should  te  deducted  imder  Schedules  A,  B, 
C.or  D).  Do  not  include  interest  on  indebtedness  Incurred  for  the  purchase 
of  bonds  and  other  obligations,  tho  interest  on  which  is  exempt  from  tajt, 
except  interest  on  indebtedness  Inourred  to  purchase  or  carry  obligations  of 
the  United  States  Issned  alter  September  24,  J917,  and  origlDally  subscribed 
for  by  the  taxpayer. 

21.  TAXES  PAID. 

Enter  as  It«m  U  personal  brres  paid  and  all  taxes  on  property  not  used 
in  business  or  profession,  rot  Including  those  assessed  against  local  benefits 
of  a  kmd  lending  to  increase  the  value  of  the  property.  Do  not  Include 
Federal  income  taxes,  taxes  imposed  open  the  taxpayer  upon  his  Interest  as 
shareholder  or  member  of  a  corporation,  which  are  paid  by  the  corporation 
without  reimbursement  from  the  taxpayer,  nor  income  and  profits  taxes 
claimed  as  a  credit  in  Item  23,  page  1  of  the  return. 

22>  LOSSES  BY  FIRE,  STORM,  ETC. 


23.  CONTRIBUTIONS. 


or  lOF  IBB  uso  oi;  ^i)  vu»  <juim:u  ouiibo,  tuijr  ounv.  j  runv^J^j,  ui  luiy  puuitui 
subdivision  thereof,  or  the  Dlstrlrt  of  Columbia,  for  exclusively  public  pur 
poses;  (6)  any  corporation,  or  commimity  chest,  fund,  or  foimdation,  organized 
and  operated  exclusively  for  religious,  charitable,  sclenTt£c,llt«rary,  or  edu- 
cational purposes,  incluJmg  posts  of  the  Amerlctm  Legion  or  tlie  Women's 
Auxiliary  imils  thereof,  or  for  the  prerantlon  of  cruelty  to  children  or  animals, 
no  part  of  the  net  ecmin^  of  which  InuTfiS  to  the  benefit  of  any  privaia 
stockholder  or  individual;  or  (c)  tho  special  fund  for  vocational  rehaMiiialion 
authorized  by  section  7  of  tiie  \'ocatiorial  Rehabilitation  Act;  to  an  amc-i^t 
which  in  all  tho  above  cases  combined  docs  not  exceed  15  per  centum  of  the 
laxpaver's  net  income  as  computed  witliout  the  benefit  of  tnlsparafraph. 

Fiduciaries  filing  this  return  for  estates  in  tho  process  of  adrali::':tratIon 
CTQ  allowed,  in  lieu  of  tills  deduction,  that  provided  in  Sectlsc  21?  ";  cf  tha 
Revenue  Act  of  1921.  List  names  ol  organisations  and  amounts  con '... I  L:lci  to 
each  in  Schedule  F. 

24.  BAD  DEBTS. 

tnter  as  Item  14  all  bad  debts  other  than  those  claimed  as  t  d^uction 
in  Items  above.  Slate  In  Schedule  F  (a)  of  what  the  dobtj  c-.Misted,  (ft;  «  hen 
they  were  created,  (c)  when  they  beoune  due,  and  (d)  how  liifv  were  ?ctually 
determined  to  be  -w  ortiiless. 

25.  OTHER  AUTHORIZED  DEDUCTIONS. 


If  this  return  is  filed  far  en  estate  in  the  process  of  3«ImlnistratIiD,  th»r» 
may  be  deducted  ttio  amount  of  anv  income  properly  paid  or  credited  to 
beneficiaries.    Any  dedu 


t  of  any  income  properly  paid  or  credited 
1  ^nainicd  in  Item  U  should  ba  explained 


DETACH  AND  RETAIN  THIS  INSTRUCTION  SHEET  WITH  YOUR  WORKING  PAPERS. 


1716 


Form  1122-UNITED  STATES  INTERNAL  REVENUE  SERVICE 


INFORMATION  RETURN  OF  SUBSIDIARY  OR  AFFILIATED  CORPORATION 

WHOSE  NET  INCOME  AND  INVESTED  CAPITAL  ARE  INCLUDED  IN  RETURN  OF  A  PARENT  OR  PRINCIPAL 
REPORTING  CORPORATION  FOR  PURPOSES  OF  INCOME  AND  PROFITS  TAXES 


If  return  is  for  calendar 
year  1921,  file  -t  on  or  be- 
fore March  15,  1922.  with 
tl'.e  Collector  of  Internal 
Revenue  for  the  Dittrict  in 
which  the  Subsidiary  or 
Affiliated  Corporation  has 
its  principal  office. 

If  for  a  period  other  than 
a  calendar  year,  the  return 
should  be  filed  on  or  before 
the  15th  day  of  the  third 
month  following  the  close 
of  such  period. 


FOR  CALENDAR  YEAR  1921 


Or  for  period  begun ,  1920,  and  ended . 


,1921 


(Street  and  cumber  or  rural  route) 


( Post  Office  and  State) 


(Dale  Received) 


1.  Date  incorporated Under  laws  of  what  State?.. 

2.  Kind  of  business. , 


3.  Par  value  of  capital  stock  outstanding  at  beginning  of  taxable  period: 

(o)  Common,  $ ;   (i)  preferred,  $ 

4.  Name  of  parent  corporation 

5.  Address  of  parent  corporation 

6.  Internal  revenue  district  in  wliich  consolidated  return  has  been  filed... 


(Give  district,  or  city  and  State) 

7.  The  department  prefers  that  the  entire  tax  shown  on  a  consolidated  return  be  paid  by  the  parent  or  principal 
reporting  corporation,  instead  of  being  apportioned  among  the  corporations  composing  the  affiliated  group. 

If  apportionment  is  made,  state  the  amount  of  income  and  profits  taxes  for  the  taxable  period  to  be  assessed 
against  the  subsidiary  or  affiliated  corporation  making  this-  return $ 

We,  the  imdersigned,  president  and  treasurer  of  the  above-named  subsidiary  or  affiliated  corporation,  being 
severally  duly  sworn,  each  for  himself  deposes  and  says  that  the  foregoing  return,  including  the  accompanying 
list  (if  any),  has  been  examined  by  him  and  is  to  the  best  of  his  knowledge  and  belief  a  true  and  complete  return 
of  information  made  in  good  faith  pursuant  to  the  Revenue  Act  of  1921  and  the  Regulations  issued  thereunder. 

Sworn  to  and  subscribed  before  mo  this 


.  day  of . 


-,  1922. 


President. 


(Signature  of  olllcer  odmlnlateilng  oatb) 


Treasurer. 


1717 


Form  1061! 

r.  S.  Inthbnal  Revenue 

PARTNERSHIP  AND  PERSONAL  SERVICE  CORPORATION  RETURN  OF  INCOME 

FOR  CALENDAR  YEAR  1921 

Or  for  period  begun ,  1920,  and  ended             _ 1921 

,  PRINT  NAME  AND  ADDRESS  PLAINLY  BELOW 

Do  not  write  in  this  space 
Eumiiidb; 

THIS  RETURN  SHOULD 

BE  FILED  NOT  LATER 
THAN  THE  ISTH  DAY 
or  THE  THIRD  MONTH 

D»te  received 

FOLLOWING  THE  CLOSE 

'        I 

PERIOD 

KIND  OF  BUSINESS 


, STATE  WHETHER  PARTNERSHIP  OR  CORPORATION  . 


SCHEDULE  A— INCOME  TO  BE  ACCOUNTED  FOR  BY  MEMBERS. 


GROSS  INCOME 

Gross  sales,  less  returns  aod  allowancea ~ 

.  Less  cost  of  goods  sold,  excluflive  of  items  called  (or  separately  below  (attach  Schedule  A2),. 
Gross  income  from  services  or  operations  other  than  trading  or  manulacttuing,  less  allovancea  (attach  Schedule  A1).. 

Taxable  interest  from  all  other  sources  (not  including  interest  referred  to  under  Items  2  and  3,  Schedule  C) 

Rents „ — — 

.  Share  of  net  income  earned  by  ft  partnership  or  personal  service  corporution  (whether  received  or  not) 

.  Dividends  subject  to  surtax  oaly  (attach  Schedule  A8) „....„ . ™. — — . 

.  Dividends  subject  to  both  normal  and  surtax  (attach  Schedule  A9) — - - — 

.  Other  income  (not  including  any  amount  reported  in  Item  23  below  noi 
Total  or  Items  1  to  10... 


a  Liberty  Bonds)  (attach  Schedule  AlO).. 


DEDUCTIONS 

.  ExppnBoa  (except  amounts  reported  in  Item  2  above,  or  called  for  separately  below)  (attach  Sthedule  A12) 

.  Compensation  of  partners  or  stockholders  in  whatever  fonn  paid  (attach  Schedule  A13)  „„._ ^ 

,  Rcpaire  (including  labor,  supplies,  etc.)  (attach  Schedule  A14) 

.  Interest  (attach  Schedule  A15) ~ 

.  Taxes  (attach  Schedule  A16) - ^-. ~ — - 

Bad  debts  (attach  Sthedule  A17) — - — -. 

.  Exhaustion,  wear  and  tear  (including  obsolescence)  (attach  Schedule  A 18) ^ — 

.  Depletion  (attach  Schedule  A19) — 

.  Amortization  of  War  facilities  (attach  Schedule  A20)  _ - 

Total  of  Items  12  to  20 .' 

Item  U  minus  Item  21 _ -^ _ 

.  Profit  or  loss  on  sales  of  capital  aasetaand  misceltaueous  investmeDta  (attach  Schedule  A23) „ 

,  I/)S8C9  suBtaJni^d  by  fire,  storm,  etc.  (attach  Schedule  A24).    Extend  difference  between  or  sum  of  Items  23  and  24  . 
.  Net  Income  to  be  Accounted  for  by  Members  (Itkm  22  minus  Item  21  i 


Enter  below  the  sharo 
ns  of  the  United  Stat«3), 

If  the  distributable  iol 


Btockholder'fl  Bhare  cl  any  imomc  tax  paid  at  s 
;  poBsessioD  of  the  United  States.  (See  ija^e  1  i 
income  are  determined  on  a  basis  other  tlian  a  p 


nFporation  (except  interest  on  obliga- 
(1  profits  taxes  paid  by  the  partneiship 


Htmiu  or  F.Kt^Euair  o>  sioaioLi.iu  o>  P[iuo«.L  Sco.ct  roK.-.u.t.o...     . 

1  I>«rui» 

,...„.„.  .a,»  .,.«.„.„.»,....„„„.„.. 

sham  held!  DCor- 
poratioD. 

(ITCM^^^CUS, 

CO%  UiAXT  BOMDO. 

TUES  P.JD  TO  . 

TO  A  PoaausioK  or 

_ ...,    1 

1 L 

i         !    1 

.„._L.._._... 

,j)                                                    _ 1 

; ■ ! 

1^^ ." 1 

.___. 



■ 

i 

(it.           Totals 

» 1 -!s ...! !, L 

.-- J 

The  undersigBed.  being  severally  duly  sworn,  each  for  himself  deposes  and  a 
d  is  to  the  best  of  his  knowledge  and  belief  a  tru        ''  '"*       '  ''"  ' 

Us  issued  under  the  authority  thereof. 

Sworn  to  and  etibscribed  before  me  this 


irked  "Amended" 


1718 


I  the  fac*  of  th«  rvtunie) 


?>«uurff  nf  corpora  ti»i%, 


SCHEDULE  C— RECONCILIATION  OF  NET  INCOME  AND  ANALYSIS  OF  CHANCES  IN  SURPLUS. 

1    N.i  ,■...,,.■1.                    .,  ^    uemr. 





M,  Unallowable  deductions: 

1 

•    '1'            1                         1     t,  -^  issiiedMiiceS«ptctn'.<cfi.iyi7(e«»pi 

W  LirowB^nd  produ  Uus  paid  to  Ibe  Unilid  Sl.t«.  lis  pt^^^ona 

■> '»soUheUnlW^JSUll«issucdbero^cScpteIn■ 

"'^  ^"dliu'ons  (''h^';^-'^"'"*  «"*Uilcs.TSrtiorics.«n(J^"ti5risut 

■" 1 

(')  Rephcemenls  and  reccirals 

</)  Iiifurance  prenjiums  paid  on  the  Ufr  ot  any  officer  or  employee  tor 

..,....._ 

"'">Jf^«»i>n  F-»nu  LooiiBondjlisiiedundaFKle»lFennUftn 

■■■"■■■"1 1 1 

(<f)  Dlvjtlcniis  on  sloct  of  perMWol  stnln  eorporttfotiVirooi  pel 
'"""oie  rar  nt-d  dnrins  ihe  ptf  iod  between  January  1. 1918,  and 

1        1        1 

(f)  Interest  on  Indebtedness  idcuxtcU  for  the  purcliaU  ot  boods  and 
other  obligaijons.  ibo  iDteresi  on  vMcb  is  abolly  cieropt  from 

Viewy  liberty  Loan  3i%  Noloi,  onpnaUy  ilitaKTifacd  lor  by 

(2) 1 

1 
1 

W  AddiUonyo  wrve  lor  b^  debts  wbieh  are  not  InchlM  In  Item 

(0  Additions  tosinUits  riiod  reserve,  and  other  conUogeiirtes  (to  te 

*■  "^^dSu^fiTr  '*'^'  '*"  **""*  ***"  '"**"  "'  ^**«'>^  *'•  •» ""* •" 

""  '1  ■      1 

6.  <. aarccs otiii.si reserve»?or  conliDsendcs, elc. (to  be d«UUed): 

1        1 

(2)- - 

,„ 

"T"  \"" 

(j)  Other  uoaiicwabio  deduetiwia  (io  be'  tleiMM): 

1     r 

(J) 

t 1 1 

"^~ 

(') 

1      

T.ToUHroDilUmlS 

1. .  .1.' 

15   Total  Of  Item  H 

«     1  .  ...'     1 

""?eVfear.?a!5rf^rA' Character...'. 

■■■■■■ i i 

(O  Daio  pold Clunctfr 

(tl 

! 

n   Tolil  of  lUDM  8  to  10  Inclusive 

«.     1      1 



IT.  Other  dcblU  Io  surpiiu  (10  be  deified): 

la-ToUlIromlH 

1 1 

(M 

13.  Surplus  ftDd  undividod  proQis  as  shown  by  balance  sbool  »l  Closo  Of 

». 1 ' 1 

in   Tol.lomtmslS.ndir 

1 

SCHEDULE  D— BALANCE  SHEETS. 

Attach  hereto  balance  sheets  as  at  the  WginDuig  and  eod  of  the  accouotlug  period  (preferably  ia  parallel  columDs).  showing 
(Tb<9e  balance  sheets  ebould  be  prepared  from  the  booka  and  ahould  be  io  agreetoeot  therewith,  i 


Delened  charfes  to 


QUESTIONS. 


tsbya 


OF  BUSINESS. 

eotifyltwcorpofalK 
ildcscrlpliooolthol 


and  related  tcdustr'.es,  Inclndlog  Gshlnc.  locclnc.  Ice  harvcslloi;,  cLc  ,  and  also  the  leasing 
Btalo  the  product  or  products.  H— Mming  and  quarrymc,  locludlog  gas  aod  oil  '^■^1''' 
"  ipUed' by  Iho  llama  of  tbo  product.  D— ConstniclioD-oxcavalloos.  buildlncs, 
so  equlppliig  and  Installing  same  nlih  svslcms.  devices,  or  madilnciT,  without 
).    EZ— PubUcutUltiea— gas 

"I'-ronrems  not  falllnE  In  above 


bridees.  railroads,  ships, 

phooe:  waterworks  or  power.    E^^toragi 
nrda,  etc.)    State   proi"     '  '      ~' 

TrsdJac  U>  GooSs  bought 

doaiestie,  ladudUic  boi 


■J  (hydro 


Kfc^l 


—Leasing   transportation  c 
oot  produced  by  the  trading  eonacra, 

wboM  business  Involves  activity  (alUne  la  two  or  m 

,     coueeraed,  shonM  report  business  as  identified  witr 

example,  coocenis  In  A  or  B  whidi  also  tra 


'n  or  control  tbelr  sourca  of  matertal 
exclusively  or  mainl/,  should  to 


ptodudiu  business. 


ojtuUfvll 


OTHER 


.nswcrlo<iuesllonsl0,ll,andl2,oronyo(lhcm.li"yc';,'"thefollo«ineinformalion.<liouljbe(u/ 
10  beginning  ofUMraccauntlnc  period,  rndlcatlog  any  suMiautlal  changes  aunoG  luch  pcnod 


Nxi..OPSn*REBOU,Er. 

(Name  or  corporation  ) 

IN.m..R«por.,lo.., 

SI„,«Wd. 

.TS? 

ol^ngi. 

Shsfuheld. 

stoekboldings. 

1 

J 

■ : 1 

1 1 

1 1 

.._ 1 1 

Sl)area  oolstantUnB  beginning  of  year 

BharwouUlondJnpendofycar 

full  voting  prlvileees  dunne  t lie  onilte  accounilnc  period ;  (I)  whether  ibe  vouttg  prlvilccea  were  ciunulatlve;  (J) 
whether  these  voting  privilc«cs  «de  cxcicIshI  dunng  the  accounting  period;  (I)  tbo  oondlUons  by  which  these 
voting  privileges  may  be  socrllicod  or  acijulred. 

(6)  State  the  dividend  prlvUt^es  of  the  tespocilvo  classes  of  stocli- the  rate  ofdivjdends  paid  duri(\g  tba 
accounting  periods  the  date  and  rote  odait  dividend  payment:  and  wlwiber.  and  under  what  conditions,  the 
preferred  stock  particlpatai  In  the  earnings  atMve  the  D«ed  dividend  fate 

((f)  Show  scparotcly  the  numbrr  of  shares  or  Mch  clasi  held  by  Ibe  respecilre  stwbholders  of  each  companv, 
those  bolding  stock  In  two  or  more  ol  the  aRUlaied  corporations. 
exprcescd  ot  impUed.  and  sute  whether  such  orraogeioeiils  aroconUderodvaUd,  giving  supporting  reasons. 


I,  th»  nnaoda),  Bunogulal,  aad 


VALUATIONS  OF  CAPITAL  STOCK. 

I,  What  waatte  fair  valtH  of  Um  total  capital  stock  of  Ibe  corporation  aidatennlited  li 


AFFILIATIONS  WITH  CORPORATIONS. 

DoM  the  oorporfttko  own  •Uroctly  or  control  througli  doenly  afflUatad  I 
KM  over  1ft  per  wnl  ol  the  outstanding  voUne  capital  ilock'bl  another  corporalleoT.. 


voting  capital  stock  owand  by  aitother  oorporatlon  ot  by  I' 


pany  Iranucllont  or  arrangement  which  may  effect 
e  altlllainl  corporations  a  diipivporUonate  snare  ol 


COVCRNMCNT  CONTRACTS. 


clly  or  Indirectly,  Ih/ough  II 


ula  showing  ft 
ititrarts.  aiid  U 


AMORTIZATION. 


LIST  OF  ATTACinO  SCHEDULES. 

10.  Attach  a  lUI  ol  scbedulee  accompauylug  tUs  laturn,  giving  lot  aach  a  b 
■*»  jiaragrspb  at  top  of  pagr3  ol  Insirucilws-) 


I719 


Pag«  I  of  InslriKtJons. 


GENERAL  INSTRUCTIONS. 


Partnership  and  Personal  Se 


1.  rarlnfrship.K.—'Every  partnership,  whether  domestic  or  foreign, 
doing  business  in  the  United  States  must  make  a  return  of  income  on 
this  form  regardless  of  the  amount  of  its  gross  or  net  income.  (See  Sec- 
tions 21S  and  224  of  Revenue  Act  of  1921.) 

2.  Persorial  service  corporalioTis. — Every  personal  service  corporation 
must  make  a  return  of  income  on  this  form  regardless  of  the  amount  of  its 
gross  or  net  income.     (See  Section  218  of  Revenue  Act  of  1921.) 

3.  Personal  service  corporation  defined. — The  term  "personal  service 
corporation  ".means  a  corporation,  not  expressly  excluded,  the  income  of 
which  is  derived  from  a  profession  or  busihess  (a)  which  consists  prin- 
cipully  of  rendering  personal  service,  (h)  the  earnings  of  which  are  to  be 
ascribed  primarily  to  the  activities  of  the  principal  owners  or  stock- 
holders, and  (r)  in  which  the  employment  of  capital  is  not  necessary  or 
is  only  incidental.     (See  Section  200,  paragraph  5,  Revenue  Act  of  1921.) 

4.  Corporations  excluded, — The  following  classes  of  corporations  are 
expressly  excluded  from  classification  as  personal  service  corporations: 
(a)  Foreign  corporations;  (h)  corporations  50  per  cent  or  more  of  whose 
gross  income  consists  of  gains,  profits,  or  income  derived  from  trading  as  a 
principal;  and  (c)  corporations  50  per  cent  or  more  of  whose  gross  income 
consists  of  gains,  profits,  commissions,  or  other  income  derived  from  a 
Government  contract  or  contracts  made  between  April  6,  1917,  and 
November  11,  1918.  inclusive. 

A  corporation  is  not  a  personal  service  corporation  merely  because 
less  than  50  per  cent  of  its  gross  income  was  derived  from  trading  as  a 
principal  or  from  Government  contracts.  A  corporation  can  not  be 
considered  a  personal  service  corporation  when  another  corporation  owns 
or  controls  substantially  all  of  its  stock,  or  when  substantially  all  of  its 
stock  and  of  the  stock  of  another  corporation  (not  itself  a  personal 
service  corporation)  forming  part  of  the  same  business  enterprise  is 
owned  or  controlled  by  the  same  interests.  (See  Sections  200  and  240 
of  the  Revenue  Act  of"l921.) 

5.  More  than,  one  husincss. — A  corporation  engaged  in  two  or  more 
professions  or  businesses  which  are  more  or  less  related,  one  of  which 
docs  not  consist  of  rendering  personal  service,  is  not  a  personal  service 
corporation  unless  the  nonpersonal  service  element  is  negligible  or  merely 
incidental  and  no  appreciable  part  of  its  earnings  are  to  be  ascribed  to 
such  sources.     (See  also  Section  303  of  the  Revenue  Act  of  1921.) 

6.  Activities  of  stocJcholdcrs. — In  determining  whether  a  corporation 
is  a  personal  service  corporation,  no  weight  can  be  given  to  the  fact  that 
it  renders  personal  services  unless  (a)  the  principal  owners  or  stock- 
holders are  regularly  engaged  in  the  active  conduct  of  its  aflfairs,  and  are 
engaged  in  such  a  manner  that  the  earnings  are  to  be  ascribed  primarily 
to  their  activities,  and  (&)  its  affairs  are  conducted  principally  by  such 
owners  or  stockholders.  If  employees  contribute  substantially  to  the 
services  rendered  by  a  corporation,  it  is  not  a  personal  service  corporation 
unless  in  every  case  in  which  services  are  so  rendered  the  value  of  and  the 
compensation  charged  for  such  services  are  to  be  attributed  primarily  to 
the  experience  or  skill  of  the  principal  owners  or  stockholders. 

7.  Stoclc  interest  of  active  members. — No  corporation  or  its  owners 
or  stockholders  shall  make  a  return  in  the  first  instance  on  the  basis  of  4ts 
being  a  personal  service  corporation  unless  at  least  80  per  cent  of  its  stock 
is  held  by  those  regularly  engaged  in  the  active  conduct  of  its  aJTairs. 

8.  Capiial. — In  determining  whether  a  corporation  is  a  personal 
service  corporation,  no  weight  can  be  given  to  the  fact  that  the  invested 
capital  of  the  corporation  under  Title  III  of  the  Act  or  the  actual  invest- 
ment of  the  principal  owners  or  stockholders  is  comparatively  small. 
If  the  use  of  capital  is  necessary  or  more  than  incidental,  capital  is  a 
material  incomc-produring  factor  and  the  corporation  is  not  a  personal 
service  corporation. 

INSTRUCTIONS  FOR  FILLING  IN  SCHEDULE  B,  PAGE  I. 

9.  This  Schedule  is  to  be  used  for  showing  the  share  of  each  partner  or 
stockholder  in  the  income  of  the  partnership  or  personal  servicecorporation, 
whether  distributed  or  not.  Where  the  ownership  of  a  personal  service 
corporation  has  changed  during  the  accounting  period,  the  distributed 
portion  of  the  net  income  is  taxable  to  the  recipients,  while  the  undis- 
tributed portion  is  taxable  to  the  owners  as  at  the  end  of  the  accounting 
period. 

10.  Enter  on  lines  (a),  (6),  (c),  etc.,  the  proportionate  amount  of  the 
totals  shown  in  columns  3  and  4  to  which  each  individual  partner  or 
stockholder  is  entitled,  whether  distributed  or  not.  If  the  amount  to  be 
entered  in  colunm  4  is  a  loss,  the  amount  should  be  indicated  by  red  ink- 
er a  minus  sign. 

1 1 .  If  the  partnership  or  personal  service  corporation  received 
directly  or  through  another  partnership,  personal  service  corporation,  or  a 
fiduciary,  interest  on  corporation  bonds  containing  a  clause  by  which 
the  debtor  corporation  agrees  to  pay  the  interest  without  any  deduction 


Corporation  Return  of  Income. 

for  taxes,  and  there  were  filed  with  such  interest  coupons  a  white  certificate, 
Form  1000,  not  claiming  exemption,  a  tax  of  2  per  cent  was  paid  at  the 
source,  and  this  tax  should  be  allocated  to  the  members  or  stockholders  in 
column  ■'^ 

12.  If  any  amount  is  entered  in  column  6,  a  copy  of  Form  1116, 
completely  filled  in  and  swom  to  or  affirmed,  must  be  submitted  with 
this  return.  If  such  taxes  have  been  paid,  Form  1116  must  have 
r/tached  to  it  the  ffeceipt  or  other  evidence  of  each  such  tax  payment. 
If^suth  taxes  have  been  accrued,  Form  1116  must  have  attached  to  it 
a  copy  of  the  return  on  which  each  such  accrued  tax  was  based,  or  other 
evidence  as  to  the  accrual  of  taxes. 

13.  When  a  credit  is  claimed  on  Form  1040  or  Form  1040A  for 
accrued  taxes,  the  (!k)nimissioner  may,  as  a  condition  precedent  to  the 
allowance  of  such  credit,  require  the-  taxpayer  to  give  a  bond  (Form 
1117),  with  sureties  satisfactory  to  and  to  be  approved  by  him,  in  such 
penal  sum  as  he  may  require,  conditioned  for  the  payment  by  the  tax- 
payer of  any  amount  of  taxes  foimd  due  if  the  taxes  when  paid  differ 
from  the  amount  claimed  in  respect  thereof. 

INTEREST  ON  LIBERTY  BONDS,  ETC 

14.  In  case  the  partnership  or  personal  service  corporation  owned 
Liberty  Bonds  or  other  obligations  of  the  United  States  issued  since 
September  1,  1917  (except  Victory  Liberty  Loan  3J%  Notes,  and  postal 
saving  certificates  of  deposit),  or  a  share  of  these  obligations  held  by 
another  partnership,  personal  service  corporation,  or  a  fiduciary,  the 
partnership  or  personal  service  corporation  should  advise  each  partner 
or  stockholder  as  to  his  proportionate  amount  of  these  obligations  and  the 
interest  thereon,  in  order  that  the  partner  or  stockholder  may  determine 
whether  the  interest  is  taxable  on  his  individual  income-tax  return. 

PERIOD  COVERED. 

15.  The  accounting  period  is  the  calendar  year  ending  December  3!, 
1921,  or  the  fiscal  year  ending  on  the  last  day  of  any  month  other  than 
December  in  the  calendar  year  1921.  The  accounting  period  estabUshed 
for  the  year  immediately  preceding  must  be  adhered  to,  unless  permis- 
sion was  received  from  the  Commissioner  to  make  a  change. 

16.  If  a  partnership  or  corporation  changes  its  accounting  period, 
it  shall  as  soon  as  possible  give  to  the  collector  for  transmission  to  the 
Commissioner  written  notice  of  such  change  and  of  its  reasons  therefor. 
Upon  approval  by  the  Commissioner,  the  taxpayer  shall  thereafter  moke 
his  returns  upon  the  basis  of  the  new  accounting  period.  (See  Sections 
2V2  (c)  and  226,  Revenue  Act  of  1921.) 

TIME   AND   PLACE   FOR    FILING. 

1 7.  Returns  must  be  sent  to  the  Collector  of  Internal  Revenue  for  the 
district  in  which  the  partnership's  or  corporation's  principal  place  of 
business  is  located,  so  as  to  reach  the  Collector's  office  on  or  before  tlio 
l.'ilh  day  of  the  third  month  following  the  close  of  the  accounting  period. 

SIGNATURES  AND  VERIFICATION. 

18.  Returns  of  partnerships  must  be  swom  to  by  a  member  of  the 
partnership.  Corporation  returns  must  be  sworn  to  by  the'president ,  vice 
president,  or  other  principal  officer  and  by  the  treasurer  or  assistant 
treasurer  of  the  corporation.  If  receivers,  trustees  in  bankruptcy,  or 
assignees  are  operating  the  property  or  business  of  the  partnership  or 
corporation,  such  receivers,  trustees,  or  assignees  shall  execute  the  return 
under  oath. 

PENALTY  FOR  FAILURE  TO  FILE  RETURN  ON  TIME. 

19.  A  penalty  of  not  more  than  $1,000  attaches  for  failure  to  file  a 
return  witlun  the  time  required  by  law.  If  the  failure  is  wiUfxil  or  an 
attempt  is  made  to  defeat  or  evade  the  tax,  the  penalty  is  an  amount 
not  in  excess  of  810,000  or  imprisormient  for  not  more  than  one  year,  or 
both,  together  with  costs  of  prosecution. 

INFORMATION  AT  THE  SOURCE. 

20.  Every  corporation  making  payments  of  salaries,  wages,  interest, 
rent,  commissions,  or  other  fixed  or  determinable  income  of  SI. 000  or 
more  during  the  calendar  year,  to  any  individual  or  partnership,  is  re- 
quired to  make  a  true  and  accurate  return  to  the  Commissioner  of  Internal 
Revenue,  showing  ihe  nature  and  source  of  such  payments  and  the  name 
and  address  of  the  recipient.  Forms  1096  and  1099,  for  reporting  such 
information,  will  be  furnished  by  any  collector  of  internal  revenue.  Such 
returns  of  information  covering  the  calendar  year  1921  must  be  forwarded 
to  the  Commissioner  of  Internal  Revenue,  Sorting  Section,  Washington, 
D.  C,  in  time  to  be  received  not  loter  than  March  15,  1922. 


1720 


Pa|e  2  of  Initructioni. 


SCHEDULES  TO  BE  FURNISHED  IN   SUPPORT  OF  ITEMS  IN  SCHEDULE  A. 


'The  schedules  called  for  below  should  be  prepared  and  firmly  attached  to  the  return.  Designate  each  schedule  with  the  number  of  the  item  in 
Schedule  A  which  it  explains.  Make  schedules  on  paper  of  uniform  size,  so  far  as  practicable,  and  enter  the  name  and  address  on  each  sheet.  Attach 
&  list  of  schedules  accompanying  the  return,  giving  for  each  a  brief  title  and  schedule  nmnbcr. 


If  you  are  eogaged  in  a  trade  cr  businces  in  which  the  production,  purchaee,  or  sale 
of  merchandiBo  ia  an  income- producing  (actor,  (a)  secure  from  the  Collector  of  Internal 
Revenue  and  file  as  a  part  of  this  return  Certificate  of  Inventory.  Form  1126,  and  (6)  aubmit 
a  acbedule  showing — 

(1)  Cost  of  merchaodifie  bought  for  sale. 

(2)  Coat  of  manufacturing  or  otherwiee  producing  goods.    (List  principal  itemfi  of 

cost,  grouping  minor  items  in  one  amount.) 

(3)  Plue  inventor^'  at  beginning  of  year. 
{4)  Total  of  Items  1  to  3.  inclusive. 

*     (5)  Less  inventory  at  end  of  year. 

(6)  Cost  of  goods  sold.  Item  1  minus  Item  5. 


SCHEDULE  A8:  DIVIDENDS  SUBJECT  TO  SURTAX  ONLY. 

Submit  a  schedule  showing  the  amount  received  aa  diudeads  (o)  from  each  domestic 
corporation  other  than  a  corporation  entitled  to  the  bcnefita  of  Seiliou  2G2  of  the  Revenue 
Act  of  1921,  or  (b)  from  each  foreign  corporation  when  it  is  shown  to  the  satisfaclioa  of  the 
Commissioner  that  more  than  50  per  centum  of  thegroaa  income  of  such  foreign  corporation 
for  the  three-year  period  ending  vrith  the  close  of  ita  taxable  year  preceding  the  declaration 
o(  such  di\'idenda  (or  for  such  part  of  such  period  as  the  corporation  has  been  in  existence^ 
was  derivc-d  from  sources  within  the  United  Pt:»tes  a£  determine-!  under  the  proviBiODB  of 
SiTtion  217  of  the  Act. 

SCHEDULE    A9:    DIVIDENDS  SUBJECT  TO  BOTH  NORMAL  AND  SURTAX. 

Submit  a  schedule  showing  dividends  subject  to  both  normal  and  surtax,  whflhcrv 
received  from  foreign  or  domestic  corporations,  and  which  are  not  allowed  as  a  credit 
under  Section  216  of  the  Revenue  Act  of  1921. 

SCHEDULE  AIO:  OTHER  INCOME  (not  including  any  amount  with  reapect  to 
calcB  of  capital  aaaets  or  miaoellaneoua  tnveatmenta  nor  interest  on  Liberty 
Bond*). 

Submit  a  schedule  showing  the  source,  nature,  and  amouot  of  the  principal  item^ 
included  herein,  the  minor  items  bein^gmuped  in  one  amount. 


Submit  a  achedule  showing  character  and  amount  of  the  principal  itenu  included 
herein,  the  minor  items  being  grouped  in  one  amount. 

SCHEDULE  AI3i  COMPENSATION  OF  PARTNERS  OR  SHAREHOLDERS. 

Submit  a  schedule  showing  for  each  member  of  the  partnerehip  or  et/ickholder  of  the 
corporation  who  was  performing  active  service  or  who  received  compensation  in  any  form 
from  the  partnerBhipor  corporation,  (n)  name,  (5)  duties,  (c)  time  devoted  to  such  duties, 
and  (rf)  total  compensation  for  the  accouutL-.g  pe'-od.  A  personal  8e^^^ce  corporation 
ehould  also  explain  fully  the  manner  and  degree  in  which  the  earnings  of  the  corporation 
are  dependent  on  the  activitiea  of  the  stockholders. 


tverhead,  and  othei 


of  the  prinLipal  i 


Submit  a  schedule  showing  the  nature  and  : 
herein,  the  minor  items  being  grouped  in  one  amount. 

Incidental  repairs,  which  do  not  add  to  the  value  or  appreciably  prolong  the  life  of 
property,  are  deductible  as  expense.  Expenditui-es  lor  new  buildings  or  for  permanent 
improvements  or  betterments  ^rhith  in-rea;e  the  value  of  the  property  are  chargeable 
to  capital  account.  Expenditures  for  restoring  or  replacing  property  arc  not^ deductible 
under  this  or  any  other  item  of  the  return.  Such  expenditures  are  chargeaMo  to  capital 
account  or  to  depreciation  reserve?,  depending  on  the  treatment  of  depreciation  on  the 
looks  of  the  taxpayer. 

SCHEDULE    AIS:  INTEREST. 

Submit  a  detailed  schedule  with  reapect  to  intetMt  paid  or  credited  to  any  member. 
State  the  character  and  origin  of  the  principal  on  which  the  intercut  was  computed,  and 
whether  such  principal  ia  evidenced  by  notes  or  other  forms  of  contract.    Describe  fully. 

The  amount  of  interest  deductible  under  Item  15,  Schedule  A,  is  the  amount  of  interest 
paid  or  accrued  »nthin  the  taxable  year  on  indebted hcsp.  except  on  indebtedness  incurred 
or  continued  to  purchase  or  carry  obligations  or  pecuritica  (other  than  obligations  of  tho 
United  States  iflsued  aft^r  September  2-t,  I'J17,  and  originally  subscribed  for  by  the  tax- 
payer) the  interest  upon  which  is  wholly  exempt  from  taxation. 

SCHEDULE  A16:  TAXES. 

Submit  a  schedulo  showing  taxes  paid  or  accrued  within  the  taxable  year  except 
(a)  income,  war  profits  and  excess  pronta  taxes  imposed  by  the  authority  of  the  Uoit<-d 
State*,  (6)  w  much  of  the  income,  war  pronta  and  exc<-m  profit*  Uxcs.  imposed  by  th" 
authority  of  any  foreign  country  or  poajf-caiou  of  thf  l'nit<-d  Slal«B,  as  is  ullotwd  as  a 
cn-dit  under  Section  222,  Revenue  Act  of  1921,  (c)  inxes  osdrsaed  asainst  local  bcnffif^  of 
a  kind  tending  to  increase' the  value  of  the  properly  ninrssed,  and  (</)  taxrs  iinpofk-d  upon 
the  taxpayer  upon  his  interedl  asshareholdrr  or  member  of  a  rorporalit-n.  whirh  aro  paid 
by  the  corporation  without  rtimbursfmenl  from  thr  taxpayer. 


SCHEDULE  AI7;    BAD  DEBTS. 

Submit  a  SL-hedulo  showing  debts,  or  portions  thereof,  arising  from  sales  or  profeasjonal 
services  that  have  been  reported  os  income,  which  have  been  definitely  aacertaiocrJ  to 
bo  worthier  and  charged  0^  within  the  accounting  period,  or  such  reasonable  amount 
aa  has  been  added  to  a  re^rve  for  b:»d  debta  within  the  year. 

If  the  iimount  entered  aa  Item  17,  Schedule  A.  is  an  addition  to  a  reserve,  furnish 
proof  of  the  reasonableness  of  the  amount.  (See  Section  234  (a)  5  of  the  Revenue  Act 
of  1921  ) 

SCHEDULE  At8:  EXHAUSTION,  WEAR  AND  TEAR  (including  obsolescence). 

Submit  a  schedule  in  colutrnar  form  showing  for  each  class  of  property  the  following 
information : 

(1)  Kind  of  property  (if  buildings,  state  material  of  which  constructed). 

(2)  Date  acquired. 

(3)  Age  i\-hen  acquired. 

(4)  Coat,  or  if  acquired  prior  to  March  I,  1913,  the  fair  market  value  on  that  date. 

(5)  Probable  life  after  acquirement. 

(6)  Amount  of  depreciation  charged  off  this  yoar. 

(7)  Total  amount  of  depreciation  charged  off  previous  to  this  yoor. 

.The  total  amount  claimed  in  this  schedule  should  correspond  with  the  figures  reflected 
in  the  balance  sheet. 

If  obsDlcscenco  is  a  factor  in  determining  your  deduction,  attach  a  statement  showing 
the  amount  claimed  for  the  accounting  period  and  tho  basis  on  which  computed. 

The  amount  deductible  on  account  of  depreciation  is  an  amount  charged  off  which 
fairly  measures  the  loss  during  the  accounting  period  in  the  value  of  physical  property  by 
reason  of  exhaustion,  wear,  tear,  and  obsolescence.  Such  an  amount  should  be  determined 
on  the  basis  of  th^  cost  of  the  property,  or  if  acquired  prior  to  March  1,  1913,  the  fair  market 
value  on  thzt  date  aud  the  probable  number  of  ycara  constituting  its  life.  The  capital 
Bura  to  be  iDpUcod  should  be  charged  off  over  the  probable  life  of  the  properly  cither  in 
equal  annual  installmrols  or  ia  accordance  with  .".ny  other  recognized  trade  practice,  such 
as  an  apportionment  of  the  capital  sum  over  units  of  production  Whatever  plan  or  method 
of  apportionment  is  adopted  must  be  reasonable  and  should  be  described  in  the  return. 
Stocks,  bonds,  and  like  securities  arc  not  subject  to  exhaustion,  wear  and  tear  within  the 
meaning  of  the  law. 

SCHEDULE  A19;   DEPLETION. 

If  a  deduction  is  claimed  on  account  of  depletion,  secure  from  the  Collector  Form  D 
(minerals).  Form  E  (coal).  Form  F  (miscellaneoiH  nonraetals).  Form  0  (oil  and  gas),  or 
Form  T  (timber),  fill  in  and  fde  with  return.  If  complete  valuation  data  has  been  (lied 
with  questionnaire  in  previous  years,  then  file  with  this  return  information  necessary  to 
bring  your  depletion  schedule  up  to  date,  setting  forth  in  full  elatement  of  all  transactions 
bearing  on  deductions  or  additions  to  value  of  physical  as?etj  with  explanation  of  bow 
depletion  deduction  for  the  accounting  period  has  been  determined.  In  case  of  timber 
thia  should  be  done  by  filling  in  Form  T  (timber). 

SCHEDULE  A20:  AMORTIZATION  OF  WAR  FACILITIES. 

In  case  a  deduction  is  claimed  on  account  of  amortiution,  a  schedule  should  be  sub- 
mitted containing  the  information  called  for  in  Guide  Form  1007M,  which  explains  in 
detail  the  manner  in  which  a  claim  of  this  nature  should  bo  presented.  A  copy  of  this 
form  may  be  obtained  from  the  Commissioner.  (See  Section  H4  (o)  9  of  the  Revenue  Act 
of  1921.) 


Subm 


icht-duic 


r  form  showing  the  following  information  fur  each  a 


(1)  Kind  of  property. 

(2)  Date  acquired. 

(3)  Sale  price. 

(4)  Cu.t. 

(.')]  Fair  market  value  on  March  1,  1913,  if  acquired  prior  to  that  date. 

(6)  Cost  of  Bubsetjueut  improvements. 

(7)  Deprocialion. 

(5)  Netpro6l(orlo-:.), 

(9)  Amount  in  column  S  which  represents  good  will,  If  any. 

If  any  of  the  a.':^ets  were  acquired  prior  to  March  I,  1913,  state  how  the  fair  market 
value  oi)  that  dale  was  determined. 

In  ca^e  of  exrhanse  of  property,  submit  evidcnre  ttub-tantiatinj^  the  ba^ii  u^ed  in 
aiTinng  at  the  fair  market  value  of  the  properly  received. 

SCHEDULE  A24:  LOSSES  SUSTAINED  BY  FIRE,  STORM,  ETC. 

A  schedule  similar  to  the  ouo  requested  ubuvo  nhnuld  be  nubmittcd  with  rosport  to 
Kwea  of  property  ari-ing  from  lire?",  Ht'>rins,  shipnTeck,  or  ether  casu-olty,  or  from  (heft, 
and  not  cnmpcn-^aled  for  by  inAuraucc  or  olherwL>w,  except  that  column  3  should  show 
"IniuwDfcaiidpalvaKo"  instead  of  "Sale  price." 

CAPITAL  EMPLOYED   IN  BUSINESS. 
If  the  balance  ehcot  (S(  hedulo  D)  of  a  peraonal  nervicc  corporalion  indiinlw  that  a 
substanliol  amount  of  capiul  (invoHtod  or  borrowed)  is  employed  in  the  busine^.  submit  a 
statement  explaining  why  the  employment  of  such  capital  ii  incidental  and  aotnece^ary. 


WORKING  PAPERS. 


Everj' partnership  or  c'TiHir: 
ofCciT,  wnrkinR  papers  ^hov/int;- 

1.  The  balftiirf>  in  -- 1- 1 

wa-U'cdiii  I         ■' 

2.  Theann.'.ii.i  a    !     u 

Iftxalile  ii I 

inSvlie.!..!-       «. 

3.  The  remainder  of  e: 


m  Mb.'iild  preserve,  avaibble  U-r  innjwttion  by  a  revenue 

■f  "-tnt  ..fi  tli.>  partnerfhip'ri  or  corporation's  Ivook.-.  that 

n.  .  I  !i    HI  Ii  balance  on  account  of  each  rloM*  of  non- 
11  .v>:  ir  .l.ductton-<,  and  otiior  adjustments  indicated 
i»  It  l.-i>  i«  (•  (••  tire  numlier  o(  tho  item  in  Schedule  ('  in 
oUiHlu.  ted  waa  included. 
Kucit  balance,  analyzed  tn  show  the  amount  included 


1721 


This  form  will  not  be  accepted  unless  all  information  called  for  is  furnished. 


STATEMENT  OF  INCOME  RECEIVED  BY  NONRESIDENT  ALIEN  FROM  SOURCES  WITHIN  UNITED  STATES 


PERSONAL  EXEMPTION  CLAIMED. 


FOR  CALENDAR  YEAR  1921 


lo  be  iiled  with  withholding  agent  by  nonresident  alien  individual  owning  bonds  of  a  domestic  corporation  which  contain  a  tax-free  covenant  clause.    The 
execution  of  this  certificate  does  not  relieve  the  bond  owner  from  fiUng  oivncrship  certificates  required  by  the  regulations. 


NAMES  rHUST  BE  PRINTED  OR  WRITTEN  PLAINLY 


DEBTOR   ORGANIZATION. 


City State . 


OWNER   OF  BONDS. 


Street . 


City 

Subject  of . 


This  is  to  certify  that  the  owner  of  the  above-described  bonda 
is  a  nonresident  alien  as  to  the  United  States  and  is  a  subject 
of  the  country  as  stated  above,  and  is  entitled  to  the  personal 
exemption  of  $1,000  as  provided  by  Section  216  of  the  Revenue 
Act  of  1921. 


Bond  interest  received  during  calendar  year  with 
respect  to  tax-tree  covenant  bond.s  issued  by 
above-named  corporation $.. 

All  other  income  from  sources  in  United  States...  $  . 


Total ; 

Personal  exemption $1  ,000.00 


Note. — For  the  taxable  year  1921  and  subsequent  years,  only  $1,000  personal  exemption  is  allowed  a  nonresident  alien  indiWduol, 
whether  he  is  single,  married,  or  the  head  of  a  family,  and  regardless  of  his  nationality.    No  credit  is  allowed  for  dependents. 


TO  BE  FILLED  IN  BY  WITHHOLDING  AGENT. 


District  in  which  return  Form  1013  is  filed  

Amount  of  tax  required  to  be  withheld  at  source  as  shown  by  Form  1013,  for  1921,  $ _ 

To  be  reduced  on  accoimt  of  personal  exemption  claimed  as  indicated  by  this  certificate,  the  items  ap|icaring  on  the  following 
monthly  returns,  Form  1012:' 


Month..-. Page Amount  of  tax...  $.. 

Montli Page Amount  of  tax 

Month Page Amount  of  tajc 

Month Page Amount  of  tax...    ._. 

Total...  $.. 


Kamc  of  withholding  agent. 


1722 


APPENDIX  C 
REVENUE  ACT  OF  1921 


APPENDIX  C 

REVENUE  ACT  OF  1921 

[Public — No.  98 — 67TH  Congress.] 
[H.  R.  8245.] 

An  Act  To  reduce  and  equalize  taxation,  to  provide  revenue,  and  for 
other  purposes. 

Be  it  enacted  by  the  Senate  and  House  of  Representatives  of  the  United 
States  of  America  in  Congress  assembled, 

TITLE   I.— GENERAL    DEFINITIONS. 

Section  i.     That  this  Act  may  be  cited  as  the  "Revenue  Act  of  1931." 
Sec.  2.     That  when  used  in  this  Act — 

(i)  The  term  "person"  includes  partnerships  and  corporations,  as  well 
as  individuals ; 

(2)  The  term  "corporation"  includes  associations,  joint-stock  com- 
panies, and   insurance   companies ; 

(3)  The  term  "domestic"  when  applied  to  a  corporation  or  partner- 
ship means  created  or  organized  in  the  United  States ; 

(4)  The  term  "foreign"  when  applied  to  a  corporation  or  partnership 
means  created  or  organized  outside  the  United  States; 

(5)  The  term  "United  States"  when  used  in  a  geographical  sense 
includes  only  the  States,  the  Territories  of  Alaska  and  Hawaii,  and  the 
District  of   Columbia ; 

(6)  The  term  "Secretary"  means  the  Secretary  of  the  Treasury ; 

(7)  The  term  "Commissioner"  means  the  Commissioner  of  Internal 
Revenue ; 

(8)  The  term  "collector"  means  collector  of  internal  revenue ; 

(9)  The  term  "taxpayer"  includes  any  person,  trust  or  estate  sub- 
ject to  a  tax  imposed  by  this  Act; 

(10)  The  term  "military  or  naval  forces  of  the  United  States"  in- 
cludes the  Marine  Corps,  the  Coast  Guard,  the  Army  Nurse  Corps,  Female, 
and  the  Navy  Nurse  Corps,  Female,  but  this  shall  not  be  deemed  to  ex- 
clude other  units  otherwise  included  within  such  terms;  and 

(11)  The  term  "Government  contract"  means  (a)  a  contract  made 
with  the  United  Sfates,  or  with  any  department,  bureau,  officer,  com- 
mission, board,  or  agency,  under  the  United  States  and  acting  in  its  behalf, 
or  with  any  agency  controlled  by  any  of  the  above  if  the  contract  is  for 
the  benefit  of  the  United  States,  or   (b)   a  subcontract  made  with  a  con- 

1725 


17^6  REVENUE   ACT    OF    1921 

tractor  performing  such  a  contract  if  the  products  or  services  to  be 
furnished  under  the  subcontract  are  for  the  benefit  of  the  United  States. 
The  term  "Government  contract  or  contracts  made  between  April  6,  1917, 
and  November  11,  1918,  both  d&tes  inclusive"  when  applied  to  a  contract 
of  the  kind  referred  to  in  clause  (a)  of  this  subdivision,  includes  all  such 
contracts  which,  although  entered  into  during  such  period,  were  originally 
not  enforceable,  but  which  have  been  or  may  become  enforceable  by  reason 
of  subsequent  validation  in  pursuance  of  law. 


TITLE  II.— INCOME  TAX. 

Part  I. — General  Provisions. 

Definitions 

Sec.  200.     That  when  used  in  this  title — 

(i)  The  term  "taxable  year"  means  the  calendar  year,  or  the  fiscal 
year  ending  during  such  calendar  year,  upon  the  basis  of  which  the  net 
income  is  computed  imder  section  212  or  section  232.  The  term  "fiscal 
year"  means  an  accounting  period  of  twelve  months  ending  on  the  last 
day  of  any  month  other  than  December.  The  first  taxable  year,  to  be 
called  the  taxable  year  1921,  shall  be  the  calendar  year  1921  [1918]  or  any 
fiscal  year  ending  during  the  calendar  year  1921 ; 

(2)  The  term  "fiduciary"  means  a  guardian,  trustee,  executor,  ad- 
ministrator, receiver,  conservator,  or  any  person  acting  in  any  fiduciary 
capacity  for  any  person,  trust  or  estate ; 

(3)  The  term  "withholding  agent'"'  means  any  person  required  to  de- 
duct and  withhold  any  tax  under  the  provisions  of  section  221  or 
section  237 ; 

(4)  The  term  "paid"  for  the  purposes  of  the  deductions  and  credits 
under  this  title  means  "paid  or  accrued"  or  "paid  or  incurred,"  and  the 
terms  "paid  or  incurred"  and  "paid  or  accrued"  shall  be  construed  accord- 
ing to  the  method  of  accounting  upon  the  basis  of  which  the  net  income 
is  computed  under  section  212;  and 

(5)  The  term  "personal  service  corporation"  means  a  corporation 
whose  income  is  to  be  ascribed  primarily  to  the  activities  of  the  principal 
owners  or  stockholders  who  are  themselves  regularly  engaged  in  the 
active  conduct  of  the  afifairs  of  the  corporation  and  in  which  capital 
(whether  invested  or  borrowed)  is  not  a  material  income-producing  factor; 
but  does  not  include  any  foreign  corporation,  nor  any  corporation  50  per 
centum  or  more  of  whose  gross  income  consists  either  (i)  of  gains, 
profits,  or  income  derived  from  trading  as  a  principal,  or  (2)  of  gains, 
profits,  commissions,  or  other  income,  derived  from  a  Government  contract 
or  contracts  made  between  April  6,  1917,  and  November  11,  1918,  both 
dates  inclusive. 


REVENUE   ACT   OF   1921  1 727 

Dividends 

Sec.  201  (a)  That  tlic  term  "dividend"  when  used  in  this  title  (ex- 
cept in  paragraph  (10)  of  subdivision  (a)  of  section  234  and  paragraph 
(4)  of  subdivision  (a)  of  section  245)  means  any  distribution  made  by  a 
corporation  to  its  shareholders  or  members,  whether  in  cash  or  in  other 
property,  out  of  its  earnings  or  profits  accumulated  since  February  28, 
1913,  except  a  distribution  made  by  a  personal  service  corporation  out  of 
earnings  or  profits  accumulated  since  December  31,  1917,  and  prior  to 
January  i,  1922. 

(b)  For  the  purposes  of  this  Act  every  distribution  is  made  out  of 
earnings  or  profits,  and  from  the  most  recently  accumulated  earnings  or 
profits,  to  the  extent  of  such  earnings  or  profits  accumulated  since 
February  28,  1913 ;  but  any  earnings  or  profits  accumulated  or  increase  in 
value  of  property  accrued  prior  to  March  i,  1913,  may  be  distributed 
exempt  from  the  tax,  after  the  earnings  and  profits  accumulated  since 
February  28,  1913,  have  been  distributed.  If  any  such  tax-free  distribution 
has  been  made  the  distributee  shall  not  be  allowed  as  a  deduction  from 
gross  income  any  loss  sustained  from  the  sale  or  other  disposition  of  his 
stock  or  shares  unless,  and  then  only  to  t'he  extent  that,  the  basis  provided 
in  section  202  exceeds  the  sum  of  (i)  the  amount  realized  from  the  sale 
or  other  disposition  of  such  stock  or  shares,  and  (2)  the  aggregate  amount 
of   such   distributions   received  by  him   thereon. 

(c)  Any  distribution  (whether  in  cash  or  other  property)  made  by  a 
corporation  to  its  shareholders  or  members  otherwise  than  out  of  (i) 
earnings  or  profits  accumulated  since  February  28,  1913,  or  (2)  earnings 
or  profits  accumulated  or  increase  in  value  of  property  accrued  prior  to 
March  i,  1913,  shall  be  applied  against  and  reduce  the  basis  provided  in 
section  202  for  the  purpose  of  ascertaining  the  gain  derived  or  the  loss 
sustained  from  the  sale  or  other  disposition  of  the  stock  or  shares  by 
the  distributee. 

(d)  A  stock  dividend  shall  not  be  subject  to  tax  but  if  after  the  dis- 
tribution of  any  such  dividend  the  corporation  proceeds  to  cancel  or  redeem 
its  stock  at  such  time  and  in  such  manner  as  to  make  the  distribution  and 
cancellation  or  redemption  essentially  equivalent  to  the  distribution  of  a 
taxable  dividend,  the  amount  received  in  redemption  or  cancellation  of  the 
stock  shall  be  treated  as  a  taxable  dividend  to  the  extent  of  the  earnings 
or  profits  accumulated  by  such  corporation  after  February  28,  1913. 

(e)  For  the  purposes  of  this  Act,  a  taxable  distribution  made  by  a  cor- 
poration to  its  shareholders  or  members  shall  be  included  in  the  gross  in- 
come of  t'he  distributees  as  of  the  date  when  the  cash  or  other  property 
is  unqualifiedly  made  sul)ject  to  their  demands. 

(f)  Any  distribution  made  during  the  first  sixty  days  of  any  taxable 
year  shall  be  deemed  to  have  been  made  from  earnings  or  profits  accum- 
ulated during  preceding  taxable  years ;  but  any  distribution  made  during 
the  remainder  of  the  taxable  year  shall  be  deemed  to  have  been  made 
from  earnings  or  profit's  accumulated  between  the  close  of  the  preceding 


1-28  REVENUE   ACT    OF    1921 

taxable  year  and  the  date  of  distribution,  to  the  extent  of  such  earnings 
or  profits,  and  if  the  books  of  the  corporation  do  not  show  the  amount 
of  such  earnings  or  profits,  the  earnings  or  profits  for  the  accounting 
period  within  which  the  distribution  was  made  shall  l)e  deemed  to  have 
been  accumulated  ratably  during  such  period.  This  subdivision  shall  not  be 
in  effect  after  December  31.  1921. 

Basis  for  Determining  Gain  or  Loss 

Sec.  202.  (a)  That  the  basis  for  ascertaining  the  gain  derived  or  loss 
sustained  from  a  sale  or  other  disposition  of  property,  real,  personal,  or 
mixed,  acquired  after  February  28,  1913,  shall  be  the  cost  of  such  property: 
except  that — 

(i)  In  the  case  of  such  property,  which  should  be  included  in  the  in- 
ventory, the  basis  shall  be  the  last  inventory  value  thereof ; 

(2)  In  the  case  of  such  property,  acquired  by  gift  after  December  31, 
1920,  the  basis  shall  be  the  same  as  that  which  it  would  have  in  the  hands 
of  the  donor  or  the  last  preceding  owner  by  whom  it  was  not  acquired  by 
gift.  If  the  facts  necessary  to  determine  such  basis  are  unknown  to  the 
donee,  the  Commissioner  shall,  if  possible,  obtain  such  facts  from  such 
donor  or  last  preceding  owner,  or  any  other  person  cognizant  thereof.  If 
the  Commissioner  finds  it  impossible  to  obtain  such  facts,  the  basis  shall 
be^  the  value  of  such  property  as  found  by  the  Commissioner  as  of  the 
date  or  approximate  date  at  which,  according  to  the  best  information  the 
Commissioner  is  able  to  obtain,  such  property  was  acquired  by  such  donor 
or  last  preceding  owner.  In  the  case  of  such  property  acquired  by  gift 
on  or  before  December  31,  1920,  the  basis  for  ascertaining  gain  or  loss  from 
a  sale  or  other  disposition  thereof  shall  be  the  fair  market  price  or  value 
of  such  property  at  the  time  of  such  acquisition; 

(3)  In  the  case  of  such  property,  acquired  by  bequest,  devise,  or  in- 
heritance, the  basis  shall  be  the  fair  market  price  or  value  of  such  property 
at  the  time  of  such  acquisition.  The  provisions  of  this  paragraph  shall 
apply  to  the  acquisition  of  such  property  interests  as  are  specified  in  sub- 
division  (c)   or   (e)   of  section  402. 

(b)  The  basis  for  ascertaining  the  gain  derived  or  loss  sustained  from 
the  sale  or  other  disposition  of  property,  real,  personal,  or  mixed,  acquired 
before  March  i,  1913,  shall  be  the  same  as  that  provided  by  subdivision 
(a)  ;  but— 

(i)  If  its  fair  market  price  or  value  as  of  March  i,  1913,  is  in  excess 
of  such  basis,  the  gain  to  be  included  in  the  gross  income  shall  be  the 
excess  of  the  amount  realized  therefor  over  such  fair  market  price  or  value ; 

(2)  If  its  fair  market  price  or  value  as  of  March  i,  1913,  is  lower 
than  such  basis,  the  deductible  loss  is  the  excess  of  the  fair  market  price 
or  value  as  of  March  i,  1913,  over  the  amount  realized  therefor;  and 

(3)  If  the  amount  realized  therefor  is  more  than  such  basis  but  not 
more   than   its   fair  market   price   or   value   as   of   March    i,    1913,   or   less 


REVENUE   ACT   OF    1921  1 729 

than   such  basis  but  not  less   than  such    fair  market  price  or  value,   no 
gain  shall  be  included  in  and  no  loss  deducted  from  the  gross  income. 

(c)  For  the  purposes  of  this  title,  on  an  exchange  of  property,  real, 
personal  or  mixed,  for  any  other  such  property,  no  gain  or  loss  shall 
be  recognized  unless  the  property  received  in  exchange  has  a  readily 
realizable  market  value;  but  even  if  the  property  received  in  exchange 
has  a  readily  realizable  market  value,  no  gain  or  loss  shall  be  recognized — • 

(i)  When  any  such  property  held  for  investment,  or  for  productive 
use  in  trade  or  business  (not  including  stock-in-trade  or  other  property 
held  primarily  for  sale),  is  exchanged  for  property  of  a  like  kind  or  use; 

(2)  When  in  the  reorganization  of  one  or  more  corporations  a  person 
receives  in  place  of  any  stock  or  securities  owned  by  him,  stock  or  secur- 
ities in  a  corporation  a  party  to  or  resulting  from  such  reorganization. 
The  word  "reorganization,"  as  used  in  this  paragraph,  includes  a  merger 
or  consolidation  (including  the  acquisition  by  one  corporation  of  at  least 
a  majority  of  the  voting  stock  and  at  least  a  majority  of  the  total  number 
of  shares  of  all  other  classes  of  stock  of  another  corporation,  or  of  sub- 
stantially all  the  properties  of  another  corporation),  recapitalization,  or 
mere  change  in  identity,  form,  or  place  of  organization  of  a  corporation, 
(however  effected)  ;  or 

(3)  When  (A)  a  person  transfers  any  property,  real,  personal  or 
mixed,  to  a  corporation,  and  immediately  after  the  transfer  is  in  control 
of  such  corporation,  or  (B)  two  or  more  persons  transfer  any  such 
property  to  a  corporation,  and  immediately  after  the  transfer  are  in 
control  of  such  corporation,  and  the  amounts  of  stock,  securities,  or  both, 
received  by  such  persons  are  in  substantially  the  same  proportion  as  their 
interests  in  the  property  before  such  transfer.  For  the  purposes  of  this 
paragraph,  a  person  is,  or  two  or  more  persons  are,  "in  control"  of  a 
corporation  when  owning  at  least  80  per  centum  of  the  voting  stock  and 
at  least  80  per  centum,  of  the  total  number  of  shares  of  all  other  classes 
of  stock  of  the  corporation. 

(d)  (i)  Where  property  is  exchanged  for  other  property  and  no 
gain  or  loss  is  recognized  under  the  provisions  of  subdivision  (c), 
the  property  received  shall,  for  the  purposes  of  this  section,  be  treated  as 
taking  the  place  of  the  property  exchanged  therefor,  except  as  provided 
in  subdivision  (e)  ; 

(2)  Where  property  is  compulsorily  or  involuntarily  converted  into 
cash  or  its  equivalent  in  the  manner  described  in  paragraph  (12)  of  sub- 
division (a)  of  section  214  and  paragraph  (14)  of  subdivision  (a)  of 
section  234,  and  the  taxpayer  proceeds  in  good  faith  to  expend  or  set 
aside  the  proceeds  of  such  conversion  in  the  form  and  in  the  manner 
therein  provided,  the  property  acquired  shall,  for  the  purpose  of  this 
section,  be  treated  as  taking  the  place  of  a  like  proportion  of  the  property 
converted. 

(3)  Where  no  deduction  is  allowed  for  a  loss  or  a  part  thereof  under 
the  provisions  of  paragraph    (5)    of   subdivision    (a)    of   section  214  and 


I730  REVENUE   ACT    OF    1921 

paragraph  (4)  of  subdivision  (a)  of  section  234,  that  part  of  the 
property  acquired  with  relation  to  which  such  loss  is  disallowed  shall  for  the 
purposes  of  this  section  be  treated  as  taking  the  place  of  the  property 
sold  or  disposed  of. 

(e)  Where  property  is  exchanged  for  other  property  which  has  no 
readily  realizable  market  value,  together  with  money  or  other  property 
which  has  a  readily  realizable  market  value,  then  the  money  or  the 
fair  market  value  of  the  property  having  such  readily  realizable  market 
value  received  in  exchange  shall  be  applied  against  and  reduce  the  basis, 
provided  in  this  section,  of  the  property  exchanged,  and  if  in  excess  of 
such  basis,  shall  be  taxable  to  the  extent  of  the  excess ;  but  when  property 
is  exchanged  for  property  specified  in  paragraphs  (i),  (2),  and  (3)  of 
subdivision  (c)  as  received  in  exchange,  together  with  money  or  other 
property  of  a  readily  realizable  market  value  other  than  that  specified  in 
such  paragraphs,  the  money  or  the  fair  market  value  of  such  other  property 
received  in  exchange  shall  be  applied  against  and  reduce  the  basis,  pro- 
vided in  this  section,  of  the  property  exchanged,  and  if  in  excess  of  such 
basis  shall  be  taxable  to  the  extent  of  the  excess. 

(f)  Nothing  in  this  section  shall  be  construed  to  prevent  (in  the 
case  of  property  sold  under  contract  providing  for  payment  in  install- 
ments) the  taxation  of  that  portion  of  any  installment  payment  repre- 
senting gain  or  profit  in  the  year  in  which  such  payment  is  received. 

Inventories 

Sec.  203.  That  whenever  in  the  opinion  of  the  Commissioner  the  use 
of  inventories  is  necessary  in  order  clearly  to  determine  the  income  of 
any  taxpayer,  inventories  shall  be  taken  by  such  taxpayer  upon  such 
basis  as  the  Commissioner,  with  the  approval  of  the  Secretary,  may  pre- 
scribe as  conforming  as  nearly  as  may  be  to  the  best  accounting  practice 
in  the  trade  or  business  and  as  most  clearly  reflecting  the  income. 

Net  Losses 

Sec.  204.  (a)  That  as  used  in  this  section  the  term  "net  loss"  means 
only  net  losses  resulting  from  the  operation  of  any  trade  or  business 
regularly  carried  on  by  the  taxpayer  (including  losses  sustained  from  the 
sale  or  other  disposition  of  real  estate,  machinery,  and  other  capital  assets, 
used  in  the  conduct  of  such  trade  or  business)  ;  and  when  so  resulting 
means  the  excess  of  the  deductions  allowed  by  section  214  or  234,  as  the 
case  may  be,  over  the  sum  of  the  following:  (i)  the  gross  income  of  the 
taxpayer  for  the  taxable  year,  (2)  the  amount  by  which  the  interest 
received  free  from  taxation  under  this  title  exceeds  so  much  of  the  interest 
paid  or  accrued  within  the  taxable  year  on  indebtedness  as  is  not  permitted 
to  be  deducted  by  paragraph  (2)  of  subdivision  (a)  of  section  214  or  by 
paragraph  (2)  of  subdivision  (a)  of  section  234,  (3)  the  amount  by  which 
the  deductible  losses  not  sustained  in  such  trade  or  business  exceed  the 
taxable   gains   or   profits   not   derived    from   such   trade   or   business,    (4) 


REVENUE  ACT   OF   1921  1 731 

amounts  received  as  dividends  and  allowed  as  a  deduction  under  paragraph 
(6)  of  subdivision  (a)  of  section  234,  and  (5)  so  much  of  the  depletion 
deduction  allov^red  with  respect  to  any  mine,  oil  or  gas  well  as  is  based 
upon  discovery  value  in  lieu  of  cost. 

(b)  If  for  any  taxable  year  beginning  after  December  31,  1920,  it 
appears  upon  the  production  of  evidence  satisfactory  to  the  Commissioner 
that  any  taxpayer  has  sustained  a  net  loss,  the  amount  thereof  shall  be 
deducted  from  the  net  income  of  the  taxpayer  for  the  succeeding 
taxable  year;  and  if  such  net  loss  is  in  excess  of  the  net  income  for  such 
succeeding  taxable  year,  the  amount  of  such  excess  shall  be  allowed  as  a 
deduction  in  computing  the  net  income  for  the  next  succeeding  taxable 
year;  the  deduction  in  all  cases  to  be  made  under  regulations  prescribed 
by  the  Commissioner  with  the  approval  of  the  Secretary. 

(c)  The  benefit  of  this  section  shall  be  allowed  to  the  members  of 
a  partnership  and  the  beneficiaries  of  an  estate  or  trust,  and  to  insurance 
companies  subject  to  the  tax  imposed  by  section  243  or  246,  under  reg- 
ulations prescribed  by  the  Commissioner  with  the  approval  of  the 
Secretary. 

(d)  If  it  appears,  upon  the  production  of  evidence  satisfactory  to  the 
Commissioner,  that  a  taxpayer  having  a  fiscal  year  beginning  in  1920  and 
ending  in  1921  has  sustained  a  net  loss  during  such  fiscal  year,  such 
taxpayer  shall  be  entitled  to  the  benefits  of  this  section  in  respect  to  the 
same  proportion  of  such  net  loss  which  the  portion  of  such  fiscal  year 
falling  within  the  calendar  year  1921  is  of  the  entire  fiscal  year. 


FISCAL    YEARS    I92O-I92I    AND    I92I-I922. 

Sec.  205.  (a)  That  if  a  taxpayer  makes  return  for  a  fiscal  year  be- 
ginning in  1920  and  ending  in  1921,  his  tax  under  this  title  for  the  taxable 
year  1921  shall  be  the  sum  of:  (i)  the  same  proportion  of  a  tax  for 
the  entire  period  computed  under  Title  II  of  the  Revenue  Act  of  1918  at 
the  rates  for  the  calendar  year  1920  which  the  portion  of  such  period  fall- 
ing within  the  calendar  year  1920  is  of  the  entire  period,  and  (2)  the  same 
proportion  of  a  tax  for  the  entire  period  computed  under  this  title  at'  the 
rates  for  the  calendar  year  1921,  which  the  portion  of  such  period  falling 
within  the  calendar  year  1921  is  of  the  entire  period. 

Any  amount  paid  before  or  after  the  passage  of  this  Act  on  account 
of  the  tax  imposed  for  such  fiscal  year  by  Title  II  of  the  Revenue  Act 
of  1918  shall  be  credited  toward  the  payment  of  the  tax  imposed  for  such 
fiscal  year  by  this  Act,  and  if  the  amount  so  paid  exceeds  the  amount  of 
such  tax  imposed  by  this  Act,  the  excess  shall  be  credited  or  refunded 
in  accordance  with  the  provisions  of  section  252. 

(b)  If  a  taxpayer  makes  return  for  a  fiscal  year  beginning  in  1921 
and  ending  in  1922,  his  tax  under  this  title  for  the  taxable  year  1922  shall 
be  the  sum  of:  (i)  the  same  proportion  of  a  tax  for  the  entire  period  com- 
puted under  this  title    (as  in   force  on  December  31,   1921)    at  the  rates 


1732  REVENUE   ACT    OF    1921 

for  the  calendar  year  1921  which  the  portion  of  such  period  falling  within 
the  calendar  year  1921  is  of  the  entire  period,  and  (2)  the  same  pro- 
portion of  a  tax  for  the  entire  period  computed  under  this  title  (as  in 
force  on  January  i,  1922)  at  the  rates  for  the  calendar  year  1922  which 
the  portion  of  such  period  falling  within  the  calendar  year  1922,  is  of  the 
entire  period :  Provided,  That  in  the  case  of  a  personal  service  corporation 
the  amount  to  be  paid  shall  be  only  that  specified  in  clause  (2). 

(c)  If  a  fiscal  year  of  a  partnership  begins  in  1920  and  ends  in  1921, 
or  begins  in  1921  and  ends  in  1922,  then  (i)  the  rates  for  the  calendar 
year  during  which  such  fiscal  year  begins  shall  apply  to  an  amount  of 
each  partner's  share  of  such  partnership  net  income  (determined  under  the 
law  applicable  to  such  year)  equal  to  the  proportion  which  the  part  of 
such  fiscal  year  falling  within  such  calendar  year  bears  to  the  full  fiscal  year, 
and  (2)  the  rates  for  the  calendar  year  during  which  such  fiscal  year 
ends  shall  apply  to  an  amount  of  each  partner's  share  of  such  partner- 
ship net  income  (determined  under  the  law  applicable  to  such  calendar 
year)  equal  to  the  proportion  which  the  part  of  such  fiscal  year  falling 
within  such  calendar  year  bears  to  the  full  fiscal  year. 

Capital  Gain 

Sec.  206.     (a)  That  for  the  purpose  of  this  title: 

(i)  The  term  "capital  gain"  means  taxable  gain  from  the  sale  or 
exchange  of  capital  assets  consummated  after  December  31,  1921 ; 

(2)  The  term  "capital  loss"  means  deductible  loss  resulting  from 
the  sale  or  exchange  of  capital  assets  consummated  after  December  31,  1921 ; 

(3)  The  term  "capital  deductions"  means  such  deductions  as  are  al- 
lowed under  this  title  for  the  purpose  of  computing  net  income  and  are 
properly  allocable  to  or  chargeable  against  items  of  capital  gain  as  defined 
in  this  section ; 

(4)  The  term  "capital  net  gain"  means  the  excess  of  the  total  amount 
of  capital  gain  over  the  sum  of  the  capital  deductions  and  capital  losses ; 

(5)  The  term  "ordinary  net  income"  means  the  net  income,  computed 
in  accordance  with  the  provisions  of  this  title,  after  excluding  all  items 
of  capital  gain,  capital  loss,  and  capital  deductions ;  and 

(6)  The  term  "capital  assets"  as  used  in  this  section  means  property 
acquired  and  held  by  the  taxpa5^er  for  profit  or  investment  for  more  than 
two  years  (whether  or  not  connected  with  his  trade  or  business),  but  does 
not  include  property  held  for  the  personal  use  or  consumption  of  the  tax- 
payer or  his  family,  or  stock  in  trade  of  the  taxpayer  or  other  property 
of  a  kind  which  would  properly  be  included  in  the  inventory  of  the  tax- 
payer if   on   hand  at  the   close   of   the   taxable   year. 

(b)  In  the  case  of  any  taxpayer  (other  than  a  corporation)  who  for 
any  taxable  year  derives  a  capital  net  gain,  there  shall  (at  the  election 
of  the  taxpayer)  be  levied,  collected  and  paid,  in  lieu  of  the  taxes  imposed 
by  sections  210  and  211  of  this  title,  a  tax  determined  as  follows: 

A  partial  tax  shall  first  be  computed  upon  the  basis  of  the  ordinary 


REVENUE   ACT    OF    1921  1 733 

net  income  at  the  rates  and  in  the  manner  provided  in  sections  210  and 
211,  and  the  total  tax  shall  be  this  amount  plus  121/2  per  centum  of  the 
capital  net  gain;  but  if  the  taxpayer  elects  to  be  taxed  under  this  section 
the  total  tax  shall  in  no  such  case  be  less  than  12^  per  centum  of  the 
total  net  income.  The  total  tax  thus  determined  shall  be  computed, 
collected  and  paid  in  the  same  manner,  at  the  same  time  and  subject  to 
the  same  provisions  of  law,  including  penalties,  as  other  taxes  under 
this  title. 

(c)  In  the  case  of  a  partnership  or  of  an  estate  or  trust,  the  proper 
part  of  each  share  of  the  net  income  which  consists,  respectively,  of 
ordinary  net  income  and  capital  net  gain,  shall  be  determined  under  rules 
and  regulations  to  be  prescribed  by  the  Commissioner  with  the  approval 
of  the  Secretary,  and  shall  be  separately  shown  in  the  return  of  the 
partnership  or  estate  or  trust,  and  shall  be  taxed  fo  the  member  or 
beneficiary  or  to  the  estate  or  trust  as  provided  in  sections  218  and  219, 
but  at  the  rates  and  in  the  manner  provided  in  subdivision  (b)  of  this 
section. 

Part   II. — Individuals. 

Normal  Tax 

Sec.  210.  That  in  lieu  of  the  tax  imposed  by  section  210  of  the  Revenue 
Act  of  1918,  there  shall  be  levied,  collected,  and  paid  for  each  taxable 
year  upon  the  net  income  of  every  individual  a  normal  tax  of  8  per  centum 
of  the  amount  of  the  net  income  in  excess  of  the  credits  provided  in 
section  216 :  Provided,  That  in  the  case  of  a  citizen  or  resident  of  the 
Unitfed  States  the  rate  upon  the  first  $4,000  of  such  excess  amount  shall 
be  4  per  centum. 

Surtax 

Sec.  211.  (a)  That,  in  lieu  of  the  tax  imposed  by  section  211  of  the 
Revenue  Act  of  1918,  but  in  addition  to  the  normal  tax  imposed  by  section 
210  of  this  Act,  there  shall  be  levied,  collected,  and  paid  for  each  taxable 
year  upon  the  net  income  of  every  individual — 

(i)  For  the  calendar  year  1921,  a  surta.x  equal  to  the  sum  of  the 
following : 

1  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $5,000 
and  does  not  exceed  $6,000. 

2  per  centum  of  the  amount  by  which  the  not  income  exceeds  $6,000 
and  does  not  exceed  $8,000; 

3  per  centum  of  the  amount  by  which  the  net  income  exceeds  $8,000 
and  does  not  exceed  $10,000; 

4  per  centum  of  the  amount  by  which  tlie  net  income  exceeds  $10,000 
and  does  not  exceed  $12,000; 

5  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $12,000 
and  does  not  exceed  $14,000; 


1734  REVENUE   ACT    OF   1921 

6  per  centum  of  the  amount  by  which  tlie  net  income  exceeds  $14,000 
and  does  not  exceed  $16,000; 

7  per  centum  of  the  amount  by  which  tlie  net  income  exceeds  $16,000 
and  does  not  exceed  $18,000; 

8  per  centum  of  the  amount  by  which  the  net  income  exceeds  $18,000 
and  does  not  exceed  $20,000; 

9  per  centum  of  the  amount  by  which  the  net  income  exceeds  $20,000 
and  does  not  exceed  $22,000 ; 

10  per  centum  of  the  amount  by  which  the  net  income  exceeds  $22,000 
and  does  not  exceed  $24,000 ; 

11  per  centum  of  the  amount  by  which  the  net  income  exceeds  $24,000 
and  does  not  exceed  $26,000; 

12  per  centum  of  the  amount  by  which  the  net  income  exceeds  $26,000 
and  does  not  exceed  $28,000; 

13  per  centum  of  the  amount  by  which  the  net  income  exceeds  $28,000 
and  does  not  exceed  $30,000; 

14  per  centum  of  the  amount  by  which  the  net  income  exceeds  $30,000 
but  does  not  exceed  $32,000; 

15  per  centum  of  the  amount  by  which  the  net  income  exceeds  $32,000 
and  does  not  exceed  $34,000; 

16  per  centum  of  the  amount  by  which  the  net  income  exceeds  $34,000 
and  does  not  exceed  $36,000; 

17  per  centum  of  the  amount  by  which  the  net  income  exceeds  $36,000 
and  does  not  exceed  $38,000; 

18  per  centum  of  the  amount  by  which  the  net  income  exceeds  $38,000 
and  does  not  exceed  $40,000; 

19  per  centum  of  the  amount  by  which  the  net  income  exceeds  $40,000 
and  does  not  exceed  $42,000; 

20  per  centum  of  the  amount  by  which  the  net  income  exceeds  $42,000 
and  does  not  exceed  $44,000; 

21  per  centum  of  the  amount  by  which  the  net  income  exceeds  $44,000 
and  does  not  exceed  $46,000; 

22  per  centum  of  the  amount  by  which  the  net  income  exceeds  $46,000 
and  does  not  exceed  $48,000 ; 

2;i  per  centum  of  the  amount  1)y  which  the  net  income  exceeds  $48,000 
and  does  not  exceed  $50,000; 

24  per  centum  of  the  amount  by  which  the  net  income  exceeds  $50,000 
and  does  not  exceed  $52,000; 

25  per  centum  of  the  amount  by  which  the  net  income  exceeds  $52,000 
and  does  not  exceed  $54,000; 

26  per  centum  of  the  amount  by  which  the  net  income  exceeds  $54,000 
and  does  not  exceed  $56,000; 

27  per  centum  of  the  amount  by  which  the  net  income  exceeds  $56,000 
and  does  not  exceed  $58,000; 

28  per  centum  of  the  amount  by  which  the  net  income  exceeds  $58,000 
and  does  not  exceed  $60,000; 


REVENUE   ACT   OF    1921  1 735 

29  per  centum  of  the  amount  by  which  the  net  income  exceeds  $60,000 
and  does  not  exceed  $62,000; 

30  per  centum  of  the  amount  by  which  the  net  income  exceeds  $62,000 
and  does  not  exceed  $64,000; 

31  per  centum  of  the  amount  by  which  the  net  income  exceeds  $64,000 
and  does  not  exceed  $66,000; 

32  per  centum  of  the  amount  by  which  the  net  income  exceeds  $66,000 
and  does  not  exceed  $68,000; 

S3  per  centum  of  the  amount  by  which  the  net  income  exceeds  $68,000 
and  does  not  exceed  $70,000; 

34  per  centum  of  the  amount  by  which  the  net  income  exceeds  $70,000 
and  does  not  exceed  $72,000; 

35  per  centum  of  the  amount  by  which  the  net  income  exceeds  $72,000 
and  does  not  exceed  $74,000; 

36  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $74,000 
and  does  not  exceed  $76,000; 

27  per  centum  of  the  amount  by  which  the  net  income  exceeds  $76,000 
and  does  not  exceed  $78,000 ; 

38  per  centum  of  the  amount  by  which  the  net  income  exceeds  $78,000 
and  does  not  exceed  $80,000; 

39  per  centum  of  the  amount  by  which  the  net  income  exceeds  $8o,oeo 
and  does  not  exceed  $82,000; 

40  per  centum  of  the  amount  by  which  the  net  income  exceeds  $82,000 
and  does  not  exceed  $84,000; 

41  per  centum  of  the  amount  by  which  the  net  income  exceeds  $84,000 
and  does  not  exceed  $86,000; 

42  per  centum  of  the  amount  by  which  the  net  income  exceeds  $86,000 
and  does  not  exceed  $88,000; 

43  per  centum  of  the  amount  by  which  the  net  income  exceeds  $88,000 
and  does  not  exceed  $90,000; 

44  per  centum  of  the  amount  by  which  the  net  income  exceeds  $90,000 
and  does  not  exceed  $92,000; 

45  per  centum  of  the  amount  by  which  the  net  income  exceeds  $92,000 
and  does  not  exceed  $94,000; 

46  per  centum  of  the  amount  by  which  the  net  income  exceeds  $94,000 
and  does  not  exceed  $96,000; 

47  per  centum  of  the  amount  by  which  the  net  income  exceeds  $96,000 
and  does  not  exceed  $98,000; 

48  per  centum  of  the  amount  by  which  the  net  income  exceeds  $98,000 
and  does  not  exceed  $100,000; 

52  per  centum  of  the  amount  by  which  the  net  income  exceeds  $100,000 
and  does  not  exceed  $150,000; 

56  per  centum  of  the  amount  by  which  the  net  income  exceeds  $150,000 
and  does  not  exceed  $200,000; 

60  per  centum  of  the  amount  by  which  the  net  income  exceeds  $200,000 
and  does  not  exceed  $300,000; 


1736  REVENUE   ACT    OF    1921 

63  per  centum  of  the  amount  by  which  the  net  income  exceeds  $300,000 
and  does  not  exceed  $500,000; 

64  per  centum  of  the  amount  by  which  the  net  income  exceeds  $500,000 
and  does  not  exceed  $1,000,000; 

65  per  centum  of  the  amount  by  which  the  net  income  exceeds  $1,000,000; 
(2)     For  the  calendar  .year   1922  and  each  calendar  year  thereafter,  a 

surtax  equal  to  the  sum  of  the  following : 

1  per  centum  of  the  amount  by   which   the   net   income  exceeds  $6,000 
and    does    not   exceed   $10,000; 

2  per  centum  of  the  amount  by  which  the  net  income  exceeds  $10,000 
and   does   not   exceed   $12,000; 

3  per  centum  of  the  amount  by  which  the  net  income  exceeds  $12,000 
and   does   not   exceed   $14,000; 

4  per  centum  of  the  amount  by  which  the  net'  income  exceeds  $14,000 
and   does    not   exceed   $16,000; 

5  per  centum  of  the  amount  by  which  the  net  income  exceeds  $16,000 
and   does   not  exceed  $18,000; 

6  per  centum  of  the  amount  by  wiiich  the  net  income  exceeds  $18,000 
and   does    not   exceed   $20,000; 

8  per  centum  of  the  amount  by  which  the  net  income  exceeds  $20,000 
and    does    not   exceed  $22,000; 

9  per  centum  of  the  amount  by  which   the  net  income  exceeds  $22,000 
and   does   not   exceed   $24,000; 

10  per  centum  of  the  amount  by  which  the  net  income  exceeds  $24,000 
and   does  not   exceed   $26,000; 

11  per  centum  of  the  amount  by  which  the  net  income  exceeds  $26,000 
and   does  not   exceed   $28,000 ; 

12  per  centum  of  the  amount  Ijy  which  the  net  income  exceeds  $28,000 
and   does  not   exceed   $30,000; 

13  per  centum  of  the  amount  by  which  the  net  income  exceeds  $30,000 
and   does  not   exceed   $32,000; 

15  per  centum  of  the  amount  by  which  the  net  income  exceeds  $32,000 
and   does    not   exceed   $36,000; 

16  per  centum  of  the  amount  by  which  the  net  income  exceeds  $36,000 
and   does   not   exceed   $38,000 ; 

17  per  centum  of  the  amount  by  which  the  net  income  exceeds  $38,000 
and    does   not   exceed   $40,000; 

18  per  centum  of  the  amount  by  which  the  net  income  exceeds  $40,000 
and   does   not   exceed   $42,000; 

19  per  centum  of  the  amount  by  which  the  net  income  exceeds  $42,000 
and   does   not   exceed   $44,000; 

20  per  centum  of  the  amount  by  which  the  net  income  exceeds  $44,000 
and   does   not   exceed   $46,000; 

21  per  centum  of  the  amount  by  ^vhich  the  net  income  exceeds  $46,000 
and    does    not   exceed   $48,000; 


REVENUE   ACT    OF    1921  1 737 

22  per  centum  of  the  amount  by  which  the  net  income  exceeds  $48,000 
and    does    not   exceed   $50,000; 

23  per  centum  of  the  amount  by  which  the  net  income  exceeds  $50,000 
and   does   not   exceed   $52,000; 

24  per  centum  of  the  amount  by  which  the  net'  income  exceeds  $52,000 
and  does  not  exceed  $54,000; 

25  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $S4,ooo 
and   does   not  exceed   $56,ooo; 

26  per  centum  of  the  amount  by  which  the  net  income  exceeds  $56,000 
and   does   not   exceed   $58,000; 

2,y  per  centum  of  the  amount  by  which  the  net  income  exceeds  $58,000 
and   does   not   exceed  $60,000; 

28  per  centum  of  the  amount  by  which  the  net  income  exceeds  $60,000 
and   does   not   exceed   $62,000; 

29  per  centum  of  the  amount  by  which  the  net  income  exceeds  $62,000 
and   does   not   exceed   $64,000; 

30  per  centum  of  the  amount  by  which  the  net'  income  exceeds  $64,000 
and    does   not   exceed   $66,000 ; 

31  per  centum  of  the  amount  by  which  the  net  income  exceeds  $66,000 
and   does   not   exceed   $68,000; 

32  per  centum  of  the  amount  by  which  the  net  income  exceeds  $68,000 
and   does   not   exceed   $70,000; 

2,2,  per  centum  of  the  amount  by  which  the  net  income  exceeds  $70,000 
and   does   not   exceed   $72,000; 

34  per  centum  of  the  amount  by  which  the  net  income  exceeds  $72,000 
and   does   not   exceed   $74,000; 

35  per  centum  of  the  amount  l)y  whicli  tiie  net  income  exceeds  $74,000 
and  docs  not  exceed  $76,000; 

36  per  centum  of  the  amount  by  whicli  the  net'  income  exceeds  $76,000 
and   does   not   exceed  $78,000; 

2,^  per  centum  of  the  amount  by  which  the  net  income  exceeds  $78,000 
and   does   not   exceed   $80,000; 

38  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $80,000 
and   does   not   exceed   $82,000; 

39  per  centum  of  the  amount  by  which  the  net  income  exceeds  $82,000 
and    does   not   exceed   $84,000; 

40  per  centum  of  the  amount  by  which  the  net  income  exceeds  $84,000 
and  does   not  exceed  $86,000; 

41  per  centum  of  the  amount  by  which  the  net  income  exceeds  $86,000 
and   does    not   exceed   $88,000; 

42  per  centum  of  the  amount  by  wliich  the  net  income  exceeds  $88,000 
and    does   not    exceed   $90,000; 

43  per  centum  of  the  amount  by  which  the  net  income  exceeds  $90,000 
and   does   not   exceed  $92,000; 

44  per  centum  of  the  amount  by  which  the  net  income  exceeds  $92,000 
and   docs   not  exceed   $94,000; 


1^38  REVENUE   ACT   OF   1921 

45  per  centum  of  the  amount  by  which  the  net  income  exceeds  $94,000 
and   does   not    exceed   $96,000; 

46  per  centum  of  the  amount  by  which  the  net  income  exceeds  $96,000 
and   does   not   exceed  $98,000; 

47  per  centum  of  the  amount  by  which  the  net  income  exceeds  $98,000 
and  does  not  exceed  $100,000; 

48  per  centum  of  the  amount  liy  which  the  net  income  exceeds  $100,000 
and  does  not  exceed  $150,000; 

49  per  centum  of  the  amount  by  which  the  net  income  exceeds  $150,000 
and  does  not  exceed  $200,000; 

50  per  centum  of  the  amount  by  which  the  net  income  exceeds  $200,000. 
(b)     In  the  case  of  a  bona  fide  sale  of  mines,  oil  or  gas  wells,  or  any 

interest  therein,  where  the  principal  value  of  the  property  has  been  dem- 
onstrated by  prospecting  or  exploration  and  discovery  work  done  by  the 
taxpayer,  the  portion  of  the  tax  imposed  by  this  section  attributable  to 
such  sale  shall  not  exceed,  for  the  calendar  year  1921,  20  per  centum,  and 
for  each  calendar  3'ear  thereafter  16  per  centum  of  the  selling  price  of 
such  property  or  interest. 

Net  Income  of  Individuals  Defined 

Sec.  212.  (a)  That  in  the  case  of  an  individual  the  term  "net  in- 
come" means  the  gross  income  as  defined  in  section  213,  less  the  deductions 
allowed  by  section  214. 

(b)  The  net  income  shall  be  computed  upon  the  basis  of  the  taxpayer's 
annual  accounting  period  (fiscal  year  or  calendar  year,  as  the  case  may  be) 
in  accordance  with  the  method  of  accounting  regularly  employed  in  keep- 
ing the  books  of  such  taxpayer;  but  if  no  such  method  of  accounting  has 
been  so  employed,  or  if  the  method  employed  does  not  clearly  reflect  the 
income,  the  computation  shall  be  made  upon  such  basis  and  in  such 
manner  as  in  the  opinion  of  the  Commissioner  does  clearly  reflect  the  income. 
If  the  taxpayer's  annual  accounting  period  is  other  than  a  fiscal  year  as 
defined  in  section  200  or  if  the  taxpayer  has  no  annual  accounting  period 
or  does  not  keep  books,  the  net  income  shall  be  computed  on  the  basis 
of  the  calendar  year. 

(c)  If  a  taxpayer  changes  his  accounting  period  from  fiscal  year 
to  calendar  year,  from  calendar  year  to  fiscal  year,  or  from  one  fiscal 
year  to  another,  the  net  income  shall,  with  the  approval  of  the  Commis- 
sioner, be  computed  on  the  basis  of  such  new  accounting  period,  subject 
t'o  the  provisions  of  section  226. 

Gross  Income  Defined 

Sec.  213.  That  for  the  purposes  of  this  title  (except  as  otherwise  pro- 
vided in  section  233)  the  term  "gross  income" — 

(a)  Includes  gains,  profits,  and  income  derived  from  salaries,  wages, 
or  compensation  for  personal  service  (including  in  the  case  of  the  Presi- 
dent of  the  United  States,  the  judges  of  the  Supreme  and  inferior  courts 


REVENUE  ACT   OF   1921  I73() 

of  the  United  States,  and  all  other  officers  and  employees,  whether  elected 
or  appointed,  of  the  United  States,  Alaska,  Hawaii,  or  any  political  sub- 
division thereof,  or  the  District  of  Columbia,  the  compensation  received 
as  such),  of  whatever  kind  and  in  whatever  form  paid,  or  from  pro- 
fessions, vocations,  trades,  businesses,  commerce,  or  sales,  or  dealings  in 
property,  whether  real  or  personal,  growing  out  of  the  ownership  or  use 
of  or  interest  in  such  property ;  also  from  interest,  rent,  dividends,  secur- 
ities, or  the  transaction  of  any  business  carried  on  for  gain  or  profit,  or 
gains  or  profit's,  and  income  derived  from  any  source  whatever.  The 
amount  of  all  such  items  (except  as  provided  in  subdivision  (e)  of 
section  201)  shall  be  included  in  the  gross  income  for  the  taxable  year  in 
which  received  by  the  taxpayer,  unless,  under  methods  of  accounting  per- 
mitted under  subdivision  (b)  of  section  212,  any  such  amounts  are  to  be 
properly  accounted  for  as  of  a  different  period;  but 

(b)  Does  not  include  the  following  items,  which  shall  be  exempt  from 
taxation  under  this  title : 

(i)  The  proceeds  of  life  insurance  policies  paid  upon  the  death  of 
tile  insured; 

(2)  The  amount  received  by  the  insured  as  a  return  of  premium  or 
premiums  paid  by  him  under  life  insurance,  endowment,  or  annuity  con- 
tracts, either  during  the  term,  or  at  the  maturity  of  the  term  mentioned 
in  the  contract  or  upon  surrender  of  the  contract ; 

(3)  The  value  of  property  acquired  by  gift,  bequest,  devise,  or  descent 
(but  the  income  from  such  property  shall  be  included  in  gross  income)  ; 

(4)  Interest  upon  (a)  the  obligations  of  a  State,  Territory,  or  any 
political  subdivision  thereof,  or  the  District  of  Columbia;  or  (b)  secur- 
ities issued  under  the  provisions  of  the  Federal  Farm  Loan  Act  of  July 
17,  1916;  or  (c)  the  obligations  of  the  United  States  or  its  possessions; 
or  (d)  bonds  issued  by  the  War  Finance  Corporation.  In  the  case  of 
obligations  of  the  United  States  issued  after  September  i,  1917  (other 
than  postal  saving  certificates  of  deposit)  and  in  the  case  of  bonds  issued 
by  the  War  Finance  Corporation,  the  interest  shall  be  exempt  only  if  and 
to  the  extent  provided  in  the  respective  Acts  authorizing  the  issue  thereof 
as  amended  and  supplemented  and  shall  be  excluded  from  gross  income 
only  if  and  to  the  extent  it  is  wholly  exempt  to  the  taxpayer  from  income, 
war-profits  and  excess-profits  taxes ; 

(5)  The  income  of  foreign  governments  received  from  investments 
in  the  United  States  in  stocks,  bonds,  or  other  domestic  securities,  owned 
by  such  foreign  governments,  or  from  interest  on  deposits  in  banks  in  the 
United  States  of  moneys  belonging  to  such  foreign  governments,  or  from 
any  other  source  within  the  United  States ; 

(6)  Amounts  received,  through  accident  or  heallli  insurance  or  under 
workmen's  compensation  acts,  as  compensation  for  personal  injuries  or 
sickness,  plus  the  amount  of  any  damages  received  whether  by  suit  or 
agreement  on  account  of  such  injuries  or  sickness; 

(7)  Income   derived   from   any  public  utility  or   the  exercise  of  any 


I740  REVENUE  ACT   OF   1921 

essential  governmental  function  and  accruing  to  any  State,  Territory,  or 
the  District  of  Columbia,  or  any  political  subdivision  of  a  State  or  Ter- 
ritory, or  income  accruing  to  the  Government  of  any  possession  of  the 
United  States,  or  any  political  subdivision  thereof. 

Whenever  any  State,  Territory,  or  the  District  of  Columbia,  or  any 
political  subdivision  of  a  State  or  Territory,  prior  to  September  8,  1916, 
entered  in  good  faith  into  a  contract  with  any  person,  the  object  and  pur- 
pose of  which  is  to  acquire,  construct,  operate,  or  maintain  a  public  utility, 
no  tax  shall  be  levied  under  the  provisions  of  this  title  upon  the  income 
derived  from  the  operation  of  such  public  utility,  so  far  as  the  payment 
thereof  will  impose  a  loss  or  burden  upon  such  State,  Territory,  District  of 
Columbia,  or  political  subdivision;  but  this  provision  is  not  intended  and 
shall  not  be  construed  to  confer  upon  such  person  any  financial  gain 
or  exemption  or  to  relieve  such  person  from  the  payment  of  a  tax  as 
provided  for  in  this  title  upon  the  part  or  portion  of  such  income  fo  which 
such  person  is  entitled  under  such  contract ; 

(8)  The  income  of  a  nonresident  alien  or  a  foreign  corporation  which 
consists  exclusively  of  earnings  derived  from  the  operation  of  a  ship  or 
ships  documented  under  the  laws  of  a  foreign  country  which  grants  an 
equivalent  exemption  to  citizens  of  the  United  States  and  to  corporations 
organized  in  the  United  States ; 

(9)  Amounts  received  as  compensation,  family  allotments  and  allow- 
ances under  the  provisions  of  the  War  Risk  Insurance  and  the  Vocational 
Rehabilitation  Acts,  or  as  pensions  from  the  United  States  for  service  of 
fhe  beneficiary  or  another  in  the  military  or  naval  forces  of  the  United 
States  in  time  of  war; 

(10)  So  much  of  the  amount  received  by  an  individual  after  December 
31,  1921,  and  before  January  i,  1927,  as  dividends  or  interest  from  domestic 
building  and  loan  associations,  operated  exclusively  for  the  purpose  of 
making  loans  to  members,  as  does  not  exceed  $300; 

(11)  The  rental  value  of  a  dwelling  house  and  appurtenances  thereof 
furnished  to  a  minister  of  the  gospel  as  part  of  his  compensation ; 

(12)  The  receipts  of  shipowners'  mutual  protection  and  indemnity 
associations,  not  organized  for  profit,  and  no  part  of  that  net  earnings 
of  which  inures  to  the  benefit  of  any  private  stockholder  or  member  but 
such  corporations  shall  be  subject  as  other  persons  to  the  tax  upon  their 
net  income  from  interest,  dividends,  and  rents. 

(c)  In  the  case  of  a  nonresident  alien  individual,  gross  income  means 
only  the  gross  income  from  sources  within  the  United  States,  determined 
under  the  provisions  of  section  217. 

Deductions  Allowed  Individuals 

Sec.  214.  (a)  That  in  computing  net  income  there  shall  be  allowed 
as  deductions : 

(i)  All  the  ordinary  and  necessary  expenses  paid  or  incurred  during  the 
taxable  year  in  carrying  on  any  trade  or  business,  including  a  reasonable 


REVENUE   ACT    OF    1921  1 741 

allowance  for  salaries  or  other  compensation  for  personal  services  actually 
rendered;  traveling  expenses  (including  the  entire  amount  expended  for 
meals  and  lodging)  while  away  from  home  in  the  pursuit  of  a  trade  or 
business;  and  rentals  or  other  payments  required  to  be  made  as  a  condition 
to  the  continued  use  or  possession,  for  purposes  of  the  trade  or  business, 
of  property  to  which  the  taxpayer  has  not  taken  or  is  not  taking  title  or 
in  which  he  has  no  equity; 

(2)  All  interest  paid  or  accrued  within  the  taxable  year  on  indebtedness, 
except  on  indebtedness  incurred  or  continued  to  purchase  or  carry  obliga- 
tions or  securities  (other  than  obligations  of  the  United  States  issued  after 
September  24,  1917,  and  originally  subscribed  for  by  the  taxpayer)  the 
interest  upon  which  is  wholly  exempt  from  taxation  under  this  title ; 

(3)  Taxes  paid  or  accrued  within  the  taxable  year  except  (a)  income, 
war-profits,  and  excess-profits  taxes  imposed  by  the  authority  of  the 
United  States,  (b)  so  much  of  the  income,  war-profits  and  excess-profits 
taxes,  imposed  by  the  authority  of  any  foreign  country  or  possession  of  the 
United  States,  as  is  allowed  as  a  credit  under  section  222  (c)  taxes  assessed 
against  local  benefits  of  a  kind  tending  to  increase  the  value  of  the  prop- 
erty assessed,  and  (d)  taxes  imposed  upon  the  taxpayer  upon  his  interest 
as  shareholder  or  member  of  a  corporation,  which  are  paid  by  the  cor- 
poration without  reimbursement  from  the  taxpayer.  For  the  purpose  of 
this  paragraph  estate,  inheritance,"  legacy,  and  succession  taxes  acrue  on 
the  due  date  thereof  except  as  otherwise  provided  by  the  law  of  the 
jurisdiction  imposing  such  taxes; 

(4)  Losses  sustained  during  the  taxable  year  and  not  compensated 
for  by  insurance  or  otherwise,  if  incurred  in  trade  or  business; 

(5)  Losses  sustained  during  the  taxable  year  and  not  compensated 
for  by  insurance  or  otherwise,  if  incurred  in  any  transaction  entered  into 
for  profit,  though  not  connected  with  the  trade  or  business ;  but  in  the 
case  of  a  nonresident  alien  individual  only  if  and  to  the  extent  that  the 
profit,  if  such  transaction  had  resulted  in  a  profit,  would  be  taxable  under 
this  title.  No  deduction  shall  be  allowed  under  this  paragraph  for  any  loss 
claimed  to  have  been  sustained  in  any  sale  or  other  disposition  of  shares 
of  stock  or  securities  made  after  the  passage  of  this  Act  where  it  appears 
that  within  thirty  days  before  or  after  the  date  of  such  sale  or  other  dis- 
position the  taxpayer  has  acquired  (otherwise  than  by  bequest  or  in- 
heritance) substantially  identical  property,  and  the  property  so  acquired  is 
held  by  the  taxpayer  for  any  period  after  such  sale  or  other  disposition. 
If  such  acquisition  is  to  the  extent  of  part  only  of  substantially  identical 
property,  then  only  a  proportionate  part  of  the  loss  shall  be  disallowed ; 

(6)  Losses  sustained  during  the  taxable  year  of  property  not  con- 
nected with  the  trade  or  business  (but  in  the  case  of  a  nonresident  alein 
individual  only  property  within  the  United  States)  if  arising  from  fires, 
storms,  shipwreck,  or  other  casualty,  or  from  theft,  and  if  not  com- 
pensated for  by  insurance  or  otherwise.  Losses  allowed  under  paragraphs 
(4),   (5),  and  (6)  of  this  subdivision  shall  be  deducted  as  of  the  taxable 


1742  REVENUE   ACT   OF   1921 

year  in  which  sustained  unless,  in  order  to  clearly  reflect  the  income,  the 
loss  should,  in  the  opinion  of  the  Commissioner,  be  accounted  for  as  of  a 
different  period.  In  case  of  losses  arising  from  destruction  of  or  damage 
to  property,  where  the  property  so  destroyed  or  damaged  was  acquired 
before  March  i,  1913,  the  deductions  shall  be  computed  upon  the  basis  of 
its  fair  market  price  or  value  as  of  March  i,  1913; 

(7)  Debts  ascertained  to  be  worthless  and  charged  off  within  the 
taxable  year  (or,  in  the  discretion  of  the  Commissioner,  a  reasonable  addi- 
tion to  a  reserve  for  bad  debts)  ;  and  when  satisfied  that  a  debt  is  recover- 
able only  in  part,  the  Commissioner  may  allow  such  debt  to  be  charged 
ofif  in  part; 

(8)  A  reasonable  allowance  for  the  exhaustion,  wear  and  tear  of 
property  used  in  the  trade  or  business,  including  a  reasonable  allowance 
for  obsolescence.  In  the  case  of  such  property  acquired  before  Alarch  i, 
1913,  this  deduction  shall  be  computed  upon  the  basis  of  its  fair  market 
price  or  value  as  of  March  i,  1913; 

(9)  In  the  case  of  buildings,  machinery,  equipment,  or  other  facilities, 
constructed,  erected,  installed,  or  acquired,  on  or  after  April  6,  1917,  for 
the  production  of  articles  contributing  to  the  prosecution  of  the  war 
against  the  German  Government,  and  in  the  case  of  vessels  constructed  or 
acquired  on  or  after  such  date  for  the  transportation  of  articles  or  men 
contributing  to  the  prosecution  of  such'  war,  there  shall  be  allowed,  for 
any  taxable  year  ending  before  March  3,  1924  (if  claim  therefor  was 
made  at  the  time  of  filing  return  for  the  taxable  year  1918,  1919,  1920,  or 
1921)  a  reasonable  deduction  for  the  amortization  of  such  part  of  the 
cost  of  such  facilities  or  vessels  as  has  been  borne  by  the  taxpayer,  but 
not  again  including  any  amount  otherwise  allowed  under  this  title  or 
previous  Act  of  Congress  as  a  deduction  in  computing  net  income.  At 
any  time  before  March  3,  1924,  the  Commissioner  may,  and  at  the  request 
of  the  taxpayer  shall,  reexamine  the  return,  and  if  he  then  finds  as  a 
result  of  an  appraisal  or  from  other  evidence  that  the  deduction  originally 
allowed  was  incorrect,  the  income,  war-profits,  and  excess-profits  taxes 
for  the  year  or  years  affected  shall  be  redetermined;  and  the  amount 
of  tax  due  upon  such  redetermination,  if  any,  shall  be  paid  upon  notice 
and  demand  by  the  collector,  or  the  amount  of  tax  overpaid,  if  any,  shall 
be  credited  or  refunded  to  the  taxpayer  in  accordance  with  the  provisions 
of  section  252 ; 

(10)  In  the  case  of  mines,  oil  and  gas  wells,  other  natural  deposits, 
and  timber,  a  reasonable  allowance  for  depletion  and  for  depreciation  of 
improvements,  according  to  the  peculiar  conditions  in  each  case,  based 
upon  cost  including  cost  of  development  not  otherwise  deducted :  Provided, 
That  in  the  case  of  such  properties  acquired  prior  to  March  i,  1913,  the 
fair  market  value  of  the  property  (or  the  taxpayer's  interest  therein) 
on  that  date  shall  be  taken  in  lieu  of  cost  up  to  that  date :  Provided 
further.  That  in  the  case  of  mines,  oil  and  gas  wells,  discovered  by  the 
taxpayer,  on  or  after  March   i,   1913,  and  not  acquired  as  the  result  of 


REVENUE   ACT    OF    1921  1 743 

purchase  of  a  proven  tract  or  lease,  where  the  fair  market  value  of 
the  property  is  materially  disproportionate  to  the  cost,  the  depletion  allow- 
ance shall  be  based  upon  the  fair  market  value  of  the  property  at  the  date 
of  the  discovery,  or  within  thirty  days  thereafter :  And  provided  further, 
That  such  depletion  allowance  based  on  discovery  value  shall  not  exceed 
the  net  income,  computed  without  allowance  for  depletion,  from  the 
property  upon  which  the  discovery  is  made,  except  where  such  net  income 
so  computed  is  less  than  the  depletion  allowance  based  on  cost'  or  fair 
market  value  as  of  March  i,  1913;  such  reasonable  allowance  in  all  the 
above  cases  to  be  made  under  rules  and  regulations  to  be  prescribed  by 
the  Commissioner,  with  the  approval  of  the  Secretary.  In  the  case  of 
leases  the  deductions  allowed  by  this  paragraph  Shall  be  equitably  ap- 
portioned between  the  lessor  and  lessee; 

(11)  Contributions  or  gifts  made  within  the  taxable  year  to  or  for  the 
use  of :  (A)  The  United  States,  any  State,  Territory,  or  any  political  sub- 
division thereof,  or  the  District  of  Columbia,  for  exclusively  public  pur- 
poses; (B)  any  corporation,  or  community  chest,  fund,  or  foundation, 
organized  and  operated  exclusively  for  religious,  charitable,  scientific, 
literary,  or  educational  purposes,  including  posts  of  the  American  Legion 
or  the  women's  auxiliary  units  thereof,  or  for  the  prevention  of  cruelty 
to  children  or  animals,  no  part  of  the  net  earnings  of  which  inures  to  the 
benefit  of  any  private  stockholder  or  individual;  or  (C)  the  special  fund 
for  vocational  rehabilitation  authorized  by  section  7  of  the  Vocational 
Rehabilitation  Act;  to  an  amount  which  in  all  the  above  cases  combined 
does  not  exceed  15  per  centum  of  the  taxpayer's  net  income  as  computed 
without  the  benefit  of  this  paragraph.  In  case  of  a  nonresident  alien 
individual  this  deduction  shall  be  allowed  only  as  to  contributions  or  gifts 
made  to  domestic  corporations,  or  to  community  chest's,  funds  or  found- 
ations, created  in  the  United  States,  or  to  such  vocational  rehabilitation 
fund.  Such  contributions  or  gifts  shall  be  allowable  as  deductions  only 
if  verified  under  rules  and  regulations  prescribed  by  the  Commissioner, 
with  the  approval  of  the  Secretary; 

(12)  If  property  is  compulsorily  or  involuntarily  converted  into  cash 
or  its  equivalent  as  a  result  of  (A)  its  destruction  in  whole  or  in  part, 
(B)  theft  or  seizure,  or  (C)  an  exercise  of  the  power  of  requisition  or 
condemnation,  or  the  threat  or  imminence  thereof;  and  if  the  taxpayer 
proceeds  forthwith  in  good  faith,  under  regulations  prescribed  by  the 
Commissioner  with  the  approval  of  the  Secretary,  to  expend  the  proceeds 
of  such  conversion  in  the  acquisition  of  other  property  of  a  character 
similar  or  related  in  service  or  use  to  the  property  so  converted,  or  in 
the  acquisition  of  80  per  centum  or  more  of  the  stock  or  shares  of  a  cor- 
poration owning  such  other  property,  or  in  the  establishment  of  a  re- 
placement fund,  then  there  shall  be  allowed  as  a  deduction  such  portion 
of  a  gain  derived  as  the  portion  of  the  proceeds  so  expended  bears  to  th« 
entire  proceeds.  The  provisions  of  this  paragraph  prescribing  the  con- 
ditions under  which  a  deduction  may  be  taken  in  respect  of  the  proceeds 


1744  REVENUE  ACT   OF   1921 

or  gains  derived  from  the  compulsory  or  involuntary  conversion  of 
property  into  cash  or  its  equivalent,  shall  apply  so  far  as  may  be  practicable 
to  the  exemption  or  exclusion  of  such  proceeds  or  gains  from  gross 
income  under  prior  income,  war-profits  and  excess-profits  fax  acts. 

(b)  In  the  case  of  a  nonresident  alien  individual,  the  deductions  al- 
lowed in  subdivision  (a),  except  those  allowed  in  paragraphs  (5),  (6), 
and  (11),  shall  be  allowed  only  if  and  to  the  extent  that  they  are  con- 
nected with  income  from  sources  within  the  United  States ;  and  the 
proper  apportionment  and  allocation  of  the  deductions  with  respect  to 
sources  of  income  within  and  without  the  United  States  shall  be  deter- 
mined as  provided  in  section  217  under  rules  and  regulations  prescribed 
by  the  Commissioner  with  the  approval  of  the  Secretary.  In  the  case  of 
a  citizen  entitled  to  the  benefits  of  section  262  the  deductions  shall  be  the 
same  and  shall  be  determined  in  the  same  manner  as  in  the  case  of  a  non- 
resident alien  individual. 

Items  Not  Deductible 

Sec.  215.  (a)  That  in  computing  net  income  no  deduction  shall  in 
any  case  be  allowed  in  respect  of — 

(i)   Personal,  living,  or  family  expenses; 

(2)  Any  amount  paid  out  for  new  buildings  or  for  permanent  im- 
provements or  betterment's  made  to  increase  the  value  of  any  property 
or  estate; 

(3)  Any  amount  expended  in  restoring  property  or  in  making  good  the 
exhaustion  thereof  for  w^hich  an  allowance  is  or  has  been  made;  or 

(4)  Premiums  paid  on  any  life  insurance  policy  covering  the  life  of 
any  officer  or  employee,  or  of  any  person  financially  interested  in  any 
trade  or  business  carried  on  by  the  taxpayer,  when  the  taxpayer  is 
directly  or  indirectly  a  beneficiary  under  such  policy. 

(b)  Amounts  paid  under  the  laws  of  any  State,  Territory,  District'  of 
Columbia,  possession  of  the  United  States,  or  foreign  country  as  income 
to  the  holder  of  a  life  or  terminable  interest  acquired  by  gift,  bequest, 
or  inheritance  shall  not  be  reduced  or  diminished  by  any  deduction  for 
shrinkage  (by  whatever  name  called)  in  the  value  of  such  interest  due 
to  the  lapse  of  time,  nor  by  any  deduction  allowed  by  this  Act  for  the 
purpose  of  computing  the  net  income  of  an  estate  or  trust  but  not 
allowed  under  the  laws  of  such  State,  Territory,  District  of  Columbia, 
possession  of  the  United  States,  or  foreign  country  for  the  purpose  of 
compufiner  the  income  to  which  such  holder  is  entitled. 

Credits  Allowed  Individuals 

Sec.  216.  That  for  the  purpose  of  the  normal  tax  onlv  there  shall  be 
allowed  the  following  credits : 

(a)  The  amount  received  as  dividends  (i)  from  a  domestic  corpora- 
tion other  than  a  corporation  entitled  to  the  benefits  of  section  262.  or 
(2)  from  a  foreign  corporation  when  it  is  shown  to  the  satisfaction  of  the 


REVENUE   ACT    OF    1921  1 745 

Commissioner  that  more  than  50  per  centum  of  the  gross  income  of  such 
foreign  corporation  for  the  three-year  period  ending  with  the  close  of 
its  taxable  year  preceding  the  declaration  of  such  dividends  for  for  such 
part  of  such  ceriod  as  the  corporation  has  been  in  existence")  was  derived 
from  sources  within  the  United  States  as  determined  under  the  orovisions 
of  section  217; 

(b)  The  amount  received  as  interest  upon  obligations  of  the  United 
States  and  bonds  issued  by  the  War  Finance  Corporation,  which  is  in- 
cluded in  gross  income  under  section  213 ; 

(c)  In  the  case  of  a  single  person,  a  personal  exemption  of  $1,000 ;  or 
in  the  case  of  the  head  of  a  family  or  a  married  person  living  with  husband 
or  wife,  a  personal  exemption  of  $2,500,  unless  the  net  income  is  in  excess 
of  $5,000,  in  which  case  the  personal  exemption  shall  be  $2,000.  A  hus- 
band and  wife  living  together  shall  receive  but  one  personal  exemption. 
The  amount  of  such  personal  exemption  shall  be  $2,500,  unless  the 
aggregate  net  income  of  such  husband  and  wife  is  in  excess  of  $S,ooo, 
in  which  case  the  amount  of  such  personal  exemption  shall  be  $2,000.  If 
such  husband  and  wife  make  separate  returns,  the  personal  exemption  may 
be  taken  by  either  or  divided  between  them.  In  no  case  shall  the  reduction 
of  the  personal  exemption  from  $2,500  to  $2,000  operate  to  increase  the 
tax,  which  would  be  payable  if  the  exemption  were  $2,500,  by  more  than 
the  amount  of  the  net  income  in  excess  of  $5,000; 

(d)  $400  for  each  person  (other  than  husband  or  wife)  dependent 
upon  and  receiving  his  chief  support  from  the  taxpayer  if  such  dependent 
person  is  under  eighteen  years  of  age  or  is  incapable  of  self-support  be- 
cause  mentally   or   physically   defective. 

(e)  In  the  case  of  a  nonresident  alien  individual  or  of  a  citizen  entitled 
to  the  benefits  of  section  262,  the  personal  exemption  shall  be  only  $1,000, 
and  he  shall  not  be  entitled  to  the  credit  provided  in  subdivision  (d). 

(f)  The  credits  allowed  by  subdivisions  (c),  (d),  and  (e)  of  this 
section  shall  be  determined  by  the  status  of  the  taxpayer  on  the  last  day 
of  the  period  for  which  the  return  of  income  is  made;  but  in  the  case 
of  an  individual  who  dies  during  the  taxable  year,  such  credits  shall  be 
determined  by  his  status  at  the  time  of  his  death,  and  in  such  case  full 
credits  shall  be  allowed  to  the  surviving  spouse,  if  any,  according  to  his 
or  her  status  at  the  close  of  the  period  for  which  such  survivor  makes 
return  of  income. 

Net  Income  of  Nonresident  Alien  Individuals 

Sec.  217.  (a)  That'  in  the  case  of  a  nonresident  alien  individual  or 
of  a  citizen  entitled  to  the  benefits  of  section  262,  the  following  items  of 
gross  income  shall  be  treated  as  income  from  sources  within  the  United 
States : 

(i)  Interest  on  bonds,  notes,  or  otlicr  interest-bearing  obligations  of 
residents,  corporate  or  otherwise,  not  including  (A)  interest  on  deposits 
with  persons  carrying  on  the  banking  business  paid  to  persons  not  engaged 


1746  REVENUE   ACT   OF    1921 

in  business  with  the  United  States  and  not  having  an  office  or  place  of 
business  therein,  or  (B)  interest  received  from  a  resident  alien  individual 
or  a  resident  foreign  corporation  when  it  is  shown  to  the  satisfaction  of 
the  Commissioner  that  less  than  20  per  centum  of  the  gross  income  of 
such  resident  payor  has  been  derived  from  sources  within  the  United  States, 
as  determined  under  the  provisions  of  this  section,  for  the  three-year 
period  ending  with  the  close  of  the  taxable  year  of  such  payor,  or  for 
such  part  of  such  period  immediately  preceding  the  close  of  such  taxable 
year  as  may  be  applicable ; 

(2)  The  amount  received  as  dividends  (A)  from  a  domestic  corpora- 
tion other  than  a  corporation  entitled  to  the  benefits  of  section  262,  or 
(B)  from  a  foreign  corporation  unless  less  than  50  per  centum  of  the 
gross  income  of  such  foreign  corporation  for  the  three-year  period 
ending  with  the  close  of  its  taxable  year  preceding  the  declaration  of  such 
dividends  (or  for  such  part  of  such  period  as  the  corporation  has  been 
in  existence)  was  derived  from  sources  within  the  United  States  as  de- 
termined under  the  provisions  of  this  section; 

(3)  Compensation  for  labor  or  personal  services  performed  in  the 
United  States; 

(4)  Rentals  or  royalties  from  property  located  in  the  United  States  or 
from  any  interest  in  such  property,  including  rentals  or  royalties  for  the 
use  of  or  for  the  privilege  of  using  in  the  United  States,  patents,  copyrights, 
secret  processes  and  formulas,  good  will,  trade-marks,  trade  brands,  fran- 
chises, and  other  like  property;  and 

(5)  Gains,  profits  and  income  from  the  sale  of  real  property  located  in 
the  United  States. 

(b)  From  the  items  of  gross  income  specified  in  subdivision  (a) 
there  shall  be  deducted  the  expenses,  losses,  and  other  deductions  properly 
apportioned  or  allocated  thereto  and  a  ratable  part  of  any  expenses,  losses, 
or  other  deductions  which  can  not  definitely  be  allocated  to  some  item  or 
class  of  gross  income.  The  remainder,  if  any,  shall  be  included  in  full  at 
net  income  from  sources  within  the  United  States. 

(c)  The  following  items  of  gross  income  shall  be  treated  as  income 
from  sources  without  the  United  States : 

(i)  Interest  other  than  that  derived  from  sources  within  the  United 
States  as  provided  in  paragraph  (i)  of  subdivision  (a)  ; 

(2)  Dividends  other  than  those  derived  from  sources  within  the 
United  States  as  provided  in  paragraph  (2)  of  subdivision  (a)  ; 

(3)  Compensation  for  labor  or  personal  service  performed  without  the 
United  States ; 

(4)  Rentals  or  royalties  from  property  located  without  the  United  States 
or  from  any  interest  in  such  property,  including  rentals  or  royalties  for 
the  use  of  or  for  the  privilege  of  using  without  the  United  States,  patents, 
copyrights,  secret  processes  and  formulas,  good  will,  trade-marks,  trade 
brands,   franchises,  and  other  like  property;  and 


REVENUE  ACT   OF   1921  1747 

(S)  Gains,  profits,  and  income  from  the  sale  of  real  property  located 
without  the  United  States ; 

(d)  From  th-e  items  of  gross  income  specified  in  subdivision  (c)  there 
shall  be  deducted  the  expenses,  losses,  and  other  deductions  properly  ap- 
portioned or  allocated  thereto,  and  a  ratable  part  of  any  expenses,  losses, 
or  other  deductions  which  can  not  definitely  be  allocated  to  some  item  or 
class  of  gross  income.  The  remainder,  if  any,  shall  be  treated  in  full  as 
net  income  from  sources  without  the  United  States. 

(e)  Items  of  gross  income,  expenses,  losses  and  deductions,  other  than 
those  specified  in  subdivisions  (a)  and  (c),  shall  be  allocated  or  apportioned 
to  sources  within  or  without  the  United  States  under  rules  and  regulations 
prescribed  bj'  the  Commissioner  with  the  approval  of  the  Secretary.  Where 
items  of  gross  income  are  separately  allocated  to  sources  within  the  United 
States,  there  shall  be  deducted  (for  the  purpose  of  computing  the  net 
income  therefrom)  the  expenses,  losses  and  other  deductions  properly 
apportioned  or  allocated  thereto  and  a  ratable  part  of  other  expenses, 
losses  or  other  deductions  which  can  not  definitely  be  allocated  to  some 
item  or  class  of  gross  income.  The  remainder,  if  any,  shall  be  included 
in  full  as  net  income  from  sources  within  the  United  States.  In  the 
case  of  gross  income  derived  from  sources  partly  within  and  partly 
without  the  United  States,  the  net  income  may  first  be  computed  by 
deducting  the  expenses,  losses  or  other  deductions  apportioned  or  allocated 
thereto  and  a  ratable  part  of  any  expenses,  losses  or  other  deductions 
which  can  not  definitely  be  allocated  to  some  item  or  class  of  gross  in- 
come; and  the  portion  of  such  net  income  attributable  to  sources  within 
the  United  States  may  be  determined  by  processes  or  formulas  of  general 
apportionment  prescribed  by  the  Commissioner  with  the  approval  of  the 
Secretary.  Gains,  profits  and  income  from  (i)  transportation  or  other 
services  rendered  partly  within  and  partly  without  the  United  States,  or 
(2)  from  the  sale  of  personal  property  produced  (in  whole  or  in  part)  by 
the  taxpayer  within  and  sold  without  the  United  States,  or  produced  (in 
whole  or  in  part)  by  the  taxpayer  without  and  sold  within  the  United 
States,  shall  be  treated  as  derived  partly  from  sources  within  and  partly 
from  sources  without  the  United  States.  Gains,  profits  and  income  derived 
from  the  purchase  of  personal  property  within  and  its  sale  without  the 
United  States  or  from  the  purchase  of  personal  property  without  and  its 
sale  within  the  United  States,  shall  be  treated  as  derived  entirely  from  the 
country  in  which  sold. 

(f)  As  used  in  this  section  the  words  "sale"  or  "sold"  include  "ex- 
change" or  "exchanged" ;  and  the  word  "produced"  includes  "created,"  "fab- 
ricated," "manufactured,"  "extracted,"  "processed,"  "cured,"  or  "aged." 

(g)  A  nonresident  alien  individual  or  a  citizen  entitled  to  the  benefits 
of  section  262  shall  receive  the  benefit  of  the  deductions  and  credits  allowed 
in  this  title  only  by  filing  or  causing  to  be  filed  with  the  collector  a  true 
and  accurate  return  of  his  total  income  received  from  all  sources  corporate 
or  otherwise  in  the  United  States  in  the  manner  prescribed  in  this  title; 


f748  REVENUE   ACT    OF    1921 

including  therein  all  the  information  which  the  Commissioner  may  deem, 
necessary  for  the  calculation  of  such  deductions  and  credits:  Provided, 
That  the  benefit  of  the  credit  allowed  in  subdivision  (e)'  of  section  216 
may,  in  the  discretion  of  the  Commissioner,  be  received  by  filing  a  claim 
therefor  with  the  withholding  agent.  In  case  of  failure  to  file  a  return, 
the  collector  shall  collect  the  tax  on  such  income,  and  all  property  belonging 
to  such  nonresident  alien  individual  or  foreign  trader  shall  be  liable  to 
distraint  for  the  tax. 

Partnerships  and  Personal  Service  Corporations 

Sec.  218.  (a)  That  individuals  carrying  on  business  in  partnership 
shall  be  liable  for  income  tax  only  in  their  individual  capacity.  There 
shall  be  included  in  computing  the  net  income  of  each  partner  his  dis- 
tributive share,  whether  distributed  or  not,  of  the  net  income  of  the  part- 
nership for  the  taxable  year,  or,  if  his  net  income  for  such  taxable  year 
is  computed  upon  the  basis  of  a  period  different  from  that  upon  the 
basis  of  which  the  net  income  of  the  partnership  is  computed,  then  his 
distributive  share  of  the  net  income  of  the  partnership  for  any  account- 
ing period  of  the  partnership  ending  within  the  fiscal  or  calendar  year 
uppn  the  basis  of  which  the  partner's  net  income  is  computed. 

(b)  The  partner  shall,  for  the  purpose  of  the  normal  tax,  be  allowed 
as  credits,  in  addition  to  the  credit's  allowed  to  him  under  section  216, 
his  proportionate  share  of  such  amounts  specified  in  subdivisions  (a) 
and  (b)   of  section  216  as  are  received  by  the  partnership. 

(c)  The  net  income  of  the  partnership  shall  be  computed  in  the  same 
manner  and  on  the  same  basis  as  provided  in  section  212  except  that  the 
deduction  provided  in  paragraph  (11)  of  subdivision  (a)  of  section  214 
shall  not  be  allowed. 

(d)  Personal  service  corporations  shall  not  be  subject  to  taxation 
under  this  title,  but  the  individual  stockholders  thereof  shall  be  taxed  in 
the  same  manner  as  the  members  of  partnerships.  All  the  provisions  of 
this  title  relating  to  partnerships  and  the  members  thereof  shall  so  far  as 
practicable  apply  to  personal  service  corporations  ^nd  the  stockholders 
thereof :  Provided,  That  for  the  purpose  of  this  subdivision  amounts  distri- 
buted by  a  personal  service  corporation  during  its  taxable  year  shall  be 
accounted  for  by  the  distributees;  and  any  portion  of  the  net  income 
remaining  undistributed  at  the  close  of  its  taxable  year  shall  be  accounted 
for  by  the  stockholders  of  such  corporation  at  the  close  of  its  taxable  year 
in  proportion  to  their  respective  shares. 

This  subdivision  shall  not  be  in  effect  after  December  31,  1921.  In  the 
case  of  a  personal  service  corporation  having  a  fiscal  year  beginning  in 
1921  and  ending  in  1922,  amounts  distributed  prior  to  January  I,  1922,  to 
its  stockholders  out  of  earnings  or  profits  accumulated  after  December 
31,  1920,  shall  be  taxed  to  the  distributees ;  and  the  stockholders  of  record 
on  December  31,  1921,  shall  be  taxed  upon  their  distributive  shares  of 
the  difference    (if  any)   between  such  distributive  profits  and  the  portion 


REVENUE   ACT    OF    1921  1 749 

of  the  corporation's  net  income  assignable  to  the  calendar  year  1921,  de- 
termined in  the  manner  provided  in  clause  (i)  of  subdivision  (c)  of  section 
205  of  this  Act. 

Estates  and  Trusts 

Sec.  219.  (a)  That  the  tax  imposed  by  sections  210  and  211  shall  apply 
fo  the  income  of  estates  or  of  any  kind  of  property  held  in  trust,  in- 
cluding— 

(i)  Income  received  by  estates  of  deceased  persons  during  the  period 
of  administration  or  settlement  of  the  estate; 

(2)  Income  accumulated  in  trust  for  the  benefit  of  unborn  or  un- 
ascertained persons  or  persons  with  contingent  int'erests ; 

(3)  Income  held  for  future  distribution  under  the  terms  of  the  will 
or  trust;  and 

(4)  Income  which  is  to  be  distributed  to  the  beneficiaries  periodically, 
whether  or  not  at  regular  intervals,  and  the  income  collected  by  a  guardian 
of  an  infant  to  be  held  or  distributed  as  the  court  may  direct. 

(b)  The  fiduciary  shall  be  responsible  for  making  the  return  of  income 
for  the  estate  or  trust  for  which  he  acts.  The  net  income  of  the  estate 
or  trust  shall  be  computed  in  the  same  manner  and  on  the  same  basis 
as  provided  in  section  212,  except  that  (in  lieu  of  the  deduction  authorized 
by  paragraph  (11)  of  subdivision  (a)  of  section  214)  there  shall  also 
be  allowed  as  a  deduction,  without  limitation,  any  part  of  the  gross 
income  which,  pursuant  to  the  terms  of  the  will  or  deed  creating  the 
trust,  is  during  the  taxable  year  paid  or  permanently  set  aside  for  the 
purposes  and  in  the  manner  specified  in  paragraph  (11)  of  subdivision 
(a)  of  section  214.  In  cases  in  which  there  is  any  income  of  the  class 
described  in  paragraph  (4)  of  subdivision  (a)  of  this  section  the  fiduciary 
sliall  include  in  the  return  a  statement  of  the  income  of  the  estate  or  trust 
which,  pursuant  to  the  instrument  or  order  governing  the  distribution, 
is  distributable  to  each  beneficiary,  whether  or  not  distributed  before  the 
close  of  the  taxable  year  for  which  the  return  is  made. 

(c)  In  cases  under  paragraphs  (i),  (2),  or  (3)  of  subdivision  (a) 
or  in  any  other  case  within  subdivision  (a)  of  this  section  except  para- 
graph (4)  thereof  the  tax  shall  be  imposed  upon  the  net  income  of  the 
estate  or  trust  and  shall  be  paid  l)y  the  fiduciary,  except  that  in  determin- 
ing the  net  income  of  the  estate  of  any  deceased  person  during  the  period 
of  administration  or  settlement  there  may  be  deducted  the  amount  of  any 
income  properly  paid  or  credited  to  any  legatee,  heir  or  other  beneficiary. 
In  such  cases  the  estate  or  trust  shall,  for  the  purpose  of  the  normal 
tax,  be  allowed  the  same  credits  as  are  allowed  to  single  persons  under 
section  216. 

(d)  In  cases  under  paragraph  (4)  of  subdivision  (a),  and  in  the  case 
of  any  income  of  an  estate  during  the  period  of  administration  or  settle- 
ment permitted  by  subdivision  (c)  to  be  deducted  from  the  net  income 
upon  which  tax  is  to  be  paid  by  the  fiduciary,  the  tax  shall  not  be  paid 


I750  REVENUE   ACT    OF    1921 

by  the  fiduciary,  but  there  shall  be  included  in  computing  the  net  income 
of  each  beneficiary  that  part  of  the  income  of  the  estate  or  trust  for  its 
taxable  year  which,  pursuant  to  the  instrument  or  order  governing  the 
distribution,  is  distributable  to  such  beneficiary,  whether  distributed  or 
not,  or,  if  his  taxable  year  is  different  from  that  of  the  estate  or  trust, 
then  there  shall  be  included  in  computing  his  net  income  his  distributive 
share  of  the  income  of  the  estate  or  trust  for  its  taxable  year  ending 
within  the  taxable  year  of  the  beneficiary.  In  such  cases  the  beneficiar>' 
shall,  for  the  purpose  of  the  normal  tax,  be  allowed  as  credits,  in  addition 
to  the  credits  allowed  to  him  under  section  216,  his  proportionate  share  of 
such  amounts  specified  in  subdivisions  (a)  and  (b)  of  section  216  as  are 
received  by  the  estate  or  trust. 

(e)  In  the  case  of  an  estate  or  trust  the  income  of  which  consists  both  of 
income  of  the  class  described  in  paragraph  (4)  of  subdivision  (a)  of  this 
section  and  other  income,  the  net  income  of  the  estate  or  trust  shall  be 
computed  and  a  return  thereof  made  by  the  fiduciary  in  accordance  with 
subdivision  (b)  and  the  tax  shall  be  imposed,  and  shall  be  paid  by  the 
fiduciary  in  accordance  with  subdivision  (c),  except  that  there  shall  be 
allowed  as  an  additional  deduction  in  computing  the  net  income  of  the 
estate  or  trust  that  part  of  its  income  of  the  class  described  in  para- 
graph (4)  of  subdivision  (a)  which,  pursuant  to  the  instrument  or  order 
governing  the  distribution,  is  distributable  during  its  taxable  year  to  the 
beneficiaries.  In  cases  under  this  subdivision  there  shall  be  included,  as 
provided  in  subdivision  (d)  of  this  section,  in  computing  the  net  income 
of  each  beneficiary,  that  part  of  the  income  of  the  estate  or  trust  which, 
pursuant  to  the  instrument  or  order  governing  the  distribution,  is  distribut- 
able during  the  taxable  j^ear  to  such  beneficiary. 

(f)  A  trust  created  by  an  employer  as  a  part  of  a  stock  bonus  or 
profit-sharing  plan  for  the  exclusive  benefit  of  some  or  all  of  his  em- 
ployees, to  which  contributions  are  made  by  such  employer,  or  employees, 
or  both,  for  the  purpose  of  distributing  to  such  employees  the  earnings  and 
principal  of  the  fund  accumulated  by  the  trust  in  accordance  with  such 
plan,  shall  not  be  taxable  under  this  section,  but  the  amount  'actually  dis- 
tributed or  made  available  to  any  distributee  shall  be  taxable  to  him  in  the 
year  in  which  so  distributed  or  made  available  to  the  extent  that  it  exceeds 
the  amounts  paid  in  by  him.  Such  distributees  shall  for  the  purpose  of 
the  normal  tax  be  allowed  as  credits  that  part  of  the  amount  so  distributed 
or  made  available  as  represents  the  items  specified  in  subdivisions  (a)  and 
(b)  of  section  216. 

Evasion  of  Surtaxes  by  Incorporation 

Sec.  220.  That  if  any  corporation,  however  created  or  organized,  is 
formed  or  availed  of  for  the  purpose  of  preventing  the  imposition  of  the 
surtax  upon  its  stockholders  or  members  through  the  medium  of  per- 
mitting its  gains  and  profits  to  accumulate  instead  of  being  divided  or  dis- 
tributed, there  shall  be  levied,  collected,   and  paid  for  each  taxable  year 


REVENUE   ACT   OF   1921  -  1751 

upon  the  net  income  of  such  corporation  a  tax  equal  to  25  per  centum 
of  the  amount  thereof,  which  shall  be  in  addition  to  the  tax  imposed  by 
section  230  of  this  title  and  shall  be  computed,  collected,  and  paid  upon 
the  same  basis  and  in  the  same  manner  and  subject  to  the  same  pro- 
visions of  law,  including  penalties,  as  that  tax :  Provided,  That  if  all  the 
stockholders  or  members  of  such  corporation  agree  thereto,  the  Com- 
missioner may,  in  lieu  of  all  income,  war-profits  and  excess-profit's  taxes 
imposed  upon  the  corporation  for  the  taxable  year,  tax  the  stockholders 
or  members  of  such  corporation  upon  their  distributive  shares  in  the  net 
income  of  the  corporation  for  the  taxable  year  in  the  same  manner  as 
provided  in  subdivision  (a)  of  section  218  in  the  case  of  members  of  a 
partnership.  The  fact  that  any  corporation  is  a  mere  holding  company, 
or  that  the  gains  and  profits  are  permitted  to  accumulate  beyond  the 
reasonable  needs  of  the  business,  shall  be  prima  facie  evidence  of  a  pur- 
pose to  escape  the  surtax;  but  the  fact  that  the  gains  and  profits  are  in 
any  case  permitted  to  accumulate  and  become  surplus  shall  not  be  con- 
strued as  evidence  of  a  purpose  to  escape  the  tax  in  such  case  unless  the 
Commissioner  certifies  that  in  his  opinion  such  accumulation  is  unreason- 
able for  the  purposes  of  the  business.  When  requested  by  the  Com- 
missioner, or  any  collector,  every  corporation  shall  forward  to  him  a 
correct  statement  of  such  gains  and  profits  and  the  names  and  addresses 
of  the  individuals  or  shareholders  who  would  be  entitled  to  the  same 
if  divided  or  distributed,  and  of  the  amounts  that  would  be  payable  to 
each. 

Payment  of  Individual's  Tax  at  Source 

Sec.  221.  (a)  That  all  individuals,  corporations,  and  partnerships,  in 
whatever  capacity  acting,  including  lessees  or  mortgagors  of  real  or  per- 
sonal property,  fiduciaries,  employers,  and  all  officers  and  employees  of 
the  United  States  having  the  control,  receipt,  custody,  disposal,  or  pay- 
ment of  interest  (except  interest  on  deposits  with  persons  carrying  on 
the  banking  business  paid  to  persons  not  engaged  in  business  in  the 
United  States  and  not  having  an  office  or  place  of  business  therein),  rent, 
salaries,  wages,  premiums,  annuities,  compensations,  remunerations,  emol- 
uments, or  other  fixed  or  determinable  annual  or  periodical  gains,  profits, 
and  income,  of  any  nonresident  alien  individual  or  partnership  composed 
in  whole  or  in  part  of  nonresident  aliens  (other  than  income  received  as 
dividends  of  the  class  allowed  as  a  credit  by  subdivision  (a)  of  section 
216)  shall  (except  in  the  cases  provided  for  in  subdivision  (b)  and 
except  as  otherwise  provided  in  regulations  prescribed  by  the  Commissioner 
under  section  217)  deduct  and  withhold  from  such  annual  or  periodical 
gains,  profits  and  income  a  tax  equal  to  8  per  centum  thereof :  Provided, 
That  the  Commissioner  may  authorize  such  tax  to  be  deducted  and  with- 
held from  the  interest  upon  any  securities  the  owners  of  which  are  not 
known  to  the  withholding  agent. 

(b)   In  any  case  where  bonds,   mortgages,  or  deeds  of  trust,  or  other 


1752  REVENUE   ACT    OF    1921 

similar  obligations  of  a  corporation  contain  a  contract  or  provision  by 
which  the  obligor  agrees  to  pay  any  portion  of  the  tax  imposed  by  this 
title  upon  the  obligee,  or  to  reimburse  the  obligee  for  any  portion  of  the 
tax,  or  to  pay  the  interest  without  deduction  for  any  tax  which  the 
obligor  may  be  required  or  permitted  to  pay  thereon,  or  to  retain  there- 
from under  any  law  of  the  United  States,  the  obligor  shall  deduct  and 
withhold  a  tax  equal  to  2  per  centum  of  the  interest  upon  such  bonds, 
mortgages,  deeds  of  trust,  or  other  obligations,  whether  such. interest  is 
payable  annually  or  at  shorter  or  longer  periods  and  whether  payable  to 
a  nonresident  alien  individual  or  to  an  individual  citizen  or  resident  of 
the  United  States  or  to  a  partnership :  Provided,  That  the  Commissioner 
may  authorize  such  tax  to  be  deducted  and  withheld  in  the  case  of  interest 
upon  any  such  bonds,  mortgages,  deeds  of  trust,  or  other  obligations,  the 
owners  of  which  are  not  known  to  the  withholding  agent.  Such  de- 
duction and  withholding  shall  not  be  required  in  the  case  of  a  citizen 
or  resident  entitled  to  receive  such  interest,  if  he  files  with  the  with- 
holding agent  on  or  before  February  i  a  signed  notice  in  writing  claiming 
the  benefit  of  the  credits  provided  in  subdivisions  (c)  and  (d)  of  section 
216;  nor  in  the  case  of  a  nonresident  alien  individual  if  so  provided  for 
in  regulations  prescribed  by  the  Commissioner  under  subdivision  (g) 
of  section  217. 

(c)  Every  individual,  corporation,  or  partnership  required  to  deduct 
and  withhold  any  tax  under  this  section  shall  make  return  thereof  on  or 
before  March  i  of  each  year  and  shall  on  or  before  June  15  pay  the  tax 
to  the  official  of  the  United  States  Government  authorized  to  receive  it. 
Every  such  individual,  corporation,  or  partnership  is  hereby  made  liable 
for  such  tax  and  is  hereby  indemnified  against  the  claims  and  demands 
of  any  individual,  corporation,  or  partnership  for  the  amount  of  any  pay- 
ment made  in  accordance  with  the  provisions  of  this  section. 

(d)  Income  upon  which  any  tax  is  required  to  be  withheld  at  the 
source  under  this  section  shall  be  included  in  the  return  of  the  recipient 
of  such  income,  but  any  amount  of  tax  so  withheld  shall  be  credited 
against  the  amount  of  income  tax  as  computed  in  such  return. 

(e)  If  any  tax  required  under  this  section  to  be  deducted  and  with- 
held is  paid  by  the  recipient  of  the  income,  it  shall  not  be  re-collected 
from  the  withholding  agent ;  nor  in  cases  in  which  the  tax  is  so  paid  shall 
any  penalty  is  imposed  upon  or  collected  from  the  recipient  of  the  income 
or  the  withholding  agent  for  failure  to  return  or  pay  the  same,  unless 
such  failure  was  fraudulent  and  for  the  purpose  of  evading  payment. 

Credit  for  Taxes  in  Case  of  Individuals 

Sec.  222.  (a)  That  the  tax  computed  under  Part  II  of  this  title  shall 
be  credited  with : 

(i)  In  the  case  of  a  citizen  of  the  United  States  the  amount  of  any 
income,  war-profits  and  excess-profits  taxes  paid  during  the  taxable  year 
to  any  foreign  country  or  to  any  possession  of  the  United  States;  and 


REVENUE   ACT   OF    1921  1 753 

(2)  In  the  case  of  a  resident  of  the  United  States,  the  amount  of 
any  such  taxes  paid  during  the  taxable  year  to  any  possession  of  the 
United  States ;  and 

(3)  In  the  case  of  an  alien  resident  of  the  United  States,  the  amount 
of  any  such  taxes  paid  during  the  taxable  year  to  any  foreign  country, 
if  the  foreign  country  of  which  such  alien  resident  is  a  citizen  or  subject, 
in  imposing  such  taxes,  allows  a  similar  credit  to  citizens  of  the  United 
States  residing  in  such  country ;  and 

(4)  In  the  case  of  any  such  individual  who  is  a  member  of  a  partner- 
ship or  a  beneficiary  of  an  estate  or  trust,  his  proportionate  share  of 
such  taxes  of  the  partnership  or  the  estate  or  trust  paid  during  the  taxable 
year  to  a  foreign  country  or  to  any  possession  of  the  United  States,  as 
the  case  may  be. 

(5)  The  above  credit's  shall  not  be  allowed  in  the  case  of  a  citizen 
entitled  to  the  benefits  of  section  262 ;  and  in  no  other  case  shall  the  amount 
of  credit,  taken  under  this  subdivision  exceed  the  same  proportion  of  the 
tax,  against  which  such  credit  is  taken,  which  the  taxpayer's  net  income 
(computed  without  deduction  for  any  income,  war-profits  and  excess- 
profits  taxes  imposed  by  any  foreign  country  or  possession  of  the  United 
States)  from  sources  without  the  United  States  bears  to  his  entire  net 
income  (computed  without  such  deduction)   for  the  same  taxable  year. 

(b)  If  accrued  taxes  when  paid  differ  from  the  amounts  claimed  as 
credits  by  the  taxpaj-er,  or  if  any  tax  paid  is  refunded  in  whole  or  in 
part,  the  taxpayer  shall  notify  the  Commissioner,  who  shall  redetermine 
the  amount  of  the  tax  due  under  Part  II  of  this  title  for  the  year  or 
years  affected,  and  the  amount  of  tax  due  upon  such  redetermination,  if 
any,  shall  be  paid  by  the  taxpayer  upon  notice  and  demand  by  the  col- 
lector, or  the  amount  of  tax  overpaid,  if  any,  shall  be  credited  or  refunded 
to  the  taxpayer  in  accordance  with  the  provisions  of  section  252.  In  the 
case  of  such  a  tax  accrued  but  not  paid,  the  Commissioner  as  a  condi- 
tion precedent  to  the  allowance  of  this  credit  may  require  the  taxpayer 
to  give  a  bond  with  sureties  satisfactory  to  and  to  be  approved  by  the 
Commissioner  in  such  penal  sum  as  the  Commissioner  may  require,  condi- 
tioned for  the  payment  by  the  taxpayer  of  any  amount  of  tax  found  due 
upon  any  such  redetermination ;  and  the  bond  herein  prescribed  shall  con- 
fain  such  further  conditions  as  the  Commissioner  may  require. 

(c)  These  credits  shall  be  allowed  only  if  the  taxpayer  furnishes 
evidence  satisfactory  to  the  Commissioner  showing  the  amount  of  income 
derived  from  sources  without  the  United  States,  and  all  other  information 
necessary  for  the  verification  and  computation  of  such  credits. 

(d)  If  the  taxpayer  makes  a  return  for  a  fiscal  year  beginning  in  1920 
and  ending  in  1921,  the  credit  for  the  entire  fiscal  year  shall,  not- 
withstanding any  provision  of  this  Act,  be  determined  under  the  provisions 
of  this  section ;  and  the  Commissioner  is  authorized  to  disallow,  in  whole 
or  part,  any  such  credit  which  he  finds  has  already  been  taken  by  the 
taxpayer. 


1754 


REVENUE   ACT    OF    1921 


Individual  Returns 

Sec.  223.  (a)  That  the  following  individuals  shall  each  make  under 
oath  a  return  stating  specifically  the  items  of  his  gross  income  and  the 
deductions  and  credits  allowed  under  this  title — 

(i)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$1,000  or  over,  if  single,  or  if  married  and  not  living  with  husband  or 
wife; 

(2)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$2,000  or  over,  if  married  and  living  with  husband  or  wife;  and 

(3)  Every  individual  having  a  gross  income  for  the  taxable  year  of 
$5,000  or  over,  regardless  of  the  amount  of  his  net  income. 

(b)  If  a  husband  and  wife  living  together  have  an  aggregate  net  income 
for  the  taxable  year  of  $2,000  or  over,  or  an  aggregate  gross  income  for 
such  year  of  $5,000  or  over — 

(i)   Each  shall  make  such  a  return,  or 

(2)  The  income  of  each  shall  be  included  in  a  single  joint  return, 
in  which  case  the  tax  shall  be  computed  on  the  aggregate  income. 

(c)  If  the  taxpayer  is  unable  to  make  his  own  return,  the  return  shall 
be  made  by  a  duly  authorized  agent  or  by  the  guardian  or  other  person 
charged  with  the  care  of  the  person  or  property  of  such  taxpayer. 

Partnership  Returns 

Sec.  224.  That  every  partnership  shall  make  a  return  for  each  tax- 
able year,  stating  specifically  the  items  of  its  gross  income  and  the  de- 
ductions allowed  by  this  title,  and  shall  include  in  the  return  the  names 
and  addresses  of  the  individuals  who  would  be  entitled  to  share  in  the 
net  income  if  distributed  and  the  amount  of  the  distributive  share  of  each 
individual.     The  return  shall  be  sworn  to  by  any  one  of  the  partners. 

Fiduciary  Returns 

Sec.  225.  (a)  That  every  fiduciary  (except  a  receiver  appointed  by 
authority  of  law  in  possession  of  part  only  of  the  property  of  an  individual) 
shall  make  under  oath  a  return  for  any  of  the  following  individuals, 
estates,  or  trusts  for  which  he  acts,  stating  specifically  the  items  of  gross 
income  thereof  and  the  deductions  and  credits  allowed  under'  this  title — 

(i)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$1,000  or  over,  if  single,  or  if  married  and  not  living  with  husband  or 
wife; 

(2)  Every  individual  having  a  net  income  for  the  taxable  year  of 
$2,000  or  over,  if  married  and  living  with  husband  or  wife; 

(3)  Every  individual  having  a  gross  income  for  the  taxable  year  of 
$5,000  or  over,  regardless  of  the  amount  of  his  net  income; 

(4)  Every  estate  or  trust  the  net  income  of  which  for  the  taxable 
year  is  $1,000  or  over;  and 

(5)  Every  estate  or  trust  of  which  any  beneficiary  is  a  nonresident 
alien. 

(b)  Under   such   regulations  as  the  Commissioner  with  the  approval 


REVENUE  ACT   OF   1921  1 75  5 

of  the  Secretary  may  prescribe  a  return  made  by  one  of  two  or  more 
joint  fiduciaries  and  filed  in  the  office  of  the  collector  of  the  district 
where  such  fiduciary  resides  shall  be  sufficient  compliance  with  the  above 
requirement.  Such  fiduciary  shall  make  oath  (i)  that  he  has  sufficient 
knowledge  of  the  affairs  of  the  individual,  estate  or  trust  for  which 
the  return  is  made,  to  enable  him  to  make  the  return,  and  (2)  that  the 
return  is  to  the  best  of  his  knowledge  and  belief,  true  and  correct.  Any 
fiduciary  required  to  make  a  return  under  this  Act  shall  be  subject  to  all 
the  provisions  of  this  Act  which  apply  to  individuals. 

Returns  for  a  Period  of  Less  Than  Twelve  Months 

Sec.  226.  (a)  That  if  a  taxpayer,  with  the  approval  of  the  Com- 
missioner, changes  the  basis  of  computing  net  income  from  fiscal  year 
to  calendar  year  a  separate  return  shall  be  made  for  the  period  between 
the  close  of  the  last  fiscal  year  for  which  return  was  made  and  the 
following  December  31.  If  the  change  is  from  calendar  year  to  fiscal 
year,  a  separate  return  shall  be  made  for  the  period  between  the  close  of 
the  last"  calendar  year  for  which  return  was  made  and  the  date  designated 
as  the  close  of  the  fiscal  year.  If  the  change  is  from  one  fiscal  year  to 
another  fiscal  year  a  separate  return  shall  be  made  for  the  period  between 
the  close  of  the  former  fiscal  year  and  the  date  designated  as  the  close 
of  the  new  fiscal  year. 

(b)  In  all  cases  where  a  separate  return  is  made  for  a  part  of  a 
taxable  year  the  net  income  shall  be  computed  on  the  basis  of  such  period 
for  which  separate  return  is  made,  and  the  tax  shall  be  paid  thereon  at 
the  rate  for  the  calendar  year  in  which  such  period  is  included- 

(c)  In  the  case  of  a  return  for  a  period  of  less  than  one  year  the 
net  income  shall  be  placed  on  an  annual  basis  by  multiplying  the  amount 
thereof  by  twelve  and  dividing  by  the  number  of  months  included  in  such 
period;  and  the  tax  shall  be  such  part  of  a  tax  computed  on  such  annual 
basis  as  the  number  of  months  in  such  period  is  of  twelve  months. 

Time    and    Place    for    Filing    Individual,    Partnership,    and    Fiduciary 
Returns 

Sec.  227.  (a)  That  returns  (except  in  the  case  of  nonresident  aliens) 
shall  be  made  on  or  before  the  fifteenth  day  of  the  third  month  following 
the  close  of  the  fiscal  year,  or,  if  the  return  is  made  on  the  basis  of  the 
calendar  year,  then  the  return  shall  be  made  on  or  before  the  15th  day  of 
March.  In  the  case  of  a  nonresident  alien  individual  returns  shall  be 
made  on  or  before  the  fifteenth  day  of  the  sixth  month  following  the 
close  of  the  fiscal  year,  or,  if  the  return  is  made  on  the  basis  of  the 
calendar  year,  then  the  return  shall  be  made  on  or  before  the  isth  day  of 
June.  The  Commissioner  may  grant  a  reasonable  extension  of  time  for 
filing  returns  whenever  in  his  judgment  good  cause  exists  and  shall  keep 
a  record  of  every  such  extenr.ion  and  the  reason  therefor.  Except  in  the 
case  of  taxpayers  who  are  abroad,  no  such  extension  shall  be  for  more 
than  six  months. 


1756 


REVENUE   ACT   OF    1921 


(b)  Returns  shall  be  made  to  the  collector  for  the  district  in  which 
is  located  the  legal  residence  or  principal  place  of  business  of  the  person 
making  the  return,  or,  if  he  has  no  legal  residence  or  principal  place  of 
business  in  the  United  States,  then  to  the  collector  at  Baltimore,  Mary- 
land. 

Understatement  in  Returns 

Sec.  228.  That  if  the  collector  or  deputy  collector  has  reason  to  believe 
that  the  amount  of  any  income  returned  is  understated,  he  shall  give  due 
notice  to  the  taxpayer  making  the  return  to  show  cause  why  the  amount 
of  the  return  should  not  be  increased,  and  upon  proof  of  the  amount 
understated,  may  increase  the  same  accordingly.  Such  taxpayer  may 
furnish  sworn  testimony  to  prove  any  relevant  fact's  and  if  dissatisfied 
with  the  decision  of  the  collector  may  appeal  to  the  Commissioner  for  his 
decision,  under  such  rules  of  procedure  as  may  be  prescribed  by  the 
Commissioner  with  the  approval  of  the  Secretary. 

Incorporation  of  Individual  or  Partnership  Business 

Sec.  22g.  That  in  the  case  of  the  organization  as  a  corporation  within 
four  months  after  the  passage  of  this  act  of  any  trade  or  business  in 
which  capital  is  a  material  income-producing  factor,  and  which  was  pre- 
viously owned  by  a  partnership  or  individual,  the  net  income  of  such  trade 
or  business  from  January  i,  1921,  to  the  date  of  such  organization  may 
at  the  option  of  the  individual  or  partnership  be  taxed  as  the  net  income 
of  a  corporation  is  taxed  under  Titles  II  and  III ;  in  which  event  the  net 
income  and  .invested  capital  of  such  trade  or  business  shall  be  com- 
puted as  if  such  corporation  had  been  in  existence  on  and  after  January 
I,  1921,  and  the  undistributed  profits  or  earnings  of  such  trade  or  business 
shall  not  be  subject  to  the  surtaxes  imposed  in  section  211,  but  amounts 
distributed  on  and  after  January  i,  1921,  from  the  earnings  or  profits 
of  such  trade  or  business  accumulated  after  December  31,  1920,  shall  be 
taxed  to  the  recipients  as  dividends ;  and  all  the  provisions  of  Titles  II 
and  III  relating  to  corporations  shall  so  far  as  practicable  apply  to  such 
trade  or  business :  Provided,  That  this  section  shall  not  apply  to  any  trade 
or  business,  the  net  income  of  which  for  the  taxable  year  1921  was  less 
than  20  per  centum  of  its  invested  capital  for  such  year:  Provided  further. 
That  any  taxpayer  who  fakes  advantage  of  this  section  shall  pay  the  tax 
imposed  by  section  1000  of  the  Revenue  Act  of  1918  as  if  such  taxpayer 
had  been  a  corporation  on  and  after  January  i,  1921. 

Part  III. — Corporations. 

Tax  on  Corporations 

Sf.c.  230.  That,  in  lieu  of  the  tax  imposed  by  section  230  of  the  Revenue 
Act  of  1 918,  there  shall  be  levied,  collected,  and  paid  for  each  taxable  year 
upon  the  net  income  of  every  corporation  a  tax  at  the  following  rates : 


REVENUE   ACT    OF    1921  1757 

(a)  For  the  calendar  year  1921,  10  per  centum  of  the  amount  of  the 
net  income  in  excess  of  the  credits  provided  in  section  236;  and 

(b)  For  each  calendar  year  thereafter,  12I/2  per  centum  of  such  excess 
amount. 

Conditional  and  Other  Exemptions  of  Corporations 

Sec.  231.  That  the  following  organizations  shall  be  exempt'  from  tax- 
ation under  this  title — 

(1)  Labor,  agricultural,  or  horticultural  organizations; 

(2)  Mutual  savings  banks  not  having  a  capital  stock  represented  by 
shares ; 

(3)  Fraternal  beneficiary  societies,  orders  or  associations,  (a)  operating 
under  the  lodge  system  or  for  the  exclusive  benefit  of  the  members  of 
a  fraternity  itself  operating  under  the  lodge  system;  and  (b)  providing 
for  the  payment  of  life,  sick,  accident,  or  other  benefits  to  the  members 
of  such  society,  order,  or  association  or  their  dependents; 

(4)  Domestic  building  and  loan  associations  substantially  all  the  busi- 
ness of  which  is  confined  to  making  loans  to  members;  and  cooperative 
banks  without  capital  stock  organized  and  operated  for  mutual  purposes 
and  without  profit ; 

(5)  Cemetery  companies  owned  and  operated  exclusively  for  the  benefit 
of  their  members  or  which  are  not  operated  for  profit;  and  any  corporation 
chartered  solely  for  burial  purposes  as  a  cemetery  corporation  and  not 
permitted  by  it's  charter  to  engage  in  any  business  not  necessarily  incident 
to  that  purpose,  no  part  of  the  net  earnings  of  which  inures  to  the  benefit 
of  any  private  stockholder  or  individual ; 

(6)  Corporations,  and  any  community  chest,  fund,  or  foundation, 
organized  and  operated  exclusively  for  religious,  charitable,  scientific, 
literary,  or  educational  purposes,  or  for  the  prevention  of  cruelty  to 
children  or  animals,  no  part  of  the  net  earnings  of  which  inures  to  the 
benefit  of  any  private  stockholder  or  individual ; 

(7)  Business  leagues,  chambers  of  commerce,  or  boards  of  trade,  not 
organized  for  profit  and  no  part'  of  the  net  earnings  of  which  inures  to 
the  benefit  of  any  private  stockholder  or  individual; 

(8)  Civic  leagues  or  organizations  not  organized  for  profit  but  operated 
exclusively  for  the  promotion  of  social  welfare; 

(9)  Clubs  organized  and  operated  exclusively  for  pleasure,  recreation, 
and  other  nonprofitable  purposes,  no  part  of  the  net  earnings  of  which 
inures  to  the  benefit  of  any  private  stockholder  or  member; 

(10)  Farmers'  or  other  mutual  hail,  cyclone,  or  fire  insurance  com- 
panies, mutual  ditch  or  irrigation  companies,  mutual  or  cooperative 
telephone  companies,  or  like  organizations  of  a  purely  local  character,  the 
income  of  which  consists  solely  of  assessments,  dues,  and  fees  collected 
from  members  for  the  sole  purpose  of  meeting  expenses ; 

(11)  Farmers',  fruit  growers',  or  like  associations,  organized  and  op- 
crated  as  sales  agents  for  the  purpose  of  marketing  the  products  of  members 


17^8  REVENUE   ACT    OF    1921 

and  turning  back  to  them  the  proceeds  of  sales,  less  the  necessary  selling 
expenses,  on  the  basis  of  the  quantity  of  produce  furnished  by  them;  or 
organized  and  operated  as  purchasing  agents  for  the  purpose  of  purchas- 
ing supplies  and  equipment  for  the  use  of  members  and  turning  over  such 
supplies  and  equipment  to  such  members  at  actual  cost,  plus  necessary  ex- 
penses ; 

(12)  Corporations  organized  for  the  exclusive  purpose  of  holding  title 
to  property,  collecting  income  therefrom,  and  turning  over  the  entire 
amount  thereof,  less  expenses,  fo  an  organization  which  itself  is  exempt 
from  the  tax  imposed  by  this  title; 

(13)  Federal  land  banks  and  national  farm-loan  associations  as  pro- 
vided in  section  26  of  the  Act  approved  July  17,  1916,  entitled  "An  Act 
to  proyide  capital  for  agricultural  development,  to  create  standard  forms 
of  investment  based  upon  farm  mortgage,  to  equalize  rates  of  interest  upon 
farm  loans,  to  furnish  a  market  for  United  States  bonds,  to  create  Gov- 
ernment depositaries  and  financial  agents  for  the  United  States,  and  for 
other  purposes" ; 

(14)  Personal  service  corporations.  This  subdivision  shall  not  be  in 
effect  after  December  31,  1921. 

Net  Income  of   Corporations   Defined 

Sec.  232.  That  in  the  case  of  a  corporation  subject  to  the  tax  imposed 
by  section  230  the  term  "net  income"  means  the  gross  income  as  defined 
in  section  233  less  the  deductions  allowed  by  section  234,  and  the  net 
income  shall  be  computed  on  the  same  basis  as  is  provided  in  subdivision 
(b)  of  section  212  or  in  section  226.  In  the  case  of  a  foreign  corporation 
or  of  a  corporation  entitled  to  the  benefits  of  section  262  the  computation 
shall  also  be  made  in  the  manner  provided  in  section  217. 

Gross  Income  of  Corporations  Defined 

Sec.  233.  (a)  That  in  the  case  of  a  corporation  subject  to  the  tax 
imposed  by  section  230  the  term  "gross  income"  means  the  gross  income 
as  defined  in  sections  213  and  217,  except  that  mutual  marine  insurance 
companies  shall  include  in  gross  income  the  gross  premiums  collected  and 
received  by  them  less  amounts  paid  for  reinsurance. 

(b)  In  the  case  of  a  foreign  corporation,  gross  income  means  only 
gross  income  from  sources  within  the  United  States,  determined  (except 
in  the  case  of  insurance  companies  subject  to  the  tax  imposed  by  sections 
243  or  246)  in  the  manner  provided  in  section  217. 

Deductions  Allowed  Corporations 

Sec.  234.  (a)  That  in  computing  the  net  income  of  a  corporation 
subject  to  the  tax  imposed  by  section  230  there  shall  be  allowed  as  de- 
ductions : 

(i)  All  the  ordinary  and  necessary  expenses  paid  or  incurred  during 
the  taxable  year  in  carrying  on  any  trade  or  business,  including  a  reason- 


REVENUE   ACT   OF    1921  I759 

able  allowance  for  salaries  or  other  compensation  for  personal  services 
actually  rendered,  and  including  rentals  or  other  payments  required  to 
be  made  as  a  condition  to  the  continued  use  or  possession  of  property  to 
which  the  corporation  has  not  taken  or  is  not  taking  title,  or  in  which 
it  has  no  equity ; 

(2)  All  interest  paid  or  accrued  within  the  taxable  year  on  its  in- 
debtedness, except  on  indebtedness  incurred  or  continued  to  purchase  or 
carry  obligations  or  securities  (other  than  obligations  of  the  United  States 
issued  after  September  24,  1917,  and  originally  subscribed  for  by  the  tax- 
payer) the  interest  upon  which  is  wholly  exempt  from  taxation  under 
this  title; 

(3)  Taxes  paid  or  accrued  within  the  taxable  year  except  (a)  income, 
war-profits  and  excess-profits  taxes  imposed  by  the  authority  of  the  United 
States,  (b)  so  much  of  the  income,  war-profits  and  excess-profits  taxes 
imposed  by  the  authority  of  any  foreign  country  or  possession  of  the 
United  States  as  is  allowed  as  a  credit  under  section  238,  and  (c)  taxes 
assessed  against  local  benefits  of  a  kind  tending  to  increase  the  value  of 
the  property  assessed.  In  the  case  of  obligors  specified  in  subdivision  (b) 
of  section  221  no  deduction  for  the  payment  of  the  tax  imposed  by  this 
title,  or  any  other  tax  paid  pursuant  to  the  contract  or  provision  referred 
to  in  that  subdivision,  shall  be  allowed  nor  shall  such  tax  be  included  in 
the  gross  income  of  the  obligee.  The  deduction  allowed  by  this  para- 
graph shall  be  allowed  in  the  case  of  taxes  imposed  upon  a  shareholder 
or  member  of  a  corporation  upon  his  interest  as  shareholder  or  member 
which  are  paid  by  the  corporation  without  reimbursement  from  the 
shareholder  or  member,  but  in  such  cases  no  deduction  shall  be  al- 
lowed the  shareholder  or  member  for  the  amount  of  such  taxes.  For  the 
purpose  of  this  paragraph,  estate,  inheritance,  legacy,  and  succession  taxes 
accrue  on  the  due  date  thereof  except  as  otherwise  provided  by  the  law 
of  the  jurisdiction  imposing  such  taxes; 

(4)  Losses  sustained  during  the  taxable  year  and  not  compensated  for 
by  insurance  or  otherwise;  unless,  in  order  to  clearly  reflect  the  income, 
the  loss  should  in  the  opinion  of  the  Commissioner  be  accounted  for  as 
of  a  different  period.  No  deduction  shall  be  allowed  for  any  loss  claimed 
to  have  been  sustained  in  any  sale  or  other  disposition  of  shares  of  stock 
or  securities  made  after  the  passage  of  this  Act  where  it  appears  that  within 
thirty  days  before  or  after  the  date  of  such  sale  or  other  disposition  the 
taxpayer  has  acquired  (otherwise  than  by  bequest  or  inheritance)  sub- 
stantially identical  property,  and  the  property  so  acquired  is  held  by  the  tax- 
payer for  any  period  after  such  sale  or  other  disposition,  unless  such  claim 
is  made  by  a  dealer  in  stock  or  securities  and  with  respect  to  a  transaction 
made  in  the  ordinary  course  of  its  business.  If  such  acquisition  is  to  the 
extent  of  part  only  of  substantially  identical  property,  then  only  a  pro- 
portionate part  of  the  loss  shall  be  disallowed.  In  case  of  losses  arising 
from  destruction  of  or  damage  to  property,  where  the  property  so  des- 
troyed or  damaged  was  acquired  before  March  i,  1913,  the  deduction  shall 


1760  REVENUE   ACT    OF    1921 

be  computed  upon  the  basis  of  its  fair  market  price  or  value  as  of  March 

I,  1913; 

(5)  Debts  ascertained  to  be  worthless  and  charged  off  within  the 
taxable  year  (or  in  the  discretion  of  the  Commissioner,  a  reasonable  addition 
to  a  reserve  for  bad  debts)  ;  and  when  satisfied  that  a  debt  is  recoverable 
only  in  part,  the  Commissioner  may  allow  such  debt  to  be  charged  oflF 
in  part ; 

(6)  The  amount  received  as  dividends  (A)  from  a  domestic  corpora- 
tion other  than  a  corporation  entitled  to  the  benefits  of  section  262,  or 
(B)  from  any  foreign  corporation  when  it  is  shown  to  the  satisfaction 
of  the  Commissioner  that  more  than  50  per  centum  of  the  gross  income 
of  such  foreign  corporation  for  the  three-year  period  ending  with  the  close 
of  its  taxable  year  preceding  the  declaration  of  such  dividends  (or  for 
such  part  of  such  period  as  the  foreign  corporation  has  been  in  existence) 
was  derived  from  sources  within  the  United  States  as  determined  under 
section  217; 

(7)  A  reasonable  allowance  for  the  exhaustion,  wear  and  tear  of 
property  used  in  the  trade  or  business,  including  a  reasonable  allowance 
for  obsolescence.  In  the  case  of  such  property  acquired  before  March  i, 
1913,  this  deduction  shall  be  computed  upon  the  basis  of  its  fair  market 
price  or  value  as  of  March  i,  1913; 

(8)  In  the  case  of  buildings,  machinery,  equipment,  or  other  facilities, 
constructed,  erected,  installed,  or  acquired,  on  or  after  April  6,  1917,  for 
the  production  of  articles  contributing  to  the  prosecution  of  the  war 
against  the  German  Government,  and  in  the  case  of  vessels  constructed  or 
acquired  on  or  after  such  date  for  the  transportation  of  articles  or  men 
contributing  to  the  prosecution  of  such  war,  there  shall  be  allowed,  for 
any  taxable  year  ending  before  March  3,  1924  (if  claim  therefor  was  made 
at  the  time  of  filing  return  for  the  taxable  year  1918,  1919,  1920,  or  1921) 
a  reasonable  deduction  for  the  amortization  of  such  part  of  the  cost  of 
such  facilities  or  vessels  as  has  been  borne  by  the  taxpayer,  but  not  again 
including  any  amount  otherwise  allowed  under  this  title  or  previous  Acts 
of  Congress  as  a  deduction  in  computing  net  income.  At  any  time  before 
March  3,  1924,  the  Commissioner  may,  and  at  the  request  of  the  tax- 
payer shall,  reexamine  the  return,  and  if  he  then  finds  as  a  result  of  an 
appraisal  or  from  other  evidence  that  the  deduction  originally  allowed 
was  incorrect,  the  income,  war-profits,  and  excess-profit's  taxes  for  the 
year  or  years  afifected  shall  be  redetermined  and  the  amount  of  tax  due 
upon  such  redetermination,  if  any,  shall  be  paid  upon  notice  and  demand 
by  the  collector,  or  the  amount  of  tax  overpaid,  if  any,  shall  be  credited  or 
refunded  to  the  taxpayer  in  accordance  with  the  provisions  of  section  252; 

(9)  In  the  case  of  mines,  oil  and  gas  wells,  other  natural  deposits,  and 
timber,  a  reasonable  allowance  for  depletion  and  for  depreciation  of  im- 
provements, according  to  the  peculiar  conditions  in  each  case,  based  upon 
cost  including  cost  of  development  not  otherwise  deducted :  Provided, 
That  in  the  case  of  such  properties  acquired  prior  to  March  i,  1913,  the 


REVENUE   ACT   OF   1921  1761 

fair  market  value  of  the  property  (or  the  taxpayer's  interest  therein)  on 
that  date  shall  be  taken  in  lieu  of  cost  up  to  that  date:  Provided  further, 
That  in  the  case  of  mines,  oil  and  gas  wells,  discovered  by  the  taxpayer, 
on  or  after  March  i,  1913,  and  not  acquired  as  the  result  of  purchase  of 
a  proven  tract  or  lease,  where  the  fair  market  value  of  the  property  is 
materially  disproportionate  to  the  cost,  the  depletion  allowance  shall  be 
based  upon  the  fair  market  value  of  the  property  at  the  date  of  the  dis- 
covery, or  within  thirty  days  thereafter:  And  provided  further.  That  such 
depletion  allowance  based  on  discovery  value  shall  not  exceed  the  net 
income,  computed  without  allowance  for  depletion,  from  the  property 
upon  which  the  discovery  is  made,  except  where  such  net  income  so  com- 
puted is  less  than  the  depletion  allowance  based  on  cost  or  fair  market 
value  as  of  March  i,  1913;  such  reasonable  allowance  in  all  the  above 
cases  to  be  made  under  rules  and  regulations  to  be  prescribed  by  the 
Commisioner  with  the  approval  of  the 'Secretary.  In  the  case  of  leases 
the  deductions  allowed  by  this  paragraph  shall  be  equitably  apportioned 
between  the  lessor  and  lessee; 

(10)  In  the  case  of  insurance  companies  (other  than  life  insurance 
companies),  in  addition  to  the  above  (unless  otherwise  allowed)  :  (A) 
The  net  addition  required  by  law  to  be  made  within  the  taxable  year  to 
reserve  funds  (including  in  the  case  of  assessment  insurance  companies 
the  actual  deposit  of  sums  with  State  or  Territorial  officers  pursuant  to 
law  as  additions  to  guarantee  or  reserve  funds)  ;  and  (B)  the  sums  other 
than  dividends  paid  within  the  taxable  year  on  policy  and  annuity  con- 
tracts. After  December  31,  1921,  this  subdivision  shall  apply  only  to 
mutual  insurance  companies  other  than  life  insurance  companies; 

(11)  In  the  case  of  corporations  (except  those  taxed  under  section  243) 
issuing  policies  covering  life,  health,  and  accident  insurance  combined  in 
one  policy  issued  on  the  weekly  premium  payment  plan  continuing  for 
life  and  not  subject  to  cancellation,  in  addition  to  the  above," such  portion 
of  the  net  addition  (not  required  by  law)  made  within  the  taxable  year 
to  reserve  funds  as  the  Commissioner  finds  to  be  required  for  the  pro- 
tection of  the  holders  of  such  policies  only.  This  subdivision  shall  not 
be  in  effect  after  December  31,  1921 ; 

(12)  In  the  case  of  mutual  marine  insurance  companies,  there  shall 
be  allowed,  in  addition  to  the  deductions  allowed  in  paragraphs  (i)  to 
(10),  inclusive,  and  paragraph  (14),  unless  otherwise  allowed,  amounts 
repaid  to  policyholders  on  account  of  premiums  previously  paid  by  them, 
and  interest  paid  upon  such  amounts  between  the  ascertainment  and  the 
payment  thereof ; 

(j3)  In  the  case  of  mutual  insurance  companies  (including  interinsurers 
and  reciprocal  underwriters,  but  not  including  mutual  life  or  mutual 
marine  insurance  companies)  requiring  their  members  to  make  premium 
deposits  to  provide  for  losses  and  expenses,  there  shall  be  allowed,  in 
addition  to  the  deductions  allowed  in  paragraphs  (i)  to  (10),  inclusive, 
and   paragraph    (14),   unless   otherwise   allowed,   the  amount   of   premium 


1762  REVENUE   ACT    OF    1921 

deposits  returned  to  their  policyholders  and  the  amount  of  premium  de- 
posits retained  for  the  payment'  of  losses,  expenses,  and  reinsurance  re- 
serves ; 

(14)  If  property  is  compulsorily  or  involuntarily  converted  into  cash 
or  its  equivalent  as  a  result  of  (A)  its  destruction  in  whole  or  in  part, 
(B)  theft  or  seizure,  or  (C)  an  exercise  of  the  power  of  requisition  or 
condemnation,  or  the  threat  or  imminence  thereof ;  and  if  the  taxpayer 
proceeds  forthwith  in  good  faith  under  regulations  prescribed  by  the 
Commissioner  with  the  approval  of  the  Secretary,  to  expend  the  proceeds  of 
such  conversion  in  the  acquisition  of  other  property  of  a  character  similar 
or  related  in  service  or  use  to  the  property  so  converted,  or  in  the 
acquisition  of  80  per  centum  or  more  of  the  stock  or  shares  of  a  cor- 
poration owning  such  other  property,  or  in  the  establishment  of  a  re- 
placement fund,  then  there  shall  be  allowed  as  a  deduction  such  portion 
of  the  gain  derived  as  the  portion*  of  the  proceeds  so  expended  bears  to 
the  entire  proceeds.  The  provision  of  this  paragraph  prescribing  the  con- 
ditions under  which  a  deduction  may  be  taken  in  respect  of  the  proceeds 
or  gains  derived  from  the  compulsory  or  involuntary  conversion  of 
property  into  cash  or  its  equivalent,  shall  apply  so  far  as  may  be 
practicable  to  the  exemption  or  exclusion  of  such  proceeds  or  gains  from 
gross  income  under  prior  income,  war-profits  and  excess-profits  tax  Acts. 

(b)  In  the  case  of  a  foreign  corporation  or  of  a  corporation  entitled 
to  the  benefit's  of  section  262  the  deductions  allowed  in  subdivision  (a) 
shall  be  allowed  only  if  and  to  the  extent  that  they  are  connected  ■with 
income  from  sources  within  the  United  States;  and  the  proper  apportion- 
ment and  allocation  of  the  deductions  with  respect  to  sources  within 
and  without  the  United  States  shall  be  determined  as  provided  in  section 
217  under  rules  and  regulations  prescribed  by  the  Commissioner  with  the 
approval  of  the  Secretary. 

Items  Not  Deductible  by  Corporations 

Sec.  235.  That  in  computing  net  income  no  deduction  shall  in  any 
case  be  allowed  in  respect  of  any  of  the  items  specified  in  section  215. 

Credits  Allowed  Corporations 

Sec.  236.     That  for  the  purpose  only  of  the  tax  imposed  by  section  230 
there  shall  be  allowed  the  following  credits : 

(a)  The  amount  received  as  interest  upon  obligations  of  the  United 
States  and  bonds  issued  by  the  War  Finance  Corporation,  which  is  included 
in  gross  income  under  section  233 ; 

(b)  In  the  case  of  a  domestic  corporation  the  net  income  of  which 
is  $25,000  or  less,  a  specific  credit  of  $2,000;  but  if  the  net  income  is 
more  than  $25,000  the  tax  imposed  by  section  230  shall  not  exceed  the  tax 
which  would  be  payable  if  the  $2,000  credit  were  allowed,  plus  the  amount 
of  the  net  income  in  excess  of  $25,000;  and 

(c)  The  amount  of  any  war-profits  and  excess-profits  taxes  imposed 


REVENUE   ACT    OF    1921  1 763 

by  Act  of   Congress   for  the  same  taxable  year.     The  credit  allowed  by 
this  subdivision  shall  be  determined  as  follows : 

(1)  In  the  case  of  a  corporation  which  makes  return  for  a  fiscal 
year  beginning  in  1920  and  ending  in  1921,  in  computing  the  income  tax 
as  provided  in  subdivision  (a)  of  section  205,  the  portion  of  the  war- 
profits  and  excess-profits  tax  computed  for  the  entire  period  under  clause 
(i)  of  subdivision  (a)  of  section  335  shall  be  credited  against  the  net 
income  computed  for  the  entire  period  as  provided  in  clause  (i)  of  sub- 
division (a)  of  section  205,  and  the  portion  of  the  war-profits  and  excess- 
profits  tax  computed  for  the  entire  period  under  clause  (2)  of  subdivision 
(a)  of  section  335  shall  be  credited  against  the  net  income  computed  for 
the  entire  period  as  provided  in  clause  (2)  of  subdivision  (a)  of 
section  205. 

(2)  In  the  case  of  a  corporation  which  makes  return  for  a  fiscal  year 
beginning  in  1921  and  ending  in  1922,  in  computing  the  income  tax  as 
provided  in  subdivision  (b)  of  section  205,  the  war-profits  and  excess- 
profits  tax  computed  under  subdivision  (b)  of  section  335  shall  be  credited 
against  the  net  income  computed  for  the  entire  period  as  provided  in 
clause  (i)  of  subdivision  (b)  of  section  205. 

Payment  of  Corporation  Income  Tax  at  Source 

Sec.  237.  That  in  the  case  of  foreign  corporations  subject  to  taxation 
under  this  title  not  engaged  in  trade  or  business  within  the  United  States 
and  not  having  any  office  or  place  of  business  therein,  there  shall  be  de- 
ducted and  withheld  at  the  source  in  the  same  manner  and  upon  the  same 
items  of  income  as  is  provided  in  section  221  a  tax  equal  to  I2j/^  per 
centum  thereof  (but  during  the  calendar  year  1921  only  10  per  centum), 
and  such  tax  shall  be  returned  and  paid  in  the  same  manner  and  subject 
to  the  same  conditions  as  provided  in  that  section :  Provided,  That  in  the 
case  of  interest  described  in  subdivision  (b)  of  that  section  the  deduction 
and  withholding  shall  be  at  the  rate  of  2  per  centum. 

Credit  for  Taxes  in  Case  of  Corporations 

Sec.  238.  (a)  That  in  the  case  of  a  domestic  corporation  the  tax 
imposed  by  this  title,  plus  the  war-profits  and  excess-profits  taxes,  if 
any,  shall  be  credited  with  the  amount  of  any  income,  war-profits,  and 
excess-profits  taxes  paid  during  the  same  taxable  year  to  any  foreign 
country,  or  to  any  possession  of  the  United  States:  Provided,  That  the 
amount  of  credit  taken  under  this  subdivision  shall  in  no  case  exceed  the 
same  proportion  of  the  taxes,  against  which  such  credit  is  taken,  which 
the  taxpayer's  net  income  (computed  without  deduction  for  any  income, 
war-profits,  and  excess-profits  taxes  imposed  by  any  foreign  country  or 
possession  of  the  United  States)  from  sources  without  the  United  States 
bears  to  its  entire  net  income  (computed  without  such  deduction)  for  the 
same  taxable  year.  In  the  case  of  domestic  insurance  companies  subject 
to  the  tax  imposed  by  section  243  or  246,  the  term  "net  income",  as  used 


1764  REVENUE   ACT    OF    1921 

in  this  subdivision  means  net  income  as  defined  in  sections  245  and  246, 
respectively. 

(b)  If  accrued  taxes  when  paid  differ  from  the  amounts  claimed  as 
credits  by  the  corporation,  or  if  any  tax  paid  is  refunded  in  whole  or  in 
part,  the  corporation  shall  at  once  notify  the  Commissioner,  who  shall 
redetermine  the  amount  of  the  income,  war-profits  and  excess-profits 
taxes  for  the  year  or  years  affected,  and  the  amount  of  taxes  due  upon 
such  redetermination,  if  any,  shall  be  paid  by  the  corporation  upon  notice 
and  demand  by  the  collector,  or  the  amount  of  taxes  overpaid,  if  any, 
shall  be  credited  or  refunded  to  the  corporation  in  accordance  with  the 
provisions  of  section  252.  In  the  case  of  such  a  tax  accrued  but  not  paid, 
the  Commissioner  as  a  condition  precedent  to  the  allowance  of  this  credit 
may  require  the  corporation  to  give  a  bond  with  sureties  satisfactory  to 
and  to  be  approved  by  him  in  such  penal  sum  as  he  may  require,  con- 
ditioned for  the  payment  by  the  taxpayer  of  any  amount  of  taxes  found 
due  upon  any  such  redetermination ;  and  the  bond  herein  prescribed  shall 
contain  such  further  conditions  as  the  Commissioner  may  require. 

(c)  These  credits  shall  be  allowed  only  if  the  taxpayer  furnishes  evi- 
dence satisfactory  to  the  Commissioner  showing  the  amount  of  income 
derived  from  sources  without  the  United  States,  and  all  ofher  information 
necessary  for  the  verification  and  computation  of  such  credit. 

(d)  If  a  domestic  corporation  makes  a  return  for  a  fiscal  year  begin- 
ning in  1920  and  ending  in  1921,  the  credit  for  the  entire  fiscal  year  shall, 
notwithstanding  any  provision  of  this  Act,  be  determined  under  the  pro- 
visions of  this  section ;  and  the  Commissioner  is  authorized  to  disallow, 
in  whole  or  in  part,  any  such  credit  which  he  finds  has  already  been  taken 
by  the  taxpayer. 

(e)  For  the  purposes  of  this  section  a  domestic  corporation  which 
owns  a  majority  of  the  voting  stock  of  a  foreign  corporation  from  which 
it  receives  dividends  (not  deductible  under  section  234)  in  any  taxable 
year  shall  be  deemed  to  have  paid  the  same  proportion  of  any  income, 
war-profits,  or  excess-profits  taxes  paid  by  such  foreign  corporation  to 
any  foreign  country  or  to  any  possession  of  the  United  States,  upon  or 
with  respect  to  the  accumulated  profits  of  such  foreign  corporation  from 
which  such  dividends  were  paid,  which  the  amount  of  such  dividends  bears 
to  the  amount  of  such  accumulated  profits :  Provided,  That  the  credit 
allowed  to  any  domestic  corporation  under  this  subdivision  shall 
in  no  case  exceed  the  same  proportion  of  the  taxes  against  which  it  is 
credited,  which  the  amount  of  such  dividends  bears  to  the  amount  of  the 
entire  net  income  of  the  domestic  corporation  in  which  such  dividends  are 
included.  The  term  "accumulated  profits"  when  used  in  this  subdivision 
in  reference  to  a  foreign  corporation,  means  the  amount  of  its  gains, 
profits,  or  income  in  excess  of  the  income,  war-profits,  and  excess-profit's 
taxes  imposed  upon  or  with  respect  to  such  profits  or  income;  and  the 
Commissioner  with  the  approval  of  the  Secretary  shall  have  full  power 
to  determine    from  the  accumulated   profits  of   what  year  or  years   such 


REVENUE   ACT   OF    1921  1765 

dividends  were  paid;  treating  dividends  paid  in  the  first  sixty  days  of  any 
year  as  having  been  paid  from  the  accumulated  profits  of  the  preceding 
year  or  years  (unless  to  his  satisfaction  shown  otherwise),  and  in  other 
respects  treating  dividends  as  having  been  paid  from  the  most  recently 
accumulated  gains,  profits,  or  earnings.  In  the  acse  of  a  foreign  corpora- 
ation,  the  income,  war-profits,  and  excess-profits  taxes  of  which  are 
determined  on  the  basis  of  an  accounting  period  of  less  than  one  year, 
the  word  "year"  as  used  in  this  subdivision  shall  be  construed  to  mean 
such  accounting  period. 

(f)  For  the  purposes  of  this  section  a  corporation  entitled  to  the 
benefits  of  section  262  shall  be  treated  as  a  foreign  corporation. 

Corporation  Returns 

Sec.  239.  (a)  That  every  corporation  subject  to  taxation  under  this 
title  and  every  personal  service  corporation  shall  make  a  return,  stating 
specifically  the  items  of  its  gross  income  and  the  deductions  and  credits 
allowed  by  this  title.  The  return  shall  be  sworn  to  by  the  president, 
vice  president,  or  other  principal  officer  and  by  the  treasurer  or  assistant 
treasurer.  If  any  foreign  corporation  has  no  office  or  place  of  business 
in  the  United  States  but  has  an  agent  in  the  United  States,  the  return 
shall  be  made  by  the  agent.  In  cases  where  receivers,  trustees  in  bank- 
ruptcy, or  assignees  are  operating  the  property  or  business  of  corporations, 
such  receivers,  trustees  or  assignees  shall  make  returns  for  such  corpora- 
tions in  the  same  manner  and  form  as  corporations  are  required  to  make 
returns.  Any  tax  due  on  the  basis  of  such  returns  made  by  receivers, 
trustees,  or  assignees  shall  be  collected  in  the  same  manner  as  if  collected 
from  the  corporations  of  whose  business  or  property  they  have  custody 
and  control. 

(b)  Returns  made  under  this  section  shall  be  subject  to  the  pro- 
visions of  sections  226  and  228.  When  return  is  made  under  section  226 
the  credit  provided  in  subdivision  (b)  of  section  236  shall  be  reduced  to 
an  amount  which  bears  the  same  ratio  to  the  full  credit  therein  provided 
as  the  number  of  months  in  the  period  for  which  such  return  is  made 
bears  to  twelve  months. 

(c)  There  shall  be  included  in  the  return  or  appended  thereto  a  state- 
ment of  such  facts  as  will  enable  the  Commissioner  to  determine  the 
portion  of  the  earnings  or  profits  of  the  corporation  (including  gains, 
profits  and  income  not  taxed)  accumulated  during  the  taxable  year  for 
which  the  return  is  made,  which  have  been  distributed  or  ordered  to  be 
distributed,  respectively,  to  its  stockholders  or  members  during  such  year. 

Consolidated  Returns  of  Corporations 

Sec.  240.  (a)  That  corporations  which  are  affiliated  within  the  meaning 
of  this  section  may,  for  any  taxable  year  beginning  on  or  after  January 
I,  1922,  make  separate  returns  or,  under  regulations  prescribed  by  the 
Commissioner   with   the   approval   of   the   Secretary,   make   a   consolidated 


1766  REVENUE   ACT    OF    1921 

return  of  net  income  for  the  purpose  of  this  title,  in  which  case  the  taxes 
thereunder  shall  be  computed  and  determined  upon  the  basis  of  such 
return.  If  return  is  made  on  either  of  such  bases,  all  returns  thereafter 
made  shall  be  upon  the  same  basis  unless  permission  to  change  the  basis 
is  granted  by  the  Commissioner. 

(b)  In  any  case  in  which  a  tax  is  assessed  upon  the  basis  of  a  consol- 
idated return,  the  total  tax  shall  be  computed  in  the  first  instance  as 
a  unit  and  shall  then  be  assessed  upon  the  respective  affiliated  corporations 
in  such  proportion  as  may  be  agreed  upon  among  them,  or,  in  the  absence 
of  any  such  agreement,  then  on  the  basis  of  the  net  income  properly  assign- 
able to  each.  There  shall  be  allowed  in  computing  the  income  tax  only 
one  specific  credit  computed  as  provided  in  subdivision  (b)  of  section  236. 

(c)  For  the  purpose  of  this  section  two  or  more  domestic  corporations 
shall  be  deemed  to  be  affiliated  (i)  if  one  corporation  owns  directly  or 
controls  through  closely  affiliated  interests  or  by  a  nominee  or  nominees 
substantially  all  the  stock  of  the  other  or  others,  or  (2)  if  sub- 
stantially all  the  stock  of  two  or  more  corporations  is  owned  or  con- 
trolled by  the  same  interests. 

(d)  For  the  purposes  of  this  section  a  corporation  entitled  to  the 
benefits  of  section  262  shall  be  treated  as  a  foreign  corporation :  Provided, 
That  in  any  case  of  two  or  more  related  trades  or  businesses  (whether  un- 
incorporated or  incorporated  and  whether  organized  in  the  United  States 
or  not)  owned  or  controlled  directly  or  indirectly  by  the  same  interests, 
the  Commissioner  may  consolidate  the  accounts  of  such  related  trades  and 
businesses,  in  any  proper  case,  for  the  purpose  of  making  an  accurate 
distribution  or  apportionment  of  gains,  profits,  income,  deductions,  or 
capital  between  or  among  such  related  trades  or  businesses. 

(e)  Corporations  which  are  affiliated  within  the  meaning  of  this  section 
shall  make  consolidated  returns  for  any  taxable  year  beginning  prior 
to  January  i,  1922,  in  the  same  manner  and  subject  to  the  same  conditions 
as  provided  by  the  Revenue  Act  of  1918. 

Time  and  Place  for  Filing  Corporate  Returns 

Sec.  241.  (a)  That  returns  of  corporations  shall  be  made  at  the 
same  time  as  is  provided  in  subdivision  (a)  of  section  227,  except  that 
in  the  case  of  foreign  corporations  not  having  any  office  or  place  of 
business  in  the  United  States  returns  shall  be  made  at  the  same  time  as 
provided  in  section  227  in  the  case  of  a  nonresident  alien  individual. 

(b)  Returns  shall  be  made  to  the  collector  of  the  district  in  which  is 
located  the  principal  place  of  business  or  principal  office  or  agency  of  the 
corporation,  or,  if  it  has  110  principal  place  of  business  or  principal  office 
or  agency  in  the  United  States,  then  to  the  collector  at  Baltimore, 
Maryland. 

Taxes  on  Insurance  Companies 

Sec.  242.     That  when  used  in  this  title  the  term  "life  insurance  com- 


REVENUE   ACT   OF   1921  1767 

pany"  means  an  insurance  company  engaged  in  the  business  of  issuing  life 
insurance  and  annuity  contracts  (including  contracts  of  combined  life, 
health,  and  accident  insurance),  the  reserve  funds  of  which  held  for  the 
fulfillment  of  such  contracts  comprise  more  than  50  per  centum  of  its 
total  reserve  funds. 

Sec.  243.  That  in  lieu  of  the  taxes  imposed  by  sections  230  and  1000 
and  by  Title  III,  there  shall  be  levied,  collected,  and  paid  for  the  calendar 
year  1921  and  for  each  taxable  year  thereafter  upon  the  net  income  of 
every  life  insurance  company  a  tax  as  follows : 

(i)  In  the  case  of  a  domestic  life  insurance  company,  the  same  per- 
centage of  its  net  income  as  is  imposed  upon  other  corporations  by 
section  230 ; 

(2)  In  the  case  of  a  foreign  life  insurance  company,  the  same  per- 
centage of  its  net  income  from  sources  within  the  United  States  as  is 
imposed  upon  the  net  income  of  other  corporations  by  section  230. 

Sec.  244.  (a)  That  in  the  case  of  a  life  insurance  company,  the  term 
"gross  income"  means  the  gross  amount  of  income  received  during  the 
taxable  year  from  interest,  dividends,  and  rents. 

(b)  The  term  "reserve  funds  required  by  law"  includes,  in  the  case 
of  assessment  insurance  sums  actually  deposited  by  any  company  or  associ- 
ation with  State  or  Territorial  officers  pursuant  to  law  as  guaranty  or 
reserve  funds,  and  any  funds  maintained  under  the  charter  or  articles 
of  incorporation  of  the  company  or  association  exclusively  for  the  payment 
of  claims  arising  under  certificates  of  membership  or  policies  issued  upon 
the  assessment  plan  and  not  subject  to  any  other  use. 

Sec.  245.  (a)  That  in  the  case  of  a  life  insurance  company  the  term 
"net  income"  means  the  gross  income  less — 

(1)  The  amount  of  interest  received  during  the  taxable  year  which 
under  paragraph  (4)  of  subdivision  (b)  of  section  213  is  exempt  from 
taxation  under  this  title  ; 

(2)  An  amount  equal  to  the  excess,  if  any,  over  the  deduction  specified 
in  paragraph  (i)  of  this  subdivision,  of  4  per  centum  of  the  mean  of 
the  reserve  funds  required  by  law  and  held  at  the  beginning  and  end 
of  the  taxable  year,  plus  (in  case  of  life  insurance  companies  issuing 
policies  covering  life,  health,  and  accident  insurance  combined  in  one 
policy  issued  on  the  weekly  premium  payment  plan,  continuing  for  life 
and  not  subject  to  cancellation)  4  per  centum  of  the  mean  of  such 
reserve  funds  (not  required  by  law)  held  at  the  beginning  and  end  of  the 
taxable  year,  as  the  Commissioner  finds  to  be  necessary  for  the  protection 
of  the  holders  of  such  policies  only; 

(3)  The  amount  received  as  dividends  (A)  from  a  domestic  corpora- 
tion other  than  a  corporation  entitled  to  the  benefits  of  section  262,  or  (B) 
from  any  foreign  corporation  when  it  is  shown  to  the  satisfaction  of  the 
Commissioner  that  more  than  50  per  centum  of  the  gross  income  of  such 
foreign  corporation  for  the  three-year  period  ending  with  the  close  of 
its  taxable  year  preceding  the  declaration  of  such  dividends   (or  for  such 


1768  REVENUE   ACT    OF    1921 

part  of  such  period  as  the  foreign  corporation  has  been  in  existence) 
was  derived  from  sources  within  the  United  States  as  determined  under 
section  217 ; 

(4)  An  amount  equal  to  2  per  centum  of  any  sums  held  at  the  end 
of  the  taxable  year  as  a  reserve  for  dividends  (other  than  dividends 
payable  during  the  year  following  the  taxable  year)  the  payment  of 
which  is  deferred  for  a  period  of  not  less  than  five  years  from  the  date 
of  the  policy  contract ; 

(5)  Investment  expenses  paid  during  the  taxable  year:  Provided, 
That  if  any  general  expenses  are  in  part  assigned  to  or  included  in  the 
investment  expenses,  the  total  deduction  under  this  paragraph  shall  not 
exceed  one-fourth  of  i  per  centum  of  the  book  value  of  the  mean  of  the 
invested  assets  held  at  the  beginning  and  end  of  the  taxable  year; 

(6)  Taxes  and  other  expenses  paid  during  the  taxable  year  exclusively 
upon  or  with  respect  to  the  real  estate  owned  by  the  company,  not  in- 
cluding taxes  assessed  against  local  benefits  of  a  kind  tending  to  increase 
the  value  of  the  property  assessed,  and  not  including  any  amount  paid 
out  for  new  buildings,  or  for  permanent  improvements  or  betterments 
made  to  increase  the  value  of  any  property.  The  deduction  alowed  by  this 
paragraph  shall  be  allowed  in  the  cases  of  taxes  imposed  upon  a  share- 
holder or  member  of  a  company  upon  his  interest  as  shareholder  or 
member,  which  are  paid  by  the  company  without  reimbursement  from  the 
shareholder  or  member,  but  in  such  case  no  deduction  shall  be  allowed  the 
shareholder  or  member  for  the  amount  of  such  taxes ; 

(7)  A  reasonable  allowance  for  the  exhaustion,  wear  and  tear  of 
property,  including  a  reasonable  allowance  for  obsolescence.  In  the  case 
of  property  acquired  before  March  i,  1913,  this  deduction  shall  be  com- 
puted upon  the  basis  of  its  fair  market  price  or  value  as  of  March  i,  1913; 

(8)  All  interest  paid  or  accrued  within  the  taxable  year  on  its  indebted- 
ness, except  on  indebtedness  incurred  or  continued  to  purchase  or  carry 
obligations  or  securities  (other  than  obligations  of  the  United  States 
issued  after  September  24,  1917,  and  originally  subscribed  for  by  the 
taxpayer)  the  interest  upon  which  is  wholly  exempt  from  taxation  under 
this  title ; 

(9)  In  the  case  of  a  domestic  life  insurance  company,  the  net  income 
of  which  (computed  without  the  benefit  of  this  paragraph)  is  $25,000 
or  less,  the  sum  of  $2,000;  but  if  the  net  income  is  more  than  $25,000  the 
tax  imposed .  by  section  243  shall  not  exceed  the  tax  which  would  be 
payable  if  the  $2,000  credit  were  allowed,  plus  the  amount  of  the  net 
income  in  excess  of  $25,000. 

(b)  No  deduction  shall  be  made  under  paragraphs  (6)  and  (7)  of 
subdivision  (a)  on  account  of  any  real  estate  owned  and  occupied  in 
whole  or  in  part  by  a  life  insurance  company  unless  there  is  included 
in  the  return  of  gross  income  the  rental  value  of  the  space  so  occupied. 
Such  rental  value  shall  be  not  less  than  a  sum  which  in  addition  to  any 
rents  received  from  other  tenants  shall  provide  a  net  income    (after  de- 


REVENUE   ACT   OF   1921  1 769 

ducting  taxes,  depreciation,  and  all  other  expenses)  at  the  rate  of  4  per 
centum  per  annum  of  the  book  value  at  the  end  of  the  taxable  year  of  the 
real  estate  so  owned  or  occupied. 

(c)  In  the  case  of  a  foreign  life  insurance  company  the  amount  of  its 
net  income  for  any  taxable  year  from  sources  within  the  United  States 
shall  be  the  same  proportion  of  its  net  income  for  the  taxable  year  from 
sources  within  and  without  the  United  States,  which  the  reserve  funds  re- 
quired by  law  and  held  by  it  at  the  end  of  the  taxable  year  upon  business 
transacted  within  the  United  States  is  of  the  reserve  funds  held  by  it  at 
the  end  of  the  taxable  year  upon  all  business  transacted. 

Sec.  246.  (a)  That,  in  lieu  of  the  taxes  imposed  by  sections  230  and 
1000,  there  shall  be  levied,  collected  and  paid  for  the  calendar  year  1922, 
and  for  each  taxable  year  thereafter,  upon  the  net  income  of  every  in- 
surance company  (other  than  a  life  or  mutual  insurance  company)  a  tax 
as  follows : 

(i)  In  the  case  of  such  a  domestic  insurance  company  the  same  per- 
centage of  its  net  income  as  is  imposed  upon  other  corporations  by 
section  230; 

(2)  In  the  case  of  such  a  foreign  insurance  company  the  same  per- 
centage of  its  net  income  from  sources  within  the  United  States  as  is 
imposed  upon  the  net  income  of  other  corporations  by  section  230. 

(b)  In  the  case  of  an  insurance  company  subject  to  the  tax  imposed 
by  this  section — 

(i)  The  term  "gross  income"  means  the  combined  gross  amount,  earned 
during  the  taxable  year,  from  investment  income  and  from  underwriting 
income  as  provided  in  this  subdivision,  computed  on  the  basis  of  under- 
writing and  investment  exhibit  of  the  annual  statement  approved  by  the 
National   Convention  of   Insurance   Commissioners ; 

(2)  The  term  "net  iricome"  means  the  gross  income  as  defined  in 
paragraph  (i)  of  this  subdivision  less  the  deductions  allowed  by  section  247; 

(3)  The  term  "investment  income"  means  the  gross  amount  of  income 
earned  during  the  taxable  year  from  interest,  dividends  and  rents,  com- 
puted as  follows : 

To  all  interest,  dividends  and  rents  received  during  the  taxable  year, 
add  interest,  dividends  and  rents  due  and  accrued  at  the  end  of  the  taxable 
year,  and  deduct  all  interest,  dividends  and  rents  due  and  accrued  at  the 
end  of  the  preceding  taxable  year ; 

(4)  The  term  "underwriting  income"  means  the  premiums  earned  on 
insurance  contracts  during  the  taxable  year  less  losses  incurred  and  ex- 
penses incurred; 

(5)  The  term  "premiums  earned  on  insurance  contracts  during  the 
taxable  year"  means  an  amount  computed  as  follows : 

From  the  amount  of  gross  premiums  written  on  insurance  contracts 
during  the  taxable  year,  deduct  return  premiums  and  premiums  paid  for 
reinsurance.  To  the  result  so  obtained  add  unearned  premiums  on  out- 
standing business  at  the  end   of   the  preceding  taxable  year  and   deduct 


I770  REVENUE   ACT.  OF    1921 

unearned   premiums    on   outstanding  business   at   the   end   of   the  taxable 
year; 

(6)  The  term  "losses  incurred"  means  losses  incurred  during  the  tax- 
able year  on  insurance  contracts,  computed  as  follows  : 

To  losses  paid  during  the  taxable  year,  add  salvage  and  reinsurance 
recoverable  outstanding  at  the  end  of  the  preceding  taxable  year,  and  de- 
duct salvage  and  reinsurance  recoverable  outstanding  at  the  end  of  the 
taxable  year.  To  the  result  so  obtained  add  all  unpaid  losses  outstanding 
at  the  end  of  the  taxable  year  and  deduct  unpaid  losses  outstanding  at  the 
end  of  the  preceding  taxable  year; 

(7)  The  term  "expenses  incurred"  means  all  expenses  shown  on  the 
annual  statement  approved  by  the  National  Convention  of  Insurance  Com- 
missioners, and  shall  be  computed  as  follows : 

To  all  expenses  paid  during  the  taxable  year  add  expenses  unpaid  at 
the  end  of  the  taxable  j'ear  and  deduct  expenses  unpaid  at  the  end  of  the 
preceding  taxable  year.  For  the  purpose  of  computing  the  net  income  sub- 
ject to  the  tax  imposed  by  this  section  there  shall  be  deducted  from  expenses 
incurred  as  defined  in  this  paragraph  all  expenses  incurred  which  are  not 
allowed  as  deductions  by  section  247. 

Sec.  247.  (a)  That  in  computing  the  net  income  of  an  insurance  com- 
pany subject  to  the  tax  imposed  by  section  246  there  shall  be  allowed  as 
deductions : 

(i)  All  ordinary  and  necessary  expenses  incurred,  as  provided  in  para- 
graph  (i)  of  subdivision   (a)   of  section  234; 

(2)  All  interest  as  provided  in  paragraph  (2)  of  subdivision  (a)  of 
section  234; 

(3)  Taxes  as  provided  in  paragraph   (3)   of  subdivision  (a)  of  section 

234; 

(4)  Losses  incurred  ;  , 

(5)  Bad  debts  in  the  nature  of  agency  balances  and  bills  receivable 
ascertained  to  be  worthless  and  charged  off  within  the  taxable  year; 

(6)  The  amount  received  as  dividends  from  corporations  as  provided  in 
paragraph  (6)  of  subdivision  (a)  of  section  234; 

(7)  The  amount  of  interest  earned  during  the  taxable  year  which  under 
paragraph  (4)  of  subdivision  (b)  of  section  213  is  exempt  from  taxation 
under  this  title,  and  the  amount  of  interest  allowed  as  a  credit  under  sub- 
division  (a)  of  section  236 ; 

(8)  A  reasonable  allowance,  for  the  exhaustion,  wear  and  tear  of 
property,  as  provided  in  paragraph  (7)  of  subdivision  (a)  of  section  234; 

(9)  In  the  case  of  such  a  domestic  insurance  company,  the  net  income 
of  which  (computed  without  the  benefit  of  this  paragraph)  is  $25,000  or 
less,  the  sum  of  $2,000;  but  if  the  net  income  is  more  than  $25,000  the  tax 
imposed  by  section  246  shall  not  exceed  the  tax  which  would  be  payable 
if  the  $2,000  credit  were  allowed,  plus  the  amount  of  the  net  income  in 
excess  of  $25,000. 

(b)   In   the    case   of   a    foreign   corporation   the   deductions   allowed    in 


I 


REVENUE   ACT    OF    1921  1 771 

this  section  shall  be  allowed  to  the  extent  provided  in  subidvision   (b)   of 
section  234. 

(c)  Nothing  in  this  section  or  in  section  246  shall  be  construed  to 
permit  the  same  item  to  be  twice  deducted. 

Part  IV. — Administrative  Provisions. 

Payment  of  Taxes 

Sec.  250.  (a)  That  except  as  otherwise  provided  in  this  section  and 
sections  221  and  237  the  tax  shall  be  paid  in  four  installments,  each  con- 
sisting of  one-fourth  of  the  total  amount  of  the  tax.  The  first  installment 
shall  be  paid  at  the  time  fixed  by  law  for  filing  the  return,  and  the  second 
installment  shall  be  paid  on  the  fifteenth  day  of  the  third  month,  the  third 
installment  on  the  fifteenth  day  of  the  sixth  month,  and  the  fourth  install- 
ment on  the  fifteenth  day  of  the  ninth  month,  after  the  time  fixed  by  law 
for  filing  the  return.  Where  an  extension  of  time  for  filing  a  return  is 
granted  the  time  for  payment  of  the  first  installment  shall  be  postponed 
until  the  date  of  the  expiration  of  the  period  of  the  extension,  but  the  time 
for  payment  of  the  other  installments  shall  not  be  postponed  unless  the 
Commissioner  so  provides  in  granting  the  extension.  In  any  case  in  which 
the  time  for  the  payment  of  any  installment  is  at  the  request  of  the  tax- 
payer thus  postponed,  there  shall  be  added  as  a  part  of  such  installment  in- 
terest thereon  at  the  rate  of  one-half  of  i  per  centum  per  month  from  the 
time  it  would  have  been  due  if  no  extension  had  been  granted,  until  paid. 
If  any  installment  is  not  paid  when  due,  the  whole  amount  of  the  tax  unpaid 
shall  become  due  and  payable  upon  notice  and  demand  by  the  collector. 

The  tax  may  at  the  option  of  the  taxpayer  be  paid  in  a  single  payment 
instead  of  installments,  in  which  case  the  total  amount  shall  be  paid  on 
or  before  the  time  fixed  by  law  for  filing  the  return,  or,  where  an  extension 
of  time  for  filing  the  return  has  been  granted,  on  or  before  the  expiration 
of  the  period  of  such  extension. 

(b)  As  soon  as  practicable  after  the  return  is  filed,  the  Commissioner 
shall  examine  it.  If  it  then  appears  that  the  correct  amount  of  the  tax  is 
greater  or  less  than  that  shown  in  the  return,  the  installments  shall  be 
recomputed.  If  the  amount  already  paid  exceeds  that  which  should  have 
been  paid  on  the  basis  of  the  installments  as  recomputed,  the  excess  so  paid 
shall  be  credited  against  the  subsequent  installments;  and  if  the  amount 
already  paid  exceeds  the  correct  amount  of  the  tax,  the  excess  shall  be 
credited  or  refunded  to  the  taxpayer  in  accordance  with  the  provisions  of 
section  252. 

If  the  amount  already  paid  is  less  than  that  which  should  have  been  paid, 
the  difference,  to  the  extent  not  covered  by  any  credits  due  to  the  tax- 
payer under  section  252  (hereinafter  called  "deficiency"),  together  with 
interest  thereon  at  the  rate  of  one-half  of  i  per  centum  per  month  from  the 
time  the  tax  was  due  (or,  if  paid  on  the  installment  basis,  on  the  deficiency 
of  each  installment  from  the  time  the  installment'  was  due),  shall  be  paid 


1772  REVENUE   ACT    OF    1921 

upon  notice  and  demand  by  the  collector.  If  any  part  of  the  deficiency  is  due 
to  negligence  or  intentional  disregard  of  authorized  rules  and  regulations 
with  knowledge  thereof,  but  without  intent  to  defraud,  there  shall  be  added 
as  part  of  the  tax  5  per  centum  of  the  total  amount  of  the  deficiency  in 
the  tax,  and  interest  in  such  a  case  shall  be  collected  at  the  rate  of  i  per 
centum  per  month  on  the  amount  of  such  deficiency  in  the  tax  from  the 
time  it  was  due  (or,  if  paid  on  the  installment  basis,  on  the  amount  of  the 
deficiency  in  each  installment  from  the  time  the  installment  was  due), 
which  penalty  and  interest  shall  become  due  and  payable  upon  notice  and 
demand  by  the  collector.  If  any  part  of  the  deficiency  is  due  to  fraud  with 
intent  to  evade  tax,  then,  in  lieu  of  the  penalty  provided  by  section  3176  of  the 
Revised  Statutes,  as  amended,  for  false  or  fraudulent  returns  willfully  made, 
but  in  addition  to  other  penalties  provided  by  law  for  false  or  fraudulent 
returns,  there  shall  be  added  as  part  of  the  tax  50  per  centum  of  the  total 
amount  of  the  deficiency  in  the  tax.  In  such  case  the  whole  amount  of 
the  fax  unpaid,  including  the  penalty  so  added,  shall  become  due  and  pay- 
able upon  notice  and  demand  by  the  collector. 

(c)  If  the  return  is  made  pursuant  to  section  3176  of  the  Revised 
Statutes  as  amended,  the  amount  of  tax  determined  to  be  due  under  such 
return  shall  be  paid  upon  notice  and  demand  by  the  collector. 

(d)  The  amount  of  income,  excess-profits,  or  war-profits  taxes  due 
under  any  return  made  under  this  Act  for  the  taxable  year  1921  or  suc- 
ceeding taxable  years  shall  be  determined  and  assessed  by  the  Commissioner 
within  four  years  after  the  return  was  filed,  and  the  amount  of  any  such 
faxes  due  under  any  return  made  under  this  Act  for  prior  taxable  years 
or  under  prior  income,  excess-profits,  or  war-profits  tax  Acts,  or  under 
section  38  of  the  Act  entitled  "An  Act  to  provide  revenue,  equalize  duties, 
and  encourage  the  industries  of  the  United  States,  and  for  other  purposes," 
approved  August  5,  1909,  shall  be  determined  and  assessed  within  five  years 
after  the  return  was  filed,  unless  both  the  Commissioner  and  the  taxpaj-er 
consent  in  writing  to  a  later  determination,  assessment,  and  collection  of 
the  tax;  and  no  suit  or  proceeding  for  the  collection  of  any  such  taxes  due 
under  this  Act  or  under  prior  income,  excess-profits,  or  war-profits  tax 
Acts,  or  of  any  taxes  due  under  section  38  of  such  Act  of  August  5,  1909, 
shall  be  begun,  after  the  expiration  of  five  years  after  the  date  when  such 
return  was  filed,  but  this  shall  not  affect  suits  or  proceedings  begun  at  the 
time  of  the  passage  of  this  Act :  Provided,  That  in  the  case  of  income  re- 
ceived during  the  lifetime  of  a  decedent,  all  taxes  due  thereon  shall  be  de- 
termined and  assessed  by  the  Commissioner  within  one  year  after  written 
request  therefor  by  the  executor,  administrator,  or  other  fiduciary  represent- 
ing the  estate  of  such  decedent :  Proz'ided  further,  That  in  the  case  of  a 
false  or  fraudulent  return  with  intent  to  evade  tax,  or  of  a  failure  to  file  a 
required  return,  the  amount  of  tax  due  may  be  determined,  assessed,  and 
collected,  and  a  suit  or  proceeding  for  the  coQection  of  such  amount  may 
be  begtui,  at  any  time  after  it  becomes  due :  Provided  further,  That  in 
cases  coming  within  the  scope  of  paragraph,    ig)   gf  subdivision    (a)   of 


REVENUE   ACT   OF   1921  1773 

section  214,  or  of  paragraph  (8)  of  subdivision  (a)  of  section  234,  or  in 
cases  of  final  settlement  of  losses  and  other  deductions  tentatively  allowed 
by  the  Commissioner  pending  a  determination  of  the  exact  amount  de- 
ductible, the  amount  of  tax  or  deficiency  in  tax  due  may  be  determined, 
assessed,  and  collected  at  any  time ;  but  prior  to  the  assessment  thereof  the 
taxpayer  shall  be  notified  and  given  a  period  of  not  less  than  thirty  days  in 
which  to  file  an  appeal  and  be  heard  as  hereinafter  provided  in  this  sub- 
division. 

If  upon  examination  of  a  return  made  under  the  Revenue  Act  of  1916, 
the  Revenue  Act  of  191 7,  the  Revenue  Act  of  1918,  or  this  Act,  a  tax  or 
a  deficiency  in  tax  is  discovered,  the  taxpayer  shall  be  notified  thereof 
and  given  a  period  of  not  less  than  thirty  days  after  such  notice  is  sent 
by  registered  mail  in  which  to  file  an  appeal  and  show  cause  or  reason 
why  the  tax  or  deficiency  should  not  be  paid.  Opportunity  for  hearing 
shall  be  granted  and  a  final  decision  thereon  shall  be  made  as  quickly  as 
practicable.  Any  tax  or  deficiency  in  tax  then  determined  to  be  due  shall 
be  assessed  and  paid,  together  with  the  penalty  and  interest,  if  any,  ap- 
plicable thereto,  within  ten  days  after  notice  and  demand  by  the  collector 
as  hereinafter  provided,  and  in  such  cases  no  claim  in  abatement  of  the 
amount  so  assessed  shall  be  entertained :  Provided,  That  in  cases  where 
the  Commissioner  believes  that  the  collection  of  the  amount  due  will  be 
jeopardized  by  such  delay  he  may  make  the  assessment  without  giving 
such  notice  or  awaiting  the  conclusion  of  such  hearing. 

(e)  If  any  tax  remains  unpaid  after  the  date  when  it  is  due,  and  for 
ten  days  after  notice  and  demand  by  the  collector,  then,  except  in  the  case 
of  estates  of  insane,  deceased,  or  insolvent  persons,  there  shall  be  added  as 
part  of  the  tax  the  sum  of  5  per  centum  on  the  amount  due  but  unpaid, 
plus  interest  at  the  rate  of  i  per  centum  per  month  upon  such  amount 
from  the  time  it  became  due :  Provided,  That  as  t'o  any  such  amount  which 
is  the  subject  of  a  bona  fide  claim  for  abatement  filed  within  ten  days  after 
notice  and  demand  by  the  collector,  where  the  taxpayer  has  not  had  the 
benefit  of  the  provisions  of  subdivision  (d),  such  sum  of  5  per  centum 
shall  not  be  added  and  the  interest  from  the  time  the  amount  was  due  until 
the  claim  is  decided  shall  be  at  the  rate  of  one-half  of  i  per  centum  per 
month  on  that  part  of  the  claim  rejected. 

In  the  case  of  the  first  installment  provided  for  in  subdivision  (a) 
the  instructions  printed  on  the  return  shall  be  sufficient  notice  of  the 
date  when  the  tax  is  due  and  sufficient  demand,  and  the  taxpayer's  compu- 
tation of  the  tax  on  the  return  shall  be  sufficient  notice  of  the  amount  due. 
In  the  case  of  each  subsequent  installment  the  collector  may,  within  thirty 
days  and  not  later  than  ten  days  before  the  installment  becomes  due, 
mail  to  the  taxpayer  notice  of  the  amount  of  the  installment  and  the  date 
on  which  it  is  due  for  payment.  Such  notice  of  the  collector  shall  be 
sufficient  notice  and  sufficient  demand  under  this  section. 

(f)  In  the  case  of  any  deficiency  (except  where  the  deficiency  is  due 
to  negligence  or  to  fraud  with  intent  to  evade  tax)   where  it  is  shown  to 


t774  REVENUE   ACT    OF    1921 

the  satisfaction  of  the  Commissioner  that  the  payment  of  such  deficiency 
would  result  in  undue  hardship  to  the  taxpayer,  the  Commissioner  may, 
with  the  approval  of  the  Secretary,  extend  the  time  for  the  payment  of 
such  deficiency  or  any  part  thereof  for  such  period  not  in  excess  of  eighteen 
months  from  the  passage  of  this  Act  as  the  Commissioner  may  determine. 
In  such  case  the  Commissioner  may  require  the  taxpayer  to  furnish  a  bond 
with  sufficient  sureties  conditioned  upon  the  payment  of  the  deficiency  in 
accordance  with  the  terms  of  the  extension  granted,  there  shall  be  added 
in  lieu  of  other  interest  provided  by  law,  as  a  part  of  such  deficiency,  in- 
terest thereon  at  the  rate  of  two-thirds  of  i  per  centum  per  month  from 
the  time  such  extension  is  granted;  except  where  such  other  interest  pro- 
vided by  law  is  in  excess  of  interest  at  the  rate  of  two-thirds  of  i  per 
centum  per  month.  If  the  deficiency  or  any  part  thereof  is  not  paid  in 
accordance  with  the  terms  of  the  extension  granted,  there  shall  be  added 
as  part  of  the  deficiency,  in  lieu  of  other  interest  and  penalties  provided 
by  law,  the  sum  of  5  per  centum  of  the  deficiency  and  interest  on  the 
deficiency  at  the  rate  of  i  per  centum  per  month  from  the  time  it  becomes 
payable  in  accordance  with  the  terms  of  such  extension. 

(g)  If  the  Commissioner  finds  that  a  taxpayer  designs  quickly  to  de- 
part from  the  United  States  or  to  remove  his  property  therefrom,  or  to 
conceal  himself  or  his  property  therein,  or  to  do  any  other  act  tending  to 
prejudice  or  to  render  wholly  or  partly  ineffectual  proceedings  to  collect 
the  tax  for  the  taxable  year  then  last  past  or  the  taxable  year  then  cur- 
rent unless  such  proceedings  be  brought  without  delay,  the  Commissioner 
shall  declare  the  taxable  period  for  such  taxpayer  immediately  terminated 
and  shall  cause  notice  of  such  finding  and  declaration  to  be  given  the  tax- 
payer, together  with  a  demand  for  immediate  payment  of  the  tax  for  the 
taxable  period  so  declared  terminated  and  of  the  tax  for  the  preceding 
taxable  year  or  so  much  of  said  tax  as  is  unpaid,  whether  or  not  the  time 
otherwise  allowed  by  law  for  filing  return  and  paying  the  tax  has  ex- 
pired ;  and  such  taxes  shall  thereupon  become  immediately  due  and  pay- 
able. In  any  action  or  suit  brought  to  enforce  payment  of  taxes  made  due 
and  payable  by  virtue  of  the  provisions  of  this  subdivision  the  finding  of 
the  Commissioner,  made  as  herein  provided,  whether  made  after  notice  to 
the  taxpayer  or  not,  shall  be  for  all  purposes  presumptive  evidence  of  the 
taxpayer's  design.  A  taxpayer  who  is  not  in  default  in  making  any  return 
or  paying  income,  war-profits,  or  excess-profits  tax  under  any  Act  of  Con- 
gress may  furnish  to  the  United  States,  under  regulations  to  be  prescribed 
by  the  Commissioner  with  the  approval  of  the  Secretary,  security  approved 
by  the  Commissioner  that  he  will  duly  make  the  return  next  thereafter  re- 
quired to  be  filed  and  pay  the  tax  next  thereafter  required  to  be  paid.  The 
Commissioner  may  approve  and  accept  in  like  manner  security  for  return 
and  payment  of  taxes  made  due  and  payable  by  virtue  of  the  provisions  of 
this  subdivision,  provided  the  taxpayer  has  paid  in  full  all  other  income, 
war-profits,  or  excess-profits  taxes  due  from  him  under  any  Act  of  Con- 
gress.    If  security  is  approved  and  accepted  pursuant  to  the  provisions  of 


REVENUE   ACT    OF    1921  1 775 

this  subdivision  and  such  further  or  other  security  with  respect  to  the  tax 
or  taxes  covered  thereby  is  given  as  the  Commissioner  shall  from  time  to 
time  find  necessary  and  require,  payment  of  such  taxes  shall  not  be  en- 
forced by  any  proceedings  under  the  provisions  of  this  subdivision  prior 
to  the  expiration  of  the  time  otherwise  allowed  for  paying  such  respective 
taxes.  In  the  case,  of  a  citizen  of  the  United  States  about  to  depart  from 
the  United  States  the  Commissioner  may,  at  his  discretion,  waive  any  or 
all  of  the  requirements  placed  on  the  taxpayer  by  this  subdivision.  No 
alien  shall  depart  from  the  United  States  unless  he  first  secures  from  the 
collector  or  agent  in  charge  a  certificate  that  he  has  complied  with  all  the 
obligations  imposed  upon  him  by  the  income,  war-profits,  and  excess- 
profits  tax  laws.  If  a  taxpayer  violates  or  attempts  to  violate  this  sub- 
division there  shall,  in  addition  to  all  other  penalties,  be  added  as  part  of 
the  tax  25  per  centum  of  the  total  amount  of  the  tax  or  deficiency  in  the 
tax,  together  with  interest  at  the  rate  of  i  per  centum  per  month  from 
the  time  and  fax  became  due. 

(h)  The  provisions  of  subdivisions  (e),  (f)  and  (g)  of  this  section 
shall  apply  to  the  assessment  and  collection  of  taxes  which  have  accrued 
or  may  accrue  under  the  Revenue  Act  of  1917,  the  Revenue  Act  of  1918 
or  this  Act. 

Receipts  for  Taxes 

Sec.  251.  That  every  collector  to  whom  any  payment  of  any  tax  is 
made  under  the  provisions  of  this  title  shall  upon  request  give  to  the 
person  making  such  payment  a  full  written  or  printed  receipt,  stating  the 
amount  paid  and  the  particular  account  for  which  such  payment  was 
made;  and  whenever  any  debtor  pays  taxes  on  account  of  payments  made 
or  to  be  made  by  him  to  separate  creditors  the  collector  shall,  if  requested 
by  such  debtor,  give  a  separate  receipt  for  the  tax  paid  on  account  of  each 
creditor  in  such  form  that  the  debtor  can  conveniently  produce  such  receipts 
separately  to  his  several  creditors  in  satisfaction  of  their  respective  de- 
mands up  to  the  amounts  stated  in  the  receipts ;  and  such  receipts  shall  be 
sufficient  evidence  in  favor  of  such  debtor  to  justify  him  in  withholding 
from  his  next  payment  to  his  creditor  the  amount  therein  stated ;  but  the 
creditor  may,  upon  giving  to  his  debtor  a  full  written  receipt  acknowledging 
the  payment  to  him  of  any  sum  actually  paid  and  accepting  the  amount 
of  tax  paid  as  aforesaid  (specifying  the  same)  as  a  further  satisfaction 
of  the  debt  to  that  amount,  require  the  surrender  to  him  of  such  col- 
lector's  receipt. 

Refunds 

Sec.  252.  That  if,  upon  examination  of  any  return  of  income  made 
pursuant  to  this  Act,  the  Act  of  August  5,  1909,  entitled  "An  Act  to  pro- 
vide revenue,  equalize  duties,  and  encourage  the  industries  of  the  United 
States,  and  for  other  jjurposes,"  the  Act  of  October  3,  1913,  entitled  "An 
Act  to   reduce  tariff  duties  and  to  provide  revenue  for  the  Government, 


1776  REVENUE   ACT    OF    1921 

and  for  other  purposes,"  the  Revenue  Act  of  1916,  as  amended,  the 
Revenue  Act  of  1917,  or  the  Revenue  Act  of  1918,  it  appears  that  an 
amount  of  income,  war-profits  or  excess-profits  tax  has  been  paid  in  ex- 
cess of  that  properly  due,  then,  notwithstanding  the  provisions  of  section 
3228  of  the  Revised  Statutes,  the  amount  of  the  excess  shall  be  credited 
against  any  income,  war-profits  or  excess-profits  taxes,  or  installment 
thereof,  then  due  from  the  taxpayer  under  any  other  return,  and  any 
balance  of  such  excess  shall  be  immediately  refunded  to  the  taxpayer : 
Provided,  That  no  such  credit  or  refund  shall  be  allowed  or  made  after 
five  years  from  the  date  when  the  return  was  due,  unless  before  the  ex- 
piration of  such  five  years  a  claim  therefor  is  filed  by  the  taxpayer: 
Provided  further,  That  if  upon  examination  of  any  return  of  income  made 
pursuant  to  the  Revenue  Act  of  1917,  the  Revenue  Act  of  1918,  or  this  Act, 
the  invested  capital  of  a  taxpayer  is  decreased  by  the  Commissioner,  and 
such  decrease  is  due  to  the  fact  that  the  taxpayer  failed  to  take  adequate 
deductions  in  previous  years,  with  the  result  that  an  amount  of  income 
tax  in  excess  of  that  properly  due  was  paid  in  any  previous  year  or  years, 
then,  notwithstanding  any  other  provision  of  law  and  regardless  of  the 
expiration  of  such  five-year  period,  the  amount  of  such  excess  shall, 
without  the  filing  of  any  claim  therefor,  be  credited  or  refunded  as  pro- 
vided in  this  section:  A7id  provided  further.  That  nothing  in  this  section 
shall  be  construed  to  bar  from  allowance  claims  for  refund  filed  prior  to 
the  passage  of  the  Revenue  Act  of  1918  under  subdivision  (a)  of  section 
14  of  the  Revenue  Act  of  1916,  or  filed  prior  to  the  passage  of  this  Act 
under  section  252  of  the  Revenue  Act  of  1918. 

Penalties 

Sec.  253.  That  any  individual,  corporation,  or  partnership  required 
under  this  title  to  pay  or  collect  any  tax,  to  make  a  return  or  to  supply  in- 
formation, who  fails  to  pay  or  collect  such  tax,  to  make  such  return,  or 
to  supply  such  information  at  the  time  or  times  required  under  this  title, 
shall  be  liable  to  a  penalty  of  not  more  than  $1,000.  Any  individual,  cor- 
poration, or  partnership,  or  any  officer  or  employee  of  any  corporation  or 
member  or  employee  of  a  partnership,  who  willfully  refuses  to  pay 
or  collect  such  tax,  to  make  such  return,  or  to  supply  such  in- 
formation at  the  time  or  times  required  under  this  title,  or  who  willfully 
attempts  in  any  manner  to  defeat  or  evade  the  tax  imposed  by  this  title, 
shall  be  guilty  of  a  misdemeanor  and  shall  be  fined  not  more  than  $10,000 
or  imprisoned  for  not  more  than  one  year,  or  both,  together  with  the  costs 
of   prosecution. 

Returns  of  Payments  of  Dividends 

Sec.  254.  That  every  corporation  subject  to  the  tax  imposed  by  this 
title  and  every  personal  service  corporation  shall,  when  required  by  the 
Commissioner,  render  a  correct  return,  duly  verified  under  oath,  of  its 
payments  of  dividends,  stating  the  name  and  address  of  each  stockholder. 


REVENUE   ACT    OF    1921  1 777 

the  number  of  shares  owned  by  him,  and  the  amount  of  dividends  paid  to 
him. 

Returns  of  Brokers 

Sec.  255.  That  every  individual,  corporation,  or  partnership  doing 
business  as  a  broker  shall,  when  required  by  the  Commissioner,  render  a 
correct  return  duly  verified  under  oath,  under  such  rules  and  regulations 
as^the  Commissioner,  with  the  approval  of  the  Secretary,  may  prescribe, 
showing  the  names  of  customers  for  whom  such  individual,  corporation, 
or  partnership  has  transacted  any  business,  for  such  details  as  to  the 
profits,  losses,  or  other  information  which  the  Commissioner  may  require, 
as  to  each  of  such  customers,  as  will  enable  the  Commissioner  to  determine 
whether  all  income  tax  due  on  profit's  or  gains  of  such  customers  has  been 
paid. 

Information  at  Source 

Sec.  256.  That  all  individuals,  corporations  and  partnerships  in 
whatever  capacity  acting,  including  lessees  or  mortgagors  of  real  or  per- 
sonal property,  fiduciaries,  and  employers,  making  payment  to  another  in- 
dividual, corporation,  or  partnership,  of  interest,  rent,  salaries,  wages, 
premiums,  annuities,  compensations,  remunerations,  emoluments  or  other 
fixed  or  determinable  gains,  profits,  and  income  (other  than  payments 
described  in  sections  254  and  255),  of  $1,000  or  more  in  any  taxable  year, 
or,  in  the  case  of  such  payments  made  by  the  United  States,  the  officers 
or  employees  of  the  United  States  having  information  as  to  such  payments 
and  required  to  make  returns  in  regard  thereto  by  the  regulations  herein- 
after provided  for,  shall  render  a  true  and  accurate  return  to  the  Com- 
missioner, under  such  regulations  and  in  such  form  and  manner  and  to 
such  extent  as  may  be  prescribed  by  him  with  the  approval  of  the  Secretary, 
setting  forth  the  amount  of  such  gains,  profits,  and  income,  and  the  name 
and  address  of  the  recipient  of  such  payment. 

Such  returns  may  be  required,  regardless  of  amounts,  (i)  in  the  case 
of  payments  of  interest  upon  bonds,  mortgages,  deeds  of  trust',  or  other 
similar  obligations  of  corporations,  and  (2)  in  the  case  of  collections 
of  items  (not  payable  in  the  United  States)  of  interest  upon  the  bonds 
of  foreign  countries  and  interest  upon  the  bonds  of  and  dividends  from 
foreign  corporations  by  individuals,  corporations,  or  partnerships,  under- 
taking as  a  matter  of  business  or  for  profit  the  collection  of  foreign  pay- 
ments of  such  interest  or  dividends  by  means  of  coupons,  checks,  or  bills 
of  exchange. 

When  necessary  to  make  effective  the  provisions  of  this  section  the 
name  and  address  of  the  recipient  of  income  shall  be  furnished  upon  de- 
mand of  the  individual,  corporation,  or  partnership  paying  the  income. 

The  provisions  of  this  section  shall  apply  to  the  calendar  year  1921  and 
each  calendar  year  thereafter,  but  shall  not  apply  to  the  payment  of  in- 
terest on  obligations  of  the  United  States. 


1778  REVENUE   ACT    OF    1921 

Returns  to  Be  Public  Records 

Sec.  257.  That  returns  upon  which  the  fax  has  been  determined  by  the 
Commissioner  shall  constitute  public  records ;  but  they  shall  be  open  to 
inspection  only  upon  order  of  the  President  and  under  rules  and  regula- 
tions prescribed  by  the  Secretary  and  approved  by  the  President :  Provided, 
That  the  proper  officers  of  any  State  imposing  an  income  tax  may,  upon 
request  of  the  governor  thereof,  have  access  to  the  returns  of  any  corpora- 
tion, or  to  an  abstract  thereof  showing  the  name  and  income  of  the  cor- 
poration, at  such  times  and  in  such  manner  as  the  Secretary  may  pre- 
scribe :  Provided  further,  That  all  bona  fide  stockholders  of  record  owning 
I  per  centum  or  more  of  the  outstanding  stock  of  any  corporation  shall, 
upon  making  request  of  the  Commissioner,  be  allowed  to  examine  the  an- 
nual income  returns  of  such  corporation  and  of  its  subsidiaries.  Any 
stockholder  who  pursuant  to  the  provisions  of  this  section  is  allowed  to 
examine  the  return  of  any  corporation,  and  who  makes  known  in  any 
manner  whatever  not  provided  by  law  the  amount  or  source  of  income, 
profits,  losses,  expenditures,  or  any  particular  thereof,  set  forth  or  dis- 
closed in  any  such  return,  shall  be  guilty  of  a  misdemeanor  and  be  pun- 
ished by  a  fine  not  exceeding  $1,000,  or  by  imprisonment  not  exceeding 
one  year,  or  both. 

The  Commissioner  shall  as  soon  as  practicable  in  each  year  cause  to 
be  prepared  and  made  available  to  public  inspection  in  such  manner  as 
he  may  determine,  in  the  office  of  the  collector  in  each  internal-revenue 
district  and  in  such  other  places  as  he  may  determine,  lists  containing 
the  names  and  the  post-office  addresses  of  all  individuals  making  income- 
tax  returns  in  such  district. 

Publication  of  Statistics 

Sec.  258.  That  the  Commissioner,  with  the  approval  of  the  Secretary, 
shall  prepare  and  publish  annually  statistics  reasonably  available  with  re- 
spect to  the  operation  of  the  income,  war-profits  and  excess-profits  tax 
laws,  including  classifications  of  taxpayers  and  of  income,  the  amounts 
allowed  as  deductions,  exemptions,  and  credits,  and  any  other  facts  deemed 
pertinent  and  valuable. 

Collection  of  Foreign  Items 

Sec.  259.  That  all  individuals,  corporations,  or  partnerships  under- 
taking as  a  matter  of  business  or  for  profit  the  collection  of  foreign  pay- 
ments of  interest  or  dividends  by  means  of  coupons,  checks,  or  bills  of  ex- 
change shall  obtain  a  license  from  the  Commissioner  and  shall  be  subject 
to  such  regulations  enabling  the  Government  to  obtain  the  information 
required  under  this  title  as  the  Commissioner,  with  the  approval  of  the 
Secretary,  shall  prescribe ;  and  whoever  knowingly  undertakes  to  collect 
such  payment's  without  having  obtained  a  license  therefor,  or  without 
complying  with  such  regulations,  shall  be  guilty  of  a  misdemeanor  and 
shall  be  fined  not  more  than  $5,000,  or  imprisoned  for  not  more  than  one 
year,  or  both. 


REVENUE   ACT    OF    1921  1779 

Citizens  of  Possessions  of  the  United  States 

Sec.  260.  That  any  individual  who  is  a  citizen  of  any  possession  of 
the  United  States  (but  not  otherwise  a  citizen  of  the  United  States)  and 
who  is  not  a  resident  of  the  United  States,  shall  be  subject  to  taxation 
under  his  title  only  as  to  income  derived  from  sources  within  the  United 
States,  and  in  such  case  the  tax  shall  be  computed  and  paid  in  the  same 
manner  and  subject  to  the  same  conditions  as  in  the  case  of  other  persons 
who  are  taxable  only  as  to  income  derived  from  such  sources. 

Nothing  in  this  section  shall  be  construed  to  alter  or  amend  the  pro- 
visions of  the  Act  entitled  "An  Act  making  appropriations  for  the  naval 
service  for  the  fiscal  year  ending  June  30,  1922,  and  for  other  purposes," 
approved  July  12,  1921,  relating  to  the  imposition  of  income  taxes  in  the 
Virgin  Islands  of  the  United  States. 

Porto  Rico  and  Philippine  Islands 

Sec.  261.  That  in  Porto  Rico  and  the  Philippine  Islands  the  income 
tax  shall  be  levied,  assessed,  collected,  and  paid  as  provided  by  law  prior 
to  the  passage  of  this  Act. 

The  Porto  Rican  or  Philippine  Legislature  shall  have  power  by  due 
enactment  to  amend,  alter,  modify,  or  repeal  the  income  tax  laws  in 
force  in  Porto  Rico  or  the  Philippine  Islands,  respectively. 

Income  from  Sources  Within  the  Possessions  of  the  United  States 

Sec.  262.  (a)  That  in  the  case  of  citizens  of  the  United  States  or 
domestic  corporations,  satisfying  the  following  conditions,  gross  income 
means  only  gross  income   from  sources  within  the   United   States — 

(i)  If  80  per  centum  or  more  of  the  gross  income  of  such  citizen  or 
domestic  corporation  (computed  without  the  benefit  of  this  section)  for 
the  three-year  period  immediately  preceding  the  close  of  the  taxable  year 
(or  for  such  part  of  such  period  immediately  preceding  the  close  of  such 
taxable  year  as  may  be  applicable)  was  derived  from  sources  within  a 
possession  of  the  United  States ;  and 

(2)  If,  in  the  case  of  such  corporation,  50  per  centum  or  more  of 
its  gross  income  (computed  without  the  benefit  of  this  section)  for  such 
period  or  such  part  thereof  was  derived  from  the  active  conduct  of  a 
trade  or  business  within  a  possession  of  the  United  States ;  or 

(3)  If,  in  the  case  of  such  citizen,  50  per  centum  or  more  of  his  gross 
income  (computed  without  the  benefit  of  this,  section)  for  such  period 
or  such  part  thereof  was  derived  from  the  active  conduct  of  a  trade  or 
business  within  a  possession  of  the  United  States  either  on  his  own  ac- 
count or  as  an  employee  or  agent  of  another. 

(b)  Notwithstanding  the  provisions  of  subdivision  (a)  there  shall 
be  included  in  gross  income  all  amounts  received  by  such  citizens  or  cor- 
porations within  the  United  States,  whether  derived  from  sources  within 
or  without  the  United  States. 


1780  REVENUE   ACT    OF    1921 

(c)  As  used  in  this  section  the  term  "possession  of  the  United  States" 
does  not  include  the  Virgin  Islands  of  the  United  States. 

Effective  Date  of  Title 

Sec.  263.  That  this  title  shall  take  effect  as  of  January  i,  1921. 

TITLE    III.— WAR-PROFITS    AND    EXCESS-PROFITS 
TAX  FOR  1921. 

Part  I. — General  Definitions, 

Sec.  300.  That  when  used  in  this  title  the  terms  "taxable  year,"  "fiscal 
year,"  "personal  service  corporation,"  "paid  or  accrued,"  and  "dividends" 
shall  have  the  same  meaning  as  provided  for  the  purposes  of  income  tax  in 
sections  200  and  201. 

Part  II. — Imposition  of  Tax 

Sec.  301.  (a)  That  in  lieu  of  the  tax  imposed  by  Title  III  of  the 
Revenue  Act  of  1918,  but  in  addition  to  the  other  taxes  imposed  by  this 
Act,  there  shall  be  levied,  collected  and  paid  for  the  calendar  year  1921 
upon  the  net  income  of  every  corporation  (except  corporations  taxable 
under  subdivision  (b)  of  this  section)  a  tax  equal  to  the  sum  of  the 
following : 

First  Bracket 

20  per  centum  of  the  amount  of  the  net  income  in  excess  of  the  excess- 
profits  credit  (determined  under  section  312)  and  not  in  excess  of  20 
per  centum  of  the  invested  capital; 

Second  Bracket 

40  per  centum  of  the  amount  of  the  net  income  in  excess  of  20  per 
per  centum  of  the  invested  capital; 

(b)  For  the  calendar  year  1921  there  shall  be  levied,  collected,  and 
paid  upon  the  net  income  of  every  corporation  which  derives  in  such 
year  a  net  income  of  more  than  $10,000  from  any  Government  contract 
or  contracts  made  between  April  6,  1917,  and  November  11,  1918,  both 
dates  inclusive,  a  tax  equal  to  the  sum  of  the  following: 

(i)  Such  a  portion  of  a  tax  computed  at  the  rates  specified  in  sub- 
division (a)  of  section  301  of  the  Revenue  Act  of  1918,  as  the  part  of  the 
net  income  attributable  to  such  Government  contract  or  contracts  bears 
to  the  entire  net  income.  In  computing  such  tax  the  excess-profits  credit 
and  the  war-profits  credit  which  would  be  applicable  to  such  calendar  year 
under  the  Revenue  Act  of  1918  if  it  had  been  continued  in  force,  shall 
be  used ; 


REVENUE   ACT    OF    1921  1781 

(2)  Such  a  portion  of  a  tax  computed  at  the  rates  specified  in  sub- 
division (a)  of  this  section  as  the  part  of  the  net  income  not  attributable 
to  such  Government  contract'  or  contracts  bears  to  the  entire  net  income. 

For  the  purpose  of  determining  the  part  of  the  net  income  attributable 
to  such  Government  contract  or  contracts,  the  proper  apportionment  and 
allocation  of  the  deductions  with  respect  to  gross  income  derived  from 
such  Government  contract  or  contracts  and  from  other  sources,  respec- 
tively, shall  be  determined  under  rules  and  regulations  prescribed  by  the 
Commissioner  with  the  approval  of  the  Secretary. 

(c)  In  any  case  where  the  full  amount  of  the  excess-profits  credit  is 
not  allowed  under  the  first  bracket  of  subdivision  (a),  by  reason  of  the 
fact  that  such  credit  is  in  excess  of  20  per  centum  of  the  invested  capital, 
the  part  not  so  allowed  shall  be  deducted  from  the  amount  in  the  second 
bracket. 

Sec.  302.  That  the  tax  imposed  by  subdivision  (a)  of  section  301  shall 
in  no  case  be  more  than  20  per  centum  of  the  amount  of  the  net  income  in 
excess  of  $3,000  and  not  in  excess  of  $20,000,  plus  40  per  centum  of  the 
amount  of  the  net  income  in  excess  of  $20,000;  and  the  limitations  im- 
posed by  section  302  of  the  Revenue  Act  of  1918  (upon  taxes  computed  un- 
der subdivision  (c)  of  section  301  of  that  Act)  are  hereby  made  applicable 
to  taxes  computed  under  subdivision  (b)  of  section  301  of  this  Act. 
Nothing  in  this  section  shall  be  construed  in  such  manner  as  to  increase 
the  tax  imposed  by  section  301   of  this  Act. 

Sec.  303.  That  if  part  of  the  net  income  of  a  corporation  is  derived 
(i)  from  a  trade  or  business  (or  a  branch  of  a  trade  or  business)  in  which 
the  employment  of  capital  is  necessary,  and  (2)  a  part  (constituting  not 
less  than  30  per  centum  of  its  total  net  income)  is  derived  from  a  separate 
trade  or  business  (or  a  distinctly  separate  branch  of  the  trade  or  business) 
which  if  constituting  the  sole  trade  or  business  would  bring  it  within  the 
class  of  "personal  service  corporations,"  then  (under  regulations  prescribed 
by  the  Commissioner  with  the  approval  of  the  Secretary)  the  tax  upon 
the  first  part  of  such  net  income  shall  be  separately  computed  (allowing 
in  such  computation  only  the  same  proportionate  part  of  the  credits 
authorized  in  section  312),  and  the  fax  upon  the  second  part  shall  be  the 
same  percentage  thereof  as  the  tax  so  computed  upon  the  first  part  is  of 
such  first  part :  Provided,  That  the  tax  upon  such  second  part  shall  in 
no  case  be  less  than  20  per  centum  thereof,  unless  the  tax  upon  the  entire 
net  income,  if  computed  without  benefit  of  this  section,  would  constitute 
less  than  20  per  centum  of  such  entire  net  income,  in  which  event  the  tax 
shall  be  determined  upon  the  entire  net  income,  without  reference  to  this 
section,  as  other  taxes  are  determined  under  this  title.  The  total  tax 
computed  under  this  section  shall  be  subject  to  the  limitations  provided  in 
section  302. 

Sec.  304.  (a)  That  the  corporations  enumerated  in  section  231  shall, 
to  the  extent  that  they  are  exempt  from  income  tax  under  Title  II,  be 
exempt  from  taxation  under  this  title. 


1782  REVENUE    ACT    OF    1921 

(b)  Any  corporation  whose  net  income  for  the  taxable  year  is  less 
than  $3,000  shall  be  exempt  from  taxation  under  this  title. 

(c)  In  the  case  of  any  corporation  engaged  in  the  mining  of  gold,  the 
portion  of  the  net  income  derived  from  the  mining  of  gold  shall  be  exempt 
from  the  tax  imposed  by  this  title  or  any  tax  imposed  by  Title  II  of  the 
Revenue  Act  of  1917,  and  the  tax  on  the  remaining  portion  of  the  net  in- 
come shall  be  the  same  proportion  of  a  tax  computed  without  the  benefit 
of  this  subdivision  which  such  remaining  portion  of  the  net  income  bears 
to  the  entire  net  income. 

Sec.  305.  That  if  a  tax  is  computed  under  this  title  for  a  period  of 
less  than  twelve  months,  the  specific  exemption  of  $3,000,  wherever  re- 
ferred to  in  this  title,  shall  be  reduced  to  an  amount  which  is  the  same 
proportion  of  $3,000  as  the  number  of  months  in  the  period  is  of  twelve 
months. 

Part  III. — Excess-Profits  Credit. 

Sec.  312.  That  the  excess-profits  credit  shall  consist  of  a  specific  exemp- 
tion of  $3,000  plus  an  amount  equal  to  8  per  centum  of  the  invested 
capital   for  the  taxable  year. 

A  foreign  corporation  or  a  corporation  entitled  to  the  benefits  of  sec- 
tion 262  shall  not  be  entitled  to  the  specific  exemption  of  $3,000. 

Part  IV. — Net  Income. 

Sec.  320.  That  for  the  purpose  of  this  title  the  net  income  of  a  corpora- 
tion shall  be  ascertained  and  returned  for  the  taxable  year  upon  the  same 
basis  and  in  the  same  manner  as  provided  for  income  tax  purposes  in  Title  II 
of  this  Act. 

Part  V. — Invested  Capital. 

Sec.  325.     (a)  That  as  used  in  this  title — 

The  term  "intangible  property"  means  patents,  copyrights,  secret 
processes  and  formulae,  good  will,  trade-marks,  trade-brands,  franchises, 
and  other  like  property; 

The  term  "tangible  property"  means  stocks,  bonds,  notes,  and  other 
evidences  of  indebtedness,  bills  and  accounts  receivable,  leaseholds,  and 
other   property   other   than    intangible   property; 

The  term  "borrowed  capital"  means  money  or  other  property  borrowed, 
whether    represented   by  bonds,   notes,   open   accounts,   or   otherwise ; 

The  term  "inadmissible  assets"  means  stocks,  bonds,  and  other  obliga- 
tions (other  than  obligations  of  the  United  States),  the  dividends  or  in- 
terest from  which  is  not  included  in  computing  net  income,  but  where  the 
income  derived  from  such  assets  consists  in  part  of  gain  or  profit  derived 
from  the  sale  or  other  disposition  thereof,  or  where  all  or  part  of  the 


REV'ENUE   ACT    OF    1921  1783 

interest  derived  from  such  assets  is  in  effect  included  in  the  net  income 
because  of  the  limitation  on  the  deduction  of  interest  under  paragraph  (2) 
of  subdivision  (a)  of  section  234,  a  corresponding  part  of  the  capital  in- 
vested in  such  assets  shall  not  be  deemed  to  be  inadmissible  assets ; 

The  term  "admissible  assets"  means  all  assets  other  than  inadmissible 
assets,  valued  in  accordance  vv-ith  the  provisions  of  subdivision  (a)  of 
section  326  and  section  331. 

(b)  For  the  purposes  of  this  title  the  par  value  of  stock  or  shares  shall, 
in  the  case  of  stock  or  shares  issued  at  a  nominal  value  or  having  no  par 
value,  be  deemed  to  be  the  fair  market  value  as  of  the  date  or  dates  of 
issue  of  such  stock  or  shares. 

Sec.  326.  (a)  That  as  used  in  this  title  the  term  "invested  capital" 
for  any  year  means  (except  as  provided  in  subdivision  (b)  and  (c)  of 
this  section)  : 

(i)   Actual  cash  bona  fide  paid  in   for  stock  or  shares; 

(2)  Actual  cash  value  of  tangible  property,  other  than  cash,  bona  fide 
paid  in  for  stock  or  shares,  at  the  time  of  such  payment,  but  in  no  case 
to  exceed  the  par  value  of  the  original  stock  or  shares  specifically  issued 
therefor,  unless  the  actual  cash  value  of  such  tangible  property  at  the 
time  paid  in  is  shovi^n  to  the  satisfaction  of  the  Commissioner  to  have  been 
clearly  and  substantially  in  excess  of  such  par  value,  in  which  case  such 
excess  shall  be  treated  as  paid-in  surplus  :  Provided,  That  the  Commis- 
sioner shall  keep  a  record  of  all  cases  in  which  tangible  property  is  in- 
cluded in  invested  capital  at  a  value  in  excess  of  the  stock  or  shares  issued 
therefor,  containing  the  name  and  address  of  each  taxpayer,  the  business 
in  which  engaged,  the  amount  of  invested  capital  and  net  income  shown 
by  the  return,  the  value  of  the  tangible  property  at  the  time  paid  in,  the 
par  value  of  the  stock  or  shares  specifically  issued  therefor,  and  the  amount 
included  under  this  paragraph  as  paid-in  surplus.  The  Commissioner 
shall  furnish  a  copy  of  such  record  and  other  detailed  information  with  re- 
spect to  such  cases  when  required  by  resolution  of  either  House  of  Con- 
gress, without  regard  to  the  restrictions  contained  in  section  257 ; 

(3)  Paid-in  or  earned  surplus  and  undivided  profits;  not  including 
surplus  and  undivided   profits  earned  during  the  year ; 

(4)  Intangible  property  bona  fide  paid  in  for  stock  or  shares  prior 
to  March  3,  1917,  in  an  amount  not  exceeding  (a)  the  actual  cash  value 
of  such  property  at  the  time  paid  in,  (b)  the  par  vakic  of  the  stock  or  shares 
issued  therefor,  or  (c)  in  the  aggregate  25  per  centum  of  the  par  value 
of  the  total  stock  or  shares  of  the  corporation  outstanding  on  March  3, 
1917,  whichever  is  lowest; 

(5)  Intangible  property  bona  fide  paid  in  for  stock  or  shares  on  or 
after  March  3,  1917,  in  an  amount  not  exceeding  (a)  the  actual  cash  value 
of  such  property  at  the  time  paid  in,  (b)  the  par  value  of  the  stock  or 
shares  issued  therefor,  or  (c)  in  the  aggregate  25  per  centum  of  the  par 
value  of  the  total  stock  or  shares  of  the  corporation  outstanding  at  the 
beginning  of  the  taxable  year,  whichever  is  lowest:  Provided,  That  in  no 


1784  REVENUE   ACT    OF    1921 

case  shall  the  total  amount  included  under  paragraphs  (4)  and  (5)  exceed 
in  the  aggregate  25  per  centum  of  the  par  value  of  the  total  stock  or  shares 
of  the  corporation  outstanding  at  the  beginning  of  the  taxable  year ;  but 

(b)  As  used  in  this  title  the  term  "invested  capital"  does  not  include 
borrowed  capital. 

(c)  There  shall  be  deducted  from  invested  capital  as  above  defined  a 
percentage  thereof  equal  to  the  percentage  which  the  amount  of  inadmis- 
sible assets  is  of  the  amount  of  admissible  and  inadmissible  assets  held 
during  the  taxable  year. 

(d)  The  invested  capital  for  any  period  shall  be  the  average  invested 
capital  for  such  period,  but  in  the  case  of  a  corporation  making  a  return 
for  a  fractional  part  of  a  year,  it  shall  be  the  same  fractional  part  of  such 
average  invested  capital. 

Sec.  327.  That  in  the  following  cases  the  tax  shall  be  determined  as 
provided  in  section  328: 

(a)  Where  the  Commissioner  is  unable  to  determine  the  invested  capi- 
tal as  provided  in  section  326; 

(b)  In  the  case  of  a  foreign  corporation  or  of  a  corporation  entitled 
to  the  benefits  of  section  262 ; 

(c)  Where  a  mixed  aggregate  of  tangible  ^property  and  intangible  prop- 
erty has  been  paid  in  for  stock  or  for  stock  and  bonds  and  the  Commis- 
sioner is  unable  satisfactorily  to  determine  the  respective  values  of  the 
several  classes  of  property  at  the  time  of  payment,  or  to  distinguish  the 
classes  of  property  paid  in  for  stock  and  for  bonds,  respectively; 

(d)  Where  upon  application  by  the  corporation  the  Commissioner  finds 
and  so  declares  of  record  that  the  tax  if  determined  without  benefit  of  this 
section  would,  owing  to  abnormal  conditions  affecting  the  capital  or  in- 
come of  the  corporation,  work  upon  the  corporation  an  exceptional  hard- 
ship evidenced  by  gross  disproportion  between  the  tax  computed  without 
benefit  of  this  section  and  the  tax  computed  by  reference  to  the  repre- 
sentative corporations  specified  in  section  328.  This  subdivision  shall  not 
apply  to  any  case  (i)  in  which  the  tax  (computed  without  benefit  of  this 
section)  is  high  merely  because  the  corporation  earned  within  the  taxable 
year  a  high  rate  of  profit  upon  a  normal  invested  capital,  nor  (2)  in  which 
50  per  centum  or  more  of  the  gross  income  of  the  corporation  for  the 
taxable  year  (computed  under  section  233  of  Title  II)  consists  of  gains, 
profit's,  commissions,  or  other  income,  derived  on  a  cost-plus  basis  from  a 
Government  contract  or  contracts  made  between  April  6,  1917,  and  No- 
vember II,   1918,  both  dates  inclusive. 

Sec.  328.  (a)  That  in  the  cases  specified  in  section  327  the  tax  shall 
be  the  amount  which  bears  the  same  ratio  to  the  net  income  of  the  tax- 
payer (in  excess  of  the  specific  exemption  of  $3,000)  for  the  taxable  year, 
as  the  average  tax  of  representative  corporations  engaged  in  a  like  or 
similar  trade  or  business,  bears  to  their  average  net  income  (in  excess  of 
the  specific  exemption  of  $3,000)  for  such  year.  In  the  case  of  a  foreign 
corporation   or   of    a    corporation   entitled   to   the   benefits    of    section   262 


REVENUE   ACT    OF    1921  1 785 

the  tax   shall  be  computed   without   deducting  the   specific  exemption   of 
$3,000  either  for  the  taxpayer  or  the  representative  corporations. 

In  computing  the  tax  under  this  section  the  Commissioner  shall  com- 
pare the  taxpayer  only  with  representative  corporations  whose  invested 
capital  can  be  satisfactorily  determined  under  section  326  and  which  are, 
as  nearly  as  may  be,  similarly  circumstanced  with  respect  to  gross  income, 
net  income,  profits  per  unit  of  business  transacted  and  capital  employed, 
the  amounts  and  rate  of  war  profits  or  excess  profits,  and  all  other  relevant 
facts  and  circumstances. 

(b)  For  the  purposes  of  subdivision  (a)  the  ratios  between  the  aver- 
age tax  and  the  average  net  income  of  representative  corporations  shall 
be  determined  by  the  Commissioner  in  accordance  with  regulations  pre- 
scribed by  him  with  the  approval  of  the  Secretary. 

(c)  The  Commissioner  shall  keep  a  record  of  all  cases  in  which  the 
tax  is  determined  in  the  manner  prescribed  in  subdivision  (a),  containing 
the  name  and  address  of  each  taxpayer,  the  business  in  which  engaged,  the 
amount  of  invested  capital  and  net  income  shown  by  the  return,  and  the 
amount  of  invested  capital  as  determined  under  such  subdivision.  The 
Commissioner  shall  furnish  a  copy  of  such  record  and  other  detailed  in- 
formation with  respect  to  such  cases  when  required  by  resolution  of  either 
House  of  Congress,  without  regard  to  the  restrictions  contained  in  section 
257. 

Part  VI. — Reorganizations. 

Sec.  331.  That  in  the  case  of  the  reorganization,  consolidation,  or  change 
of  ownership  of  a  trade  or  business,  or  change  of  ownership  of  property, 
after  March  3,  1917,  if  an  interest  or  control  in  such  trade  or  business 
or  property  of  50  per  centum  or  more  remains  in  the  same  persons,  or 
any  of  them,  then  no  asset  transferred  or  received  from  the  previous  owner 
shall,  for  the  purpose  of  determining  invested  capital,  be  allowed  a  greater 
value  than  would  have  been  allowed  under  this  title  in  computing  the  in- 
vested capital  of  such  previous  owner  if  such  asset  had  not  been  so  trans- 
ferred or  received :  Provided,  That  if  such  previous  owner  was  not  a  cor- 
poration, then  the  value  of  any  asset  so  transferred  or  received  shall  be 
taken  at  its  cost  of  acquisition  (at  the  date  when  acquired  by  such  previous 
owner)  with  proper  allowance  for  depreciation,  impairment,  betterment  or 
development,  but  no  addition  to  the  original  cost  shall  be  made  for  any 
charge  or  expenditure  deducted  as  expense  or  otherwise  on  or  after  March 
I,  1913,  in  computing  the  net  income  of  such  previous  owner  for  purposes 
of  taxation. 

Part  VII. — Miscellaneous. 

Skc.  335.  (a)  That  if  a  corporation  (other  than  a  personal  service 
corporation)   makes  return  for  a  fiscal  year  beginning  in  1920  and  ending 


1786  REVENUE   ACT    OF    1921 

in  1921,  the  war-profits  and  excess-profits  tax  for  the  taxable  year  1921 
shall  be  the  sum  of:  (i)  the  same  proportion  of  a  tax  for  the  entire 
period  computed  under  the  Revenue  Act  of  1918,  which  the  portion  of  such 
period  falling  within  the  calendar  year  1920  is  of  the  entire  period,  and 
(2)  the  same  proportion  of  a  tax  for  the  entire  period  computed  under 
this  title,  which  the  portion  of  such  period  falling  within  the  calendar 
year  1921  is  of  the  entire  period.  Any  amount  heretofore  or  hereafter  paid 
on  account  of  the  tax  imposed  for  such  taxable  year  by  the  Revenue  Act 
of  1918  shall  be  credited  towards  the  payment  of  the  tax  as  above  computed, 
and  if  the  amount  so  paid  exceeds  the  amount  of  such  tax,  the  excess 
shall  be  credited  or  refunded  to  the  corporation  in  accordance  with  the 
provisions  of  section  252  of  this  Act. 

(b)  If  a  corporation  (other  than  a  personal  service  corporation)  makes 
a  return  for  a  fiscal  year  beginning  in  1921  and  ending  in  1922,  the  war- 
profits  and  excess-profits  tax  for  the  portion  of  the  year  falling  within 
the  calendar  year  1921  shall  be  an  amount  equivalent  to  the  same  pro- 
portion of  a  tax  for  the  entire  period  computed  under  this  title,  which 
the  portion  of  such  period  falling  within  the  calendar  year  1921  is  of  the 
entire  period. 

Sec.  336.  That  every  corporation,  not  exempt  under  section  304,  shall 
make  a  return  for  the  purposes  of  this  title.  Such  returns  shall  be  made, 
and  the  taxes  imposed  by  this  title  shall  be  paid,  at  the  same  times  and 
places,  in  the  same  manner,  and  subject  to  the  same  conditions,  as  is  pro- 
vided in  the  case  of  returns  and  payment  of  income  tax  by  corporations 
for  the  purposes  of  Title  II,  and  all  the  provisions  of  that  title  not  in- 
applicable, including  penalties,  are  hereby  made  applicable  to  the  taxes 
imposed  by  this -title. 

Sec.  337.  That  in  the  case  of  a  bona  fide  sale  of  mines,  oil  or  gas 
wells,  or  any  interest  therein,  where  the  prinicipal  value  of  the  property 
has  been  demonstrated  by  prospecting  or  exploration  and  discovery  work 
done  by  the  taxpayer,  the  portion  of  the  tax  imposed  by  this  title  at- 
tributable to  such  sale  shall  not  exceed  20  per  centum  of  the  selling  price 
of  such  property  or  interest. 

Effective  Date  of  Title 

Sec.  338.  That  this  title  shall  take  effect  as  of  January  i,  1921. 

TITLE  IV.— ESTATE  TAX. 

Sec.  400.  That  when  used  in  this  title — 

The  term  "executor"  means  the  executor  or  administrator  of  the 
decedent,  or,  if  there  is  no  executor  or  administrator,  any  person  in 
actual  or  constructive  possession  of  any  property  of  the  decedent; 

The  term  "net  estate"  means  the  net  estate  as  determined  under  the 
provisions  of  section  403 ; 

The  term  "month"  means  calendar  month ;  and 


REVENUE   ACT   OF   1921  1787 

The  term  "collector"  means  the  collector  of  internal  revenue  of  the 
district  in  which  was  the  domicile  of  the  decedent  at  the  time  of  his 
death,  or,  if  there  was  no  such  domicile  in  the  United  States,  then  the 
collector  of  the  district  in  which  is  situated  the  part  of  the  gross  estate  of 
the  decedent  in  the  United  States,  or,  if  such  part  of  the  gross  estate  is 
situated  in  more  than  one  district,  then  the  collector  of  internal  revenue 
of  such  district  as  may  be  designated  by  the  Commissioner. 

Sec.  401.  That,  in  lieu  of  the  tax  imposed  by  Title  IV  of  the  Revenue 
Act  of  1918,  a  tax  equal  to  the  sum  of  the  following  percentages  of  the 
value  of  the  net  estate  (determined  as  provided  in  section  403)  is  hei^eby 
imposed  upon  the  transfer  of  the  net  estate  of  every  decedent  dying  after 
the  passage  of  this  Act,  whether  a  resident  or  nonresident  of  the  United 
States : 

1  per  centum  of  the  amount  of  the  net  estate  not  in  excess  of  $50,000; 

2  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $50,000 
and   does   not  exceed  $150,000; 

3  per  centum  of  the  amount  by  whicli  the  net  estate  exceeds  $150,000 
and  does  not  exceed  $250,000; 

4  per  centum  of  the  amount  l)y  whicli  the  net  estate  exceeds  $250,000 
and  does  not  exceed  $450,000; 

6  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $450,000 
and  does  not  exceed  $760,000 ; 

8  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $750,000 
and  does  not  exceed  $1,000,000; 

ro  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $1,000,000 
and  does  not  exceed  $1,500,000; 

12  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $1,500,000 
and  does  not  exceed  $2,000,000; 

14  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $2,000,000 
and  does  not  exceed  $3,000,000; 

16  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $3,000,000 
and  does  not  exceed  $4,000,000; 

18  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $4,000,000 
and  does  not  exceed  $5,000,000 ; 

20  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $5,000,000 
and  does  not  exceed  $8,000,000; 

22  per  centum  of  the  amount  liy  wliicli  the  net  estate  exceeds  $8,000,000 
and  does  not  exceed  $10,000,000;  and 

25  per  centum  of  the  amount  by  which  the  net  estate  exceeds  $10,000,000. 

The  taxes  imposed  by  this  title  or  by  Title  II  of  the  Revenue  Act  of 
1916  (as  amended  by  the  Act  entitled  "An  Act  to  provide  increased  revenue 
to  defray  the  expenses  of  the  increased  appropriations  for  the  Army  and 
Navy  and  the  extensions  of  fortifications,  and  for  other  purposes,"  ap- 
proved March  3,  1917)  or  by  Title  IX  of  the  Revenue  Act  of  1917,  or  by 
Title  IV  of  the  Revenue  Act  of  1918,  shall  not  apply  to  the  transfer  of  the 
net  estate  of  any  decedent  who  has  died  or  may  die  from  injuries  received 


1788  REVENUE   ACT    OF   1921 

or  disease  contracted  in  line  of  duty  while  serving  in  the  military  or  naval 
forces  of  the  United  States  in  the  war  against  the  German  Government,  or 
to  the  transfer  of  the  net  estat'e  of  any  citizen  of  the  United  States  who 
has  died  or  may  die  from  injuries  received  or  disease  contracted  in  line 
of  duty  while  serving  in  the  military  or  naval  forces  of  any  country  ^yhile 
associated  with  the  United  States  in  the  prosecution  of  such  war,  or  prior 
to  the  entrance  therein  of  the  United  States,  and  any  tax  collected  upon 
such  transfer  shall  be  refunded  to  the  estate  of  such  decedent. 

Sec.  402.  That  the  value  of  the  gross  estate  of  the  decedent  shall  be 
determined  by  including  the  value  at  the  time  of  his  death  of  all  property, 
real  or  personal,  tangible  or  intangible,  wherever  situated — 

(a)  To  the  extent  of  the  interest  therein  of  the  decedent  at  the  time 
of  his  death  which  after  his  death  is  subject  to  the  payment  of  the  charges 
against  his  estate  and  the  expenses  of  its  administration  and  is  subject  to 
distribution  as  part  of  his  estate; 

(b)  To  the  extent  of  any  interest  therein  of  the  surviving  spouse,  ex- 
isting at  the  time  of  the  decedent's  death  as  dower,  curtesy,  or  by  virtue 
of  a  statute  creating  an  estate  in  Heu  of  dower  or  curtesy; 

(c)  To  the  extent  of  any  interest  therein  of  which  the  decedent  has 
at  any  time  made  a  transfer,  or  with  respect  to  which  he  has  at  any  time 
created  a  trust,  in  contemplation  of  or  intended  to  take  effect  in  possession 
or  enjoyment  at  or  after  his  death  (whether  such  transfer  or  trust  is  made 
or  created  before  or  after  the  passage  of  this  Act),  except  in  case  of  a 
bona  fide  sale  for  a  fair  consideration  in  money  or  money's  worth.  Any 
transfer  of  a  material  part  of  his  property  in  the  nature  of  a  final  disposi- 
tion or  distribution  thereof,  made  by  the  decedent  within  two  years  prior 
to  his  death  without  such  a  consideration,  shall,  unless  shown  to  the  con- 
trary, be  deemed  to  have  been  made  in  contemplation  of  death  within  the 
meaning  of  this  title; 

(d)  To  the  extent  of  the  interest  therein  held  jointly  or  as  tenants  in 
the  entirety  by  the  decedent  and  any  other  person,  or  deposited  in  banks 
or  other  institutions  in  their  joint  names  and  payable  to  either  or  the  sur- 
vivor, except  such  part  thereof  as  may  be  shown  to  have  originally  be- 
longed to  such  other  person  and  never  to  have  been  received  or  acquired 
by  the  latter  from  the  decedent  for  less  than  a  fair  consideration  in  money 
or  money's  worth :  Provided,  That  where  such  property  or  any  part  there- 
of, or  part  of  the  consideration  with  which  such  property  was  acquired,  is 
shown  to  have  been  at  any  time  acquired  by  such  other  person  from  the 
decedent  for  less  than  a  fair  consideration  in  money  or  money's  worth, 
there  shall  be  excepted  only  such  part  of  the  value  of  such  property  as  is 
proportionate  to  the  consideration  furnished  by  such  other  person : 
Provided  further,  That  where  any  property  has  been  acquired  by  gift, 
bequest,  devise,  or  inheritance,  as  a  tenancy  in  the  entirety  by  the  decedent 
and  spouse,  or  where  so  acquired  by  the  decedent  and  any  other  person 
as  joint  tenants  and  their  interests  are  not  otherwise  specified  or  fixed 
by  law,  then  to  the  extent  of  one-half  of  the  value  thereof; 


REVENUE   ACT    OF   1921  1 789 

(e)  To  the  extent  of  any  property  passing  under  a  general  power  of 
appointment  exercised  by  the  decedent  (i)  by  will,  or  (2)  by  deed 
executed  in  contemplation  of,  or  intended  to  take  effect  in  possession  or 
enjoyment  at  or  after,  his  death,  except  in  case  of  a  bona  fide  sale  for  a 
fair  consideration  in  money  or  money's  worth ;  and 

(f)  To  the  extent  of  the  amount  receivable  by  the  executor  as  insur- 
ance under  policies  taken  out  by  the  decedent  upon  his  own  life;  and  to  the 
extent  of  the  excess  over  $40,000  of  the  amount  receivable  by  all  other 
beneficiaries  as  insurance  under  policies  taken  out  by  the  decedent  upon 
his  own  life. 

Sec.  403.  That  for  the  purpose  of  the  tax  the  value  of  the  net  estate 
shall  be  determined — 

(a)  In  the  case  of  a  resident,  by  deducting  from  the  value  of  the 
gross  estate — 

(i)  Such  amounts  for  funeral  expenses,  administration  expenses,  claims 
against  the  estate,  unpaid  mortgages  upon,  or  any  indebtedness  in  respect 
t'o,  property  (except,  in  the  case  of  a  resident  decedent,  where  such  prop- 
erty is  not  situated  in  the  United  States),  losses  incurred  during  the  set- 
tlement of  the  estate  arising  from  fires,  storms,  shipwreck,  or  other  casualty, 
or  from  theft,  when  such  losses  are  not  compensated  for  by  insurance  or 
otherwise,  and  such  amounts  reasonably  required  and  actually  expended 
for  the  support  during  the  settlement  of  the  estate  of  those  dependent 
upon  the  decedent,  as  are  allowed  by  the  laws  of  the  jurisdiction,  whether 
within  or  without  the  United  States,  under  which  the  estate  is  being  ad- 
ministered, but  not  including  any  income  taxes  upon  income  received 
after  the  death  of  the  decedent,  or  any  estate,  succession,  legacj',  or  in- 
heritance taxes ; 

(2)  An  amount  equal  to  the  value  of  any  property  forming  a  part  of  the 
gross  estate  situated  in  the  United  States  of  any  person  who  died  within 
five  years  prior  to  the  death  of  the  decedent  where  such  property  can  be 
identified  as  having  been  received  by  the  decedent  from  such  prior  decedent 
by  gift,  bequest,  devise,  or  inheritance,  or  which  can  be  identified  as  having 
been  acquired  in  exchange  for  property  so  received :  Provided,  That  this 
deduction  shall  be  allowed  only  where  an  estate  tax  under  this  or  any 
prior  Act  of  Congress  was  paid  by  or  on  behalf  of  the  estate  of  such 
prior  decedent,  and  only  in  the  amount  of  the  value  placed  by  the  Com- 
missioner on  such  property  in  determining  the  value  of  the  gross  estate 
of  such  prior  decedent,  and  only  to  the  extent  that  the  value  of  such 
property  is  included  in  the  decedent's  gross  estate  and  not  deducted  under 
paragraphs  (i)  or  (3)  of  subdivision  (a)  of  this  section.  This  deduction 
shall  be  made  in  case  of  the  estates  of  all  decedents  who  have  died  since 
September  8,  1916; 

(3)  The  amount  of  all  bequests,  legacies,  devices,  or  transfers,  except 
bona  fide  sates  for  a  fair  consideration  in  money  or  money's  worth,  in  con- 
templation of  or  intended  to  take  effect  in  possession  or  enjoyment  at  or 
after  the  decedent's  death,  to  or   for  the  use  of  the  United  States,  any 


I790  '        REVENUE   ACT    OF    1921 

State,  Terrilui-y,  any  political  subdivision  thereof,  or  the  District  of  Colum- 
bia, for  exclusively  public  purposes,  or  to  or  for  the  use  of  any  corporation 
organized  and  operated  exclusively  for  religious,  charitable,  scientific, 
literary,  or  educational  purposes,  including  the  encouragement  of  art  and 
the  prevention  of  cruelty  to  children  or  animals,  no  part  of  the  net  earnings 
of  which  inures  to  the  benefit  of  any  private  stockholder  or  individual, 
or  to  a  trustee  or  trustees  exclusively  for  such  religious,  charitable,  scien- 
tific, literary,  or  educational  purposes.  This  deduction  shall  be  made  in 
case  of  the  estates  of  all  decedents  who  have  died  since  December  31, 
1917;  and 

(4)   An  exemption  of  $50,000; 

(b)  In  the  case  of  a  nonresident,  by  deducting  from  the  value  of  that 
part  of  his  gross  estate  which  at  the  time  of  his  death  is  situated  in  the 
United  States — 

(i)  That  proportion  of  the  deductions  specified  in  paragraph  (i)  of 
subdivision  (a)  of  this  section  which  the  value  of  such  part  bears  to  the 
value  of  his  entire  gross  estate,  wherever  situated,  but  in  no  case  shall  the 
amount  so  deducted  exceed  10  per  centum  of  the  value  of  that  part  of  his 
gross  estate  which  at  the  time  of  his  death  is  situated  in  the  United  States ; 

(2)  An  amount  equal  to  the  value  of  any  property  forming  a  part  of 
the  gross  estate  situated  in  the  United  States  of  any  person  who  died 
within  five  years  prior  to  the  death  of  the  decedent  where  such  property 
can  be  identified  as  having  been  received  by  the  decedent  from  such  prior 
decedent  by  gift,  bequest,  devise,  or  inheritance,  or  which  can  be  identified 
as  having  been  acquired  in  exchange  for  property  so  received :  Provided, 
That  this  deduction  shall  be  allowed  only  where  an  estate  tax  under  this 
or  any  prior  Act  of  Congress  was  paid  by  or  on  behalf  of  the  estate  of  such 
prior  decedent,  and  only  in  the  amount  of  the  value  placed  by  the  Com- 
missioner on  such  property  in  determining  the  value  of  the  gross  estate 
of  such  prior  decedent,  and  only  to  the  extent  that  the  value  of  such  prop- 
erty is  included  in  that  part  of  the  decedent's  gross  estate  which  at  the 
time  of  his  death  is  situated  in  the  United  States  and  not  deducted  under 
paragraphs  (i)  or  (3)  of  subdivision  (b)  of  this  section.  This  deduction 
shall  be  made  in  case  of  the  estates  of  all  decedents  who  have  died  since 
September  8,  1916;  and 

(3)  The  amount  of  all  bequests,  legacies,  devises  or  transfers,  except 
bona  fide  sales  for  a  fair  consideration,  in  money,  or  money's  worth,  in 
contemplation  of  or  intended  to  take  effect  in  possession  or  enjoyment  at 
or  after  the  decedent's  death,  to  or  for  the  use  of  the  United  States,  any 
State,  Territory,  any  political  subdivision  thereof,  or  the  District  of 
Columbia,  for  exclusively  public  purposes,  or  to  or  for  the  use  of  any  do- 
mestic corporation  organized  and  operated  exclusively  for  religious,  chari- 
table, scientific,  literary,  or  educational  purposes,  including  the  encourage- 
ment of  art  and  the  prevention  of  cruelty  to  children  or  animals,  no  part 
of  the  net  earnings  of  which  inures  to  the  benefit  of  any  private  stock- 
holder or  individual,  or  U>  a  trustee  or  trustees  exclusively  for  such  religious, 


REVENUE   ACT   OF   1921  1791 

charitable,  scientific,  literary,  or  educational  purposes  within  the  United 
States.  This  deduction  shall  be  made  in  case  of  the  estates  of  all  decedents 
who  have  died  since  December  31,  1917. 

No  deduction  shall  be  allowed  in  the  case  of  a  nonresident  unless  the 
executor  includes  in  the  return  required  to  be  filed  under  section  404  the 
value  at  the  time  of  his  death  of  that  part  of  the  gross  estate  of  the  non- 
resident not  situated  in  the  United  States. 

For  the  purpose  of  this  title  stock  in  a  domestic  corporation  owned 
and  held  by  a  nonresident  decedent  shall  be  deemed  property  within  the 
United  States,  and  any  property  of  which  the  decedent  has  made  a  transfer 
or  with  respect  to  which  he  has  created  a  trust,  within  the  meaning  of 
subdivision  (c)  of  section  402,  shall  be  deemed  to  be  situated  in  the  United 
States,  if  so  situated  either  at  the  time  of  the  transfer  or  the  creation  of 
the  trust,  or -at  the  time  of  the  decedent's  death. 

The  amount  receivable  as  insurance  upon  the  life  of  a  nonresident  de- 
cedent, and  any  moneys  deposited  with  any  person  carrying  on  the  bank- 
ing business,  by  or  for  a  nonresident  decedent  who  was  not  engaged  in 
business  in  the  United  States  at  the  time  of  his  death,  shall  not,  for  the 
purpose  of  this  title,  be  deemed  property  within  the  United  States. 

Alissionaries  duly  commissioned  and  serving  under  boards  of  foreign 
missions  of  the  various  religious  denominations  in  the  United  States, 
dying  while  in  the  foreign  missionary  service  of  such  boards,  shall  not, 
by  reason  merely  of  their  intention  to  permanently  remain  in  such  foreign 
service,  be  deemed  nonresidents  of  the  United  States,  but  shall  be  pre- 
sumed to  be  residents  of  the  State,  the  District  of  Columbia,  or  the 
Territories  of  Alaska  or  Hawaii  wherein  they  respectively  resided  at  the 
time  of  their  commission  and  their  departure  for  such  foreign  service. 

In  the  case  of  any  estate  in  respect  to  which  the  tax  has  been  paid,  if 
necessary  to  allow  the  benefit  of  the  deduction  under  paragraphs  (2) 
and  (3)  of  subdivision  (a)  or  (b)  the  tax  shall  be  redetermined  and 
any  excess  of  tax  paid  shall  be  refunded  to  the  executor. 

Sec.  404.  That  the  executor,  within  two  months  after  the  decedent's 
death,  or  within  a  like  period  after  qualifying  as  such,  shall  give  written 
notice  thereof  to  the  collector.  The  executor  shall  also,  at  such  times 
and  in  such  manner  as  may  be  required  by  regulations  made  pursuant  to 
law,  file  with  the  collector  a  return  under  oath  in  duplicate,  setting 
forth  (a)  the  value  of  the  gross  estate  of  the  decedent  at  the  time  of 
his  death,  or  in  case  of  a  nonresident,  of  that  part  of  his  gross  estate 
situated  in  the  United  States;  (b)  the  deductions  allowed  under  section 
403;  (c)  the  value  of  the  net  estate  of  the  decedent  as  defined  in  section 
403 ;  and  (d)  the  tax  paid  or  payable  thereon ;  or  such  part  of  such  in- 
formation as  may  at  the  time  be  ascertainable  and  such  supplemental  data 
as  may  be  necessary  to  establish  the  correct  tax. 

Returns  shall  be  made  in  all  cases  where  the  gross  estate  at  the  death 
of  the  decedent  exceeds  $50,000,  and  in  the  case  of  the  estate  of  every  non- 
resident any  part  of  whose  gross  estate  is  situated  in  the   United  States. 


1/92 


REVENUE   ACT    OF    1921 


If  the  executor  is  unable  to  make  a  complete  return  as  to  any  part  of  the 
gross  estate  of  the  decedent,  he  shall  include  in  his  return  a  description 
of  such  part  and  the  name  of  every  person  holding  a  legal  or  beneficial 
interest  therein,  and  upon  notice  from  the  collector  such  .person  shall 
in  like  manner  make  a  return  as  to  such  part  of  the  gross  estate.  The 
Commissioner  shall  make  all  assessments  of  the  tax  under  the  authority 
of  existing  administrative  special  and  general  provisions  of  law  relating 
to  the  assessment  and  collection  of  taxes. 

Sec.  405.  That  if  no  administration  is  granted  upon  the  estate  of  a 
decedent,  or  if  no  return  is  filed  as  provided  in  section  404,  or  if  a  return 
contains  a  false  or.  incorrect  statement  of  a  material  fact,  the  collector  or 
deputy  collector  shall  make  a  return  and  the  Commissioner  shall  assess 
the  tax  thereon. 

Sec.  406.  That  the  tax  shall  be  due  and  payable  one  year  after  the 
decedent's  death ;  but  in  any  case  where  the  Commissioner  finds  that  pay- 
ment of  the  tax  within  such  period  would  impose  undue  hardship  upon  the 
estate,  he  may  grant  an  extension  or  extensions  of  time  for  payment 
not  to  exceed  three  years  from  the  due  date. 

The  executor  shall  pay  the  tax  to  the  collector  or  deputy  collector, 
and  to  such  portion  of  the  tax,  not  paid  within  one  year  and  six  months 
after  the  decedent's  death,  interest  at  the  rate  of  6  per  centum  per  annum 
from  the  expiration  of  one  year  after  such  death  shall  be  added  as 
part  of  the  tax  irrespective  of  any  extension  or  extensions  of  time  that 
may  have  been  granted  for  the  payment  of  the  tax,  or  any  portion 
thereof. 

Sec.  407.  That  where  the  amount  of  tax  shown  upon  a  return  made 
in  good  faith  has  been  fully  paid,  or  time  for  payment  has  been  ex- 
tended, as  provided  in  section  406,  beyond  one  year  and  six  months  after 
the  decedent's  death,  and  an  additional  amount  of  tax  is,  after  the  ex- 
piration of  such  period  of  one  year  and  six  months,  found  to  be  due,  then 
such  additional  amount  shall  be  paid  upon  notice  and  demand  by  the 
collector,  and  if  it  remains  unpaid  for  one  month  after  such  notice  and 
demand  there  shall  be  added  as  part  of  the  tax  interest  on  such  additional 
amount  at  the  rate  of  10  per  centum  per  annum  from  the  expiration  of 
such  period  until  paid,  and  such  additional  tax  and  interest  shall,  until 
paid,  be  and  remain  a  lien  upon  the  entire  gross  estate. 

The  collector  shall  grant  to  the  person  paying  the  tax  duplicate  re- 
ceipts, either  of  which  shall  be  sufficient  evidence  of  such  payment,  and 
shall  entitle  the  executor  to  be  credited  and  allowed  the  amount  thereof 
by  any  court  having  jurisdiction  to  audit  or  settle  his  accounts. 

If  the  executor  files  a  complete  return  and  makes  written  application 
to  the  Commissioner  for  determination  of  the  amount  of  the  tax  and  dis- 
charge from  personal  liability  therefor,  the  Commissioner,  as  soon  as 
possible  and  in  any  event  within  one  year  after  receipt  of  such  application, 
shall  notifj^  the  executor  of  the  amount  of  the  tax,  and  upon  payment 
thereof   the  executor  shall  be  discharged   from   personal   liaibility   for  any 


I 
I 


REVENUE   ACT    OF    1921  1 793 

additional  tax  thereafter  found  to  be  due,  and  shall  be  entitled  to  receive 
a  receipt  or  writing  showing  such  discharge :  Provided,  however,  That  such 
discharge  shall  not  operate  to  release  the  gross  estate  from  the  lien  of 
any  additional  tax  that  may  hereafter  be  found  to  be  due  while  the  title 
to  such  gross  estate  remains  in  the  heirs,  devisees,  or  distributees  thereof ; 
but  no  part  of  such  gross  estate  shall  be  subject  to  such  lien  or  to  any 
claim  or  demand  for  any  such  tax  if  the  title  thereto  has  passed  to  a  bona 
fide  purchaser  for  value. 

Sec.  408.  That  if  the  tax  herein  imposed  is  not  paid  on  or  before 
the  due  date  thereof  the  collector  shall,  upon  instruction  from  the  Com- 
missioner, proceed  to  collect  t'he  tax  under  the  provisions  of  general  law, 
or  commence  appropriate  proceedings  in  any  court  of  the  United  States, 
in  the  name  of  the  United  States,  to  subject  the  property  of  the  decedent 
t'o  be  sold  under  the  judgment  or  decree  of  the  court.  From  the  proceeds 
of  such  sale  the  amount  of  the  tax,  together  with  the  costs  and  expenses 
of  every  description  to  be  allowed  by  the  court,  shall  be  first  paid,  and  the 
balance  shall  be  deposited  according  to  the  order  of  the  court,  to  be 
paid  under  its  direction  to  the  person  entitled  thereto. 

If  the  tax  or  any  part  thereof  is  paid  by,  or  collected  out  of  that 
part  of  the  estate  passing  to  or  in  the  possession  of,  any  person  other  than 
the  executor  in  his  capacity  as  such,  such  person  shall  be  entitled  to  re- 
imbursement out  of  any  part  of  the  estate  still  undistributed  or  by  a  just 
and  equitable  contribution  by  the  persons  whose  interest  in  the  estate 
of  the  decedent  would  have  been  reduced  if  the  tax  had  been  paid  before 
the  distribution  of  the  estate  or  whose  interest  is  subject  to  equal  or  prior 
liability  for  the  payment  of  taxes,  debts,  or  other  charges  against  the 
estate,  it  being  the  purpose  and  intent  of  this  title  that  so  far  as  is 
practicable  and  unless  otherwise  directed  by  the  will  of  the  decedent  the 
tax  shall  be  paid  out  of  the  estate  before  its  distribution.  If  any  part  of 
the  gross  estate  consists  of  proceeds  of  policies  of  insurance  upon  the  life 
of  the  decedent  receivable  by  a  beneficiary  other  than  the  executor,  the 
executor  shall  be  entitled  to  recover  from  such  beneficiary  such  portion 
of  the  total  tax  paid  as  the  proceeds,  in  excess  of  $40,000,  of  such  policies 
bear  to  the  net  estate.  If  there  is  more  than  one  such  beneficiary  the 
executor  shall  be  entitled  to  recover  from  such  beneficiaries  in  the  same 
ratio. 

Sec.  409.  That  unless  the  tax  is  sooner  paid  in  full,  it  shall  be  a  lien 
for  ten  years  upon  the  gross  estate  of  the  decedent,  except  that  such  part 
of  the  gross  estate  as  is  used  for  the  payment  of  charges  against  the 
estate  and  expenses  of  its  administration,  allowed  by  any  court  having 
jurisdiction  thereof,  shall  be  divested  of  such  lien.  If  the  Commissioner 
is  satisfied  that  the  tax  liability  of  an  estate  has  been  fully  discharged 
or  provided  for,  he  may,  under  regulations  prescribed  by  him  with  the 
approval  of  the  Secretary,  issue  his  certificate,  releasing  any  or  all  prop- 
erty of  such  estate  from  the  lien  herein  imposed. 

If   (a)   the  decedent  makes  a  transfer  of,  or  creates  a  trust  with  re- 


1794  REVENUE  ACT   OF   1921 

spect  to,  any  property  in  contemplation  of  or  intended  to  take  effect  in 
possession  or  enjoyment  at  or  after  his  death  (except  in  the  case  of  a 
bona  fide  sale  for  a  fair  consideration  in  money  or  money's  worth)  or  (b) 
if  insurance  passes  under  a  contract  executed  by  the  decedent  in  favor  of 
a  specific  beneficiary,  and  if  in  either  case  the  tax  in  respect  thereto  is 
not  paid  when  due,  then  the  transferee,  trustee,  or  beneficiary  shall  be 
personally  liable  for  such  tax,  and  such  property,  to  the  extent  of  the  de- 
cedent's interest  therein  at  the  time  of  such  transfer,  or  to  the  extent 
of  such  beneficiary's  interest  under  such  contract  of  insurance,  shall  be 
subject  to  a  like  lien  equal  to  the  amount  of  such  tax.  Any  part  of 
such  property  sold  by  such  transferee  or  trustee  to  a  bona  fide  purchaser 
for  a  fair  consideration  in  money  or  money's  worth  shall  be  divested  of 
the  lien  and  a  like  lien  shall  then  attach  to  all  the  property  of  such 
transferee  or  trustee,  except  any  part  sold  to  a  bona  fide  purchaser  for  a 
fair  consideration  in  money  or  money's  worth. 

Sec.  410.  That  whoever  knowingly  makes  any  false  statement  in  any 
notice  or  return  required  to  be  filed  under  this  title  shall  be  liable  to  a 
penalty  of  not  exceeding  $5,000,  or  imprisonment  not  exceeding  one  year, 
or  both. 

Whoever  fails  to  comply  with  any  duty  imposed  upon  him  by  section 
404,  or,  having  in  his  possession  or  control  any  record,  file,  or  paper, 
containing  or  supposed  to  contain  any  information  concerning  the  estate 
of  the  decedent,  or,  having  in  his  possession  or  control  any  property  com- 
prised in  the  gross  estate  of  the  decedent,  fails  to  exhibit  the  same  upon 
request  to  the  Commissioner  or  any  collector  or  law  officer  of  the  United 
States,  or  his  duly  authorized  deputy  or  agent,  who  desires  to  examine 
the  same  in  the  performance  of  his  duties  under  this  title,  shall  be  liable 
to  a  penalty  of  not  exceeding  $500,  to  be  recovered,  with  costs  of  suit, 
in  a  civil  action  in  the  name  of  the  United  States. 

Sec.  411.  (a)  That  the  term  "resident"  as  used  in  this  title  includes 
a  citizen  of  the  United  States  with  respect  to  whose  property  any  probate 
or  administration  proceedings  are  had  in  the  United  States  Court  for 
China.  Where  no  part  of  the  gross  estate  qf  such  decedent  is  situated  in 
the  United  States  at  the  time  of  his  death,  the  total  amount  of  tax  due 
under  this  title  shall  be  paid  to  or  collected  by  the  clerk  of  such  court, 
but  where  any  part  of  the  gross  estate  of  such  decedent  is  situated  in 
the  United  States  at  the  time  of  his  death,  the  tax  due  under  this  title 
shall  be  paid  to  or  collected  by  the  collector  of  the  district  in  which  is 
situated  the  part  of  the  gross  estate  in  the  United  States,  or,  if  such  part 
is  situated  in  more  than  one  district,  then  the  collector  of  such  district 
as  may  be  designated  by  the  Commissioner. 

(b)  For  the  purpose  of  this  section  the  clerk  of  the  United  States 
Court  for  China  shall  be  a  collector  for  the  territorial  jurisdiction  of  such 
court,  and  taxes  shall  be  collected  by  and  paid  to  him  in  the  same  manner 
and  subject  to  the  same  provisions  of  law,  including  penalties,  as  the 
taxes  collected  by  and  paid  to  a  collector  in  the  United  States. 


REVENUE   ACT   OF    1921  1 795 

(c)  The  proviso  in  the  Act  entitled  "An  Act  making  appropriation  for 
t'he  Diplomatic  and  Consular  Service  for  the  fiscal  year  ending  June  30, 
1921,"  approved  June  4,  1920,  which  reads  as  follows :  "Provided,  That 
in  probate  and  administration  proceedings  there  shall  be  collected  by  said 
clerk,  before  entering  the  order  of  final  distribution,  to  be  paid  into  the 
Treasury  of  the  United  States,  the  same  inheritance  taxes  from  time  to 
time  collected  under  the  laws  enacted  by  the  Congress  of  the  United 
States  from  the  estates  of  decedents  residing  within  the  territorial  juris- 
diction of  the  United  States,"  is  hereby  repealed.  • 

TITLE  X.— SPECIAL  TAXES. 

Capital  Stock  Tax 

Sec.  iooo.  (a)  That  on  and  after  July  i,  1922,  in  lieu  of  the  tax 
imposed  by  section  1000  of  the  Revenue  Act  of  1918 — 

(i)  Every  domestic  corporation  shall  pay  annually  a  special  excise 
tax  with  respect  to  carrying  on  or  doing  business,  equivalent  to  $1  for 
each  $1,000  of  so  much  of  the  fair  average  value  of  its  capital  stock  for 
the  preceding  year  ending  June  30  as  is  in  excess  of  $S,ooo.  In  estimating 
the  value  of  capital  stock  the  surplus  and  undivided  profits  shall  be  in- 
cluded ; 

(2)  Every  foreign  corporation  shall  pay  annually  a  special  excise 
fax  with  respect  to  carrying  on  or  doing  business  in  the  United  States, 
equivalent  to  $1  for  each  $1,000  of  the  average  amount  of  capital  employed 
in  the  transaction  of  its  business  in  the  United  States  during  the  preceding 
year  ending  June  30. 

(b)  The  taxes  imposed  by  this  section  shall  not  apply  in  any  year  to 
any  corporation  which  was  not  engaged  in  business  (or,  in  the  case  of  a 
foreign  corporation,  not  engaged  in  business  in  the  United  States)  during  the 
preceding  year  ending  June  30,  nor  to  any  corporation  enumerated  in 
section  231,  nor  to  any  insurance  company  subject  to  the  tax  imposed  by 
section  243  or  246. 

(c)  Section  257  shall  apply  to  all  returns  filed  with  the  Commissioner 
for  purposes  of  the  tax  imposed  by  this  section. 

TITLE     XIIL— GENERAL     ADMINISTRATIVE     PRO- 
VISIONS. 

Laws  Made  Applicable 

Sec.  1300.  That  all  administrative,  special,  or  stamp  provisions  of 
law,  including  the  law  relating  to  the  assessment  of  taxes,  so  far  as 
applicable,  are  hereby  extended  to  and  made  a  part  of  this  Act,  and  every 
person  liable  to  any  tax  imposed  by  this  Act,  or  for  the  collection  thereof, 
shall  keep  such  records  and  render,  under  oath,  such  statements  and  returns, 


1796  REVENUE   ACT    OF    1921 

and   shall    coniplj-   with   such   regulations  as   the   Commissioner,   with   the 
approval  of  the  Secretary,  may  from  time  to  time  prescribe. 

Penalties 

Sec.  1302.  (a)  That  any  person  required  under  Titles  V,  VI,  VII, 
VIII,  IX,  X,  or  XII,  to  pay,  or  to  collect,  account  for  and  pay  over  any 
tax,  or  required  by  law  or  regulations  made  under  authority  thereof  to 
make  a  return  or  supply  any  information  for  the  purposes  of  the  com- 
putation, assessment,  or  collection  of  any  such  tax,  who  fails  to  pay,  collect, 
or  truly  account  for  and  pay  over  any  such  tax,  make  any  such  return 
or  supply  any  such  information  at  the  time  or  times  required  by  law  or 
regulation  shall  in  addition  to  other  penalties  provided  by  law  be  subject 
to  a  penalty  of  not  more  than  $1,000. 

(b)  Any  person  who  willfully  refuses  to  pay,  collect,  or  truly  account 
for  and  pay  over  any  such  tax,  make  such  return  or  supply  such  informa- 
tion at  the  time  or  times  required  by  law  or  regulation,  or  who  w-illfully 
attempts  in  any  manner  to  evade  such  tax,  shall  be  guilty  of  a  mis- 
demeanor and  in  addition  to  other  penalties  provided  by  law  shall  be 
fined  not  more  than  $10,000  or  imprisoned  for  not  more  than  one  year, 
or  both,  together  with  the  costs  of  prosecution. 

(c)  Any  person  who  willfully  refuses  to  pay,  collect,  or  truly  account 
for  and  pay  over  any  such  tax  shall  in  addition  to  other  penalties  provided 
by  law  be  liable  to  a  penalty  of  the  amount  of  the  tax  evaded,  or  not  paid, 
collected,  or  accounted  for  and  paid  over,  to  be  assessed  and  collected  in 
the  same  manner  as  taxes  are  assessed  and  collected:  Provided,  Iwivever. 
That  no  penalty  shall  be  assessed  under  this  subdivision  for  any  offense 
for  which  a  penalty  may  be  assessed  under  authority  of  section  3176 
of  the  Revised  Statutes,  as  amended,  or  for  any  offense  for  which  a 
penalty  has  been  recovered  under  section  3256  of  the  Revised  Statutes. 

(d)  The  term  "person"  as  used  in  this  section  includes  an  officer  or 
employee  of  a  corporation  or  a  member  or  employee  of  a  partnership, 
who  as  such  officer,  employee,  or-  member  is  under  a  duty  to  perform  the 
act  in  respect  of  which  the  violation  occurs.     ■ 

Rules  and  Regulations 

Sec.  1303.  That  the  Commissioner,  with  the  approval  of  the  Secretary, 
is  hereby  authorized  to  make  all  needful  rules  and  regulations  for  the 
enforcement  of  the  provisions  of  this  Act. 

The  Commissioner,  with  such  approval  may  by  regulation  provide  that 
any  return  required  by  Titles  V,  VI,  VII,  VIII,  IX,  or  X  to  be  under 
oath  may,  if  the  amount  of  the  tax  covered  thereby  is  not  in  excess  of 
$10,  be  signed  or  acknowledged  before  two  witnesses  instead  of  under  oath. 

Fractional  Parts  of  a  Cent 

Sec.  1306.  That  in  the  paynieiU  of  any  ta.\  under  this  Act  not  payable 
by  stamp  a  fractional  part  of  a  cent  shall  be  disregarded  unless  it  amounts 
to  one-half  cent  or  more,  in  which  case  it  shall  be  increased  to  i  cent. 


REVENUE    ACT    OF    1921  1797 

Returns 

Sec.  1307.  That  whenever  in  the  judgment  of  the  Commissioner  neces- 
sary he  may  require  any  person,  by  notice  served  upon  him,  to  make  a 
return  or  such  statements  as  he  deems  sufficient  to  show  whether  or  not 
such  person  is  Hable  to  tax. 

Examination  of  Books  and  Witnesses 

Sec.  1308.  That  the  Commissioner,  for  the  purpose  of  ascertaining  the 
correctness  of  any  return  or  for  the  purpose  of  making  a  return  where 
none  has  been  made,  is  hereby  authorized,  by  any  revenue  agent  or  inspector 
designated  by  him  for  that  purpose,  to  examine  any  books,  papers,  records, 
or  memoranda  bearing  upon  the  matters  required  to  be  included  in  the 
return,  and  may  require  the  attendance  of  the  person  rendering  the  return 
or  of  any  officer  or  employee  of  such  person,  or  the  attendance  of  any 
other  person  having  knowledge  in  the  premises,  and  may  take  his  testimony 
with  reference  to  the  matter  required  by  law  to  be  included  in  such  return, 
with  power  to  administer  oaths  to  such  person  or  persons. 

Unnecessary  Examinations 

Sec.  1309.  That  no  taxpayer  shall  be  subjected  to  unnecessary  examin- 
ations or  investigations,  and  only  one  inspection  of  a  taxpayer's  books  of 
account  shall  be  made  for  each  taxable  year  unless  the  taxpayer  requests 
otherwise  or  unless  the  Commissioner,  after  investigation,  notifies  the  tax- 
payer in  writing  that  an  additional  inspection  is  necessary. 

Jurisdiction  of  Courts 

Sec.  1310.  (a)  That  if  any  person  is  summoned  under  this  Act  to 
appear,  to  testify,  or  to  produce  books,  paper  or  other  data,  the  district 
court  of  the  United  States  for  the  district  in  which  such  person  resides 
shall  have  jurisdiction  bv  appropriate  process  to  compel  such  attendance, 
testimony,  or  production  of  books,  papers,  or  other  data. 

(b)  The  district  courts  of  the  United  States  at  the  instance  of  the 
United  States  are  hereby  invested  with  such  jurisdiction  to  make  and 
issue,  both  in  actions  at  law  and  suits  in  equity,  writs  and  orders  of  in- 
junction, and  of  ne  exeat  republica,  orders  appointing  receivers,  and  such 
other  orders  and  process,  and  to  render  such  judgments  and  decrees, 
granting  in  proper  cases  both  legal  and  equitable  relief  together,  as  may 
be  necessary  or  appropriate  for  the  enforcement  of  the  provisions  of  this 
Act.  The  remedies  hereby  provided  are  in  addition  to  and  not  exclusive 
of  any  and  all  other  remedies  of  the  United  States  in  such  courts  or 
otherwise  to  enforce  such  provisions. 

(c)  Paragraph  Twentieth  of  section  24  of  the  Judicial  Code  is  amended 
by  adding  at  the  end  thereof  the  following  new  paragraph : 

"Concurrent  with  the  Court  of  Claims,  of  any  suit  or  proceeding, 
commenced  after  the  passage  of  the  Revenue  Act  of  1921,  for  the  recovery 
of  any  infernal-revenue  tax  alleged  to  have  been  erroneously  or  illegally 
assessed   or  collected,  or  of  any  penalty  claimed  to  have   been   collected 


1798  REVENUE   ACT   OF    1921 

without  authority  or  any  sum  alleged  to  have  been  excessive  or  in  any 
manner  wrongfully  collected,  under  the  internal-revenue  laws,  even  if  the 
claim  exceeds  $10,000,  if  the  collector  of  internal-revenue  by  whom  such 
tax,  penalty,  or  sum  was  collected  is  dead  at  the  time  such  suit  or  pro- 
ceeding is  commenced." 

Amendments  to  Revised  Statutes 

Sec.  131 1.  That  sections  3164,  3165,  3167,  3172,  3173  and  3176  of  the 
Revised  Statutes,  as  amended,  are  reenacted,  without  change,  as  follows : 

"Sec.  3164.  It  shall  be  the  duty  of  every  collector  of  internal  revenue 
having  knowledge  of  any  willful  violation  of  any  law  of  the  United 
States  relating  to  the  revenue,  within  thirty  days  after  coming  into 
possession  of  such  knowledge,  to  file  with  the  district  attorney  of  the 
district  in  which  any  fine,  penalty,  or  forfeiture  may  be  incurred,  a  state- 
ment of  all  the  facts  and  circumstances  of  the  case  within  his  knowledge, 
together  with  the  names  of  the  witnesses,  setting  forth  the  provisions  of 
law  believed  to  be  so  violated  on  which  reliance  may  be  had  for  con- 
demnation or  conviction. 

"Sec.  3165.  Every  collector,  deputy  collector,  internal-revenue  agent, 
and  internal-revenue  officer  assigned  to  duty  under  an  internal-revenue 
agent,  is  authorized  to  administer  oaths  and  to  take  evidence  touching 
any  part  of  the  administration  of  the  internal-revenue  laws  with  which 
he  is  charged,  or  where  such  oaths  and  evidence  are  authorized  by  law  or 
regulation  authorized  by  law  to  be  taken. 

"Sec.  3167.  It  shall  be  unlawful  for  any  collector,  deputy  collector, 
agent,  clerk,  or  other  officer  or  employee  of  the  United  States  to  divulge 
or  to  make  known  in  any  manner  whatever  not  provided  by  law  to  any 
person  the  operations,  style  of  work,  or  apparatus  of  any  manufacturer 
or  producer  visited  by  him  in  the  discharge  of  his  official  duties,  or  the 
amount  or  source  of  income,  profits,  losses,  expenditures,  or  any  particular 
thereof,  set  forth  or  disclosed  in  any  income  return,  or  to  permit  any 
income  return  or  copy  thereof  or  any  book  containing  anj'  abstract  or 
particulars  thereof  to  be  seen  or  examined  by  any  person  except  as 
provided  by  law;  and  it  shall  be  unlawful  for  any  person  to  print  or 
publish  in  any  manner  whatever  not  provided  by  law  any  income  return, 
or  any  part  thereof  or  source  of  income,  profits,  losses,  or  expenditures 
appearing  in  any  income  return ;  and  any  offense  against  the  foregoing 
provision  shall  be  a  misdemeanor  and  be  punished  by  a  fine  not  exceeding 
$1,000  or  by  imprisonment  not  exceeding  one  year,  or  both,  at  the  dis- 
cretion of  the  court ;  and  if  the  offender  be  an  officer  or  employee  of  the 
United  States  he  shall  be  dismissed  from  office  or  discharged  from  em- 
ployment. 

"Sec.  3172.  Every  collector  shall,  from  time  to  time,  cause  his  deputies 
to  proceed  through  every  part  of  his  district  and  inquire  after  and  con- 
cerning all  persons  therein  who  are  liable  to  pay  any  internal-revenue  tax, 
and  all  persons  owning  or  having  the  care  and  management  of  any  objects 


REVENUE   ACT   OF   1921  1799 

liable  to  pay  any  tax,  and  to  make  a  list  of  such  persons  and  enumerate 
said  objects. 

"Sec.  3173.  It  shall  be  the  duty  of  any  person,  partnership,  firm,  as- 
sociation, or  corporation,  made  liable  to  any  duty,  special  tax,  or  other 
tax  imposed  by  law,  when  not  otherwise  provided  for,  (i)  in  case  of  a 
special  tax,  on  or  before  the  thirty-first  day  of  July  in  each  year,  and  (2) 
in  other  cases  before  the  day  on  which  the  taxes  accrue,  to  make  a  list 
or  return,  verified  by  oath,  to  the  collector  or  a  deputy  collector  of  the 
district  where  located,  of  the  articles  or  objects,  including  the  quantity 
of  goods,  wares,  and  merchandise,  made  or  sold  and  charged  with  a  tax, 
the  several  rates  and  aggregate  amount',  according  to  the  forms  and 
regulations  to  be  prescribed  by  the  Commissioner  of  Internal  Revenue, 
with  the  approval  of  the  Secretary  of  the  Treasury,  for  which  such  person, 
partnership,  firm,  association,  or  corporation  is  liable:  Provided^  That  if 
any  person  liable  to  pay  any  duty  or  fax,  or  owning,  possessing,  or  having 
the  care  or  management  of  property,  goods,  wares,  and  merchandise,  articles 
or  objects  liable  to  pay  any  duty,  tax,  or  license,  shall  fail  to  make  and  ex- 
hibit a  list  or  return  required  by  law,  but  shall  consent  to  disclose  the 
particulars  of  any  and  all  the  property,  goods,  wares,  and  merchandise, 
articles,  and  objects  liable  to  pay  any  duty  or  tax,  or  any  business  or 
occupation  liable  to  pay  any  tax  as  aforesaid,  then,  and  in  that  case,  it 
shall  be  the  duty  of  the  collector  or  deputy  collector  to  make  such  list  or 
return,  which,  being  distinctly  read,  consented  to,  and  signed  and  verified 
by  oath  by  the  person  so  owning,  possessing,  or  having  the  care  and 
management  as  aforesaid,  may  be  received  as  the  list  of  such  person : 
Provided  further.  That  in  case  no  annual  list  or  return  has  been  rendered 
by  such  person  to  the  collector  or  deputy  collector  as  required  by  law,  and 
the  person  shall  be  absent  from  his  or  her  residence  or  place  of  business 
at  the  time  the  collector  or  a  deputy  collector  shall  call  for  the  annual  list 
or  return,  it  shall  be  the  duty  of  such  collector  or  deputy  collector  to 
leave  at  such  place  of  residence  or  business,  with  some  one  of  suitable  age 
and  discretion,  if  such  be  present,  otherwise  to  deposit  in  the  nearest  post 
office,  a  note  or  memorandum,  addressed  to  such  person,  requiring  him  or 
her  to  render  to  such  collector  or  deputy  collector  the  list  or  return  re- 
quired by  law  within  ten  days  from  the  date  of  such  note  or  memorandum, 
verified  by  oath.  And  if  any  person,  on  being  notified  or  required  as  afore- 
said, shall  refuse  or  neglect  to  render  such  list  or  return  within  the 
time  required  as  aforesaid,  or  whenever  any  person  who  is  required  to 
deliver  a  monthly  or  other  return  of  objects  subject  to  tax  fails  to  do  so 
at  the  time  required,  or  delivers  any  return  which,  in  the  opinion  of  the 
collector,  is  erroneous,  false,  or  fraudulent,  or  contains  any  undervaluation 
or  understatement,  or  refuses  to  allow  any  regularly  authorized  Govern- 
ment officer  to  examine  the  books  of  such  person,  firm,  or  corporation,  it 
shall  be  unlawful  for  the  collector  to  summon  such  person,  or  any  other 
person  having  possession,  custody,  or  care  of  books  of  account  containing 
entries  relating  to  the  business  of  such  person  or  any  other  person  he  may 


l8oo  REVENUE   ACT    OF    1921 

deem  proper,  to  appear  before  him  and  produce  such  books  at  a  time  and 
place  named  in  the  summons,  and  to  give  testimony  or  answer  inter- 
rogatories, under  oath,  respecting  any  objects  or  income  Hable  fo  tax  or 
the  returns  thereof.  The  collector  may  summon  any  person  residing  or 
found  within  the  State  or  Territory  in  which  his  district  lies ;  and  when 
the  person  intended  to  be  summoned  does  not  reside  and  can  not  be 
found  within  such  State  or  Territory,  he  may  enter  any  collection  district 
where  such  person  may  be  found  and  there  make  the  examination  herein 
authorized.  And  to  this  end  he  may  there  exercise  all  the  authority  which 
he  might  lawfully  exercise  in  the  district  for  which  he  was  commissioned : 
Provided,  That  'person,'  as  used  in  this  section,  shall  be  construed  to  in- 
clude any  corporation,  joint-stock  company  or  association,  or  insurance 
company  when  such  construction  is  necessary  to  carry  out  its  provisions. 

"Sec.  3176.  If  any  person,  corporation,  company,  or  association  fails 
to  make  and  file  a  return  or  list  at  the  time  prescribed  by  law  or  by  regu- 
lation made  under  authority  of  law,  or  makes,  willfully  or  otherwise,  a 
false  or  fraudulent  return  or  list,  the  collector  or  deputy  collector  shall 
make  the  return  or  list  from  his  own  knowledge  and  from  such  information 
as  he  can  obtain  through  testimony  or  otherwise.  In  any  such  case  the 
Commissioner  may,  from  his  own  knowledge  and  from  such  information  as 
he  can  obtain  through  testimony  or  otherwise,  make  a  return  or  amend 
any  return  made  by  a  collector  or  deputy  collector.  Any  return  or  list 
so  made  and  subscribed  by  the  Commisioner,  or  by  a  collector  or  deputy 
collector  and  approved  by  the  Commissioner,  shall  be  prima  facie  good 
and  sufficient  for  all  legal  purposes. 

"If  the  failure  to  file  a  return  or  list  is  due  to  sickness  or  absence,  the 
collector  may  allow  such  further  time,  not  exceeding  thirty  days,  for 
making  and  filing  the  return  or  list  as  he  deems  proper. 

"The  Commissioner  of  Internal  Revenue  shall  determine  and  assess 
all  taxes,  other  than  stamp  taxes,  as  to  which  returns  or  lists  are  so  made 
under  the  provisions  of  this  section.  In  case  of  any  failure  to  make  and 
file  a  return  or  list  within  the  time  prescribed  by  law,  or  prescribed  by 
the  Commissioner  of  Internal  Revenue  or  the  collector  in  pursuance  of  law, 
the  Commissioner  of  Internal  Revenue  shall  add  to  the  tax  25  per  centum 
of  its  amount,  except  that  when  a  return  is  filed  after  such  time  and  it  is 
shown  that  the  failure  to  file  it  was  due  to  a  reasonable  cause  and  not 
to  willful  neglect,  no  such  addition  shall  be  made  to  the  tax.  In  case  a 
false  and  fraudulent  return  or  list  is  willfully  made,  the  Commissioner 
of  Internal  Revenue  shall  add  to  the  tax  50  per  centum  of  its  amount. 

"The  amount  so  added  to  any  tax  shall  be  collected  at  the  same  time 
and  in  the  same  manner  and  as  a  part  of  the  tax  unless  the  tax  has  been 
paid  before  the  discovery  of  the  neglect,  falsity,  or  fraud,  in  which  case 
the  amount  so  added  shall  be  collected  in  the  same  manner  as  the  tax." 

Final  Determinations  and  Assessments 

Sec.   1312.     That  if  after  a  determination  and   assessment   in  any  case 


REVENUE   ACT    OF    1921  1801 

the  taxpayer  lias  without  protest  paid  in  wliole  any  tax  or  penalty,  or 
accepted  any  abatement,  credit,  or  refund  based  on  such  determination  and 
assessment,  and  an  agreement  is  made  in  writing  between  the  taxpayer  and 
the  Commissioner,  with  the  approval  of  t'he  Secretary,  that  such  determin- 
ation and  assessment  shall  be  final  and  conclusive,  then  (except  upon  a 
showing  of  fraud  or  malfeasance  or  misrepresentation  of  fact  materially 
affecting  the  determination  or  assessment  thus  made)  (r)  the  case  shall 
not  be  reopened  or  the  determination  and  assessment  modified  by  any 
officer,  employee,  or  agent  of  the  United  States,  and  (2)  no  suit,  action, 
or  proceeding  to  annul,  modify,  or  set  aside  such  determination  or  assess- 
ment shall  be  entertained  by  any  court  of  the  United  States. 

Administrative  Review 

Sec.  1313.  That  in  the  absence  of  fraud  or  mistake  in  mathematical 
calculation,  the  findings  of  facts  in  and  the  decision  of  the  Commissioner 
upon  (or  in  case  the  Secretary  is  authorized  to  approve  the  same,  then 
after  such  approval)  the  merits  of  any  claim  presented  under  or  authorized 
by  the  internal-revenue  laws  shall  not  be  subject  to  review  by  any  other 
administrative  officer,  employee,  or  agent  of  the  United  States. 

Retroactive  Regulations 

Sec.  1314.  That  in  case  a  regulation  or  Treasury  decision  relating  to 
the  internal-revenue  laws  made  by  the  Commissioner  or  the  Secretary,  or  by 
the  Commissioner  with  the  approval  of  the  Secretary,  is  reversed  by  a 
subsequent  regulation  or  Treasury  decision,  and  such  reversal  is  not  im- 
mediately occasioned  or  required  by  a  decision  of  a  court  of  competent 
jurisdiction,  such  subsequent  regulation  or  Treasury  decision  may,  in  the 
discretion  of  the  Commissioner,  with  the  approval  of  the  Secretary,  be 
applied  without  retroactive  effect. 

Refunds 

Sec.  1315.  That  section  3220  of  the  Revised  Statutes,  as  amended,  is 
reenacted  without  change,  as  follows  : 

"Sec.  3220.  The  Commissioner  of  Internal  Revenue,  subject  to  reg- 
ulations prescribed  by  the  Secretary  of  the  Treasury,  is  authorized  to  remit, 
refund,  and  pay  back  all  taxes  erroneously  or  illegally  assessed  or  collected, 
all  penalties  collected  without  authority,  and  all  taxes  that  appear  to  be 
unjustly  assessed  or  excessive  in  amount,  or  -in  any  manner  wrongfully 
collected ;  also  to  repay  to  any  collector  or  deputy  collector  the  full  amount 
of  such  sums  of  money  as  may  be  recovered  against  him  in  any  court,  for 
any  internal  revenue  taxes  collected  by  him,  with  the  cost  and  expenses 
of  suit;  also  all  damages  and  costs  recovered  against  any  assessor,  assistant 
assessor,  collector,  deputy  collector,  agent,  or  inspector,  in  any  suit  brought 
against  him  by  reason  of  anything  done  in  the  due  performance  of  his 
official  duty,  and  shall  make  report  to  Congress  at  the  beginning  of  each 
regular  session  of  Congress  of  al!   transactions  under  this  section." 


i8o2  REVENUE  ACT   OF   1921 

Sec.  1316.  That  section  3228  of  the  Revised  Statutes  is  amended  to 
read  as  follows : 

"Sec.  3228.  All  claims  for  the  refunding  or  crediting  of  any  internal 
revenue  tax  alleged  to  have  been  erroneously  or  illegally  assessed  or  col- 
lected, or  of  any  penalty  alleged  to  have  been  collected  without  authority, 
or  of  any  sum  alleged  to  have  been  excessive  or  in  any  manner  wrong- 
fully collected,  must  be  presented  to  the  Commissioner  of  Internal  Revenue 
within  four  years  next  after  payment  of  such  tax,  penalty,  or  sum." 

This  section,  except  as  modified  by  section  252,  shall  apply  retroactively 
to  claims  for  refund  under  the  Revenue  Act  of  1916,  the  Revenue  Act 
of  1917,  and  the  Revenue  Act  of  1918. 

Sec.  1317.  That  the  paragraph  of  section  3689  of  the  Revised  Statutes, 
as  amended,  reading  as  follows:  "Refunding  taxes  illegally  collected  (in- 
ternal revenue)  :  To  refund  and  pay  back  duties  erroneously  or  illegally 
assessed  or  collected  under  the  internal  revenue  laws,"  is  repealed  from 
and  after  June  30,  1920;  and  the  Secretary  and  Treasury  shall  submit  for 
the  fiscal  year  1921  and  annually  thereafter,  an  estimate  of  appropriations 
to  refund  and  pay  back  duties  or  taxes  erroneously  or  illegally  assessed 
or  collected  under  the  internal-revenue  laws,  and  to  pay  judgments,  including 
interest  and  costs,  rendered  for  taxes  or  penalties  erroneously  or  illegally 
assessed  or  collected  under  the  internal-revenue  laws. 

Limitations  upon  Suits  and  Prosecutions 

Sec.  1318.  That  section  3226  of  the  Revised  Statutes  is  amended  to 
read  as  follows : 

"Sec.  3226.  No  suit  or  proceeding  shall  be  maintained  in  any  court 
for  the  recovery  of  any  internal-revenue  tax  alleged  to  have  been  erro- 
neously or  illegally  assessed  or  collected,  or  of  any  penalty  claimed  to  have 
been  collected  without  authority,  or  of  any  sum  alleged  to  have  been 
excessive  or  in  any  manner  wrongfully  collected,  until  a  claim  for  refund 
or  credit  has  been  duly  filed  with  the  Commissioner  of  Internal  Revenue, 
according  to  the  provisions  of  law  in  that  regard,  and  the  regulations 
of  the  Secretary  of  the  Treasury  established  in  pursuance  thereof.  No 
such  suit  or  proceeding  shall  be  begun  before  the  expiration  of  six  months 
from  the  date  of  filing  such  claim  unless  the  Commissioner  renders  a 
decision  thereon  within  that  time,  nor  after  the  expiration  of  five  years 
from  the  date  of  the  payment  of  such  tax  penalty,  or  sum." 

This  section  shall  not  affect  any  suit  or  proceeding  instituted  prior  to 
the  passage  of  this  Act,  but  shall  apply  to  all  suits  and  proceedings  in- 
stituted after  the  passage  of  this  Act,  whether  or  not  barred  by  prior 
Acts  of  Congress. 

Sec.  1319.  That  section  3227  of  the  Revised  Statutes  is  hereby  repealed 
but  such  repeal  shall  not  affect  any  suit  or  proceeding  instituted  prior 
to  the  passage  of  this  Act. 

Sec.  1320.  That  no  suit  or  proceeding  for  the  collection  of  any  in- 
ternal revenue  tax  shall  be  begun  after  the  expiration  of  five  years  from 


REVENUE  ACT   OF   1921  1803 

the  time  such  tax  was  due,  except  in  the  case  of  fraud  with  intent  to  evade 
tax,  or  willful  attention  in  any  manner  to  defeat  or  evade  tax.  This  sec- 
tion shall  not  apply  to  suits  or  proceedings  for  the  collection  of  taxes 
under  section  250  of  this  Act,  nor  fo  suits  or  proceedings  begun  at  the 
time  of  the  passage  of  this  Act. 

Sec.  1321.  (a)  That  the  Act  entitled  "An  Act  to  limit  the  time 
within  which  prosecutions  may  be  instituted  against  persons  charged  with 
violating  internal-revenue  laws,"  approved  July  5,  1884,  is  amended  to 
read  as  follows : 

"That  no  person  shall  be  prosecuted,  tried,  or  punished  for  any  of 
the  various  offenses  arising  under  the  internal-revenue  laws  of  the  United 
States  unless  the  indictment  is  found  or  the  information  instituted  within 
three  years  next  after  the  commission  of  the  offense:  Provided,  That  the 
time  during  which  the  person  committing  the  offense  is  absent  from  the 
district  wherein  the  same  is  committed  shall  not  be  taken  as  any  part 
of  the  time  limited  by  law  for  the  commencement  of  such  proceedings : 
Provided  further,  That  the  provisions  of  this  Act  shall  not  apply  to  offenses 
committed  prior  to  its  passage :  Provided  further.  That  where  a  complaint 
shall  be  instituted  before  a  commissioner  of  the  United  States  within  the 
period  above  limited,  the  time  shall  be  extended  until  the  discharge  of  the 
grand  jury  at  its  next  session  within  the  district:  And  provided  further, 
That  this  Act  shall  not  apply  to  offenses  committed  by  oflficers  of  the 
United  States." 

(b)  Any  prosecution  or  proceeding  under  an  indictment  found  or  in- 
formation instituted  prior  to  the  passage  of  this  Act  shall  not  be  affected 
in  any  manner  by  this  amendment,  but  such  prosecution  or  proceeding 
shall  be  subject  to  the  limitations  imposed  by  law  prior  to  the  passage 
of  this  Act. 

Assessments 

Sec.  1322.  That  all  infernal  revenue  taxes,  except  as  provided  in  section 
250  of  this  Act,  shall,  notwithstanding  the  provisions  of  section  3182  of 
the  Revised  Statutes  or  any  other  provision  of  law,  be  assessed  within 
four  years  after  such  taxes  became  due,  but  in  the  case  of  fraud  with 
intent  to  evade  tax  or  willful  attempt  in  any  manner  to  defeat  or  evade 
tax,  such  tax  may  be  assessed  at  any  time. 

Fraudulent  Returns 

Sec.  1323.  That  section  3225  of  the  Revised  Statutes  of  the  United 
States,  as  amended,  is  reenacted  without  change  as  follows : 

"Sec.  3225.  When  a  second  assessment  is  made  in  case  of  any  list, 
statement,  or  return,  which  in  the  opinion  of  the  collector  or  deputy 
collector  was  false  or  fraudulent,  or  contained  any  understatement  or  un- 
dervaluation, such  assessment  shall  not  be  remitted,  nor  shall  taxes 
collected  under  such  assessment  be  refunded  or  paid  back,  or  recovered  by 
any  iuit,  Holess  it  is  proved  that  such  list,  statement,  or  return  was  not 


l8o4  REVENUE    ACT    OF    1921 

willfully  false  or  fraudulent  and  did  not  contain  any  willful  understatement 
or  undervaluation." 

Interest  on  Refunds  and  Judgments 

Sec.  1324.  (a)  That  upon  the  allowance  of  a  claim  for  the  refund 
of  or  credit  for  internal  revenue  taxes  paid,  interest  shall  be  allowed  and 
paid  upon  the  total  amount  of  such  refund  or  credit  at  the  rate  of  one- 
half  of  I  per  centum  per  month  to  the  date  of  such  allowance,  as  follows : 
(i)  if  such  amount  was  paid  under  a  specific  protest  setting  forth  in 
detail  the  basis  of  and  reasons  for  such  protest,  from  the  time  when  such 
tax  was  paid,  or  (2)  if  such  amount  was  not  paid  under  protest  but  pur- 
suant to  an  additional  assessment,  from  the  time  such  additional  assessment 
was  paid,  or  (3)  if  no  protest  was  made  and  the  tax  was  not  paid 
pursuant  to  an  additional  assessment,  from  six  months  after  the  date  of 
filing  of  such  claim  for  refund  or  credit.  The  term  "additional  assess- 
ment" as  used  in  this  section  means  a  further  assessment  for  a  tax  of 
the  same  character  previously  paid  in  part. 

(b)  Section  177  of  the  Judicial  Code  is  amended  to  read  as  follows: 
"Sec.  177.  No  interest  shall  be  allowed  on  any  claim  up  to  the  time  of 
the  rendition  of  judgment  by  the  Court  of  Claims,  unless  upon  a  contract 
expressly  stipulating  for  the  payment  of  interest,  except  that  interest  may 
be  allowed  in  any  judgment  of  any  court  rendered  after  the  passage  of 
the  Revenue  Act  of  1921  against  the  United  States  for  any  internal-revenue 
tax  erroneously  or  illegally  assessed  or  collected,  or  for  any  penalty  col- 
lected without  authority  or  any  sum  which  was  excessive  or  in  any  manner 
wrongfully  collected,  under  the  internal-revenue  laws." 

Payment  of  Taxes  by  Check  or  United  States  Securities 

Sec.  1325.  That  collectors  may  receive,  at  par  with  an  adjustment  for 
accrued  interest',  notes  or  certificates  of  indebtedness  issued  by  the  United 
States  and' uncertified  checks  in  payment  of  income,  war-profits  and  excess- 
profits  taxes  and  any  other  taxes  payable  other  than  by  stamp,  during 
such  time  and  under  such  regulations  as  the  Commissioner,  with  the 
approval  of  the  Secretary,  shall  prescribe ;  but  if  a  check  so  received  is 
not  paid  by  the  bank  on  which  it  is  drawn  the  person  by  whom  such 
check  has  been  tendered  shall  remain  liable  for  the  payment  of  the  tax 
and  for  all  legal  penalties  and  additions  the  same  as  if  such  check  had  not 
been  tendered. 

Frauds  on  Purchasers 

Sec.  1326.  That  whoever  in  connection  with  the  sale  of  lease,  or  offer 
for  sale  or  lease,  of  any  article,  or  for  the  purpose  of  making  such  sale 
or  lease,  makes  any  statement,  written  or  oral,  (i)  intended  or  calculated 
to  lead  any  person  to  believe  that  any  part  of  the  price  at  which  such' 
article  is  sold  or  leased,  or  offered  for  sale  or  lease,  consists  of  a  tax 
imposed  under  the   authority   of   the   United   States,   or    (2)    ascribing   a 


REVENUE   ACT   OF    1921  1805 

particular  part  of  such  price  to  a  tax  imposed  under  the  authority  of  the 
United  States,  knowing  that  such  statement  is  false  or  that  the  tax  is 
not  so  great  as  the  portion  of  such  price  ascribed  to  such  tax,  shall  be 
guilty  of  a  misdemeanor  and  upon  conviction  thereof  shall  be  punished  by 
a  fine  of  not  more  than  $1,000  or  by  imprisonment  not  exceeding  one 
year,  or  both. 

Tax  Simplification  Board 

Sec.  1327.  (a)  That  there  is  hereby  established  in  the  Department 
of  the  Treasury  a  board  to  be  known  as  the  "Tax  Simplification  Board" 
(hereinafter  in  this  section  called  the  "Board"),  to  be  composed  as  follows: 

(i)  Three  members  who  shall  represent  the  public,  to  be  appointed  by 
the  President;  and 

(2)  Three  members  who  shall  represent  the  Bureau  of  Internal 
Revenue  and  shall  be  officers  or  employees  of  the  United  States  serving 
in  such  Bureau,  to  be  appointed  by  the  Secretary. 

(b)  Any  vacancy  in  the  Board  shall  be  filled  in  the  same  manner  as 
the  original  appointment.  The  members  representing  the  public  shall 
serve  without  compensation  except  reimbursement  for  traveling,  sub- 
sistence, and  other  necessary  expenses  incurred  in  the  performance  of  the 
duties  vested  in  them  by  this  section.  The  members  representing  the 
Bureau  of  Internal  Revenue  shall  serve  without  compensation  in  addition 
to  that  received  for  their  service  in  such  Bureau. 

(c)  The  Secretary  shall  furnish  the  Board  with  such  clerical  assist- 
ance, quarters  and  stationery,  furniture,  office  equipment,  and  other  sup- 
plies as  may  be  necessary  for  the  performance  of  the  duties  vested  in  them 
by  this  section. 

(d)  It  shall  be  the  duty  of  the  Board  to  investigate  the  procedure  of 
and  the  forms  used  by  the  Bureau  in  the  administration  of  the  internal 
revenue  laws,  and  to  make  recommendations  in  respect  to  the  simplification 
thereof.  The  Board  shall  make  a  report  to  the  Congress  on  or  before 
the  first  Monday  of  December  in  each  year. 

(e)  The  expenditures  of  the  Board  shall  be  paid  upon  vouchers  ap- 
proved by  the  Board  and  signed  by  the  chairman  thereof.  For  the  ex- 
penditures of  the  Board  for  the  fiscal  year  ending  June  30,  1922,  there  is 
authorized  to  be  appropriated,  out  of  any  money  in  the  Treasury  not 
otherwise  appropriated,  the  sum  of  $10,000. 

(f)  The  Board  shall  cease  to  exist  on  December  31,  1924. 

Consolidation  of  Liberty  Bond  Tax  Exemptions 

Sec.  1328.  That  the  various  Acts  authorizing  the  issues  of  Liberty 
bonds  are  amended  and  supplemented  as  follows : 

(a)  On  and  after  January  i,  1921,  4  per  centum  and  4^4  per  centum 
Liberty  bonds  shall  be  exempt  from  graduated  additional  income  taxes, 
commonly  known  as  surtaxes,  and  excess-profits  and  war-profits  taxes, 
now    or    hereafter    imposed    by    the    United    States    upon    the    inc(jme    or 


i8o6  REVENUE  ACT   OF  1921 

profits  of  individuals,  partnerships,  corporations,  or  associations  in  respect 
to  the  interest  on  aggregate  principal  amounts  thereof  as  follows: 

9  Until  the  expiration  of  two  years  after  the  date  of  the  termination 
of  the  war  between  the  United  States  and  the  German  Government,  as 
fixed  by  proclamation  of  the  President,  on  $125,000  aggregate  principal 
amount ;  and  for  three  years  more  on  $50,000  aggregate  principal  amount. 

(b)  The  exemptions  provided  in  subdivision  (a)  shall  be  in  addition 
to  the  exemptions  provided  in  section  7  of  the  Second  Liberty  Bond  Act, 
and  in  addition  to  the  exemption  provided  in  subdivision  (3)  of  section  I 
of  the  Supplement  to  the  Second  Liberty  Bond  Act  in  respect  to  bonds 
issued  upon  conversion  of  3]4  per  centum  bonds,  but  shall  be  in  lieu  of 
the  exemptions  provided  and  free  from  the  conditions  and  limitations  im- 
posed in  subdivisions  (i)  and  (2)  of  section  i  of  the  Supplement  to 
Second  Liberty  Bond  Act  and  in  section  2  of  the  Victory  Liberty 
Loan  Act. 

Deposit  of  United  States  Bonds  or  Notes  in  Lieu  of  Surety 

Sec.  1329.  That  wherever  by  the  laws  of  the  United  States  or  regula- 
tions made  pursuant  thereto,  any  person  is  required  to  furnish  any 
recognizance,  stipulation,  bond,  guaranty,  or  undertaking,  hereinafter  called 
"penal  bond,"  with  surety  or  sureties,  such  person  may,  in  lieu  of  such 
surety  or  sureties,  deposit  as  security  with  the  official  having  authority  to 
approve  such  penal  bond,  United  States  Liberty  bonds  or  other  bonds 
or  notes  of  the  United  States  in  a  sum  equal  at  their  par  value  to  the 
amount  of  such  penal  bond  required  to  be  furnished,  together  with  an 
agreement  authorizing  such  official  to  collect  or  sell  such  bonds  or  notes 
so  deposited  in  case  of  any  default  in  the  performance  of  any  of  the 
conditions  or  stipulations  of  such  penal  bond.  The  acceptance  of  such 
United  States  bonds  or  notes  in  lieu  of  surety  or  sureties  required  by  law 
shall  have  the  same  force  and  effect  as  individual  or  corporate  sureties,  or 
certified  checks,  bank  drafts,  post-office  money  orders,  or  cash,  for  the 
penalty  or  amount  of  such  penal  bond.  The  bonds  or  notes  deposited  here- 
under and  such  other  United  States  bonds  or  notes  as  may  be  sub- 
stituted therefor  from  time  to  time  as  such  security,  may  be  deposited 
with  the  Treasurer  of  the  United  States,  a  Federal  reserve  bank,  or  other 
depositary  duly  designated  for  that  purpose  by  the  Secretary,  which  shall 
issue  receipt  therefor,  describing  such  bonds  or  notes  so  deposited.  As 
soon  as  security  for  the  performance  of  such  penal  bond  is  no  longer 
necessary,  such  bonds  or  notes  so  deposited,  shall  be  returned  to  the 
depositor :  Provided,  That  in  case  a  person  or  persons  supplying  a  con- 
tractor with  labor  or  material  as  provided  by  the  Act  of  Congress,  ap- 
proved February  24,  1905  (33  Stat.  811),  entitled  "An  Act  to  amend  an 
Act  approved  August  thirteenth,  eighteen  hundred  and  ninety-four,  en- 
titled 'An  Act  for  the  protection  of  persons  furnishing  materials  and 
labor  for  the  construction  of  public  works,' "  shall  file  with  the  obligee, 
at  any  time  after  a  default  in  the  performance  of  any  contract  subject  to 


REVENUE   ACT   OF   1921  1807 

said  Acts,  the  application  and  affidavit  therein  provided,  the  obligee  shall 
not  deliver  to  the  obligor  the  deposited  bonds  or  notes  nor  any  surplus 
proceeds  thereof  until  the  expiration  of  the  time  limited  by  said  Acts 
for  the  institution  of  suit  by  such  person  or  persons,  and,  in  case  suit  shall  be 
instituted  within  such  time,  shall  hold  said  bonds  or  notes  or  proceeds 
subject  to  the  order  of  the  court  having  jurisdiction  thereof:  Provided 
further.  That  nothing  herein  contained  shall  afifect  or  impair  the  priority 
of  the  claim  of  the  United  States  against  the  bonds  or  notes  deposited  or 
any  right  or  remedy  granted  by  said  Acts  or  by  this  section  to  the  United 
States  for  default  upon  any  obligation  of  said  penal  bonds :  Proznded 
further.  That  all  laws  inconsistent  with  this  section  are  hereby  so  modified 
as  to  conform  to  the  provisions  hereof :  And  provided  further.  That  nothing 
contained  herein  shall  affect  the  authority  of  courts  over  the  security,  where 
such  bonds  are  taken  as  security  in  judicial  proceedings,  or  the  authority 
of  any  administrative  officer  of  the  United  States  to  receive  United  States 
bonds  for  security  in  cases  authorized  by  existing  laws.  The  Secretary 
may  prescribe  rules  and  regulations  necessary  and  proper  for  carrying 
this  section  into  effect. 

Lost  Stamps  for  Tobacco,  Cigars,  and  So  Forth 

Sec.  1330.  That  section  3315  of  the  Revised  Statutes,  as  amended,  is 
reenacted  without  change,  as  follows : 

"Sec.  3315.  The  Commissioner  of  Internal  Revenue  may,  under  regu- 
lations prescribed  by  him  with  the  approval  of  the  Secretary  of  the 
Treasury,  issue  stamps  for  restamping  packages  of  distilled  spirits,  to- 
bacco, cigars,  snuff,  cigarettes,  fermented  liquors,  and  wines  which  have 
been  duly  stamped  but  from  which  the  stamps  have  been  lost  or  destroyed 
by  unavoidable  accident." 

Consolidated  Returns  for  Year  1917 

Sec.  1331.  (a)  That  Title  II  of  the  Revenue  Act  of  1917  shall  be 
construed  to  impose  the  taxes  therein  mentioned  upon  the  basis  of  consoli- 
dated returns  of  net  income  and  invested  capital  in  the  case  of  domestic  cor- 
porations and  domestic  partnerships  that  were  affiliated  during  the  cal- 
endar year  1917. 

(b)  For  the  purpose  of  this  section  a  corporation  or  partnership  was 
affiliated  with  one  or  more  corporations  or  partnerships  (i)  when  such 
corporation  or  partnership  owned  directly  or  controlled  through  closely 
affiliated  interests  or  by  a  nominee  or  nominees  all  or  substantially  all  the 
stock  of  the  other  or  others,  or  (2)  when  substantially  all  the  stock  of  two 
or  more  corporations  or  the  business  of  two  or  more  partnerships  was 
owned  by  the  same  interests :  Provided,  That  such  corporations  or  partner- 
ships were  engaged  in  the  same  or  a  closely  related  business,  or  one  cor- 
poration or  partnership  bought  from  or  sold  to  another  corporation  or 
partnership  products  or  services  at  prices  above  or  below  the  current  mar- 
ket, thus  effecting  an  artificial  distribution  of  profits,  or  one  corporation  or 


REVENUE   ACT    OF    1921 

partnership  in  any  way  so  arranged  its  financial  relationships  with  another 
corporation  or  partnership  as  to  assign  to  it  a  disproportionate  share  of 
net  income  or  invested  capital.  For  the  purposes  of  this  section,  public 
service  corporations  which  (i)  were  operated  independently,  (2)  were 
not  physically  connected  or  merged  and  (3)  did  not  receive  special  per- 
mission to  make  a  consolidated  return,  shall  not  be  construed  to  have  been 
affiliated ;  but  a  railroad  or  other  public  utility  which  was  owned  by  an  in- 
dustrial corporation  and  was  operated  as  a  plant  facility  or  as  an  integral 
part  of  a  group  organization  of  affiliated  corporations  which  were  re- 
quired to  file  a  consolidated  return,  shall  be  construed  to  have  been 
affiliated. 

(c)  The  provisions  of  this  section  are  declaratory  of  the  provisions  of 
Title  II  of  the  Revenue  Act  of  1917. 

Alternative  Tax  on  Personal  Service  Corporations 

Sec.  1332.  (a)  That  if  either  subdivision  (e)  of  section  218  of  the 
Revenue  Act  of  1918  or  subdivision  (d)  of  section  218  of  this  Act  is  by 
final  adjudication  declared  invalid,  there  shall,  in  addition  to  all  other  taxes, 
be  levied,  collected,  and  paid  on  the  net  income  (as  defined  in  section 
2^2)  received  during  the  calendar  years  1918,  1919,  1920,  and  1921,  by 
every  personal  service  corporation  (as  defined  in  section  200)  included 
within  the  provisions  of  such  subdivisions,  a  tax  equal  to  the  taxes  imposed 
by  Titles  II  and  III  of  the  Revenue  Act  of  1918  and,  in  the  case  of  income 
received  during  the  calendar  year  1921,  by  Titles  II  and  III  of  this  Act. 

(b)  In  such  event  every  such  personal  service  corporation  shall,  on  or 
before  the  fifteenth  day  of  the  sixth  month  following  the  date  of  entry 
of  decree  upon  such  final  adjudication,  make  a  return  of  any  income  re- 
ceived during  each  of  the  calendar  years  1918,  1919,  1920,  and  1921  in  the 
manner  prescribed  by  the  Revenue  Act  of  1918  (or  in  the  manner  prescribed 
by  this  Act,  in  the  case  of  income  received  during  the  calendar  year 
1921).  Such  return  shall  be  made  and  the  net  income  shall  be  computed  on 
the  basis  of  the  taxpayer's  annual  accounting  period  (fiscal  year  or  calen- 
dar year,  as  the  case  may  be)  in  the  manner  provided  for  other  corpora- 
tions under  the  Revenue  Act  of  1918  and  this  Act. 

(c)  If  either  subdivision  (e)  of  section  218  of  the  Revenue  Act  of 
1918  or  subdivision  (d)  of  section  218  of  this  Act  is  so  declared  invalid, 
claims  for  credit  or  refund  of  taxes  paid  under  both  such  sections  shall 
be  allowed,  if  made  within  the  time  provided  in  subdivision  (f)  of  this 
section. 

(d)  In  case  the  claims  for  credit  or  refund,  filed  within  six  months 
from  such  date  of  entry  of  decree,  represent  less  than  30  per  centum 
of  the  outstanding  stock  or  shares  in  the  corporation,  the  amount  of  taxes 
imposed  by  this  section  upon  such  corporation  shall  be  reduced  to  that 
proportion  thereof  which  the  number  of  stock  or  shares  owned  by  the 
shareholders  or  members  making  such  claims  bears  to  the  total  number 
of  stock  or  shares  outstanding. 


REVENUE   ACT    OF    1921  1 809 

(e)  The  tax  imposed  by  this  section  shall  be  assessed,  collected,  and 
paid  upon  the  same  basis,  in  the  same  manner,  and  subject  to  the  same  pro- 
visions of  law,  including  penalties,  as  the  taxes  imposed  by  sections  230 
and  301  of  the  Revenue  Act  of  1918  (or  by  sections  230  and  301  of  this 
Act,  in  the  case  of  income  received  during  the  calendar  year  1921),  but  no 
interest  or  penalties  shall  be  due  or  payable  thereon  for  any  period  prior 
to  the  date  upon  which  the  return  is  by  this  section  required  to  be  made  and 
the  first  installment  paid.  The  amount  of  tax  paid  by  any  shareholder  or 
member  of  a  personal  service  corporation  pursuant  to  the  provisions  of 
subdivision  (e)  of  section  218  of  the  Revenue  Act  of  1918  or  subdivision 
(d)  of  section  218  of  this  Act  shall  be  credited  against  the  tax  due  from 
such  corporation  under  this  section  upon  the  joint  written  application  of 
such  corporation  and  such  shareholder  or  member  of  his  representatives, 
heirs,  or  assigns,  if  such  application  is  filed  with  the  Commissioner  within 
six  months  from  such  date  of  entry  of  decree. 

(f)  Notwithstanding  any  other  provision  of  law,  no  claim  for  a  credit 
or  refund  of  taxes  paid  under  subdivision  (e)  of  section  218  of  the  Reve- 
nue Act  of  1918  or  subdivision  (d)  of  section  218  of  this  Act,  may  be 
filed  after  the  expiration  of  six  months  from  such  date  of  entry  of  de- 
cree :  Provided,  however.  That  a  personal  service  corporation  of  which 
no  shareholder  or  member  has  filed  such  claim  within  such  period  of  six 
months  shall  not  be  subject  to  the  tax  imposed  by  this  section. 


TITLE  XIV.— GENERAL  PROVISIONS 

Repeals 

Sec.  1400.  (a)  That  the  following  parts  of  the  Revenue  Act  of  1918 
are  repealed,  to  take  effect  (except  as  otherwise  provided  in  this  Act)  on 
January  i,  1922,  subject  to  the  limitations  provided  in  subdivision   (b)  : 

Title  II  (called  "Income  Tax")  as  of  January  i,  1921 ; 

Title  III  (called  "War-Profits  and  Excess-Profits  Tax")  as  of  Jan- 
uary  I,   1921 ; 

Title  IV  (called  "Estate  Tax")  on  the  passage  of  this  Act; 

Title  X  (called  "Special  Taxes")  ; 

Sections  1314,  1315,  1316,  1317,  1319,  and  1320  of  Title  XIII  (Ijeing 
certain  administrative  provisions)   on  the  passage  of  this  Act. 

(b)  The  parts  of  the  Revenue  Act  of  1918  which  are  repealed  by  tliis 
Act  shall  (unless  otherwise  specifically  provided  in  this  Act)  remain  in 
force  for  the  assessment  and  collection  of  all  taxes  whicli  have  accrued 
under  the  Revenue  Act  of  1918  at  the  time  such  parts  cease  to  be  in  effect, 
and  for  the  imposition  and  collection  of  all  penalties  or  forfeitures  which 
have  accrued  or  may  accrue  in  relation  to  any  such  taxes.  In  the  case  of  any 
tax  imposed  by  any  part  of  the  Revenue  Act  of  1918  repealed'  by  this 
Act,  if  there  is  a  tax  imposed  by  this  Act  in  lieu  thereof,  the  provision 
imposing  such  tax  shall  remain  in  force  until  the  corresponding  tax  under 


l8io  REVENUE  ACT   OF   1921 

this  Act  takes  effect  under  the  provisions  of  this  Act.  The  unexpended 
balance  of  any  appropriation  heretofore  made  and  now  available  for  the 
administration  of  any  such  part  of  the  Revenue  Act  of  1918  shall  be  avail- 
able for  the  administration  of  this  Act  or  the  corresponding  provision 
thereof. 

Increase  in  Treasury  Savings  Certificate  Limit 

Sec.  1402.  That  section  6  of  the  Second  Liberty  Bond  Act,  as  amended, 
is  amended  by  striking  out  in  the  next  to  the  last  sentence  thereof  the 
figures  "$i,ooo"  and  inserting  in  Heu  thereof  the  figures  "$5,000." 

Saving  Clause  in  Event  of  Unconstitutionality 

Sec.  1403.  That  if  any  provision  of  this  Act,  or  the  application  thereof 
to  any  person  or  circumstances,  is  held  invalid,  the  remainder  of  the  Act, 
and  the  application  of  such  provision  to  other  persons  or  circumstances, 
shall  not  be  affected  thereby. 

Effective  Date  of  Act, 

Sec.  1404.  That  except  as  otherwise  provided,  this  Act  shall  take  ef- 
fect upon  its  passage. 

Approved,  November  23,  1921,  at  3.55  p.  m. 


INDEX  TO  SECTIONS  OF  INCOME  TAX  LAW 
AND  REVISED  STATUTES 

(Principal  references  in  heavy  faced  type) 
Section  of  Law  Page  Reference 

2 I27I 

200  ( I ) 64 

(2) ' 1326 

(3) ■ 324 

(4) 383,  847 

(5) 531,  823 

201  (a) 705»  713 

(b) 716,  728,  747,  991 

(c) 748,  751 

(d) 764 

(e) 707 

(f ) 728 

202  (a)  ( I ) 456 

(2) 519,  619,  622 

(3) 625 

(b)  (I) 569 

(2) 570 

(3) 570 

(c)  (i) 535,  545 

(2) 535,  556,  557 

(3) 536,  560 

(d)  (I) 590 

(2) 505 

(3) 591 

(e) 592 

(f) 488 

203 452 

204  (a) 1023 

?b) 804,  1022 

(c) 804,  1028,  1364 

(d)  .  .  . 1026,   1364 

205  (a) 163 

(b) 165 

(c) 791 

206  (a)  (1-6) 628 

(b) 628 

(c) 804 

1811 


l8i2  INDEX   TO    SECTIONS    OF   LAW 

Section  of  Law  Page  Reference 

210 155,  1297 

211  (a)  (1-2) 156 

(b) 159 

212  (b) 64,  379,  847,  1332 

(c) 65 

213  (a) 401,  446,  640,  661,  693,  703 

(b)  (i) 352,  522 

(2) 354 

(3) 355,  518 

(4) 359,  681 

(5) •* 364,  952 

(6) 351,  444 

(7) 50 

(9) 351.  411 

(10) 362,  671 

(11) 363,  422 

(12) 363 

(c) 1276 

214  (a)  (i) 852,  864.  870 

(2) 923 

(3) 938 

(4) 977 

(5) 977,  994 

(6) 860,  978 

(7) 1030 

(8) 1050,  1 130 

(9) 199,  1150 

(10) 1167 

(11) 1241 

(12) 504 

(b) 1292 

215  (a)  (i) 853 

(2) 853,  1051 

(3) 853,  1051 

(4) 853,  894 

(b) 1371 

216  (a) 347,  704 

(b) 350 

(c) 171,  338 

(d) 338 

(e) 1295 

(0 343 

217  (a)  (i) 1278 

(2) 1279 

(3-5) 1280 


INDEX   TO    SECTIONS    OF   LAW  1813 

Section  of  Law  Page  Reference 

(e) 1281 

218  (a) 798 

(b) 800 

(c) 799 

(d) 814,  820 

219  (a)  (i) 1329 

(2-4) 1330 

C^) 1335,  1338.  1365 

(c) 1347,  1349,  1368 

(d) 1349 

(e) 1357 

(0 1375 

220 1260 

221  (a) 1306 

(b) 323.  324.  327,  33i»  1307 

(c) 328 

222  (a)  (1-3)  .  . 942 

(4) 943.  1368 

(5) 943 

(b-d) 943 

223  (a)  (1-3) 75 

(b)  (1-2) 78 

(c) 77 

224 788,  1302 

225  (a)  (1-5) 1330 

(b) 1335 

226  (a) 69 

(b) 70 

(c) 70,  167 

22^   (a) 54.  55,  1304.  1331 

(b) 63,  1304 

228 143 

229 796,  1657 

230  (a) 161,  1297 

(b) 161,  1297 

231  (i) 34 

(2) 35 

(3) 36,  1401 

(4) 37 

(5) 39 

(6) 39 

(7) 43 

(8) 43 

(9) 44 

(10) 1401 


i8i4  INDEX   TO    SECTIONS    OF   LAW 

Section  of  Law  Page  Reference 

(ii) 44 

(12) 46 

(13)-. • 46 

(14) 46 

233  (a) 518,  522,  1394 

(b) 1277 

234  (a)  (I) 852 

(2) 923 

(3) 679,  931,  939 

(4) 978 

(5) 1030 

(6) 760,  1612 

(7) 1050 

(8) 1150 

(9) "67 

(10) 1396 

(II) 1398 

(12) 1400 

(13) 1400 

(14) 504 

(b) 1292 

235 853 

236  (a) 350 

(b) 172,  346,  1629 

(c)  (i) 940 

(2) 941 

-^zi 327,  1307 

238  (a) 947 

(b-d) 943 

(e) 948 

(f ) 948 

239  (a) 90,  100,  102,  1328 

(c) 104 

240  (a) 106,  108,  1628 

(b) 209,  1633 

(d) 789,  1303,  1629,  1631 

(e) 1574,  1628 

241  (a) 1304 

(b) 63,  1304 

242 1378 

243 • 1379 

244  (a) 1380 

(b) 1381 

245  (a)  (i) 1380 

(2). 1381 


INDEX  TO   SECTIONS   OF  LAW  1815 

Section  of  Law  Page  Reference 

(3) 1382 

(4) 1382 

(5) 1383 

(6) 1384 

(7) 1383 

(8) 1385 

(9) 1386 

(b) 1385 

(c) 1386 

246  (a) 1387 

(b)  (i) 1388 

(2) 1389 

(3) 1388 

(4) 1388 

(5) 1389 

(6) 1391 

(7) 1390 

247  (a)  (i) 1390 

(2) 1391 

(3) 1391 

(4) 1391 

(5) 1392 

(6) 1392 

(7) 1392 

(8) 1393 

(9) 1393 

(b) 1394 

250  (a) 217 

(b) i35»  140,  209 

(c) 223 

(d) 195,  198,  202,  208,  241 

(e) 144.  218,  243,  1357 

(f) 227 

(g) 214,  1298 

(h) 1299 

251 229 

252 255,  262,  277 

253 132,  i37»  144 

254 105,  301 

255 302 

256 292,  294,  298,  318,  320 

257 115.  121,  123,  126 

258 126 

259 320,  1321 

260 1322 


i8i6         INDEX  TO  SECTIONS  OF  LAW 

Section  of  Law  Page  Reference 

261 .  1323 

262  (a) 1324 

(1-2) 1324 

(3) 1325 

(b) ; 1325 

301  (b) :- 1572 

304  (c) 1568 

320 231 

325  (a) 1612 

328  (b) 1640 

335  (a) 1573,  1579 

(b) 1580 

401 1425.  1430 

402  (a) 1432 

(b) 1454 

(c) 1457 

(d) 1461 

(e) 1462 

(f) 1465 

403  (a)  (i) 1468 

(2) 1477 

(3) 1476.  1480 

(4) 1484 

(b)  (1-2) i486 

(3) 1485,  i486,  1513 

404 1489.  1496 

405 1503 

406 1504 

407 1521 

408 1522,  1523 

409 1507.  1508 

410 1510 

411 1516 

1000  (a)  (i) 1528,  1533,  1537,  1548 

(2) 1555 

(b) 1535 

1300 ' 53 

1303 54 

1307 54 

1308 113 

1309 182 

1310  (a) 113 

(b) 113 

(c) 268 


INDEX   TO    SECTIONS    OF   LAW  1817 

Section  of  Law  Page  Reference 

1311 56,  125,  131,  132,  134,  173,  174,  194,  1503 

1312 210 

1313 211 

1314 182,  240 

1315 262 

1316 Ill,  257 

1317 275 

1318 263 

1321  (a) 152 

(b) 153 

1323 276 

1324  (a) 271 

(b) 272 

1325 224 

1327  (a-f) 179 

1328 683 

1331  (a-c) 1627 

1332  (a-f) 815 

1400 1515 

Revised  Statutes 

1046 153 

1047 152 

3224 249 

3467 1514 


INDEX  TO  ARTICLES  OF   REGULATIONS   62 

(Also  Regulations  37  and  50) 
(Principal  references  indicated  in  heavy  faced  type) 

Article  Numbers  Page  References 

12 159 

13 159 

21 376 

22 375,  380,  849 

23 379.   385,  847,  849 

24 380,  1086 

25 66 

26 71 

32 402,  414,  420,  444,  890,  892 

33 430,  431,  438,  891 

34 437 

36 449 

37 411 

38 1408 

39 55o>    587 

40 652 

41 549 

42 488 

43 503 

44 498 

45 498 

46 500 

47 676,  677,  758 

48 694 

49 506 

50 519,    1006 

51 513,  532,  649,  1045 

52 388 

53 388,  662,  673 

72 351,  354,  444 

73 355,  368 

74 360,  665 

75 361,  691 

76 362,  705 

82 685 

83 683 

84 689 

1819 


l820         INDEX   TO    ARTICLES    OF    REGULATIONS   62 

Article  Numbers  Page  References 

85 686 

86 364,  95^.  1285 

87 51,  918 

88 366,  404-  413 

89 672,  1286,  1395 

90 377.  417-  663,  676 

91 916 

92 1276 

93 1289 

94 1285 

lOI 896 

loia 864 

103 911.  1058 

104 862 

105 875 

106 734.  882 

107 883,  887 

108 888 

109 701,  903,  906,  1099 

no 141  o,  141 2 

III no,  381,  919 

121 924,  926,  931 

122 932 

131 957.  971 

132 958,  959 

133 967 

134 962 

135 957 

141 803.  1002 

142 997»  998 

143 1 134 

144 986,  988 

145 1410,  1414.  1415,  1416 

146 981 

147 •• 994 

151 452,  1030,  1037,  1040,  1043,  1045,  1047 

152 1036,  1037 

153 1044 

154 1038,  1039 

155 1031 

161 1055,  1131 

162 1056,  1057,  1058.  1088,  1095,  1098 

163 1097 

164 1068,  1071 

165 1075 


INDEX    TO   ARTICLES    OF   REGULATIONS   62         1821 

Article  Numbers  Page  References 

166 1081,  1089 

167 mo,  iiii,  1112 

168 1115 

169 1065 

170 1072 

171 1413 

181 531,  1151,  1159 

182 1160 

183 1154,  1158 

184 1160 

185 1162 

186 , 1164 

187 1165 

188 1166 

189 1 166 

201 1 172,  1 173,  121 1,  12 16 

202 1215 

203 1224 

204 1217 

205 1 1 74 

206 1175,  1178,  1181,  1182,  1186 

207 1 193 

208 1 183 

210 1208 

215 645,  1221,  1223 

216 1213 

217 1214 

219 1 194.  1 196 

222 1 104 

224 1 105 

225 1 107 

227 1234 

229 1234 

230 1235 

231 1 119 

232 1120 

233 1236 

234 1237 

235 1238 

236 1239 

251 1244,  1246,  1247,  1248 

261 507 

262 508 

263 509 

291 861,  863,  867,  869,  870,  893.  896 


l822         INDEX   TO   ARTICLES    OF   REGULATIONS   62 

Article  Numbers  Page  References 

292 855 

293 648,  650,  891,  909,  913,  990,  1064,  1360 

294 895 

295 986,  1371 

302 340 

303 343 

304-  .  • 340 

305 1333 

306 1296 

311 1271 

311a 1273 

312 , 1272,  1517 

313 1272 

314 1275 

315 1316 

317 1279 

319 1280 

320 1296 

323 1 282 

324 1293 

325 1294 

326 1281 

327 1282 

328 1284 

329 1295 

331 790 

332 791,  804 

333 800 

334 791 

335 • 793,  794 

336 819 

337 821 

338 819,  822 

339 838 

341 1338,  1352 

342 1338 

343 1335,  1358 

344  1348 

345 1350 

346 345,  1368 

347 1369 

348 1375 

351 1261 

352 1261 

353 1262 


INDEX   TO   ARTICLES   OF   REGULATIONS   62         1823 

Article  Numbers  Page  References 

361 337 

362 294,  1310 

364 1313 

365 306,  318,  1309 

366 310 

367 310 

368 310 

369 311 

370 315 

371 298,  1318 

372 1311 

373 299 

374 314.  1344 

375 1319.  1320 

382 951 

383 953 

384 955 

385 945 

401 75 

402 78 

403 84 

404 1297,  1299 

405 705,  1301 

406 78 

407 73,  138 

411 1302 

412 , 788 

421 1330 

422 1339 

423 1340 

424 102,  1341 

425 1300,  1344 

431 72 

442 1333 

443 57 

444 58 

445 59 

446 54,  60,  63 

447 86 

451 144 

511 47 

512 35 

513 35 

514 36 


l824         INDEX    TO   ARTICLES    OF   REGULATIONS   62 

Article  Numbers  Page  References 

515 37 

516 39 

517 39 

518 43 

519 43 

520 44 

521 1402 

522 45.  758,  1412 

531 846 

541 522,  640 

542 • 670 

543 -524,  909,  1017 

544 520 

545 523,  669,  1014 

546 573 

547 699 

548 221 

549 • 1394 

550 1278 

562 915.  1249 

563 926,  979,  1016.  1017 

564 926,  932 

565 928,  971 

567 902 

568 1390 

569 : 1396 

570 1399 

571 1400 

572 1400 

573 1293 

581 1086 

582 908,  909 

601 1308,  1320 

611 955 

612 951 

621 96,  221 

622 102,  1341 

623 1405 

624 818 

625 100,  1302 

634 100 

637 789,  1629 

651 55 

661 1379 

671 1 380 


INDEX   TO    ARTICLES    OF    REGULATIONS   62         1825 

Article  Numbers  Page  References 

681 1381 

682 1383 

683 1383 

684 1384 

685 1385 

686 1385 

687 1386 

691 1387 

692 1389 

693 1391 

7Z'2' 1577 

733 1577 

751 1379 

870 1620 

912 1641 

913 1642 

1003 146 

1004 133 

1005 140 

1006 202 

1007 219 

1009 231 

loio • 232 

loi  1 233 

IOI2 194 

IOI4 227 

1032 245 

1034 277 

1035 278 

1036 252 

IO5I 274 

1055 138,  321 

1060 • 105,  302 

1065 302 

IO7I 293 

1072 295 

1073 303 

1074 309 

1075 301.  1320 

1076 300 

1077 316 

1078 317 

1079 299 

1080 317 

1090 n6,  ii8,  119,  120 


1826         INDEX   TO   ARTICLES    OF   REGULATIONS   62 

Article  Numbers  Page  References 

091 117,  120 

092 122 

093 124 

loi 127 

III 320,  1322 

121 1322,  1323 

132 368,  1323 

133 1323 

502 91 

503 92 

504 1328 

505 811 

506 811 

507 • 785 

508 1378 

509 787,  1271 

510 103 

521 1326 

522 77.  1327 

523 825 

524 828 

525 829 

526 833 

527 832 

528 834 

529 837 

530 837 

531 835 

532 836 

533 383,  1309 

541 706,  707.  740 

542 728 

543 • 716,  991 

544 750 

545 749 

546 744 

547 734,  739/  74i 

548 751.  771,  774 

561 570»  596,  984 

562 619 

563 620 

564 536,  537 

566 544,  545,  556,  561 

567 590,  591 

568 594 


INDEX   TO   ARTICLES    OF   REGULATIONS   62         1827 

Article  Numbers  Page  References 

1570 797,  806 

1581 453,  454,  470 

1582 457,  467 

1583 460 

1584 464 

1585 481 

1586 1416 

1588 476 

1601 1023 

1602 1029 

1604 1026 

1605 1025 

1623 163 

1624 165 

1651 629,  633,  1280 

1652 638 

1653 804 

1721 172 

1731 225 

1 732 226 

1736 816 

Regulations  37 

4 1429 

5 1429 

8 1426 

9 1430 

10 1431 

II 1432 

12 1433 

13 1433 

14 1435 

15 1437,  1439,  1443,  1444,  1445,  1446,  1447 

16 1448 

17 1447,  1449 

18 1449 

19 1438 

20 1452 

21 1456 

22 1457 

23 1457 

24 1459 

25 1460 

26 1460 


l828         INDEX    TO    ARTICLES    OF    REGULATIONS    37 

Artiij..  .m.  .'.iijiiivo  Page  References 

27 1461 

30 1463 

31 1464 

32 1465 

33 14S7 

34 1467 

^6 1468 

37 1469 

38 1469 

39 1470 

40 1470 

41 M7I 

42 147^ 

43 1472 

44 1473 

45 1473 

46 1473 

47 1474 

48 1474 

49 1436,  1474 

51 1480 

52 1479 

53 1481 

54 m8i 

55 1483 

56 1484 

57 H84 

58 1484 

59 1487 

61 1487 

63 1487 

64 1488 

65 1489 

67 1489 

68 1490 

69 1491 

7'^ 1491 

7' 1492 

7- 1492 

73 1493 

74 1493 

75 1494 

75  (a) 1494 

/6 1494.  1495 

77 1497 


INDEX   TO    ARTICLES    OF   REGULATIONS    37  jgoq 

AuTiCLE  Numbers  Pace  References 

78 1497 

79 1498 

80 1499 

81 1500 

82 1501 

83 1501 

84 1501 

85 1502 

86 1502 

87 1503 

88 1501 

89 1503 

90 1504 

91 1505.  1506 

92 1518 

93 1518 

94 1520 

95 1520 

96 1520 

97 1522 

98 1506 

99 1509 

100 1509 

loi 1507 

102 1510 

103 1510 

104 1510 

105 1511 

106 151 1 

107 1511 

108 1512 

109 1512 

no 1512 

III 1513 

112 1512 

114 1514 

115 1514 

116 1522 

117 1514 

118 1514 

119 1515 

120 1515 

I2T I516 


1830    INDEX  TO  ARTICLES  OF  REGULATIONS  50 

Article  Numbers  Page  References 

Regulations  .so 

1 1528 

2 1529 

3 1531 

4 1532 

5 1532 

6 1531 

7 1531 

8 1529 

9 1555 

10 1533.  1561 

II 1534 

12 1535 

13 1538 

14 1539 

15 1539 

16 1548 

17 1555 

18 1556 

19 1557 

20 1556 

21 1557 

26 1536 

28 1537 

30 1559 

31 1538 

32 1558 

33 1548 

34 1549 

35 1550 

36 1553 

37 1559 

39 1560 

40 1560 

41 1555 

42 1554 

43 1554 


GENERAL  INDEX 

[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


'v-2    Letter, 
Foi-  additional  tax  payments,  201 
nATEHEN'T  Claims  (See  "Ciaimsfor  Abate- 
ment") 

ir.-iENCE, 

Additional   time   allowed,    21 S 
I'enaities  waived  for,   150 
vxouKTiNG    Methods, 
(See    also    "Computation    of    tax") 
Accrual    basis,    933 

Former    Procedure,    934 
Amortization,    1164 
Bad   debts,    1032 
Chnni-jes    in,    384 
Claims   for   incorrect,    1 1 1 
Conversion   of   property,    506-508 
Deductions,    847 

Uninsured   losses,    loii 
Depletion, 

Deductible   even   if   not   on   books,    1215 

Mineral    property,    1213-1214 
Depreciation,    1052,   1067 
Desirability  of  good,  848 
Farmers,     141 9 

Accrual  basis,    1420 
Gross    income   from   business.   447 
Holding  companies,   losses,    1018 

Former    procedure,     1019 
Income   from   business,    448-449 
Individuals,    383,   448 

Apportioning   income   from   joint   owner- 
ship of   U.   S.   bonds,   688-690 
Instalment    sales,    487-504 
Inventories,  467 
Liberty  bonds. 

Accrual    of    interest,    C87 
Net  losses,   computation,    1 024-1 026 
Non-resident   aliens. 

Apportionment  of   deductions,    1294 
Obsolescence,    1133 
Partnership, 

Cash   or  accrual  basis,   806 

Distributive  share  of  net  income,   790 

Fiscal   years,    791-796 

Gifts,  800 
Patents,  650 
Personal   service   corporations. 

Losses    of    subsidiary,    829 
■  Procedure,    379-391 
Reconciled   with   returns,    162 
Segregation  of  lump  sum  purchasps.    lo'.? 
Separate    ledger    account,     lAheriy    '    •   ' 

interest,   687 


.\cc'ii;nting   Methods — {Ciittiniied) 
"Short   sales"   inventories,   4S3 
Treasury  stock,   525-527 
Accounting  Period, 

Amortization  claims,    1162 
Change  by  individual,  69 

Former   procedure,   70 
Changes   in,    69,    163-171 

For  fiduciaries,    1332 
1 921   law,    66,   448 

Notice  of  change  must  be   iiim,   ;  >  ,  . 
Partnerships,    87,    805 

Former  procedure,  88 
Penalties  for  failure  to  report  changes,  b8 
Procedure  for  changing,  70 

Former   procedure,    70 
Recognition  as  taxable   year,   67 
Twelve    months    established    period,    72 
Accounts   Payable, 

Inventoried    on    basis    of    cost    or    market. 

Accounts    Receivable,   452 

Inventoried    on    basis    of    cost    or    iiKirkct, 

393 
'Suspense  account,"   517 
Uncollectible,    as    bad    debts,    452 
Uncollectible,    because    of    moratorium    in 

Cuba,    1043 
When   taxable,   538 
Accrual  of  Income, 

Adjustments  on  amended  returns,  381 
Amounts  paid  differ  from,  955 
Change    from    cash    to,    384 
Deductions  determined  Ijy,  8(7,  854,  933 

Former   procedure,   9,-i4 
Interest  accrued,  when  not  deductible.  934 
New  York  State  franchise  tax,  973 
New   York   State  income  tax,  973 
Permitted   for   deductions,    972 
Permitted  in  accounting  procedure,  413 
Rents,   693 

Sale    of    property    ac(iuired    before    Marv.-!i 
'.    1913.    377 
A'\  RUED    Expenses, 

Deductible,   853 
AiCRUEU   OR   Paid, 
Farm  accounts,   1420 

'■  '        ■   '  n  indebtedness  of  bfc  insurance 
^s,    1385 
'    .lii'sitii','  net  income,  379,  381 
'<'■  inpanics  not  deduct 

.   ■'      l<K-KU-Ai.s. 

■riptive   of   depreciation,    1050 


[See  also  Estate,  Capital  liiock,  and  Excess  Proiils  Indexes] 


i834 


GENERAL   INDEX 


Acreage,    Un drilled    (See   also    "Undrilled 
Acreage  of  Wells") 

Helping  the   South,   96-99 
Ad   Valorem    Penalties, 

Fraudulent   returns,    134 
Additional  Tax  Payments  (See  also  "Un- 
derstatement") 

A-2   Letter,    201 

Amended   returns,   procedure,    no,    112 

Bankruptcy,  validity  of  tax,  275 

Collector  may   refuse   appeal,   208 

Erroneous   claims    should  be   heard   before 
interest   commences,    235 

Extension  of   time   for,   227 

Hearings  before   Income  Tax   Unit,   203 

Interest   on,   208 

Notice  to  pay,  202 

Notices   sent  by  mail,    206 

Notification   of,   under    1921    law,   208 

Procedure    when    due,    200-213 

Protests,    201-204,    286-289 

Suits    at   law    for,    235 

Time  for  filing  appeals,   203-205 
Administration  of  Act,    173-234 

Advisory   Tax    Board,    abolished,    175 

Assessments,    194 

Limitation    period,    195-200 

Collectors    of    tax,    173 

Committee    on   Appeals    and    Review,    175- 
179 

Evasion,    proceedings    in    case    of    contem- 
plated,   214 

Final  closing  of  case,   209-213 

Internal    Revenue   Bureau,    173 

Interpretations    of    statutes,    188-191 

Regulations      governing      practice      before 
Treasury,    180-182 

Retroactive   regulations,    182 

Tax    Simplification    Board,    179 
Administration  of  Estate, 

Period   of,    defined,    1335 
Administrative  Review,  211 
Administrators   (See   "Executor,"   "Estates 

and   Trusts,"   "Fiduciaries") 
Advertising  Agency, 

As    personal    service    corporation,    833 
Advertising  Expenses, 

As    goodwill    deductible,    1254 

Deferred  charges,   911 
Advisory  Tax   Board, 

Abolished,    175 
Affidavits,    -j-j,    78 

Affiliated     Corporations,     90     (See     also 
"Consolidated    Returns"') 

Claims   for   credit,   283 

Exemptions   on   United   States   bonds,    691 

Foreign, 

Consolidated    returns,     1303 
Consolidated  returns,  not  permitted,   105 

Income  from,   consolidated   returns,   530 


Affiliated  Corporations — (ContiKued) 

Losses, 

Accounting    methods,    1018 
Former    procedure,    1019 

Penalties   waived   for,    151 

Personal    service   corporation. 

Procedure  by   parent  company,   account- 
ing   for    losses,    829 

Returns,    100 

Government    contract    corporations,     105 
Former    Procedure,    105 

Sale    of    replacement   property   to   corpora- 
tion,   509 

Separate    returns,    103,    104 

Stock   dividends   received   from,   768 
Agents    (See    also    "Withholding    Agent") 

Before   Treasury  defined,    180 

Commissions    paid    to,    deductible,    890 

Compensation    for    personal    services,    389 

Correction  of  ownership  certificates,  312 

Fiduciary    vs.,    1327 

Foreign    corporation. 

Responsible    for    return,    1303 

License  required   for  collection  of   foreign 
items,    320 

Responsibility   of    in    accepting    incomplete 
ownership   certificates,    308 

Returns  by,   77 

For  foreign  corporation,  100 
For  non-resident  aliens,  1299 
For  soldiers  and  sailors,  86 
Form  to  be  used,   77 

Versus   fiduciary,    77 
Agreements, 

When   taxable,    538 
Agricultural    Organizations, 

J^xemptions,    34 

Interest    on   bonds    in    Michigan,    not    tax- 
exempt,    666 

When    taxable,    35 
Alaska, 

Citizen    of,    taxed    as    non-resident    alien, 
1322 

Compensation    of    government    employees, 
not   exempt,    401 
Alien   Enemies, 

Property     returned     by     Alien     Property 
Custodian,    913 
Alien    Property   Custodian, 

Cash     received     as     return     of     property 
seized,    512 

Expenses   of   obtaining   return   of   property 
not    deductible,    913 

Not   a    fiduciary,    1327 

Returns,    money   and    other    property   sur- 
rendered   to,    1304 

Withholding   in   case   of,    1320 
Aliens     (See    also    "Foreign    Corporation," 
Non-Resident         Aliens,"         "Resident 
Aliens") 

Claims  for  refund,   254 

Deductions   allowable,    1292-1295 

Gross    income,    1276-1278 

Leaving   U.    S.,    215 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1835 


Aliens — {Continued) 
Residence, 

Certificate  claiming,   form   1078,   1275 

Loss    of,    1272 

Proof  of,   1272 
Resident, 

Status  of  citizen,  344 

Wife   residing   abroad,    344 
Returns  of  information  at  the  source,  299 
Seaman, 

Proof   of   residence,    1273 

Residence,    how    established,    1273 
Status  determined  on  last  day  of  taxable 

period,    1273 
Withholding   from,    327 
Alimony, 
Exempt,  367 

Former  procedure,   367 
Not   deductible,   870 
Allocation    of    Dividends    to    Particular 

Years,    727-731 

Allocation  of  Earnings  to  Distributions, 

107 
Allowances  to    Minors,   861 
Ambassadors, 
Foreign,    364 

Status,    non-resident    aliens,    1274 
Income,  when  taxable,   1286 
Amended  Returns, 

Acceptable    to    Treasury,    1067 
Adjustments    for    prior    years,    382,    383, 

848 
Barred    four  years   after    payment,    ii  i 
Community  property  of  husband  and  wife, 

82,    III 

As   defined   by  Texan  law,  400 
Consent    of    Treasury    Department,    no 
Corporations,     109-127 

Due  to   wrong   accounting   practice,    in 

Payment   of   tax,    when   due,    113 

Procedure,    109 

"Suspense   account"    included,    517 
Correct  former  erroneous  practice,  1067 
Corrections     for     previous    year    not     in- 
cluded,   381 
Deducting   for   depreciation   permissible   if 

no  bad  faith  shown,  1068 
Depreciation  allowance,  1066 
Fraudulent,    136 

Government  contracts  adjustments,  533-534 
Husband  and  wife,  84 
Individuals,    109-127 

Procedure,    109 
Minor   items,    1 1 1 
Penalties    for    false    returns,    1 1 1 
Personal    service   corporation,    establishing 

status,  841 
Prior  years,    iii,   112 
Requested  by  taxpayer,   1 1  o 
Returned    for    corrections,    procedure,    109 
To  reflect  true  net  income,   381 
When   not    required,    109 


American    Legion, 

Gifts  to,    1 242-1 243 
American    Red    Cross    (See    "Red    Cross") 
Amortization, 

Bond   premiums  or   discounts,    :o'6 
Defined,    1151 

Limitation    period   for   deficiency    tax,    198 
Amortization  of  War  Facilities, 
Accounting    methods,    1164 
Accounting    period,    1162 
Allowance     previously     made,     considered 

income,    1159 
Apportionment   of  loss  over  periods,    1162 
"Articles    contributing    to    the    prosecution 

of  the  war,"   defined,   11 54 
Buildings,    1158 

Contracted   for,    prior   to   the   Armistice, 

1 1 59 
Claim    must    be    filed    with    1921    return, 

1149 
Computation   of   loss,    1160-1164 

Former    procedure,    1161 
Deductions    for,    1149-1166 
Depreciation   allowance   included,    ii6o 
Estimates    to    be    adjusted    before    March 

3,    1924,    1 165 
Evidence    secured    from    War    Industries 

Board  to  secure  claim,    1157 
Former   procedure,    1135 
Government   contracts,    531-532 
Law    of    1918,    1149 
Law  of   1921,   1 149 
Limitation  dates,   1150 
Limitation   date  as  of  February  29,    1924, 

1150 
Machinery,   1158 
Net  income  for  period  of,   1162 
Property    not    completed    before    close    of 

war,    1 162 
Property    which    may   be    amortized,    11 58 
Railroads    denied    deductions,    11 54 
Re-examination   of   claim,    199,    1150,    1165 
Tables   for   depletion,    11 80 
Taxpayer's    statement,     1152-1154 
Annuities, 

Amounts    deducted    for    by    civil    service 

employees,    should    be    reported    for    in- 
come  tax,    413 
Income   from,    defined,    677 
Need  not  be  reported,  303 
Payment   of   tax    at   source,    1306 
Anti-Trust  Act, 

Fine  paid  for  violation  of,  not  deductible, 

922 
Apartment  Houses   (See  also  "Buildings") 

Obsolescence,    11 4 1 
Apartments, 

Co-operatively    owned,    not   exempt,    46 
Rental   of   subleased,   904 
Appeals,   235-290 

Against  additional  assessments,  201-208 
Cases   arising  prior  to    igai    law,   213 
Collector  may   refuse  granting  of,   203-206 
Committee   on,    175-179 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1836 


GENERAL   INDEX 


Appsals — <Xuniinucd) 
Hearings    for,    203 

Time    for    filing,     for    additional    assess- 
-  -rs,  203-205 

AXD  Review,  Committee  on, 
tions    and    organization,    175-179 
.■viiKAioi;KS,      United     States,     Board     of, 
G::xi:R.\r-   (See  "Board  of  United  States 

Geneiai    Appraisers")  

Appkeciation,     535      (See     also     "Gain     or 
Loss,"  ■  "Valuation") 
A'-.-v,.ed   prior  to 
.     i\ii,k    values,    58-' 

Cost   as  bas's   for   aeterniinnicc.    ;>>> 

Gifts,    not   income,    623 

Land,  1142 

?.Iust   have    occurred    during    period    when 

!av>'    was   effective,    583 
OiTselting   depreciation,    1063 
Propert-y,    535 

Realization    of,    in    value    of    assets,    tax- 
able,  567 
Unimproved    land    on   which   lessees   erect 

buildings,    695-696 
Unrealized,   not   income,   809 
Architect, 

Fees  of,  not  deductible,  913 
Army   Officers    (See   also   "Un'^-''-^'^''"' 

Personal    expenses,    867 
Assessments, 

(See     also    "Additional     Tax    Payments," 

"Claims    for    Abatement") 
Amortization    claim     or     deduction     tenta- 
tively allowed,   198 
Appeals  before   (See  "Appeals") 
As  business  expenses,   deductible,   970 
Authority    to    make,    194 
Bank    stock    of    decedent,    not    deductible, 

1360 
Changed     interpretations    retrnn^-tivp       '  ui 
Claims   for   over,   235-290 
Consolidated  returns,   209 
Erroneous    or    illegal    assessed    taxes    must 

be    paid,    223 
Estates    and    trusts,    197 
Final    determination,    209-213 
Five-year   limitation,    196 
Four-year  limitation,    195 
Fraudulent    returns,    no    limitation    period, 

19S 
Limitation    of    period,    195-200 

Extension    of,    199 
Local    improvement,    not    deductible,    966- 
968 

Former    procedure,    9C6 
Local    improvement,    not    increasing    value 

of    property,    deductible,    968 
On   capital   stock,   990 
Protection    of    taxpayers,    237 
Special   assessments   not  deductible,    937 
Special  assessments  when  deductible,  966- 

970 
Stocl:  ital  Stock") 


Assessments — (Continued) 

Suits    for    restraining,    249 

Taxpaj-er's    right   to    question,    237 
Assets    (See  also  "Capital  Assets") 

Intangible, 

Depreciation,   1098 
Obsolescence,    1 1 44 
Valuation  of,   655 
Assignee, 

Mv.st  withhold,    1309 

"'   * -rns    by,    102 

\rroNS  (See  also  under  specific  kinds. 
.:  "Common  Law  Tru^fs"  "InMit 
Stock   Companies,"   etc.) 

As  corporation,   91 

Building   and   loan. 

Exempt    income    from,    310 

Co-operative,   farmers',    141 2 

Dues    to,    as    business    expenses    are    de- 
ductible,  917 

Gifts    to    be    deductible    must   be   made    to 
public,    1 243 

Law,    1916,    1329 

Partnership  banks  as,   92 

Partnerships    vs.,    92 

Shipowners'     mutual     protection     and     in- 
demnity,   363 

Trusts   vs.,    93,    1 328-1329 
Attorney    (See   also   "Lawyers") 

Before  Treasury   defined.    iSo 

Fees,    deductihl ■■ 
AroiTs, 

Returns,    194,    200 
Authors, 

Income    from   royalties,    647 

Returns,    647 
.Vl  U);.:o3ii,E   Service, 

As    compensation    for    personal    services, 
440 
.\  utomobii.es. 

Dealers    in   second-hand,    486 

Deduction   for  damages  to,  860 

Deductions   for  up-keep,    868 

Farmers',    141 3 

License   fees  deductible,   957 

Travel    by,    868,   869 

Used,    as   part   payment,   502 


Bad    Debts,    1030- 1049 

Accounting  method,  452,    1032 

Accounts   uncollectible    because    of   mora- 
torium in  Cuba.   1043 

Bankruptcy   claim,    1037,    1040 

Bankruptcy,  test  of,  1043 
Former    Procedure,    1043 

Banks,     under     government     supervision. 
1047 

Bonds,   worthless,    1038 

Book    entries    required    if   deductions    are 
claimed,   391 

Claim   against   decedent's   estate,    1037 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1837 


A')   DiiBTS — (Continued) 

(.'ollateral   securities,    1043 

Computation   of,   in  instalment  sales,  495- 
497 

Corporations     under     government     super- 
vision,  1047 

Deductions  for  taxable  year   1931,   1031 

Deductions,  reported  in  return  of  income, 
1036 

Defined,    1039 

Double     deduction     permitted     for,     1921, 
1032 

Foreclosure    of   mortgage,    1044 
Former    Procedure,    1044 

Gifts    not   deductible,    1035 

Insurance   companies,    1393 

Personal  loans,  not  deductible,   1035 

Promissory   notes   endorsed,    1045 

Reasonable     addition     to     a     reserve     for, 
deductible,    1030 

Recovery    of,    513-51S,    io45 

Reserve  for,  deductible,   1030 

Returns  must  be  charged  off  within  year, 
1048 
Former  Procedure,    1048 

Russian   property,    1043 

Special    types,    1037 

"Unsecured   and   nnpreferred   debts"   dis- 
tinguished    from     others     in     cases     of 
bankruptcy,    1044 

Valtiation, 

As  of  March    1,  1913,  1039,   1043 
Worthless,   defined,    1039,    1040 
Bailments, 

Included    in   inventory,    455 

B A  X  K     ACCEPTAN  CES, 

Profits    from    purchase    and    sale    not    in- 
terest,   1310 
i'.AXK  Accounts, 

Inspector's    ri.-::'!-  -.i'-    taxpayer's. 

IIS 
iJANK  Stock, 

Local    taxes    paid    l)y    l-.ank    as    equivakiu 
of  dividend,   733 

Local    taxes   paid   by    banks, 
Former  procedure,   734 

Taxes    paid   by    bank    not    deductible    by 
shareholders,    957 

BANKRUPTCY, 

Basis    for    determining    worthlessncss    of 

debt,    1040,   1043 
Corporations,   penalties  waived   for,   151 
Deductions   for  claims,   1037.   '043 
Referee   in. 

Not  a  judge  of  inferior   court,   403 

Subject    to    income    tax    under    Act    of 
1918,   403 
Rentals   to    stockholders    deductible    from 

gross  income,   727 
Returns,    102 
Validity   of  tax,   37s 
ISanks    (See    also    "Federal    Land    Banks," 

"Mutual     Savings     Banks,"     "Nation-I 

Banks") 

[See  also  Estate,  Capital  Stock, 


Banks — (Cciitiinicd) 

As  dealers  in  securities,  485 

Assessment   for  insuring   deposits,   903 

Correction    of    ownership    certificates    by, 
312 

Depositors   as    preferred    creditors,    1343- 
1344 

Duty    of,    regarding    foreign     items    pre- 
sented   without    certilicates,    317 

Interest   on   deposits,    667 
Former   procedure,   667 

Liability  as  to  ownership  certificates,  313, 
319 

License    required    for    collection    of    for- 
eign  items,   330 

May  keep  additional  records  for  deprecia- 
tion  purposes,    1065 

Mutual    savings    exemptions,    33 

Of    deposit, 

Deductions     for    interest    paid     on    de- 
posits,   927 

Partnership    bank    as    association,    93 

Partnership    bank    as    partnership,    gz 

Private    lanks    as    associations,    93 

Responsibility   of   in  accep'.ing   incomplete 
ownership  certificates,   308 

Use   of   stamps   and   facsimile   signatures, 
319 
"Base  Stock"   Method, 

Of   taking   inventories,   469 
Baseball    Players, 

Amount   paid   by   club   to   secure  services 
deductible,    917 
Basic  Date  Deferred,   1173 
Beneficiaries, 

Deductions    for   payments   to,    1358,    1339 

Dedncuohs, 

Foreign   taxes,    943 

For    slninkage,    1369-1374 

Losses,    1364 

Depreciation    claimed    by,    1073 

Distributive    share    must    be    incluiKi    m 
tax   return,    1338 

Fxemptions,    345 

Incjonie    distributed    by    fidvxiaries    subject 
to    tax,    1330 

Income    received    from    estates    or    trusts, 
not  units,   when  taxable,    i3C>9-'374 

Income   received   through   fiduciaries,   fax- 
able  to,    1349-1350 

Income  tax  paid  by  fiduciary,  1308 

Net   income   taxes   paid   by,    1357 

Net  losses,  deductible,   1028 

Non-resident  alien,   1300 
Return  by  fiduciary,   1344 

Right   to   inspect    returns   of   estates,    119 

Hen'EVOlrnt      Societies      (Scf      "!•"• 'ikiI 

Beneficiary    Societies") 
i;i: ,  ,-|  ..;    rS.-.     ..',-"    "'imiiblii 


ymenl  of  taxes.  . 

ai.d  -L-Cvcss  Profits  Iiv' 


1838 


GENERAL   INDEX 


Board  and  Lodging, 
Taxable  income,  438 
When   returnable,    296 
Board    of    United    States    General    Ap- 
praisers, 
Compensation  for  members  subject  to  in- 
come  tax,   403 
Boards  of  Education, 

Gifts  to,  deductible,  1245 
Boards  of  Trade, 

Dues  paid  to,  deductible,  917 
Exemptions,    43 
Boilers, 

Depreciation,    1080,    1088 
Bondholders, 

Purchase   of  assets  by,    5^2 
Bonds    (See   also   "Exempt   Bonds,"   "Farm 
Loan       Bonds,"        "Liberty       Bonds," 
"Municipal     Bonds,"     "Tax-Free     Cov- 
ent   Bonds") 
Deposited   with   claim   for   abatement,   246 
Discount    on. 

Prorating    of    loss,    1013 
Treated  in  same  way  as  interest  paid, 
926 
Fidelity   (See  "Fidelity  Bonds") 
Foreign  countries,  information  at  source, 

298 
Interest  from  foreign,  316 
Interest    on,    668 

Form    for    non-resident    aliens,    13 13 
Of    agricultural    and    horticultural    so- 
cieties  in   Michigan,    not   tax-exempt, 
666 
Withholding,    19 13 

Withholding   from   in    case   of   non-resi- 
dent   alien,    1312 
Matured,  losses  on,  deductible,    1016 
Mortgage    indebtedness    of    municipalities 

and  states  not  exempt,  665 
Not   required   by    receiver   for    abatement 

claim,   248 
Ownership  certificates,  306-319 
Redemption   of,   669 
Registered, 

Foreign,  information  at  source,   300 
Ownership    certificates,    315 
Returns  of  information  at  source,   298 
Surety,   filed   with   Treasury,    229 
War    Finance    Corporation,    350 
Worthless,    as   bad   debts,    1038 
Bonus, 

As  distribution  of  profits,  419 
Deductible    by    lessee    through    depletion, 

1226 
Deductible   if  reasonable,   883 
Distinguished      from      compensation      for 

personal  services,   417 
Military   and  naval    forces   of  the   United 

States,    tax-exempt,    411 
Paid, 

Deductible     as    compensation    paid,    if 

reasonable,  419 
Early  delivery  of  steamship,  deductible, 
918 


Bonus — (.Continued) 
Paid — (.Continued) 

For   previous  year,  not  deductible,   885 

Taxable   as  expense,   419,  421 
Received  as  stock,   523 
Restoration     of,     to     capital     account     of 

mineral  property,   1223 
To  lessees  and  lessors  of  oil  wells,   121 6, 

1221 
War   service,   exempt   from  tax,   363 
Book  Values, 

Increased  valuations  from  writing  up,  not 

taxable,  582 
Books, 

Depreciation,    1088 
Books  of  Account   (See  also   "Accounting 

Methods,"      "Examination     of     Books, 

Papers  and  Persons") 
Failure  to  keep,   65 
Limitation  period  to  examine,    199 
Lump     sum     purchases,     segregation     of, 

1067 
Bootlegging, 

Income  taxable,   447 
Branches,  Foreign, 

Payments    to     alien     employees    by,     need 

not  be  reported,  303 
Breach    of   Promise, 

Payments,    not    deductible,    870 
Brokers, 
Deductions, 

Inventoried  shrinkage  in  securities,  986 

Former  procedure,  986 
Payments    to    customers    need   not   be    re- 
ported,  303 
Returns  on   customers. 

Former    procedure,    302 

Payments  to   customers,    302 
Building  and  Loan  Associations, 
Exemptions,   27 

In    dividends,    362 
Foreign,   not   exempt,   48 
Shareholders*    credits    taxable,    671 
Buildings, 

Amortization,    1158 

Cost  of  demolition  not  deductible,   998 

Depreciation,    1079,    1088 

Destroyed,     on    leased     land,    deductions 

for,  694 
Fireproof,    obsolescence,    1141 
Improvements  on  not  deductible,   853 
Loft,   obsolescence   of,    1142 
Loss   from  demolition  deductible,   997 
New,    built   on   leased   ground,    694 
Obsolescence,   1134,   1139,   1141,   1142 
Payment  for  new,  not  deductible,    1051 
Under     construction,     depreciation,     1090 
Business, 

Income    from. 

Bonus    received    in    stock,    523 

Taxable,  31 

Types  taxable  and  non-taxable,   516-328 
Business   Discontinued, 

Obsolescence    procedure,    1139 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1839 


Business  Expense, 

Assessments    deductible    as,    970 

Deductions,  851,  852,  855 

Defined,    855 

Distinguished    from    capital    outlay,    85:, 

907-915 
Distinguished    from   gifts,    1248 
Distinguished     from     personal     expenses, 

852,   854 
Gifts   of   merchandise,    1254 
Insurance,  851 
Insurance    companies, 

Deductions   for,    1390 
Life    insurance    companies, 

Deductions     for     investment     expenses, 
1383 
Organization    expenses,    907 
Professional    men,    862,    864 
Rent    (See    "Rent    as    Expense") 
Segregation    of,    857-859 
Traveling   expenses    (See    "Traveling   ex- 
penses") 
''Treating  money"  deductible,   1254 
Business  Leagues, 
Exemptions,    43 
"Business   or  Trade," 

Definition   of,   854 
Business  Taxes, 
Deductible,    958 


Calculation    of    Tax     (See    "Computation 

of  Tax") 
Calendar  Year, 

Returns  of   information   at   source,   294 
Returns  on  basis   of,   297 
Campaign    Contributions, 

Not   deductible,    915 
Capital, 

Distribution  of,  should  be  coincident  with 

reduction    in   capital    stuck,    744,    745 
Interest    on    taxpayer's    own    capital,    not 

deductible,    932 
Personal    service     corporations,    permitted 

use    of    in,    835-837  ^ 
Repairs    chargeable    to    capital    if    perma- 
nent,    1 064 
Capital  Assets    (See   also   "Assets,"   "Gain 
or   Loss,"   "Capital    Net   Gains") 
Adjustment  by  appraisal  of  various  dates, 

6X2 

Appreciation,     Supreme     Court     decision, 

583 

Defined,    628 

Diminished  value  not  to  be  deducted, 
294 

Inventory    method,    588 

Losses   on   sale   of,  979,    989,   996 

Obsolescence    of,    1134 

Patents,   651 

Profits  from  sale  or  exchange.  Law  of 
1 921,    804 

Purchase    of    by    bondholders,    562 

Recoverable  through  depletion  and  depre- 
ciation,    1 224-1 227 

Recovery   not   current   expense,    380 


Capital  Assets — (Ccmtiniied) 
Reinvestment     of    proceeds     of     sale    of, 

1265 
Revaluation,    1070 

As   of    January    i,    1909,    584 
As  of  March    i,   1913,  583 
Not    equivalent    to    inventories,    582 
Sale   of   by   corporation,    554 

Former    procedure,    554 
Sale    of    should    be    added     to    gross    in- 
come,    143 
Should     be     transferred     at     gross     book 

value,     1070 
Surplus     from     sale     of,     distribution     of, 

when    necessary    1266 
Valuation    (See    "Valuation") 
Capital    Expenditures, 

Losses    so    considered,    1007 
Capital  Gains, 

Securities    sold    by    estates,    amelioration 

of  surtax  under  tax  on,   1374 
Stock   dividends    carried   2   years,   taxable 
as,    770 
Capital  Investment, 

Development     costs     may     be     added     to, 
1228 
Capital  Net  Gain, 
Copyright,    640 
Defined,    628 
Patents,    640 
Realized   after   December   31,    1921,   under 

1921    law,    567 
Taxable,    162 
Capital    Stock, 
Assessments,    990 

Not    deductible,    909 
Close  corporation,  615 
Expenses    incurred    in    selling,    909 
Federal  reserve  banks,  dividends  exempt, 

362 
Increase    in,   with    cash    dividend,    taxable, 

764 
Interest    paid    on    instalment    subscriptions 

to    capital    stock,    not   deductible,    932 
Redemption  of   by  corporation,    1017 
Sale    of,    at    premium   or    discount,    524 
Stockholders'    voluntary    assessments,    tax- 
exempt,    520 
Valuation,    determination    of,    614-616 
Capital    Stock    Tax     (See    separate    index 

on  p.   1903) 
Capital      Surplus       (See      also      "Surplus 
Fund") 
Dividends    from,    716,    746 
Source   of,    746 
Case    (Law)    Defined,    210 
Cases   (See  "Decisions") 
Cash. 

Income    other    than,    taxable,    430 

Instalment    payments   as,    489 

Instalment    payment    equivalent    of    cash, 

500 
Instalment    payments    not     equivalent     of, 

498-500 
Notes  not  readily  discountable,  no  equiva- 
lent   for,    501 


[See  also  Estate,  Capital  Stock,  and   Excess  Profits  Indexes] 


1840 


GENERAL   INDEX 


Cash  Basis  (See  also  "Accrual  of  Income") 
Change    to    accrual    method,    384,    414 
Method    of    computing    net    income,    383 
Cash    Dividenps, 
Taxable,    -jiz 
With    increase    in    capital    stock,    taxable, 

764 
With  option   to   buy,   taxable,    764 
Cash    Registers, 

Depreciation,     1093 
Casualties, 

Losses,    1008-1011 

Deductions   for,   860    (See   also   "Insur- 
ance") 
Former    procedure,    1 008 
"Catch-All"     Provisiox,   in   Law,   373 
Cattle    (See    "Live    Stock") 

CE.V!iTERY     COMPANIES, 

Exemptions,    39 

Family,    gifts    not    deductible,    1245 
Cent, 

Fractional    part    of,    172 
Certificates    of    Compliance, 
Citizen    leaving   country,    215 
Certificates   of    Deposit, 

Interest    on,    deductible,    926 
Certificates    of    Indebtedness     (See    also 
"Treasury      Certificates      of      Indebted- 
ness") 
Of  a  staie  territory,   etc.,   deductions   for, 

928 
Payment  of   tax  by,   225 
State,    territory    or    subdivision,    exempt, 
361 
Certificates  of   Ownership    (See   "Owner- 
ship   Certificates") 
Certificates  of  Profit, 

As    scrip    dividends,    taxable    income,    742 
Certificates    of    Sale, 

For    non-payment    of    taxes    not    exempt, 
360 
Chambers  of  Commerce, 

Dues   paid    to,   deductible,   917 
Exemptions,    43 
Charitable  Organizations, 
Exemptions,    39 
Gifts    to,    1358,    1359 
Deductions    for,    1341 
Charitable    Purpose, 

Credit    in     separate     returns     of    husband 
and   wife,    S 
Chart, 

Origin    and    roi-.^c    ■•■'    i.^rms,    307 

CrilARTERS, 

Forfeited,    penalties    waived    for,    15' 
Chemical    Industry, 

Depreoiation,     1093 
Cheques, 

Payment    of    tax,    224 
Children    (See    "Minors") 
Christmas    Gifts, 

Deductible,    886 

When    deductible,    1248 

When    nr.t    taxable,    4-:o 
Church    Dues, 

Deductible,    1245 

fSep   nV.o   Estat  ■ 


Church    Pews, 

Rents,    deductible,     1245 
Churches, 

Gifts    to,    deductible,     1243 
Citizens, 

Alien    resident    as,    344 
Credits, 

Foreign  taxes,   946 
Deductions, 

Foreign    taxes,    942,    946 

Taxes,    938 
Defined,    368 

Employed   by  a  foreigzi   government,   365 
Income, 

Sources     within     United     States,     1378- 
1281 
Leaving   country, 

Certificate   of   compliance,   215 

Consular    receipt    for    payment    of    tax, 
216 

Penalties     for     failure    to     file     returns, 
138 
Naturalized,    non-resident,,   status,     1274 
Residing    abroad. 

Extension    of    time    for    filing    returns, 
59 

Notice    of    payment    sent    to,    219 

Payments   by    mail,    219 

Penalties   waived   for,    150 
Taxes, 

Deductions,   938 
Civic    Leagues, 

Exemptions,    43 
Civil    Service    Employees, 

/Vraounts      deducted      from      salaries      for 

annuities     should     be     reported     for     in- 
come  tax,   413 
Payments     to     by     g:jvein!nent     need     n&t 

be   reported,    303 
Claims, 

In    business,    not    income,    5'S 
Claims,    Committee   on. 

Cases    before,    213 
Claims    for   Ab.\tement,    111 
Audititnal    assessments,    200-313 
"Bona    fide    claim,"   definition,    246 
Claims    for    refund    vs.,    241 
Collector's   procedure,    241 
Collector's    right    to    require    bond,    246 
Community     property     of     husband     and 

wife,   S3 
Do  not  constitute  appeal  to  Commissioner, 

-'6s 
Filing,    236,    241 

Time   for,    242 
Five-year    limit    not    applicable,    273 
Interest,    if    claim   denied,    143,    248 

Former   procedure,    143 
Liquidating    corporation,    269 
Notice    of    denial    should   be    sent,    213 
Penalties    when   not   bona  fide,    246 
Pending    an    appeal,    213 
Procedure,    241 
Receivers,    248 
I'o.cctcl,    by    collector,    20S,    347 

nd  Excess  Profits  Indexes] 


GENERAL   INDEX 


1841 


Claims   for   Abatement — {Continued) 
Stockholders'    suits,    251 
When    allowable,    244 
Claims   for  Allowance  on   Net  Loss, 

Filing,    1029 
Claims       for      Amortization,       1149-1151- 

1165-1166 
Claims     for     Credit,     277-286     (See     also 

"Claims       for      Abatement,"       "Credit 

Against    Income") 
Affiliated   corpi  rations,   2S3 
Applied    against    income,    war    profits,    or 

excess    profits   tax,    278 
Community     property      of      husband     and 

wife,    83 
Corporations,     when     successor     may     file 

claim,    284 
Defined,   287 
Excess    profits    tax,    283 
Filing, 

Place    when    district    is    changed,    282 

Procedure,     277 

Time,    277 
Husband    and    wife,    285 
Interest    allowable    in    suit,    271 
Interest    on,    244 
Notice    of    denial    sent,    213 
Partnerships,    284 

Patents,    revaluations    prior    to    1917,    653 
Personal    service    corporations, 

Allowed    to   stockholders,    838 
Profits,    undistributed,    285 
Rejected,    278 

Interest    rates,    248 

Procedure    for,    248 
Stock    dividends,    780 
Substitute   claims   for   refund   for,    278 
Time    when    made    or    allowed,     280 
Claims     for    Refund,    235-290     (See    also 

"Amended    Returns") 
Additional    assessment,    207 
Aliens,   resident   and   non  resident,    254 
Appeal    to    Commissioner,    265 
Appeals    must    be    made    before    suit    can 

be    brought,    26^ 
Claims    for    abatement    vs.,    241 
Community      property      of     husband     and 

wife,  83 
Denied,    782 

Dividends    carried    on    margin,    781 
Erroneously  or   illegally   collected,   252 
Failure    to    deduct    such    loss    in    original 

return,    381 
Filing,    236,    241,    253,    278 
Filing    of    not    necessary    in    some    cases, 

254 
Five-year    limit,    255,    257 
Four-year    limit,    357 

Fraudulent    or    undervalued    returns,    276 
Interest    allowable    in    suit,    271 
1913-16    returns,    112 
1914   and    prior   not   allowed,    261 
1918    law,    256,    262 

Losses   sustained    in    tgi?,    not   offset,   97^' 
Not   a   suit    against   the    Government,    252 
Notice    of    denial    to    grant    suit,    213 
On    establishment    of    residence,    1317 


CL.iiiis   roR   Refund- — (Continurd) 

Patents,    revaluations    prior    to    191 7,    653 

Pajment    (See    "Refund,    Payment") 

Payments      withheld      from      non-resident 
aliens,     13 17 

Power     of     attorney     sufficient     for    filing, 
253 

Procedure,    252 

Proof    of    appeal    to    Commissioner    rests 
with    taxpayer,    264 

Receipt    should    accompany,    252 

Stock    dividends,     780 

Stock     dividends     on     shares     carried     by 
broker,    781 

Suits    against    collector,    263 
Five-year    limit,    263 
Former     procedure,     263 
Procedure,    273 

Taxpayer's    death,    252 

Two-year    limit,    257 

Withholding    of    excessive    tax,    330 
Claims,       Mining       (See       "Discovery      of 

Mines") 
Clergymen, 

Compensation    received,    not    taxable,    421 

Fees    received,    taxable,    420 

House    rent    exempt,    362,    422 

Rental    value    of    house    not    taxable,    362 
Closed    Transactions    (See    also    "Continu- 
ing  Transaction,"    "Sale    of   Property") 

Basis     of    net    income    of    subscribers    to 
stock,    786 

Defined,    536 

Depreciation    allowances,    1070 

Property     transferred     to     corporation     in 
exchange   for   stock,    544 

Sale    on    instalment    plan,    548 

Sales    covered    by    open    drafts    not    con- 
sidered,   528 
Clothing    (See   also    "Uniforms") 

Deduction    for,   868 
Clubs, 

Gifts    to    make    good    deficit,    not    deduc- 
tible,   1245 

Social,     exempt,    44 
Coal    Mines    (See    "Mines") 
Collateral, 

Interest     on     securities     used     as,     when 
deductible,    930 
Collateral  Securities, 

Depreciation,    1043 
Collection    of    Accounts    (See    also    "Bad 
Debts") 

Accounts    uncollectible    because    of    mora- 
torium in  Cuba,   1043 

Instalment    payments,    497 
Collection    of    Tax     (See    also    "Payment 
of  Tax") 

Py    distraint,    _•,;  1 

Liens,    232 

Xon-rcsident   aliens,    1270 
Collectors    of   Tax,    173 

Authority  to    grant   extension    of    linic    for 
tiling    returns,    56,    58 

Claims     for    abatement, 

Payment    dcnian<led    p'lulinq;,    .;  1 7 


[See  also  Estaf^    C?.t)ital   Slock,  and  Excess  Profits  Indexes] 


1842 


GENERAL   INDEX 


Collectors  of  Tax — {Continued) 
Claims    for   abatement — (Continued) 
Procedure,    241 
Right    to    require    bond,    246 
Claims   for    credit,    procedure,    277 
Claims    for    refund,    procedure,    252 
Not     authorized     to     waive     penalties     or 

interest,    149 
Notice    of    alleged    understatement,    143 
Returns   made   by,    131 
Suits  against  taxpayers,  230 
Colleges   and    Universities, 

"Land-grant"    colleges,    taxability    of    pro- 
fessors'  salaries,   412 
Commissioner  of   Internal   Revenue   (See 
also    "Internal    Revenue    Bureau") 
Authority   to   grant   extension  of   time    for 

filing    returns,    56-58 
Authority    to    pay    refund,    262 
Authority    to    require    returns,    $2-53 
Claims  for  refund  may  be  filed  with,  ;;53 
Consent  to  change  to  accrual  method  from 

cash  basis,    384 
Discretionary     powers      in      compromising 

claims,    149 
Organization    of    Bureau,    173 
Powers   of,   874 
Commissions   Paid, 

On  insurance  premiums  deductible,  890 
On     single     transaction,     information     not 

required   at   source,    294 
To    agents,    deductible,    890 
To    salesmen,   deductible,   890 
To   special    counsel    for    state    comptroller 

are    tax    exempt,    408 
To    stockbrokers,    not    deductible,    891 
Commissions  Received, 
Are   taxable,   420 
By    receivers    appointed    by    state    courts, 

not  taxable,   405 
By   salesmen,    taxable,    420 
Committee  on   Appeals  and  Review, 
Functions    and    organization,    1 75-1 79 
Hearings   before,    205 
Committee    on    Enrollment    and    Disbar- 
ment,  U.    S.   Treasury,    180 
Common     Law    Partnerships     (See    "Lim- 
ited   partnerships") 
Common    Law    Trusts, 

As    corporation,    91 
Community   Chests, 

Gifts    to,    1242 
Community     Funds, 

Exemptions,    39 
Community     Property     of    Husband     and 
Wife,    hi 
Advantages    in    certain    states,    82 
Amended    returns,    82 
Defined,    395 

By    laws    of    Texas,    82,    403 
States    using    principle    of,    82 
Compensation  for   Personal  Services,  401 
(See      also     "Bonus,"      "Commissions," 
"Pensions,"     "Salaries,"     "Wages") 
Accounting    procedure,    413 
Agent    for    firm,    389 


Compensation     for     Personal     Services — 

iCcntinucd) 
As     distinguished    from    gifts,     dividends, 

etc.,    417-445 
Automobile    service   as,   440 
"Back    pa3'," 

As   a   gift,   416 

As   income,   416 
Board    and    lodging. 

Of       domestic       servant,       as      taxable 
income,   296 

Received  by   seamen,   not   taxable,    296, 
439 
Board    as   taxable   income,    438 
Bonus    distinguished    from,    417 
Cases     wherein     compensation     paid     was 

held    reasonable,    879-881 
Cases     wherein     compensation     paid     was 

held    unreasonable,    881 
Christmas    gifts,    deductible    or   otherwise, 

420 
Civil     service     employees     should     report 

amounts     deducted     for     annuities     for 

income    tax,    413 
Clergymen,    not    taxable,    421 
Clerical     assistants    of     state     subject     to 

tax,    406 
Computation    of    tax,    425-430 
Contractor's     income     from     public     work 

taxable,    411 
Deductions    for,    852,    861,    870-876 

Not    permissible,    861 

Test    for,    875,    876 
Determination    of    reasonableness    of,    874 
Determined     after     close     of     fiscal     year, 

690 
Discounted    promissory    notes,    accoimting 

for   proceeds,    438 
Employee      housing,       rent,       as      taxable 

income,    296,    438-440 
Employees   of    railway   companies,    subject 

to    tax,    406 
Employees'    profit-sharing    fund    as,    436 
Employees      receiving      salaries      partially 

paid  by  corporation  and  by  county,  407 
Engineers     having     contract     with     state, 

subject   to   tax,   403 
Executors     and     administrators,     not     ex- 
empt,   407 
Exempt    incomes    under    Acts     of     19 13, 

191 6,     1 91 7,    former    procedure,    402 
Fees     and     compensation     of     jurors     of 

state,    county    or    municipal    courts,    are 

tax-exempt,    412 
Fees       for       public       service,       conflicting 

decisions,    409 
Fees   paid   to   jurors,    taxable   income,   412 
Fees    paid   to   state   witnesses   taxable,   412 
Fees   received   by    the   clergymen,    taxable, 

420 
Gifts    distinguished    from,    417 
Gifts    made    by    employsrs    to    employees, 

when    taxable,    419 
Government  employees  subject  to  tax,  410 
Heat  as,   440 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1843 


Compensation     for     Personal     Services — 
iContimied') 

Included    in    gross    income,     liSo 

Income    from,    31 

Former    procedure,    401 
Taxable    in    whatever    kind    and    form 
paid,    430 

Individuals,    recomputation    of,    422-423 

Life  insurance  premiums  on  groups,  not 
income    to    employee,    43 1 

Light    as,    440 

Maintenance  for  service  in  American 
Red    Cross    as,    444 

"Market  value"  of  compensation  paid 
other  than  in  cash,  included  as  in- 
come,   431 

Members  of  draft  boards,  pay  not  ex- 
empt,   411 

Mileage    as,    443 

Mortgages    on    property, 
As    security    of    loan,    43S 
Received    as   commission,   43S 

National   Guard,    partly   exempt,   409 

Partner  deceased,  taxable  income  defined, 
438 

Pensions    (See   also    ''Pensions") 

Deduction    for    sick,    insurance    funds, 
444 

Per    diem    allowances,    as,    443 

Percentage  of  profits  basis,  deductible, 
892 

Percentage    of    profits    basis,    taxable,    420 

Pilots   employed   by  state   commission,   409 

Profit-sharing  distributions  distinguished 
from,    417 

Promissory   notes    as    compensation,   437 

Railroad    passes    as,    441 

Receiver's  compensation  fixed  by  state 
courts,    taxable,    405 

Rent    as    taxable    income,    438 

Returns  of  information  at  source,  296- 
297 

School  officers,  not  public  employee,  sub- 
ject   to    tax,    407 

Services  prior  to  March  i,  191 3,  how 
far    taxable,    417 

Soldiers   and   sailors,   410 
Former    procedure,    410 

Special    counsel    to    city,    not    exempt,    408 

State    officers    and    employees,    403 

Stock    paid    and    received   by   way    of,    431 

Stock  paid  as  compensation  deductible, 
891 

"Supper    money"    as,    440 

Taxable    in    whatever    form    paid,    375 

Teachers  of  the  territory  of  Hawaii,  sub- 
ject   to    tax,    410 

Telephone    as,    440 

Tips,    taxable,    420 

Treatment    of    excessive,    882 
Former    procedure,    882 

Trustee,  fee  taxable  as  to  what  year,  416 


Compensation     for     Personal     Services — 
(^Continited) 

Trustee     in     dissolution      of     corporation 
not     exempt     under     Connecticut     state 
law,    408 
Compromises     of     Taxes     and     Penalties, 
149,    152 

Bars    prosecution,    152 
("omputation    of    Tax    (See   also   "Account- 
ing   methods") 

Accuracy    essential,     162 

Beneficiary,     1357 

Capital    gain    or    loss,    577-581 

Corporation, 

Partly    personal    service,    839 
With  net  income  of  $25,100,  346 
With  net  income  of  $125,300,   347 

Estates    and    trusts,     1329 

Export    business,    527-528 

Fiduciary,     1357 

Fractional    part    of    cent    not    to    be    dis- 
regarded,   172 

Government    contracts,    528-534 

Initial    payments,    501 

Instalment    plan    sales,    487-504 

Insurance,      funds,      "self -insurance"      re- 
serves,   522 

Method    of,     428-430 
Problems,    425-430 

Net    losses,    1024-1026 

1921    law,    changes    summarized,    154 

Partnerships, 

Fiscal       years       1920-1 921,       1921-1922, 
791-796 

Personal,    339 

Real    estate    sold    on    instalment   payments, 
498-504 

Real    estate    sold    or    exchanged,    498-504 

Sale    of    a    business,    value    of    goodwill, 
612 

Sale  or  exchange  of  property. 
Capital  gain  or  loss,  577-581 
Continuing    transaction,    591-595 

Sources    both    within   and    without    United 
States,    1284 
Congressional   Record,    672 
Connecticut, 

Compensation  of   trustee   in  dissolution  of 
corporation,    subject    to   tax,    408 
Consignment   Sales    (See   "Sales") 
Consolidated  Returns,   103,    104 

Assessments    on,    209 

Computation    of    lax,    104 

Distribution   of    tax,    104 

Foreign  corporations,  1303 
Former  procedure,  1303 
Not    permitted,    105 

Former    procedure,    104 

Incomes    from,    530 

191 8    law,    16,    1020 

Partnerships    may    be    included,    788 
Former    procedure,    789 

Separate    returns    in    place   of,    103,    104 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 844 


GENERAL   INDEX 


Consolidations, 

Penalties    waived    for,    151 

When    not    closed    transactions,    556 
Construction, 

Interest   charged   to,    not   taxable,    668 

Interest     on,     deductible     if     not     capital- 
i::ed,    929 
Constructive    Receipt    of    Income, 

As    opposed    to    accrual    of    income,    387, 
414,    707 
Consular  Receipts,   316 
Consuls, 

Foreign,   364 
Containers, 

Depreciation,    1093 
Continuing    Transactions,    556    (See    also 
"Closed   Transactions") 

Basis   for   computing   profit   on,    589-595 

Computation    of    tax,    571-595 

Defined,     536 

Illustrations   of,    561 

Sale    on    instalment   plan,    548 
Contractors, 

Computation   of  income,   449 

For     public    work    not     public    employees, 
411 
Contracts     (See     also     "Government     Con- 
tracts") 

Cancelled,    losses    deductible,    1000 

Compensation    fixed    by,    877 

Decedent's   contract   filled  by  executor,   no 
income    accrues,    1359 

Depreciation,    1094 

Former    procedure,    449,    450 

Long-term,    defined,    449 

Salaries    fixed   by,    877 

State    engineers,    405 

Supplemental,        considered        government 
contracts,    530 

When    taxable,    538 
Contributions    (See   "Gifts") 
Conversion    of    Property,    506-508 
Co-operative   Associations, 

Apartments    owned    cn-nperatively    not    ex- 
empt,   46 

Exemptions,    44 

Farmers',    141 2 
Co-operative   Banks, 

Exemptions,    37 

Foreign    not    exempt,    48 
Co-operative   Stores, 

University,    not    exempt,    46 
Copper   Mines    (See   "Mines") 

COPI'RIGHTS, 

British    practice,    648 
Capital    net    gain,    640 
Computing    profit    of,    648 
Cost    of,    not    deductible,    913 
Deductions    permissible,    648 
Depreciation,     1095 

Depreciation   since    Feb.    28,    19 13,    652 
Expenses   for   securing,   are  invested    capi- 
tal,   648 
Royalties   reported   as  gross   income,   647 


Corporations    (See  also    "Foreign   Corpora- 
tion,"    "Liquidating    Corporations") 
Afriiiated    (See    "Affiliated    Corporations") 
Agricultural,  gifts  to  fairs  not  deductible, 

1253 

Amended     returns     (See     "Amended     Re- 
turns,  Corporations") 

As  associations,    returns,    97 

As   limited   partnerships,    90 

Assets,   without   penalties   waived   for,    151 

Assigned,    penalties    waived    for,    151 

Assignees'    returns,    102 

Cancellation    of    indebtedness    to,    or    by, 
stockholder,    520 

Capital  assets,   sale  of,   554 
Former  procedure,  554 

Capital    gains    tax    limitation    not    applica- 
ble to,    161 

Capital     stock     redeemed,     not     deductible 
loss,    1017 

Change   of  name,    returns,    100 

Charter    forfeited,    penalties    waived     for, 
151 

Claims   for  abatement   by   receivers,   248 

Claims   for    credit, 

Affiliated    corporations,    283 

When    successor   may    file    claim,    2S4 

Considerable    income    from    personal    serv- 
ice,  graduated   tax   rates,   826 

Consolidated      (See     "Affiliated     Corpora- 
tions,"   "Consolidated   Returns") 

Contributions   by   stockholders,    990 

Credits,    172,   337 

Credits  against  income  foreign  taxes,   y-i; 
Former  procedure,   947 

Debtor,  becomes  insolvent,    1041 

Deductions,  31,  852,  853,  923 
Bad   debts,    1030,    1041 
Cash    discounts,    527 
Compensation      for     personal      services, 

852,    878,    882 
Excess    profits    tax,    940 
Gifts,     1 241 
Interest   paid,    923 
Pensions,    888 

Former    procedure,    8S9 
Real   estate    held    for   profit,    84S 
Salaries,   874,    886 
Taxes,    939 

Former   procedure,   939 
VS'elfare   work,   887 

Defined,    90 

Defunct,    penalties    waived    for,    151 

Depreciation   mUst    be    entered    on   books, 
1064-1065 

Dissolved     (See     also     "I^iquidating     Cor- 
poration") 
Penalties   waived   for,    151 

Dividends, 

Guaranteed,  as  rental  equivalent,  699 
Paid  in  Liberty  bonds,  losses  on,  98S 
Received,    760-761 

Former    procedure,    761 


[See  also  Estate,  Capita!  Slock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1845 


C'iRPOK.'..  :i,.\..      ,  Li-nlinueu) 
Dividends — iConiinued) 

Tax-exempt   when   received   from   oil.i 
corporations     taxable     under     federal 
law,    704 

When    taxed,    704 

Former   proceduie,   704 
Domestic    (See    "Domestic    Corporation") 
Domestic,      control      foreign      subsid'ary. 

credit    for    taxes,    948-951 

Former   procedure,   948,    951 
Excess  profits  tax,   160 

Credits    for,    940 
Exc'se  tax  of   1909,   7,   8 
ICxc  su-    i:ix,    revaluation   as    of   January    i, 

1009,    applicable   to,    1070 
ICxemi't'.ons.    89 

Classification,    34-31 

Corporations     serving     exempt     corpora- 
tion,  46 

Establishing    right   to    exciT!T^('nn.     \y 

United   States  bonds,   691 

Withholding    obligatiors.    v 
Extension     of     time     for     filing     returns, 

55-60 
Federal    taxes   assumed   by   corporation   is- 
suing    tax-free     bonds     not     deductible 

as   interest,    931 
Fines    paid    for    violation    of    Anti-Trust 

Act   not  deductible,   922 
Fiscal  year  basis,   64 

Foreign     branches,     appraisal     of     cur- 
rency  in   dollars,    392 

Penalties  viraived  for,   131 

Returns,    90 
Foreign    (See    "Foreign    Corporation") 

Defined,    1271 
Foreign  taxes,   limitation  of  credit,  948 
Gifts, 

Christmas,   886 

Received,   not  taxable   income,   374,   518 

Sale  of,   519 

When   deductible,    1249,    125 1 
Former    procedure,    1251 
In    partnerships,    810 
Inactive, 

Penalties  waived   for,    151 

Returns,  95 
Incomplete,   returns,   95 
Information    at    source,    392 
Insolvent,    penalties,   waived   for,    151 
Insurance    of    employees    or    officers,    for 

benefit  of   employer,   43 1 ,   41 3 

Not   deductible,    894 
Former  procedure,   89  1 
Interest   as   rental    equivalent,    0<jy 
Interest     from     foreign     subsidiaries,     al- 
lowable   deductions,    679 
Joint  stock  companies,  defined,  91 
Law  of    1 92 1,    20 
Legally  non-existent,  91 
Limit     on     deductions     for     dci 

1051 
Limited    partnerships  as,   811 


■^ee    "Liquidatini; 


Bonds   sold  -or   redeemed,    1016 

Deductible,    978 

Former   procedure,    978 

Individual's     share,      when     deductible, 
1005 

Limitation   on   deductions,    1020 

Sales   of   securities,   989 

Securities    issued    and    redeemed,    1013- 
1018 

"Wash   sales"   of   securities,   993-993 
Mergers, 

Penalties   w;>" '■  1    '■'•'-     1-' 

Returns,    i(f. 
Gifts. 
Kew, 

Fiscal  period,  65 

Returns  by,  99 

Former    procedure,    og 

To  evade  taxation,  990 
i\ot     distributing     earnings,     as     personal 

service   corporations.   839 

Former  procedure,   839 
Not      organized      for      profits,      penalties 

waived   for,    151 
Organization  expenses  not  deductible,   907 
Outlawed   accounts   taxable   income,    520 
Ownership  certificates  net  required  for  re- 
gistered   bonds,    313 
Partnerships    reorganized    as,    returns    on 

basis    of    calendar    year    for    employees' 

salaries,    297 
I'aymen;   of  tax   at  source,    1306 

Mot    deductible,    332 
Payments    to,    need    not    be    reported,    303 
Personal    service    corporations    (See    "I'er- 

sonal    Service    Ccr|)orations") 
Purchasing     replacement     property     from 

si-l)sidiary,    509 
Rate  increase  under  law  of  10:8.   13 
Receiver  appointed   for. 
Reorganizations,    100 

Exchange  of  securities  ini   l.ia.i^ih.-,   -,.,  j 

To  evade  tax,    193 
Retroactive      incorporation     for      partner- 
ships, 

Law   of    1921,   796 
Returns,    53,   69,    75-129 

Affidavits,   90 

Annual     basis     for     fraclii  iial     part     of 
year,    167 

Change  of  name,    100 

Con.solidated     (See     "CoiiMilMi^n- 1      U: 
turns") 

Dividends   pa'.!,    m;,     ioi 
Former    ; 

Exempt,    8' ' 

Fiscal    year    ii.-is  j^,    im,    1  c  1   : 

Government  contract  corp.iia 

Former    procedure.    103 
Inactive   cnrioralions,   95 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1846 


GENERAL   INDEX 


Corporations — (Continued) 
Returns — (Contini(ed) 

Incomplete    corporations,    95 
Inspection,    119,    123 
Liquidating,    55,    102 
Mergers,    100 
New    corporations,    99 

Former    procedure,    99 
Place    for    filing,    63 
Receivers,  402 
Reorganizations,    100 
Time   for   filing,   54 
Time   for   filing   extended   to   March    15, 

58 
When  exempt  from  making,   89 
Salaries    paid   by,    874 
Sale  of,   penalties  waived  for,    151 
Subsidiary  (See  "Affiliated  Corporations") 
Tax-free   covenant  bonds,   322-333 
Tax  on  net  earnings,   703 
Tax   paid   by,    by    contract,    1307 
Tax    paid    on   tax-free    covenants,    refund- 
able,  when,   972 
Tax   rate    applicable   to,    160 

Former    procedure,    161 
Tax   rate,   increased,    18,   31 
Trading,    when    may    qualify    as    personal 

service,    826-827,   829-832 
Trustees    in    bankruptcy,    returns    by,    102 
Undistributed   profits,    1259-1325 

Claims  for  credit,  285 
With  large  government   contracts   not   per- 
sonal   service   corporations,    839 
Withholding    interest    on   bonds,    must    re- 
port, 305 
Corrected    Returns     (See    "Amended    Re- 
turns") 
Cost, 

Basis  for  ascertaining  capital  gain  or  loss, 

569 
Operating,    mines,    11 82 
Cost  or  Market  Value   (See  also  "Market 
Value") 
Accounts    receivable    and    accounts    pay- 
able  inventoried  on  basis  of,   393 
Basis    for    obsolescence,    11 35 
Inventories,    459-469 
Cost  Systems  (See  "Accounting  Methods") 
Costumes,   Theatrical, 

Depreciation,    1093 
Cotton    Exchanges, 

Shares    carrying,    dividend    rights, 
Not  exempt,  43 
Council    of    National    Defense, 

Gifts  to,   deductible,   1245 
Counsel,   Special   (See  "Special  Counsel") 
Coupons, 

Interest    coupons    presented    without    own- 
ership   certificates,    311 
Matured    interest    coupons,    388 
Used   as   purchase   price   for   other   securi 
ties,    67s 
Court   Decisions    (See   "Decisions") 


Courts,  State, 

Clerks   of   State   courts  employing  clerical 

assistants,    406 
Compensation    of    jurors    of    state,    county 

or  municipal  court,  not  taxable,   412 
No  jurisdiction  to  determine  federal  taxes, 

268-271 
Receiver's  compensation  fixed  by  taxable 

income,  405 
Cows  (See  "Live  Stock") 
Credit    Unions, 

Exemptions,    38 
Credits  Against  Income,  845-850  (See  also 

"Deductions,"    "Exempt    Income") 
Allowable   to   estates   and   trusts,    1368 

Former   procedure,    1368 
Amounts    paid    differ   from   accruals,    955 
Claims,    where    accurate    records    are    not 

kept,  960 
Corporations,    172 
Defined,  337 
Dividends,   31,    155 
Domestic    corporation    controlling    foreign 

subsidiary,    948-951 
"Former    procedure,    948,    951 
Estates   and   trusts. 

Payments    to    beneficiaries,    1358,    1359 
Excess    profits    tax,    940 

Former   procedure,    801 
For   dependents. 

Not    reduced    on    returns    covering   frac- 
tional part  of  year,   169 

Not   reduced   on   returns   covering  frac- 
tional   part    of    year,    former    proced- 
ure,   169 
For    local    or    state    tax,    on    account    of 

taxes   paid    by   bank   on   bank    stock    as 

equivalent  to   dividend,   734 
Foreign    corporations,    1296 
Foreign    countries    which    do    and    do    not 

allow,   for  United  States  taxes,  945 

Former   procedure,   945 
Foreign  taxes,  942-944 

Corporations,    947 

Former    procedure,    947 

Forms  to  be  used,   956 

Limitation  of,  943,   948 

Procedure    for    securing,    953 

Under   fiscal   year   basis,   954 
Former    procedure,   954 
Income    on   certain   securities,    155 
Individuals,    337-345 
Insurance    companies,     1393 
Liberty   bonds,    interest,   31 
Massachusetts    trusts    operating    property 

in    foreign    country. 

Foreign    tax   credits   not   allowed,    956 
Method    of    treatment,    845 
Non-resident  aliens, 

Filing    returns,    1295 

Former    procedure,     1295 
Normal    tax,    155 

Liquidating    dividends,    749 


[See  also  Estate,  Capital  Stock,  and  Excess  Pr.'Qfit^  iQC^Qi^es] 


GENERAL   INDEX 


1847 


Credits  Against  Income — iCcmtinucd) 
Partnerships,    800 

Information    needed    to    take    advantage 
of,    802 
Payments    of    tax    at    source,    333 
Special,    life    insurance    companies,     1386 
Taxes,    937-974 

Tax-free    covenant    bonds,    333 
Criminal  Proceedings,   152 

Officers    of    the    United    States,    153 
Crops, 

Insurance,    900,    1409 

Rental     paid     in     crop     shares,     not     re- 
ported,   294 
Cuba, 

Accounts    uncollectible    because    of    mora- 
torium   in,    1043 

CURLE,     J.     H. 

On    interest    rate    of    mines,    1 1 88 
Customs   Duties, 
Deductible,   959 


Dairymen's  Associations, 

Exemptions,    45 
Damages, 

Alienation  of  wife's  affection,  not  exempt, 

352 
Automobiles,    860 

Awards   by   Arbitration   Board,    514 
Breach  of   promise  suit  not  exempt,  352, 

870 
Claims  for,  vested  before  March    i,   1913, 

not   taxable,    514-515 
Patents,    damages    received    for    infringe- 
ments,  income  or  capital,  649 
Personal    injury,    loii 
Proceeds  from,  not  taxable,  444 
Date    (See    "Basic    Date") 
Date  of  Payment, 

Additional    assessment    extension    of,    227 
Last  due  date,  54,   57 
Date  of  Tax  Return, 

Determined   for  tax  rate   on  dividends  by 
date   of  dividend   payment,    708-711 
Death    (See   also    "Decedents"), 

Penalties    waived    for,    150 
Debentures, 

Holders    must   file    ownership    certificates, 
308 
Debtor    Corporations     (See     "Returns    of 

Information   at    Source") 
Debts, 

Secured     debt     laws,     taxes     paid     states 
under. 
Deductible,    957 
Debts,    Bad    (See   "Bad    Debts") 
Decedent, 

Assessment  on  bank   stock, 

Not    deductible,    1360 
Claim  for  bad  debts  against  estates,    1037 
Penalty  exemption  for  estates,    147 


Decedent —  {Continued) 

Status    at    time    of    death    determines    ex- 
emption,   343 
Taxable   income   not    realized    on    passage 

of  estate  from,  to  executor,   1358 
Decisions, 
Court, 

Uncertainty  of,   1063 
Courts   overrule  treasury  rulings,   238-239 
Table   of,   ix 

Taxpayer's    right    to    appeal    from,  '238 
Deductions,   845-850    (See   also    "Deprecia- 
tion,"   "Interest,"    "Losses,"    etc.) 
Accounting   method,    847 
Accounts    receivable,    basis   for,    1037 
Accrual    method,    847,   933,   972 
Advances    to   salesmen,    878 
Adjustment   of  taxes   of   prior   years,    966 
Agents'   commissions,    890 
Allowable,    lists   of,    845 
Amortization   of   war    facilities,    1149-1166 

(For  complete  list  of  subjects  see  under 
"Amortization  of   War   Facilities") 
Annuities     by     civil     service     employees, 

should  be  reported  fo,r  income  tax,  413 
Assessments    deductible    as    business    ex- 
pense,   970 
Assessment   on  decedent's   bank   stock. 

Not  deductible,   1360 
Attorneys'    fees,    141 5 
Automobiles, 

Damages,  860 

License   fees,   957 

Upkeep   of,   868 
Bad    debts,    391,    1030-1049 

(For    full    list    of    subjects    see    "Bad 
Debts") 
Bank   charge    on    tax-exempt    obligations, 

938 
Bank   of   deposit,   for  deposits,   927 
Bank    stock,    taxes    paid    by    banks    not 

deductible   by   shareholders,    957 
Baseball    player's   services,   917 
Beneficiaries, 

Foreign  taxes,  943 
Bond  discount,  926 
Bonus,    883,    885,    918 

(See   also   "Bonus") 
Buildings,    demolished,   997 
Business    expenses,    851,    852,    855 

(For  full  list  of  subjects  see  "Business 
Expenses") 
Business   taxes,   958 
Cancellation   of  contracts,    1000 
("apital    deductions    defined,    628 
Casualties,    860,    1008-1011 

Former  procedure,  1008 
Certificates  of  deposit,  926 
Certificates    of    indebtedness    of    a    state 

or   territory,   928 
Christmas  gifts,  885 
Church    dues,    1245 
Citizens   of   the   United    States, 

Foreign    taxes,    942 
Commuters'    fare,    865 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 848 


GENERAL    INDEX 


Deductions — (Cintinticd) 
Compensation  for  personal   services,   8;u 

878 

(For   full    list    see    "Compensation    for 
Personal  Services") 
Construction   if  not  capitalized,  929 
Contributions  by   stockholders,   990 
Corporations     (See     "Corporations") 
Criticism   of,    936 
Customs    duties,    959 
Damages    (See    "Damages") 
Debt   recoverable    only   in   part,    1030 
Deferred    payments    to   lessor,    907 
Depletion,    1 197-1239     (See    "Depletion") 

Limitation      on,     based     on      discovery 
value,     121 1 
Depositors'    guaranty    fund,    902 
Depreciation,    31,    693,    863.    1050-1129 

(See    "Depreciation") 

Allowed   on    estates,    1363 
Determined  by  accrual  of   income,   854 
Dividends  paid  by  court  order,  928 
Dues  to  board  of  trade,  917 
Dues    to    labor    unions,    917 
Duplicate  to   be  avoided,  1132 
Estates   and    trusts, 

Administration  expenses  not  deductible, 
1360 

Charitable    contribution,    1358,    1359 

Current   expenses,    1360 

Federal  estate   tax,    1361 
Former  Procedure,   1361 

Not   treated    as   units,    1369-1374 
Expenses   for   sale  of  property  by   estate, 

1363 
Fiduciaries,   gifts,    1365 

Local    benefit    taxes    not    deductible    by 
estates   and    trusts,    1362 

Losses,    by    estates,    1364 

Stamp    taxes    on    sale    of    property    by 
executor,   1363 

Unrealized    loss    not    deductii)le    by    es- 
tates,   1362 
Excess   Profits   Tax, 

Corporations,    940 
Excise   taxes,   958,   960 

Former  procedure,  960 
Expenses,   31,   851-922 

(For     complete     list     of     subjects     see 
"Business    Expenses,"     "Expenses") 

Former    procedure,    852 
Farmers,  1410,  1411 
Federal    income    tax    not    deductible,    964 

Former   Procedure,    964 
Federal    tax    paid    by    corporation    under 

tax-free    covenants    not    deductible,    971 
Fidelity   bonds. 

Premiums  on,  896 
Fire    loss,    860,    1008-1011,    1415 

Former  procedure,    roo8 
Flood,    14 1 5 
Foreign    dividends,    944 
Frost.    1415 
Gambling,    1006 
German    investments,    987 


-    "Gifts") 
I'oiiiK'i-    I'l-ofcdure,    124J 
I'oiding   companies,    50 
Ifoiding    companies'    losst-. 

Former  procedure,    1018 
Illegal    Transactions,    looG 
Improvements,    693,    853 
Included  in  gross  income,   1279 
Income   and    excess   profits   taxes,    423 
From    foreign    sources,    1270 
Former  procedure,    1270 
Inconsistencies   in   lav.',    846 
Individuals,    31,    831,    853 
Foreign  taxes,  943 
Former  procedure,   853 
Tax  on,  851,   852,  853 
Taxes,    938 

Former        Procedure,    939 
Inheritance    tax,    937,    961 
Insurance, 

As  business  expense,  851 
Insurance  companies,   not  life   or   mutual, 

1390-1394 
Insurance  premiums,   869 
Commissions  paid  on,  890 
Croup,    S95 
Life.    S93,    897 
Paid    by    insured,    853 
Property,   896 

Workmen's    compensation,    898 
Interest,    31,    9^3-936 

(For     complete     list     of     subjects     see 

"Interest") 
From    foreign    subsidiaries,    678 
Interest    on    indebtedness,    924 
Interstate   Commerce    Commission, 

Payments  to,   91S 
Judgments, 

Amounts  paid  on.  919 
Former   procedure,   919 
Law   of    1921, 

"Relief"   provisions,    1021 
Former  procedure,    1021 
Licenses,   958 

Life    insurance    companies,    1380-1386 
Limitation    for,    929,    1020 
Former  procedure,   1029 
Limitation       period       when       tentatively 

allowed,    198 
Limited   to   those   specified   in   the   statv.te, 

845 
Loans,  929 

Secured  to  purchase  or  carry  U.  S. 
government  bonds,  not  deductible, 
924 

Former    Procedure,   924 
Local    improvement    assessments    not    de- 
ductible,  966-968 
Former   Procedure,   966 
Local    improvement    deduclil.i;-.    v   >^ 
Losses,   31,   975-1029 

By   theft   or   embezzlement,    3S1,    84S 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


Deductions — (Ctntiiiited) 
Luxury    taxes,    960 

Former  procedure,   960 
Machinery,    scrapped,   997 
Maintenance  funds,   917 
Maintenance    of    records,    914 
Method    of   treatment,    845 
Money   borrowed   on   loan,   929 
Mortgages,   926. 

Mutual    Shipowners'    Protection    and    In- 
demnity   Association,    365,    1395 
Net  losses,   1023-1029 
Non-resident    aliens,    1 292-1 395 

Apportionment,     1294 

Filing  returns,    1295 
Obsolescence,     1130-1149 

(For     complete     list     of     subjects     sec 
"Obsolescence") 
Partnerships,    S70,    892 

For   gifts,    799 

Former  procedure,   799 

Foreign  taxes,  943 

Information   needed   to    take    advantage 
of,    802 

Losses,  803 
Patent  litigation,   631,    11 12 
Patents, 

Depreciation,    not    obligatory,    652 
Penalty    additions    to    taxes    may    or    may 

not   be,    966 
Pensions,    888-889 

Former    procedure,    889 
Pension,    sick,    insurance    funds    as    com- 
pensation for  personal  services,  444 
Personal    expenses    (See    "Personal    Ex- 
penses") 
Pew  rents,   1245 
Postage  not  deductible,  971 
Profit    participation    by    employee,    892 
Property   destroyed,    694 
Property, 

Revaluation,    1002 
Real    estate. 

Buildings     destroyed,     on    leased    land, 
694 

Erection    of   buildings,    694 

Mortgages,   926 

Payment   on   cancellation   of  lease,   904, 

905 

Redetermination   or    examination    of,    199 

Rent    except    for    business    purposes,    not 
deductible,    932 

Rental  of  subleased  apartment,  904 

Rentals     paid     to     stockholders    in     bank- 
ruptcy,   727 

Repairs,   incidental,   91  i 

Resident  aliens, 

Foreign   taxes,    942 
Taxes,  938 

Resid-?ntial    property,    1002 

Russian    investments,    987 

Salaries,    870-876 

(For     complete     1  s<      of     subjects     see 
"Salaries") 

Sale   of   capital   assets,   979 


.  I  ^. ,  J    ;>.j — (Ci.  ntint(ed) 
Salesmen's   commissions,  890 
Scrip   dividends,    926 
Secured     debt     laws,     taxes     paid     states 

under,  957 
Securities   given   as   collateral,   930 
Shipwreck,    860 

Special  assessments,   when,  960-970 
Speculation,  996 
Stamp   taxes,   959  , 

State    taxes,    937 

Paid    by    banks,    734 
Stockholders'    commissions,    891 
Storm,   losses  by,   860,    1415 
Tax-exempt   securities,    923,    924 
Tax-free   covenant   bonds,    323-333,    677 
Taxes    paid,    31,    937-974 

Criticism    of    law,    963 

Federal    not    deductible,    927 

Federal      not     deductible     on     tax-free 
covenant    bonds,    when    paid    by    cor- 
poration,   928 
Former  Procedure,   928 

Foreign,    937,    942-944,    946 

Former    procedure,    974 

Overdue,    federal,    927 

Paid  by   husband   for   residence  title   to 
which    is   in    wife's   name,   963 

Paid    by   tenant,    903 

Paid   for  another  person,   963 
Teachers,    863 
Theft,    860,    1008-1011 

Former    procedure,    1008 
Trading   stamps,    916 

Former  procedure,  916 
Transactions   entered   into   for   profit,   999 
Traveling  expenses,   856 

By   automobile,    868,   869 

Of  commuters,   856 
Undistributed    surplus,    tax    on,    not    de- 
ductible,  971 
X'ictory   notes   deductible,   925 
Victory   notes  not  deductible,  923,  924 
Wages,    870-876 
Welfare   work,   887 
Worthless    stock,    988 

Former    procedure,    989 
Deferred  Charges, 
Advertising,    911 
Defined,    490 
Dividends, 

Deductible     for     life     insurance     com- 
panies,   1383 
Deficiencv    Tax     (See     "Additional     Tax 

Payments") 
Dei-inoufncy    (See   "Failure    to   Make    Re- 
turn") 
Ufn-.ny.  G.  a., 

On   interest   r-i'--   "f   mlur^.    iiSo 
Dependents, 
Exemptions, 

Allowed,    j.iS,    j|'i.i|3 

Kot  reduced  on  return  conccrninR  frac- 
lioual     pari    of    year,     K.0 
I'lirmcr  procedure,    i(<o 


[See  also  Estate,  Capitm  Stock,  and   Excess  Profits  Indexes] 


i85o 


GENERAL   INDEX 


Dependents — (Continued) 
Joint   support   of,    342 
Test   of  dependency,  340 
With  home   elsewhere,   341 
Depletion, 

Allowance,  defined,  1208 

How  computed,   121 1 

For  mines,   oil  wells,  641-647 

Former    procedure,    642 
Amortization    table    for,    11 80 
Basic    date,    642 

Defined,    1173,    1208 
Basis  of,    1 167,    1171-1174 

Appreciation    arising    out    of    reapprais- 
als,   1172 

Cost   or    price,    1174 

Former    procedure,     11 68 
Bonus  deductible   by    lessee,    1226 
Cost   or   price,    1200,    1210,    121 1 
Deductible    even    if    not    on    books,     1215 

Former    procedure,    1215 
Deduction  based  on  discovery  value,   121 1 

Discovery  value  under  lease  from  gov- 
ernment,  1229 
.Dividends    from    depletion    reserves,    743 
Factors   for   deduction,    1169 
Fair    market    value,    1173 
Fair  market  value  basis  for,  541 
Former   procedure,    1168,    1169 
Gasoline   absorbed   from   gas,    1 203-1 204 
General    procedure,    1171 
Law  of   1921,   1167 
Lessees,    allowance   for,    1 224-1 226 
Lessees  and  lessors, 

Allowance    for,    1216-1226 
Mineral    deposits, 

Valuation    of,    1181 
Mineral    deposit   defined,    11 74 
Minerals,    defined,    11 74 
Mineral  property  defined,    11 73 
Mines, 

Advance    royalties,    1229 

Copper,    1209 

Determination    of    quantity    of    ore    in, 
1183-1186 

Development     costs,      how     accounted, 
1228 

Discovery   of  mines,   1194-1196 

Discoveries    of    mines    and    oil    wells, 
basis   for,   1228 

"Discovery    value"    of    mines    and    oil 
wells  basis  for,   160 

Rate  of  interest,    1187-1192 

Resources,   unworkable,    1231-1233 

Valuation,    11 74-1 196 

Valuation,    calculation    of,     11 86 
No   further  deductions  allowed   when   re- 
serves    for,     equal     capital     investment, 

1 1 69 

Operating  owner  allowed,  1215 
Operating  profit,  defined,  11 74 
Records   necessary  to   support  valuations, 

1 1 70 

Recovery    of   capital,    1224-1227 


Depletion — (Continued) 

Reserves,    dividends   from,    1231 

Former    procedure,    1231 
Returns,    statement    to    be    attached    to, 

1214 
Revaluation    after    March     i,    1913,    not 

permitted    except    in    cases    of    discov- 
eries,   1205-1206 
Royalties,   645 

Stockholders,  no  deductions  for,  1216 
Sinking  fund  for,  not  established,  11 79 
Timber, 

Determination    of    quantity,     1238 

Evidence    required   to   support,    1236 

Located    in    Canada,    1238 

Market    value,    1237 
Treasury  requirements  to  support  charges 

of,    1204 
Valuation,    1168,    11 71 

Discovery   value   or   cost,    11 71 
Wells,    oil  and   gas,    1202,    1210-11 

Evidence   required   to   support,    1204 
Deposit,   Certificates  of   (See  "Certificate 

of   Deposit") 
Depositors, 

When   preferred   creditors,    1343-J344 
"Depositors'  Guaranty  Fund', 

Deductible,   902 
Depreciation, 
Accrued, 

Included  in  each  year's  return,  1067 
After    distribution    of    net    income,    1071 
Allowance    claimed    must   be    entered    on 

taxpayers'  books,   1067 
Allowed    in    ascertaining   capital    gain    or 

loss,  569-582 
Alterations,  1086 
Assets    transferred    at    gross    book    value 

increase    allowances   for,    1070 
Attitude    of   Treasury   toward,   improved, 

1053 
Automobiles,   868,    1087 
Banks   may   keep   additional   records    for, 

1065 
Basis    of   computation,    1051,    1068 
Boilers,    1080 
Books,    1088 
Buildings,    997,    io88 

On  leased  land,   1079 

Under   construction,    1090 
Cases    of    period   Jan.    1,    1909 — Feb.    28, 

19 1 3,  dependent  on  fair  value  of  prop- 
erty on  Jan.  i,  1909,  1070 
Cash    registers,    1093 

Charges  for  current  only  applicable,  1066 
Chemical    industry,    1093 
Collateral   securities,    1043 
Computation   of,    1076 
Conditions    precedent    to    allowances    for, 

1055 
Containers,    1093 
Contracts,    1094 
Copyrights,    1095 

Since  Feb.  28,  1913,  652 
Cost   or  value  as  of  Mar.    i,    1913,    1068 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1851 


Depreciation — {Continued) 
Costumes,  theatrical,  1095 
Deductions    only     during    taxable     years, 

1137 
Deductions,   863,    1050-1129 

Allowed    to    estates,    1363 

In  excess  of  net  earnings,  1071 

Permitted   for,   in    1921    law,    1050 
Former  procedure,   1050 
Defined,    1050 
Designs,    1 1 14 
Distinguished      from      replacement      cost, 

1055 
Distribution    of, 

On    leased    property,    694 
Dividends  from  depreciation  reserve,   743 
Earning    power    of    individuals,    1058 
Electrotypes,    1096 
Equipment, 

Acquired  before  April   6,    191 7,    1083 

Purchased   on  rental   plan,   912 
Erroneously  considered   an  elastic   factor, 

1051 
Farms,    1413 
Fiduciaries,    1072 

And  estates,    1072 
Formulas  deductible  if  worthless,   1096 
Foundries,    1096 

Furniture    arid    fixtures,    1056,    1096 
Gas  property,   1078,  11 07 
Genius  not   subject   to,    1058 
Goodwill,    1097 

None   allowed  when  purchased,   609 
Government      policy      toward,      mistaken, 

J052 
Greater    in    1917    and    191S    than    in    pre- 
war period,   1067 
Hat  factories,   1098 
Horses,    1098 

Importance   of  consistent  plan,    1055 
Improvements,    1051,    1086 
Insurance    companies,    1393 
Intangible  property,  1098 
Inventories, 

Not  applicable,   1057 

Obsolete  items,  474 
Joint    owners,    distribution    between,    1074 
Land,    1098,    11 06 
Leaseholds,  11 00-11 01 

Limited,    1097 

Value    of,    at   March    i,    19 '3.    may    be 
used    for,    iioi 
Life    insurance    companies,    1384 
Limit  on   deductions  for,   by   corporations 

or    individuals,    1051 

Former    procedure,    1097 
Literary   ability   not   subject   to,    1058 
Local    conditions    determine,    1080 
Machinery     and     equipment,     997.     1102, 

1 1 19 

Effect    of    "overtime"    and    "overload," 
1080 

Leased,    1061 

Replacement    vs.    supplies,    1060 


Depreciation — {Cciitinited) 

Market    value     of    assets     of     liquidating 

corporation,   basis   for,    1070 
Methods   of   determining,    1053,    1075 

Fixed    percentage    on    flat    basis,    1075, 
1077 

Fixed    percentage     on     reducing    scale 
basis,   107s 

Production,    1075,    1077 

Sinking   fund,    1075 
Mine    equipment,    11 04 
Mines,    10-9 
Must   be   entered    on    books,    1064 

Former    procedure,    1064 
Net  profits  determined   after   depreciation 

deducted,    1052 
Off'set   by   appreciation,    1063 
Oil    property,    1078,    1107 
Orchards,    1109,    1414 
Organization    expenses,    11 09 
Patents,    1095,    1109-1113 

Based   on   fair  market   value    at   March 
1,    1913,    iiii 
Former    procedure,    11 11 

Deduction  not   obligatory,    652 

Readjustment     permitted     on     accounts 
prior  to  1917,  653 

Since   Feb.    28,   1913,   652 
Patterns,    11 14 

Permanent   discontinuance,    1072 
Physicians,    1116 
Printing,    11 16 

Prior  years  not   allowed,    1137 
Professional   men,    11 16 
Proper    records   of,    1065 
Property, 

Acquired  after  March   i,   1913,   1071 

Acquired   by   gift,    1073 

Cost   basis,    former   procedure,    1069 

Kept    in    repair,    1058 
Treasury    ruling,    1059 

Subject  to,   1056,    1057,   1077 
Radium,    11 16 
Railroad    roadway,    1061 
Railroad    sidings,    11 17 
Rotes,    1075-1129 

Adjustment  of  substantial  cirors,   1081 

Alteration  in,   1066 

Excessive,    1083 

Must  be  reasonable,    1075 

Should   be   based  on   actual   investment, 
1053 

Specific   suggestions,    1084-1129 

Suggested    by    British    War    Ministry, 

1054 

Tables,    1123-1128 
Reorganization   of  business,    1069 
Repairs   and   replacements,   912,    1058 

Deduction  must  not  be  duplicated,  1058 

Future,    10O9 

Permanent,    1064 
Reserves   for,    1074,    1207,    1210,    1214 
Residences, 

Gain  on  sale   of,   1057 

Rental    value,    581 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


'0- 


GENERAL    INDEX 


Depkeciation — (Continued) 
Residences — (Coniimied) 

Rented   part   of   year,    1056 

Saiblet,    1056 

Used   partly   for   business,    1056 
Shipping    industry,     11 17 
Soap    industry,    11 18 
Steamships,    11 17 
Styles  and,    11 14 
Tables,    1123-1128 

Taxpayers  shouid   insist   on   proper   allow- 
ances,   1055 
Textile    industry,    11 18 
Timber,     1079 

Improvements,    1234 

Industry,    11 19 
Tools,    1 121 

Treasury,    definition   of,    1051 
Typewriters,     1121 
Uniforms,    1122 
"Useful    life"    defined,    1055 
Use    of    a    number    of    ledger    accounts 

simplifies,    1067 
Vital    issue   in    accoi.inting,    1052 
Wagons,    1 1 22 
War    property,     1079,     1082.       (See    also 

"Amortization   of  War   Facilities") 
Wood-working     industry,     11 22 

Designs, 

Depreciation,    11 14 
Discontinuance, 

Depreciation    in    cases    of,    1072 
Discount, 

Bonds   sold,    prorating    of    loss,    1013 

Cash,   tax-exempt,   527 

Note    belonging    to    state    territory,    etc., 

exempt,    360 
On  bonds,  treated  same  as  interest,  926 
On    Treasury    certificates,    688 
Reserves   for,   451 

Sale    and    retirement    of    bonds,    523 
Discoveries  OF  Wells, 
Depletion    basis,     1228 
Former   procedure,    1218 
Discovery  of  Mines, 
By   improvements,    1193 
Defined,    1194 

Depletion  value,    1167,    117: 
"Discovery   value", 
Ascertained,    541,    601 
Basis    for    depletion,    169 
Not    a    factor    in    computing    profit    on 
sale  of  deposits,   160 
Fair   market   value. 

Disproportionate   to   cost,    1194 
Must  exceed  cost,    1205 
Value    30    days   after   discovery,    1196 
Dissolution     (See     "Liquidating    Corpora- 
tion,"   "Partnerships") 
District   of   Columbia, 

Citizen    of,    taxed    as    non-resident    alien, 
1322 


I.MSTRICT     (II       ("oLUilBIA (CoiltillUCd) 

("ompensation    of    government    employees, 

not  exempt,  401,  410 
Interest     in     obligations    of,     tax-exempt, 

360,    664,  681 
Dividends,      703-762      (See      also      "Stock 

Dividends") 
As   income,    703,    709 
Building   and    loan   associations,    362 
Cash, 

As   taxable    income,    717,    732 

Effect    of    60    day    clause    of    Revenue 
Act  of  1918  on,  733 

Paid   out   of   appreciation   of   good   will, 
tax-exempt,   746 

With  increase  in  capital  stock,  taxable, 
764 

With  option  to  bviy,  taxable,  764 
Corporations    in     Philippines     and     Porto 

Rico    classed    as    foreign    corporations, 

349 
Credit  against  income   from,   712,  749 
Credit   for,   in  partnerships,    800 
Credit   for   normal   tax,    135 

Dividends     from     certain     corporations 
taxed    in    Porto    Rico    or    the    Philip- 
pines   excepted,    704 
Date   of   payment   determines   year  of   tax 

rate,   708 
Deductions,    scrip,    interest,    742 
Deferred, 

Deductions     for     life     insurance     com- 
panies,  1383 

When  taxable,  755 
Defined,    705,    719 
Distributions, 

Allocation  of  earnings   to,    T07 

By    foreign    corporations,    711 

Computation   of  gains  or  losses  in,    725 

During   first    60   days    of    taxable    year, 

l-"ormer    procedure,    706 

Government    securities,    740 

Subsequent  to  first   60  days  of  taxable 
year,    738 

Tax-free,   losses   on,   991-993 

What   constitutes,    707 
Exempt    from   normal    tax,    347,    703 

Former    procedure,    348,    712 

Limitation    of    1921    law,    711 
Federal    reserve   banks,   exempt,   362,    705 
Foreign   corporations. 

Exemptions,    349 

Information  at  source,  298 
Foreign,  deductions  for,  944 
From  depreciation  r.nd  depletion  reseives, 

743 

Former   prpcedure,   744 
Holding   companies    exempt    on    received, 

50 
In  kind,  759 
Liberty    bonds    distributed    as,    losses    on. 

988 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1853 


DiviDEXDS — iCintinucd) 
L:le-   insurance    companies, 

Deductions,    1392 

Deductions  on,  allowable,  1382 
Life    insurance   policies,    354,    757 
Liquidation,    706,    716,    745,    748,    755 
Local   taxes   paid   by   bank   on   bank  stock 

as    equivalent   of,    734 
Owners  of  record  liable,  exception,   705 
Paid, 

By   court    order,    528 

From  appreciation   of  fixed  assets,   716, 

From    capital    surplus,    716,    728,    746 

From    depreciation    reserves,    716,    728 

In  debenture  bonds,  taxable,  741 

In  scrip,  not  taxable, ^^779 

In   stock  of  another  corporation,   not   a 
stock   dividend,    769 

Other   than   in  cash,    734,    749 

Partly     in     cash,     partly     in    shares     of 
new  issue,  732 

Returns,    107,    301 

Former   procedure,    301 

To   partnerships,    802 
Personal    service    corporations,    349,    70s, 

706,    713-71S 

Former    procedure,    349 
Premiums/  on    redeemed    stock,     1018 
Received, 

By    corporations,    760-761 

By   one   corporation    from   another,    348 
Former   procedure,    348 
Refunds,  not  taxable,  758 
Recision   by   directors,    708-711 
Returned     by     stockholders,     tax-exempt, 

708-71 1 
Scrip,  as  cash,  taxable,   741 
Scrip,   not  taxable,   779 
State   bonds    as,    taxable,    740 
Status    of,    received    during    60    days    of 

taxable   year,    733 
Stock    of    another    corporation,    dividends 

paid  in  not  'considered  a  stock  dividend, 

739 
Surplus    accrued    after    March     i,     1913, 

725-727,   730 
Surplus    accrued   out   of,    prior    to    March 

1,    1913,    716,    718-725 
Taxable,    31,    703 
Tax-free,    703 
Tontine    policies,    758 
Uncertain   character,    703.    756 
Domestic    Corporations     (See    also     "Cor- 
porations") 
Defined,   90 
Dividends, 

When    eligible     for     credits    or    deduc- 
tions, 802 
Gifts  to, .deductible,  1242 
Income   derived   from   U.    S.    possessions, 

1325 
Not    required    to    withhold.    328 
Operating  abr*oad,  91 


Domestic  Corporations — {Continued) 
Ownership   certificates   not    required,    308 
Owning    foreign   branch    olfices,    392 
Domestic    Partxersiiips, 

(See  also  "Partnerships") 
Defined,    787 
Domicile, 

Change  of,  does  not  affect  right  of  hus- 
band and  wife  to  make  amended  re- 
turn, 84 

Donations   (See  also   "Gifts") 

Christmas    gifts — classified    as,    1248 

Double   Taxation, 

Confusion  between  repairs  and  deprecia- 
tion,   1060 

Drainage, 

Referee  in,  exempt  from  income  lax,  405 
Dry  Goods   Dealers, 

Inventories,   475-478 
Due   Date   (See   "Date  of  Payment,"   "Last 

Due   Date") 
Dues  Paid  to  Chambers  of  Commerce,  917 


E 

Earning    .  I  ndividual, 

Potential,     not     subject     to     depreciation, 
ios8 
Earnings    (See  also  "Capital   Gain,"   "Divi- 
dends,"  "Gain  or  Loss,"  "Profits") 
Ascertaining     net,     in     sale     of     business, 
604-612 
i.DrcATioNAL   Organizations, 
Exemptions,  39 
Gifts  to,   1241,   1245 
Electrotypes, 

Depreciation,    7096 
Embezzlement, 

Losses,   381,    848.    ion 
Former   procedure,    loii 
Eminent   Domain. 

Damages    awarded    for    condemned    prop 

erty,  whi.n  taxable,   SM 
Interest    on    awards    by,    663 
Employees    (See    also    "Civil    Service    Em- 
ployees,"   "Compensation    for    Personal 
Service,"    "Government    Employees") 
Alien, 

Employer's    duty    to    determine    status, 

1275 
Withholding   of    tax,    1306 

Coin  pensat  ion     for     injuries     or     sickness 
need  not  be  reported,  303 

Defined,    405 

Kslimalc     of      payments      permitted      em- 
ployers,   295 

I''xcniption    of   non-rcsidcnt    alien,    1316 

Gifts    or   bonuses,    4i9-.|^3 

'nformation    at    source    tu    l)C    furnislud 
on   payments   over  $1,000,   295 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


i854 


GENERAL   INDEX 


Employees — (Can  tinned') 
Public, 

Compensation     received     partially     from 
corporation   and  from  county,   subject 
to  tax,  407 
Tax   on   employee's   salary   withheld, 
Gross   payment   reported,   296 
Employees'    Profit-Sharing    Fund, 

As    compensation     for    personal     services, 
436 
Employers, 

Christmas  gifts  deducted  by,  taxable,  420 
Duties     of     in     withholding,     non-resident 

aliens,    1315 
Duty    to    determine    status    of    alien    em- 
ployes,   1275 
Returns   of    information   at   the   source   on 

payments  of   $1,000  or  more,  295-297 
Withholding  tax  of  alien  employees,    1306 
Employment, 

Fees   paid   to    secure,    deductible,    918 
Employment  Associations, 

Engaged  in  profit  making,  not  exempt,  35 
Enemies, 

Non-resident, 

Extension  of  time   for  filing  returns,   60 
Engineers, 

Having    contract    with    state,     subject    to 
tax,  40s 
Equipment, 

Depreciation,      1060,      1061,      1080,      1102, 

1 119 
Payment    on    rental    plan    technically    ex- 
pense, 912 
Sale    of,    1409 
Erosion, 

Losses,   1099 
Escrows, 

Purchase     price     not     taxable     until     re- 
ceived,   375 
Estate  Tax, 

Liberty  bonds,   680 
Estates   and  Trusts,    (See   also    "Fiduciar- 
ies") 
Assessment    period    limited    to    one    year, 

197 
Associations    vs.,    92 
Bad    debts    against,    1037 
Beneficiaries, 

Non-resident   aliens,    1300 
When    taxable,     1330 
Benefits    from    accident    or    health    insui'- 

ance   exempt,   351 
Capital    gains    provision,    effect    on    sales 

by,    1374 
Capital    losses, 

How  deducted,    1372 
Credits   allowable,    1368 

Former  procedure,    1368 
Decedent's     contract     filled     by     executor, 

no   income   accrues,    1359 
Deduction   for   depreciation,    1363 
Deductions, 

Assessments    on    decedent's    bank    stock 
not  deductible,    1360 


Estates  and  Trusts — (Continued) 

Deductions — (Continued) 

Expenses    for    sale   of   property,    1363 
Federal    estate    tax,    deductible,    1361 

Former  procedure,    1361 
For     shrinkage     in     securities     not     al- 
lowed,   986 
Gifts,    1365 

Local  benefit  taxes  not  deductible,   1362 
Losses,    1364 

Stamp  taxes   on   sale   of  property,    1363 
Unrealized  loss  not  deductible,   1362 

Enemy   aliens,    1355 

Estate   during   period    of   settlement,    1329 

Executor   obligated    to,    1368 

Exemptions,    1359 

For  wards  and  beneficiaries,   345 

Former    procedure,    345 

Life   insurance   policies,    1359 

Former    procedure,    1359 

Expenses   of   administration,    1360 

For  religious  purposes,  exemptions,  40 

Income,     accounting     period     other    than 
calendar  year,    1332 

Income    from     Liberty    bonds,    apportion- 
ment  to   beneficiaries,    688-690 

Income  from  property  bequeathed  to  state 
institution,   361 

Interest   received   by   legatee,    674 

Net    income   taxes, 

Paid    by    beneficiary,     1357 
Paid    by    fiduciary,    1357 

Net    losses    deductible,    1028 

Net     taxable     income,     determination     of, 
^  1358,   1359 

Non-resident    alien    beneficiary,    1300 

Non-resident   aliens,    taxable,    1354-1355 

Not   treated   as    units,    1369-1374 
Former   procedure,    1369 

Period   of   administration   defined,    1335 

Responsibility    of   fiduciary,    1328,    1335 

Returns, 

By   executor,    1332-1335 

Fiduciaries,    required    to    make,    1330 

Inspection,    119 

Sale     of     stock     dividends,     taxability     of 
income   from,    1361 

Tax  follows  estate,   1348 

Tax    liability    may    follow    residuary    leg- 
atee,   1352 

Tax,    when    payable    by    fiduciary,    1347 

Taxable  income  under  profit-sharing  plan, 
137s 

Unit,   estates  and  trusts  which   cannot  be 
treated    as,    1336-1338 

Valuation,    625-627 
Evasion  of  Tax  (See  also  "Failure  to  Make 
Return,"   "Fraudulent   Returns,"   "Pen- 
alties") 

Extent    of,    1 91-194 

Proceedings  in  case  of   contemplated,   214 

Undistributed    profits,    1260 
Examination    of   Books,   Papers  and    Per- 
sons, 

Limitation    period,    195-200 

Powers   of  Treasury   officers,    113 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1855 


Examination   of   Books,   Papers,  ane  Per- 
sons—  {Continued) 
Unnecessary,    182 
Yearly    examinations,    115 

Excess  Profits  Tax,   89    (See   also  separate 
index  on  p.   1907 

Consolidated     returns     of     affiliated     cor- 
porations. 
Former    procedure,    104 

Corporations,    i6o 

Partly  personal  service,   graduated  rate, 
826 

Credit    for,   283,    940 

Credit    for    191 7    tax. 
Former  procedure,   801 

Deductions, 

Foreign    taxes,    942 
From    payment,    423 

Dividends,     cash,     bearing     of     sixty-day 
clause  of  Revenue  Act  of   191 8  on,  733 

Exemptions,  law  of   1921,   683 

Forms   to   be  used    for   credits,   956 

Interest  on  U.  S.  bonds,   680,   682 

Life   insurance   companies   not   subject   to, 
1379 

Liquidation    dividends,    749 

Not  deductible,   938,   939 

Partnership    credits   on,    803 

Repeal  of,    17,   32 

Reserves  for,   729 
Exchange,   Foreign, 

Appraisal     of,     in     dollars,     for     foreign 
branch,   392 

Current    assets    and    liabilities,    394 

Current    rate,    392 

Dealers  in,  inventories,  486 

Fluctuations   not   affected,    393 

Liquidating     liabilities     to     foreign     credi- 
tors,   393 

On   income   accruing    abroad,    392 

Profits    on    foreign    obligations,    when    ex- 
empt,   1286 

Rates   for   previous   years,    392 

Shrinkage   in    value   not   deductible,   986 
Exchange   of   Property     (See  also    "Prop- 
erty,"   "Sale   of    Property") 

Acquired    by   gift,    619-625 

Allocation   of    income,    1 282-1 284 

Cash    received    in    continuing    transaction, 
592 

Closed   transactions,    536.    556 

For  other  property,   590 

Former    procedure,    564,    565,    566 

Gains    or   losses    from,    535 

Income  from,  535-566 

Inheritance, 

Valuation     of     property     acquired     by, 
625-627 

Insurance   policies,   method   of   calculating, 
553 

Market  value  at  March   i,  1913,   596 

No   "fair  market   value"   no   gain   or   loss, 
543 

No   gain   or   loss   recognised,    590 

Property   of  a   different   kind   or   use,    545 


Exchange   of   Property — {Continued) 

"Readily     realizable     market     value"     de- 
fined,   537 
Necessary    to    constitute     closed     trans- 
action,   536,    559 
Former  procedure,  537 

Real   estate,   498-504 

Real  estate  dealer's  transactions,  taxa- 
bility  of,   547 

Records  of  transaction  should  be  kept, 
590 

Tax  question,  where  change  in  substance 
or   form,   559,    563 

Transfer  by  individual  to  corporation,  559 
Exchange  of   Securities    (See  also  "Sale 
of    Securities") 

Exchanged    in    reorganizations, 
Not   taxable,    556,    558 

Former   procedure,    564,    565,    566 

Income   from,    535-566 

Not  taxable  in  corporation  reorganiza- 
tions,   536 

"Readily  realizable  market  value"  neces- 
sary to  constitute  closed  transaction, 
538 

Tax  question,  where   change  in  substance 
or   form,   559,    563 
Excise   Tax,    (See   also   separate   index   on 
p.    1903) 

Deductible,    when,    958,    959 

Deductions,   960 

Former  procedure,   960 

Revaluation    applicable    to,     1070 

Stock   dividends,    783 
Executor   (See  also   "Estates  and  Trusts," 
"Fiduciary") 

Capital    gains    provision, 
Effect  on  sales  by,   1374 

Deductions, 

Expenses  for  sale  of  property,    1363 

For    depreciation,    1363 

Gifts,    1365 

Losses,    1364 

Stamp   taxes   on   sale  of  property,    1363 

Defined,   407 

Obligated   to   estate,    1368 

Property  passing  to,  from  decedent,  not 
taxable,    1358 

Property    sold    by,    taxable,    1358 

Remuneration  provided  by  will,  taxable, 
421 

Returns, 

Determination    of    net    taxable    income 

during    administration,    1358,    1359 
For  property  turned  over  to,   1339-1340 
Made   for   enemy   alien,    1235 

Right  to  inspect  returns  of  estate  filed 
by   decedent,    119 

Taxable  income. 

Not  realized  on  passage  of   estate   from 

dtccdent   to,    1358 
Under  profit  sharing  plan,    1375 
Exempt  Bonds     (See  "Exempt   Securities") 
Exempt  Income    (See  also  "Credits"  "Pay- 
ment  of  Tax  at   Source,"   "Stock   Divi- 
dends") 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1856 


GENERAL   INDEX 


X  iCM  I'T     I  NCOM  E (,  C  Olltlll  lied  ) 

Alimony,   367 

Former   procedure,    367 
■"Back  pay"  as  a  gifl,  416 
Building    and    loan    association    dividends, 

362 
Classification,    32,    33 
Credits  and   deductions,    33 
Damages    received,   not    exempt,    352 
Defined,  32,  337 
Dependents,   340-343 
Dividends, 

Foreign    ccrporaticns,    349 

Former  procedure,   348 

From  American  corporations  subject  to 

income  tax,   33 
On  stock  of  federal  reserve  banks,   705 
Out  of   surplus  to   March   i,    1913,   718, 
750 
Employees    of    universities    under    Smith- 
Lever   Act,    412 
Estates    and    trusts,    1359 
Excess-profits   tax. 

Former  procedure,   801 
Excessive      compensation,     considered     as 
stock    dividends,    exempt    from    normal 
tax,  734 
Federal   Farm   loan  bonds,   33,   34 
Fiscal   years  ending   in    1921,   686 
Foreign    corporations,    1296 

U.   S.   bonds,   692 
Foreign   diplomatic   ministers,   364 
Foreign    governments,    316 

Having   investments   in   the   U.    S.,    364 
Gifts,    355-359 
Husband   and   wife,    171 
Living    together,    343 
Individuals,  337-345 

Calculated   on  normal   tax  cnly,    337 
Dependents,    338 

Dividends,   31,   34,    81,    i55>    348,   703 
Dying  during  taxable  year,  343 
Former   procedure,    338 
Interest   on    certain   securities,    15s 
Not   reduced   on   returns   covering   frac- 
tional part   of   year,    169 
Former    procedure,    1 69 
Reduction   cf,    171 

Status   at   end   cf   year   determines,    343 
Valid    for    normal    tax   only,    344 
War    service,    362 

When   exempt   from   v/ithholding,    331 
Inheritances,  355359 
Judges,    United    States,    365,    401 
Jurors    of    a    state,    county,    or    municipal 

court,  412 
Law   of    1913,   9 
Law  of   1921,  20,  683 
Lawyers   employed   by   state,    409 
Lfss  than   year,   686 
Life  insurance  benefits,  352-355 
Life    insurance   policies,   675 

Former    procedure,    675 
Minister's    house,    rental    value    en,    362, 

422 
Minors,    341 


ExuMPT   Income — '  l-  aiuuiiicd) 
Municipal    employees,   366 
Mutual     savings     banks     without     capital 

stock,  35 
National    G'uard,    partly    exempt,    409 
Non-profit    making    organizations,    34 
Non-resident   aliens. 

Benefit    of    exemptions  and    credits,    299 
Employee,    13 16 

Former  procedure,    1295 
Income   passing   through   banks   for   col- 
lection,   316 
Tax-free   covenant   bend   interest,   299 
United   States  bonds,    692 
?Jotary   public,   407 
Pensions,    for    milicary    or    naval    service. 

351 
President   of  the  U.    S.,   365,   401 
Profits   f rr  ni   sale  of   vessels,   369 

Former    procedure,   369 
Receivers   appointed    by    state   courts,    ^0^ 
Referee  in  drainage,   405 
Rfturns  should  be  filed,  33 
Soldiers    and     ?-''  '   :  .ier    procrdu:e, 

410 
Sources,    681 

Special  counsel   ft;'   stai.e  comptroller,  408 
Special   counsel    to   city   net   an   emploj-ee, 

408  ^  \ 

Special    exemptions,   0^2-684 
State  bonds,  33,  34 
State  officers  and  employ^lss,  33,   366,  403 
State   pensicns,    tax-exempt,^ 
States    and    territ:;ries    for    ii^ome    from 

public    utilities,    50 
United    States    bonds,    33,    34 
War   Finance    Corporation   bonds,   3'^ 
War    risk    insurance,    351 
Exempt   Organizations,    34-51 
Agricultural,    34 
Associations    crganiz;d     to    carry     freight 

by  boat,  43 
Banks, 

Federal   land,  46 
Mutual    savings,    35 
Boards  of  trade,   43 
Building  and  loan  associations,   37 
■lusncss   leagues,    43 
Cemetery  companies,   39 
Chambers   cf    Commerce,   43 
Charitable,   39 
Civic   leagues,   43 
Clearing   House    associations,    43 
Clubs,    44 

Community   funds,   39 
Cc-operative,    44 
Co-operative    banks   v.ithout    capital    stock, 

37 
Corporations,   34-51 

Designed    for    scientifie    purposes,    39 
Personal  service   corpcrations,  46 

Former    procedure,    46 
Serving   exempt   corporations,   46 
Former    procedure,    46 
Credit   unions,   38 
Dairymen's,   45 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1857 


Exempt  Organizations — {Continued) 

Educational,    39 

Fairs,    county,    35 

Farmers',   44 

Federal    land    banks,    46 

Fraternal    beneficiary    societies,    36,    1401 

Fruit    growers',    44 

Holding    companies,    50 
Former    procedure,    50 

Horticultural,    34 

Insurance,    1401-1406 

Insurance     departments     in     mutual     sav- 
ings banks,   35 

Labor,    34 

Literary    societies,    39 

Mutual   insurance   of   certain  kinds,    1401- 
140S 

National   farm  loan   associations,   46 

Non-profit    making,    34 

Orchestral    societies,    40 

Procedure  to  establish   exemption,   47 

Purchasing    agencies    for    farmers,    45 

Religious  associations,   39 

Savings    banks,    mutual,    35 

Scientific   societies,    39 

Shipowners'     mutual     protection     and     in- 
demnity association,    363,    1395 

Societies    for    the    prevention    of    cruelty 
to    children    or    animals,    exemptions, 
39 
Former   procedure,    39 

Exempt  Securities, 

Building  and  loan  associations,   362 

Certificates    of    indebtedness     of    a    state, 
territory,    etc.,    361 

Exemption    periods    depending    on    termi- 
nation of  war  with   Germany,   685 

Farm  loan  bonds,   33,   34,  361 

Federal     Reserve    Bank    stock    dividends, 
362 

Filing  of  returns,  33 

Interest    from,   need   not   be  reported,    76 

Interest   on   loan   to   purchase,   not   deduc- 
tible,   1385,    1391 

Interest  on  tax-exempt  bonds,  801 

Interest  on,  when  used  as  collateral,   not 
deductible,    930 

Interest  paid  to  carry,  923,   924 

Law  of   1921,  22 

Liberty  bonds,   350 

Ownership  certificate  not  required,   319 

Philippine  4   per  cent  bonds   of    1914-34, 
361 

Sale  of,  when   taxable,   554 

State  bonds,  33,  34,  360 

Statement  of,  not  required,   360 

Territorial   bonds,   34,   360 

United    States   bonds,   33,   34 

Unlimited   as   to   time,    684 

Victory   notes,    350 

War  Finance   Corporation  bonfls,   34,   350 
Exemption   Certificates, 

Non-resident    aliens,    1313-1314 
Exemption  of  Person, 

Definition,    32 


Exhaustion    (See    "Depreciation") 
Expenses, 

Accounting    in    instalment    sales,    497 

Accounting    procedure,    380 

Accrued,   deductible,   853 

Army    officers,    867 

Business    (See    "Business    Expenses") 

Cumulative    depreciation    allowances    for, 
1058, 

Deductions,   31,  419,   851-922 
Former   procedure,   852 
On     real     estate     owned     by     insurance 
companies,   1384 

Farmers,    1412,    141 3 

Improvements    deductible,    if    not    perma- 
nent,   1059 

Incurred    in    purchase    of    Treasury    stock 
not  deductible,  910 

Lobbying,    915 

Organization,    depreciation,    11 09 

Personal    (See    "Personal    Expenses") 

Traveling    (See    "Traveling    Expenses") 

Uncertain,   deduction    for,   929 
Export   Business, 

Income    from,    527-528 

Profit   from   unpaid   drafts,   377 
Extension  of  Time  for  Payment, 

Additional    assessment,    227 
Extension   of  Time   for  Filing   Returns, 

Absence,   56-58 

Authority    of    Commissioner,    56,    58 
Former    procedure,    56 

Authority    of   local   collectors,    56,    58 

Causes   must   be   explained,    58 

Citizens   residing  abroad,   59 

Does    not    authorize    delay     in     filing    re- 
turns  of   information,    303 

Foreign    corporations,    1305 

Granted     to     corporations     to     March     15, 
1922,   58 

Instalment   payments,   217 
Former  procedure,   217 

Joint    returns    by    husband    and    wife,    56 

Non-resident    aliens,    1305,    1331 

Non-resident    enemies,    60 

Partnerships,    788 

Penalties   waived   for,    149 

Sickness,    56-58 

Soldiers   and    sailors,    86 

Tentative    return,    57 

Termination    of    war,    61  63 

Time    for   filing,    60 


Facsimile  Signatures, 

Ownership    certificate,    319 

Substitute    certificates,    319 
Factories     (See     "Buildings,"     "Industrial 

llants") 
Failure   to    Make    Return, 

Ad    valorem  or  percentage  penalty,    134 

Citizen  leaving   country,    138 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1858 


GENERAL   INDEX 


Failure  to  Make  Return — (Ccmtinued) 

Collector   to    supply    deficiency,    131 

Legal   reasons   for,    132 

Penalties,    131-139 

Former  procedure,    133 

Specific  fine,    132 

Willful  neglect,   131,   137 
Fair       Market       Value       (See       "Market 

Value") 
Fairs, 

County,   exemptions,   35 

Gifts   to,   by  agricultural    corporations  not 
deductible,    1233 
False  Returns  (See  "Fraudulent  Returns") 
Fakm    (See  "Farmers") 

Definition   of,    1410 
Farm   Loan   Associations, 

Exemptions,    46 
Farm   Loan   Bonds, 

Interest    on    loans    secured    for    purchase 
of,   not   deductible,    929 

Tax-exempt,   33,   361,   680,   681,   682,   691 
"Farm-Price   Methods," 

Inventory,    1 417-14 18 
Farmers,    1407-1420    ' 

Accounting,   1419 
Accrual    basis,    1420 

Allowance     for     living     expenses     unjust, 
1407 

Assessment   of   tax  difficult,    1407 

Attorneys'   fees  deductible,    1415 

Automobiles,   1413 
Upkeep,    1413 

Commercial    and    otherwise,    1410 

Computing  income  on   crop  basis,    1409 

Deductions,    14 10 

Depreciation,    1414 

Depreciation    of   land,    1099 

Depreciation    on    farm   buildings,    1056 

Deterioration    of    held    products,    1415 

Development    expenses,    1413 

Exchange    of    produce    for    merchandise, 
1409 

Expenses  deductible  and  otherwise,    141 2, 

1413 
Form    1040    F    optional,    1419 
"Gentlemen,"    definition   of,    1410 
Inventories,   462 

Former   procedure,   462 
Inventory  methods,  1416-1419 
Inventory    system,     1408 
Items   included   in   income,   1408 
Live  stock,    14 13 
Losses,    1410,   1411,    1414 
Death   of  live  stock,    141 6 
Frost,    storm,    flood   or    fire,    1415 
May   be  applied   against   profits   of   suc- 
ceeding  years,    1419 
Former   procedure,    1419 
Machinery    and    buildings,    141 3 
Orchards,   depreciation    of,    1414 
Proceeds  of  crop  insurance,   1409 
Rents   received   in  crop   shares,    1409 
Sale    of   machinery,    etc.,    1409 
Taxable  on  sale  of  property,    1408 
Tools,    14 13 


Farmers'   Associations, 

Exemptions,    44,    46,    141 2 
Federal  Agencies, 

Right    to    inspect    returns,    120-121 
Federal     Employees      (See     "Government 

Employees") 
Federal   Land   Banks, 
Dividends  exempt,   361 
Exemptions,    46 
Federal  Reserve   Banks, 

Dividends   on  capital   stock   exempt,    362, 

705 
Federal      Taxes      (See      "Income      Tax," 

"Taxes,"   etc.) 
Fees, 

Architects,  913 
Jury,   412 

Lawyer  or  attorney,  from  illegal  transac- 
tion  not   deductible,    921 
Paid    to    secure    employment,    deductible, 

918 
Received   as   income   from    professions    or 

vocations,   401 
Received   by   clergyman,    taxable,    420 
Received   by  notaries  public,   not  taxable, 

407 
Fidelity   Bonds, 

Premium   on,   deductible,   896 
Fiduciaries,   1326-1376 
Accounting  period. 

Other   than   calendar   year,    1332 
Agent   vs.,    1327 

Alien   Property   Custodian   not   a,    1327 
Associations    vs.    trust,     1328-1329 
Beneficiaries, 

Deduction    for    shrinkage    in    securities 
not  allowed,  986 
Capital  gains  provision. 

Effect  on  sales  by  fiduciaries,   1374 
Deductions, 

Depreciation    allowed    to,    1363 

Expenses   for   sale   of  property,    1363 

Federal    estate    tax,    1361 
Former    procedure,    1361 

Gifts,    1365 

Losses,    1364 

Stamp  taxes  on  sale  of  property,   1363 
Defined,   77,   1326 
Depreciation    claimed    by,    1072 
Estate   of  an  enemy  alien,    1355 
Executor  as,    1332-1335 
Exemptions   from   penalties,    1337 
Former     procedure,      1326,      1332,      1333, 

1341,    1348,    1349.    1351 
Income, 

Accumulated  in  trust,  1330 

Distributable    to     beneficiaries,     1330 

Held   for   future  distribution,    1330 
Income  of  discretionary  trust   taxable  to, 

1351 
Income  of  minors  taxable  to,  *348 
Liberty  bond  interest,   when  taxable,   690 
Net  income  taxes  paid  by,    1357 
Non-resident  aliens,    1331 
Ownership   certificates,   314,    1344-1345 
Payment   of  tax,    1347-1357 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1859 


Fiduciaries — (.Continued) 

Payment  of  tax  at  source,   1306 
Payments   to  beneficiaries  not  taxable  to, 

1349 
Penalties,   exemptions,    147 
Receivers,  not  all  classed  as,   1328 
Responsibility    of,    1328,    1335 
Returns,   87,    1330-1346 

Beneficiaries,    1339 

Beneficiaries,   distributive  share  includ- 
ed in,   1338 

Committee    for    incompetent,    1339 

Determination    of    net    taxable    income 
during  administration,    1358,    1359 

Forms  of,    1346 

Guardian    for    minors,    1339 

Information   at   source,    297,    1344-1346 

Joint  fiduciaries,   1330,   1335 

Non-resident     alien     beneficiary,     1344, 
1356 

Place  for  filing,   1331 

Receivers,    1341-1344 

Revocable  trust,    1340 

Salaries,   297 

Several  trusts,  1340 

Trustee   in   bankruptcy,    1341 

When  due,    1331 

When   required,    1330 
Revocable    and    irrevocable    trusts,     1340, 

1350 

Grantor  taxable,    1352-1354 
Salaries    paid   to    fiduciaries,    included    in 

returns,  297 
Several   trusts,    separate   incomes   taxable, 

1340,   1352 
Taxable   income    not   realized    on   passage 

of    estate    from    decedent    to    executor, 

1358 
Taxable  income  under  profit  sharing  plan, 

1375 
Taxed    for    estates    and    trusts,    1368 

Former   procedure,    1368 
Unrealized   losses   not   deductible,    1362 
Fifty   Per   Cent   Penalty,    134 
Filing  of  Return    (See  "Failure  to  Make 

Return,"  "Returns") 
Fines  (See  "Penalties") 

FiNLAY,  J.  R., 

On  interest  rate  of  mines,    11 88 
Fire  Losses,  978,  1008-1011,  1415 
Deductions  for,   860 
Former  procedure,    1008 
Fire  Relief  Certificates, 

Exempt,   360 
Fiscal  Years     (See   also   "Accounting   Per- 
iod") 
Application    of    different    rates,    794-796 

Former   procedure,    795 
Chang'es    in    making    returns,    64-71,    163- 
166 
Former  procedure,  66,  71 
New  corporations,   65 
Corporations, 

Ended  in  1921,  164 
Ended  in  1922,  165 
Penalties   waived   for,    151 


Fiscal  Years — (.Continued) 

Credits  for  foreign  taxes  under,  954 

Former   procedure,   954 
Defined,  64 

Ending   in    1921,    164,    165 
Ending  in   1922,   165 
Individuals,   448 

Ending    in    1921,    164 
Fractional   part  of   year,    170 
Net   losses   deductible,   1026 
1920-1921, 

Apportionment     of    partnership     income 

to  each  year,  791 
Computation   of   net   income,   792 
1921-1922, 

Apportionment     of     partnership     income 

to   each   year,    791 
Computation    of    net    income,    792 
Partnerships,    164,    791-796,    806 

Former  procedure,  297,   791 
Personal    service    corporations,    164,    819- 

823 
Returns  on   basis  of,   64-71 
Fixtures    (See   "Furniture  and   Fixtures") 
Flood, 

Losses,    1415 
Florists, 

Inventories,    1418 
Food   Administration    Grain    Corporation 
Notes, 
Tax-exempt,  .667 
Foreign   Bank, 

Interest  on  drafts  subject  to  withholding, 
1308 
Foreign  Branches, 

Assets  and  liabilities  as   inventory   items, 

393 
Domestic    corporations    owning,    392 
Foreign  Corporations   (See  also  "Payment 
of    Tax    at    Source — Foreign    Corpora- 
tions") 
Building    and    loan    associations,    not    ex- 
empt,  48 
Consolidated    returns    not    permitted,    105 
Co-operative    banks    not    exempt,    48 
Credits,    1296 

Deductions    allowable,-  1292-1295 
Defined,  90 
Deriving    income    from    U.    S.    and    I'orto 

Rico,    1323 
Dividends, 
Exempt,  348 

Information    at    source,    298 
Paid  by,  need  not  be  reported,  303 
When  eligible  for  credits  or  deductions, 
802 
Exempt  income.  United  States  bonds,  692 
"Foreign"   defined,    1271 
Gross  income,  defined,   1276 
Income, 

From     dividends     of     taxable     domestic 

corporations,    711-712 
From  operation  of  ships,  when  exempt, 

1286 
Rulings   regarding    sources   wilhiii    Uni- 
ted  States,    1286-1292 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


i86o 


GENERAL   INDEX 


Foreign   Corporations — {Continued) 

Interest   on   deposits   with   domestic   banks 
not    taxable,    1309 

Method    of    dividend    return,    712 

Non-resident, 
Defined,  300 
Payment   of   tax   at   source,   330 

Not    personal    service    corporations,    838 

Ownership    certificates,    315,    316 

Payment    of    tax    at   source,    1307,    1308 
Not     required     if     doing     business     in 
United    States,    328 

Philippine    Islands,    349 

Porto   Rico,    349 

Resident   and   nonresident,    1271 
Consolidated,    1303 

Former    procedure,    1303 

Returns, 

Dividends    paid,    302 

Dividends   paid,    former   procedure,    301 

Extension   of   time   for    filing,    1305 

Filed    by    agent,    100 

Forms  required,    1302 

Made  by  resident  agent,   1303 

Time   and   place    for    filing,    1304 

Should     notify     stockholders    of    right    to 
credit,    349 

Tax    rate,    1297 

With    fiscal    agent    here,    withholding   pro- 
cedure,   1312 

Withholding  from,   327 

Withholding   returns. 
Form  used,  310 
Foreign   Countries, 

Bonds,    information   at   source,   298 

Citizens  leaving  for,  215 

Defined  under  section  238(a),  234(a),  951 
Former  procedure,   952 

France,   practice   of   taxation   in   gambling, 
447-448 

Great     Britain,     practice     of     taxation     in 
betting,  447 

List  of,  which  do  and  do  not  allow  United 
States  citizens  credits  for  United  States 
taxes,  945 
Former   procedure,   945 

Ownership  certificates  required  with  bonds 
of,  containing   tax-free   covenant   clause, 
316 
Foreign  Diplomatic  Ministers,  364 
Foreign    Exchange    (See    "Exchang'e,    For- 
eign") 
Foreign   Governments, 

Defined,  364 

Income  received  by  exempt  but  should  be 
reported,   316,  364 

Income,   when   taxable,    1285 
Foreign    Insurance   Companies    (See    '"In- 
surance    companies,"     "Life     insurance 
companies,"     "Mutual     insurance     com- 
panies") 
Foreign  Items, 

Defined,  300 

Income   from,  when   deductible,    1287 

Licenst   for  collection   of,   320,    1321 


Foreign    Items — (Continued) 

Ownership  certificates,   items   for,   299 

Presented    without    ownership    certificates, 
317 

Return  of   information  at   the  source,   299 

Source  of  information,  300 
Foreign   Partnerships   (See  also  "Partner- 
ships") 

Not    affected    by    withholding    provisions, 
1306 

Ownership    certificates    for    bonds    of,    316 

Returns   required,   301 
Foreign   Taxes, 

Credits   against   income,    corporations,   947 
Former  procedure,   947 

Deductions,    946 
Forgiveness  of  Indebtedness,  519,  520 
Forms  of   Returns   (See  list  preceding  Ap- 
pendix  B) 

1040   F  optional,   1419 
Formulas, 

Deductible  if  worthless,   1096 
Foundries, 

Depreciation,  1 096 
Fractional  Part  of  Cent,  172 
Fractional  Part  of  Year, 

Liquidating  corporation,   55,  220 

Returns  covering,   167,    169,   170 
Fraternal  Beneficiary   Society, 

Defined,  37 

Exemptions,  36,   1401 
Fraudulent  returns,   109-127 

Action   to  recover   refunds,   276 

Extent   of,    191-194 

No  limitation  period  for,   198 

Penalties,    133-138 
Compromise   of,    149 
Freight  Bills, 

Need   not  be   reported,   303 
Frost, 

Losses,   1415 
Fruit  Growers'  Associations, 

Stock   owned   outside   association — not   ex- 
empt, 45 
Furniture   and   Fixtures, 

Depreciation,    1056,    1096 

Obsolescence,    1142 
"Future"    Contracts, 

Inventories,  former  procedure,  472 

With  reference  to  inventories,  472-474 
"Future"  Delivery  of  Goods,  479-48O 
"Futures,"   Speculation  in,  448 


Gain  or  Loss  (See  also  "Capital  Gains," 
"Capital  Net  Gains,"  "Exchange  of 
Property,"    "Sale   of   Property") 

Application  of  "tax-free"   distribution,  582 

Appreciation. 

Accrued  prior  to   March   i,    1913,   567 
As  of  March   i,    1913,   583 
Of  property  must  have  occurred  during 
period  when  law  is  effective,  583 

Ascertainment    of,    569-582 

Ascertainment    of   net    earnings,    604-612 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


ibOl 


Gain  or   Loss — {Continued) 

Basis   for   ascertaining   when   appreciation 
is  realized,  569-582 

Bonus  received  as  stock,  523 

Buildings  or   improvements   destroyed,   on 
leased  land,  694 

Claims    due    March    i,    1913,   defined,    378 

Comparative  value  of  similar  property,  614 

Computations,   577-581 

Tax-free  distributions,  725 

Corporations,    property    acquired    by    gift, 
sale   of,    519 

Cost    as    basis    for    determining    apprecia- 
tion,  588 

Defined,   628 

Exchange  of  property  by  continuing  trans- 
action, 589-595 

Former  procedure,  567,  568,  569 

Instalment   houses,   491-497 

Law  of   1921,   627 

Partnerships,  distributive  share,   790 

Property     acquired     after     February     28, 
1913,   569 

Property   acquired  before   March    i,    1913, 
569 

Property  acquired  by  inheritance,  625-627 

Property   requisitioned   or   destroyed,    504- 
508 

Prorating  land  and  crop  values,   614 

Prorating  method,   616-619 

Provisions,    1921    law,    17 

Real  estate  development  work,   503 

Real  estate  in  lots,   503 

Real    estate   on    instalment   payment,   498- 
504 

Revaluations,   582-586 

Sale  of  goodwill,  602-612 

Sale  of  mines,   599 

Limitation   of  surtax,    159 

Sale  of  oil  and  gas  wells,  599 

Sale    of    property    by    continuing    transac- 
tions,   589-595 

Securities, 

When  shares  of  same  issues  are  bought 
and  sold  at  different  dates,   587 

Securities  sold,   587 

Between  interest  dates,  674 

Surplus  arising  from  reappraisals  not  tax- 
able,  582 

Tax   limitation   not    applicable   to   corpora- 
tions,   161 

Taxable,   567 

Treasury   interpretation,   432 

Value   of  claims   for   infringements,    judg- 
ments, etc.,  602 

"Wash  sales,"   591,  993-995 

By  partnerships,  computation  of  net  in- 
come, 794 

When  none  recognized,  590 
Gambling      (See     also     "Betting,"      "Race 
Track") 

French   practice   of  taxation,   447-448 
Games,  taxable,  447 

Losses,   1006 
Gas  Property, 

Depreciation,    1078,    1107 


Gas  Wells    (See  "Wells,  Oil  and  Gas") 
Gasoline, 

Depletion  on,  absorbed  from  gas,  1203- 
1204 

Farmers,   141 3 
Genius, 

Not  subject  to  depreciation,    1058 
"Gentlemen"  Farmers, 

Definition  of,  1410 
German  Investments, 

When  worthless,  987 
Gifts, 

Abandonment  of  terms,  "Gifts,  dona- 
tions," etc.,  in  books  of  account  sug- 
gested,  125 1 

American    Legion,    1242 

Annuities  as,   677 

Appreciation  of,   not  income,  623 

"Back  pay,"   416 

Bad  debt,  not  deductible,  1035 

Boards   of   education,   deductible,    1245 

By    partnerships,    when    ground     for    de- 
ductions  or  credits,   803 
Former  procedure,   803 

Charitable   organizations,    1241 
When  deductible,  886,   1248 

Clubs,  gifts  to  make  good  deficit  not  de- 
ductible,  124s 

Colorable,   357,  624 

Community  chests,   1242 

Corporations  receiving,  when  not  taxable, 
374,   518 

Corporations,   when  deductible,    1249 
Former  procedure,    1251 

Council  of  national  defense,  1245 

Deductions,  851,  1241-1255 
Fiduciaries',    1365 
Former  procedure,    1242 

Depreciation  of  property  acquired  by, 
1073,    1247 

Distinguished     from     business     expenses, 
1248 
Former    procedure,    1248 

Distinguished  from  compensation  for  per- 
sonal  services,  417 

Domestic  corporations,   1242 

Educational  organizations,    1241 

Exemptions,   355-359 

Fairs,  not  deductible  by  agricultural  cor- 
porations,   1253 

Family  cemetery  corporation,  gifts  nut  de- 
ductible,   1245 

Forgiveness  of  indebtedness,   519-520 

Fraudulent,  357 

Fund  for  vocational  rehabilitation,   1242 

Homestead     acquired     from     government, 

Income  from  sale  or  exchange  of  property 

acquired  by,  619-625 
Individuals,    may    deduct    up    to     15    per 

cent   on   net    income,    1241 
Literary   organizations,    1241 
Losses  from  sale  of,  995 
Marriage    settlements,    355 
Memorial  associations,  deductible,   1244 
Memorial   funds,   not   deductible,    1245 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 862 


GENERAL   INDEX 


Guts—  {Contin  ued) 

Merchandise,    to    charitable    and    religious 
organizations,  deductible,   1254 
Municipalities,  deductible,   1242 
National    dry    federation,    not    deductible, 

1245 

Non-resident  aliens,  when  deductible,  1293 

Partnership, 

Deductible  up  to    15   per  cent,    799 

Former   procedure,   799 
Individual  credits  for,   1247 
May  deduct  gifts  in  the  nattire  of  busi- 
ness expenses,   1241 

Pensions  as,  359 

Pensions  to  widows,  as,  421 

Pledges,  when  deductible,   1246 

Police  pension  funds,  deductible,   1245 

Premiums  on  life  insurance  policy  as, 
1246 

Procedure   in   reporting,    1246 

Property  bequeathed  to  state  institution, 
361 

Provisions  of   1921  law,  20 

Public  high  school,  not  deductible,   1245 

Public  purposes. 

Former  procedure,    1242 

Railroad  passes,  357 

Real    estate    for   park   purposes,    1244 

Reconstruction  work  in  Porto  Rico,   1244 

Red  Cross,  by  corporations,  not  deductible, 
1247,    1253 
Former  procedure,    1248 

Religious  organizations,   1241 

Requirements  for  deductibility,  1242,  1243 

Scientific  organizations,   1241 

States  of  United   States,   deductible,    1242 

Street  railway  company,  'donation  to  in- 
duce to  extend  track,  not  deductible, 
1250 

Treasury  rulings  holding  gifts  deductible, 
1244 

Treasury  rulings  holding  gifts  not  de- 
ductible,   124s 

"Treating  money"  deductible,  1234 

United  States,  deductible,  1242 

Valuation,    1247 

Former  procedure,  1247 

War  chest  funds,   1242 
Goods  Purchased  But  Not  Delivered,  469- 

472 
Goodwill, 

Considered  as  source  of  dividends,  746, 
780 

Deductible  as   advertising   expenses,    1254 

Depreciation,    1097 

Obsolescence,    1144 

Of  liquor  business,    1146 

Patents,  652,  654 

Payment  for,  not  deductible,  91s 

Proceeds   from   sale   of,   taxable,    549 

Treasury  allows  no  depreciated  on  pur- 
chased,  609 

Valuation  of,   602-612,  807 
Government    Bonds    (See    "United    States 
Bonds") 


Government  Contracts, 
Adjustments,   533-534 
Amortization  allowances,  531-532 
Cancelled,  losses  deductible,  1001 
Copies  should  be  filed,  106 
Corporations  must  make  separate  returns, 

105 

Former  procedure,   105 
Defined,  106,  528,  530 

Former  procedure,   107 
Form  not  enforcible,  530 
Income  from,  528-534 
Law  of    1921   concerning,  528 
Personal  service  corporations,  531 
Provisions  will   not  affect   income  in  and 

after   1922,   531 
Returns   for  corporations  formed  for  pur- 
pose,  105 
Supplemental   contracts  as,   530 
Treasury  ruling  concerning,  529 
Government    Employees    (See    also    "Civil 

Service  Employees") 
Compensation,  401 

In  District  of  Columbia,  Porto  Rico, 
Philippine  Islands,  subject  to  tax, 
410 

Under  Act  of  1918,  403 
Must  make  return  on  payments  at  source, 

293 

Not   exempt   from   income   tax   unless  spe- 
cifically  designated,   401 

Payments  to  by  government  need  not  be 
reported,   303 
Government  Officials, 

Personal   expenses,    867 
Gross  Income, 

Business    life    insurance    premiums,    ex- 
cluded   from,    522 

Citizens,    sources    within    United    States, 
1278-1281 

Computation  for  tax,   155,  379 

Contractors,   449 

Corporations,  items,   31 

Deductions    for    rentals     paid     to     stock- 
holders, allowable,  727 

Deductions  from,  to  ascertain  net  income, 
155 

Defined,  376,  446,  681,  703 

Dividends  on  corporate  stock,  389 

Exclusions   from,    1284-1286 
Dividends,    715 

Interest    from    building    and    loan    asso- 
ciation shares,  671 
Loss   sustained   from  warrants   received 
for  public  work  done,   411 

Foreign   corporations. 
Computation  by,   1277 
Defined,   1276 

Inclusions   in. 

Income  derived  from  dividends,  703 
Sale  of  capital  assets,   142 

Income    of    revocable    trust    included    in 
grantor's,   1352-1354 

Individuals,  75 
Items,   31 
Returns,  52 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1863 


Gross  Income — iConiinued) 

Insurance  companies,  1387,   1388 
Interest   on    matured    coupons,    388 
Interest  to  be  reported,   661 
Life  insurance  companies,    1380 
Mutual  insurance  companies,   1394 
Mutual  marine  insurance  companies,   1400 
Non-resident   aliens,    1269 
Computation  by,    1277 
Defined,  1276 

Former  procedure,    1276 
Sources   within   United   States,    1278-1281 

Former  procedure,  1290 
Sources  wathout  United   States,   1281-1284 
Taxable  distribution  made  by  corporation, 

included  in,   707 
Taxable,   if  $5,000  or  over,    1330 
Group  Insurance,  431 

Premiums  deductible,   895 
Guardians   (See  also  "Fiduciaries") 
As  fiduciary,    1326 
Returns   filed   by,    77 
Returns  for  minors,   1339 


H 


Hammond,  John  Hays, 

On  interest  rate  of  mines,   11 89 
Hat  Factories, 

Depreciation,    1098 
Hawaii, 

Citizen    of,    taxed    as    non-resident    alien, 

1322 
Compensation    of    government    employees, 

not  exempt,  401 
Compensation  of  teachers  taxable,  410 
Head  of  Family, 
Defined,  340 

Dependents   residing  elsewhere,   341 
Kxemptions,  338 
Minors  as,  341 

Unmarried  person  as,  75,  77,  341 
Heat  and  Light, 

As  compensation  for  personal  services,  440 
Holding  Companies, 
Exemptions,  50 

Former  procedure,  50 
Losses, 

Accounting  methods,   1018 
Former  procedure,   1019 
Returns,    1020 
Must  be  filed,  99 
Required  on  exempt   income,   50 

Ho^^ESTEADS, 

Value  at  date  of  acquisition,   624 
Hoover,  H.  C., 

JDn  mining  risks,  1188 
Horses  (See  also  "Live  Stock") 

Depreciation,  1098 

Race   track  winnings   paid   to  non-resident 
alien   not  subject  to  withholding,  310 
Horticultural  Organizations, 

Exemptions,  34 

Interest    on    bonds    in    Michigan,    not    tax- 
exempt,   666 


Hoskold's   Formula, 
Table  based  on,  600 

HOTIiLS, 

Obsolescence,    1141 
Humane  Societies, 

Gifts  to,   1242 
Husband  and  Wife, 
Alimony,    367,    870 

Former  procedure,   367 
Claims  for  credit,  285 
Community  property,   82,    iii,   395 

Amended    returns,    82 

Change  of  domicile,  84 
Credits,  338 
Deductions  for  taxes  paid  by  husband  on 

residence    title    to    which    is    in    wife's 

name,  963 
Exempt  income,   338 
Exemptions,  171,  338 
Extension  of   time   for  filing  joint   return, 

56 
Incompetency  of  one,   344 
Joint  exemptions,   171,  338,  343 
Joint  returns,   76,   79 

Claims  for   credit,   285 

Computated   on  aggregate   income,    79 

Extension   of   time,    56 

Inspection,    118 

When   desirable,  79,   80,  82 
Returns,    75,   78-84 

Losses,  80 
Separate  returns,   76,  78,  80,  82 
Separation     of     necessitates     separate     re- 
turns,   79 
Surtax,   79,  80 
What   constitutes   living   with    husband   or 

wife,  343 
Wife  takes  no  personal   exemption,   81 


Illegal  Transactions, 
Losses, 

Deductible,   1006 
Illness, 

Penalties   waived    for,    150 
Improvements, 

Deductible   as   expense    if   not   pcrniaTicnt, 

1059 
Deductions  not  allowable,  853 
Depreciation,  1086 

Expenses   for   on    property   owned   by   life 
insurance     companies     not     deductible, 
1384 
Made  by  lessee,  693 
Made  by  lessee,  destroyed,  deduction  for, 

694 
Permanent,  693 

Not  deductible,  1051 
Obsolescence  when  business  is  discon- 
tinued, 1 139 
Income,  371-400,  446-534  ('See  also  "Gross 
Income,"  "Income  from  Business," 
"Net  Income,"  "Royalties  as  Income," 
"Unc.inicil    Income") 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


i864 


GENERAL   INDEX 


Income — (Continued) 

Accruing  abroad,  rate  of  exchange,  392 

Accumulated  in  trust  subject  to  tax,  1330 

Annuities,  when  taxable,   677 

"Back  pay"  as,  416 

Bad   debts,   513-SiS.   1030-1036 

Bonus,   422 

Capital   gains   as,    567-638 

"Catch-all"   provision,  in  law,  372 

Community  property  of  husband  and  wife, 

8j.    Ill,  395 

Compensation     for    personal     service     tax- 
able, 375 

Compensation   paid    other   than   cash,    430- 
445^ 

Copyrights,   647 

Credited   but   not   paid,    295 

Credits   for   normal   tax   on   certain  securi- 
ties,   155 

Damages    from    patent    infringement,    649 

Defined,   373 

Distribution  of,   4 

Dividends   (See  "Dividends"') 

As  prima  facie  income  of  record  owner, 
705 

Earned    and    unearned,    23 

Fixed  and  determinable. 
Defined,   294 
Subject  to   withholding,   1310 

From    dividends    (See    "Dividends") 

Future     distribution     through     fiduciaries, 
1330 

General    treatment,   371-375 

Government    contracts    provision    concern- 
ing,   531 

Inheritance,  property  acquired  by,  625627 

Instalment  payments  as,  489 

Insurance  companies,    1387-1390 
Investment    income,    1388 

Interest    accrued    on    bonds    sold    between 
dates,   674 

Interest  due,  686 

Liberty  bond   interest,   680-691 

Non-resident  aliens,    1269 
Exemptions,    1285 

Rulings,  regarding  income  sources  with- 
in United  States,  1286-1292 

Ordinary  net  income,  defined,   628 

Outlawed  accounts  taxable,   520 

Partnerships,  784-813 

Patents,  640 
Sale  of,  648 

Personal    service  corporations,    813-841 

Prior, 

Limitation    on,    195-200 

Limitation    on,    former    procedure,     196- 

197 

Profit  on  goods  sold  by  consignee,  384 

Profit-sharing,  422,   1375 

Promissory   notes,   437 

Received  from  estates  or  trusts,  not  units, 
when  taxable,    1369-1374 

Rents   (See  "Rent  as  Income") 

Royalties,    640-649 

Sale   and   exchange,    536 


Income — (Continued) 

Sale  and  exchange  of  capital  assets,   567- 
638 

Sale  or  exchange  of  property  acquired  by 
gift,  619-625 

Sinking    fund    interest    or    gains,    taxable, 
670 

Sources,  372,  430,  447 

Sources    within    United    States,    1278-1281 
Former  procedure,    1290 

Sources  without  United  States,   1281-1284 

Statistics,    126-127 

Stockholder    of    personal    service    corpora- 
tions,  822 

Tax    (See   "Payment  of  Tax   at  Source") 

Tax    collected    from     non-resident    aliens, 
1306 

Tax     paid    by    vendee     for    vendnr,    con- 
sidered   taxable    income   to    vendor,    521 

Taxable   defined,   371-400 

Taxable,    under    profit-sharing    plan, 
Defined,   1375 

Unearned, 

Insufficiently   taxed,   859 

United   States  bonds,   680-691 
Income  from   Business,   446-534 

Accounting   procedure,    448-449 

Bottlegging,  447 

Contractors,  449 

Exports,    527-528 

Gambling,   447 

Gifts    received    by    corporations,    374,    518 

Government  contracts,    528-534 

Instalment  plan  sales,  487-504 

Partial  sales   of  stock,   474-475 

Proceeds     from     business     life     insurance 
benefits,    523 

Self-purchase    of    bonds    and    stocks,    524 

Types  taxable  and  non-taxable,  516-528 
Income  Tax, 

Administration,    173-234,    238 

Civil   War   period,   7 

Collectors,    173 

Cost  of   administration,  4 

Deduction    of,    in    ascertaining    net    learn- 
ings,  604-607 

English   system  effective,    10 

History,    7 

Law, 

General   provisions,  372 

M-ethod   of  calculating,  428-430 

Not  deductible,   937 

Principles,   1-27 

Sixteenth    Constitutional    Amendment,    7 

Source  of  revenue,  4 

State,  6 

Statistics,   5  • 

Wben  payable,    1305 
Income  Tax  Collector, 

Examination  of   returns  by,   203 
Income  Tax  Inspectors, 

Duties,    114 
Income  Tax,  State, 

Dividends,  when  taxable,  704 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1865 


Income  Tax  Unit, 

Appeals   before,   203-208 
Decision   sent   by   registered   mail,   206 
Organization,   183-188 
Chart,   184 
Incompetents, 

Husband  or  wife,  344 
Returns  by   fiduciary,    77,    1339 
Indebtedness, 

Forgiveness   for,    519-520 
Individuals,    Tax    on,    688-690    (See    also 
"Aliens,"   "Non-Resident  Aliens,"   Resi- 
dent Aliens") 
Accounting  methods,  383 
Accounting  procedure,  448 
Corporations, 

Losses,  when  deductible,   1005 
Credits,  155,  337 
Credits  for  foreign  taxes, 
Forms  to  be  used,  956 
Deductions,  851,  852,   853   (See  also  "De- 
ductions") 
For  losses,  977 

Former   procedure,    975 
Former  procedure,   853 
Gifts,    1241 
Dependents,  338 
Earning   power   of,    1058 
Exempt    income     (See    "Exempt    Income, 

Individuals") 
Extension  of  time  for  filing  returns,  55-59 
Fiscal  year  basis,   64,    164 
Foreign   taxes. 

Limitation  of  credit,  943 
Gross  income, 

Sources     within     United     States,     1278- 
1281 
Head   of   family, 

Defined,  340 
List  of  taxpayers  posted,-  126-127 
Losses," 

Deductible,   looi 

"Wash  sales"  of  securities,  993-995 
Member   of    corporation,    should    make   re- 
turns as  a  corporation,  89 
Members  of  partnerships,   784 
Members  of   personal  service  corporations, 

784 
Net  income,   determination  of,   155 
Net  losses,  1024- 1026 
Net  losses,   when  deductible,  980 
Normal  tax,   155 
Partnerships, 
Accounting  period,  80s 
Losses  deductible,  1005 
Payment  at  source,   1306 
Penalties, 

Former  procedure,    137 
Personal  expenses, 

Losses  not  deductible,   1004 
Personal   injury,   damages   for, 

Not  deductible,   loii 
Personal  residence, 

Loss   from   sale  not   deductible,    1002 
Rate  payable,   155 

Former  procedure,   155 


Individuals — {Ccntintied) 

Retroactive   incorporation    of    partnerships 

permitted,   796 
Returns,   52,   75-129 

Annual    basis    for    fractional     part    of 

year,  169 
Extension   of   time,   59 
Fiscal  year  basis,    164 
Inspections,   1:8 
Place  for  filing,  63 
Time  for  filing,  54 
Unmarried    persons,    52,    75 
Surtax,   155 

Withholding  exemptions,  331 
Industrial  Plant, 

Fund   to   induce  to  locate,   not   deductible, 
124s 
Information   at   Source   (See   "Returns  of 

Information  at  'Source") 
Infringement    of    Patents    (See    "Patent 

Infringement") 
Inheritance, 

Property  acquired  by. 
Former  procedure,  625 
Income  of,   only,  taxable,   355 
Valuation   of,   625-627 
Securities  acquired   by,   625-627 
Inheritance  Tax, 

Deductions   927,   961 
Injunction, 

Not  granted  in  suits  to  restrain  collection 

of  taxes,  250 
Stockholders,   250 
Injuries, 

Compensation    to    'employees    for    sickness 
or  injuries  need  not  be  reported,  303 
Insolvency, 

Corporations,    penalties    waived    for,    151 
Inspection  of  Returns,  116-125 

Attitude    of    inspectors    toward    deprecia- 
tion,  1053 
By  beneficiary  of  trust,   119 
By  federal  agencies,   120-121 

Former  procedure,    120 
By   stockholder,    119,    123 
Former  procedure,    123 
Estates  and  trusts,   119 
Husband   and   wife,    118 
Individuals,    118 
Partnerships,   11 8- 119 
Penalties    for    disclosure    of     information, 

124-125 
Procedure  to  secure  permission,   ii6,   122 
State    officers    have    access    to    corporation 
returns,    118,    121 
Former  procedure,    121 
Who  has  right  to,    1x5-116 
Instalment  Payments, 

Allocated  to  particular  accounts,  495 
Application   of,   495 
As  bad  debts,  495-497 
As   cash,   489 
As   income,   489 

Business   life   insurance    benefits    received 
as,  arc  taxable  income,  523 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 866 


GENERAL   INDEX 


Instalment  Payments — {Conlinucd) 
Initial  payments,   501 
Inventories  of   sales  under,   487-504 
Mortgages  given  as,  498 
Obligation     of     purchaser     equivalent     of 

cash,    500 
Obligation  of  purchaser   not  equivalent  of 

cash,   498-500 
On   capital   stock. 

Interest  not  deductible,   932 
Reserve   fund,    497 

Ruling  on  repossession  of  real  estate.  503 
Sales  of   property. 

When  taxable,   548 
Used   automobiles   as,    502 
Instructions   to   Taxpayer, 

With  intent  to  defraud^   138 
Insurance   (See  also  "Premiums") 
Accident, 

Exemption   for  benefits,    351,   444,   895 
As  a  business  expense,  851 
Business, 

Benefits   from   an   income,    522 
Contributions  for,   deducted  from  salaries 

or  wag'es,  are  income,  444 
Crop,   1409 

Reserves  not  deductible,   900 
Fire, 

Affected  by  book  valuations,   1052 
Funds,    "self-insurance"    reserves    not    de- 
ductible,   522 
Health, 

Benefit   exemption,    351,   444 
Life     (See     also     "Life     Insurance     Com- 
panies") 
Benefit  exemptions,   352-355 

Former   procedure,   352 
Deductions     on     premiums    when     bene- 
ficiary  is  charitable   corporation,    1246 
Distributions     on     paid-up    policies     are 
corporate    dividends,    subject    to    sur- 
tax  by    individual,    7S7-7S8 
Dividends,  354 

Policies,  cash  surrender  value,  677 
Policies,   exemptions,  675,   1359 

Former  procedure,  1359 
Policies,  income  from,  675 
Premiums,    deductions    and    allowances, 

893-897 
Premiums    on   group    insurance,    431 
Premiums    on    gruup    insurance    deduc- 
tible,  895 
Returns  on  basis   of   investment   income 
only,    100 
Policies, 

Policies,  combined,  on   weekly   premium 

payment   plan,    1398 
Method     of     calculating     profit     on     ex- 
change,  553 
Premiums  paid  on,  to  secure  loans,  896 
Value  of  as  of  March  i,  1913,  378 
Premiums, 

Commissions  paid  or  deductible,  890 
Deductions  and  allowances,  853,  869 
Paid   in   advance,   902 


Insurance — {Continued) 

Proceeds,    when   taxable   and    net    taxable, 

444  I  : 

Former    procedure,    444 
Property, 

Premiums,   when  deductible,   896 
Reserves    to    equalize    profits    not    deduc- 
tible,   900 
Reserves   to   protect   bank   deposits,    when 

deductible,   902 
Returns,    100 

"Self-insurance"    reserves,    898 
War  risk, 

Exemptions,   351 
Workmen's    compensation,    898 

Exemption    for    benefits,    351,    444 

State    funds   exempt,   51 
Insurance  Companies,   1377-1406   (See  also 

"Life   Insurance    Companies,"    "Mutual 

Insurance    Companies") 
Agency    run    by    building    and    loan    asso- 
ciation  not  exempt,   38 
Deductions, 

Depreciation,    1393 

Dividends,    1392 

Expenses,   1390 

Interest,    1393 

Not    allowed,    1391 
Defined,    1378 
Exemptions    for    departments    in     mutual 

savings    banks,    35 
Exempt    from    tax,    1401-1406 
Expenses    incurred,    defined,    1390 
Foreign, 

Net    income,    1387 

Taxable  income,  1393 
Former   procedure,    1377 
Gross  income,    1387,   1388 
Income, 

Classes   of,    1387-1390 
Investment   income,    1388 
Life    (See  '"Life   Insurance   Companies") 
Losses,    1391,    1406 

Bad   debts,    1392 
Mutual  marine, 

Exemptions,    363 
Net    income,    1387,    1389 
Net  losses,   deductible,    1028 
Not   life  or  mutual,    1387-1394 
Premiums   earned,    defined,    1389 
Returns,    1405 
Specific    credits,    1393 
Tax    rates,    1387 
Taxes    paid    or    accrued    not    deductible, 

1391 
Underwriting   income,    1388 

Intent  to  Defraud   (See   "Fraudulent  Re- 
turns") 
Interest,   661-679 

Accounting    in   instalment    sales,    497 
Accounting    procedure. 

Accrual  basis  permitted,  933 
Former   procedure,   934 
Accrued, 

But    not    collected,    taxable,    662 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1867 


Interest — {Continued) 
Accrued — {Continued) 

But    not    collected,    former    procedure, 

663 
Liberty    bonds,    687 
Not   deductible,    934 
Prior   to   January   i,    1909,   not   taxable, 

663 
Prior  to  March   i,    1913,  378,   663 

Former    procedure,    663 
Upon  conversion   of   Victory   notes,   685 
Additional    assessments,    208 
Awards   under  power  of  eminent  domain, 

66s 
Bank    deposits    taxable,    667 
Non-resident     aliens,     131 1 
Bonds, 

Form    for    non-resident    aliens,     1313 
Bonds  of   irrigation  districts,  664 
Bonds    paid    at    or    before    maturity,    tax- 
able, 668 
Building  and  loan  association  shares,  671 
Chargtd  to  construction,  not  taxable,  668 
Claims    for   abatement,    143,   242 
Not  bona  fide,  246 
Rejected,  248 
Claims    for    corrections    should    be    made 
before    interest    is   charged    against   tax- 
payers,   23s 
Claims  for  credit,  271 
Claims    for    refund,    271 
Community     property     of     husband     and 

wife   under   Texan   law,   400 
Coupons      presented      without      ownership 

certificate,   311 
Credits   for,   in  partnerships,   800 
Deductions,    923-936 

Bank     charges     on     tax-exempt     obliga- 
tions,   928 
Bank  of  deposit,  for  deposits,  927 
Certificates  of   deposit,   926 
Construction    if   not  capitalized,   929 
Corporations,   923 
Criticism   of,   936 

For  interest   on  indebtedness,   when  al- 
lowed,   924 
Individuals,    923 
Insurance   companies,    1393 
Life   insurance   companies,    1380 
Money   borrowed   on   loan,   929 
Not    permitted,    929 
Overdue   Federal   taxes,   927 
Real    estate    mortgages,    926 
Scrip  dividends,   926 
Securities  given  as  collateral,   930 
State   taxes,   927 

Victory    notes    in    original    subscriber's 
hands,   indebtedness   incurred   to  buy, 
92s 
Defined,    661 

Derived   from   accounts  charged   by   stock- 
brokers,   670 
Dividends   on    preferred    slock   not    dccuc- 
tiblc,   932 


Interest — {Continued) 

Dividends  paid   by   court   order. 

Deductible,   928 
Drafts,  1308 

Exempt    from    normal    tax,    350 
Exemptions,    special,    682-684 
Federal     taxes     assumed     by     corporation 

issuing    tax-free    bonds,    931 
Federal    taxes,    overdue. 

Deductions  for,  927 
Food    Administration     Grain    Corporation 

notes,   tax-exempt,   66y 
Foreign    subsidiaries,    678 
Ground  rents  deductible  as  rent,  931 
Included    in   gross   income,    1278 
Income  from,   taxable,   31 
Income    of   year    when    due,    collected    or 

not,   686 
Liberty  bonds. 

Accounting   method,    687 
Loans   to    subscribers    not    exempt,    667 
Life   insurance   policies,    354 
Limitations    for    deductions,    929 
Loans    to    purchase    or    carry    U.    S.    gov- 
ernment    bonds,     not     deductible,     924, 
929,    1385,    1391 

Former  procedure,   924 
Loans   to    purchase    securities,    1385,    1391 
Matured   coupons,  388 

Mortgage  indebtedness  assumed  by  muni- 
cipality,   664-665 
Obligations    of    states    and    political    sub- 
divisions,  664 
Paid   but   not   used,   taxable,   388 
Paid    on    instalment    subscriptions    to    cap- 
ital  stock,   not   deductible,   932 
Paid    on   taxpayer's    own    capital    not    de- 
ductible,  932 
Paid   to   carry   tax-exempt   securities,    123, 

924 
Paid  to  carry  Victory  notes,  923,   924 
Paid   to    partners,    935 

Former  procedure,   935 
Payment    of    tax    at    source,    1306 
Promissory    note    of   state,    territory,   'etc., 

exempt,    361 
Rate  on  mining  investments,   1187-1191 
Received   by   legatee,   674 
Rental    equivalent,    by    corporations,    699 
Scrip    dividends. 

Deductible,    926 
Securities      acquired       behvcen       interest 

dates,    674 
Sinking    fund,    interest    or    gains    taxable, 

670 
Subject   to  surtax   and   excess   profits   tax, 
682 
Former  procedure,  682 
Tax-exempt,  excluded  from  gross  income, 

681 
Tax-exempt   securities,    801 

Former   procedure,   801 
United    States    bonds. 

Held    by   partnerships,    802 

Former  procedure,   802 
Loans   to  purchase,   929,   1385,    1391 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


i868 


GENERAL   INDEX 


Interest — (Ccntinucd) 

Unpaid    taxes,    144-147,    217,    220 

When    time    of    payment    of    deficiency 
is   extended,    228 
Interest   "Imputed," 

Defined,   932 
Internal  Revenue   Bureau, 

Administration   of,    173 

Organization,    183-188 
Chart,    184 

Procedure,    174 

Report,    1921,   3 
Interstate   Commerce    Commission, 

Amounts  paid    to   by   railroads   deductible, 
918 
Inventories,   386,    452-512 

Accounting   methods,   467 

Bailments,   455 

"Base    Stock"    method,    469 

Cost  or  market  values,  393,  459-469,   1213 

Date   for  taking,   453 

Dealers   in   foreign   exchange,   486 

Dealers   in   personal   property,   488 

Dealers    in   real    estate,    486 

Dealers   in   securities,    481-489 

Defined,   454-456 

Depreciation    not    permissible,     1057 

Dry   goods   dealers,   475-478 

Estimate  not   permitted,   453 

Farmers,  462,   1416-1419 

Florists,    1418 

Former  procedure,  452,  456,  462,  472, 
481,  498,  504,  512,  520,  522,  523,  524, 
531.    533 

"Future"  contracts,  472-474 

Goods   in   process   and   finished,   478-479 

Goods  purchased  but  not  delivered,  469- 
472 

Goods    sold    for    future    delivery,    479-480 

Live    stock    raisers,    462 

Losses    established    by,    985 
Former   procedure,    986 

Lumber    industry,    462 

Market   or   eost   values,   459-469,    1213 

Obsolete  items,   474 

Partial  sales  of   stock,  474-475 

Prohibition    ruling,    475 

Repossession   of   real   estate   ruling,    503 

Required  under   1918  law,   452 

Revaluations  of  capital  assets  not  equiva- 
lent,   582 

Second-hand    automobiles,    486 

Securities, 

Dealers        may        deduct        inventoried 
shrinkage,    986 

"Short   Sales,"  483 

Taxpayer's  notices  to  Treasury  of  method 
adopted,    480 

Tobacco    industry,   461 

Use  of  to   determine   losses,    979 

Valuation,  general  basis,  456-459 

Valuation,   in  organization  change,  486 
Investment   Companies, 

Undistributed  profits  invested  in  market- 
able securities,  taxable,   1262 


Investment   Income, 

Insurance    companies,     1388 
Investment    Information    Bureau, 

Not   exempt,   43 
Investments, 
Expenses  for, 

Deductible      for     life     insurance      com- 
pany,    1383 
German,    987 
Russian,    987 
Irrigation    Districts, 
Interest   on   bonds,    664 
Former  procedure,  664 


Joint  Adventures, 

Not  associations,   91 
Joint  Exemption   for  Husband  and  Wife 

(See  "Husband  and  Wife") 
Joint   Ownership, 

Depreciation  divisible  between,    1074 
Not    necessarily    partnership,    785-787 
Joint    Returns    of    Husband    and    Wife 

(See    "Husband    and    Wife") 
Joint   Stock   Companies, 

Defined,   gi 
Judges, 

Territorial    courts. 

Compensation     for     judges     subject     to 
income  tax,  403 
United  States, 

Not   exempt,    365,    401 
Judgments, 

Amounts    paid    on,    deductible,    919 

Former    procedure,    919 
Valuation  of  claim,  602 
Jury  Fees, 

Deductions   and    exemptions,   412 


K 

Kentucky, 

Pensions   to    Civil   War   veterans,   subject 

to  tax,  409 
State    law    concerning    irrevocable    trusts, 

1350 


Labor    Organizations, 

Dues    paid    to,    deductible,    917 

Employment  associations    of,   not   exempt, 
35 

Exemptions,   34 
Land    (See    also    "Real    Estate") 

Appreciation  of,   when  building  on  it  be- 
comes obsolete,    1142 

Depreciation,    1070,    1098,    1106 

Sold    for   non-payment    of   taxes,    665 
Last   Due  Date, 

Defined,    54 

Extension    of   time    for   filing    returns,    57 
Law  of  1909,   7-8 

Decisions    on   corporate    losses,    1015 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1869 


Law  of  1913,  9,  447 
Law   of   1916,    11 

.Association    vs.    trust,    1329 
Law  of   1917,   12 

Compared   with    igi3-:gi6,    1214 
Law  of  1918,   14-17 

Compared   with   previous  laws,   447 
Deductions    for    property    losses,    983 

Former   procedure,    983 
Holding   companies,   consolidated    returns, 

1020 
Instalment    plan   sales,    488 
Limitation  period,   196 
Net  losses,    1022 
Requiring  inventories,  452 
Law  of   1921,   17-25 

Amortization   provisions,    1149 

Capital  gains  under,    567,  804 

Compared  with  previous  laws,  447 

Deductions   for   property   losses,   983 

Features,    154 

Fiscal    year    for    individuals,    448 

Limitation    period,    197 

Loss    on    sale    of    property    acquired    by 

gift,   995 
Net  losses,   "relief"  provisions,!  1022 
Non-resident  aliens,  taxable  income,  1269 
Prorated    replacement    "cost",    512 
Repeal  of  profits  tax,  531 
Retroactive  provisions,  24 
Lawyers, 

Employed   by    state,    not    subject    to    tax, 

409 
Fees  paid  by  maker   of  illegal   sales,  not 

deductible,  pai 
Special    counsels,    408 
Leaseholds       (See      also      "Lessees      and 
Lessors,"   "Rent") 
Coal    and   oil   lands,    643-647 
Depreciation,    11 00 

Value  of,  at  March  i,  1913,  may  be  used 
for   depreciation,    iioi 
Leaving  Country, 

Certificate    of    compliance,    215 
Consular  receipts,  216 
Legal  Holiday, 

When  last  due  date,   54 
Legatees     (See     "Beneficiaries,"     "Estates 

and  Trusts")     , 
Legislation   Alternative, 
Constitutionality    of,    816 
Lessees    and    Lessors     (See    also     "Lease- 
holds,"   "Royalties   as   Income") 
Advance    royalties,    depletion    basis,    1229 
Corporations    as,    dividends     or    interest 

as   rental    equivalent,    699 
Cost    of    lease    may    be    apportioned    over 

term   as    rent,   906 
Deductions   for    payment    on    cancellation 

of  lease,  905 
Deductions  where  property  destroyed,  694 
Deferred    payments    to    lessor    deductible 

when   accrued,  907 
Depletion    allowance,    1216-1226 


Lessees  and  Lessors — (.Cotitiniied) 

Depletion,    apportionment    between,    1223 
Depreciation    allowance,    695 
Depreciation    of    residences    rented    part 

of   year,    1056 
Depreciation    of    residences    used    partly 

for    business,    or    sublet,    1056 
Erection   of   buildings,  deduction   for,   694 
Improvements   made   by,   693 
Life    tenant,    stock   dividend    property    of, 

783 
Limited     leases     subject     to    depreciation, 
1097 

Former    procedure,    1097 
Market    value    of    property    leased    prior 

to  March   i,    1913,  695-696 
Mines,   interest   rate  on,   1190 
Mining   lease  as   distinguished  from  sale, 

1227 
Payment   of  tax   at  source,    1306 
Premium    paid    to    secure    leasehold,    90s 
Rental    of   subleased    apartment,    904 
Royalties   on   oil   and  gas    wells,    1198 
Tax   liabilities,   693 
Taxes,     expenditure,     700-701 
Former   procedure,    700-701 
Taxes    paid    by    tenant,    903 
Liabilities, 

Not  used  to  reduce  income  of  subsequent 
years,  381 
Liability  of  Tax, 
By  lessor,  693 
By  fiduciaries,    1348 
By   receivers,  248 
Residuary  legatee,    1352 
Several  trusts,  separate  incomes,   1352 
Liberty    Bonds    (See    also    "United    States 
Bonds") 
Accepted  as  security,   247 
Corporation   holdings   in,   740 
Distributed  as  dividends,   740 
Distributed    in    dividends,    losses    on,    988 
Estate   tax,   subject   to,   680 
Exemption  periods  depending  on  termina- 
tion  of    war   with   Germany,    685 
Exemptions,    681 
Interest, 

Accounting    method,    687 
Accrual   of,   687 
Exempt,   31,  350 
Law    of    1921,    20 

Loans  to   subscribers   not   exempt,   667 
Payment    of    tax   by,    226 
Special  exemptions  from  additional  taxes, 
682-684 
License, 

Collection   of   foreign   items,    1321 
Required    for  collection   of  foreign   items, 
320 
License  Fees, 

Automobile    licenses    deductible,    957 
Deductible,    958 
F-iens, 

For    non-payment   of   tax,    23a 


[See  also  Estate,  Capital  Stock,  and   Excess  Profits  Indexes] 


1870 


GENERAL  INDEX 


Life    Insurance    (See    "Insurance,    Life") 
Life  Insurance  Companies   (See  also  "In- 
surance   Companies,"     "Mutual    Insur- 
ance Companies") 

Credits,    specific,    1386 

Deduction, 

Depreciation,    1384 

Dividends    of    certain    kind,     1382 

Expenses    on     real    estate    owned     by, 

1384 
Interest,    1380 
Interest    on    loans    to    purchase    other 

securities,    1385 
Investment  expenses,    1383 
Real  estate  owned  by,  1384 
Rental  value   must   be   included   on    re- 
turns,   1385 
Reserve    fund    earnings,    1381 
Taxes    paid    in    real    estate    owned    by, 
1384 

Defined,    1378 

Domestic,  tax   rate,    1379 

Foreign, 

Tax    rate,    1379 

Taxable    income    of,     1386 

Gross   income,    1380 

Interest   on    loans,   deductible   and   other- 
wise,   1385 

Net   income,    1380 

Not    subject   to    excess    profits    tax,    1379 

Reserve    funds    defined,    1381 

Stockholder,     deductions     for     taxes    im- 
posed upon,    1384 

Tax   rate,    1379 
Light, 
,    As    compensation     for    personal    services, 

440 
"Like  Kind" 

Property    of,    defined,    545,    558 
Limitation    Period    for  Assessments   (See 

"Assessments") 
Limited  Partnerships,   (See  also  "Partner- 
ships") 

As   corporation,    90,    811 

Defined,   784 

Dissolved, 

Disposition     of    surplus,     563 

Distinctions    between,    811 
Former   procedure,   811 

Distribution    of    profits,    813 

Liquidating,    563 

Ohio,    812 

Pennsylvania   type,   812 

Virginia,    812 
Liquidating  Corporations, 

Claims   for    abatement,    269 

Compensation     of    trustees     not     exempt 

.    from  tax,  408 

Disposition   of   surplus,    563 

Law  of    1921,    221 

Liability   of   receiver    or   trustee,    221 

Liability  of  stockholder,   222 

Market    value     of    assets    basis    for    de- 
preciation,   1070 


Liquidating   Corporations — iCcmtinued) 
Payment  of  tax,  220 
Returns,   S5 

Returns  by   receiver   or  trustee,    102 
Liquidating  Dividends, 

In  excess  profits  tax,  as  dividends,  749 
Provisions    under    1917    and    prior    laws, 

7S3-7S5 
Provisions    under    1918   law,    751-753 
Tax-exempt   if  paid   from   capital   surplus 

at  March   i,    1913,  748 
Taxable,    749 
Liquidating       Partnerships       (See       also 

"Limited    Partnerships,    Liquidating") 
Liquor  Business    (See  also  "Bootlegging") 
Ooodwill,   1146 

Obsolescence    due     to     prohibition,     X144- 
1149 
List  of  Individuals,  Making  returns  to  be 

posted,    126 
Literary    Organizations, 

Gifts,    1 24 1 
Literary  Societies, 

Exemptions,    39 
Live  Stock,   1413 
Accounting,    1419 
Death   of,    1416 
Live  Stock  Raisers, 
Inventories,    462 

Former  procedure,  463 
Loan     Associations     (See     "Building    and 

Loan     Associations") 
Loans, 

Interest    not    deductible,    secured   to    buy 
or   carry   U.    S.    bonds,   924 
Former  procedure,   924 
Interest,    when    deductible,    929 
Personal,    not    deductible,    1035 
Premiums    paid    on    insurance    policies    to 
secure,    896 
Lobbying    Expenses, 

Not   deductible,    915 
Local   Improvement   Taxes, 

Not   deductible,   938,   939. 
Lodge  System, 
Defined,    36 
Losses     (See     also     "Amortization,"     "Bad 
Debts,"  "Gain  or  Loss,"  "Net  Losses") 
Adjustment  of  losses  must  be  made  dur- 
ing  taxable    year,    1137 
As    capital    expenditure,    1007 
Assessments    on    stock,    990 
Business,    729-730,    999 
Cancellation    of    contracts,    1000 
Capital,    in    estates    and    trusts,    how   de- 
ducted,  1372 
Casualties,    860,     1008-1011 
Former    procedure,    1008 
Collateral   security,    1043 
Contributions    by    stockholders,    990 
Corporations, 

Bonds,  sold  or  redeemed,    1016 
Deductions   for,  978 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1871 


Losses — (Continued) 

Corporations — (.Cc»ttinued) 

Individual's     share,     when     deductible, 

loos 
Securities   issued    and    redeemed,    1013- 
1018 
Deductions    for,    31,    975-1029 
Computation,    1009 
Estates,    1364 
Limitations,    1020 
Depreciation   (See   "Depreciation") 
Embezzlement,    381 
Erosionr  1099 
Farmers',    1410,    141 1,    1414 

Applied    against    profits    of    succeeding 

years,   14 19 
Former  procedure,  14:9 
Fire,   860,  978,    1008-1011,   1415 

Former    procedure,    1008 
Flood,    141S 
Frost,    141  s 
Holding  companies, 

Accounting  methods,   1018 
Former  procedure,   1019 
Husband    and    wife,    80 
Illegal   transactions,    1006 
Individuals, 

Deductions,    977 

Former    procedure,    975 
Insurance   companies,    1391,    1406 
Inventories  to   establish,   985 

Former   procedure,   986 
Lawful    gambling,    1007 
Law  of   1921,   "relief"  provisions,   1021 
Liberty    bonds    as    dividends,    988 
Limitation  on. 

Former    procedure,    1029 
Live  stock,   1416 
Non-resident     aliens,      when     deductible, 

1293 
Obsolescence,   1134-1149 
Partnership, 

Deductions,    803 

Individual    share   deductible,    1005 
When   deductible,   980 
Property, 

Determination  and   measurement,  when 

deductible,    982-985 
Revaluation,    1002 

Scrapping  of  buildings  and  machinery, 
997 
Replacement    fund,    505-512 
Reserve    against    mutual    insurance    com- 
panies, not  deductible,    1397 
Reserves   for,    729 
Russian  investments,  1042 
Sale    of   capital   assets,    996 
Sale   of   property   acquired   by   gift,   995 
Sale    of    securities,    989 
Shipwreck,    860,    978 
Speculation,  996 

Former  procedure,   996 
Storm,    860,   978,    1415 


Losses — {Continued) 

Sustained   after   March    i,    1913,   deducti- 
ble,  982 
Former    procedure,    982 

Tax-free   distributions,   991-993 

Theft    or    embezzlement,    381,     848,    860, 
978,    1008-1011 
Former    procedure,    1008 

Uninsured,    accounting    methods,    loii 

Unrealized     loss     not     deductible     by     es- 
tates,   1363 

"Wash    sales"    to    establish,    993-995 
Former    procedure,   993 

Year   when   deductible,   980 
Former    procedure,    980 
Lumber   Industry    (See    also    "Timber") 

Inventories,    462 
Luxury  Taxes,  j 

Deductions,   960 

Law    of    1918,    15 


M 

Machinery, 

Amortization,    11 58 

Depreciation,    1054,    1080,    1102,    1119 

Depreciation    when    replaced    by   new    in 
vention,   1057 

Farm,    1413 

Leased, 

Depreciation,    1061 

Obsolescence,    1134 

Replacement    vs.    supplies,    1060 

Sale    of,    1409 

Scrapped, 

Loss   deductible,   997 
Mail, 

Notices  from  Income   Tax   Unit  sent  by, 
206 

Sending   return    by,   63 
Maintenance  Funds, 

Required  by   law,   deductible,   917 
Manufacturers, 

Production   and   distribution   both    within 
and   without   United   States, 
Allocation    of    income,     1 282-1 284 

Taxes  payable  by,  not  deductible  by  con- 
sumer, 960 

March   i,  1913   (See  also  "Market  Value") 

Basis    for   valuation. 

In    sale    of    property,    589 
Mines,    oil   wells,   642 

Basis   of   appreciation,    569 

Changes    in    value    in,    compared    to   Feb- 
ruary   38,    1913,    615 

Date    for    revaluation. 

Supreme   Court   Decision,   583 

Determination    of    value   as    of,    596 

Income  accruing  before,  not  taxable,  377 

Patent  valuation  as  of,   648,   651-659 

Property, 

Valuation    of   acquired   before,    982-984 
Marine  Insurance  Companies, 

Gross   income,    1400 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


I«72 


GENERAL   INDEX 


Market   Price, 
Defined,  431 

Fair   market   values,    542 
March    i,   1913,   596 
Market  Value   (See  also  "Cost  or  Market 

Value,"   "March   i,    1913") 
As  of  March    i,   19 13 

Basis    for   ascertaining   capital    gain   or 
loss,    569 
Buildings    erected    on    unimproved    land, 

695-696 
Defined,   464,    539 
Fair,   539,   543,   597 
Fair  market  value  defined,    11 73 
Goods    in    process    and    finished,    478-479 
Mines,    1175 

Net    selling    prices    vs.,    466-467 
Patents,    651,    655659 
Property, 

Acquired  before  March   i,   1913.  982-984 

Leased,  prior  to  March  i,  1913,  695-696 
"Readily   realizable    market   value." 

Defined,   539 
Received    as    compensation    for    personal 

services,  431 
Timber,    how    determined,    1237 
Wells,   oil  and  gas. 

Fair    market   value    must    exceed    cost, 

1205 

Marriage   Settlements, 
Considered    gifts,    355 
Married     Persons      (See      "Husband     and 

and    Wife") 
Massachusetts  Trusts, 
As   associations,   93 
As  trust,   93 

Operating   property   in   foreign  country, 
Credits    for    foreign    taxes   not   deducti- 
ble, 956 
Memorial   Association, 

Gifts    to,    deductible,     1244 
Memorial  Fund, 

Gifts     to     funds     distributing    income     to 
charities,    not    deductible,     1245 
Merchandise, 

Gifts    of,    to    charitable    and   religious    or- 
ganizations, deductible,   1254 
Merchandise   Bills, 

Need    not    be    reported,    303 
Merchant   Marine   Act,    1920,   369 
Mergers, 

Defined,   558 

Penalties  waived   for,    151 
Returns,    100 

When    not    closed    transactions,    556 
Michigan, 

Interest    on    bonds    of    agricultural    and 
horticultural    societies,    not   tax-exempt, 
666 
Mileage, 

As    compensation    for    personal    services, 

443 
To     military     and     naval     forces     of    the 
United  States,  tax-exempt,  411 


Military    and    Naval    Forces     (See    also 
"Sailors,"   "Soldiers") 
How    far   taxable,   440 
Penalties    waived    for,    150 
Military    Uniforms, 
Depreciation,    1123 
Mine   Equipment, 

Depreciation,    11 04-11 07 
Mineral   Deposit, 
Defined,    1174 
Determination     of     quantity     of     ore     in 

mine,    1183-1186 
Valuation,    11 81 
Mineral   Property, 

Accounting     methods     for     deduction     of 

depletion     of,     1213 
Capital  adjustments,   645-647 

Former    procedure,     645 
Defined,    11 73 
Income    adjustments,    645-647 

Former  protedure,   645 
Returns    for    deduction    for    depletion    of, 
1214 

In     case     of     fractional     interests     and 
leaseholds,   1214 
Royalties   received   from,   644-647 
Valuation   of,    657 
Minerals,   Defined,    1174 

Depreciation    through    depletion    not    per- 
missible,   1057 
Mines    (See    also    "Discovery    of    Mines") 
Amortization   table,    11 79 
Average     selling    price     of     mineral     de- 
posit,   1 1 83 
Depletion, 

Basis  of,   1 167 

"Discovery    value"    of    mines    and    oil 

bases  for,    160 
Of  copper   mines,    1209 
Of  silver   mines,    1210 
Resources,    unworkable,    1231-1233 
Depreciation,    1079 
Determination     of     quantity     of     ore     in 

mine,    1 183-1 186 
Discovery   of,    1194 

By   improvements,    1195 
Value   30  days  after,   11 96 
Dividends    from   depletion    reserves,    1231 
Fair  market   value,    11 75 
Intensive    production,    1183 
Interest   rate  on,    1187-1192 

For   lessors,    1190 
Lease   as  distinguished   from   sale,    1227 
Life    of,    II 83 

Proven   tract    or   lease,    1196 
Repairs    and    replacements. 

Factor    of    operating   cost,    11 82 
Revaluations,   1196 
Risks,     1 1 87 

Royalties   and    depletion    charges,    640-647 
Royalties    from,    644-647 
Depletion    basis,    1229 
Sale    of,    limitation    of    surtax,    159 
Sinking  funds  for,   not  established,    11 79 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


i«73 


Mines — (Continued) 
Valuation,    1174-1196 

Aflfected  by  life   of  mine,    11 83 
As   of  March   i,   1913,  599 
Calculation,   11 86 
Fair  rate  of  interest,   11 87 
Mineral  deposits,   1181 
Tables,    600 
Mining  Partnerships, 

As  association,   91 
Ministers   (See   "Clergymen") 
Minors, 

Allowance   to    not   deductible,    861 

As    head   of   family,   341 

Emancipation    of,   defined,    85 

Making    own    returns,    342 

Not   exempt,    84,   342 

Parent's    right    to    earnings,    85 

Returns    by,    1348 

Returns    by    fiduciary,    77,    84 

Former    procedure,    84 
Wages  paid   to,    861 
Moratorium, 

In   Cuba,   accounts   uncollectible,   because 
of,    1043 
Mortgages, 

As   compensation,    438 
As   instalment  payments,   498 
Assumed    by   municipality,    664-665 
First    mortgage   bonds. 

Ownership    certificates   required,    319 
Foreclosure    as    a    bad    debt,    1044 

Former    procedure,    1044 
Interest   on,    deductible,   926 
Receiver's   returns    on    foreclosures,    103 
Municipal  Bonds, 
Interest, 

On  loans  secured  for  purchase  of,  not 
deductible,   929 
Ownership    certificates   not   required,   319 
Sale  of,  at  a  discount,   666 
Municipal   Government, 

Returns  of  information  at   source,   303 
Municipal  Officers  and  Employees, 
Exempt,  366 
Special    counsel. 

Definition    of    term,    408 
Municipalities, 

Gifts    to,    deductible,    1242 
Musical  Organizations, 
Gifts    to,    deductible,     1245 
Orchestral    societies. 
Exemptions,    40 
Mutual    Insurance    Companies,    1394-1401 
(See      also      "Insurance      Companies," 
"Life   Insurance   Companies") 
Automobile    owners    insurance    exchanges 

exempt,    1404 
Certain   kinds   exempt,    1401 
Combined  policy  on  weekly  premium  pay- 
ment  plan,    1398 
Deductions,    1395 
Net   additions   to    reserve    funds,    1396- 
'399 


Mutual       Insurance       Companies— (Ct/i- 

tiniied) 
Deductions — (.Continued) 

Premium  deposits  returned  or  retained, 
1400 

Unearned    premium   fund    of   fire    com- 
panies,  1396 
Gross  income,    1394 
Marine, 

Gross   income  of,    1400 
Reciprocal    indemnity. 

Exchange   not  necessarily  exempt,   1404 
Reserve    funds,    1396-1399 
Returns,    100 

Shipowners'    Mutual    Protection    and    In- 
demnity Association,  363,    1395 
State    created    mutual    liability    company 

not   exempt,    1403 
Mutual  Savings  Banks, 
Exemptions,    35 
Run    for    speculation,    not    exempt,    36 

N 

National  Banks, 

Liquidation    of,    procedure    for    receiver, 

1342 
Stock    dividends,    766 
National  Dry  Federation, 

Gifts    not   deductible,    1245 
National  Farm  Loan  Associations, 

Exemptions,    46 
National  Guard, 

Compensation,   partly   exempt,    409 
Natural  Resources   (See  "Mines,"  "Wells, 

Oil    and    Gas") 
Naval  Uniforms, 

Depreciation,    11 22 
Negligence    (See    also    "Failure    to    Make 
Returns,"     "Penalties") 
Returns,    109-127 
Without    intent   to    defraud, 
Defined,    140,   142 
Net   Income, 

Accounting    methods    to    reflect    true    in- 
come,   379,    414 
Adjustments     on     amended     returns     for 

prior   years,    112 
Amortization    period,    11 62 
Ascertained,    155 
Cash    or    accrual    method    of    computing, 

383 
Changing    from    cash    or    accrual    method 

of   computing,    384 
Computation  of  tax,  70,   155,  379,  414 
Corporations,    items,    31 
Deductions    for   bad    debts,    1031 
Defined,    376,   697,    719,   846 
Estates  and  trusts. 

Credits    allowable,    1368 
Foreign  life  insurance  company,    1386 
Individuals,   31,   71,   155 
Insurance   companies,    1387,    1389 
Interest    on    tax-exempt    bonds    excluded, 
801 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


i874 


GENERAL   INDEX 


Net  Income — {Caiitinued) 

Inventory  of  merchandise  on  hand,  380 
Life    insurance    companies,    1380 
No    specific    method    prescribed,    414 
Obsolescence  deducted  from,    11 30 
Outlawed   accounts,    included   in,    520 
Partnerships, 

Accounting    period,    805 

Defined,    799 

Fiscal   years,    1 920-1922,    792-795 

How  determined,   798 

Identity    of    income    limited,    801 

Method    of    distribution,    790 

Taxable  on  individuals,  790 
Periods  for  which  computed,  380,  384 
Sources  both  within  and  without  United 

States, 

Computation,   1282 
Under   $3,000, 

Penalties    waived    for,    150 
Net    Losses, 

Computation,    1024-1026 

Deduction  based  on  discovery  value,  121 1 

Deductions  for,  72,  1023-1029 

Former  procedure,   72 

Transactions    entered    into    for    profit, 
999 
Defined,    1023 
Filing    claim,    1029 
Fiscal    year,    1026 

Former    procedure,     1027 
Individuals, 

Deductions,    999,    looi 
Law   of   1 92 1,    1022 
Partnerships,   804 

Personal    service    corporation,    838 
Presupposes    depreciation,    1052 
Net  Selling  Prices, 

Versus    market    value,    466-467 
New  York  State  Franchise  Tax, 
Accrual   basis,   973 
Prorated  when  reporting  on  calendar  year 

basis,    973 
New  York  State  Income  Tax, 

Accrual  method,   973 
No  Par  Value  Stock, 

As    element    of    capital   surplus,    746 
Non-Resident  Aliens,   1269-1325   (See  also 

"Aliens,"    "Resident    Aliens") 
Agents   of. 

Responsibility  for  making  return,    1299 
Beneficiaries, 

Returns  for,   1300 
Citizens    of   U.    S.    possessions  taxed   as, 

1322 
Collection    of    taxes, 

Methods,    1270 
Credits,    1295 

Filing   returns,    1295 

Former    procedure,    1295 
Deduction    allowable,    1292-1295 
Deductions, 

Apportionment,    1294 

Filing    returns,    1295 

Gifts,    1242 


Non-Resident  Aliens — {Continued) 
Deductions    for    losses,    977 
Defined,    1271 
Dividends,    record    vs.    actual    owner    of 

stock,    705 
Estates    taxable,    1354-1355 
Exempt   income. 

Income  passing  through  banks  for  col- 
lection,  316 

United    States   bonds,    692 
Exemptions,     1269 

Extension  of  time  for  filing  returns,   1331 
Fiduciaries, 

Withholding  of  tax  at  the  source,   1356 
Form    for   interest    payments    on    foreign 

bonds    when    no    withholding    required, 

1313 
Form    for    personal    exemption    on    tax- 
free    covenant    bond    interest,    1313 
Gross   income. 

Defined,    1269,    1276 
Income, 

From    operation    of    ships,     when     ex- 
empt,  1286 

Rulings       regarding       sources       within 
United   States,   1 286-1 292 

Sources     within     and     without    United 
States,    1278-1292 

Specific  exemptions,    1285 
Must   include  gross  payments   in   returns, 

1306 
New  law  applying  to   Philippine  Islands, 

1324 
Ownership   certificates, 

For  registered  bonds,  309,  315,  316 
Payment  at   source,    330 

(For  full  entries  see  "Payment  of  Tax 
at   source — non-resident  aliens") 
Returns,    1297 

Extension   of   time   for   filing,    1305 

Forms   required,    1301 

Of  information  as  to  payments  to,  1320 

Required   for   sailing   permits,    1297 

Responsibility    of    agent    for,    1399 

Time  and   place   for  filing,    1304 
Tax   rate,    1297 

Tax-exempt    income,    1 284-1 286 
Tax-free    covenant    bonds,    2%    withheld, 

299 
Widow, 

Status  of,  1274 
Withholding  from,   1306-131 1 
Withholding    returns, 

Form   used,    310 
Non-Resident  Foreign   Corporations    (See 

"Foreign    Corporations") 
Non-Resident  Foreign  Partnerships   (See 

"Partnerships — Foreign") 
Normal    Tax    (See    also    "Credits    Against 

Income") 
Exemptions,    337 
Individuals,    155 

Personal    exemption    only    valid,    344 
Notary  Public, 

Fees    received   by,    exempt,   407 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1875 


Notes   Receivable, 

Basis  for,   1037 
Notice, 

Claims   denied,   313 
Notice  and   Demand   for   Payment, 

Citizens    abroad,    319 

Delinquent   assessment  payable  upon,   223 

Penalties   cannot   be    imposed   until    sent, 
218 

Reasonable  time  must  be  given,  219 


Oaths, 

Administration    of,    78 
Obsolescence,   1130-1 149   (See  also  "Amor- 
tization    of    War    Facilities,"     "Deple- 
tion,"   "Depreciation") 

Abandonment    of    property,    necessary    to 
claim,    1 146 

Accounting    methods,    1133 
Former   procedure,    1135 

Accrued    prior   to    191 8   not   accumulative, 
1138, 

Accrued    prior    to    January    i,     1918,    not 
deductible,    1138 

Adjustment   of   accounts,    1136 

Apartment    houses,    1141 

Basis     for     value     of     property     acquired 
after   March,    1913,    1135 

Basis  for  value  of  property  acquired  prior 
to   March    1,    1913,   113s 

Buildings,    1134,    1140 

On  appreciated   land,   1142 

Business    discontinued,    1139 

Capital    assets,    1134 

Deducted    from   net  incoine,    1130 

Estimation    of,    1 133 

Extraordinary,    X134 

Fireproof    buildings,    1141 

Fixtures,    1143 

Future,    1137 

Goodwill,    1142 

Of    liquor   business,    1146 

Hotels,    1 141 

Improvements,   11 39 

Intangible    assets,    1142 

Inventories,    474 

Land,    1143 

Liquor  business  due  to  prohibition,    1144- 
1149 

Loft  building,   1142 

Machinery,    1134 

Not   retroactive   beyond   January    i,    1918, 
1138 

Ordinary,     included     in    annual     deprecia- 
tion allowance,    1130 

Property,  1134 

Value  as  of  March   i,   1913,   1134 

Vineyards,    1146 
Office, 

In   owned   residence,   864 

In  rented  residence,   863 


Officers      (See      also      "Army      Officers," 
"School    Officers") 
Definition   of  term,   405 
Of    the    United    States,    criminal    proceed- 
ings,   153 
Ohio, 

Partnership    taxable    as    corporation,    812 
Oil   and   Gas   Wells    (See   "Wells") 
Oil  Property, 

Depreciation,    1078,    1107 
Oil  Wells   ('See  "Wells,  Oil  and  Gas") 
Operating  Lessee  of   Mine   (See  "Lessees 

and   Lessors") 
Operating  Owner, 

Depletion    allowance,    1215 
Vs.    operating    lessee,    deduction    for    de- 
pletion,  1225 
Options, 

When   taxable,    538,    552 
Orchards, 

Depreciation,    1109,    1414 
Orchestr^vl  Societies, 

Exemptions,   40 
Organizations, 

ExTempt    (See    "Exempt    Organizations") 
Incomplete, 

Penalties   waived   for,    150 
Trade    associations    dues    as    business    ex- 
pense are  deductible,  917 
Organization  Expenses, 
Depreciation,    11 09 
Not  deductible,  907 
OvER-AssESSMENTS    (Sce    "Assessments") 
Overpayments   (See  "Claims  for  Refund") 
"Overtime," 

Depreciation    due   to,    1080 
Ownership  Certificates,   306-319 

A-ctual   owner,   use   of    form    1087    (rev.) 

to  disclose,  318 
Bonds   sold   between   interest  dates,   313 

Former  procedure,   314 
Correction    of,    by   bank    or   other    collect- 
ing agencies,  312 
Debentures,    holders    of    must    file,    308 
Defined,    120 

Facsimile    signatures,    319 
Fiduciaries,    314 

Use   of  proper,    1344 
Filed  when  no  actual  withholding,  310 
Filed   with   interest   payments,   transmitted 

to  Commissioner,  299 
First    mortgage    bonds,    319 
Foreign   corporations,   316,  317 
Foreign    items,    299,    316 

Presented    without    certificates,    317 
Forms  used,   304 

When    withholding   is   required,    309 
Information,   should   be  complete,    30S 
Interest   coupons   presented    without,   311 
Joint   owners   of   bonds,   314 
Liability   of   b.nnks   and    agrnts,    312 
Marital    status    of    owner    eliminated    on, 

308 
Necessary,    even    whore    exempt  ion    certi- 
ficates arc   filed,    13 14 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1876 


GENERAL  INDEX 


Ownership  Certificates — ^Continued) 
Non-resident   aliens,   316,    1312 

Claiming    exemption    on    tax-free    cove- 
nant   bonds,    form   used,    309 
Partnerships, 

F'oreign,    316 

Holding   registered   bonds,   315 
Payer    has    right    to    demand    name    and 

address    of    recipient    of    income,    320 
Personal   service   corporations,   315 
Procedure    when    not    accompanying    cou- 
pons,  311 
Promissory    notes,    319 
Registered   bonds,   315 
Substitute   certificates,    310 

Withholding  agent  should  forward  with 
monthly    returns,    298 
Tax   withheld   at   source. 

Forms   used,   309 
To   disclose   actual    owner,    317 
Withholding    agent    should    forward    with 

monthly  returns,   298 


Paid  or   Accrued, 

Defined,    383,    847 
Paid  or  Incurred, 

Defined,    383 
Parks, 

Gifts  of  real   estate  for,   deductible,    1244 
Partnerships     (See    also    "Domestic    Part- 
nerships,"   "Limited    Partnerships") 
Accounting    method, 

Cash  or  accrual  basis,   806 
Personal   and   partnership   accounts  dif- 
fer,   87 
Former    procedure,    88 
Accounting  period,  805 
Affiliations, 

Former   procedure,    104 
Associations   vs.,   92 
Banks, 

As   associations,    92 
As   partnership,   92 
Changes  during  taxable   year,   797 
Changes   in   organization, 

Procedure,    806-809 
Claims   for   credit,   284 
Composed    of   corporation,    810 
Computation    of   tax. 

Fiscal      years       1920-1921,       1921-1922, 
791-796 
Consolidated    returns,    788 
Former    procedure,    789 
On    excess     profits     tax    when    affiliated 
with    corporations, 
Former    procedure,    104 
When     affiliated     with     corporations, 
Former    procedure,    104 
Credits, 

For  certain  dividends  and  interest,  800 
For    foreign    taxes,    forms    to    be   used, 

956 
Information    needed    to    take    advantage 
of,   802 


Partnerships — (Cc-ntinued) 
Deductions,    870 

For    gifts,    799,    1241 
Former    procedure,    799 

For  losses,   803 

Foreign  taxes,   943 

Information     needed     to     take     advan- 
tage  of,   802 
Defined,    784,    785,    787 
Dissolution,    procedure,    806-809 
Distributions   other   than   in   cash,    809 
Distributive    shares    of    members. 

Deduction     of     notarial     fees     received 
under  state  commission,  407 

Included    in   gross    income,    155 

Profits,    155 

Shown   on    return    of   firm,    407 

Taxability,   790 
Fiscal   year,   791-796,   806 

Former  procedure,   791 
Foreign      (See     also      "Foreign      partner- 
ships") 

Defined,    1271 

Forms   for   returns,    1302 

Not  affected  by  withholding  provisions, 
1306 
Gifts    individual    credits    for    partnership 

gifts,    1247 
Identity   of    income, 

Former  procedure,   801 

Limited,    801 
Income   from,    784-813 
Income  from   Liberty  bonds. 

Apportionment   to   mtmbers,    688690 
Incorporated,    should    make    returns    as    a 

corporation.    89 
Information  at  source,    292 
Interest   paid   to   partners,   935 

Former  procedure,   935 
Inventory     valuation     when     changed     to 

corporate    form,    486 
Joint   ownership   of   property    not   partner- 
ship  per  se,    785 

Former  procedure,   785 
Joint    venture    in    stock    subscription,    not 

partnership,    785 
Joint    venture    of    corporation     and     indi- 
vidual,  not   partnership,   785 
Law   of    1 92 1,    right    to    incorporate,    796 
Limited     (See     "Limited     Partnerships") 
Liquidating, 

Procedure,   806-809 
Losses, 

Individual's     share    deductible,     loos 

When    deductible.    980 
Mining,    as   association,    91 
Net  income. 

Defined,  799 

How   determined,    798 
Net    loss    provision,    804 
Net   lossces,   deductible   by    partners,    1028 
Not   taxed   as  such,  690 

Former    procedure,    690 
Ownership      certificates       for       registered 

bonds,    315 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1877 


Tartnerships — (Cmttiinicd) 

Participation    in    profits    by    employee    de- 
ductible,   892 
Partners, 

Considered   as   persons,    87,    337 

Not    exempt   from    withholding,    331 
Payment  of  tax   at   source,    1306 
Personal      service      corporations      grouped 

with,    iss 
Personal     service     corporations     included. 

813 
Profits,    389 

Distributive    shares     included    in    gross 
income,    155 

Return  of  estimated,  on  joint  accounts, 
.  786 
Reorganized   as  corporations. 

Returns   on   bases   of   calendar   year   for 
employees'   salaries,    297 
Return   by   receiver,    797 
Returns,    S3,    87,    297,    787-789 

Fiscal  year  basis,  64,    164 
Former   procedure,    64,    297 

Former  procedure,   788  / 

Individual   partners,  87 

Inspection,    1:8 

Inspection   by   single    partner,    119 

Purposes,    798 
Salaries   paid   to   partners,   892 

Included    in    returns,    297 
Withholding   in    case   of,    1308 
Withholding   returns. 

Form   used,   310 
Patent  Infringement,   381 

Damages  received,   income  or  capital,   649 
Profits   from,   641 
Recoveries   for,   513 
Value   of   claim,   602 
Patents, 

Accounting  methods,    650 
Applications   for, 

Valuation    of,   659 
Capital   net  gain,   640 

Deduction     for     depreciation     not     obliga- 
tory,  652 
Depreciation,    1095,    1109-1113 

Based   on   fair   market   value    at    March 
I,    1913,    nil 

Former    procedure,    1 1 1 1 

Of   royalties,   660 

Since    Feb.    28,    1913,    652 
Development    costs,    650 
Distinguished    from    goodwill,    652,    654 
Income   from,   640,   641,   648-660 
Intangible   property,    651 
Life   of,    in    foreign    countries,    11  14 
Litigation   expense  deductible,   651 
Litigation  on,  deductible,    11 12 
Royalties,   648 

Former  procedure,   648 
Tax    on    royalties    withheld,    1310 
Valuation, 

as  of   March    i,    i9'3.   651-659 

Readjustment     permitted     on     accounts 
prior    to     1917.    653 
Valuation    method,    433,    651 


Patriotic    Organizations, 

Not    exempt,    36 
Patterns, 

Depreciation,    11 14 
Tavment  of  Refund   (See  "Refunds") 
Payment  of  Tax, 

Adjustment    for    prior    years,    112,    256 
By   mail,    219 

Citizens  traveling  or  residing  abroad,  218 
Erroneous     or     illegally     assessed     taxes 

must   be    paid,    223 
Instalment    method,    216 

Citizens  abroad,   219 

Former  procedure,  216 

Notice  and  demand   for,   218 

Understatement    of    tax,    217 
Interest    on    instalment    overdue,    217 
Interest    on    unpaid,    220 
Liquidating    corporation,    220 
Methods,    224-227 
Notice  for  unpaid,   218 
Penalties    for    failure   or    delay,    144-147 
Penalties  for  unpaid,    144-147,   220,   244 
Protests    for    additional    assessments,    286- 

289 
Receipt   for,    229 

Suit    to    restrain,    not    maintainable,    249 
Payment    of    Tax     at    Source     (See     also 

"Income    Tax") 
Agreements    to    pay   tax,    1307 
Assignee,     1309 

By     individuals,     corporations,    and    part- 
nerships,   1306 
Corporations, 

Amount  to  be  withheld,   324 
Corporations    not    having    tax-free    bonds, 

330 
Discussion,  322 
Domestic  corporations. 

Not   required   to   withhold,   328 

Payments  to   foreign   corporations,    1310 
Exemptions,    331 
Foreign    corporations,    1307,    1308 

Certificates    showing    place    of    business, 
1320 

Filing   of   return   does  not    relieve   with- 
holding,   1309 
Former  procedure,    1309 

Form  for  interest  on  bonds,    13 13 

Not   required   to   withhold,   328 

With    fiscal    agents   here,    13 12 
Foreign  partnerships  not  affected  by,   1306 
Former   procedure,   323 
Interest    on     drafts    accepted     l)y     foreign 

bank  subject   to   withholding.    1308 
Interest    paid    after    due,    330 
License    for    collection    of     foreign    items, 

1321 
Nonresident    aliens. 

And    corporations,    330 

Bond     interest     and     ownership     certifi- 
cates,    13 1 2 

Citizens  of   U.   S.   possessions,    1322 

Definition   of    fixed   and    determined   an- 
nual  or  periodical   income,    1310 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1878 


GENERAL  INDEX 


Payment  of  Tax   at   Source — (Ccmttnued) 
Non-Resident   Aliens — {Contimted) 

Duties   of   employers,    1315 

Exemption    certificates,    1313.    1314 

Exemption    of   employee,    13 16 

Interest    on    bank    balances,    131 1 
Forrner  procedure,    131 1 

No    withholding    on    bond    interest    due 
prior   to    March    ij    1913,   299 

Owner   of   foreign  item   unknown,    1314 

Partnerships,    1308 

Procedure    of    Alien    Property    Custo- 
dian,   1320 

Race  track  winnings  not  subject,    13 10 

Rates  on  bond  interest,  1315 

Refunds,    1317 

Return  of  tax  withheld,   13 18 
Former    procedure,    1318 

Returns   of   withholding  agent,    13 19 

Ships'    captains,    131 1 
Obligor   corporation,   amount   withheld   by, 

324 
Owner   unknown,    327,    329,    1307,    1314 
Penalties,     1321 

Personal   service   corporations,   328 
Relief   from   does   not   make   income  non- 
taxable,   13 II 
Returns,    305 
Tax    collected    from    non-resident    aliens, 

1306 
Tax   paid   by   withholding   agents,    328 
Tax-free   covenant  bonds,    1306   (See  also 

"Tax-Free   Covenant   Bonds") 
Withholding   agent. 

Defined,    324,     1309 

Not  liable,   328 
Penalties,    109-127,    128-153 
Abatement    claims, 

False,    246 
Additions,    to   taxes   may   or   may   not   be 

deductible,    966 
Ad   valorem,    134 
Appeals   from,    143 
Apply    only    after    notice   and    assessment, 

147 
Certain   cases  exempt   from,    1357 
Citizen    leaving    country, 

Failure  to  make   return,   138 
Community     property     of     husband     and 

wife   under   Texan   law,   400 
Compromise  of,   149,    152,   333 

Bars   prosecution,    153 
Deceased    person's    estates,    148 
Delinquency  in  filing  returns,   152 
Disclosure     of     information     of     returns, 

124-125 
Failure    or   delay   in  payment,    144:47 
Failure   to   make   returns,    131-139 

Former   procedure,    132,    133,    137 
False    or    fraudulent   returns,    133-138 
Fifty    per   cent,    134 
Fraudulent    amended    returns,    136 
Interest    on    instalment    overdue,    217 
Interest  on   unpaid   taxes,    144-147 
Negligence,    140 


Penalties — {Continued) 

Non-resident   aliens,    failure   to    make    re- 
turn for  sailing  permit,   1298 

Not   subject  to   suit,    149-151 

Notice  and   demand   must  be   sent  before 
imposing,  218 

Recovery  of,   for  taxes   illegally  paid,    148 
Former  procedure,    148 

Returns     of     information     at     source     re- 
fused,  321 

Specific,  not  subject  to  suit,  149 

Suits   at   law,   271 

Barred  after  5  years,   152 
Specific   penalties    not    subject    of    suit, 
149 

Synopsis,    128-131 

Tentative  returns,    57-59 

Understatement,    135,    139-144 

Unpaid   taxes. 
Interest   on,    220 

Waived,    140 

When  applicable,   1357 
Pensions, 

As  gifts,   359  , 

Deductions  for  are  income,  444 

Military    or   naval,    exemptions,    351 

Not  taxable,  411 

Former  procedure,  411 

Police  pension  funds. 

Gifts  to,    deductible,    1245 

Retired    pay    allowances    paid    by    United 
States,    not   taxable    as   income,   411 

State,    tax-exempt,    411 

To    Civil    War    veterans,    not    exempt    in 
Kentucky,  409 

To   employees,   deductible,   888 

United    States,    to    widows,    not    taxable, 
421 
Per  Diem  Allowance, 

As    compensation    for    personal    services, 
443 
Personal  Expenses, 

Alimonj^,   870 

Army    officers,    867 

Breach   of  promise,   870 

Clothing,   deductions   for,   868 

Deductions,    851,   855 

Defined,    855 

Distinguished     from     business     expenses, 
S57 
Importance    of    precise    distinction,    858 

Government    officials,    867 

Premiums   on   insurance    (See   "Insurance 
premiums") 
Personal  Injuries,   381 
Personal   Property, 

Dealers    in,    inventories,    488-489 

Income   from   sale  or   exchange,    1282-1284 
Personal    Residence    (See    "Property    De- 
preciation") 
Personal   Service    (See  "Compensation   for 

Personal  Service") 
Personal    Service    Corporations, 

Abolished   by   law   of    1921,    18 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1879 


Tersonal      Service      Corporations — (Con- 
tinued) 

Accumulated     dividends     should     be     de- 
clared,   841 

Affiliated    corporation, 

Losses,  accounting  procedure  for  parent 
company,  829 

Alternative    tax    provision,    814-817 

Amended   returns,   when   establishing   sta- 
tus as,  841 

Capital,   use   of    in,    835-837 

Change    of  tax   basis,    820 

Changes    in    ownership,    837 

Classed    with    partnerships,    155,    164 
Former  procedure,   349 

Computation    of    tax    when    corporation    is 
partly,    839 

Considered   as    partnerships,    813 

Corporations, 

Not      distributing      earnings,      may      be 
classed  as,   839 
Former  procedure,   839 
With    large    government    contracts    may 
not    qualify,    839 

Defined,   823-825 

Distributions  that   are   not   dividends,   713 

Dividends,  349 

Distribution,   705-706 

During    or    subsequent    to    60    days    of 

taxable   year,   729 
When  taxable,   713-714 

Earnings  from   stockholders'  services,   833 

Excess   profits  tax. 

Forms  to  be  used  for  credits,  956 

Excluded,     stockholders'     principal    duties 
being  supervisory,   834 

Exemptions,   46 

Former   procedure,   46 

Fiscal   years,    819-823 

Foreign     corporations     cannot    be     classed 
as,    838 

Government  contracts  not  considered,  531 

Holding    companies,    when    may    qualify, 
828 

Income,   813-841 

Income  from  Liberty  bonds. 

Apportionment    to    members,    688-690 

Net  loss  provision,   838 

Ownership    certificates,    315 

Percentage    of    stock    held    by    those    con- 
ducting, 837 

Personal    service,    what    constitutes,    829- 

833 
Profits    undistributed,    155 
Returns,  53,  90,  818-819 

Dividends   paid,    108,   302 
Former  procedure,  301 

Fiscal   year   basis,    164 

Information  at  source,  297 

What  must  be  included,  714 
Salaries    paid    to    members,    included    in 

return,    297 
Specific  examples,  832 
Stockholders, 

Credits  allowed,  838 

Ex'emptions,   690 


Personal      Service      Corporations — (Coii- 
tinued) 
Stockholders — (Continued) 
Income   to   be   reported,    8.'2 
Status   of,   840 
Tax    liability,    155 

"Trading"    corporations   cannot    qualify, 

when,   826 
"Trading"     corporations     may     qualify, 
when,  827 
Trading   corporations,   when    may   qualify, 

827 
Types    of    organizations    classed    as,    829- 
840  ^J 

Undistributed  profits,   155 
With  substantial  capital  may  qualify,   827 
With    substantial    income    from    personal 

service,  may  qualify,  825 
Withholding   of,   after    1921,    329 
Withholding     returns     on     tax-free     cove- 
nant bonds. 
Form  used,   310 
Personal     Services,     Income     from     (See 
"Compensation  for  Personal  Services") 
Philippine   Islands, 

Compensation    of    government    employees 

not    exempt,   410 
Corporations    in,    classed    as    foreign,    349 
Dividends,   how  treated,   704 
New   taxation   law,    1324 
Not   included    in    1921    law,   368 
Taxation  of   non-residents   of,    1323 
Physicians, 

Depreciation  claims,   11 16 
Pilots, 

Compensation   not   exempt,    409 
Pledges, 

When    deductible,    1246 
Political    Subdivision    of    State   or   Ter- 
ritory, 
Defined,    664 
Income   from    public    service   corporations 

exempt,    50 
Interest  on   obligations  exempt,   360,    664, 

681 
Ownership    certificates   not   required,    318 
Political   Subdivision   of   U.    S., 

Defined,    360 
Porto  Rico, 

Compensation    of    government     ciuiiloyees 

not    exempt,   410 
Corporations    in,    classed    as    foreign,    349 
Dividends,  how  treated,  704 
Gifts     for     reconstruction     work,     deduc- 
tible,   1244 
Not   included   in    1921    law,   368 
Taxation    of    corporations,    1323 
Taxation    of    nonresidents    of,    1323 
Postage, 

Not   deductible    as    tax,    971 
Postal  Savings, 

Deposits   exempt,    680 
Former  procedure,  680 
Postmasters, 

Cannot   administer   oallis,   78 


[See  also  Estate,  Capital  Stock,  and   Excess  Profits  Indexes] 


i88o 


GENERAL  INDEX 


Premiums      (See      also      "Insurance-Prem- 
iums") 

As  earned  income,    1389 

As  taxable  income,  445 

Capital  stock  redeemed,  not  a  deductible 
loss,   1 01 7 

Included  in  gross  income  of  mutual  in- 
surance   companies,    139S 

Life  insurance  policy,  deduction  when 
beneficiary  is  charitable  corporation, 
1246 

Mutual    insurance    companies, 

Deposits    returned    or    retained,    deduc- 
tions for,    1400 

Mutual  marine  insurance  companies,  1400 

Of  business  life  insurance,  excluded  from 
gross  income,   522 

Payment  of  tax  at  source,    1306 

Received  by  mutual  marine  insurance 
companies  paid  out  for  reinsurance  not 
included   as   gross   income,    1393 

Unearned,    of    fire    insurance    companies, 
1396 
Present   Worth, 

Tables,   600 
President  of  the  U.  S., 

Income   not   exempt,    365,    401 
Prices, 

March    i,    1913    and    February    28,    1913. 

61S 
Market,  at  March  i,   1913,  596 
Printing, 

Depreciation,    1116 
Prior     Years     (See     also     "Amended     Re- 
turns") 
Limitation    on    assessment    for,    195-200 
Former    procedure,    196-197 
Proceedings  at  Law  (See  "Suits  at  Law") 
Production   Decline   Curves  for   Gas   and 

Oil   Wells,    1197 
Professional   Men, 

Business    expenses   of,    862 
Depreciation    claims,     1116 
Depreciation  on  residences  used   for  busi- 
ness,   1056 
Office    in    owned    residence,    864 
Office  in  rented  residence,  863 
Rentals   paid   by,    907 
Professional  Services, 

Charges   for,   need  not  be   reported,   303 
Fees    received   as    income    from,    295,    401 
Professors, 

Salaries  in  land-grant  and  states'  colleg'es 
not   taxable,   412 
Profit  and  Loss, 

Affected  by   erroneous  depreciation   state- 
ments,   1051 
Profit-Sharing, 

Actual  payment   from  fund  allowable  de- 
ductions,  436 
Distributions     from,     distinguished     from 
compensation      for      personal      servicts, 

417 
Employees'    Profit-sharing   Fund,   as   com- 
pensation,  436 


Profit-Sharing — (Ccntinued) 

Income    from    fund    taxable    as    firm's    in- 
come, 436 
Problems   in,   425-430 
Taxable    income    under. 
Defined,    1375 
Profits      (See      also      "Gains,"      "Capital 
Gains,"   "Capital   Net   Gains") 
"Accumulated,"  defined,  729 
"Appropriated,"    389 

As   a    source    of   dividends,    720-725,    729 
Copyrights, 

Computation   of,   648 
"Credited    or    set    apart,"    389 
Defined,    976 
Distribution  of. 

Limited   partnerships,    813 
From  patent  infringements,   641 
From  sale  of   patents  and  copyrights,   640 
Operating,    defined,    1174 
Outlawed   accounts  as,    520 
Partnerships,   389 
Partnership, 

Return     of     estimated,     on     joint     ac- 
counts,   786 
Patents,  640,  648 

Realized    from    sale    of    property,    31 
Sale   or  exchange  of  capital   assets, 

Law  of    1 92 1,   804 
Sales,   consignment,   384 
Tax-free   distribution   of, 

Losses,  991-993 
Undistributed,    1259-1286 

Accumulations    taxed    if    evasions    pur- 
poseful,   1261 
Accumulations    taxed    if    unreasonable, 
1262 

Not  retroactive,    1263 
Claims  for  credit,  285 
Common    stock,    reduction    of,    1264 
Individual   stockholders  taxable,    1259 

Former    procedure,     1259 
Investment    of    accumulations    in    U.    S. 

obligations,     1264 
Limited  partnerships,  813 
Personal    service    corporations,    155 
Reinvestment    of    proceeds    of    sale    of 

capital    assets,    1265 
Retirement     or     purchase    of    preferred 
stock    with,     1264 
Former   procedure,    1264 
Stockholders      taxed      on       distributive 

shares  if  so  elected,   1268 
Surplus   from    sale   of   capital    assets   or 

from   excess   funds,    1266 
Surtax    payable   by   corporation,    1259 
Former    procedure,    1259 
Prohibition, 

Obsolescence    due    to,    1144-1149 
Ruling    concerning    inventories,    475 
Promissory   Notes, 
As    compensation,    437 

Discounted,    accounting   for  proceeds,   437 
Not     equivalent     of    cash     unless     readily 

discounted,   548 
Ownership  certificates  not  required,   319 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1881 


Property   (See  also  "Capital  Assets,"  "De- 
preciation,"    "Exchange    gf    Property," 

"Sale  of  Property") 
Accounting    in    conversion    of,    506-508 
Acquired  by  gift. 

Losses   from   sale  of,  995 
Ai)preciation    (See    "Appreciations") 
Corporations, 

Sale   of   property   acquired  by   gift,    519 
Depreciation    (See    also    "Depreciation") 

Aquired   by   gift,    1247 

Personal    residence,    1228 
Discovery    value    ascertained,    541 
Expenses  for  replacement,   509 
Expenses    of     obtaining    return     of     from 

Alien    Property    Custodian    not    deduc- 
tible,  913 
Fair    market   value    March    i,    1913,    basis 
of   determining  loss,   982-984 

Former  procedure,  982 
Held    March    i,    191 3,   not  taxable,  982 
Income    from    sales    and    exchanges,    535- 

566,    1282-1284 
Intangible, 

Depreciation,    1098 

Patents,   651-659 
Inventories    to    establish    losses,    985 

Former   procedure,   986 
"Like  kind"  of, 

Defined,  545 
"Like   kind    or   use"    of. 

Defined,    558 
Losses, 

Determination    and    measurement    when 
deductible,    982-985 
Market  price,  982 
Notes    given    for,    treated    as    instalment 

payments,    502 
Obsolescence,    1134 
Proceeds     of     property     requisitioned     or 

destroyed,   504 
Profits   from   sale   taxable,    31 
Prorating  replacement,   512 
Replacement   in    kind,    508 
Restoration    of,    not    deductible,    1051 
Revaluation, 

Losses   deductible,    1002 
Scrapping    of    buildings    and    machinery. 

Losses   deductible,   997 
Subject    to    depreciation,    1057 
Use   of,  not  taxable,  374 
Valuation,     basis     for     determining,     fair 

market   value,    543 
Prorating   Method, 

Land   and   crop   values,   613 
Validity    of,    616-619 
Public  Employees   (See  "Government  Em- 
ployees") 
Public  Grant  (See  "Homestead") 
Public  High  School, 

Gifts   not   deductible   if    used    for   athletic 

purposes,    1245 
Public   Service    Corporation, 
Fiscal  year  fixed  by  state,  69 
Income  of  states  from,   exempt,    50 


Public  Utility, 

May   deduct    earnings    paid   to   city,    state, 
etc.,    918 
Publishing, 

Depreciation,    1096 
Purchasing    Agencies,    Farmers', 

Exemptions,    45 


Race   or   Race   Track   Associations, 

Not   exempt,    1310 
Race  Track  Winnings, 

Of     non-resident     alien,     not     subject     to 
withholding,    1310 
Radium, 

Depreciation,    iii6 
Kailroads, 

Commuters'   fares,  not  deductible.  865 

Compensation     of    employees,    subject    to 
tax,   400 

Deduction   for    amortization   denied,    1154 

Depreciation   of    roadway,    1061 

May    deduct    amounts    paid    to    Interstate 
Commerce   Commission,  918 

Passes   on. 

As  compensation   for  personal   services, 

441 

As   gifts,   357 

Sidings,    depreciation,    11 17 
Railroad  Fare  (See  "Traveling  Expenses") 
Rates,    Tax    (See    "Computation   of    Tax," 

"Tax    Rates") 
Ration   Money, 

To  military  and  naval  forces  of  the 
United  States,  tax-exempt,  411 
Real  Estate  (See  also  "Building,"  "De- 
preciation," "Lessee  and  Lessor," 
"Property,"  "Rent  as  Income,"  "Title 
to    Property") 

Acquired    by    inheritance,    627 

Carrying  charges  on,   914 

Corporations    holding    for    profit,     deduc- 
tions   for,    848 

Cost  of  development  work,   503 

Damages    for    condemned    projicrty,    wlicii 
taxable,    514 

Depreciation, 

Not   permissible,    1057 
Of    residences,    1056 

Exchange    of,    by    dealers,    taxability    of, 
547 

Gifts    of,    for    park    purposes    deductible, 
1344 

Inventories,    486 

Obsolescence   of   buildings,    1139 

Owned   by   life   insurance   companies,   de- 
ductions for,  expenses  and   taxes,    1384 

Payments     to     increase     value     not     de- 
ductible,  1051 

Hesidcnce  of  clergymen,   not  taxable,   423 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 882 


GENERAL   INDEX 


Real  Estate — (.Continued) 
Sale   of,   498-504 
In  lots,  503 

Or    exchange,     included    in    gross    in- 
come,   1280 
Valuation, 

Inventory   method,   985 
Former   procedure,   986 
Receipts, 

Distinguished   from  accrual,   387,   414 
For    taxes,    issued    only    on    request,    229 
Receivers, 

All  not  classed   as  fiduciaries,    1328 
Appointed  by   state   court,    405 
Claims   for   abatement,    248 
Commissions  received,  when  appointed  by 

state,  not  taxable,  405 
Compensation  fixed  by  state  court. 
Approved   by   federal   court,   405 
Not   taxable,    405 
Taxable   income,  405 
Compensation     of,     partly     state,     partly 

federal,   405 
Liquidating  corporation,   221 
Partnership   returns  made  by,   797 
Procedure     in     liquidation     of     national 

banks,   1342 
Responsibility  in  filing  returns,   1343 
Returns    by,    102,    1341-1344 
Returns  of  information  by,  294 
Reciprocal   Indemnity    Exchange, 

Not  necessarily  exempt,   1404 
Record  vs.  Actual  Owner  of  Stock, 

Non-resident  aliens,  705 
Records, 

Claims,    where    accurate    records    are   not 
kept,    960 
Recoveries, 
Bad  debts,  513 

Charged  off,    1045 
Damages,    awarded    by    arbitration   board, 

S14 
Of    claims,    if    vested    before    March     i, 

1913,   514-315 
Patent    infringement,    513 
Red   Cross, 

Donations    to,    by    corporations,    not    de- 
ductible,    1247,    I2S3 
Former   procedure,    1248 
Maintenance   for   service    in,    as  compen- 
sation for  personal  services,  444 
Referee, 

In   bankruptcy,    not   a   judge    of    inferior 

court,    403 
In   drainage, 

Appointed    by    district    judge    of    state 

judicial     district,     405 
Exempt   from  income  tax  under  Act  of 
1918,   405 
Refunds,    252-277    (See    also    "Claims    for 
Refund") 
Excess   tax    on    oil    royalties,    641 
Interest  on,   under   1921   law,  21 
Payment,   262,   27s 

Under     protest,     286-289 


Regulations, 
Retroactive,  182 
Treasury     interpretations,     188-191,     238, 

239 
Rkligious   Organizations, 

Compensation    received    by    members    of, 

when   taxable,   420 
Exemptions,   39 
Gifts   to,    1 24 1 
Remainderman, 

Stock  dividend  property  of,   782 
Rent, 

Payment  of  tax  at  source,   1306 
Rent  as  Expense,  852 
Deductible,    855 
Life   insurance   companies,   item   must   be 

included    in    return    to    receive    deduc- 
tion,   1384,    1385 
Minister's  house  exempt,   362,  422 
Office, 

In    owned    residence,    864 

In  rented  residence,  863 
Paid   to    real   estate   agents   need   not    be 

reported,  303 
Paid   to   stockholders,   not  dividends,   903 
Payment    for    cancellation    of    lease    de- 
ductible, 904 
Permanent   improvements,    903 
Premium    paid    to    secure    leasehold,    905 
Rental      of      subleased      apartment      de 

ductible,  904 
Taxes  paid  by  tenant,   903 
When  deductible,   902 
Rent  as  Income,  693-703,   1280 
Accrual   basis,    693 
Cash  basis,   693 
Cash   or  its  equivalent  must  be   returned 

for  taxation,   702 
Defined,    693 
Depreciation  of  residences. 

Rented  part  of  year,  1056 

Used    partly    for    business,    or    sublet. 
1056 
Dividends,   guaranteed,   as   rental   cquiva 

lent,   by  corporations,  699 
Expenditure    by   lessees   for   taxes,    700 
Ground   rent. 

Defined,    932 

Not    deductible    as    income,    deductible 
as   rent,   931 

Not   deductible   as   interest,   931 
Houses    occupied   rent-free,   702 
Housing  of  employee  as   taxable   income, 

438-440 
Interest   as   equivalent   of,   699 
Must   be    reported   by   agent,    303 
Not   reported   when  paid   in  crop  shares, 

294 
Permanent    improvements,    693 
Report    of,    on    accrual    basis    or    actual 

receipt   basis,    693 
Securities   as   payment   for,   699 
Subject   to    taxation,    693 
Taxable,    31 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1883 


Reorganization, 

Closed        transaction,        may        constitute, 

tliough      control     remains      in      former 

owner,    560 
Defined,    557 

Depreciation  computation  in  case  of,  1069 
Exchanges   of   securities   not  taxable,    556 
Purchase    of   assets   by   bondholders,    562 
Returns,    100 
Securities  exchanged  in,  not  taxable,  556, 

558 
Tax     question     where     change     in     sub- 
stance or  form  of  securities  exchanged, 

559,   563 
When  continuing  transactions,   536 
When  not  closed  transactions,   556 

Former   procedure,   556 
Repairs, 
And   replacements,   included  in   operating 

costs  of  mines,    11 83 
Capital  expenditures  in  some  cases,  1063 
Incidental,    deductible,    911 

Distinguished   from   replacement   items, 
1061 
Not    to    be    confused    with    depreciation, 

913 
Replacement  Cost, 

Future,     not     a     factor     in     depreciation 

charge,   1069 
Replacement  Funds, 

Cash     received     as    return     of     property 

through  Alien  Property  Custodian,  512 
For   losses,    505-512,    591 
Rulings   concerning,    510-512 
Reserve  Funds, 

Bad   debts,   deductible,    1030-1035 
Fire  insurance  companies,  1396 
For  depreciation,   1074 
Reserves, 

For  discount,  451 
For   obsolescence,    1131 
Instalment  business,  497 
Insurance    companies, 

For    unpaid     losses    not    a    deduction, 

1397 

Issuing  combined  policies,  1397 

Net  additions  to,  deductible,  1396 
Life   insurance   companies, 

Deductions,    1381 

Defined,    1381 
Mutual    insurance    companies. 

Additions  to  deductible,   1396 
"Self-insurance,"    898 
To   equalize   profits,   900 
To    protect   bank   deposits,   902 

Residences, 

Co-operatively    owned    apartments,    46 
Cost    of    not   deductible    by    depreciation, 

1057 
Deduction  for  taxes  paid  by  husband  for 

residence    title    to    which    is    in    wife's 

name,   963 
Depreciation   of,    1056 


Residences — (Continued) 

Establishment,    refund    claims    on,    1317, 

1318 
Loss   on    sale   not   deductible,    1003 
Tax      on      individual's      own      residence, 
rental   value  -of   which    is   not   taxable, 
deductible,    963 
Tax   on   taxpayer's   residence,   deductible, 
968 
Resident, 

Defined,    368 
Resident  Aliens  (See  also  "Aliens,"  "Non- 
resident Aliens"), 
Credits, 

Foreign   taxes,    946 
Deductions, 

Foreign  taxes,  942,  946 
Taxes,  938 
Withholding  upon  change  of  status,    1275 
Resources,   Unworkable, 

Depletion,    1231-1233 
Retailers, 

Inventories,  475-478 
Retroactive    Regulations,    182 
Retroactive  Taxation, 
Stock    dividends,    783 
Returns     (See    also    "Amended    returns," 
"Forms    of    Returns,"     "Inspection    of 
Returns,"    "Returns   of   Information    at 
Source"), 
Access  to,    117 

Alien  Property  Custodian,  1304 
Amended    (see    "Amended   returns") 
Affidavit,    77,    78 
Agents,   77 

Form  tc  be  used,   77 
Annual  basis    (see   also    "Returns,   Fiscal 
Year    Basis") 

Fractional    part    of    year,    167 
Assignee's  returns,   loa 
Auditing   of,    194,    200 
Bad  debts, 

Reported,  to  be  deducted,   1036 
Books    of    account    reconciled    with,    162 
By   oath,    78 
Certified   copies    of   as   evidence   in   suits 

at  law,    120 
Change   in   accounting  period,    procedure, 

6S 

Community     property     of     husband     and 
wife,   filed  separately,   82 

Confidential   rights,    117 

Consolidated      (see      "Consolidated      Re- 
turns") 

Foreign  corporations. 
Former  procedure,   1303 

Contractors,    449-450 

Corporations      (see      "Corporations,      re- 
turns") 

Dealers  in  securities,  484-485 

Defined,    52 

Depletion,    statement    of,    1214 

Tn     case    of     fractional    interests    and 
Iciscliolds,    1314 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 884 


GENERAL   INDEX 


Returns — (.Continued) 

Each  year's  must  be  complete,  848 
Erroneous    information,    penalties    waived 

for,    150 
Executors  make,   for   estates,    1355 
Exempt    securities    need    not    be    listed, 

360 
Extension    of    time    for    filing    (see    "Ex- 
tension  of   Time    for   Filing  Returns") 
Failure   to   make,    131-139 

Former  procedure,  133 
Fiduciaries,    87,     1330-1346 

Beneficiaries,   1339 

Committee    for    incompetent,    1339 

Distributive  share  of  beneficiaries,  1338 

Estates  and  trusts  not  treated  as  unit, 
1336-1338 

Form  to  be  used,  77,  1346 

Guardian  for  minors,   1339 

Information    at    the    source,     1344-1346 

Joint,     1330,1335 

Non-resident  alien  beneficiary,  1344 

Place  for  filing,    1331 

Property  turned  over  to,  1339-1340 

Receivers,    1341-1344 

Revocable  trust,   1340 

Several    trusts,    1340 

Trustee   in  bankruptcy,    1341 

When  due,  1331 

When    required,    1330 
Filing    (see    also    "Failure    to    Make    Re- 
turns") 

Amortization    claim    with     1921    return, 
1150 

By  mail,  63 

Delinquency  in,    152 

Exempt  securities,   33 

Filed    on    time,    penalties    waived    for, 
149 

Foreign  corporations,   1309 

Partnerships,    787-789 

Wrong    district,    penalties    waived    for, 
150 
Final    (see   "Final  Returns") 

Closing   of,   209-213 
Fiscal    year  basis,    163-166 
Foreign  corporations,    1296 

Agent   responsible,    1303 

Agent's    return,    100 

Consolidated     returns,     1303 

Extension    of    time    for    filing,    1305 

Forms   required,    1302 

Time    and   place    for   filing,    1304 
Foreign    partnerships, 

Forms    required,    1302 
Forms,  72-74 
Fraudulent,   109-127 

Penalty    for   abetting,    133-138 
Gross   income,   individual    returns,   52 
Guardians,    77 
Holding  companies,   99 
Husband    and    wife    (see    "Husband    and 

Wife") 


Retirns — {Cofitinued) 

Imperfect     or     incorrect     not     acceptable, 

138 
Inactive    corporations,    95 
Incompetents,   77 
Incomplete   corporations,    95 
Individuals,    52,    75-129 

Fiscal    year    basis    for     fractional    part 
of    year,    170 

Gross  income,   75 

Last  due  date,   55 

Partner   as,    87 

Who   must  make,   75 
Inspection   (see  "Inspection  of  Returns") 
Instalment    dealers,    488 
Insurance  companies,    100,   1405 
Interest    from   tax-exempt   securities   need 

not  be   reported,   76 
Internal  Revenue  Commissioner,   52-53 
Mailed    on    time,    penalties    waived    for, 

149 
Married    persons,    52,    75 
Military   and   naval    forces,    78,    86 
Minors,    77,    84,    1348 

Emancipation    of    minor,    85 

Former  procedure,  84 
Negligent,    109-127 
Non-resident  aliens,   1297 

Beneficiaries,    1300 

Extension  of  time   for  filing,   1305 

Filing    of    for    deductions    and    credits, 
1295 

Forms   required,    1301 

Required    for    sailing    permit,    1297 

Responsibility   of  agent   for,    1299 

Time  and  place   for  filing,    1304 
Partnerships,    87 

By  receiver,  797 

Former   procedure,    53 

Purposes,    798 
Personal  service  corporations,  53,  90,  818- 

819 

What  must  be  included,   714 
Place   for  filing,  63 
Receivers,   102,   797 

Mortgage   foreclosure,    103 

Responsibility   in   filing,    1343 
Re-examination   of,   199 

Amortization    claim,    1150,    1165 
Requirements,    52 
Soldiers  and  sailors,   86 
Special    kinds,    54 
Taxable  year,    64 
Tentative,   57-59,    I39 

Penalties  waived   for,    150 
Time  for   filing,   54,    57 

Former   procedure,    54 
Trustees, 

In  bankruptcy,  102 

In  dissolution  of  corporations,   1341 
Understatement,    135,    139-144 
Unmarried   persons,   52,   75 
Who  shall  make,  52,   75 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


i88; 


Returns    of    Information    at    Source, 
Actual  owner,   317 
Alien     employees,     by     foreign    branches, 

need  not  be  reported,  303 
Aliens,   non-resident,   299 
Amount  to   be   reported,   293 
Annuities    need   not   be    reported,    303 
Bills     for    professional    services     not     re- 
ported,  303 
Board    and    lodging    of    employees,    296 
Bonds.    298 

Sold    between   interest  dates,    313 

Sold    between    interest    dates,     former 
procedure,    314 
Brokers, 

Payments    to    customers,    303 

Returns  on  customers,  302 

Returns     on     customers,     former     pro- 
cedure,   302 
Calendar  year,  294 
Civil    service     employees,     303 
Classes    about    which    furnished,    292 
Classification,    292 
Commission    on   single   transaction  not  to 

be    reported,    295 
Compensation    for   personal   services,    295- 

297 
Compensation    to    employees    for    injuries 

or   sickness   need   not  be   reported,   303 
Corporations,    315 

Must    furnish,    292 

Payments   to,   not   to   be   reported,   303 
Debtor      corporation      ownership      certifi- 
cates,   299 
Discussion,    291 
Dividends,    domestic    or    resident    foreign 

corporations,  303 
Dividends  paid,  301 

Former  procedure,  301 
Employers   must   furnish,    292 
Examination    of    bank    accounts,    1 1  s 
Extension    of    time    for    filing,    303 
Failure   to  file,   penalties,    134 

Former  procedure,  132 
Fees    for    professional    services    to    be    re- 
ported,   29s 
Fiduciaries,    297,    314,    1344-1346 
Fixed   and   determinable   income,   defined, 

294 
Foreign   countries,   bonds   of,    298 
Foreign   dividends,   298 
Foreign  items. 

Defined,  300 

Ownership  certificates,   299 
Form   of   certificate    when   withholding   is 

required,  309 
Forms   of,    293,    305,    309.    1346 

Former  procedure,  293 
Freight  bills,   303 
Individuals   must    furnish,    292 
License    for    collection    of    foreign    items, 

1331 
Merchandise  bills,   303 
Monthly  and  annual,  by  agent,  298 

Former   procedure,   298 


Returns  uf  Information — (.Continued) 

Municipal   government,   303 

Non-resident    aliens,     301 

Non-resident    corporations,    source    of    in- 
formation, 300 

Ownership   certificates,    120 
As  returns,   299 
Forms  and  uses,   304,  306-319 
Necessity  for,   1345 
Shall    constitute,    306 

Partnerships,    297 
Foreign,  301 
Must   furnish,  292 

Payments, 

On    which    required,    293 
Requiring   no    information,    list    of,    30J 
To    agents    of    $1,000    or    more    to    be 
reported,  293 
Former  procedure,   293 
To  employees  must  be  reported,  295 
To    nonresident   aliens,    1320 

Penalties   for   refusal,    321 

Personal    service   corporations,    297 

Rent    paid    to    real    estate    agents    need 
not  be   reported,   303 

Soldiers  and  sailors,  payments  to  by  gov- 
ernment need  not  be  reported,  303 

State    or    political    subdivisions,    303 

Storage    bills,    303 

Substitute  certificate,  310 

Telegram  bills,  303 

Telephone  bills,  303 

War    Finance    Corporation    bonds,    318 

Who   must  furnish,   292 
Revaluation      (See     also      "Appreciation," 
"Valuation"), 

As    of    Jan.     i,     1909,    applicable    to    cor- 
poration   excise    tax    only,    1070 

Gain  or  loss  through,   582-586 

How   entered   on   books,    582 

Mines,    1 1 76 

Property, 

Losses  deductible,    1002 

Securities, 

Permitted  dealers,  986 

Surplus   from,    not   taxable,    583 
Roadway, 

Depreciation    of    railroad,    106 1 
Royalties    as    Income,    640-649,    6»)(i,    1280 

-Advance     royalties,     1229 

Basis   of   patent  valuation,   655 

Copyrights,    647 

Depletion   allowances,    1216 

Depletion    applicalile,    645 

Depreciation    charges,    660 

Mines,   oil    wells,   etc.,    640 
Depletion  allowances,  641-647 
Depletion     allowances,     former     proced- 
ure,   642 

Patents,  648660 

Tax    on    payments   withheld,    1310 

Taxable,   31 

Waived   for   several   years,  647 

Wells,   gas  and   oil,    1198 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 886 


GENERAL   INDEX 


Russian    Investments, 

When    worthless,    987 
Russian    Property, 

Deductions  for  bad  debts,   1043 


Sailing  Permits, 

Non-resident     aliens,      returns     required, 

1297 
Sailors, 

Board   and   lodging  as  compensation,   not 

taxable  income,   439 
Compensation    for    active    service    during 

war    exempt   up   to    $3,500,   410 
Items    to   be    included    in   the    $3,500   ex- 
emption of  the   1918  law,  411 
Payments   to   by  government  need   not  be 

reported,   303 
Returns,   86 

Special    exemption    of    1918    law    not    re- 
enacted  in  1 92 1,  410 
Salaries    (See    also    "Bonuses,"    "Compen- 
sation   for   Personal   Services") 
Contingent,   deductible   in  year   paid,   884 
Deductions    for,    870-876 
Deductions    for    annuities,    civil    service 

employees,   413 
Definition    of     "Including    a     reasonable 

allowance  for  salaries,"  871 
Determined  after  close  of  fiscal  year,  884 
Fiduciaries,    included   in   returns,    297 
Fixed   by   contract,   877 

Lump   sum    payment   of,    878 
Must  not  be  unreasonable,  875-876 
Paid   by  corporations,   874 
Paid  by  exempt  corporation. 

Taxable,   49,    51 
Partners, 

Included   in   returns,    297 

Taxable    income,   805 
Payment  of  tax  at  source,   1306 
Personal    service    corporations,    included 

in    return,    297 
Professors',     in     land-grant    and     states' 

colleges  not  taxable,   412 
Received   as   income   from   professions   or 

vocations,   401 
Voted   subsequent   to   close   of  books   not 

deductible,    886 
Sale    and    Exchange    of    Capital    Assets 

(See     "Capital     Gain,"     "Exchange     of 

Property,"    "Sale    of    Property") 
Sale  of  Ore, 

Lease   as  distinguished   from,    1227 
Sale  of  Property   (See  also  "Exchange  of 

Property,"  "Property") 
Acquired  by  gift,  619-625 
Acquired    by    inheritance, 

Income  only  taxable,  355 
Allocation    of    income,    1282-1284 
Basis  for  determining  gain  or  loss  when 

appreciation  is  realized,   569-582 


Sale  of  Property — {Continued) 
Capital   assets   of   corporation,    554 

Former    procedure,    554 
Deferred    tax    on    instalment    plan    sales, 

549 
Expenses    for    sale    of,    by    estate,    when 

deductible,    1363 
Fair    market    value. 

Defined,   539 
Goodwill,    549,    602-612 
Income   from,    535-566 
Market   value   at  March    i,    1913,    596 
Mines,    159,    599 
Obsolescence,    1130-1149 
Options,    538 

Profit    realized    from,    taxable,    31 
Vessels, 

Profits    from    under    Merchant    Marine 
Act,   1920,  369 
Wells,    599 
Sale  of  Rights, 

Stockholder's,      to      subscribe      for      new 

stock,  taxable,  550 

Sale   of    Securities    (See    also    "Exchange 

of   Securities") 
Acquired  by  inheritance,   625-627 
Basis,    when    shares    of    same    issue    are 

bought     and    sold    at    different    dates, 

587 
Income  from,  535-566 
Losses  on,  989 
Right    to    subscribe    to    stock, 

When    taxable,    550 
Tax   exempt. 

When  taxable,  554 
To   establish   losses,  993-995 

Former    procedure,    993 
Valuation  of  stock  sold  at  varying  prices, 

March  i,  1913,  614-616 
Sale  of   Stock  Dividends, 

Taxability   of   income   from,   belonging  to 

trust    estates,    1361 
Sales     (See    also    "Closed    Transactions"), 
Export    business,    unpaid    drafts    not    in- 
cluded as   profit,  377 
Goodwill,  proceeds  taxable,   549 
In  escrow,  375 

Instalment    plan,    487-504,    548,     549 
Of  capital  assets,  partnership  profits,  law 

of    1921,   804 
What  constitutes  closed  transactions,   536 
When   taxable,    548 
Salesmen, 

Advances   to    deductible,    878 
Commissions  received  by,  taxable,  420 
Sanitarium, 

Not  in  personal   service  class,   834 
School  Officers, 

Compensation  when  not  public  employer, 

subject  to  tax,  407 
Scientific  Organizations, 

Gifts  to,   1241 
Scientific  Societies, 
Exemptions,  39 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1887 


Scrip  Dividends, 

As  cash  dividends,  taxable,  741 
Interest  on,  742 

Deductible,  926 
Not   taxable,    779 

Reaeemable    in    cash    or    stock,    taxability 
questioned,  743 
Seamen    (See    also    "Sailors,"    "Ship    Cap- 
tains") 
Alien, 

Proof   of    residence,    1373 
Residence,   how   established,    1273 
Non-resident,   wages,    when  taxable,    1289 
Seasonal  Business, 

Reorganization   of   corporations   doing. 
Returns,    loi 
Securities     (See     also     "Liberty     Bonds," 
"Exchange     of     Securities,"     "Sale     of 
Securities,"     "United     States    Bonds") 
Carried    on    margin    with    broker, 

Stock  dividends,   refunds,  781 
Collateral, 

Depreciation   of,    1043 
Interest  deductions,  930 
Corporations,    losses    in    issuance    at    re- 
demption,   1013 
Dealers   in, 
Defined,  481 

Inventories,    481-489,    582,    985 
Former  procedure,  986 
German,   987 

Government,      discount     on     bonds,     ac- 
counting for  proceeds,   741 
Income  from  interest. 

Acquired    between    interest    dates,    674 
Losses,  accrued, 

"Wash   sales"    to   establish,   993-995 
Former  procedure,  993 
Revaluation, 

Permitted   to   dealers   only,   986 
Russian,   987 

Sold    by   estates,   advantages   to,    of   capi- 
tal  gains   provision,    1374 
Tax-exempt,    378 
Valuation, 

At   date   available,    626 
When    acquired    by    inheritance,    626 
Services,     Personal     (See    "Compensation 

for   Personal    Services") 
Shares    (See   also    "Stock") 

Distributive,    in    partnerships,    taxability, 
790 
Sheep  (See  "Live  Stock") 
Shipping  Industry, 
Depreciation,   11 17 
Shipowners'  Mutual  Protection  and  In- 
demnity  Associations,   363 
Income  of,  365,    1395 
Ships    (See    "Vessels") 
Ships'  Captains, 

Not  subject  to  withholding,  131 1 
Shipwreck, 

Loss   by,    S'Jo,   978 


Sickness, 

Compensation   to    employees    for    sickness 

need  not  be  reported,  303 
Penalties    waived    for,    150 
Silver    Mines    (See    "Mines") 
Single     Persons     (See     "Unmarried     Per- 
sons") 
Sinking  Funds, 

Interest   or   gain   from,    taxable,   670 
Not  established  for  mines,    11 79 
Smith-Lever  Act,   1914, 

Salaries  in  colleges  under,  412 
Soap  Industry, 

Depreciation,    11 18 
Society   por   the   Prevention   of   Cruelty 
to  Animals, 
Gifts   deductible,   39,    1242 
Society   for  the   Prevention   of   Cruelty 
to  Children, 
Former    procedure,    39 
Gifts    deductible,    39,    1242 
Soldiers, 

Compensation    for    active    service    during 

war   exempt  up   to   $3,500,  410 
Items   to   be   included   in   the    $3,500    ex- 
emption of  the   1918  law,  41: 
Payments   to  by  government  need  not  be 

reported,     303 
Returns,   86 

Special    exemption    of    1918    law    not    re- 
enacted  in  1921,  410 
Special  Counsel, 
Compensation    of. 

To   city,   not  exempt   from   income  tax, 

408 
To  state  comptroller,  not  exempt  from 
income  tax,  408 
Specific    Exemptions    (See    "Exempt    In- 

come") 
Speculation, 

Losses,   deductions,   996 
Former    procedure,    996 
Speculation    in    "Futures," 

Taxable,   448 
Stamp   Taxes, 

Deductible    only    by    person   levied    upon, 

959 
Deductible  on  sale  of  property  by  execu- 
tor,   1363 
State, 

Community     property     of     husband     and 

wife  as  defined  in,   395 
Interest    on    obligations    of   political    sub- 
divisions   of,    tax-exempt,    664 
Public    service    corporation, 
Fiscal  year  fixed,  Cg 
State  Bonds, 
Interest, 

On  loans  secured  for  purchase  of,  not 
deductible,    929 
When    distributed    as   dividends,    taxable, 
740 
State  Courts   (See   "Courts,   State") 
State   Income  Tax,    6 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


State  Officers  and  Employees, 
Exempt,    366,   403 

Former   procedure,   403 
Right  to   inspect  returns,   118,   121 
Salaries  exempt,  33 

Special     counsel     for     state     comptroller, 
408 
State  Securities, 

Exempt,  360 
State    Witness    (See    "Witnesses,    State") 
States  of  the  U.   S., 
Deductions, 

Taxes    paid    to,    under    secured    debts 
laws,   957 
Defined,   368 

Former   procedure,    368 
Exemptions,     income     from     public     serv- 
ice  corporations,   50 
Gifts  to. 
Deductible,    1242 

Returns    of    information    at    the    source, 
303 
State  Taxes, 

Deductions  for,  927 
Statistical    Information, 

Income  tax,  publication  of,  126-127 
Steamship   Companies,    Foreign, 
Income, 

Sources  within  United   States,   1290 
Steamships    (See   "Vessels") 
Stock    (See   also    "Bank    Stock,"    "No    Par 
Value    Stock,"    "Sale    of    Stock") 
Building    and    loan    associations,    673 
Capital, 

Certificates      must      be      canceled      or 
stamped    for    payments    required    by 
reduction    of,    747 
Exchange   for   cash   considered   as   pur- 
chase  of  old  stock,   735 
Proper   procedure  in  reduction   of  capi- 
tal  stock,    747 
Reduction    of,    747 
Determination   of  value  of  stock   received 
as  compensation,  431-434 
Former    procedure,    431 
Joint     subscription    not    partnership,     785 
Received  as  bonus,   533 
Record     owner     responsible     for     return, 

1301 
Retirement  of  common,  with  surplus  earn- 
ings,  when  taxable,   1264 
Sale   on   instalment   plan. 

Closed   or   continuing  transactions,   549 
Sale    or    retirement    by    corporation,    523 
Self-purchase    by    corporation,    524 
Stamp    taxes    on,    should    be    treated    as 
taxes,   960 

Former   procedure,   960 
Stockholding   taxes    paid   by    corporations. 

Not  deductible,   938,  939 
Subscription     rights,     when    taxable,     530 
Taxes   paid  by  corporation  not  deductible 

by    shareholders,    957 
Treasury,    accounting    procedure,    523-527 


Stock — iContinned) 
Valuation,   543 
Worthless,   deductible,   988 

Former    procedure,    9*89 
Stock  Brokers, 

Interest    derived    from    accounts    of,    670 
Stock  Dividends, 
Allocation   to, 

Different  years,    728 

Earliest  purchaser,  775 

Periods    when    accumulated,    728 
Amount    received    in    redemption    of    can- 
cellation,   taxabje,    764 
Appreciation  of  assets  as  source   of,   780 
Cancellation   of,  taxable,  764 
Carried     two     years,    taxable     as    capital 

gains,   770 
Cash   dividends,   764 
Corporations, 

Domestic,  705-706 

Resident,     foreign,    705-706 
Credits,    780 

Declared    by    national    banks,    766 
Defined,    764,    765 

Effect  on   surplus  at  March   i,   1913,   732 
Excise  tax,   783 
Fractional    shares    received    as    dividend, 

779 
Goodwill  as  source  of,  780 
Guaranteed,     as     rental     equivalent,     by 

corporations,   699 
History    of    taxable    question    (see    book, 

"Income    Tax   Procedure") 
National  banks  may  not  lawfully  declare, 

766 
Not  a  distribution,   768 
Not  taxable,   763 
Paid     in    stock    of    another    corporation, 

not,    730,    769 
Personal  service  corporations. 

Supreme   court  decision,   814 
Preferred    stock,    not    deductible,    932 
Preferred    stock    not    taxable,    768 
Property     of     life    tenant     or     remainder- 
man,  782 
Reappraisal    as    source    of,    780 
Redemption    of,    taxable,    764 
Refunds,    780 

Refusable,   708,    782 
Retroactive   tax,    783 
Sale   by   trust   estate, 

Taxability   of  income    from,    1361 
Sale    of 

Basis    for    determining    gain    or    loss, 
771 

Computation  of  profit   or   loss,    770-780 

Computation,    shares   of  different   char- 
acter,  774 

Computation,  shares  of  same  character, 
7TI-773 

Computation,    shares    purchased    at    dif- 
ferent times  and  prices,  774 
Shares    carried    on    margin    with    broker, 

Refunds,  781- 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1889 


Stock  Dividends — {Continued) 

Stockholders  to  be  advised,  714 

Subsidiary    corporations,    768 

Surplus, 

Accumulated    prior   to    March    i,    1913, 

767 
And    undivided    profits    as    source    of, 

711 
As   source    of,    780 
Capitalized  by  means  of,  767 

Taxable  when   set  apart   for  stockholders, 
388 
Stockholders, 

"Bargain"    purchase,    capital    assets,    989 

Compensation  of  deductible,    877 

Contributions  to   creditors,    990 

Deductions     on     taxes    paid     by    life     in- 
surance   company,    1384 

Depletion     claims,    not    allowed,     1216 

Dividends  in   Liberty  bonds. 
Losses  on,  988 

Dividends,    owners    of    record    liable,    ex- 
ception,   70s 

Injunction    not    granted    in    suits    to    re- 
strain collection  of  taxes,  250 

Inspection    of    returns,    119,    123 

Liability    of, 

Liquidating   corporation,    222 

Personal    service    corporations. 
Changes   in,   837 
Exemptions,  690 
Income  to  be  reported,  822 
Returns,   155,  819 
Service    must    be    principally    rendered 

by,    829-833 
Status  of,  840 
Taxed  as  individuals,   784,   814 

Profits    on    sale    of    rights    10    subscribe 
to   stock,   taxable,    550 

Taxable    for    sale    of    corporation's    capi- 
tal  assets,    554 
Former    procedure,    554 

Taxable      for      undistributed      dividends, 
when,    706 

Taxable    for    undistributed    profits,    706, 

1359 

Former   procedure,    1259 
Taxable     on    distributive     shares,     if     so 

elected,    1268 
Voluntary    assessments,    tax-exempt,    520 
Stock  of  Other  Companies, 

Dividends     paid     in,     not     considered     a 

stock   dividend,    730 
Redemption   of,  755 

At     substantial     premiums,     is     a     dis- 
tribution of  surplus,   758 
Stock  Preferred, 
Retirement  of. 

Contractual,    747 
Retirement     of     preferred,     with     surplus 

earnings,   not   taxable,    1264 

Former  procedure,   1264 
Stock   dividends   in,   not  taxable,    768 
Storage   Bills, 

Need   not   be    reported,   303 


Storm   Losses,  978,    1415 

Deductions  for,   860,   978,    141 5 
Street   Railway   Companies, 

Donations    to    induce    to    extend    tracks, 
not    deductible,    1250 
Stumpage, 

Revaluation     in     depletion     not     allowed, 
1335 
Styles, 

Depreciation   and,   11 14 
Subscriptions    (See  "Gifts") 
Subscription    Rights, 

Stock,    when    taxable,    550 
Subsidiary    Corporations    (See    "Affiliated 

Corporations") 
Substitute    Certificates, 

For   ownership,  310 
Suits  at  Law, 

Certified    copies    of    returns    for    use    as 

evidence,    120 
Claims  for  refund,  procedure,   252-277 
Collection  of  taxes  by  suit,  231 
Compromise   of   penalties  bars,   153 
Criminal    proceedings,    152 
Income    assessments,    236 
Injunctions   to   restrain   collection   of   tax, 

250 
Must    be    brought    against    collector    who 

collected   tax,   267 
Recovery     of    penalties,     foundation     for, 

149 
Recovery    of    taxes    wrongfully    collected, 

373 
Specific    penalties   not   subject   of,    149 
Time     limit    for     action    by    government, 

153 
Where  collector  dead,   268 

"Supper  Money," 

As    compensation    for    personal     services, 
440 
Surplus       (See      also       "Profits,       Undis- 
tributed"), 
Arising     from     reappraisals     not     taxable, 

582 
Capitalized    by    means   of   stock    dividend, 

767 
Dissolved    limited    partnerships. 

Disposition    of    surplus.    563 
Distribution    of,    when    necessary,    1266 
Dividend    distributions    made    from,    746, 

780 
Effect    of    stock    dividend    on    surplus    at 

March    i,    1913,   746 
Personal    service    corporations. 

Accumulated    prior    and    subsequent    to 
January    i,    1918,    840 
Taxation    of    undistributed    profits,     1259- 

1335 
Undistributed,    not    (Icduclible,    071 

Surtax, 

Computation  of,    i  s^' 
Corporations   not    liable    lo,    /u.i 
Kvasion    of    on     iniilislributcd    pidfil.    by 
corporations,     12^10 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1890 


GENERAL   INDEX 


S  u  RTAX —  (Continued) 

Husband  and  wife,   79,   80 

Former   procedure,   79 
Imposed   on  net   income,   377 
Individuals,    31,     155,     156 
Individuals    of    partnerships. 

Avoidable  by  retroactive  incorporation, 
796 
Law  of  1931,   18,  683 
Mineral   deposits,  sale  of,   159 

1921  rates,    156 

1 93 1    rates   on   cash   dividends  as   taxable 
income,   732 

1922  rates,    156 

On  interest  on  certain  U.  S.  bonds,  680, 

682 
Partnership   profits,   803 
Payable   when   normal   tax   exempt,   156 
Personal    service    corporations,    819 
Rate    of,    156 

Former    procedure,     156 

Non-resident   aliens,    1297 
Sale  of  mineral  deposits,   159 
Tax    on,    for    individuals    exempt    under 

normal   tax,    344 
Undistributed  profits,  payable  by  corpora- 
tion,   1259 

Former    procedure,    1259 
Wisconsin,    974 
Syndicates, 

Not  associations,  91 


Tables, 

Amortization,    11 80 
Decisions,   ix 

Present   worth   of   each   dollar   of   operat- 
ing profit, 
Hoskold's    formula,    600 
Tables  of  Depreciation    Rates,    1123-1128 
Tax      Collectors      (See      "Collectors      of 

Taxes") 
Tax  Paid,  Refundable,  972 
Tax   Payment   (See   "Payment  of  Tax") 
Additional     (See    "Additional    Tax    Pay- 
ments") 
Tax    Rates,    154-172    (See   also    "Computa- 
tion   of    Tax,"    "Net    Income,"    "Sur- 
taxes") 
Corporations,    160 

Outlawed    accounts    subject    to,    520 
Prorated  for  fraction  of  year,   167 
Estates  and  trusts,    1329 
Foreign    corporations,    1297 
Gross  income  of  individual,    1330 
Individuals,    155    (See   "Individuals,    Tax 

on") 
Insurance  companies,    1379,   1387 
1 91 7   laws,    13 

1921    law,    changes   summarized,    154 
Non-resident   aliens,    1297 
Repeal    of   profits   tax,    531 
Tax    Simplification    Board, 

Organized    under    1921    law,    21,    179 
Taxable   Year, 

Change   in,    163-171 

[See  also  Estate,  Capital  Stock 


Taxable   Year — (Continued) 

Changes   in,    1027 

Defined,    64 

Different    tax   rates,    733 

Returns  on   basis   of,    63-72 

Status  at  end  of  determines  exemption, 
343 

Uncompleted   for  corporations  in  dissolu- 
tion,  55 
Taxation, 

British    practice   in    betting,    447 

French   practice  in   gambling,  447-44S 
Tax-Exempt      Securities     (See     "Exempt 

Securities") 
Tax-Free  Covenant  Bonds    (See  also   "Ex- 
empt Bonds,"  "Ownership  Certificates," 
"Payment    of    Tax    at    Source,"    "Re- 
turns   of    Information    at     Source") 

Corporations  issuing,    931 

Deductions  for,   677 
Former  procedure,    678 

Defined,    323 

Due  prior  March  i,  1913,  330 

Federal  tax  paid,  not  deductible,  928,  971 
Former  procedure,   972 

Form  for  personal  exemption  claimed  by 
non-resident  alien  on  interest  from, 
1313 

From   whom    withheld,   327 

Legal   theory   of   deduction,    324 

Limitation  of  debtor  corporation's  lia- 
bility,   335  ^ 

Ownership    certificates,    306-319 

Taxpayers,   list   posted,    126 

Withholding   provisions   apply   to,    1306 
Taxes,    (See  also   "Computation   of  Taxes" 
and  special  subjects  in  body  of  index) 

Adjustment  of  taxes   of  prior   years,  966 

Bank  stock,  paid  by  bank  not  deductible 
by   shareholders,   957 

Claims    for   credit. 

Applied  against  income,  war  profits,  or 
excess    profits   tax,   278 

Corporations, 
Deductions,    939 

Former    procedure,    939 

Credit    for    payment,    1368 

Customs    duties   deductible,    959 

Deductions,    937-974 

Accrual  method  permitted,  973 

Former   procedure,   973 
Criticism   of    law,   963 
Excise  taxes,   960 

Former   procedure,   960 
For    interest    on    overdue    federal,    927 
For  taxes  paid  for  another  person,  963 
Former    procedure,    974 
Luxury    taxes,    960 

Former    procedure,    960 
Not   allowed,   931 

Real    estate    owned    by    life    insurance 
company,    1384 

Foreign, 

Credits    for    domestic    corporation    con- 
trolling foreign   subsidiary,   948-951 
Former  procedure,  948,   951 

and  Excess  Profits  Indexes] 


GENERAL  INDEX 


1891 


Taxes — (.Caniinucd) 

Foreign — iCo-ntinucd) 

Credit  for,  under  fiscal  year  basis,  954 

Former   procedure,   954 
Deductions,    937,    942-944 
Forms  to  be  used  for  credits,  956 
Limitation  of  credit,  943,  948 
Massachusetts    trust,   956 
Procedure    for    securing    credit,    953 

Foreign    dividends, 
Deductions,    944 

Individuals, 

Deductions,   938 

Former    procedure,    939 

Inheritance  taxes  deductible,   961 

Local  improvement  assessments  not  de- 
ductible,  966-968 

Former    procedure,    966 

Local  improvement  assessments  not  in- 
creasing value  of  property,  deductible, 
968 

Paid   by   tenant,   deductible,   903 

Paid  by  vendee  for  vendor,  taxable  to 
vendor,    521 

Paid  for  another  person,  deductions,  963 

Paid  or  accrued  by  insurance  companies 
not    deductible,    1391 

Paid  states  under   secured   debt  laws, 
Deductible,  957 

Payable  by  manufacturer,  not  deductible 
by    consumer,   960 

Penalty  additions  to  may  or  may  not  be 
deductible,    966 

Stamp   taxes. 

Deductible  only  by  person  levied  upon, 

9S9 
On   stock,   960 

Former  procedure,   960 

State, 

Deductions    for,    927 

Undistributed    surplus,    tax    on    not    de- 
ductible,  971 
Teachers, 

Deductions  for   courses,    863 

Hawaii   not  exempt,   410 
Telegram   Bills, 

Need    not   be    reported,    303 
Telephone, 

As  compensation  for  personal  services, 
440 

Bills,  need  not  be  reported,  303 
Territories  of  the  U.  S., 

Compensation  of  government  employees 
not   exempt,   410 

Exemptions  for  citizens  residing  in,  368 
Former   procedure,    368 

Interest  on  obligations  of  political  sub- 
divisions   of,    tax-exempt,    664 

Securities   exempt,    360 

Texas, 

Community  property  of  husband  and  wife 
as    defined   by   Texan    law,    400 
Textile  Industry, 

Depreciation,    11 18 


Theft  or  Embezzlement, 

Loss   by,    860,    978,    1 008-1 01 1 
Former    procedure,    1008,    loii 
Timber, 

Depletion,    1234 
Basis  of,   1 167 
Computation,   1234 
Determination  of  quantity,   i.'38 
Market  value,    1237 
Depreciation,   1079,    1119 

Improvements,    1334 
Lease  as   distinguished   from   sale,    1227 
Valuation, 

Located  in  Canada,   1338 
Tips  and  Gratuities,  Taxable,  420 
Title  Abstract   Companies, 

Maintenance   of  records   deductible,   914 
Title  to  Property, 

Cost   of   defending   or    perfecting,   not   de- 
ductible,   913 
Tobacco  Industry, 
Inventories,   461 
Tools, 

Depreciation,    1121 
Farmers,    1413 
"Trading  as  a  Principal," 

Defined,  827 
Trading  Stamps, 

Expenditures  on,  deductible,   916 
Former  procedure,   916 
Transfer  of  Property   (See   "Exchange   of 

Property,"    "Royalties") 
Traveling    Expenses, 

Deductions   for,    851,   853,   856,   864-867 
Of   commuter,   855,   856 
Travel    by    automobile,    868,    869 
Treasury    Certificates    of     Indebtedness 
(See  also  "United  States  Bonds") 
Exemptions,  688 
Treasury   Notes, 
No   cxeu'iptions,   683 
Payment  of  tax   by,  223 
Treasury    Stock,    Accounting    Procedure, 

525-527 
Treasury    of    the    United     States     (See 

"United    States   Treasury") 
"Treating   Money," 

Deductible,   1254 
Trees   (See  "Orchards,"  "Timber") 
Trust   Companies, 

Contributions  to,  for  charitable  purposes, 

not    deductible,    1245 
Use    of   stamps    and    facsimile    signatures, 
3'9 
Trust  Estates, 

Depreciation     not    deductible     from    indi- 
vidual's  tax,    1072 
Trustees, 

Compensation    over    period    of   years    tax- 
able as  of  wliat  year,  416 
In   bankruptcy,   returns   by,    loa,    1341 
In   dissolution   of  corporafioii. 

Compensation   of,  fixed   by  court,   408 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1892 


GENERAL   INDEX 


Trustees — (Continued) 

In      Dissolution      of      Corporation — (Con- 
tinued) 

Definition  of  term,   408 

In   returns   by,    1341 
Income   of  discretionary   trust  taxable   to, 

1351 
Liquidating    corporation,    221 
Payments   to    trustee   for   ultimate   benefit 

of   taxpayer    not    deductible,    921 
Remuneration    provided    by    will,    taxable, 

421 
Trusts     (See    also     "Estates    and    Trusts," 

"Fiduciaries") 
Irrevocable,      defined      under       Kentucky 

state  laws,  1350 
Law  of  1916,  1329 
Revocable,   1340 

Grantor  taxable,    1352-1354 
Several   trusts,   separate   returns,    1340 
Typewriters, 

Depreciation,    1121 

u 

Understatements     (See     also     "Additional 
Tax    Payments") 
Claim    by    government,    refund,    276 
Made  in  good  faith,   140,   141,  217 

Former    procedure,     140 
Made    through   negligence,    140 
Notice    from    collector,    143 
Penalties,    135,    139-144 
Underwriting   Income, 

Insurance    companies,    138S 
Undistributed  Profits    (See   "Profits,   Un- 
distributed") 
Undrilled  Acreage  of  Wells, 

Valuation,    1203 
Unearned    Income, 

Insufficiently   taxed,    859 
Unearned  Increment, 

Earnings  and  profits  do   not   include,    721 
Uniforms    (See    also    "Clothing") 

Depreciation.    11 22 
United   States, 
Defined,    1271 
Gifts  to,  deductible,    1242 
Possessions,   citizens  of,    13J2 
United    States    Bonds, 

Accepted    as    security,     247 
Capitalization    of    interest    received,    aban- 
doned,   684 
Exemptions,   350,   680-691 
Interest, 

Need  not  be  reported,  303 
On  loans   secured    for   purchase   of,  not 
deductible,    929 
•         On  loans  secured  to  purchase  or  carry, 
not    deductible.    924 
Former    procedure,    934 
Non-resident   aliens,    owned   by.    1285 
Ownership   certificates  not   required.   318 
Undistributed    profits,    investment    of,    un- 
taxable,   1364 


United  States  General  Appraisers,  Board 
of   (See   "Board  of  United   States  Gen- 
eral   Appraisers") 
United    States   Treasury, 

Decisions   merely    interpretations,    238 
Interpretations    of    statutes,     188-191 
Regulations     governing     practice     before, 

180-182,    238,    239 
Taxpayer's  appeals  from  decisions  of,  239 
Taxpayer's    notice    of    inventory,    method 
adopted,    480 
University  Stores, 

Not   exempt,   46 
Unmarried  Persons, 

."Vs    head    of   family,    341 
Exemptions,    341 
Returns   by,    75 
L'nworkable    Resources    (See    "Resources, 

Unworkable") 
"Useful   Life," 

Defined,    1055,   1090 

War  property,   1079,    1082 


Valuation  (See  also  "Cost  or  Market 
Value,"  "Market  Value,"  "Revalua- 
tion") 

Assets  of  old  partnership  taken  over,  809 

Book,  excessive,  1053 

Book   value,    810 

Capital  assets. 

Adjustments    of    appraisals    of    various 

dates,  612 
Fixed  by  appraisers  of  state  court  may 
be   rebutted,   616 

Capital    stock,    614-616 

Claims,    602 

Dividends    paid    in, 

Liberty    bonds    and    other    government 

securities,    740 
Property,   735 
Stock,    735 

Gifts,    1243,    1247 

Former  procedure,  1247 

Goodwill,    602-612,    807 

Homesteads    acquired    from    government, 
624 

Infringements,  602 

Inventories, 

General    basis    for,    456-459 

Judgments,   603 

Land  with  crops  growing  thereon,  614 

Market,   to   lessee,    1224- 1226 

Market   value    of    stock    received    by    way 
of    compensation,    431 

Mineral    deposits,    1181 

Mineral   properties,   1217-1221 

Mines,    1174-1196 

As    of  March    t.    1913,    599 
For    depletion   allowance,    1168,    1171 
Revaluation  after  March    i,    1913,    1329 
Tables,    600 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


GENERAL   INDEX 


1893 


\"all"atio.\ —  I  Continued) 
Mining    claims,    6s7 
Obsolescence,    1134 
Patents, 

Application  for,  659 

Capital    value    on    or    after    March     i, 
1913,   648 

Damages  for  infringements,  649 

Intangible     property,    651 

Method    of,    433 

Method  of  valuing,   651,   654-659 

Readjustment     permitted     on     accounts 
prior   to    1917,   653 
Pro    rata    method,    616-619 
Property, 

Acquired    by    inheritance,    625-627 

Determination    of    losses,     982-985 

Leased,   prior  to   March    i,    191 3,    694 
Prorating    replacements,     512 

Replaced    in    kind,    508 

Requisitioned    or    destroyed,    504-508 
Real  estate, 

Cost   of   development    work,    503 

Sold    or    exchanged,    569-582 
Sale    of   a    business,    602-612 
Securities, 

Acquired   by    inheritance,    626 

Revaluation   permitted   dealers,  986 
Shrinkage   of,   in   securities, 

"Wash   sales"   to   establish,   993 
Former    procedure,    993 
Similar    property,    614 
Tables    for    mines,    600 
Used  automobiles  as  instalment  payments, 

502 

Value     or     cost    basis    by     discoverer     of 
mine',    1228 

Wells,    oil   and   gas. 

For  depletion  allowance,  1171 
Method  of  determining,  1197 
Risks    affecting    rate    of    return,     1202- 

I.!03 

Undrilled    acreage,     1203 
Vessels. 

Bonus    for    earlv   delivery    of,    deductible, 

918 
Depreciation,   11 17 

Exemption    of    profits    from    sale    of,    369 
Former    procedure,     369 
Victory   Notes, 

Exempt   interest    on,    350 
Interest, 

Accrued    upon    conversion    of,    685 

On  loans  secured  for  purchase  of,  when 

deductible,  939 
Paid    to    buy    or    carry    deductible    only 
when    in   hands    of   original    subscrib- 
ers,   925 
Paid   to  carry,   923,   934 
Payment  of  tax  by,  226 

\'1NE  YARDS. 

Obsolescence     not     allowed     unless    aban- 
doned,   1 146 


Virginia, 

Partnershii)«, 
Status  of,   8i2 
Virgin    Islands, 

Taxation    of   citizen   of,    1322 
Vocational     Rehabilitation,     Fund     for, 

Gifts   to,    1242 
Vocational    Rehabilitation    Act, 

Payments  received  by  military  and  naval 
forces  of  the  United  States  under,  tax- 
exempt,    411 

Former   procedure,    411 
Vocations    (See   "Professions") 
Voluntary    Assessment  of   Stock,    520 


w 

Wages    fSee    also    "Compensation    for    Per- 
sonal  Servfce,"  "Salaries") 
Alien    (See   "Payment   of   Tax   at    Source 

— non-resident   aliens") 
Deductions    for,    870-876 
Included    in    gross    income,    1280 
Paid    to    children,    861 
Payment    of    tax   at    source,    1306 
Received    as   income    from    professions   or 
vocations,   401 
Wagons, 

Depreciation,    i  i  22 
War.    1 1 

Termination,    61-63,    411 

For   amortization   purposes,    11 50 
War  Facilities  (See  "Amortization  of  War 

Facilities") 
War   Camp   Community   Funds, 

Gifts    to,    deductible,     1243 
War   Chest    Funds, 

(Jifts    to,    deductible,     1243 
War    Finance   Corporation    Bonds, 
Exemptions.    350,    680,    681,    685 
Ownership   certificates   must   be    filed,   318 
War    Industries    Board, 

Industries      regvilated      by,      can      secure 
evidence    for   amortization    claims,    11 57 
War  Profits  Tax   (See  also  "Excess  Profits 
Tax") 
Exemptions,    law    of    1921.    683 
On  United  States  bonds,  680 
War   Property, 

Depreciation,    1079,    1082 
Warrants     Received     for     Public     Work 
Done, 
Face   value    is   taxable   income,   411 
War   Risk   Insurance   Act. 

Pavments  received   by   military  and   naval 
forces    of     the     United     .States     under, 
tax-exempt.    41  i 
War    Service. 

Bonus    for.    not    taxable.    363 
Excmp'.ion   expired,    362 
Wards, 

l-'xcniplions.    345 


[See, also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


1 894 


GENERAL   INDEX 


"Wash    Sales,"    20 

Basis    when    loss    on    is    denied,    591 
Collateral    securities,     1043 
Partnerships, 

Computation    of   net   income,    794 
To    establish    losses,    993-995 

Former    procedure,    993 

Not   deductible,    977 
Welfare    Work, 

Deductions    for,    887 
Wells,   Oil  and  Gas, 
Depletion,    1202,    1210-11 

Allowance,    1216 

Basis    of,    1 167 

"Discovery    value"    of    mines    and    oil 
basis   for,    160 
Development  costs,    how  accounted,    1228 
Discoveries    (See    "Discoveries    of    Mines 

and    Wells") 
Economic  limit,   deiined,    1200 
Inventories     of     raw     products,     cost     or 

market   value,    1213 
Participating   lease,    643 
Present    value   method,    1201 
Prices    for    the   oil    or    gas    unit, 

How   estimated,    1200 
Production    costs,    1201 
Production    decline    curves,    1197 
Royalties   and    depletion    charges,    640-647 
Sale  of,   limitation   of   surtax,    159 
Valuation, 

As   of  March    r,    19 13,   599,   642 

Method    of    determining,     1197 

Risks    affecting    rate    of    return,     1202- 
1203 

Undrilled    acreage,     1203 
Widows, 

Pension  received  from  United  States,  not 

taxable,    421 
Wife    (See    "Husband    and    Wife") 


WiSCOiN'SI.N, 

Interest  on  tax  certificates  issued  for 
land  sold  for  non-payment  of  taxes, 
exempt,   665 

Surtax,   974 

Withholding     (See    "Payment    of    Tax    at 
Source") 

WiTHHOLDixG    AoENT     (See     also    "Owner- 
ship   Certificates") 
Defined,    324,    1309 
Fiduciaries,    1356 

Former    procedure,    1356 
Filing  of  exemption  certificate   with,   1314 
Liability    of,    328 
Monthly    and    annual    returns,    298 

Former    procedure,    298 
Non-resident    aliens. 
Claims,   299 
Returns,    301 
Owners  not   known   to,    1307 
Return   of   tax   withheld,    13 18 

Former    procedure,    1318 
Withholding   returns,    owner   unknown   to 
agent, 
Form   used,    310 
Tax   paid   by,    328 
Withholding    of    Tax     at     Source     (See 

"Payment    of    Tax    at    Source") 
"Within    the  Taxable   Year," 

Defined,    1049 
Witnesses,   State, 

Fees  paid   to   are   taxable,    412 
Wood-Working    Industry, 

Depreciation,    1122 
Workmen's    Compensation, 

Insurance    premiums    deductible,    898 
Workmen's    Compensation    Insurance, 

State    funds    exempt,    51 
Worthless   Debts    (See  "Bad   Debts") 


[See  also  Estate,  Capital  Stock,  and  Excess  Profits  Indexes] 


INDEX— FEDERAL  ESTATE  TAX 

[See  also  General,  Capital  Stock,  and  Excess  Profits  Indexes] 


INDEX— FEDERAL  ESTATE  TAX 


Accounts    Receivable, 
Valuation,    1446-1447 
Administration-, 

Expenses    allowed    resident    estates,     1471 
Annuities, 

Computation,    1455-1456 
Valuation,    1452-1454 
Appointment, 

Property   passing    under    power    of,    1462- 
1464 
Appr.\isals, 

Household    goods    and    personal    effects, 
1449-1450 
Assessments, 
Additional, 

Interest  on,   1520,   1521 
Determined    within    one    year,     1521 
Attorney's   Fees  Allowed    from   Resident 
Estate,    1472 

B 

Bank  Deposits, 

As   cash,    in   valuation  pf   property,    1437 
Bonds, 

Valuation    of   property,    1439 
Broker, 

Indebtedness    to,    deductible    from    gross 
estate,    1440 
Business, 

Valuation    of    interest    in,    1444-1445 


Close  Corporation, 

Valuation    of    securities,    1440-14. 

C'OLLECTION    of    TaX,     I  532 

Collectors, 

Returns   made   by,    1503 
Community    Property, 

Valuation,    1450-1452 
Courtesy    Valuation,    1454,    1456 
Crops,  Valuation,    1447 


D 

Deductions, 

Gifts,    non-resident    estate,    1487 
Gross    estate, 

Indebtedness   to    broker,    1440 
If   decedent   died   prior   to   Feb.   25,    1919, 

1469 
Losses    from   casualty    or    theft,    1474 
Miscellaneous      administration      expenses 

allowed    resident    estate,    1473 
Xon-resident   estates,    1486-1488 
Property  acquired  in  exchange,    1479 
Property    previously    taxed,    1476-1479 
Resident    estates,    1468-1476 
Specific  exemption,   resident  estates,    14S4 
Support  of  dependents,    1475  / 
Taxes    upon    resident   estates,    1473 
Unpaid     mortgages     on     resident     estate, 
1474 

Dividends, 

When  not  included  in  gross  estate,   1434 

Dower,    Valuation,   1454,    1456 


Cash, 

Accounting   for   in   valuation   of  property, 
1437 
Cemetery  Lot, 

Included    in    gross    estate,    1434 
Cheques, 

In    payment    of   tax,    1506 
China, 

Proceedings   for  United   States  Court  for 
China,    1516 
Citizens, 

Coming  under  extra-territorial  court,  1516 
Claims  for  Abatement,  1511 

Filed  after   30  days,    1437 

Interest    accrued    on,    15 12 

Limitation     period,     15 12 
Claims   for   Rekund,    1512 

Filed    after    30    days.    1437 

Military   exemption,   procedure,    1431-1432 

Transfer   of   estate   exempt,    1431 


Estate  (See  also  "Gross  Estate,"  "Net 
Estate,"  "Non-Resident  Estate,"  "Resi- 
dent Estate") 

Deductions    allowed    residents,    i468-i476 

Description   of   taxable,    1429 

Status    of    certain    property    of    non-resi- 
dent,   1485 
Examination    qf    Kfturn,    149R,    1514 
Executor. 

Appraisal    of    household    goods    and    per- 
sonal  effects   by,    1448-1440 

Commission   allowed    for    resident   estates 
1471-1472 

Commission    not    entitled    to,    1472 

Duly  to  keep  record.s,   1514 

Duly  to   render  statements,    1514 

Liability    of,    IJM.    'S'8 

Payment    nf    fax    by,     1518 


[See  also  General,  Capital  Stock,  and  Excess  Profits  Indexes] 


1898 


INDEX— FEDERAL  ESTATE  TAX 


Executor — {Continued) 

Sixty   day    notice,    1489 

When    not    yet    appointed,    1490 
Exemptions, 

Military    exemption,    1430,    1492 


Failure    to    Exhibit    Records    on     Prop- 
erty,   1511 
Failure   to   File    Notice,    1510 
Failure  to   File   Return,    1510 
Federal  Estate  Tax, 

How   computed,    1424,    1426 

Law,    definitions    in,     1425 

Law,    summary,    1424-1425 

Rates,    1425-1427 
Fraudulent    Returns,    1510 


Gift,  , 

Transfer   of  property  by  way   of,  taxable, 

1457  _ 

Goodwill, 

How    computed,    Treasury    decision,    1446 
Valuation,    1445 
Gross    Estate, 

Amount    of   filed    within    60   days,    1489 
Cemetery    lot    part    of,    1434 
Deductions,    1468-1488 

Indebtedness   to    broker,    1440 
Dividends,    when   not   included,    i434 
Interest   on   notes   included    in,    1443 
Life    insurance,    when    included    in,    1468 
Market   value   of,    1434 
Real   property   included  in,   1433 
Transfer    of    property,    when    included    in 

return    of,    1423 
Valuation,    1432,    1437-1468 

H 

Household  Effects,   Valuation,    1447 


Insurance, 

Life, 

Partially   exempt  from  tax,    1 465-1 46S 

Payment    of   non-resident   estate,    1495 
Insurance    Companies, 

Sixty   day    notice,    1491.    M94 
Interest, 

Accrual     of,     as     affected     by     abatement 
claim,    1 512 

In   additional  tax   payments,   1520,    1521 

Notes,  how   computed,   1443 

Urtder    Act    of    1916,    1515 

Unpaid    taxes,    1520 


Jewels, 

Valuation,    1447 
Joint   Property, 

Taxable,    1460-1462 

Former   procedure,    1461 


Liability, 

Of   executors,    1514,    1518 

Of    transferee   and    insurance    beneficiary, 
1507 
Liberty    Bonds, 

In    payment    of    tax,     1505 
Lien, 

Amount    limited,    1507 

For   unpaid   taxes,    1508 

Release    of,    1509 


M 

Market   Value, 

Gross   estate,    1434 

Property,    real,    1437 

Stocks  and  bonds,   1439 
Military  and  Naval  Forces, 

Claims   for   refund,    1431-1432 

Defined,    1430 

Exemptions,     1430,     1492 
Missionaries, 

As    residents,    1485 


N 


Net   Estate, 

Determining  non-residents',    1484,    1488 

Military  and  naval   forces,   exempt,   1430 

Rates  of  tax,    1425-1427 

Tax  computed   on   value   of,   1424 
Non-Combatants,   Taxable,    1430 
Non-Residents, 

Deductions  allowed   estates   of,    i486 

Determining  net  estate  of,   1484,   1488 

Payment    of    tax,    1489 

Status    of   certain    property    of,    1485 
Non-Resident    Estate, 

Claims    and    expenses    allowed,    1487 

Insurance    payments,    1495 

Public,     cliaritable     or     similar     gifts     al- 
lowed,   1487 

Return   form,    1501 

Sixty     day    notices,     1493-1496 

Transfer    agents'    sixty    day    notice,    1493 

Transfer  of  stock,   1494 
Notes, 

Valuation,    1443- 1444 
Notice   to   be   Filed, 

By  others  than  executor  or  administrator, 
1490 

Executors    of    exempt    estates,     1492 

Executor's    60    day,    1489 

Failure    to,    1510 

Insurance     company's     sixty     day     notice, 
1492.    1494 

Non-resident  estate,    1493 

Transfer    agent,     i493 

When    no    executor    appointed,    1491 

When     property     not     within"    executor's 
control,    1491 


[See  also  General,  Capital  Stock,  and  Excess  Profits  Indexes] 


INDEX— FEDERAL  ESTATE  TAX 


1899 


Patents, 

Valuation,    1445 
Payment  of  Tax, 

By    executor,    's 1 8 

Extension   of   time   for,    T-09 

Interest     on    additional     payinents,     1520, 

l.i2I 

Liability     of     transferee     and     insurance 

beneficiary,    1507 
Liberty   bonds  as,    1505 
Xon-residents,    1489 

Payable    in    full    within    one    year,    1504 
Receipts    in    duplicate,    1521 
Reimbursements,   right   to,    1506,    1523 
Uncertified   checks,    1506 
Unpaid    tax    a    lien    on    estate,    1508 
Penalties,    1510 

Compromise    or    remittance,    1512 
Interest    on    unpaid    taxes,    1520 
Personal  Effects, 

Valuation,    1447-1448 
Property, 

Acquired    in    exchange,    deductible,    1479 
Held   jointly    (See    "Joint    Property") 
Passing  under  power  of  appointment  (See 

"Appointment") 
Previously    taxed,    deductible,    1476-1479 
Real, 

Included    in   gross   estate,    1433 

Valuation,    1437 
Transfer  of  (See  "Transfer  of  Property") 
Valuation    of    (See    "Valuation") 


Real    Estate    (See    "Property,    Real") 
Receipts, 

For  payment   of  tax,    issued   in   duplicate, 
1521 
Records, 

Kept   by   executor,    1514 

KEFfNDS,      I  51  2 

Reimbursement, 

For    tax    payment,     1506,     1523 
Repeal  of  Act,   151 5 
Resident, 

Defined,    1429 
Resident  Estates, 

Amount  of  gross  estate  filed  within  60 
days,    1489 

Deductions  allowed,  1469-1488  (For  com- 
plete list  of  subjects,  see  "Dciiuc- 
tions") 

Executor's    60    day    notice,    1489 

Insurance   companies'   notice,    1492 

Not   subject  to    estate   tax,    1424 

Sixty-day    notices,     1 489-1492 
Residents, 

Missionaries  as,    1485 
Returns,   1496-1503 

Adjustment,    1520 

Date  of   filing,    i497 

Examination    of,    1498,    i5'4 


Extension    of    time    for    filing,    1500 
Failure    to   file,    1510 
False  or   fraudulent,    1510 
Forms,    1500 

Non-resident  estate,    1501 
Investigations    of,    1498,    1514 
Made    by    collector,    1503 
Right    of    disclosure,    1502 
When   no    return  has  been   made,    1497 
Who   shall   make,    1499 


Securities, 

Valuation,    1440 
Statements, 

Executor's   duty    to    render,    15 14 
Stock, 

Transfer   of,   non-resident   decedent,    1494 

Valuation,    1439 


Tables, 

Computation    of   annuities,    i455-i45( 

Federal  estate   tax  rates,   1425-1427 
Transfer   Agents, 

Sixty-day    notice,    1493 
Transfer   of   Property, 

By    gift,    I4S7 

In    lifetime    of    decedent,    1456-1460 

Taxable,    1459 

Two   years   prior   to   death,    to   avoid   taXi 
.  '423 

Valuation,    1460  • 

Trustees,  ' 

As  executor,   not   entitled    to   commission, 
1473 

u 

United  States  'Court  for  China, 
Proceedings,    1516 


Valuation, 

-Accounts    receivable,     1446-1447 

Annuities,    1452-1454 

Bonds,    1439 

Community    property,    1450-1452 

Crops,    1447-1448 

Dower   and   courtesy,    1454,    1456 

Coodwill,    1445 

Cross    estate,    1433 

Household   effects,    1447 

Interest    in    business,     1444-1445 

Jewels,    1447 

Notes.    1443-1444 

Returns,    1424 

Securities,    1440 

In    close    corporation.    1440-1443 

Stocks,    1439 

Transfer   of   property,    1460 
X'ali'e.   Dffined,    143s 


[See  also  General,  Capital  Stock,  and  Excess  Profits  Indexes] 


INDEX— FEDERAL  CAPITAL  STOCK  TAX 

[See  also  General,  Estate,  and  Excess  Profits  Indexes] 


INDEX- FEDERAL  CAPITAL  STOCK  TAX 


Additional    Tax   Payments, 

Limitations   on,    1563 
Affiliated    Corporations, 

Returns,    1549 
Assessments,   1553 

Final,   1562 
Associations, 

Xot    exempt,    1531 


Capital, 

Employed    in    the    U.    S.    by    foreign    cor- 
poration,   1555 
Claims   for   Abatement,    1559 
Claims    for   Refund,    1559 

Limitation    of    interest    on,    1564 

Limitations   on,    1563 
Computation    of   Tax, 

Domestic   corporations,   rate   and,    1537 
Former    procedure,     1537 
Consolidated  Returns. 

Not   permitted,    1549 
Corporations, 

"Doing    business"    as    basis    for,    1533 

Election    to    be    taxed    as,     1561 
Former    procedure,     1561 

Exemptions,    1533,    1536 


D 


Deductions,    1348 

Domestic    corporations,    $5,000    permitted, 
J  524 
Former    procedure,    1324 
Foreign   corporations,    no   deductions   per- 
mitted,    1324 
"Doing    Business," 

Basis    for    taxing     domestic     corporations 

under,  1533 
Defined,  1355 
Illustrations    of    not,     1534.     '535 

Former    procedure,    1535 
Period    of,   determines   tax    liability,    1536 
Former    procedure,     1336 
Domestic    Corporations, 

Deduction   of   $3,000   permitted,    1524 

Defined,    1329 

Effective  date,   1528 

Fair  value,  methods  of  ascertaining.   1338- 

IS47 

Former  procelure,    1344 
Rate   and    computatinn    of   tax.    133; 


■  Former  procedure,   1337 
Scope  of  taxj   1328 

Former    procedure,    1524 
"Doing  business"   illustrated,    1334 
Effective    date,    1528 
Scope    of   tax,    152S 


E 


Examination   of   Books,   Papers  and   Per- 
sons, 

Unnecessary,    1564 
Exemptions, 

Associations    not    exempt,    1331 

Corporations,    1336 

Corporations    exempt    under    income    tax 
law  also  exempt  under,   1323 

Corporations,    listed,     1535 

Corporations    not    "doing    business"    cer- 
tain,  1526 

Individuals,    1523 

Insurance    companies,    1524,    1333 
Former    procedure,     1324 

Joint    stock    companies    not    exempt,    1531 

I^imited    partnerships,    1332 

Limited    partnerships    not    exempt,     1331, 
■53a 

Massachusetts    trusts,    1331 

Partnership    banks,    1532 

Partnerships,    1523 

Personal    service    corporations,     1329 
Former    procedure,     1329 

Returns   of  corporations  claiming  exemp- 
tion,   1337 
Extension   of  Time   for    Filing  Returns, 

None    granted,    1333 


Failure   to   Make   Return,   1534 
"Fair   Value," 

Methods   of   ascertaining,    1338,    1347 
Former    procedure,    1344 
Foreign    Corporations,    isss-issq 

Deductions    not    permitted    to,     1324 

Returns,     1358 
Fr/M'dim.ent    Returns,    1334 


Income    Capitalized, 
Issuance    of    new    stock 

i.';47 

Individuals. 

Exemptions,     132; 


mil     .illc-rl. 


[See  also  General,  Estate,  and  Excess  Profits  Indexes] 

1903 


1904 


INDEX— FEDERAL  CAPITAL  STOCK  TAX 


Inspection   of   Returns,    1559 
Insurance    Companies, 

Exempt,    1524,    1533 

Former    procedure,    1524 
Interest, 

Limit   on   refunds  and  judgments,   1564 


Former    procedure,    1553 

Medium    of,    1560 
Penalties,   1554 
Personal  Service  Corporations, 

Exemptions,    1329 

No    intention   to    tax,    1562 


Joint  .  Stock    Companies, 
Not  exempt  from,    1531 

Judgments, 

Limitation   of  interest   on,    1564 


M 


Returns,   1536 

Corporations   claiming   exemption,    1337 

Former    procedure,    1326 
Tentative,    1349 
Time   for   filing,    1348 
Time    of   making,    1348 


Massachusetts   Trusts, 

Exempt,    1 53 1 
Munition   Manufacturers, 

Credit    for    tax,    1561 

Former    procedure,     1564 


Partnership    Banks, 
Exemptions,     1325 
Limited,    exempt,    1332 
Limited,    not    exempt,    1331. 
When    not    exempt,    1332 

Payment  of   Tax,    1353 
Dishonored   cheques,    1360 


Stock, 

Calculation   fair   value,    1347 
Income    capitalized    not    affected    by   issu- 
ance   of   new,    1347 
Preferred, 

Calculation  of  fair  value,   1347 
Suits   at   Law, 

Limitation    on,    1563 


Treasury    Decisions    not   Necessarily   Re- 
troactive,   1363 


[See  also  General,  Estate,  and  Excess  Profits  Indexes] 


INDEX— EXCESS  PROFITS  TAX 

[See  also  General,  Estate,  and  Capital  Stock  Indexes] 


INDEX— EXCESS  PROFITS  TAX 


Accounting  Procedtre   (See  "Computaticn 

of  Tax") 
"Actual   Value," 

Defined,    1600 
Adjustments, 

Capital,  surplus,  reserves  and  liabilities, 
1616-1620 

Depreciation,   1600 
Admissible   Assets, 

Percentage  of  average,  to  total  admis- 
sible and  inadmissible,  determines  re- 
duction   of    invested    capital,    1615 

Reserves   for   bad   debts,    16 14 

Stocks  of  domestic  so-called  "foreign 
trade"    corporations,    1613 

Stock    of    foreign     corporation    of    which 
dividends    are    not     deductible,     1612 
Affiliated   Corporations, 

Consolidated  returns,  IS74,  1626-1637 
(For  full  entries  see  "Consolidated 
returns"') 

Distribution   of  tax   among,    1633 

Pre-war    period. 

Computation,    former    procedure,    1637 
Computaticn    of    invested    capital,    1633- 
1637 
Amended  Returns   (See  "Returns,  Amend- 
ed") 
Appeal  to   Courts. 

Right    of,    from    Trea3ui>    <lecisions,    1640 
Appraisals, 

Not    invested    capital,    1589 

Retrospective,  basis  for  allowance  of 
paid-in    surplus,    1595 

Should   be   verified,    1594 

To  establish  claim  for  paid-in  surplus, 
1591-1593 

Used    to    restore    to    accounts    capital    ex- 
penditures  previously   absorbed,    1589 
Appreciation, 

Accrued  prior  to  March  i,  1913,  included 
in   invested   capital   when   realized,    1622 

Excluded    from    computation    of    invested 
capital,    1587,    1604 
Assets    (See    "Admissible    Assets,"    "Inad- 
missible Assets") 

Adjustment   of  values,    1587-1607 

Depreciation    of,    i6or 

Inadmissible,  1612-1616  (See  "Inadmis- 
sible  Assets") 

Increase   in   book   value,    iS99 

Reorganizatif  ns,    valuation,     1656-1657 

Sale  of,    1647 

Tangible    (See   "Tangible   Property") 

Transfer   not    replacement.    1633 

Transfer  of,    1594 


B 

Bonds, 

Discount,    1608 
Borrowed  Capital   (See  "Invested   Capital, 
Borrowed") 


Capital    (See   "Invested   Capital") 
Capital  Stock, 

Instalment    payments,     1616 
Claims  for  Credit, 

Overpayments,    1642 
Commissioner  of  Internal  Revenue, 

Empowered    to    consolidate    returns,    1629- 
163 1 
Comparatives, 

Selection    of,    for    relief    sections,    1638 
Compensation   for   Personal   Services, 

Exemption,   1669 
Computation  of  Tax,  1575-1582 

Fiscal     years    ending     1921,     1922,     1579- 

1582 
Foreign   corporations,    1646 
Former   procedure,    1581 
Government    contracts,    1576 
Invested    capital,    1656 

Pre-war   period,    1635-1637 
Former  procedure,    1637 
Limitation,    illustration,     1577 
Consolidated  Returns,   1574,   1626-1637 
Commissioner    empowered    to    make,    1629 
Corporations     classed     under     §  242     ex- 
cluded,  1630 
Distribution  of  tax,    1633 
Foreign    corporations.    Commissioner    em- 
powered   to    make,    1629 
-     Government    contract    corporations,     1631 
Law   of    1 92 1,    1626 
Not  permitted   where  parent  ownership   is 

less  than  95  per  cent  of  stock.    1631 
Optional    after     January     i,     1922,     1627- 

1630 
"Same    interest"    interpreted,    1632 
Specific  credit  allowed,   1628,   1633 
.Stock    control    of    95    per    cent    essential 

for,    1 63 1 
Transfer   of  assets   not    replacement,    1633 
Contracts, 

Constituting  paid-in   surplus,    1599 
Unperformed,    161 1 
Corporations   (See  also  "Affiliated  Corpora- 
tions,"   "Domestic    Corporations,"    For- 
eign    Corporalii  IIS,"    "I'ersonal    Service 
('orporaliniis"; 


[See  also  General,  Estate,  and  Capital  Stock  Indexes] 
1907 


1908 


INDEX— EXCESS   PROFITS    TAX 


Corporations — {Continued) 

Borrowtd     capital     is     "numiiial"     capital, 
1664-1668 

Classed     as      having     "nominal     capital," 
1662 

Consolidated    returns,    1626-1637 

Consolidated    with    partnerships, 
Allocation    of   tax,    1634 

Demand     notes    to    stockholders,     not     a 
liability,    1584 

Exempt,    1569 

Exemption,   $3,000,   restriction   on,    1582 

Gold    mining,    exempt,    1568 

Government    contracts,    returns,    1572 

Income    derived    from    possession    of    Uni- 
ted States, 
Excess    profits   tax,    1571 

Invested     capital     (See     "Invested     Capi- 
tal") 

Liquidating     (See    "Liquidating    Corpora- 
tions") 

Relief,    1644-1646 

Returns,    iS7i-iS75 

Fractional     part     of     year,     illustration, 
1578 

Salaries   to   officers. 

Distinguished       from      distribution      of 
profits,    1647 

Salaries    waived    by    officers,    paid-in    sur- 
plus,  1597 

Subject    to    excess    profits   tax,    1567 
Credits, 

Affiliated     corporation,     only     one     under 
consolidated  returns,   1628,   1633 

Claims    for,    against    overpayment,    1642 

Corporations,   domestic. 

Restriction    on    $3,000    exemption,    1582 

Government    contracts,    1576 


Debts, 

Bad,    reserves    for,    1614-1616 
Deductions, 

Computation,    former    jirocedure,    1583 

Depletion,   1617 
Depletion, 

Deductions,    161 7 

Mines,    161 7 

Reserves,   1619 
Depreciation, 

Adjustment    of    returns,    1646 

Allowance  for,   1601 

Cared   for  by   charges   to   expense,    1602 

Compared   with   actual    assets,    1601 

Failure  to  write   off,   not   "affirmative   evi- 
dence,"   1602 

Reducing    surplus    by    claims    for,     1600 

Value   of,   in   adjustment   of   invested   cap- 
ital   under    reorganizations,     1648 
Discount, 

Bonds,    1608 
Dividends. 

Changes  in   taxability,    1646 


Dividends — (Continued) 
Date   payable,    1623 
Left   in   business,    1585 
New    provisions    affecting    admissibility   of 

assets,    1612 
Paid    in    interest-bearing    notes,     1624 
"Payable  as   convenient,"    1623 
Domestic    Corporations, 

Consolidated    returns,    1626-1637 
Instalment   payments. 

Pending   consideration   of    claim    for   re- 
lief,   1641 
Restrictions   on   exemption,    1582 


E 

Excess    Profits   Tax, 

Constitutionality    of,    1583 
Exemptions, 

Corporations,    restrictions    on     S3. 000    ex- 
emption,   1582 

Gold   mining  income,    1568 


Federal  Taxes  (See  "Taxes") 
Fiscal  Year, 

Ending    1921,    1922,    1579-1582 

1920-1921,    1573 

1921-1922,    IS73 
Fiscal    Year    Corporations, 

Changes    in    admissibles    due    to   computa- 
tion under  two  laws,    1615 
Foreign    Corporations, 

Computation    of   tax,    1646 

Consolidated    returns   not   allowed,    1575 

Instalment    payments,    pending    considera- 
tion of  claim   for   relief,    1641 

Returns,      Commissioner      empowered      to 
consolidate,    1629 


Gifts, 

Tangible     property    conveyed    by,     1590 
Gold    Mining, 

Corporations   engaged    in,    exempt,    1568 
Goodwill, 

As  invested   capital,   pre-war   period,    1626 

Not    ground    for    relief,    1645 

Not  invested  capital,   1611 
Government   Contracts, 

Consolidated    returns    allowed,    1631 

Credits,  computed   under   191S   law,    1576 

Income,    1658 

Returns,   1572 


H 

Hawaii, 

Bonds,    1613 
Husband  and  Wife, 

Amended    returns    for    191 7,    former    pro- 
cedure,   1586 


[See  also  General,  Estate,  and  Capital  Stock  Indexes] 


INDEX— EXCESS    PROFITS   TAX 


1909 


Improvements,  Leaseholds,   1607 
Inadmissible    Assets,    1612-1616 

Bonds   of   Philippine   Islands,   Porto   Rico, 

Hawaii,    1613 
Dealers    in    securities,    1615 
Defined,     161 2 
School   warrants,    161 3 
Securities  in  nature  of  government  bonds, 

but   not   direct  obligations,    1613 
Two   types  now   admissible,    1612 
Income, 

From    isolated    transactions,    1569 

Former   procedure,    1569 
Government  contracts,    1658 
Income  Tax, 

Computation,     fiscal     years     ending     192 1, 

1922,    1579-1582 
Overpaid,     included     in     invested     capital, 

1619 
Individuals. 

Incorporating     before     March     23,     1922. 
1657-1658 

Former   procedure,    1657 
Instalment  Payments, 

Capital   stock,    161 6 
Insurance, 

Policies,    cash    surrender    value    of,    1607 
Insurance    Companies, 
Invested    capital,    i6o6 
Reserves,    1620 
Intangible  Property, 

Acquired    for   tangible,    1606 
Charged    off  before    1917,    1609 
Contract,   unperformed,    i6ii 
Goodwill,     1 611 
Limitation   on,    1626 
Interest, 

Liberty    bonds,     amount    taxable,     1646 
"Invested," 

Definition   of,    1599 
Invested     Capital      (See     ajso      "Nominal 

Capital,"    "Paid-in    Surplus") 
Accrued   taxes   not    deductible,    1624 
Adjustment    of    asset   values,    1587-1607 
Appraisals   not,    1589 
Appreciated    values   not,    1589 
Appreciated    values    used    in    determining, 

1595 
Appreciation      included      in,      necessitates 

amended   returns,    1604 
Appreciation   of  asset  values  has  no  place 

in,    1587 

Exception    to    rule,    1588 
Basis    for,    entirely    distinct    from    depre- 
ciation.   1604 
Borrowed,     is     "nominal     capital,"      1664- 

1668 
Cash    surrender    value    of    insurance    poli- 
cies,   1608 
Changes   in,    1620-1625 
Computation  of,    1583 

Cash  or  accrual  basis,  1584 

Leap    year,     1623 
Consolidated    returns,    1626-1637 
Contract,   unperformed,    161 1 


Invested  Capital — (Contiintcd) 

Corporation     in     process     of     liquidation, 
1625 

Cost    of    assets    on    January    i,    1917,    in- 
cluded in,   1587 

Decrease    by    payment    of    Federal    taxes, 
16x9 

Definition,    1599,    i6oi 

Definition   of    "invested,"    1588 

Discount   on  bonds,    1608 

Dividends, 

Paid    in    interest-bearing    notes,    1624 
"Payable    as    convenient,"    1623 

Expenditures    for    intangibles   charged    off 
before    191 7,     1609 

Goodwill   not,    1611 

Improvements    in   leasehold,    1607 

Inaccurately     determined     by     appraisers, 
1593 

Includes    cost    (less    depreciation)     of    all 
assets,    1603 

Increased  by  surplus   from  sale   of   capital 
assets,   1620 

Insurance    companies,    1606 

Intangible    property,    limitations    on,    1626 

Law  of   1921,   "relief  sections,"    1637-1646 

Overpaid   tax    included    in,    1619 

Partnerships,    1586 

Patents,    161 1 

Percentage    of    admissible    assets    applied 
in    determining,    1615 

Pre-war   period,    1625 
Computation,     1635-1637 
Goodwill,    1626 
Patents,    1626 

Reorganizations,   1647-1656   (See  also  "Re- 
organizations") 
Transfer   of   assets,    1594 

Reserves  for  bad  debts,   161 6 

Security    dealers    cannot    include    any    in- 
admissible assets  in,    1615 

Stock  paid   for  in  instalments,    1616 

Tangible  property  basic  evidence  of.    1 596 


Law  of  1921, 

Consolidated    returns,    1626 
Invested   capital, 

"Relief    sections,"     1637- 1646 
Lawyer, 

Income    as    executor,    when    exempt,    1570 
Leaseholds, 

Improvements   in.    1607 
Liabilities, 

Demand     notes     to     stockholders     dn     nut 
constitute,     1584 
Liberty    Bonus. 
Interest, 

Amount    taxable,    1646 
Limitation    ok   Tax,    15.761 579 

Computed     for     fraclion.il     part     of     year, 
'577 
Illustration,    1577 
Corporation    with    small    net    income,    1576 
Government   contracts,    1576 


[See  also  General,  Estate,  and  Capital  Stock  Indexes] 


lyio 


INDEX— EXCESS    PROFITS    TAX 


Liquidating  Corporations, 

Computation  of   invested  capital,    16^5 
Losses, 

Affiliated    companies,    under    consolidated 
returns,    1628 


M 

Merger, 

Property    acquired    by,     valued    at    cost, 
1598 
Mines, 

Depletion,    1617 


N 

Net  Income, 

Adjustment,     for     taxable     and     prewar 

years,    1646 
Consolidated    returns,    1626-1637 
Fiscal    years     ending     1921,     1922,     1579- 

1582 
Pre-war   period, 

Compution,    16351637 
Former   procedure,    1637 
Nominal    Capital    Tax,    1917    Law, 

Former    procedure,    1659-1670 
Notes, 

Interest-bearing,    as    dividends,    1624 


o 

Overpayments, 

Claims   for   credit,    1642 


Paid-In  Surplus, 

Appreciation   in   value   not,    1595 

Cancellation    by     stockholders    of     claims, 
1597 

Claim  for. 

Burden  of  proof  on  taxpayer,   1596 

Contracts   constituting,    1 599 

Evidence    needed    to    support    claim,    1590, 
1592 

Excess    value    of    bargain    not,    1598 

Presupposes    gift,    1598 

Retrospective    appraisals    accepted    as    evi- 
dence  of,    1597 

Retrospective    appraisals    basis    for    allow- 
ance of,    1595 

Salaries    waived    by    officers    of    corpora- 
tion,   1597 
Partnerships, 

Consolidated    returns,    1626-1637 

Consolidated    with    corporations. 
Allocation  of  tax,   1634 

Incorporating     before     March     23,     1922, 
1657-1658 
Former   procedure,    1657 

Invested   capital,    1586 


Patents, 

As    invested    capital. 
Pre-war  period,    1626 

Latent   value,    161 1 
Payment  of   Tax, 

Credit    claims    for    overpayment,    1642 

Pending    consideration    of    claim    for    re- 
lief,   1641 
Penalties, 

Failure   to   file   amended    returns,    1605 
Personal    Service    Corporations, 

Nominal  capital,    1917  law, 
Former    procedure,    1659-1670 

Status  unchanged,  1569 
Philippine   Islands, 

Bonds,    1613 
Policies, 

Insurance, 

Cash  surrender  value  of,   1607 
Porto    Rico. 

Bonds,    1613 
Pre-War    Period, 

Net  income,   adjustment   of,    1647 
Profits, 

Abnormal, 

Not    sufficient    claim    for,     1644 
Property, 

Acquired  by  merger,  valued  at  cost,  isoS 


Relief, 

Abnormal    conditions. 
Pre-war    period,    1639 

Appeal    to    courts    from    Treasury    deci- 
sion,   1640 

Claims    for    credit    against    overpayments, 
1642 

Denied,    when    expenditures    for    intangi- 
bles' can  be  restored,   1644 

Jlethod     of     payment,     when     relief     ex- 
pected,    1 64 1 

Profits,   abnormal. 

Not   sufficient   claim    for,    1644 

Selection  of  representative  concerns,   1638 

Treasury   decisions, 
Right  to  appeal,    1640 
Reorganizations,    1647-1658 

Change   of   corporate   entity. 
Intentions   of  the   law,    1648 

March   3,    1917, 
After,    1649-1655 
Prior  to,   1468-1469 
Representative  Corporations, 

Selection   of,    for   relief   sections,    1638 
Reserves, 

Bad    debts,    161 6 

Depletion,    1619 

For  bad  debts. 

Deductions    permitted.    1615 

Insurance    companies,     1620 
Returns,   1571-1575 

Amended, 

Appreciation    included    in    invested   cap- 
ital,   1604 
Appreciated    or    inflated    values,    1595 


[See  also  General,  Estate,  and  Capital  Stock  Indexes] 


INDEX— EXCESS  PROFITS  TAX 


191 1 


Return  s —  (  Contin  tied) 

Amended — (.Continued) 
Failure  to  file,   1605 
Fractional  part  of  year,   1578 
Increase   in   book  value   of   assets,    1599 
Insurance   <;ompanies,    1606 
When   not   required,    1605 

Consolidated,     1574     (See    also    "Consoli- 
dated  Returns") 

Fiscal   year,    1920-1921,    1573 

Fiscal  year   1921-1922,    1573 
Revaluation, 

Surplus    from,    1616 


Salaries, 

Distinguished  from  distribution  of  profits, 
1647 

Waived   by   officers,   paid-in   surplus,    1597 
Securities, 

Dealers  in  admissible  assets,    1615 
Stockholders, 

Cancellation   of   claims,    1597 
Supreme    Court    Decisions, 

Excess  profits  tax. 

Constitutionality    of,    1583 
Surplus  (See  also  "Paid-in  Surplus") 

Depreciation,    1600 

From   revaluation,    161 6 

Invested    capital    increased    from    sale    of 
assets,    1620 


Tangible  Property, 

Conveyed    by    gift,    1590 


Tangible  Property — (Ccmtinued) 

Intangible   property   acquired    for,    1606 
Paid    in   for   stock,    1590 
Tax    Rates,    1575-1582    (See    also    "Compu- 
tation of  tax") 
Excess  profits  tax,    1569 
Limitations,   1576-1579 

Problem     calculated     for     fraction     of 
year,  1578 
Taxable  Year, 

Affiliated    corporations. 

Consolidated    returns   optional,    1628 
Determination    of    net    income,    1646 
Taxes, 

Decrease   in    invested    capital    by    payment 
of  federal  taxes,    161 9 
"Trade   or   Business," 

Defined,    1668 
Treasury, 

Decisions,    right    of    appeal,    1640 


V 

Valuation,  ' 

"Actual   value"    defined,    1600 
Assets, 

Purposes   of    inadmissible,    computation, 
1614 
Invested     capital     under     reorganizations, 

1648-1649 
Property   acquired    by    merger,    1598 
Values, 

Appreciated,   not   invested   capital,    1589 


[See  also   General,  Estate,  and  Capital  Stock  Indexes] 


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